Buttonwood's notebook

It doesn't work every time

Wed, 08 May 2013 14:40:30 +0000

JUST caught up (via Zerohedge) with a Der Spiegel interview with Carmen Reinhart. It all fits in with your blogger's world view especially the point where she says that

You have to deal with the debt overhang one way or the other because the high debt levels are an impediment to growth, they paralyze the financial system and the credit process.

Inflate, stagnate or default has been the mantra here, since the debt survey published in 2010. Ms Reinhart mentions outright default but also - a term she helped coin - the prospect of financial repression, holding real interest rates negative as a way of transferring money from creditors to borrowers.

This is a problem (another recurring blog theme) for pension funds. As Ms Reinhart puts it

No doubt, pensions are screwed. Governments have a lot of leverage on what kinds of assets pension funds hold. In France, for example, public pension funds have shifted money from shares (on the stock market) to government bonds. Not because their returns are great, but because it is more expedient for the government. Pension funds, domestic banks and insurance companies are the most captive audiences, because governments can just change the rules of the game

Now, of course, the effect on corporate pension funds (and their employees) of financial repression is to lower investment returns, and thus increase the required contributions. Companies have responded by closing final salary schemes and by instituting defined contribution schemes, which tend to be less generous, not least because less is put in the pot. The cost of financial repression, in the long run, will be borne in part by current workers when they retire.

When it comes to funded public pension schemes (as opposed to pay-as-you-go), there is not much point in financially repressing them. What the government gains in lower bond yields, it will have to pony up in contributions and/or benefits (whatever the accounts say). Of course, governments could ask public sector workers to contribute more but there is a limit to their ability to pay, let alone their willingness to do so. (The UK's public sector pension reforms achieved very little in cost savings, in return for a lot of protest.) So this is one where current taxpayers gain, and future taxpayers lose; given the short-term nature of the electoral cycle, this is one trade politicians are happy to make.

By the way, the whole interview goes past without a mention of the 90% debt-to-GDP threshold. The article came before the paper questioning the Reinhart-Rogoff maths was published but it shows it was not the idee fixe of the duo.

A game-changer but what's the game?

Wed, 08 May 2013 14:23:49 +0000

TWO separate people said to me yesterday that Japan's decision to use monetary policy to push up inflation was a game-changer but for different reasons. The likelihood is that the policy will indeed have a big impact, but it might be too early to tell what the effect will be.

The first to use the phrase was Robert Gardner of Redington, the pensions consultancy which tends to work a lot with clients on de-risking their portfolios. He thought that Japanese policy was convincing clients that low rates were here to stay (since the market seems to believe that money will flow out of Japan and into government bonds elsewhere)*. And since, outside the US public pension sector, low rates mean higher liabilities, clients were realizing that their deficits will not suddenly disappear on the back of rising rates.

On the theme of US pension funds, Mr Gardner pointed me to a blog by Alex White on his team about the key difference between arithmetic and geometric returns. Say your portfolio doubles one year and halves the next; clearly you are back where you started and your two year return (geometrically) is zero. In arithmetic terms, however, your average return (+100% and -50%) is 25%.

As Mr White points out, this makes a lot of difference to compound returns over the long run. since 1870, the excess return from equities over Treasury bills averages 5.4% per year on an arithmetic basis; geometrically, the return is just 3.9%. The gap may sound small but investors would have earned 7.5 times as much if they had achieved the arithmetic, rather than geometric, number. Go back to the US pension fund assumption that they can earn 7.5-8% a year on their portfolios; with T-bills effectively earning zero, that means US pension funds are anticipating they will earn double the historic average excess return. Highly unlikely.

But with equity markets hitting new highs, investors are probably feeling pretty happy about their equity bet at the moment. That brings me to the second person to describe Japanese policy as a game-changer yesterday; Didier St Georges of Carmignac Gestion, the French fund management group. He thought that Japanese policy would be deflationary. If that seems odd, given that it involves money creation, note that the change in Japanese policy has been followed by a falling gold price as well as falling bond yields elsewhere.

His reasoning is that the sharp fall in the yen is giving Japanese exporters a huge competitive advantage, which will probably lead to lower import prices in other countries. (Indeed, for all that many economists deny there is a currency war going on, note that New Zealand's central bank felt obliged to admit today it had intervened to slow the pace of the dollar's rise.)

It's a bit hard to see why a deflationary impulse would be good for equities, however. Jim Reid of Deutsche Bank has been analysing the results of US companies and has found that sales growth was just 1.9% in the first quarter (after a 1.4% drop in the previous three months), a sharp slowdown from the 12.6% quarter-on-quarter growth in the third quarter of 2011. Earnings growth has been better than revenue growth, showing that companies are improving margins, but that cannot continue forever.

Some of that growth may be down to the way that share buy-backs enhance earnings per share, a subject highlighted in the recent post on Apple. As an article in the FT today from Aswath Damodaran of the Stern School of Business pointed out, this is all down to the peculiar distortions of the US tax code. The Wall Street Journal calculates that S&P 500 companies bought back $408 billion of shares last year, contributing around a fifth of the growth in per-share earnings.

It is hard to see that this financial engineering is good for the economy in the long run. Just as with the banks, a corporate sector with more equity and less debt is less vulnerable to shocks. It would be better if the corporate sector invested the money, rather than bought back shares. This is a classic case of what is good for Wall Street not being good for Main Street.

And that brings us back to the long-term impact of Japanese policy. We know that the money will end up somewhere - that there will be gainers and (inevitably) losers. But the fact that those individuals are hard to identify in advance ought to raise a question mark or two about the general thrust of the policy.

* This is not because the Japanese authorities will buy government bonds of other countries, an act that would be seen as outright currency manipulation. Instead, private sector investors will have a shortage of domestic bonds (because the Bank of Japan will be buying more) and will look elsewhere. Of course, the effect may be the same in driving the yen down so the distinction between manipulation and a yen decline as a clear by-product of official policy is a fine one.

Following the Japanese script

Thu, 02 May 2013 16:04:58 +0000

ALBERT Edwards has been plugging his ice age thesis since the late 1990s, that economies are doomed to slide into a deflationary squeeze and that equities are doomed to de-rate relative to bonds. Mind you, he does think we are nearing the end-game. In his latest note (he's at Societe Generale now, having been at Dresdner Kleinwort in the past) he writes that

with core inflation of only 1% we are only one short recession away from outright deflation. Hence we see US 10 year yields converging to Japanese-style sub-1% levels. This event will of course generate extreme central bank QE hyperactivity and despite our short-term cyclical bullishness (retaining a maximum overweight bond position) we remain of the view that on a 3-5 year time horizon bonds will prove to be a toxic investment and rapid inflation is the likely longer term outcome.

Edwards highlights the recent decline in copper prices as a sign that the deflationary pace is quickening, and also points to a slowdown in the core inflation rate in the US. Mind you, he also argues that unit labour costs are rising faster than core prices and will squeeze profit margins; the latest data (see chart) suggest they've fallen back again.

Nevertheless, equities look the odd one out at the moment, given falling bond yields and commodity prices. Edwards warns that

With the backdrop of virtually unlimited QE, we still meet almost no-one who thinks equities are at risk of a substantial decline. (But) the unfolding recession accompanied by full-blown deflation will result in a loss of investor confidence that central banks are able to prevent a Japanese-style deflationary event. The equity market will riot, Japan-style.

The not-so-Great GASB

Thu, 02 May 2013 15:40:15 +0000

THIS week's column is on American public pensions (it may be an arcane subject but it's very important). One can make perfectly valid arguments that public sector workers deserve final salary pensions because of the nature of their work, or their lower pay (although the calculations are very complex, needing to take account of qualification levels etc) or because it is dishonest to remove a right from someone who has planned their career on the assumption their pension is secure. All that is fine, provided that the cost is properly accounted for to taxpayers, so that the bargain is clear and above aboard.

When you start a pension scheme, the cash position tends to look very good; workers are contributing and few retirees are claiming. But the real cost is the pension rights that are accrued each year. As the baby boomers retire, and the elderly are living longer, the maths are shifting. For a long time, this shift was obscured by strong investment returns. But a decade of poor returns has brought the problem into sharp perspective.

Final salary pensions are a debt-like obligation, particularly in the public sector where the rights of pensioners are established in law (and even the constitution) in some states; there is an interesting case going on in Stockton, California, which may set the rights of creditors against those of pensioners. On corporate balance sheets, pension liabilities are discounted with a corporate bond yield. Falling bond yields have pushed up liabilities and widened deficits; hence many corporates have switched to defined contribution schemes. (Of course, the problem of low returns and falling rates dogs those schemes too, and are made worse by the low level of contributions that are made.)

This is NOT just a theoretical issue. If a company wants to offload its pension promise, or an individual wants to secure his pension by buying a fixed annuity, they find the cost has risen substantially.

But this doesn't show up in the public sector. It uses the expected rate of return to discount its liabilities; since the expected rate of return is higher (7.5-8% is standard) than bond yields, it makes the liabilities look smaller, and reduces the apparent cost to taxpayers. The rationale for this approach is that pension funds can afford to take a long-term view and benefit from the returns on risky assets; contributions can be smoothed over the long term, avoiding any sudden jumps in employer (taxpayer) payments.

However, this approach involves logical absurdities. Since equities are deemed to generate higher long-term returns than bonds, it means that $1000 of equities is worth more than $1000 of bonds under pension accounting. Yes, one might hope that equities will earn a risk premium over bonds over the long term, but the key word is risk. They might not. They haven't in Japan, for example, over the last 23 years. Indeed, at points in the last five years, it has been possible to find quite long time periods over which US equities haven't beaten Treasury bonds. Pension accounting treats the risk premium as guaranteed.

Some of those absurdities were highlighted in a Financial Analysts Journal piece about the rules set by GASB (Governmental Accounting Standards Board) by Robert Novy-Marx, to which my column refers. This section really catches the eye.

Under GASB, it is possible that a plan can improve its funding status by literally burning money. GASB recognizes that cash and bonds are valuable assets, but nevertheless penalizes a plan for holding these, by forcing it to recognize a larger liability. Destroying a dollar (i.e., reducing its bond holdings by a dollar while holding all other asset holdings fixed) reduces a plan’s assets by exactly a dollar, but can reduce its GASB liability by more than a dollar. In this case, a plan can reduce its GASB recognized underfunding by destroying assets.

How so? Novy-Marx gives a worked example

This can be illustrated with a simple example. Consider two pension plans, plans “A” and “B.” Plan A has a single member, a 35 year old worker with five years of service who plans to retire in thirty years with a projected salary of $105,000. The plan holds $10,000 of stocks that have an expected return of 10%. Plan B also has a single member, identical in all ways to that in plan A, holds the exact same stocks, but additionally owns $10,000 dollars worth of T-bills providing a risk-free yield of 4%. Common sense demands that plan B is better funded than plan A by exactly $10,000. Under GASB’s methodology, however, Plan A appears better funded than Plan B. To see this, suppose the workers are promised annual post retirement payments equal to 2% of their final salaries for each year of service. This implies annual payments recognized under the projected benefit obligation (PBO) of $10,500 per year (5 x 2% x $105,000/ year) starting in thirty years. If life annuities for 65 year old retirees make annual payments of 6% of the initial investment, then each employee’s currently recognized PBO liability can be satisfied with a payment in thirty years of $175,000 ($10,500 / 0.06). Plan A is, under GASB rules, fully funded. The present value of its thirty year liability of $175,000, discounted at the 10% expected return on its assets, is $10,000, the same as the value of its stock market holdings. Plan B, however, has an unfunded liability of $3,000 dollars under GASB. Its thirty year liability of $175,000 discounted at the plan's 7% expected return on assets (½ x 4% + ½ x 10%) is $23,000, $3,000 more than the value of its stocks and bonds. Despite the fact that plan B is identical to plan A in every respect except for the additional $10,000 it holds, GASB methodology holds that it is $3,000 less well funded. That is, GASB rules imply that a plan that must make a $175,000 payment in 30 years and owns $10,000 in stocks is better funded than a plan with the same liability and the same stock holdings but that additionally owns $10,000 in bonds. Plan B can thus improve its GASB funding status by $3,000 by burning its bonds.

In these days of spread-sheet errors, I thought I'd better check the calculations and they are fine. This seemed astonishing so I contacted GASB. Surely they had a reaction or rebuttal? I first contacted their press team on April 19, faxing over a copy of the article. On April 29, I finally received a response, linking to this FAQ factsheet; as I quickly pointed out, this doesn't deal with the burning money point at all. So they sent me this second factsheet, which doesn't deal with the point either. No expert was offered to deliver a rebuttal, Their last effort was a quote from a spokesman that

The GASB gave serious consideration to the views of Professor Novy-Marx when developing its new pension standards.

Hopeless. The only conclusion I can draw is that there is no answer to Novy-Marx's point and the accounting treatment for public pensions is based on a logical absurdity. As yesterday's note said, pity the taxpayer.

Pity the taxpayer

Wed, 01 May 2013 11:59:22 +0000

WHAT a crazy world. Apple, a company with $145 billion of cash, is issuing some $17 billion of debt to buy back its own shares. Why doesn't it just use its cash to do the same thing? First, because a lot of that cash is overseas, and bringing it back to America would incur a tax charge. Second, because interest rates are low and debt interest is tax-deductible, making this look a great arbitrage.

But think of it from the point of view of the hard-working American taxpayer. Apple's money will still sit overseas and not be invested at home to create jobs. Apple's tax bill will fall, as it offsets the interest payments against its profits. The buy-back will probably push up the share price in the short term*, boosting the value of executive options; profits from those options will probably be taxed at the long-term capital gains tax rate of 15%, lower than the rate many workers pay. Organising a bond issue, rather than using a company's own cash, incurs costs in the form of fees to bankers on Wall Street; the same bankers taxpayers helped support five years ago.

Yes, there will be gains to US pension funds (and individual Americans) that own Apple stock as well. And the cash that flows back to shareholders could be reinvested in new, innovative companies. Then again, ask most Americans to name an innovative company and their first pick would probably be: Apple.

ADD: In short, the whole deal is linked to tax distortions; the treatment of repatriated cash, debt versus equity and capital gains versus income. The ideal tax system, as we have argued many times, is neutral between sources of income. The tax deductibility of interest played its part in creating this mess, both in the corporate and mortgage markets. Why should the taxpayer want to encourage higher leverage, when high leverage is the root of financial crises?

UPDATE: for those who dount the above reasoning, see the piece in the FT from Aswath Damadoran of the Stern School of Business on the way this deal reflects the distrorted tax code.

* The long-term may be another matter, Companies are really bad-timers when it comes to buy-backs, as noted in a previous column. Indeed, Apple was buying back its stock in March 2012, when the shares were around $600, as opposed to $430 or so. Just a 28% loss on that deal so far.

Don't mention the war

Mon, 29 Apr 2013 13:26:00 +0000

BARRY Eichengreen is the latest commentator (in today's FT) to dismiss talk of a currency war, saying that the Bank of Japan is to be applauded, not criticised for its efforts rather than, as they were earlier in the year

impugned as an effort to depreciate the yen and gain an export advantage

The only point is that the yen has fallen and the Japanese export performance has improved. So Bloomberg wrote 11 days ago that

Japan's exports exceeded estimates in March and the trade deficit narrowed from the previous month after declines in the yen made the nation’s products more competitive in overseas markets.

Although Japanese trade with China seems to have been damaged by the political dispute, its trade to the US has picked up, particularly in transport equipment and machinery.

Meanwhile, Marchel Alexandrovich of Jefferies points out that Germany and Japan compete head-to-head in many capital goods markets and that, gioven the sharp fall on the yen against the euro, it is not surprising that German exports of machinery and equipment are now falling at an annual rate. The latest data for exports were worse than expected and the German trade association has just slashed its exports forecast for the year, admittedly down to the weak global economy rather than competition from Japan.

As Patrick Legland of SocGen remarks in a research note

Germany has benefited from a weak euro to increase its exports, especially in the past few years). Indeed, according to the Bundesbank, one of the key factors which supported German exports in 2012 was "the euro’s lower external value" along with an attractive product range. But, with the change of the BoJ’s policy, the recent sharp fall of the yen (-25% within 6 months) could have a negative impact on German exporters (facing direct competition from Japan).

Now maybe this slowdown in Germany (also marked in the recent purchasing managers' index) will prompt the ECB to cut rates and the argument of Mr Eichengreen (and others) is that it will make monetary policy easier in general and thus boost the global economy. Perhaps. But it was being argued earlier in the year that the signs of revival in the developed world economy were generally due to the determination of central banks to ease policy. And here we are in late April, with the data weakening again.

So we mustn't say it's a war. But, in this entirely peaceful scenario, German exporters know who's losing.

Bellwether signals

Fri, 26 Apr 2013 09:24:19 +0000

THE Economist organised a conference on Europe yesterday under the Bellwether title and your blogger had the honour of chairing it. There was a very high-powered list of speakers - Jorg Asmussen of the ECB, David Lipton of the IMF, Andrew Haldane of the Bank of England, Sushil Wadhwani (ex-Goldman and monetary policy committee member), Thomas Mayer of Deutsche Bank and so on.

As one might expect, when one gathers lots of economists together, there was lots of intelligent debate, but no agreed conclusion. In the morning, Mr Asmussen argued that there was no alternative to the path of fiscal austerity; in the afternoon, Jonathan Portes (of the National Institute for Economic and Social Research) said there was a general realisation that austerity had failed. When the audience was polled 49% said an austerity policy had failed Europe and 51% said it hadn't. Non-economists were given a nice insight into the state of the profession when Professor Steve Keen, on video link from Australia to argue that austerity had failed, spent part of his talk attacking Paul Krugman - surely the patron saint of all those who argue that austerity has failed.

Along with Sushil Wadhwani, Professor Keen was in favour of a helicopter drop of money - £500 or $500 to be paid to everyone on condition they used it to pay down debts. He was rather dismissive of my pettifogging questions about the details - how would you check whether they paid down the debt? To whom would it be paid - all residents, all those on the electoral roll, all those with bank accounts - but any government that adopted this policy would find the details were all-important. Giving £500 to Russian oligarchs, or illegal immigrants, or prisoners? Imagine what the tabloid press would say.

Perhaps the most interesting session came at the end, when various European economists debated the way the EU would develop. There was much talk of fiscal union, banking union and so on. But too little attention was paid to whether voters want any of this - in the creditor nations or the debtor nations. It looks remarkably as if the EU elite will once more push through a solution in the hope that voters will approve of it later - rather like the adoption of the euro itself. Mr Mayer talked of the shadow state that already exists with the unelected ECB taking on enormous powers to affect the lives of Europeans and system such as the two pack coming into force which will involve central control of budgets, as the European commission briefing explains

As part of a common budgetary timeline, euro-area Member States shall submit their draft budgetary plan for the following year to the Commission and the Eurogroup before 15 October, along with the independent macro-economic forecast on which they are based.
If the Commission assesses that the draft budgetary plan shows serious non-compliance with the SGP (Stability and Growth Pact), the Commission can require a revised draft budgetary plan. Otherwise it may address an opinion to the Member States concerned, which would also be discussed by the Eurogroup.

In short, with monetary policy out of the hands of voters (and nation states), fiscal policy will follow. So what will citizens have to vote about? Their right to pass laws is also circumscribed by European treaties. All this is rather disturbing to believers in democracy and to voters themselves who may feel, given their impotence, the desire to vote for maverick parties.

These are difficult issues. Clearly, voters cannot demand that the citizens of other countries lend them money, or at least they much expect the creditors to impose conditions if they do; in a sense, the markets have always had a veto over policy and that veto is passing to official bodies. Still, one has to wonder whether the EU is considering the trade-off between democracy and administrative (and economic) efficiency. As I quipped at the end of the day, there has been one successful European superstate - the Roman Empire - and it wasn't a democracy.

Gangs, grog, guns and GDP

Wed, 24 Apr 2013 14:15:33 +0000

IN THE popular imagination, tough economic conditions are associated with increases in crime, but as we report in the latest issue, that has not been the case with the current economic crisis in Britain. That analysis is backed up with a new report from the Institute for Economics and Peace which had made a fairly big media splash today. (The Institute also has a global terrorism index which we featured in December.)

Among the most striking finding are that, over the last five years, public disorder offences have fallen by 29% (despite the 2011 riots), violent crimes have fallen by 21%, weapons crimes have fallen by 34% and homicides by 28%. This is part of a general improvement in the developed world, in recent years; there were bigger falls in Spain and Italy, between 2008 and 2010, although not in France. As Steven Pinker noted in his book, The Better Angels of Our Nature, this can be seen as a very long-term trend. He cited a variety of factors; more organised states (so that court cases replaced feuds), trade (you're less likely to attack someone you do business with), feminisation of societies (a bigger role for women), the role of empathy (understanding that other people have needs and rights) and the growth of reason.

In the short term, what explains the trend? Our piece mentioned a number of factors; cars are harder to break into, some electronic items are not worth stealing and police tactics have improved. The IEP report floats the possibility that higher rates of imprisonment may have kept criminals off the street. But these seems to be an agreement that Britons are drinking less, particularly outside the home, and thus getting involved in fewer booze-fuelled fights. And the recession may actually help in this respect; people feel poorer and thus are less likely to go out on the tiles.

There are a few awful spots in Britain, where gang culture has taken hold of youngsters on some estates, and here deprivation may play a role; the least peaceful areas are five relatively deprived boroughs in London. But the best news of all is in the murder rate, now its lowest since 1978.

That brings one inevitably to an issue that baffles almost everyone on this side of the Atlantic; guns. What on earth explains the failure of American people to deal with this issue? It can't surely be concern with respect for individual rights since, when it comes to terrorism (which has killed fewer people overall in 20 years than guns have killed in a single year), all sorts of rights have been abrogated; detention without trial, questioning without reference to an attorney, torture, strip searches at airports etc.

The IEP report has a useful comparison. The average number of firearm-related deaths in the US in 2009-11 was 8,885; in England & Wales, it was 47. The population of the US is 311m, 5.5 times bigger than the 56m in England and Wales. In other words, allowing for population, you are 34 times more likely to be the victim of gun crime in the US than on this side of the Atlantic.

Contrast that with knife-related crime, where deaths averaged 1,754 in America and 233 in England/Wales; allowing for the population difference, you were only 36% more likely to be stabbed in the US. It would of course be very difficult to stop access to knives but we can reduce the ability to get guns.

Is the difference because Britons live in a police state? Nonsense; most of our police don't have guns, and don't want them. Is the difference because the British are generally less violent than the Americans? Quite the reverse. The overall violent crime rate was around twice the level per head of population, even after the recent fall. And it's not video games. Britons spent $1.7 billion on the industry last year or around 18% more per head than Americans.

Anyway, before the site is deluged by NRA supporters, in a world where so much of news is gloomy, it is nice to take comfort from one development; violent crime is falling in western Europe, for whatever the reason. As a measure of civilisation, along with longevity, it is a pretty good one

Good news or bad news?

Tue, 23 Apr 2013 14:19:43 +0000

BOND yields are falling. This is great for Italy and Spain where the cost of borrowing is its lowest since late 2010. But it's a bit less encouraging that German 10-year yields are down 16 basis points over the last month or that US Treasury bond yields are down 24 bp. That hardly suggests investors think that the economy is returning to normal.

It would hardly be surprising if investors had a feeling of deja vu, as the global economy flatters to deceive. World trade volume is only up around 2% over the past year. The Chinese purchasing managers' index for manufacturing was only just over 50. The composite euro zone PMI, also out today, was flat at 46.5, indicating shrinking activity; most worryingly, the German manufacturing indicator dropped from 49 to 47.9. Some think that German exporters are being squeezed by the Japanese as the latter take advantage of the weak yen. The US Markit PMI fell to 52, better than most but disappointing, especially as there was a sharpish fall in new orders.

In that context, falling bond yields are quite understandable, especially as commodity prices have been dropping, and therefore inflation is likely to subside further. David Rosenberg at Gluskin Sheff writes that

While I do see cost-push inflation as a longer-term threat, downside economic pressures over the very near-term are very likely going to cause bond yields to take another run at their cycle lows.

It is harder though to understand why equities are having a good day so far. Bloomberg cites hopes that the ECB will cut rates to bolster growth; it may be worth a try but it is hard to see that a rate of 0.75% will generate a lot more credit growth than one of 1%. It is hard to see why the Fed would slow QE in these circumstances; Capital Economics calculates a growth rate for M3 (the broad money measure that the Fed stopped calculating in 2006) and it has slowed again over the last couple of months*. Bank loans are only growing 3.6%, compared with 5.1% as recently as September.

A weak economy, low rates, low bond yields, never-ending deficits; it all looks remarkably Japanese.

*UPDATE: A reader points me to the Sober look blog which suggests the slowdown in money supply growth is linked to the rotation out of money market funds mentioned in a previous blog. Maybe, although money market funds have been shedding assets for a while.

Emerging problems

Mon, 22 Apr 2013 13:55:58 +0000

STOCKMARKETS have managed repeated rallies in the first quarters of the last few years, with analysts often citing renewed optimism about the global economy, or simply relief that disaster (a euro zone break-up, a politically-induced fiscal blow-up in the US) have been averted. The global market is duly up 6.3% so far this year. But the poor performance of emerging markets (down 4.2% so far) do not fit the traditional explanations for the rally. After all, emerging markets are perceived to be riskier and more sensitive to global trade; they should be high-beta plays, rising more in rallies and falling more in slumps.

In a research note headed "The Great Divergence", BNP Paribas suggests eight separate reasons for emerging market underperformance, ranging from poor profitability through higher inflation to a fall in commodity prices. Data from SocGen confirm the profits point; earnings per share fell 1.8% in the emerging markets last year and 8% in the BRICs (Brazil, Russia, India and China) where many investors are focused. Worse still, emerging markets are still seeing downgrades to profit forecasts for 2013 at about the same rate as the beleaguered euro zone.

In economic terms, Capital Economics points out that the trend in annual growth rates has been poor; in 2010, emerging Asia was growing at 10% and Latin America and eastern Europe at 5-6%. Now the Asian growth rate has fallen to 6%, Latin America is no better than 2% and eastern Europe is flat.

The equity underperformance ought to attract some value investors. According to SocGen, emerging markets offer a dividend yield of 3.1%, a good margin over the yield on Treasury bonds and on par with the yield on the MSCI World. Stocks also trade at a lower price-to-book ratio than developed markets. And in terms of prospective price/earnings ratios, BNP Paribas reckons that the emerging markets are on a discount of 20-25%, back where they were in the panic of 2008.

But it may take a little while for the cycle to turn. Goldman Sachs says that

We argued that for EM equity underperformance to end we would want to see signs that the China/EM activity cycle was reaccelerating and that global cyclical indicators remained firmly in “expansion mode”. Neither condition has been satisfied – our Global Leading Indicator (GLI) has moved into “slowdown” and China activity data has remained soft – and underperformance has continued. The sharp downdraft in commodity markets has added a new dimension to the pressure

That seems logical. But the view seems hard to square with the performance of US equity markets so far this year (up 9.1%) especially when US data have deteriorated recently, a development backed up by the fall in the Chicago Fed index today.

Another disconnect

Fri, 19 Apr 2013 09:43:10 +0000

IF IT seems odd that gold and Treasury bond yields are both falling when US equities have recently been reaching new highs, Dhaval Joshi of BCA Research points to another disconnect - that between US and European equities. Since the end of Janaury, the Eurostoxx had dropped 5.5% while the S&P 500 had risen by 4% (at the time his research note was published). Lest you think that is all down to the euro zone's problems, emerging markets have also been weak this year.

Is it all down to the relative strength of the US economy? Surely not. For a start, recent data such as the non-farm payrolls have been weak, Secondly, as previous posts have pointed out, there is very little connection between an equity market and domestic economic growth. Many of the companies in the S&P 500 and Eurostoxx are multinationals and thus are affected by global factors.

Indeed, most of the time, the two indices move in tandem. According to Mr Joshi, since the launch of the euro, they indices have moved in opposite directions for only 7 out of 57 quarters.

So what's going on? Mr Joshi has pointed to the disconnect between equities and commodities before and he thinks the latter are clearly signalling a slowdown in global growth. With US companies reporting some disappointing earnings numbers, it may be that the recent falls in the S&P 500 have further to go.

Rotation schmotation

Thu, 18 Apr 2013 16:09:42 +0000

ONE of the supposed themes of the year was the coming great rotation out of bonds and into equities (see my January post on this, which suggested at best there would be a mini-rotation). In fact there has been no switching out of bonds at all in the US mutual fund figures from Morningstar; in the first quarter, bond funds received $78 billion of inflows, almost exactly the same amount as flowed into the three categories of equity funds. In March, taxable bond funds were the single most popular category. Cash is definitely still flowing out of money market funds (unsurprisingly, given the yields) to the tune of $54 billion in March alone.

If you want further confirmation that bonds are not unloved, you can look at T-bonds (the yield on the 10-year has fallen a third of a point since March 11) or junk bonds, where spreads are around half a point lower than they were at the start of the year, according to S&P. This week's column focuses, through the prism of gold, about how hard it is to square the various market movements; it is possible to square falling commodity prices with lower government bond yields, but not with the Dow and S&P making all-time highs. Nor is it easy to make the case that gold is in retreat because the Fed is losing the appetite for QE; recent US data have generally been weak and, in any case, the Bank of Japan has supposedly gone QE-mad.

David Woo, the currency strategist at Bank of America Merrill Lynch describes the dilemma in a different way

The commodity market is saying global growth is slowing. The US equity market is saying US consumers are still going strong. The FX and European sovereign markets seem to believe Mrs. Watanabe is about to embark on a global shopping spree. We think it is unlikely that these markets will all turn out to be right. Something will have to give and a major re-alignment of the markets, the odds of which are rising, will probably not be either smooth or benign, in our view.

Mr Woo thinks that the evidence, such as Chinese Q1 GDP and the various EU numbers, suggest the global economy is slowing. It looks like we may be going through the familiar pattern of recent years, in which first quarter optimism peters out in the late spring. So what explains the strength of US equities? Mr Woo thinks the hope is that rising US house prices will offset the effect on consumers of austerity (don't forget the payroll tax increase), but the recent falls in consumer confidence are not encouraging; he also doubts the scope for massive Japanese buying of foreign assets, given that many institutions are already overweight.

In a slowing economy, bonds still look like a good short-term bet despite the likelihood that they will offer very poor long-term returns. A lot of people have made bearish bets on Japanese bonds in the last 20 years; they still haven't came good. Inflation expectations have come down in recent months and that, given the weakness of commodity prices, is hardly surprising (eventually, this will be good news for consumers, but only if they keep their jobs). But sluggish growth will of course mean that the debt burden will not come down, which means further crises loom.

And that brings me to the Reinhart/Rogoff brouhaha. I think I've been consistent in arguing that it's total debt, rather than just government debt that's the problem; this paper from the BIS looks at threshold numbers for household debt and corporate debt, for example. Ireland and Spain looked OK on government debt-to-GDP before the crisis but then they didn't. But it was hard not to think of the old graffito - "Archduke Franz Ferdinand found alive; First World War a mistake". Instead we could have "Debt spreadsheet wrong; four years of austerity a mistake." This reprinted graph from BCA Research shows the problem.

It seems clear there are no hard-and-fast rules. There is obviously a huge difference between America, which has the exorbitant privilege of borrowing in the global reserve currency, and Greece when it comes to scope for fiscal stimulus. Still, it is hard to believe that any country, even the US, can run deficits of 10% or so of GDP for very long without running into problems. But when everyone is cutting back, one gets a fallacy of composition at the global level; you can't reorient your economy to exports when your neighbour is trying to do the same. It would be nice to pretend that your blogger has the answer in the form of a 26-point plan to solve the world's problems but he doesn't; it's his job to ask questions.

The war on "the war on savers"

Fri, 05 Apr 2013 12:50:29 +0000

JAMES Surowiecki is a well-respected writer and I normally enjoy his New Yorker columns. But his latest effort "Shut up, savers!" is very odd. It is understandable that he might get irritated about right-wing complaints about economic policy (Rick Perry's treason comment. Jack Welch's conspiracy to hide unemployment etc); often these remarks are paranoid or silly.

But in an entire page devoted to how savers benefit in other ways from monetary policy (a stronger economy, many of them are also borrowers etc), he devotes not one word to pensions. Pensions are the single most important savings pot. And pension plans have been hit by low rates, since pensions are a bond-like liability. This is not a theoretical issue; use your pension pot to buy a fixed annuity and you will get a much lower income than 10 years ago; when a company wants to offload part of its final salary plan to an insurance company (as GM has done) the cost is much greater than it previously would have been.

But doesn't the higher stockmarket. itself a consequence of monetary policy, compensate for the rise in liabilities? No it doesn't*. At the end of 2012, the deficit of US corporate pension plans was $557 billion, the highest ever; plans were only 74% funded. Even the bumper stockmarket returns of the first quarter still leave the deficit at $372 billion. Companies had to contribute $80 billion to their pension plans last year, twice the level of a few years ago.

And then there are the state and local government pension plans, most of which are final salary. Joshua Rauh and Robert Novy-Marx have estimated that the true deficit on these plans is more than $4 trillion; closing this deficit over 30 years will require an average tax increase of $1,385 per US household per year.

For people who expect to survive on money from a private (401k-style pension) low rates mean they need to save more to generate a given retirement income. but of course, low rates are designed to encourage spending, not saving. The result may be that many people find they have entirely inadequate savings when they get to 65, and have to keep working.

These are all problems that have to be set against the potential gains to employment, borrowers etc that might flow from monetary policy. It might be legitimate to say that the problems are outweighed by the advantages. Fair enough. But not to mention pensions at all?

* On that point, most equities are owned by the wealthiest. So a policy that penalises small savers with bank deposits and pushes up equities is redistributive. Indeed, in my view, the persistent willingness of central banks over the last 25 years to cut rates to prop up the stock market when it wobbles contributed to the rise of the finance sector and of wealth inequality. They're still doing it.

A cunning plan

Fri, 05 Apr 2013 12:13:30 +0000

SO THIS is Japan's national problem. The country has a lot of debt, much of it issued by the government. On the plus side, nominal interest rates are low, making the debt easy to service (albeit that interest costs are a quarter of government spending, see Andy Xie's analysis). On the negative side, those low interest rates are a reflection of a deflationary, slow-growth environment that means its debt isn't going to disappear.

Bring forward the cunning plan. Generate inflation and consumers will start spending, business confidence will improve and growth will resume. This will reduce the government's annual deficit and reduce the real value of the debt over time. Problem solved. But what about investors? Won't they demand a higher yield to compensate for the inflation? Marty Feldstein reckons a four percentage point rise in borrowing costs will push the annual deficit to 20% of GDP (admittedly, because of the average maturity of the debt, that would take some time to occur).

But no matter, because the central bank will buy a lot of the debt; it is both indifferent to the price it pays (and the return it gets) and has a theoretically infinite balance sheet. But isn't this monetising the government debt? Not according to Gavyn Davies, writing in the FT, who says that

This is not helicopter money because the rise in JGB holdings (although more than large enough to finance the budget deficit in the next two years) is intended to be reversed in the long run.

The interesting question is whether outside investors should believe this. Mr Davies reckons the Bank of Japan will buy around 15% of GDP in the form of just long-term bonds, out of total bond purchases worth around 26% of GDP. In other words, whenever the BOJ offloads its bonds (whether it sells them outright, or doesn't repurchase them when they mature, it makes no difference), the private sector will have to absorb the surplus. Over five years, that would be 5.2% of GDP each year on top of the running deficit the government would have to finance. Worse still, investors would then be aware that the BofJ would no longer be a buyer so the rise in yields would be substantial.

No matter, some will say; better to deal with the current crisis and worry about a future problem when it happens. But of course, there was a past taboo against central bank financing of government debt because it is very habit-forming; why bother raising money from angry taxpayers or skittish private sector creditors when you can just get your friendly central bank governor to lend it you? It is easy to think this finance is costless but there must be a cost; those who pay the cost may simply be unaware of it for a while (eg the financial repression levy).

Still while one can hold down bond yields, there is nothing to stop investors from reacting in a different way and selling the yen. George Soros worried about a yen plunge yesterday saying that

If the yen starts to fall, which it has done, and people in Japan realise it's liable to continue and want to put their money abroad, then the fall may become like an avalanche

Of course, a certain amount of yen devaluation will be welcomed by the Japanese government since the prime minister called for it in December. The yen fell more than 3% against the dollar yesterday. Bill Gross said that so much yen devaluation will be needed to generate the desired inflation that other countries will complain about the trade competition.

Many will say that this is a domestic reflation policy, not a plan to boost Japan's exporters (perish the thought). Mr Davies notes that

(Nor) is it overt exchange rate manipulation Swiss-style. Having flirted with a policy of deliberately buying foreign bonds, the BOJ and the government have not pressed this button yet.

However, I rather like this tart FT paragraph by Ben McLannahan and Chris Giles

Central bankers in developed economies say action aimed at boosting a domestic economy does not represent an aggressive act, because the aim is not to move the currency, even though that might be a side-effect. It is very different, they say, from direct management of currencies, such as China's exchange rate policies, which they see as beyond the pale. Emerging economies tend to see this as semantic nonsense - a distinction without a difference.

In any case, Japan's growth may be constrained by other factors than monetary policy, such as demographics and poor labour market policies, as Stephen King of HSBC notes. Another issue is that, as this blog has noted before, a devaluation is a fall in a country's standard of living; it costs more to buy imported goods. In Britain, weaker sterling has led to above-target inflation and a squeeze in real wages. Mr Abe might find himself unpopular at home, as well as abroad, if a plunging yen eats into his citizens' spending power.

The gold bears emerge

Thu, 04 Apr 2013 12:30:03 +0000

GOLD touched $1541 an ounce today, and having fallen 18% from its high, is nearing the conventional definition of a bear market (a 20% decline). All this is occurring as the Bank of Japan cranks up the monetary presses, there is no sign of a change in expansionary monetary policy at the Fed, and an expectation that the Bank of England will ease policy once Mark Carney takes over.

Indeed, gold's fall contrasts with a sudden boom in the price of another alternative currency, Bitcoin (although the price has been hit today by attacks on the website). As Felix Salmon notes in an excellent post on the virtual money, enthusiasts for Bitcoin and gold come from separate social niches so this trend divergence is explicable, even though one might think their fundamental similarities (a restricted supply) might prompt them to be correlated in normal circumstances. Another explanation for the gap is that the Bitcoin bubble, like any other, is a case of investors piling into an illiquid asset that has suddenly made the news (the story was on the front of the FT today).

In a sense, Bitcoin, a currency with no backing at all except faith (see FT Alphaville), is reminiscent of the "undertaking of great advantage but no one to know what it is" that (perhaps apocryphally) marked the peak of the South Sea Bubble. Of course, many might remark that developed world currencies have no metallic backing and so exist on faith as well; however they do have legal tender status and have the (admittedly impaired) implied backing of the tax-raising powers of their governments. Western governments may yet undermine their currencies but they haven't so far; dollars and euros are pretty universally accepted.

But back to gold. As this blog has mentioned before, the metal is very hard to value; that was an advantage on the way up, but is a disadvantage on the way down. There is no yield and no-one really has to own it; indeed many people only own it because it has been rising for much of this century. Now the bears are starting to emerge; Patrick Legland at SG had just produced a note looking for an end-year price of $1375 an ounce (and an average 2013 price of $1500). He argues that we have not seen the inflation to justify the phenomenal rise in the gold price in recent years (it doubled after 2007); that economic growth may be returning to normal; and that the dollar has rebounded. On that last point, of the G10 major currencies, only the New Zealand dollar has outperfomed the US dollar so far this year, and that only marginally; the yen and sterling have fallen 6-7% against the greenback. Low real interest rates have helped gold (reducing the opportunity cost of holding it) but recent falls in inflation have caused real rates to rise, although they are still negative in many places.

As Mr Legland points out, the fall in gold may simply be a return to normal conditions; since the end of 1971, gold investors have suffered negative returns in 38% of all rolling one-year periods. There are other signs that commodities in general may be losing their hold on investors; copper has experienced its worst start to the year in a decade. Indeed, its fall is perhaps even more interesting than that of gold; is it a sign that the world economy is weakening (the Dr Copper theory that it's the best indicator of global activity) or a sign that, on contrast, risk appetite has shifted in favour of equities, and away from raw materials?

For what it's worth, my view is that the fall in the gold price is a much-needed shakeout, that the world economy is not as strong as the equity markets indicate, and that eventually some central banks will generate high inflation as a way of reducing the debt burden. The alternative - default - is even more painful as Greece and Cyprus have shown. But, alas, I'm not smart enough to know when that inflation will occur - not imminently.

The debt run

Tue, 26 Mar 2013 11:09:55 +0000

INFLATE, stagnate, default. That has been the choice facing highly indebted economies ever since the crisis broke in 2007-2008. It would be nice if growth could lift us out of this mess, but that looks unlikely; see how sluggish growth has become (the 2000 decade ended in 2009, before the Greek crisis hit, so this is not just an issue of austerity).

Why is this? There has been too much focus on government debt; the problem is total debt in an economy, including the financial sector, corporates and consumers. Government debt usually rises sharply when another sector is badly hit; Cypriot government debt, for example, was only 61% of GDP in 2010.

Think of debt as a claim on wealth. If a bank extends you a loan, you now have wealth in the form of money that you can spend on goods and services or use to buy an asset, such as a house; the bank also has an asset in the form of its loan, which it records on its balance sheet. Debt can thus increase rapidly relative to GDP and can help increase output, as the debtors spend their wealth.

All is well as long as the creditor is confident that the debtor can repay the debt. Indeed much debt in the modern economy is simply rolled over; businesses renew loans, homeowners replace one mortgage provider with another. And creditors are likely to be confident if GDP (and thus debtors' incomes) are rising.

One can thus have debt levels that are many times the level of GDP; i.e. there can be more claims on wealth than the annual production of goods and services. Of course, a nation's wealth (in the form of land, mineral resources etc) can be many times the value of its GDP so this may not appear to be a problem. But this is only a partial help since only a small proportion of a nation's wealth can be realised at any given year; if every American wished to sell his house to repay his debts, who would buy?

Similarly, when debt levels are many times the value of GDP, a large proportion of GDP needs to be rolled over every year. Say, debt is 400% of GDP and the average maturity of debt is five years; then 80% of GDP needs to be rolled over every year. If creditors become nervous about the debtors' ability to repay - as they will in the face of falling asset prices or stagnant incomes - they they will be unwilling to extend the loan. If debtors are able to pay out of their own resources, they will see a fall in their spending power. If debtors are able to repay by selling an asset, there will be a fall in asset prices. And if they are unable to repay, there will be a hit to the creditors' balance sheet. All three results hurt the economy.

Indeed, think of an indebted economy as like a bank. Just as a bank can function as long as too many depositors do not want to withdraw their money, the economy can function as long as too many creditors do not want repaying. the economy is thus vulnerable to a run.

When the private sector suffers a debt run, then the government can step in, rescue it and take the debt on to its balance sheet. This is fine as long as creditors have confidence in the government. As we have seen in Japan, if all the creditors are domestic, then the situation can be stable for quite a long time (although it is hard to believe that it is sustainable in the very long term). But if the creditors are foreign, as has been the case in parts of the euro-zone, a restructuring (write-off) of part of the debt will be necessary.

Inevitably there will be losers from this process. If you are a Cypriot with more than €100,000 in the two main banks, you will feel pretty hard done by. In reality, of course, a bank deposit is a loan to the bank (it is a liability on the bank balance sheet). It is thus a claim on wealth; if there is not enough wealth to meet all claims, then someone must lose out and as pointed out before, large savers are the most likely victims since they are the ones with the money.

An alternative to default is to inflate the debt away, to create so much money that the creditor suffers default in real terms, not nominal ones. As last week's column points out, this is being done in part by financial repression; holding real rates negative. Maybe this is what QE is designed to accomplish. So far, however, the central banks have had very little success in achieving the right kind of inflation; rapid growth in personal incomes. Such income growth will make it easier for individuals to repay their debts. Instead the West has tended to see imported inflation in the form of higher commodity prices. And that of course depresses real wages and makes it harder for individuals to repay their debts.

In short, we are nearly six years into this crisis and we have made precious little progress in running down debts and thus are vulnerable to further crises; Cyprus is just the latest example. Nor have we decided whether default or inflation is the preferred option. Either way, savers should beware.

Too big to guarantee

Thu, 21 Mar 2013 18:09:38 +0000

THE difficulties involved in solving the Cyprus crisis are all the greater because the banks are much bigger than the domestic economy. But Dhaval Joshi of BCA Research points out that this is true for the euro zone as a whole; the whole area has €8 trillion of deposits and only €4.5 trillion of annual government revenues. It is mathematically impossible to guarantee them all.

Aha, you might say, you don't need to; guarantee a lower limit and then depositors will feel reassured. Then there will be no bank runs and the guarantee will never be invoked. But the IMF paper highlighted in a previous post showed the problem this builds up over the long term; the whole system takes more risk because depositors and bank executives feel protected by the guarantee.

One can teach depositors a lesson by letting them lose out (moral hazard). But this hits old ladies and billionaires alike. And it causes contagion; banks tend to go bust when the economy is in crisis and the authorities don't want to induce any more panic.

The answer is to regulate the banks so they don't get too big in the first place. But of course, that boat has sailed. As with so much else in the crisis, this is another case of "I wouldn't start from here".

Keeping it real

Thu, 21 Mar 2013 16:13:31 +0000

THIS week's column points out that financial repression - holding interest rates below the rate of inflation - is a levy on savers that provokes less protest than in Cyprus, but has similar effects on purchasing power over the long run.

The last time that real rates were negative for a prolonged period was in the 1970s (see chart).

Although both rates and inflation were then much higher, the effect on the purchasing power of savers will be roughly the same if the current position is maintained (real rates on deposits averaged -3.3% in the 1970s; the gap between current base rates and inflation expectations is 2.8%). To the surprise of some at the time, Britons saved more of their income than in the 1960s, when real rates were positive and inflation was lower, and also held more of their money in the form of deposits. Instead of going on a spending spree, or piling into risky assets, cautious Britons saved more.

There are other potential effects of low rates. In an article in Tuesday's Times (behind a paywall), Stephen King of HSBC argued that "1970s-style business zombies are back". He argues that low rates and weak sterling have allowed inefficient businesses to survive, thus making life harder for new, more efficient companies to prosper.

Our financial system may then be turning some companies into the 21st-century equivalents of 1970s nationalised industries, kept alive by monetary, as opposed to taxpayer, subsidies. While in the 1970s the impact on taxpayers was clear, the pain today is felt only indirectly, most obviously through falling spending power thanks to a weakening pound.

In a previous post, I pointed to another parallel with the 1970s; the debate about the limits of Keynesian stimulus (just for clarity, drawing parallels with an era does not mean everything is the same now as it was then; we have progressed from the Osmonds to One Direction, for example). In 1976, Jim Callaghan's speech to the Labour conference was seen as a turning point in British economic policy, as it argued that there was a limit to the Keynesian demand management that had been pursued since the war. Now David Cameron and George Osborne are echoing the Callaghan line; that the scope for further stimulus is limited. Over the previous three fiscal years (2009-10 to 2011-2012), British governments have run deficits of 23% of GDP, compared with the 19% of GDP deficit run up in the fiscal years 1974-1975 to 1976-1977, which ended with Britain at the IMF (for the stats, see here, table PSF9). The cyclical position in the 1970s was a little better but not dramatically so; real GDP rose a cumulative 3% between the last quarter of 1973 and the end of 1976 and just 1.5% between the last quarter of 2008 and the last quarter of 2011.

At the same time, the phenomenon of stagflation was making economists and politicians doubt whether the trade-off between inflation and unemployment (the Phillips curve) was as straightforward as they had previously thought. In his 1976 Nobel lecture, Milton Friedman used the Callaghan quote from my other post and focused on the level of the "natural rate" of unemployment in an economy; attempts to force unemployment below this level only caused inflation to rise, which was why the Phillips curve relationship broke down. Unfortunately, like another popular economic concept - the output gap (the departure of economic output from trend growth) - there seems no way of knowing what the natural rate of unemployment might be.

This debate is also echoed in the current move to change the terms of business of central bankers. Britain changed the Bank of England's remit in the Budget yesterday, allowing it to give forward guidance (like the Fed), giving it more explicit freedom to deviate from target and allowing it to set out the trade-offs involved in target-missing eg higher inflation but lower unemployment. This has, at least, the virtue avoiding the hypocrisy of the Bank pursuing a target it hasn't met for over three years and thinks it won't meet for the next two. The markets are already wise to this, of course; inflation expectations, as measured by the gap between index-linked and conventional bond yields, are just under 3.3% for the next 10 years. The tricky bit, of course, will be avoiding the negative spiral by which higher inflation expectations mean a lower pound, which means higher inflation.

For savers, however, the outlook is clear; real rates are going to be negative for quite a while.

What does a guarantee mean?

Tue, 19 Mar 2013 15:53:34 +0000

DEPOSIT insurance schemes were a product of the 1930s, when the loss of confidence of savers caused the collapse of many small American banks, worsening the Great Depression. The practice became widespread from the 1970s onwards, with the number of countries using such schemes rising from 12 to 88 between 1974 and 2003, according to an IMF paper.

The argument for deposit insurance is that banks are inherently unstable, by virtue of their economic function; they borrow money in the form of deposits (which can be instantly withdrawn) and lend to businesses on a longer-term basis. They are thus vulnerable to destabilising and self-fulfilling bank runs. But the counter-argument is that of moral hazard; depositors have no incentive to choose between banks on grounds of riskiness, and bank executives can take risks knowing that they are underwritten by the insurance scheme.

Some jurisdictions tried to offset this by limiting the guarantee; such was the case in Britain up until 2007, when only 90% of deposits between £2000 and £35000 were covered. But the Northern Rock panic showed that even the prospect of a 10% loss caused panic so the scheme was quickly extended.

A deposit insurance scheme is designed to cope with the failure of an individual bank. But it may cause the entire banking system to become riskier. The IMF paper argued that

explicit deposit insurance has been shown to increase the likelihood of bank crises significantly. Combining deposit insurance with interest rate liberalisation makes moral hazard even worse because it permits banks to chase high-yield investments carrying heightened risk

If the entire banking system becomes risky, then the risk of an insurance scheme falls on the state. But if, as with Cyprus, the banking system is much bigger than a country's GDP, than the state will be overwhelmed. The guarantee is only as good as the guarantor. The depositors become dependent on the willingness of foreign creditors to uphold the guarantee, and as Cypriots have found to their cost, that cannot be taken for granted. The same was true of Iceland, of course. Some Britons rushed to put their money into Irish banks in 2008 when the Dublin government guaranteed all bank deposits but, as was pointed out at the time, the Irish government could not create pounds. It cannot create euros either.

In countries which can print their own currencies, governments can guarantee deposits in nominal terms, but not in real ones. The low interest rates that have propped up the banking system have eaten away at the purchasing power of savings; since 2009, British savers on a 40% tax rate (around 3.8 million middle class people) have seen a 6% decline in the purchasing power of their savings (a 6.6% gain in the best accounts, compared with a 13.4% rise in prices), even if they put the money in the best-paying accounts. That is on a par with the lower Cypriot levy.

But back to moral hazard. Let us assume that a EU-wide deposit insurance scheme was in place. The price would be greater bank regulation; it would certainly include greater controls on the ability to open a bank account and, perhaps, limits on savings rates. After all, if all banks had equal legal protection, investors would scour the continent in search of an extra few basis points; the flows could be destabilising. As the IMF paper concluded

Unless a country has strong banking regulation, a strict failed bank resolution regime, carefully designed deposit insurance with safeguards against risk, healthy private monitoring, and, most of all, strong institutions, explicit deposit insurance will only be a recipe for future bank crises.

But then we can count on the EU to devise such a smoothly running system, can't we?

UPDATE: By the way, how long can the "not a precedent" line be maintained? The Greek writeoff for private sector creditors was not a precedent; the writeoff for SNS Reeal bondholders was not a precedent; and now the Cypriot despoit levy isn't one either. If a man whacks you on the head, it isn't a precedent for him kicking you on the shins. But after a couple of blows, you still can't be blamed for feeling he's out to get you.

What will savers do?

Sun, 17 Mar 2013 10:52:37 +0000

EARLY in the crisis, a wise ex-colleague wrote to say that "Savers will pay for the mess. They are the only ones that have any money left." No doubt, he will be nodding his head at the terms of the Cypriot bail-out deal. Schumpeter carried a very effective dissection of the plan yesterday and it is always possible that the deal might collapse; the parliamentary debate has been postponed.

One has some sympathy for those trying to organise a rescue for a country where the banks are many times the size of its GDP, and where a lot of the depositors are foreign nationals. Cyprus's problems are not new, and the upper limit on insured deposits is common knowledge, so it is possible to justify a levy on deposits above the insured level. Taxing deposits below that level, however, is much harder to justify especially as it seems that senior bank bondholders will not lose out.

What incentives does this create for savers elsewhere? Cyprus will be described by the authorities as a one-off, to try and reassure the depositors of Portugal or Spain. But will Europeans believe that the authorities do not have sufficient money to make whole the depositors of tiny Cyprus but do have enough to bail out banks elsewhere?

People who don't trust banks, and keep their money under the proverbial mattress, will not be touched by this levy; in the past, such people have been regarded as eccentrics. Not any more. The same applies to people who keep their money in the form of gold, and store it in a vault. Gold's price is, of course, variable; the price fall since October in dollar terms is more than 8%, the average of the two Cypriot levies. Still, there was a pick-up in retail demand for gold in the wake of 2008's banking crisis and there may be so again.

Finally, it is worth remembering the blog's underlying thesis that the developed world's debt will not be repaid in real terms, and will thus be defaulted on or inflated away. Our bank deposits are, of course, debt as far as the banking system is concerned. If the authorities hold real interest rates negative, as they are in Britain, for example, then the effect on the after-tax purchasing power of savers after two to three years, may be as big as the Cypriot levy.

Paved with good intentions

Fri, 15 Mar 2013 11:02:30 +0000

READERS of the Financial Times might have noticed the polite version of a ding-dong in the editorial pages this week. On Wednesday, chief economics commentator Martin Wolf wrote that "Britain's austerity is indefensible", while on Thursday, economics editor Chris Giles replied that "Osborne's strategy is too timid, not too austere". Given the very turbulent times, a degree of debate is understandable and, indeed, welcome; the FT does a service to its readers by showing the range of views. (The wide range of blogs at the Economist also reflects a diversity of opinion.)

Although the debate relates to the UK, I think it has a much wider resonance. And indeed, to a student of history, it has fascinating parallels; economic policy-making was rethought in the mid-1970s, but the same debates are popping up again.

First, a brief look at the data. In the fiscal year 2009-10, before the government came to office, current spending was £575.1 billion; last year it was £618.8 billion. The annualised figure for this year is heading for £630.7 billion. If we exclude interest payments and welfare benefits, spending in 2009-10 was £377.4 billion, last year was £389.4 billion and this year we are heading for £390.4 billion. For anyone who has worked in a private sector company, these would not count as aggressive cost-cutting measures; illustrating how difficult it is to cut public spending. In real terms, there has been a fall, but the chart accompanying Martin Wolf's piece illustrates the longer-term trend; in the past 30 years, there have been three periods where the government has managed to halt the rise of public spending in real terms (of which this is the latest) interspersed by two periods of a rapid increase. In the last 10 years that the Labour government held office, public spending rose 50% in real terms. It is hard to disagree with Chris Giles when he writes that

The origin of the unsustainable fiscal position was a pre-crisis delusion that buoyant tax revenues were there to stay

Now that a gap between revenues and expenditure has emerged, what is the answer? Spend more, say some, because austerity is self-defeating, hitting consumers' incomes and thus demand; Chris Giles pokes a large hole in that argument by pointing out that private consumption is in line with the expectations set in 2010 and that the big shortfall is in exports (despite sterling's 2007-08 depreciation). As he writes

To sustain the "austerity is the main cause of weakness" argument, you therefore really need to convince people that UK austerity somehow caused more pain to French, Spanish and German households, and hence to UK exporters, than it did to UK households directly. It did not.

The case that we have tried to make at the Economist, is that the government approached austerity in the wrong way, slashing capital spending. This is the easiest thing to do but in terms of stimulating the economy, capital spending delivers the biggest bang for the buck. More infrastructure and reforms in areas such as planning will boost the long-term growth rate, and create the hope that tax revenues will rise.

But while Chris Giles makes good points, it is worth returning to Martin Wolf's piece because as the doyen of British economic commentators, he tends to reflect and anticipate the intellectual trend. Perhaps the most remarkable section of the piece is where he criticises David Cameron for saying there is no "magic money tree". Martin writes

First, there is a money tree. It is called the Bank of England, which has created £375 billion to finance its asset purchases. Second, like other solvent institutions, governments can borrow. Third, markets deem the government solvent since they are willing to lend to it at the lowest rates in UK history.

This is interesting on many levels. First, on quantitative easing. Regular readers will know that I've not been keen although it can be argued that the first round of QE, when the financial sector was in collapse, was a desperate measure needed for desperate times. At the time, people argued that this was a temporary device, akin to central bank interventions in the money markets. Four years on, we have had more and more rounds of QE and more seems certain to follow. I vividly remember debating a member of the monetary policy committee who described me as a "conspiracy theorist" for thinking that QE amounted to central bank financing of the government. But when the FT's lead commentator describes the Bank of England as a "money tree" it is clear where we are heading; last year's speech on the need for helicopter money by Adair Turner was another signal. Recently, we have seen the Treasury take back from the Bank the interest it has accumulated on its gilts; interest it will need to offset the inevitable losses involved in buying gilts above par. This money has been deemed to "reduce" the deficit. As John Kay pointed out in another Wednesday FT piece

Why lose weight when you can reset the scales?

Getting central banks to finance a deficit is very tempting because it seems the politically painless option. But it is fundamentally dishonest as Margaret Thatcher spelt out 30 years ago. She complained that her ministerial colleagues were unwilling to raise the taxes to pay for the expenditure they had agreed so argued

Let us print the money instead. Because what that is saying is let us quietly steal a cerain amount from every pound saved in building societies, in national savings, from every person who has been thrifty

This is true even if printed money does not result in hyperinflation. As Stephen King of HSBC points out in his forthcoming book "When the Money Runs Out", central banks are now acting as redistributors of wealth, taking money from those with savings in the bank and giving it to the wealthy who invest in the stockmarket; making life harder for those who have saved for a pension, so not to be dependent on the state, and easier for those who have borrowed, regardless of their ability to pay. Or indeed, by letting inflation stay above target, by forcing down real wages. These are political decisions made by unelected bankers. Dylan Grice, the former SG strategist who is now a fund manager at Edelweiss, comments on this in his first newsletter at his new post. When money is created, it is easy to think that it is "free". But it can't be, or why would we bother to raise any tax at all; why not ask the central bank to pay for everything? If the central bank really did drop money from a helicopter, it would be grabbed by the most aggressive and agile people on the street, and not by little old ladies. The former would gain, the latter would lose.

We have a slightly better understanding of who pays; whoever is furthest away from the newly created money. And we have a better understanding of how they pay; though a reduction in their own spending power.

But back to the Wolf piece. Note how we leap from point 1 to point 3; the Bank of England has bought £375 billion of gilts and "the market" is willing to lend the government money at low rates. Going back to the data, the government has borrowed £409 billion in the last three financial years and another £72.8 billion so far this year; so the Bank has bought three-quarters of all issuance (admittedly in the secondary market, but the private sector must be influenced in its actions by the knowledge the Bank is a willing buyer). The private sector has only had to absorb a net £106.8 billion, or £27 billion a year. Presumably, the effect of BofE buying has been to force down yields or what was the point? Let us jump forward to, say, 2015 when the Bank might start to run down its purchases; if it did so over five years, that would be £75 billion a year. with the government probably still in deficit to the tune of £50 billion a year. the private sector would have to increase its net demand from £27 billion a year to £125 billion a year. Let us see what the markets demand in the way of yields to do so. (In my view, this is why QE won't be unwound in the foreseeable future.)

Back to the central argument. As Chris Giles points out, Britain's finances were in a terrible state when the government took office and the government could hardly do nothing. In 1976, when Britain was forced into the arms of the IMF, it had a smaller budget deficit and trade deficit than we did in 2009-10. It was a wake-up call for the then Labour PM, Jim Callaghan, who said

We used to think that you could spend your way out of recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, and in so far as it ever did exist, it only worked on each occasion since the war by injecting a higher dose of inflation into the economy, followed by a higher level of unemployment as the next step.

Post-war British economic policy turned at this moment. The then chancellor Denis Healey even paid homage to some of the precepts of monetarism. The Labour party lost office in 1979 for 18 years and when it retuned in 1997 initially made much of its conversion to "prudence". Thirty seven years later, the same debate is being held all over again, just with a different cast. A Conservative prime minister is arguing that there must be a limit to deficit financing, just as a Labour prime minister did 37 years ago (it is not hard to imagine David Cameron making the Callaghan quote). Where there is a change is that Cameron appears to welcome the monetary financing of that deficit which his famous predecessor condemned 32 years ago.

Chasing scraps

Wed, 13 Mar 2013 13:35:24 +0000

IN A world of measly returns, investors have to chase after scraps. At the Bloomberg FX conference at the British Museum this morning, one speaker pointed out that, although the Swedish central bank has cut rates four times over the last 12 months, just the change in policy tone from easing to neutral has turned the krona into a strong currency. Indeed, the useful WCRS Bloomberg page shows that the krona has been the best performing currency over the last year; the worst (predictably) has been the yen.

The yen was bolstered for a long time by a positive real interest rate (thanks to deflation), and the apparent intention of the Japanese authorities is to turn real rates negative by pushing inflation higher. By itself, of course, a weaker yen will push up import prices, particularly in a commodity-poor country like Japan. Real rates are one potential driver for currency movements; below is a table showing the G10 countries, ranked by their real rates (3 month deposit rate minus consumer inflation) and then their performance ranking over the last 12 months.

Real rates (%) Performance

ranking

New Zealand +1.96 2

Sweden +1.15 1

Australia +0.94 6

Canada +0.62 8

Japan +0.42 10

Norway +0.38 4

Switzerland +0.35 7

US -1.3 3

Euro -1.65 5

Britain -2.23 9

As you can see, the ranking is far from a perfect match, but it is still striking that Britain with the lowest real rates is almost the worst currency performer. The pound has fallen 7.4% against the dollar over the last three months (the yen is down 14.1%) and several speakers were talking about $1.40 as a potential target for the currency over the next year. As one speaker (ironically from Argentina) remarked, a flexible inflation target is simply not credible.

As Geoffrey Kendrick of Nomura admitted, at least the debate over the yen's future under prime minister Abe and the sharp decline in the pound had livened up what had become rather dull foreign exchange markets. Before the crisis, the carry trade had been the strongest driving force in the markets (buy high-yielding currencies, short low-yielders) but now there is very little carry to trade.

Is there a currency war? Our leader line is that there isn't but Stephen Jen, the very shrewd strategist who now runs money at SLJ Macro Partners, thinks there is - that countries are trying to "pick the pockets of each other". Other highlights of Mr Jen's talk

1) With QE, the key issue is not necessarily whether the Fed stops altogether; even a reduction in its $85 billion a month of bond purchases will be taken by the markets as an important signal

2) The loan-to-deposit ratio of US banks was 1.3 before the crisis, now it is down to 0.7. European banks still have a ratio of 1.2. They want to delever but the ECB with its lending programme, has halted this deleveraging programme. But in the long run, tighter bank credit will squeeze European growth.

3) Jen thinks that the Germans believe there is no point in fiddling about with short rates. The key to helping the peripheral European economies is to lower long-term bond yields and that depends on fiscal austerity. So you need fiscal austerity to get monetary easing in the German view.

Sad Cyprus

Tue, 12 Mar 2013 14:50:46 +0000

SMALL though it is, Cyprus is emblematic of this current debt crisis. For a start, it illustrates that focusing on a country's government debt-to-GDP ratio is too narrow; in 2010, Cyprus had a government debt-to-GDP ratio of just 61%. Debt is a claim on future wealth; when it becomes clear that future wealth will not be sufficient to service this debt, a crisis will ensue. If the debt is in the private sector, and particularly the banks, the government will be dragged in; either because the economy (and tax revenues) collapse or because the state must formally assume the debts of the banking sector.

As this note from a World Bank economist points out, banking debt at end-2010 was around nine times Cyprus's GDP. Both the size of the banking sector to the economy, and its Topsy-like growth, are analogous to the situations of Iceland and Ireland. (In Luxembourg, the size of the banking sector is around 20 times GDP but this is almost completely comprised of foreign banks. In Cyprus, domestically-owned institutions account for two-thirds of all bank assets.) Furthermore, even when financial institutions are excluded, Cyprus has the second highest private sector debt-to-GDP ratio in the euro zone.

When the banking sector is so large, the domestic government clearly cannot stand behind it. Iceland needed an IMF loan; Ireland went to the EU. As part of this process, some of the debt will have to be written off. But that's the tricky bit. Who pays? If you write off debt owed to the domestic banks, then you will have to rescue the banks. If you write off uninsured deposits, then will there be a contagion effect as uninsured depositors in other countries take fright. And if you write off debt owed to official creditors, they will demand a price, in terms of austerity; that price will cause short-term damage to the economy and will be resented by the electorate.

The problem is tied up with the issue of moral hazard. This can be applied to both creditors and debtors; the former should be punished for reckless lending and the latter for living beyond their means. The collapse of Lehman Brothers is seen as an example of the faulty reasoning behind moral hazard; by letting the bank go bust, the crisis was spread throughout the financial system. But rescuing every creditor (or intervening to bail out the markets every time they falter) is the reason we are in this mess.

The best opportunity for the authorities to apply the moral hazard lesson is when the economy is going well. But at that moment, financial institutions aren't going bust. In retrospect, the opportunity was missed when Long-Term Capital Management collapsed in 1998 but at the time, everyone was worried about the Asian crisis.

Because Cyprus is small, adding its debt to that of the stronger EU nations will not make that much difference. But as a whole, the euro zone is not growing at all; the consensus forecast is for a 0.2% decline in GDP this year. If we go back to the unholy trinity of options facing indebted nations (inflate, stagnate, default), it looks as if the EU, like Japan, is opting for the second.

Fallible beings

Tue, 12 Mar 2013 11:48:27 +0000

A LOT of faith is placed in the wisdom of central bankers, by politicians and investors. The former hope that monetary policy can prop up the economy while they attempt to reduce budget deficits; the latter tend to buy equities as soon as they think central bankers are easing.

But it is worth remembering that central bankers are fallible. I've quoted Ben Bernanke before, asked about the possibility of a housing bubble in July 2005

Well, I guess I don't buy your premise...We've never had a decline in house prices on a nationwide basis.

And I just came across this quote* from Janet Yellen, Bernanke's potential successor, in a 2005 speech on housing bubbles and monetary policy. She acknowledges that house prices may be high relative to rents but adds that

In my view, the ... decision to deflate an asset price bubble rests on positive answers to three questions. First, if the bubble were to collapse on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble? My answers to these questions in the shortest possible form are, "no," "no," and "no." ... In answer to the first question on the size of the effect, it could be large enough to feel like a good-sized bump in the road, but the economy would likely to be able to absorb the shock... In answer to the second question on timing, the spending slowdown that would ensue is likely to kick in gradually... That would give the Fed time to cushion the impact with an easier policy.

Her answer to the third point is left out for reasons of space but, it echoes Alan Greenspan's argument, that a rise in interest rates is too blunt a tool and might do unnecessary damage to the rest of the economy.

Of course, Ms Yellen was not alone in failing to predict the damage that would be caused by the collapse of the housing bubble. But the fact she didn't get it right should make us pause when we assume that she, and other central bankers, will get other things right. In mid-2010, for example, the Fed thought the US economy would grow by between 2.9% and 4.5% in 2011; it actually grew 1.7%. In August 2010, the Bank of England thought the most likely UK GDP growth rate in 2011 was 3%; it managed 0.7%. Yes, one could argue both banks were blindsided by the EU crisis but Greece had been bailed out in May 2010 and the problems of Ireland and Portugal were already apparent.

Looking forward, will central banks be able to exit their current policy with anything like the ease they assume? Here is Sir Mervyn King

I have absolutely no doubt that when the time comes for us to reduce the size of our balance sheet that we'll find that a whole lot easier than we did when expanding it

Absolutely no doubt? Hmm. With that infallibility, Sir Mervyn is a shoo-in for the Papacy.

* The quote came from a proof of Stephen King's forthcoming book When the Money Runs Out, which looks very good indeed. Trying to find the original speech proved difficult; the link is to Mark Thoma's blog of the time. The link from there calls up a notice from the San Francisco Fed that the speech is no longer available. Let us charitably assume that it doesn't keep details of eight-year-old speeches.

Rough trade

Mon, 11 Mar 2013 14:20:05 +0000

WHILE there is much political debate about the size of the budget deficit in many countries, the current account deficit gets less attention. But as a research note from Stuart Parkinson and Rineesh Bansal at Deutsche Bank points out, the current account position is one of the most useful crisis indicators available. Back in 1994, for example, a current account deficit of 6% of GDP preceded Mexico's peso devaluation and emergency loan from the US. the first Asian country to get into trouble in the later 1990s was Thailand, which had a deficit of 8% of GDP.

A big deficit means a country relies on the "kindness of strangers" to provide financing. Should the foreigners lose confidence for whatever reason, a crisis can ensue. Back in mid-2006, the US had a current account deficit of 6% of GDP, with money pouring into structured credit products such as the infamous CDOs. As investors became suspicious of these vehicles, the banks struggled to get financing, and the rest is history. The US current account deficit has come down since then, but is still 3% of GDP, and is very focused on China.

The market's focus shifted to Europe in 2010 and here again, the deficits were huge; 14.9% of GDP in Greece. 10% in Spain and 5.7% in Ireland. it was hardly surprising that all three countries were dragged into the mire.

So which countries should we be alarmed about now? Of the G20 countries, five have deficits of 3% of GDP or more - the US, Australia, UK, Canada and India. The last three have all seen their trade positions deteriorate since 2006.

I've banged on about Britain's problems a lot recently but it has the worst budget deficit of the three, and the most sluggish economy; hardly surprising that sterling has been falling. India, too, is a worry; its misery index (unemployment plus inflation) is more than 20%. Canada is interesting; it is perceived to have had a good crisis, with its banks emerging virtually unscathed and the loonie turning into a petrocurrency. The Bank of Canada's governor has been headhunted by the British government. But there has been a housing bubble that Mr Carney has been trying to deflate.

Indeed, Canada is a very good example of the deficit problem. Money gets sucked in from abroad when a country runs a deficit; that money is not always invested wisely, and it often has a distorting impact. It provides the kindle from which future crises are made.