8 May 2012

Money multipliers and Basel III liquidity rules

Good Vox article by Manmohan Singh and Peter Stella about the transmission of monetary policy.

Textbooks tend to assume a very simplified model of the money creation process, in which central banks have direct control over the quantity of monetary base (i.e. currency plus commercial bank deposits at the central bank). The relationship between this monetary base and the total money supply is then governed by something called the ‘money multiplier’. This money multiplier relationship may arise due to legal minimum reserve requirements, which limit the amount of deposits a commercial bank can accept (and hence the amount of loans it can make) by the need to always hold the equivalent of X% of deposits in the form of reserves at the central bank – the quantity of which, as I said, the central bank directly controls.

I’ve always thought this model was odd. This is not least because, when I as an undergrad first looked in to what these ‘reserve requirements’ were, one of the first things I discovered is that we in the UK didn’t have a minimum reserve requirement – so in theory, banks could create an infinite amount of money from a given amount of monetary base.

Singh and Stella point out a further flaw. In today’s financial system, so-called ‘shadow banks’ (hedge funds, money-market funds, etc) clearly play a big role in the money creation process. But as well as not being subject to minimum reserve requirements, shadow banks also don’t have access to central bank deposit facilities. Therefore, for their liquidity needs, they have to rely much more on private sources – such as private repo markets. These typically require high-quality, highly-liquid assets (such as government bonds) as collateral, so shadow banks will hold such securities as their ‘reserves’.

Which leads on to Singh and Stella’s point – quantitative easing, in which the Fed and Bank of England bought up government bonds from banks, merely substituted ‘public’ bank reserves (i.e. new commercial bank deposits at the central bank) for ‘private’ reserves used by shadow banks (i.e. high-quality government bonds that were taken out of circulation). The true amount of monetary base was unchanged; so even for a given money multiplier, there will be no increase in the wider money supply.

And as a result, it’s incorrect to assume that the massive increase in measured monetary base since the crisis (Singh and Stella point out that deposits at the Fed increased from $20.8bn in 2007  to $1562.3bn in 2011) will be be inflationary – as there’s not a knock-on increase in the wider money supply.

Anyway, a (not-fully-formed!) thought follows on from this. The Basel 3 liquidity rules drawn up after the 2008-09 crisis will require banks to hold more liquid assets. I think these rules can be interpreted as a substitute for old-fashioned minimum reserve requirements, i.e. making sure that banks hold a sufficient chunk of liquid assets that enable them to meet deposit outflows. (Interestingly, the UK’s Financial Policy Committee recently left the door open to asking for powers to vary banks’ liquidity buffers over time, analogous to using minimum reserve requirements as a policy tool as is often the case in emerging market economies.)

But the Basel 3 liquidity rules’ definition of liquid assets will include both central bank reserves (i.e. Singh and Stella’s ‘public’ reserves) and high-quality sovereign debt (i.e. ‘private’ reserves). What does that mean for the money multiplier – in a world where Basel 3 supplants minimum reserve requirements as the binding constraint even for banks, does the concept of a conventional money multiplier relationship make even less sense?

7 May 2012

Spot the difference

Buttonwood points out that Francois Hollande’s plan to eradicate France’s deficit by 2017 doesn’t on the surface look that different to the UK coalition’s latest budget plans to eradicate our deficit by 2017:

TAKE two countries. One has a government “inflexibly committed to austerity”, lacking a Plan B and dragging the economy down, according to its critics. The second country has a new President who has just declared that his victory is a rejection of austerity. The victory has been hailed as a new dawn for European politics.

The first country, the UK, is aiming to balance its budget by 2017. The second country, France, plans to balance its budget by, er, 2017. Funny old world.

In reality, there’s a bit more to it: the French are trying to cut their deficit from 5.3% of GDP last year, the UK from 8.7%. So we here are still looking at an extra 3.4% of GDP worth of tightening over the five-year period.

But this still touches on my earlier point: rather than being inflexibly committed to austerity, the UK in fact seems to already be in the process of switching to a Plan B as the global economy deteriorates vis-a-vis 2010 forecasts. It’s just that loosening fiscal policy in a modern welfare-state economy with automatic stabilisers doesn’t always require a conscious decision by the government.

7 May 2012

Super Sunday (2) – Inconclusive in Greece

Yesterday’s Greek election delivered an inconclusive result, as many feared. With almost all votes counted, New Democracy (centre-right) has fallen to 19% of the vote from 33% three years ago and Pasok (centre-left) has crashed to third place with 13% down from 44%, behind the Syriza party (radical left), which is up to 17% from less than 5%.

On this basis, the two parties that supported the EU-IMF programme (ND and Pasok) would have 149 seats between them in the 300 member parliament, so would lack a majority to pass austerity measures required to unlock future tranches of the bailout loans. Even if they had a couple of extra seats, I’d wonder about the crisis of democratic legitimacy that an ND-Pasok coalition would engender – implementing further austerity with the backing of only 32% of voters (contrast with the 59% who voted for the UK’s two coalition parties in 2010).

A second election seems likely, but is far from certain to deliver a more pro-programme result. Indeed, if Syriza can win over around 131,000 voters out of the almost 1 million who voted for the next three anti-austerity left-wing parties (the Communist Party, Democratic Left and the fantastically-named Anti-Capitalism Left Cooperation for the Overthrow), then Syriza would overhaul ND as the first-past-the-post winner and benefit from the 50 bonus seats that the top-placed party receives – completely changing the context for the next parliament’s coalition negotiations and making a left-wing coalition much more likely.

A final note on Super Sunday. Buttonwood rightly points out that it is primarily this Greek result, rather than Francois Hollande’s win, that has riled the markets this morning. This of course isn’t to say market players are thrilled about Hollande. But we shouldn’t conflate the market implications of the Greek and French results, as some of the press coverage this morning seems to have done. The Greek election does raise serious questions about the sovereign’s solvency (even post-PSI) and perhaps the country’s euro membership.

France, though, will have merely unsettled people by promising a bit more political disagreement at a time of uncertainty when the markets are desperately seeking short-term stability. But if bond traders want stability, they should move to North Korea. My view remains that a more-balanced ‘good cop, bad cop’ dynamic between France and Germany may be a necessary condition for preserving the euro – and so the long-term outlook for the single currency may have been enhanced by the French voters’ choice.

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6 May 2012

Super Sunday (1) – It’s Hollande

Francois Hollande, as expected, has won the French presidential election run-off, with 52% of the vote.

In terms of first thoughts, I can’t agree with the Telegraph’s claim that this raises ‘fresh question marks over a eurozone break-up’.

The possibility of increased Franco-German divisions at the euro area’s top table are worrying some people. But the consensus seems to be that Hollande’s ‘renegotiation’ of the fiscal compact to favour growth can be done through compromises that don’t involve having to reopen the text of the treaty.

Indeed, I don’t fundamentally accept the claim that Franco-German divisions are a bad thing for Europe; diverse opinions can be a strength.

I still buy into Mark Leonard’s argument about Europe being a kind of modern-day political Hydra. To quote his example of how disagreements in Western Europe during the 90s led the post-communist countries to so radically reform their economies prior to their EU accession:

British and Nordic enthusiasm for enlargement in the East allowed the countries of Central and Eastern Europe to ‘keep faith’ as they embarked on painful processes of internal reform. At the same time, French doubts allowed the European Commission to exact concessions from them in the protracted negotiations for accession. The key feature of this ‘good cop, bad cop’ dynamic is that, even though the disagreements are genuine, the core objectives of all European countries tend to be the same […]

I think the euro area needs an equivalent dynamic to develop if it’s to convince the peripheral countries to reform their economies without dangerously eroding support for the euro among their voters and politicians – i.e. Hollande’s enthusiasm for growth, Eurobonds, etc, can allow the periphery to ‘keep faith’ in the single currency, at the same term as Merkel’s bailout scepticism extracts concessions from these countries to correct their fiscal imbalances and undertake needed economic reforms.

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6 May 2012

Are we already doing ‘Plan B’ in the UK?

Following the Q1 GDP data, there were calls from the usual politicians for the UK to switch to an economic ‘Plan B’ in place of the coalition’s planned fiscal consolidation.

Martin Wolf’s latest FT column (£££) makes a more nuanced version of the argument – in essence, that front-loaded fiscal consolidation is not credible during a recession, so pressing ahead will itself lead the market to question whether it’s politically possible to cut the deficit – and is worth a read. But it raises an interesting question for me.

Wolf points out that the government is already on course to miss its original fiscal targets set out after the election, but this hasn’t led the market to question our solvency:

Yet remember that when the chancellor announced his fiscal plans in 2010, net borrowing was supposed to be just £206bn between 2012-13 and 2015-16. In the March 2012 Budget this was up to £317bn. Did that colossal failure to hit his target destroy credibility and so lead to explosive increases in bond yields? No.

Entirely valid. But I would interpret this failure to hit the deficit targets slightly differently.

Remember, in a modern welfare-state economy, much of the fiscal stimulus during a recession comes through ‘automatic stabilisers’ (falling tax revenue, rising spending on unemployment benefits, etc) rather than conscious government actions. These can be important: note that the UK’s fiscal stimulus announced in late 2008 was meant to be a £20bn package, but public sector net borrowing actually increased by more than £80bn between 2008 and 2009, of which about £40bn was down to equity injections into RBS/Lloyds – so half of the non-bailout part of the increase in the 2009 deficit was not due to a conscious decision by the Chancellor.

And it’s these automatic stabilisers, rather than any deliberate relaxation of the government’s fiscal plans, that will have led to the changes in the fiscal projections in the next few years – reflecting the extent to which the economic environment (in the UK and abroad) has deteriorated over the last 6-12 months.

As a result of what we can call this ‘non-deliberate fiscal stimulus’, as Martin Wolf in fact separately points out on his blog, the path of the UK’s fiscal consolidation has actually now switched to something quite close to Alistair Darling’s original pre-election budget proposals:

Therefore, without the need for any deliberate decision by the coalition, can’t one argue that we’re already in the process of switching to a sort of ‘Plan B’ in UK?…

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5 May 2012

Three facts and a national accounting identity

I want to begin by stepping back from all the details and acronyms of the euro crisis –  LTROs, NCBs, ELA, SMP, EFSF and all the rest of it – and looking at some high-level macro facts.

This isn’t to suggest the details are unimportant. Far from it: I’m currently making a living out of understanding market and institutional details and how they influence events, so it’s in my interest to talk up their importance. But I think we should start out by understanding the big picture. So here are three macro facts that influence my overall view of the crisis.

Fact (1) – The euro area’s governments on average are less indebted than those of the US, UK or Japan.

The chart below shows general government net debt (historic and latest IMF forecasts) in the euro area, compared to the US, UK and Japan. You can see that debt levels in the euro area are the lowest of the four economies, which is in fact an improvement from pre-crisis relative to the US and UK.

Fact (2) – The euro area’s external balances are slightly positive, compared to current account deficits in the US and UK.

The chart shows that, overall, the euro area does not have a big current account adjustment to make relative to the rest of the world. In fact, the euro area exports to the rest of the world slightly more than it imports, in contrast to the US or UK.

The combination of (1) and (2) is the starting point for saying that the euro crisis is the result of a political coordination problem, not inexorable economic logic. If it were legitimate to analyse the euro area’s economy on a ‘consolidated’ basis – in the (implausible) extreme, if the euro area were to make the same decision as England/Wales/Scotland or New York/Texas/Florida, to become one big country – then the fiscal aspect of the euro crisis would disappear overnight (and with it, much – though not all – of the banking and growth crises that accompany it).

But such ‘consolidated’ analysis doesn’t make sense until the political coordination problem is solved. It doesn’t matter that the euro area’s net debt is a (relatively) healthy 68% of GDP when, for instance, three of its member states (Greece, Italy and Portugal) are individually liable for net debts of or above 100% of their individual GDPs. Which leads on to the third fact, concerning the scale of the imbalances that need to be addressed in the near future through further coordination.

Fact (3) – Within the euro area, Greece, Cyprus and Spain have  large fiscal and external imbalances still to address. Ireland also has a large fiscal (but not external) imbalance and Portugal has a large external (and medium fiscal) imbalance.

Let’s reflect on this for a moment. The current account matters because it tells us an economy’s reliance on foreign capital – since the flip side of a current account deficit is the capital account surplus to finance it (from the balance of payments identities).

The euro peripherals got into trouble in 2009-2010 because they’d been running large fiscal deficits (to some extent a consequence of the 2008 banking crisis) that they funded by issuing debt to foreign investors. When those foreign investors started to worry about the solvency of those governments, these foreign capital inflows would have ground to a halt and current accounts would have had to adjust immediately. Under a floating exchange rate, this would have meant a currency crisis and probable default on foreign-currency debts. Under a pegged exchange rate, this instead requires an adjustment in domestic imbalances – governments would have immediately had to cut spending and hike taxes to balance their budgets and remove the need to borrow from foreign investors, with wrenching effects on domestic demand (as in the euro-pegged Baltic states during 2008-2009).

But within the euro area, other mechanisms came into play (to briefly go into some of the institutional detail of the euro area). Specifically, EFSF-IMF lending to peripheral governments and Target 2 ‘lending’ by the Bundesbank to the peripheral national central banks (NCBs) took the place of some of the previous capital inflows. Bruegel recently published an excellent paper explaining how these official sources replaced foreign private investors after the ‘sudden stops’ in capital inflows to these countries.

Why does all this matter? Well, to wean themselves off official (EFSF-IMF and Target 2) support, Greece, Cyprus, Ireland, Portugal and Spain still have adjustments to make. But the first four of those countries only account for 6% of euro-area GDP. Frankly, the degree of political coordination needed for the other 94% to support them as they adjust really isn’t that great. And if some of those four countries were to decide to call it quits, the rest of the euro area should be able to continue pretty much okay without them. (Rather, it would be the exiting countries that are likely to suffer the most.)

Italy isn’t mentioned here for a reason: looking at the data, its fiscal deficit (3.9% of GDP – 70th largest in the world last year) and current account deficit (3.2% of GDP – 94th largest in the world last year) really aren’t that big.  Italy has a large stock of debt, which is concerning given low trend GDP growth (i.e. low growth in the ability to service those debts). But it can both address the slow-growth problem and correct the current account deficit through ‘low-hanging fruit’ reforms to labour and product markets, such as those being introduced by Mario Monti’s technocratic government (though Italy may need to rededicate itself to the Monti programme given recent signs of slippage).

This leaves Spain. Spain is where I think the real euro-area problem sits – the fiscal deficit is huge already and the government may face further costs to support the moribund banking sector. Meanwhile, unemployment is already at 24.4% and the economy is formally back in recession, yet the government somehow needs to reduce spending / increase taxes by a further 3.2% of GDP in this year alone to meet its 2012 deficit target of 5.3% of GDP. An EFSF package may be needed to recapitalise the banks or set up a bad bank to segregate their bad loans. Spain is certainly the big challenge to the future of the euro area.

And a national accounting identity

Even in the case of Spain though, there are reasons to think things aren’t quite as bad as they might appear. Look at how far to the left of the chart Spain is from the red dashed line that shows where the fiscal deficit equals the current account deficit. From the national accounting identities, we know that the current account deficit (X-M) is equal to the sum of private savings (S-I) and public savings (T-G) – in other words, for one sector (private, public or rest-of-world) to run a deficit, another sector must run a corresponding surplus. The fact that Spain’s 2011 fiscal balance (-8.5% of GDP) was so much worse than its current account balance (-3.7% of GDP) shows that the private sector is running a large financial surplus (+4.8% of GDP). This is the private sector deleveraging after its pre-crisis borrowing splurge, which contributes to the weak growth environment.

But as long as the private sector wants to run these surpluses, doesn’t it mean there is some sort of natural domestic buyer base for Spanish government debt? At the very least, Spain’s nowhere near Greece, where the ultimate source of funding for the 9.2% of GDP fiscal deficit last year was the rest of the world (the current account deficit was 9.7% of GDP) and so the government is entirely reliant on the generosity of the other euro members.

I’d be interested in other people’s thoughts. Spain clearly has a fiscal imbalance problem. But it seems to be under fewer pressures than other countries to rapidly eradicate its budget deficit, because it’s not actually as reliant as they are on foreign capital. And in fact, as long as the Banco de Espana is able to keep building up Target 2 liabilities versus other euro-area NCBs, isn’t Spain able to continue running modest current account deficits (albeit hopefully at a reducing rate), even in the face of a sudden stop in private capital inflows? And doesn’t this mean that in Spain’s case there is more scope for a ‘Plan B’ of, not a fiscal splurge, but at least a slower fiscal adjustment that need not further undermine an economy that’s already in recession? This is partly why I’m not quite as pessimistic as some people about the ability of Europe to sort its (i.e. Spain’s) mess out.

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5 May 2012

Introducing the ecoptimist

Hello and welcome to my blog – the ecoptimist.

In my job, as a macroeconomist based in London, we understandably spend a lot of time thinking about ‘tail risk’ scenarios of what could happen if the euro crisis goes nuclear. This is often to the detriment of considering ‘central’ scenarios in which Europe muddles through the crisis and sets up institutions that will make a repeat much less likely in the future.

From conversations over the last few weeks, I’ve started to wonder whether this focus has led some of my colleagues to lose sight of what a realistic scenario for the euro area might look like. The pessimistic focus of our work, along with a sometimes over-simplified 24-hour newsflow, frames the way that we view the wider outlook.

As a result, I know a lot of people who now expect – not fear as a tail risk, as I do, but actually expect as a central scenario – that the euro area will break up in the next few years amid economic depression, social unrest and nationalistic rabble-rousing.

But can that really be something to expect? In other words, does Europe really fail in 50% + 1 of the probability distribution of possible outcomes?

I think not. In fact, I’m cautiously optimistic about the longer-term outlook for Europe, albeit acknowledging that there will be bumps in the road over the next few months and years. I’ll elaborate on this in future posts. But suffice to say, I think that Europe’s problems are more about political coordination than inexorable economic logic – and I think these coordination problems are far from as insurmountable as many clever people assume.

Over the next few weeks and months then, I’ll try to back up this assertion (and others!) with facts, data and analysis, along with a healthy dose of quality economic news and research from across the web. These are certainly interesting times for Europe and the world – and I’m sure I’ll have plenty to talk about!

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