Reserved Place

Easing in

2011-11-06T15:25:00.001-08:00

A hazard of growing older is that some events that seem fresh and relevant in one's own mind mean nothing to the younger people that one increasingly works with. So it was last week, when RebelEconomist found his forthright initial reaction ("monumentally stupid") to the cut in interest rates by the European Central Bank (ECB) at the first Governing Council meeting chaired by its new president Mario Draghi quoted by a journalist without mentioning the historical context that gave rise to it. When RebelEconomist asked the journalist why he cut out the history, the journalist replied that, since he was only three years old at the time, he did not understand its impact. The purpose of this brief post is therefore to record the historical parallel that prompted RebelEconomist's critical reaction to last week's ECB ease.

The event that last week's ECB interest rate cut immediately brought to my mind was sterling's entry into the European Exchange Rate Mechanism (ERM) in October 1990.

Hopefully even relatively young readers are aware that the ERM was a system of exchange rate pegs, with some limited movement allowed in a band around each peg, between the pre-euro European national currencies, designed to provide a stepping stone on a path from freely floating exchange rates to an irrevocably fixed set of exchange rates that would render the introduction of a single European currency a formality. To maintain their currency's position relative to the other currencies in the system, countries were obliged to either intervene in the foreign exchange market, or if necessary, adjust their short-term interest rates. Short-term interest rate changes ought to affect a currency's exchange value by uncovered interest rate parity such that, for example, raising the short-term interest rate should generate an appreciation of the currency to the point where the probability of capital loss by depreciation balances the extra interest return. Given that Germany's economy was the largest in Europe, the ERM was de facto based upon the deutschmark, and since Germany's Bundesbank had a reputation for keeping inflation low, joining the ERM effectively imposed monetary discipline on its members. If a country ran a higher inflation rate than Germany for long, incipient pressure would develop in the foreign exchange market for its currency to depreciate relative to the deutschmark, and prompt a rise in that country's short-term interest rate to maintain its currency's position in the ERM, which could be expected to suppress its excess inflation.

The mistake that the UK authorities made when sterling entered the ERM was to cut the UK's official short-term interest rate ("base rate") immediately. At the time, given the ruling party's lack of enthusiasm for European integration, financial markets were sceptical about the UK authorities' motives for wanting sterling to join the ERM. It was not hard to see that, with the base rate, used by UK banks to set their mortgage rates, standing at 15%, the imperative for the politicians then in control of UK monetary policy was to lower interest rates. However, with inflation at 10.6% and rising, a base rate cut was difficult to justify without some offsetting factor such as a stronger currency. The British authorities apparently hoped that with ERM membership underpinning the currency, the base rate could be reduced substantially while strong sterling would hold down inflation.

This sceptical market view mattered, not because it represented some character judgement about the UK authorities, but because it shaped expectations about how the UK authorities would react according to the fate of sterling in the ERM, and hence how market participants would be inclined to reallocate money in response. In particular, the suspicion was that the British authorities would be unwilling to live up to their obligation to raise the base rate if and when sterling depreciation mandated it. If so, a sensible trading strategy in the event of sterling weakness would be to sell sterling in anticipation of soon being able to buy it back at a depreciated level after the UK authorities abandoned their commitment to the ERM.

Against such a background, the worst thing that the British authorities could have done would be to feed market scepticism by cutting the base rate hastily (unless a cut was mandated by sterling approaching the top of its band against one or more of the other ERM currencies). Unfortunately, that is exactly what the British authorities did. In fact, they announced a 1% cut in the base rate at the same time as they announced ERM entry, after financial markets had closed on Friday 5 October 1990, and therefore even before sterling had traded in the ERM. Although sterling did appreciate when markets reopened on the following Monday, by the end of the month sterling had depreciated below its peg to the deutschmark even with no further cuts in the base rate. The stage was set for a disappointing time for sterling in the ERM from the UK authorities' point of view, with sterling generally trading in the weak half of its ERM bands, preventing the base rate being cut below 10% despite a dramatic fall in inflation to under 4%, and culminating in the infamous Black Wednesday debacle of 16 September 1992, when despite a reported $27bn of foreign exchange intervention and a 5% increase in the base rate, the UK authorities were unable to hold sterling within its ERM bands and were forced to withdraw it from the ERM.

As a novice central banker at the time, the conclusion I drew from the ERM experience was that, if a change in monetary policy regime removes an obstacle to easing, even if easing can be justified, it is best not to ease at the first opportunity that the new regime presents, especially if the market suspects that the new regime might be softer on inflation. Better to show patience, and prepare the ground for a shift in the monetary policy stance. A delay of a month or so to skip at least one monetary policy meeting should not be a problem, because if the need for easing was that pressing, it would have no doubt been warranted under previous policy regime too.

A similar situation faced Mario Draghi last week at his first meeting of the ECB's Governing Council as ECB President. As an Italian, it was inevitable if perhaps unfair, given Italy's reputation for weak currency and large public debt, that Draghi's commitment to low inflation would be questioned (commenting on Draghi's candidacy for ECB President, the German newspaper Bild wrote "for Italians, inflation is a way of life like tomato sauce with pasta"), notwithstanding some hawkish comments he has made in recent months. In spite of this suspicion about his intentions, Draghi allowed, if not actively encouraged, last week's Governing Council meeting to cut the ECB repo rate – we are told that ECB monetary policy decisions tend to be decided by consensus rather than majority, so we can be sure that Draghi at least did not block the change. Worse, this decision came as a surprise to the market, partly since there was little sign of support for reducing the repo rate from the previous Governing Council meeting on 6 October – according to Draghi's predecessor Jean-Claude Trichet's account of that meeting in reponse to media questions, "the Governing Council found short-term interest rates to be low" - and partly because eurozone inflation presently stands at 3.0%, clearly above the ECB's target of "below but close to 2%". In view of the situation, I would say that Draghi's decision to cut the ECB repo rate last week was a tactical mistake. Draghi's action will have reinforced the market's suspicion that he will be relatively soft on inflation.

Fortunately for Draghi, the impact of his rash interest rate cut on market expectations seems to have been small – medium term (ECB presidents are appointed for a maximum term of eight years) euro area breakeven inflation rates, such as derived from five year German bunds, ticked up only a few basis points on the news. Nevertheless, such inflation expectations represent an average over a wide range of realisations of economic circumstances, and there may yet come a time when eurozone inflation is uncomfortably high, and to get it down Draghi might find it necessary to tighten monetary policy more than an ECB President who was believed to have a stronger commitment to low inflation.

Naked Hypocrisy?

2011-10-01T14:51:00.000-07:00

This is a post RebelEconomist really did not want to write, partly because he has an economic post to finish that keeps getting interrupted, and partly because he dislikes to see personal disputes aired on blogs, but RebelEconomist is angry, so here goes.

In the early, and perhaps more innocent, days of financial blogging, one of my favourite blogs was Yves Smith's Naked Capitalism, which I valued for its links to influential posts and articles elsewhere, and its somewhat more opinionated and entertaining posts than many other analytical blogs. In recent years, however, Naked Capitalism seems to have become increasingly polemical and less analytical, with a bias against bankers, advocates of conservative economic policy and creditors in general. Perhaps encouraged by this tone, Naked Capitalism's commentary has become more vitriolic and dominated by prejudiced, fixated, irrational and often long-winded ranters, with many of whom it is impossible to have a civil, constructive debate of referenced facts and counter-facts, logical arguments and counter-arguments. Even Yves herself, under the strain of the daily grind of the information gathering, writing and technical problems that she sometimes mentions, seems to have become increasingly defensive and curt with critical commenters. Nevertheless, I still do look at Naked Capitalism, and occasionally engageed in the comment discussion when I feellt like a bullfight – with myself as the matador, of course.

A particular feature of Naked Capitalism that began to disturb me was its advertising. Despite the blog's content being rightly critical of the amorality and recklessness of the financial industry, in the UK at least, Naked Capitalism often carried advertisements for some of the most predatory financial businesses. Not wanting to embarrass Yves, I first wrote to her by email three years ago to ensure that she was aware of the issue – manifested on that occasion in an advert for a leveraged property investment scheme – which I supposed might not be evident to her in the US. She thanked me for letting her know, and said that blocking such automatically-placed adverts was possible but would take some time. Therefore, when a year later I saw an advertisement for payday loans featuring an apparently carefree barefoot blonde, which looked incongruous alongside a post praising the Michael Moore film "Capitalism, a love story", it was apparent that Yves had failed to modify the selection of advertisements for her site, so I was less diplomatic and made a comment on the post, pointing out the danger of appearing to be hypocritical. In her response to my comment, Yves made the same point as a year earlier about the difficulty of blocking specific Google ads, and remarking that the income from the adverts was "chump change", which made me think "why not just do without it, then"?

Fast-forward two years, during which I had mostly held my peace about the continued appearance of sleazy finance adverts on Naked Capitalism, until last month, when I was catching up on posts I had missed during a period bereft of internet access, and came across a post attacking payday loans, accompanied by a banner advert for a payday loan firm. The post deplores annualised interest rates on US loans of up to 572%, while the annualised interest rate on a loan from the British firm advertised was 1737%! I left a (perhaps bad-mannered, in which case I apologise) comment on the post and emailed Yves a screenshot of the UK appearance of the post to show her the clash and invite a response to my comment (it being late in the comment thread by then). Again, despite Naked Capitalism having migrated from Google Blogger to WordPress since I first raised the issue, Yves cited the difficulty of rejecting particular adverts. I suggested she might be better to do without financial advertising in general, given that Naked Capitalism's advert placement service seems to select quite a few dubious ones for the UK at least. These also include adverts for IVAs (individual voluntary agreements between debtors and creditors to write off debt, which are very lucrative for the financial advisor arranging them and are therefore aggressively marketed in the UK, but by putting the debtor one step from bankruptcy, leave them in danger of losing their house if they fail to make the reduced repayments), penny stock investment schemes and even advice on using tax havens. Yves responded that she needs the advertising revenue to keep blogging. She justifiably noted that, given the content of her posts, no-one could consider her to be beholden to any of the advertisers.

While I believe that there is no question that the conflict between the content of such a post and its accompanying advertisement looks – and if benefit is derived from the advert is – hypocritical in some way, my mind is genuinely open about whether that hypocrisy matters or is unethical. First, we should be wary of making the tu quoque fallacy; that is, that doing something oneself should not make one's criticism of that action less valid. Second, it could be argued that such adverts are just rogues thrown up by a poorly-targeted advert placement service that should be tolerated for the revenue serving a good purpose that the adverts generate overall. Or even, that by taking money from payday loan firms and tax haven advisers for their adverts to appear next to posts trashing their business cunningly exploits their clumsiness to bleed and undermine them.

Although it would be foolish to accuse a blogger as obviously vehemently against sleazy finance as Yves of tailoring her content to ingratiate such advertisers, there will always be, I think, a danger of being seen to have a conflict of interest when writing opinions about business that is paying you. For example – this is for the sake of argument, not a serious accusation – this week, Yves did not include in her daily links a BBC headline story about the closure of 62 UK debt consolidation firms, for which prominent adverts regularly appear on Naked Capitalism as seen from the UK, on the grounds of their misleading marketing. A more realistic danger is that the author of a blog which makes money from adverts might be tempted to write more opinionated and controversial posts, in a more provocative style, to attract notice and stir up comment, and to post more often to keep readers checking the site, in order to increase traffic to generate more revenue. I have wondered whether this might apply to some other up-and-coming blogs that have begun to take advertising, such as Scott Sumner's Money Illusion blog, which has attracted a lot of attention lately for its radical and controversial monetary policy proposals.

Minded to write a post on the subject of advertisers and blogs myself to raise, in a detached way, these questions for discussion, I asked Yves (respecting the copyright claim which appears at the bottom of Naked Capitalism pages) for permission to use my screenshot showing the juxtaposition of her payday loan post and the payday loan advert to illustrate the hazard involved in accepting automatically-placed advertisements related to the subject of the blog. Despite having claimed to be content with the ethics of taking payday loan adverts, Yves did not give me permission to use the screenshot, questioning my motives for wanting to raise the issue - Yves seems to believe that RebelEconomist is some financial-industry-funded saboteur of blogs like hers. Yves also warned me that writing such a critical post would get me banned from commenting further on Naked Capitalism. Evidently, Yves is no longer as receptive to suggestions of hypocrisy as she was when she wrote in a July 2008 post "On moral hypocrisy", "In my book, a true friend is willing to tell you when you are off base, and that feedback is usually most valuable when you least want to hear it".

Anyway, to this I thought "no problem"; I did not see the post as a priority and would cross the bridge of being excommunicated from Naked Capitalism if and when I came to it. So yesterday, when Yves wrote a post about the hypocrisy of Friedrich Hayek and Ayn Rand (with which, by the way, I am in complete agreement) in calling for the abolition of Medicare and then using it themselves, I could not resist making a comment asking how Hayek and Rand's behaviour in criticising something that they took advantage of differed from Yves' own position on payday loan adverts. However, when I tried to do so, I found that my comment was blocked – I have apparently been banned from commenting on Naked Capitalism even before writing a critical post! I am therefore writing the post now, and being denied use of the screenshot, am providing my own version of Yves' antidote du jour instead for readers' amusement.

Right on TARGET

2011-07-06T09:21:00.000-07:00

RebelEconomist comes late to this debate, but since it appears to remain active, his views may yet be useful. For what it is worth, RebelEconomist agrees with Hans Werner Sinn's conclusions that the European Central Bank (ECB) is conducting a stealth bailout of the peripheral eurozone economies and that this bailout disadvantages German borrowers, although Sinn's explanation could have been better. The key point, which none of the articles on this subject read by RebelEconomist has made explicit however, is that, because the ECB has set apparently more lenient loan collateral standards than the market for the types of assets that peripheral countries' banks tend to hold, the eurosystem is effectively lending to these banks at a subsidised interest rate, meaning that the eurosystem has become the marginal lender that finances these countries' net euro payment outflows. At the very least, Sinn deserves kudos for raising to public attention such an arcane but significant issue, which had not occurred to RebelEconomist despite his interest in central banking.

In order to judge the arguments made by Sinn and his detractors, it is necessary to appreciate how a cross-border euro payment directly and indirectly affects the balance sheets of the various financial institutions involved. This may be seen by tracing the impact of a typical cross-border payment through the eurozone banking system. Since Sinn was criticised for associating these effects with current account imbalances, I would offer instead a simplified version of his example of an Irish farmer buying a German tractor, in which the payment is exactly the same as it would be for a capital account transaction arranged by the farmer to move his deposit from an Irish bank of questionable creditworthiness to a safer German bank. Suppose that instead of needing to borrow, the Irish farmer, being flush with EU milk subsidies, has enough cash in his bank account to pay for the tractor outright, and just writes a cheque in favour of the German tractor dealer (in the case of deposit flight, the farmer would open a German bank account and write himself a cheque).

This transaction would result in the farmer's Irish bank current account being drawn down and the same sum credited to the tractor dealer's German bank current account, while the Irish bank would make a payment to the German bank via the interbank fund transfer system that settles in their respective current accounts at their central bank.

In most monetary areas, both banks would hold their current accounts at the same central bank, and settlement would involve a simple reallocation of current account credit from the payer bank to the payee bank, with no change in the nature of the central bank's liabilities. In a regionally distributed central bank system, however, like the Federal Reserve System or the Eurosystem, banks deal only with their regional central bank. In this case, the counterpart of the decrease in the payer bank's current account balance, which represents a liability of its regional central bank, is a negative contribution to that central bank's cumulative position with the rest of the central bank system, while the counterpart of the increase in the payee bank's current account balance is a credit to its own regional central bank's cumulative relative position. In the Eurosystem, these relative positions are recorded as balances with the ECB in the interbank fund transfer system TARGET2 (Trans European Automated Real time Gross settlement Express Transfer system 2). In the absence of an existing cumulative position, the farmer's tractor purchase would generate a TARGET2 deficit at the Central Bank of Ireland and a TARGET2 surplus at the Bundesbank.

Because these bank current, or reserve, accounts at their central bank play a vital role in monetary policy operations, how banks accommodate interbank payments depends on how monetary policy is conducted in their currency area. Since these indirect effects are central to the debate stirred up by Sinn, an understanding of monetary policy operations is necessary to evaluate the arguments, so some principles and details relevant to the present discussion are explained here. Readers who believe that they are already familiar with monetary policy operations may skip the following four paragraphs. For a more complete non-technical explanation, refer to the first half or so of my "Easing understanding" post.

Positive balances in banks' current accounts at the central bank represent a secure and liquid asset and are known as "reserves". However, any interest rate paid on reserves is typically relatively low, and is not always paid on the whole balance. Banks therefore usually try to minimise their holding of reserves, subject to a constraint provided either by a ban on overdrafts or by a requirement to hold an amount of reserves representing some minimum fraction (in the eurozone, 2%) of deposits for regulatory reasons, leading banks to aim to hold on average a slightly higher level of reserves than the constraint to allow for the unpredictability of payment flows.

Monetary policy ensures that the aggregate stock of reserves held by the banks is as large as needed, and the banks distribute this stock between themselves via a money market wherein banks with surplus reserves lend to those with a shortage, typically for one day at a time. As any transaction between the banks and the central bank is also settled with reserves, the central bank can use designated transactions to adjust the overall stock of reserves. And because there is, other things equal, a one-to-one correspondence between the stock of reserves and the market-clearing interest rate in the money market (assuming a downward sloping reserves demand curve), the implication is that the central bank can also control that interest rate, and by arbitrage, short-term interest rates generally. In practice of course, central banks generally choose to explicitly set the interest rate rather than the quantity of reserves, as this approach best accommodates the impact of non-policy variations in reserves supply and demand, but note that this equivalence means that it is immaterial to the present discussion whether the central bank uses its transactions to set the stock of reserves or a money market interest rate (contrary to what some of Sinn's critics have argued). The type of transaction that central banks normally use for marginal adjustment of monetary policy is to trade debt; in particular to offer to lend to, or occasionally borrow from, the money market at a prescribed policy interest rate. These are known as open market operations (OMOs). In the eurozone, monetary policy is set by the ECB as the monetary area's central authority, but monetary policy operations are conducted by the national central banks. The policy interest rate is the ECB refinancing rate, charged on week-long loans offered in the ECB's weekly main refinancing operation.

Naturally, if there are significant disparities in creditworthiness between banks, the money market may make allowance for this by requiring less creditworthy borrowers to pay a higher interest rate to compensate lenders for the greater risk of loss. Alternatively, loans may be secured in the form of repurchase agreements (repos) to practically eliminate credit risk. To ensure access to such loans as needed, banks tend to hold some debt securities which are readily acceptable as repo collateral, notably government and government-guaranteed bonds. In a repo, the lender's objective is to take sufficient collateral to make the joint probability of the borrower defaulting and the collateral then being worth less than the value of the loan negligible. It follows that more collateral should be required if the value of the collateral offered is volatile and also that collateral with value that is positively correlated with the fortunes of the borrower is inferior. The conventional way of arranging this is to match the value of the loan with an amount of collateral valued using its market price reduced by some percentage known as a "haircut" specified for that type of collateral, with larger haircuts for collateral with a more volatile market price. Central bank lending is normally collateralised, allowing the central bank to set monetary policy by offering loans at a single rate to all counterparties without discrimination.

Although the importance of monetary policy means that OMOs tend to attract the most attention, the archetypal transaction between the central bank and banks is actually the supply of banknotes. While the aggregate stock of reserves is always greater than zero, in normal market conditions banknotes are by far the largest liability on the central bank's balance sheet, as banks draw down their reserves to pay for banknotes to meet customer demand. This demand for banknotes tends to be fairly stable, typically growing roughly in line with nominal economic activity. The result is that the central bank is structurally a net lender to the money market, regularly renewing its loans as they mature, which provides frequent opportunities to adjust interest rates. Simply renewing less than the full amount of loans maturing would usually be sufficient to adjust money market interest rates upwards; only rarely, between such opportunities, might the central banks need to borrow in the money market to adjust interest rates. As will be explained later, it is this structural central bank position as a lender to the money market that leads Sinn to argue that the size of the "stealth bailout" is limited, on the presumption that the ECB would be reluctant to become a large routine money market borrower.

The reader should now be in a position to appreciate the indirect effects of the payment generated by the Irish farmer's tractor purchase from Germany.

Assuming that the Irish bank had been managing its balance sheet to minimise its reserves holdings, in the absence of any other flows, the payment would leave the Irish bank with less reserves than it needs, because the drain on its reserves is equal to the contraction in its demand deposits and a bank's holding of reserves is typically a fraction of its deposits. The Irish bank therefore might be expected to borrow in the money market to replenish its reserves. The German bank, meanwhile, would be left with excess reserves. In the eurozone, although interest is paid on officially required reserves, no interest is paid on amounts in excess of this; the ECB does provide an overnight deposit facility, but this is intended for emergency use and, at present (since 13 May 2009), yields ¾% less than the refinancing rate. The German bank therefore might be expected to lend reserves in the money market to earn a return on its excess holding. Note, however, that the sizes of the Irish bank's shortage of reserves and the German bank's surplus, though still equal, are a little less than the value of the tractor, because the Irish bank has lost deposits and therefore needs fractionally less reserves than before, while the German bank has gained deposits and therefore needs fractionally more reserves.

Ideally, it might be expected that a bid for funds by the Irish bank at a slightly higher interest rate than generally prevailing in the money market (assuming, for the sake of argument, that money market loans are secured) reflecting its need for reserves, and an offer of funds by the German bank at a slightly lower interest rate reflecting its excess reserves, would be sufficient to ensure that the money market rebalances via a loan from the German bank to the Irish bank. In that case, the payments imbalance arising from the initial transaction would be largely offset by the opposite payment imbalance arising from the subsequent cross-border loan (note that interbank deposits are not subject to reserve requirements), without involving the central bank. From an Irish point of view, the contribution of the tractor import towards a current account deficit would be financed by a capital account surplus in the form of a private sector loan from Germany. Moreover, the contribution of the initial transaction to the Irish and German TARGET2 balances would also be largely reversed.

Since the onset of the financial crisis, however, eurozone money market conditions have not been ideal. The creditworthiness of Irish banks was in question right from the beginning, meaning that their money market counterparties became extra careful to ensure that loans to them were well collateralised. In an attempt to reassure lenders to Irish banks and forestall deposit flight, the Irish government fully guaranteed Irish bank liabilities. Naturally, this undermined the creditworthiness of the Irish state itself, initiating a series of downgrades by the credit rating agencies which prompted the money market to require larger haircuts on Irish government and government-guaranteed bonds pledged as repo collateral. Unfortunately, despite the progress towards an integrated eurozone capital market, there is still a home bias in banks' bond holdings in favour of their own country's government and government-guaranteed bonds. For Irish banks, this has meant that the main repo collateral that they are able to provide is not only less valued in the money market generally, but also less acceptable from them in particular, because its credit risk is positively correlated with their own.

For whatever reason, the ECB treated the financial crisis as a liquidity problem, and chose to continue accepting Irish government and government-guaranteed debt as collateral on much the same terms as before, as if private sector concern about Irish creditworthiness was exaggerated. The result has been that, for any given refinancing rate, the ECB is the least demanding lender in the eurozone money market in terms of collateral requirements to Irish banks. Irish banks have therefore made heavy use of ECB refinancing operations to replace deposits drawn down either by payments for net imports like tractors, or by capital flight. And in the face of this removal from the money market of a natural borrower of their excess reserves, German banks have instead tended to run down their excess reserves by not fully renewing maturing ECB loans. Consequently, TARGET2 payments from Ireland to Germany have on the whole not been offset by payments of loan capital in the opposite direction, implying a growing Irish TARGET2 liability and a growing German TARGET2 claim.

Of course, Irish-German transactions are just one example; the same process has led to generally negative contributions to TARGET2 balances in other peripheral eurozone countries with relatively poor bank and state creditworthiness, notably Greece and Portugal, and generally positive contributions to TARGET2 balances in other countries with payments surpluses such as Luxembourg (which, for its size, has a large banking industry) and the Netherlands. In the absence of a full recovery from the financial crisis, this has led over time to the large TARGET2 imbalances highlighted by Hans Werner Sinn. By offering payment deficit countries' banks loans on terms that do not, if market expectations are rational, fully reflect their higher credit risk, the ECB is effectively subsidising payment deficit countries' borrowing and, since the ECB also provides an alternative outlet for the increases in reserves generated by payment surpluses in other countries, the ECB has become a kind of central counterparty for the eurozone money market, intermediating many of its cross-border loans. The home bias of banks' bond holdings means that to some extent these ECB-intermediated loans are also indirectly funding payment deficit country governments, which also find it difficult to borrow in the international capital market at acceptable interest rates because of their own perceived poor creditworthiness.

As Sinn and other commentators on this issue have noted, interest at the ECB refinancing rate is payable on TARGET2 liabilities and paid on TARGET2 claims, but this is should not simply presumed to be the consolidated national (ie public sector, including the central bank, plus private sector) return for the countries involved. The designers of European monetary union were scrupulous to ensure that the revenue derived from supplying the monetary base (ie reserves plus banknotes) is pooled and shared out between the national central banks following an agreed formula, rather than according to where banks choose to be formally established (and hence which national central bank they deal with), and the geographical vagaries of the demand for banknotes. According to Article 32 of the Statute on the European System of Central Banks and the European Central Bank, the sum of the national central banks' "monetary income" (ie seigniorage) derived from "assets held against notes in circulation and deposit liabilities to credit institutions", less interest paid on reserves and operating costs, is "allocated to the national central banks in proportion to their paid up shares in the capital of the European Central Bank" (ie the "capital key"). For the purposes of this redistribution, the national central banks are required to "earmark" their monetary assets and liabilities according to ECB instructions which specify that positive and negative TARGET2 balances should be counted as monetary assets and liabilities respectively. The monetary income received by a national central bank is therefore independent of the size of its own TARGET2 balance and the interest rate on that balance. In fact, the consolidated national returns on payment imbalances derive from the way in which they are accommodated by private sector banks. Because the payment deficit bank and the payment surplus bank reset their reserves position by borrowing more and less respectively in the ECB refinancing operations, the return to their adjustments is indeed the refinancing rate. As explained above, however, the size of these adjustments is fractionally smaller than the size of the TARGET2 balances because of reserve requirements.

Although the payment deficit countries may pay the same interest rate on their ECB-intermediated borrowing as the payment surplus countries earn on their ECB-intermediated lending, the poorer creditworthiness of the payment deficit countries means that, for them, the ECB refinancing rate is lower in risk-adjusted terms. In the absence of any major bank defaults in the payment deficit countries so far, the subsidy provided by the ECB has been in terms of the expected cost of the credit risk it is bearing without compensation. It is therefore important to know where that risk ultimately lies. As now seems to be well understood by all the participants in this discussion (if it ever was misunderstood), because any losses sustained on ECB OMOs are, like the revenue they raise, shared between eurozone countries according to the capital key, the subsidy is effectively provided by the whole eurozone rather than just the payment surplus countries like Germany. In practice, however, payment surplus countries' share of any losses is likely to be slightly higher than their capital key, because in the event of a major loss, the most vulnerable payment deficit countries might well be unable to bear their share of loss without triggering their own default.

Does the present configuration of TARGET2 balances represent the "ECB's stealth bailout" of the payment deficit countries as Sinn contends? Though a bit polemic, the description is not unreasonable. Firstly, ECB lending is shielding those countries from the full market cost of their accumulated payments deficits. Without ECB lending, to cover its payment deficit in the eurozone money market a country like Ireland would have to sell assets to foreigners at whatever price can be obtained, such as long-term debt or even gold reserves as suggested by Sinn, either to generate incoming euro payments or to raise money to buy safer collateral to support its money market borrowing. This effective increase in the interest rates faced by that payment deficit country would be expected to reduce its domestic demand, for instance for tractor imports, and thereby choke off its payment deficit. And the present ECB policy is not simply a case of monetary easing in response to overall eurozone economic conditions helping the weakest regions most. Because the ECB is more willing to accept the payment deficit countries' government and government-guaranteed debt as loan collateral than the market, and because such debt tends to be disproportionately held by domestic banks, the ECB is effectively charging these banks a preferential risk-adjusted interest rate, in violation of (at least the spirit of) the principle that "the Eurosystem’s monetary policy operations are executed under uniform terms and conditions in all Member States", as stated in Chapter 1 of the Guideline of the European Central Bank. Secondly, while probably not deliberately so, this is also arguably a stealth bailout, because it derives from a technical decision to relax the collateral standards ostensibly for all OMO counterparties rather than accept the implications of lower credit ratings, and the details of how the bailout works are manifestly (ie judging by the protracted debate raised by Sinn) difficult to understand.

Sinn is also correct that the diversion of ECB refinancing towards payment deficit countries is constraining credit creation in Germany. German banks are not constrained in their access to as much base money as they want at the ECB refinancing rate. However, this interest rate is set to meet an inflation objective for the whole eurozone, so to the extent that the relaxation of the ECB collateral rules marginally eases monetary policy in the payment deficit countries, monetary policy must be marginally tighter elsewhere. In other words, the refinancing rate is set higher than it would be if no collateral concessions were made to payment deficit countries. This, given the one-to-one correspondence between the money market interest rate and the stock of reserves, implies less credit creation in Germany. However, considering the present divergence of the strength of economic activity between the payment surplus countries like Germany and the payment deficit countries like Ireland, somewhat tighter monetary policy in the payment surplus countries may well be appropriate.

And as Sinn argues, the size of the stock of ECB refinancing does constitute a restraint on the total size of the TARGET2 deficits. Once the payment surplus country banks have paid down their entire initial share of the stock of ECB refinancing (the liability counterpart to their required reserves then being customer deposits only), it ceases to be possible for them to invest the reserves inflow from payment deficit countries any further in this way. Although the ECB's overnight deposit facility in theory provides an unlimited interest-bearing outlet for excess reserves, the low interest rate offered on such deposits could be expected to prompt payment surplus country banks to either resume lending to payment deficit countries at interest rates they will accept or even to deter unprofitable potential depositors by measures such as by raising bank charges. Either response could be expected to slow the increase in TARGET2 imbalances. Naturally, if the ECB provided a more competitive deposit facility, such as by offering fixed-term deposits at interest rates close to the refinancing rate, this restraint on the TARGET2 imbalances would be removed. Indeed, to meet any further expansion in the payment deficit countries' borrowing at the refinancing rate without easing monetary policy, the ECB would have to borrow money from somewhere.

Finally, assuming that the present chronic TARGET2 imbalances are problematic because the obscure subsidy involved is undesirable, how can they be constrained? Clearly, in a monetary union, inter-regional payments cannot simply be suspended. The most suitable measure would be to withdraw, perhaps in stages, the borrowing subsidy that sustains the imbalances – that is, to bring the ECB's collateral standards in line with those in the market. Thereafter, to avoid a renewed build-up of risk in future, some soft limit on TARGET2 deficits, say as a percentage of national GDP, could be set, beyond which a national government is expected to take some action of its choice to inhibit further increases in its country's deficit. If the burden that this would involve is considered unreasonable for any particular payment deficit country to bear, it would be more appropriate for the rest of the eurozone to explicitly either grant that country's government the money to solve its problem by, for example, recapitalising its banks, or lend that government (more) money at clearly subsidised interest rates, such as via the European Financial Stability Facility.

Addendum on July 12th 2011

To make the relationship between TARGET2 payments and the adjustment of banks' usage of ECB refinancing operations clearer, a numerical example of the changes in the balance sheets of the institutions involved may be helpful. Continuing with the example of an Irish-German interbank payment motivated by either a tractor purchase or deposit flight, Figures 1 to 3 below show the balance sheets of the Irish payer bank, the Central Bank of Ireland (CBI), the German payee bank and the Bundesbank at various stages in the process. Figure 1 shows the situation before the payment is made, Figure 2 shows the effect of the payment alone and Figure 3 shows the balance sheets after the banks have adjusted their reserves position to accommodate the payment. In practice, since day-to-day overdrafts at the central bank are not normally permitted, banks would adjust their reserve position at the same time or even in anticipation of the payment being processed, so Figure 2 is somewhat hypothetical, except perhaps briefly intra-day.

The figures in this stylised example may be taken to be in some notional monetary unit like billions of euros. The German bank and central bank are, in balance sheet terms, about twice the size of the Irish bank and central bank. In the example, the interbank payment represents half of the existing stock of deposits held at the Irish bank. For simplicity, it is assumed that no TARGET2 balances exist before the payment is made. Both private sector banks and central banks have some equity which is invested entirely in securities which could be used as loan collateral as necessary. The only type of monetary asset held by central banks is refinancing loans to the banks. Although banknotes may have originally entered circulation by being purchased by the banks to meet customer withdrawals from their deposits, and were paid for at the time out of the banks' reserves borrowed from the central bank, it is assumed that all banknotes are now held by the public. The banks are subject to a reserve requirement of 20% of their deposits. In case it is not obvious, "secs" is securities, "depo" is deposits, "refi" is ECB refinancing loans, "res" is reserves and "o/d" is an overdraft in a bank's current account at the central bank.

Addendum on December 9th in reply to umarmung: Why debt default need not necessarily lead to euro exit

On 16 November, in response to a comment I made on Olaf Storbeck's Economics Intelligence blog, commenter umarmung asked why I believe that Greece could remain in the eurozone after defaulting on its government debt, and whether banknotes can provide an unrestricted channel for capital flight, as suggested in an FTalphaville post. Since my answer became quite long as I considered it, and since it may interest others who might not read the comments, I include it here as an addendum, rather than in the comments.

Thanks for your appreciation and good questions, umarmung. Sorry to be so slow to reply to your comment. I needed to re-read the information on the inter-regional settlement and banknote management arrangements in the eurozone before I could have confidence in my opinion.

The reason why I say that a eurozone member country which defaults on, or more realistically, restructures its government debt need not give up the euro is that such a credit event does not necessarily disrupt that country's participation in the euro payment system, including inter-district settlement via TARGET2. As described in my post, any change in a country's TARGET2 balance is matched by an incipient change in the reserves liability position on its central bank's balance sheet (Figure 2 in the post). For private sector banks, reserves are an asset, which banks collectively obtain from their national central bank by selling debt (ie borrowing) secured by pledging a sufficient amount of eligible collateral to make that debt effectively credit-risk-free. It follows that TARGET2 balances are credit-risk-free. For example, if trade drains euros from Greek banks to German banks, the TARGET2 liability incurred by the Bank of Greece displaces some of its reserves liability, but the assets exchanged for the displaced reserves remain. As long as the ability of a country's banks to find sufficient eligible collateral to obtain reserves as needed is not impaired by their government's default, that country can remain a fully functioning member of the eurozone. In principle, a eurozone government default need not threaten its country's membership of the eurozone much more than the bankruptcy of one its largest private sector companies.

In practice, however, because of the home bias of EU banks' government bond holdings, especially in the peripheral eurozone countries most at risk of default, a government default is likely to substantially depreciate, if not wipe out, the value of the collateral that its country's banks normally provide for central bank loans. Nevertheless, it may still be possible for the country's banks to carry on making euro payments. If a bank has sufficient capital to cover the loss on its government bond holdings, it may be able to supply supplementary collateral to top up the cover for its loans from the central bank. If the bank cannot provide sufficient new collateral, and cannot repay its loans from the central bank, the central bank is supposed to be able to liquidate the collateral already given by the bank to recover what it owes. Unfortunately though, the ECB's failure to tighten collateral standards and haircuts enough to reflect the true risk of eurozone government defaults means that the central bank is likely to suffer a credit loss in the event of bank failures triggered by a government default. This loss is shared by all the eurozone members in proportion to their capital key, but since the loss is then a bygone, there is no reason why the defaulting country's surviving banks should not continue to use the euro. Government defaults tend to be selective such that the government concerned keeps making some priority payments, and unlike companies, bankrupt governments are not liquidated, so that, if a defaulting government is determined that its country should remain in the eurozone, it may nevertheless be able to find the resources – eg by using its gold and foreign exchange reserves – to recapitalise its banks to allow them to replenish their stock of eligible collateral if necessary.

Of course if, regardless of such mechanisms, depositors do associate government default with withdrawal from the eurozone and the introduction of a weaker national currency, a growing likelihood of default can be expected to prompt capital flight from nominal assets like bank deposits. In that case, the banks have to find sufficient collateral to allow departing depositors to be paid off as long as the run lasts. How much money is required to ride out this run depends on the stock of bank deposits, the proportion of them which are demand or maturing deposits, and how long the run persists. Naturally, if the banks run out of sufficient eligible collateral and even the government cannot provide more, then in effect, the whole country, and not just its government, is bankrupt. Even then, the country could continue using the euro with exchange controls that restricted the value of outgoing euro payments to no more than the value of incoming payments.

I think the issue of banknotes is a red herring. As Clemens Jobst describes in the VoxEU column mentioned by lostgen above on 22 July at 01.04, the balance sheet effects of inter-district fund transfer by banknotes are very similar to those of deposit flight cleared through TARGET2. The small difference is that, instead of a TARGET2 liability (assuming no previous TARGET2 balance), the central bank of the country suffering capital flight, say Greece, incurs an extra liability to the eurosystem to add to that country's allocation of eurozone banknote circulation (equal to its capital key multiplied by 0.92 to allow for 8% of the banknote circulation to be allocated to the ECB itself) to reflect the fact that that central bank has issued more than its share of the eurozone's banknotes. Unless these banknotes are paid into commercial banks, and in turn into central banks, elsewhere in the eurozone, an offsetting adjustment – in their case an asset – appears on each of the other eurozone central banks' balance sheets in proportion to their banknote allocation key. If all the banknotes are paid into the banks and then the central bank of one eurozone country, say Germany, and redeemed, the resulting reduction in that country's net banknote issuance means that its central bank acquires the whole of the offsetting claim on the eurosystem on its balance sheet. I certainly think that the idea given in the alphaville post you mention that "Greece could theoretically continue to issue unrestricted amounts of euro banknotes" to effectively sustain eurosystem funding in the face of capital flight is wrong. Just as they lose reserves when making an inter-district payment via TARGET2, banks have to pay in reserves for the banknotes that they draw, and would still need to pledge eligible collateral when borrowing from the Bank of Greece to replenish those reserves.

It is of course true that, if the ECB permits the government bonds of a dangerously indebted or even defaulted country to be pledged as collateral in eurosystem money market operations, that country can fund itself effectively without limit via the eurosystem by selling its government bonds to its banks which then borrow from the eurosystem using these bonds as collateral at their national central bank. But this would clearly be an abuse of the eurosystem which the other members would be foolish to allow to progress very far, and could stop by either capping or suspending the acceptability of the offending country's bonds as eligible collateral.

Hopefully that explains my remark on Economics Intelligence and answers your questions satisfactorily.

Principals of subsidisation

2011-04-03T15:43:00.001-07:00

When RebelEconomist went to work in the City (of London) in the 1980s, an important perk of most UK financial jobs was a subsidised fixed-rate mortgage. In his case, this benefit was evaluated as the difference between the mortgage rate actually paid to the lender and a specified concessionary fixed rate, and paid with the employee's monthly salary. The lender was not my employer; at the time, this scheme had recently replaced another in which they lent directly to employees at a low fixed rate. For my employer, the new scheme had the benefits of divesting retail lending, which was not their normal business, and detaching them from the loan so that the benefit could easily be terminated without recovering the loan principal if the employee left and limiting their need to be involved in the event that the employee defaulted on the loan. It strikes RebelEconomist that this kind of approach would be a sensible way to tackle the eurozone debt crisis, and he was surprised not to see something similar suggested in the discussion around last week's European Council meeting in Brussels to consider measures to deal with this debt crisis and prevent repetition. This post explains how such an interest rate subsidy offers a better way of tackling the eurozone crisis than the ideas that have been more commonly discussed so far.

While the causes of the eurozone crisis vary over the countries affected, and in some cases stem from private sector uncompetitiveness or indebtedness, the immediate problem the eurozone crisis presents is a sovereign debt crisis. In some countries like Greece, it was the government itself that had accumulated an excessive amount of debt, although to some extent this reflected a weakening of business activity caused by rising domestic input costs and the depressing impact of the global financial crisis on international trade, resulting in decreased tax revenue and increased welfare payments. In other countries like Ireland, the government had been fiscally prudent, but their private sector had borrowed excessively, and to forestall the turmoil of widespread default during the financial crisis, the government chose to either borrow to bail out the private sector or else effectively take over its debts by guaranteeing them. Naturally, any increase in the loan demand from a particular borrower tends to raise the interest rate that the borrower must pay to raise new loans and refinance existing loans as they mature, but debt crises typically also involve a vicious circle as the additional interest expenditure increases the danger that the borrower will at some point be unable or unwilling to keep servicing its debt, prompting an increase in the risk premium payable on that debt. A debt crisis also decreases the market value of any existing fixed interest rate loans made to the borrower concerned and hence increases the implied market yield on that debt, but, before this debt matures, this is a bigger problem for its holders than the borrower.

A standard benchmark interest rate for sovereign debt sustainability is provided by the expected nominal GDP growth rate of the economy – to the extent that the average interest rate paid on the stock of debt exceeds this level, the country must run a primary (ie not including the interest outlay itself) budget surplus just to hold the debt stock at a steady proportion of GDP. If the country fails to achieve a primary surplus this large, its debt burden (as a proportion of GDP) grows exponentially. Depending on a country's perceived maximum politically-feasible budget surplus and expected economic growth rate (allowing for the fact that fiscal tightening tends to depress economic growth in the short term at least), there will be an interest rate above which the country is effectively excluded from the debt market, because borrowing at such rates makes default practically inevitable. For Greece and Ireland, this critical interest rate has been considered to be about seven percent.

Notwithstanding the so-called "no bailout" clause in Article 125 of the Consolidated Treaty on the Functioning of the European Union (TFEU), which stipulates that "the Union shall not be liable for or assume the commitments of...any member state", the more creditworthy eurozone countries are willing to help its more indebted members for various reasons. Ostensibly, the justification for such support may be that one eurozone sovereign default might trigger a cascade of defaults as alarmed investors shun other marginal countries' debt, potentially resulting in the break-up of the eurozone if defaulting countries reintroduce their own, devaluable, currencies. Such a motive has always been arguably consistent with the provision made in Article 122 for "Union financial assistance" to a member state in "difficulties...beyond its control", but it is now specifically permitted by Article 136, which was amended at the December 2010 European Council meeting to allow eurozone member states to establish a "stability mechanism...to safeguard the stability of the euro area as a whole". In reality, the more creditworthy countries may also be acting in their own self-interest because their banks and pension funds are the troubled countries' creditors.

An obvious way for the creditworthy countries to help the indebted countries is to reduce their interest rate expense. The creditworthy countries could achieve this either by lending them money at sub-market interest rates or by paying the indebted countries compensation for their excess interest costs, but it is conceivable that just credibly showing the willingness to support the indebted countries in some way may be sufficient to cut out the vicious circle that raises the risk premium on their debt, in which case actual assistance might not be needed. To date, as far as RebelEconomist is aware, every assistance scheme that has been used or suggested involves the creditworthy countries lending to the indebted countries directly or indirectly via supranational lending institutions, and thereby taking on the risk that the indebted countries will fail to repay the principal they have borrowed.

Assistance from EU governments and the IMF has so far taken the form of emergency lending to the indebted countries in the event that the market cost of loans to them is deemed prohibitively expensive. The first eurozone emergency loan package was a €45bn three year loan facility for Greece, comprising €30bn in bilateral loans from the (then) 16 eurozone member states and €15bn from the IMF (and therefore partly representing a further indirect loan from all 27 EU member states as well as the other members of the IMF), agreed on April 23^rd 2010. Since this amount appeared to be insufficient and failed to stem the rise in Greek government bond yields, it was quickly enlarged to €110bn (split 80:30 between the eurozone countries and the IMF) on May 2^nd even before it began to be drawn down by Greece on May 12^th. A €750bn loan facility to cover subsequent eurozone emergency lending was introduced on May 9^th 2010. This comprises a mixture of loan commitments of up to €250bn by the IMF, €60bn from the European Financial Stabilisation Mechanism (EFSM) and €440bn from the European Financial Stability Facility (EFSF). The EFSM is a loan facility, provided by the European Commission and therefore backed by all 27 EU member states, which borrows the money it disburses in the international capital market (which it is readily able to do as the EU is rated as a triple-A borrower by the major credit rating agencies). The EFSF is a limited liability special purpose vehicle (SPV) owned and severally guaranteed by eurozone member states to 120% of its lending capacity (to ensure its own triple-A rating), which also funds itself in the capital market. On November 28^th 2010, Ireland became the first country to take a loan from this facility.

The EFSF is to be replaced in 2013 by the European Stability Mechanism (ESM), another SPV. Although full details have yet to be agreed, it is planned that the ESM will lend up to €500bn and also differ from the EFSF in that (1) its loans to eurozone countries will formally rank above other unsecured loans in the creditor hierarchy and (2) that it will be backed by capital rather than guarantees. Most of this capital will, however, be callable; the difference between callable capital and guarantees being that eurozone countries would be required to pay additional capital into the ESM as the likelihood of loan defaults rises, rather than after a default has occurred.

Enthusiasts for closer European union are wont to see a crisis like the present eurozone crisis as an opportunity to advance solutions involving increased integration. An example is the proposal to extend the EFSF/ESM SPV to borrow on behalf of all eurozone countries as a centralised funding mechanism issuing "euro bonds" and on-lending to each eurozone country as required. Depending on how this European Debt Agency (EDA) was capitalised and/or guaranteed by the eurozone member states and therefore rated by the credit rating agencies, and depending on whether different countries were charged different loan rates according to their creditworthiness, this scheme could be used to subsidise the borrowing of the less creditworthy countries like Greece and Ireland, at the expense of the most creditworthy like Germany and the Netherlands. However, there might be a collective gain if the EDA was able to issue larger and more homogeneous bond issues with a price premium reflecting their greater liquidity.

Another way of ensuring that a borrower is able to obtain funding at an acceptable interest rate is to buy up the borrower's existing debt in the secondary market to hold its market interest rate down so that the borrower can issue new debt at a similar yield in the primary market. In conjunction with the May 2010 IMF/EFSM/EFSF loan package, on May 10^th the ECB announced the Securities Markets Programme (SMP) to buy government debt of those eurozone countries with escalating yields, although the ECB somewhat incredibly presented the SMP as a measure "to ensure depth and liquidity...and restore an appropriate monetary policy mechanism". The details of the SMP regarding which countries' debt to buy, how much and at what yield triggers, are left to the discretion of the ECB's Governing Council, but all purchases are funded by reducing collateralised (ie virtually risk-free) open market monetary policy lending to the market in order to sterilise the SMP's impact on the monetary policy stance. Since the eurozone countries capitalise the ECB, the SMP is also effectively backed by callable capital from the eurozone states, and indeed the ECB subsequently did call for additional capital on December 16^th 2010.

To relieve the ECB, it has been suggested that the EFSF could buy troubled eurozone government bonds, either from secondary market counterparties or from the ECB to allow it to reduce its exposure to risk. Alternatively, the EFSF could lend to the indebted countries to allow them to buy back their own debt. Since this debt trades well below par in the secondary market, such repurchases funded by new loans would certainly reduce the nominal value of a borrower's outstanding debt, and if the loan from the EFSF is at a concession to market yields, the borrower's interest rate expenditure would also be reduced.

At an informal summit on March 11^th 2011, euro area heads of government concluded that the the EFSF and ESM could buy government debt in the primary market in exceptional circumstances. While this is effectively the same as direct lending to the borrower, if primary market intervention is done in conjunction with an issue partly sold or at least offered in the market, it can ensure that the interest rate charged bears some relation to market rates.

In general, these assistance operations are undertaken subject to various conditions imposed on the borrower which ought to make default less likely, but the problem remains that, once the capital has been committed either by being transferred or pledged as callable capital or by guarantee, it is at risk of loss. Direct lending only helps the borrower if the interest rate charged is less than the rate that the market would charge, and unless the lenders are prepared to incur some (expected) cost to themselves to help the borrower, lending at sub-market rates can only be justified from the lenders' point of view if market interest rates exceed the level required to compensate for the risk of default. Similarly, buying debt in the secondary market to hold the borrower's market interest rates down is only cost-free if the market price overestimates the probability of default loss. Considering that some respected analysts consider that Greece and Ireland at least are practically insolvent, despite being assigned credit ratings several notches above the minimum (S&P presently rate Greece as BB- and Ireland as A-), it is not easy to argue that their market yields are unrealistically high. And to the extent that buybacks raise the market price of debt, they give the existing holders of the troubled debt a way out of their exposure with a windfall gain (relative to the pre-buyback value of their holding). Naturally, debt market intervention means that market prices no longer provide an undisturbed guide to market expectations of default losses. Also, if a loan or buyback has proved successful at averting an immediate debt crisis and it is unlikely that further intervention will be required in the near future, having secured concessionary funding the borrower may be less motivated to maintain the austerity required to avoid default.

To RebelEconomist, it seems that a debt subsidy payment scheme like that offered by his former employer could both insulate the creditworthy countries from default losses and give them more control over the assistance they are providing to the indebted countries. Instead of making occasional large capital commitments as loans are disbursed or buybacks are executed, the creditworthy countries would make a stream of relatively small transfer payments to compensate the indebted countries for whatever is deemed to be the excess interest expense on new borrowing from the market. According to the scheme's objectives and constraints, in each case the concessionary interest rate might, for example, be set at a level believed to make the indebted country's debt burden manageable or to match the benefactor countries' funding costs. Given this concessionary interest rate, and the average yield on bonds similar to those to be issued, the size of these subsidising payments can be estimated from sovereign borrowing forecasts. For example, if Portugal is expected to issue €20bn of debt in the next year, and its excess (eg over comparable German bunds) market yield is deemed to be 5%, a payment of €1bn is sufficient to subsidise Portugal's interest cost arising from next year's issuance down to German levels (although of course such payments would grow as long as yields remained at crisis levels). Subsidy payments could be readily adjusted according to the progress of the programme for a particular indebted country, including being suspended if that country stopped servicing its debt or failed to comply with the conditions attached to the scheme, or more optimistically, its economic performance improved so that assistance was no longer needed. Since the subsidy can be curtailed at any time, such a scheme is arguably more in line with the no-bailout clause in the TFEU, because it does not involve the EU or any member state "assuming the commitments" of another member state. This controllability should also make a subsidy payment scheme more acceptable to the benefactor countries' electorates than lending to the indebted countries. Finally, because the scheme would not involve taking over credit exposure from the debt market, indebted country bond yields would serve as a better guide to investors' expectations of default, and loans would not be made at all unless they seemed likely to be repaid.

A likely objection to a subsidy scheme might be that it involves actual fiscal transfers from the creditworthy to the indebted countries, whereas loan capital and guarantees provided via supranational institutions like the ECB and the EFSF do not, but this would be disingenuous – unless market yields really do overestimate the probability of credit losses, loan capital and guarantees can be expected to generate losses in excess of any acceptable interest rate premium charged on EFSF/ESM loans over its cost of funding. Unfortunately, however, unless such probabilistic losses seem likely to be realised within the terms of office of the politicians deciding how to tackle the eurozone crisis, they are likely to be ignored.

Setting the record curved

2011-03-01T06:01:00.000-08:00

Although RebelEconomist has always been sceptical about the more alarmist views of the global economic slowdown, he was unconvinced by Reuters' columnist John Kemp's argument, as reported by FTAlphaville, that rising commodity prices indicate that there is little or no output gap at the global level. The explanation given by John Kemp is that a negative output gap does exist in the advanced economies, but is largely offset by strong growth in emerging economies such as China. And since FTAlphaville's bloggers were enthusiastic about the idea, and seem set to refer to it again and again in future posts, RebelEconomist presents his own analysis here, which shows that a more sophisticated time-series estimate of the output gap does suggest that an output gap exists at the global level.

Briefly, the output gap theory is that actual output can differ from the potential output given by the productive capacity of the economy, and that this gap affects inflation. Most commonly, actual output falls short of potential output, in which case the output gap is defined as negative, and producers tend to mark down prices in an attempt to stimulate more demand to take up the slack. Such situations typically arise from deficient demand, in response to which producers can leave some fraction of their capacity, including both labour and equipment, unused or under-used. Actual output can conceivably also exceed sustainable potential output by measures like paying workers overtime to take less rest and postponing routine maintenance of equipment, although producers' ability to do this is limited by the tolerance of their existing workers and equipment, meaning that such a positive output gap cannot grow large or last long. During such periods when the output gap is positive, producers can be expected to mark up their prices to recoup their additional costs, which naturally chokes off some demand.

For most countries, actual output is either counted directly or can be estimated reasonably accurately from related observations such as electricity production, but by its nature, unused productive capacity is harder to observe. Given good economic statistics and knowledge of the economy-wide production function, it is possible to deduce productive capacity from surveys of the factors of production including labour and capital. A less demanding and commonly-used method is to estimate the output gap from the time-series of observations of actual output. On the assumption that macro-scale economic capacity grows steadily, potential output can be estimated by fitting a trend to the path of output, perhaps excluding the observations covering dips in actual output associated with economic slowdowns, but not excluding the peaks if positive output gaps are considered negligible (indeed, sometimes the trend is obtained by fitting a curve through the peaks only). The divergence between that trend and actual output, or to be more precise in graphical terms, the length of a vertical (ie parallel to the output axis) chord between them, is then taken to be the output gap. During an ongoing negative output gap, which is unfortunately when interest in the output gap is likely to be greatest, potential output has to be estimated by extrapolating the trend to the end of the series, which is a more ambiguous procedure than bridging a trough in the middle of the series.

There are at least two weaknesses with this output gap approach to assessing inflationary pressure. First, the assumption that potential output varies smoothly seems heroic. Obviously, disasters such as war or earthquakes can wipe out large parts of industry at a stroke, but more subtly, productive capacity constructed and organised to suit a particular understanding of the state of the economy may be rapidly rendered obsolete if actual events falsify that view. The latter scenario is arguably applicable to the present post-financial-crisis period, with the crisis itself arising as people in various developed countries with current account deficits realised that the course of debt-financed consumption growth that they were on was unsustainable, not least in the face of growing competition for resources from the developing countries. This account has been popularised in the blogosphere by Arnold Kling as a "recalculation", but has roots going back at least as far as the "malinvestment" concept of the Austrian school of economics. Clearly, if the productive capacity of the economy can in fact undergo a sharp contraction, a trend-fitting approach will yield an overestimate of the (negative) output gap for such periods. In other words, the slowdown in economic activity would reflect structural factors rather than deficient demand, implying that any attempt to boost demand to take up the estimated spare capacity will just drive up prices. Second, the economy-wide relationship between the size of the output gap and its influence on inflation of the general price level may well be complex, perhaps allowing rising prices in some bottleneck industries, such as commodity production from Earth's finite resources, to coexist with reported spare capacity in other activities and hence in the economy as a whole.

In an expanded analysis emailed to Reuters' clients (which does not seem to be freely available on the web) John Kemp presented a chart of advanced, emerging and world economy industrial production from the monthly World Trade Monitor published by the Netherlands' Centraal Planbureau (CPB). From this, he inferred, apparently by visual inspection with some kind of linear extrapolation of the recent trend in mind, that emerging economy output is roughly on trend and advanced economy output is catching up, so that, as he put it, "for the world economy as a whole, the output gap is probably small or non-existent".

This inference is based on a kind of optical illusion. The chart of CPB industrial production data (to be precise, the volume of industrial production excluding construction, expressed as an index based on the average level of industrial production over the year 2000) is reproduced below.

Here, global industrial production is calculated as a weighted sum of advanced and emerging economy values, where the weights are given by their shares of world production in 2000, comprising 65.1% and 34.9% respectively. First, as is evident from all three time-series, while there are inflections in output growth, it is an essentially exponential process. This means that a linear extrapolation of the trend to the end of the series fails to capture the characteristic steepening of the trend as time progresses. When exponential trends are fitted to the relatively stable growth of all three series in the five years prior to the onset of the financial crisis (taken to begin with the demise of Bear Stearns in March 2008, hence the trends are fitted over the period March 2003 to February 2008 inclusive), as shown in the chart, it is clear that actual output remains divergent from trend right up to the end of the series (December 2010). Second, because emerging economies are growing faster than advanced economies (their fitted trends grow at annual rates of 9.5% and 2.5% respectively, with world industrial production expanding at 5.4%), the emerging economy trend is steeper at the end of the series, implying, for any given parallel separation between the trend and actual path of output, a longer vertical chord between them and hence a larger output gap.

By my reckoning, in December 2010, even the emerging economies had a (negative) output gap representing 16.7 output index units or 7.2% of trend output at that time, while for advanced economies the output gap was 17.6 output index units or 14.9% of trend. And naturally, when the smaller but nonetheless significant output gap in the emerging economies is weighted by their relatively small share of world production, it does little to mitigate, let alone offset, the larger output gap in the advanced economies, so that it is clear that a sizable output gap does exist at the global level. Based on the trend fitted to the world output time-series directly (rather than being constructed from a weighted combination of the trends for emerging and advanced economies), the output gap at the global level is 15.1 output index units or 9.7% of trend. In conclusion, while it is possible to debate the validity and significance for inflation of time-series output gap estimates generally, fitting a realistic trend to recent years' output observations for the advanced, emerging and world economies rather than judging the trend by eye, and carefully measuring the gap between that trend and the actual observations against the output scale, strongly suggests that an output gap does presently exist at the global level.

More like zip than ZIRP

2010-10-06T15:50:00.000-07:00

Yesterday's monetary policy easing by the Bank of Japan was presented in some press reports and blog posts as a return to the zero interest rate policy (ZIRP) that Japan tried from 1999 to 2000, and again from 2001 to 2006. No doubt the press were guided by the official post-decision statement, which described the policy as a "virtually zero interest rate policy". RebelEconomist is not convinced.

To be precise, the new policy is to guide the inter-bank uncollateralised overnight call rate to a range of "0 to 0.1%", compared with its previous target of "around 0.1%" maintained since December 2008. However, as footnote 2 of yesterday's statement states, the interest paid on excess reserves under the BoJ's complementary deposit facility (originally introduced in October 2008) remains at 0.1%. As described in detail in an earlier post here, paying interest on reserves effectively sets a floor to interest rates in the inter-bank market, because it pays any bank with a reserve account at the central bank to accept loan offers below the interest rate paid on reserves and deposit the money with the central bank. Depending on the significance of inter-bank market participants without access to remunerated reserves, transactions costs and operational constraints (such as timing differences between the close of the inter-bank market and the latest transactions allowed with the central bank), arbitrage should not permit inter-bank interest rates to fall much below the rate paid on reserves. And indeed, a US Federal Reserve study of foreign central banks' experience with remunerated reserves by Bowman, Gagnon and Leahy published in March 2010 found that since the complementary deposit facility was introduced in Japan, the overnight call rate had never traded below 8 basis points. This suggests that yesterday's BoJ policy change represents a negligible easing in terms of short-term interest rates.

There was also another easing measure announced by the BoJ yesterday. The BoJ undertook to purchase outright ¥5tn (about $60bn) of longer-term government and shorter-term private sector bonds including commercial paper (CP), asset-backed commercial paper (ABCP), corporate bonds, Japanese Real Estate Investment Trusts (J-REITS) and exchange-traded funds (ETFs), partly to reduce term and credit/liquidity spreads respectively, and partly of course to supply additional base money in pursuit of the lower overnight call rate target. Of this ¥5tn, "about ¥3.5tn" ($42bn) is to be allocated to government bonds and treasury bills, and only "about ¥1tn" ($12bn) to CP, ABCP and corporate bonds. Compared with the BoJ's existing holdings of JGBs (presently ¥80tn or $960bn), the outstanding stock of JGBs (¥734tn or $8.3tn as of end-June 2010), or the total size of the Japanese bond market (about $12tn or ¥1100tn according to the BIS as of end-March 2010, of which $9.8tn comprised JGBs) the planned purchases represent modest amounts. A rough estimate of the likely effect on yields of these additional acquisitions can be derived by comparison with the estimated effect of the Fed's treasury purchases under its own quantitative easing program, as the size of the US treasury market ($10.0tn at end-March 2010) is of a similar size to the (then) $9.8tn JGB market. According to a recent Federal Reserve discussion paper by D'Amico and King, the Fed's purchase of $300bn of treasuries in 2009 generated a sustained fall in mid-curve treasury yields of about 50bps. Assuming a similar impact of BoJ purchases on the JGB market, the $42bn JGB purchase announced yesterday could be expected to reduce mid-curve yields by about 7bps only.

Overall therefore, yesterday's BoJ easing move is modest, and may have been designed as much as a concession to the BoJ's critics in government and industry as an attempt to stimulate the Japanese economy.

We had to burn the euro to save it

2010-07-26T04:08:00.000-07:00

An edited version of the following commentary on the eurozone debt crisis appears in the latest edition of a magazine for official monetary and financial institutions and the original is posted here by kind permission of the publishers.

Faced with a sovereign debt crisis that threatened to spread from Greece to at least Portugal and Spain, between March 25^th and May 10^th of this year the eurozone authorities progressively relinquished various constraints designed to maintain the ECB's solvency and detachment from fiscal policy. While the authorities' aim was to avoid a collapse of EMU as members unable to remain competitive and service their debts in euros seceded from the monetary union to reintroduce their own national currencies, the adjustments threaten to undermine the real value of the euro by weakening the ECB's balance sheet and setting precedents for similar accommodation in future. After this U-turn, investor perceptions of the euro may never be the same again – the euro may remain the currency of most EU states, but as a unit diminished in value and reputation.

The euro was conceived as a hard currency. Part of the motivation for EMU was the desire of Germany's EU partners to emulate German post-war economic success, which owed much to a hard Deutschmark that drove German industry to seek real solutions to problems like the 1970s oil shocks, rather than the inflation and devaluation palliatives tried by other European countries; Germany itself would have refused to join any less rigorous monetary union. And until the present eurozone sovereign debt crisis, the ECB had largely followed the Deutschmark model. In its first few years, the ECB withstood scepticism about an initially weak euro, and resisted calls from politicians like Oskar Lafontaine to use (the short-run ability of) monetary easing to boost economic activity. Although the ECB did cut euro short-term interest rates in response to the early (US sub-prime) phase of the global financial crisis and offered eurosystem banks unlimited loans against private sector bond collateral for periods of up to a year, unlike the US Federal Reserve the ECB declined to drive inter-bank interest rates to practically zero or purchase such bonds outright for its own balance sheet. Indeed, until this year the euro was gaining ground as a reserve currency as the more accommodating stance of the Fed and the ongoing deterioration of the US net international investment position raised doubts about the future value of the dollar.

Unfortunately, the spreading of the financial crisis to the debt of eurozone governments, especially those of Greece, Ireland, Portugal and Spain, proved to be a sterner test of the ECB's resolve. These countries had got into trouble because, since adopting the euro, they had not taken advantage of its lower interest rates to reduce their borrowing while failing to reduce their labour cost increases in line with the lower inflation of the eurozone. Even countries like Spain which had not run increased public sector deficits during the good times came to face fiscal problems as their economies were depressed by private sector debt and uncompetitiveness. This situation poses an existential threat to EMU, because one way for a member of a monetary union to tackle such difficulties is to secede from the union and reintroduce a national currency that can be devalued to reduce the real value of domestic debt and restore the competitiveness of domestic output. Obviously, this is bad for the holders of that debt, and to the extent that secession of one country makes it seem more likely that others will follow, investors will demand higher interest rates to hold those countries' debt, encouraging them to secede and so on, collapsing the monetary union through a cascade of withdrawals. Understandably therefore, the ECB may have been more inclined to acquiesce to measures to hold down marginal countries' bond yields and to err on the easy side in monetary policy to minimise their incentive to secede from EMU.

The first concession made by the ECB was in the collateral requirements for its lending to eurosystem banks. These were set in terms of agency credit ratings, no doubt to distance the ECB from the task of differentiating between the creditworthiness of eurozone governments, with the inevitable consequence that a credit rating agency decision could render a country's debt ineligible as ECB collateral at an inconvenient time. In particular, the likelihood that that Greek government debt would be downgraded below the ECB's normal A- / A3 threshold threatened to restrict the ability of Greek banks to borrow from the ECB and would have removed a key benefit supporting the value of Greek government debt. On March 25^th, however, ECB President Trichet said that investment grade (ie down to BBB- / Baa3) debt would be accepted for an indefinite period. And then on May 3^rd, with the prospect looming that Greek government debt could even be downgraded to junk status, it was announced that Greek government debt specifically would be accepted regardless of its credit rating.

The most shocking climb-down by the ECB, however, occurred on the night of May 9/10^th, when in association with the creation by EU finance ministers of a €750bn emergency funding mechanism available to any eurozone country, which added to a €110bn conditional loan facility for Greece agreed on May 2^nd, the ECB announced an outright bond purchase programme. Since the ECB had previously consistently resisted appeals to follow the Federal Reserve, Bank of England and Bank of Japan in buying bonds to enhance monetary policy easing, this change raised questions about both the ECB's commitment to inflation and its political independence.

Although the ECB presented this Securities Markets Programme (SMP) as a technical initiative "to ensure depth and liquidity in those market segments which are dysfunctional.....to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism", the SMP does potentially compromise the ECB's ability to hold down inflation in future. The concern is not so much the money-creating effect of government debt purchases, as the ECB undertook to sterilise this by introducing a week-long deposit facility (actually, given an unchanged interest rate target, routine open market operations effectively provide automatic sterilisation anyway), but rather that the SMP effectively represents an additional source of funding for eurozone governments. It is normally undesirable for a central bank to lend to its government partly because that government may be tempted to borrow and spend more than otherwise in the knowledge that, if the volume of its debt sales disturbs the market, the central bank provides a backstop, and partly because the accumulation of potentially depreciating assets on the central bank's balance sheet may restrict the central bank's ability to sell enough assets to absorb excess money to counter an inflationary threat. For these reasons, Article 123 of (the updated version of) the Maastricht Treaty specifically prohibits the ECB from purchasing debt directly from eurozone governments, and buying government debt from the market to relieve a surfeit that is impeding sales of new debt arguably violates the spirit of this rule.

The fact that Trichet had denied that the ECB governing council had even discussed government bond purchases when questioned about this at the press conference following their monetary policy meeting on the Thursday preceding the EU finance ministers' weekend summit gives the impression that the ECB was influenced by the inter-governmental negotiation. Given that these discussions were apparently fraught, with French President Sarkozy reportedly threatening to withdraw France from EMU if an agreement including a sceptical Germany represented by Chancellor Merkel could not be reached, it is not hard to imagine that the ECB was pressurised to support the package.

The retreat by the ECB is particularly disappointing because it represents a missed opportunity for Europe to interrupt the sequence of bailouts that have characterised the financial crisis since the demise of Lehman Brothers in September 2008 and to differentiate the euro as a reliably hard currency even in adverse circumstances.

Allowing at least Greece to be driven to default or restructure its government debt – assuming that Greece could not adjust its finances to service that debt – before compromising the ECB's standards would have established the principle that, in the eurozone, an individual state can run out of money like a corporation, and that the risk premium on debt should be regarded as advance compensation for genuine risk of default. With Greece's reputation for misreporting economics statistics, tax evasion and generous public sector remuneration, there was relatively little support in the rest of the eurozone for a bailout of Greece, and given the size of the fiscal adjustment that Greece must make to avoid default even with the support of its €110bn conditional loan facility, Greece may yet default anyway. It would have been better for the EU to draw the line before, say, Portugal rather than Greece.

Many commentators claim that the eurozone authorities' real reason to bail out Greece was that so much Greek debt was held by eurozone banks that even restructuring was likely to impose sufficiently large losses to bankrupt those banks and reduce Europe's banking capacity enough to cripple its economy. If so, this was an unwise decision. First, bailing out a country means saving all its creditors, making it an inefficient way to protect banks. Second, unless banks are formally bankrupted, it is difficult to make full use of their shareholders' and junior creditors' money to absorb losses, making bank failure more costly for the taxpayer. And in Europe especially, bankrupting a bank need not involve disruptive closure and complete liquidation; it is easier to nationalise a failing bank in Europe compared with America where the public are more hostile to state ownership. As it is, the danger is that bank losses on sovereign debt are offloaded to the eurozone states, increasing their indebtedness and intensifying the pressure on the ECB for further accommodation. Ironically, in making concessions to abet the eurozone bailout of Greece to avoid a mythical banking meltdown, the ECB may find that it has opened a Pandora's Box.

On thin ice

2010-03-03T12:19:00.000-08:00

Introduction

RebelEconomist apologises, if anyone cares, for his lack of posts recently, which has been mainly due to computer breakdowns that made posting cumbersome. Fortunately, his new laptop has arrived in time for him to post about a financial issue that will hit the headlines again in the next few days, and on which most media coverage so far has been, in RebelEconomist's opinion as a former central banker who knows a little about the regulatory principles involved, misleading. That issue is the dispute over to what extent, and on what terms, Iceland should reimburse the British and Dutch governments for deposit insurance payments they made to depositors in the British and Dutch Icesave branches of the Icelandic bank Landsbanki after its collapse in October 2008.

A bill passed by Iceland's parliament providing for repayment on terms acceptable to the British and Dutch is to be put to a referendum of the Icelandic people on March 6th after Iceland's President Olafur Ragnar Grimsson refused to ratify it. If Icelanders reject the bill as expected, the dispute will escalate. Inevitably, the argument comes down to legal and financial technicalities, but perhaps because this particular case involves two relatively large countries claiming money from a small one, to meet the cost of a financial bailout when public sympathy for bailouts is exhausted, discussion in even the more analytical British newspapers, like the Financial Times, Times, Guardian, Independent and even the Daily Telegraph has tended to be superficial and sentimental. RebelEconomist therefore sets out his understanding of the issue here, and offers his own assessment. In his opinion, Iceland is morally obliged to pay, and the British (for brevity I will mostly refer to the dispute between Iceland and Britain only from here on, although I believe that the Dutch position is practically the same) have dealt with Iceland fairly if rigorously. As could have been expected when Iceland allowed its economy to become dominated by financial services provided by a few institutions, the failure of one of them left Icelanders with a disproportionately large mess for a small country to clear up. Although this burden is not impossible for Iceland to carry, there is a case for all the countries of the European Economic Area (EEA) to help, since the EEA single market regulations made a substantial contribution to the debacle. Whether or not readers agree with its conclusions, RebelEconomist hopes that this post can at least facilitate a more informed debate around the referendum by providing some relevant facts with links to sources.

How European deposit protection schemes work

In order to appreciate the basis for the British claim, it is necessary to understand how deposit protection schemes work, both in general and in the EEA in particular, so please bear with a couple of paragraphs of explanation.

When a bank fails, any creditor may make a claim on the residual assets of that bank like any other business, and as ordinary unsecured creditors, bank depositors rank towards the bottom of the creditor hierarchy. Depositors are, however, generally also protected to a limited extent by a deposit guarantee scheme, designed to pay them up to a set amount in lieu of their deposit quickly, without waiting for the outcome of the liquidation procedure (known as the "pay-box" function). The money that the deposit protection scheme disburses is typically raised from insurance fees on deposits, and in principle may either be drawn from a contingency fund built up in anticipation of defaults ("ex-ante" funding) or borrowed as required – from government if not commercially – and repaid from a levy on surviving banks ("ex-post" funding). In practice, a combination of ex-ante and ex-post funding is used, with a bias towards ex-post funding to avoid the more complex administration of a large standing fund and the need for banks to tie up assets in the deposit protection scheme. In such cases it would not be alarming for a large default to more than deplete the deposit protection fund. As it pays each depositor, the deposit protection scheme takes over, or in legal jargon, is "subrogated" to, their claim on the failed bank for the amount paid (although it may additionally assist the depositor by taking responsibility for pursuing the claim for the whole deposit and splitting any proceeds with them). Thereafter the deposit protection scheme has a claim which generally ranks on a par with the claims of any other depositors, meaning that it should receive a share of the liquidator's distribution to depositors in proportion to the value of its aggregate claim ("pari passu").

Under the rules of the EU's single market, extended by the EEA Agreement to EFTA countries like Iceland, banks established in one member country (described as their "home") are allowed to operate branches in any other ("host") country with minimal supervision from the host country bank supervisors. Host countries are obliged to accept that supervision by "competent" authorities in a bank's home country is satisfactory to check the solvency of the whole bank including its branches throughout the EEA. As a safeguard, however, stipulated in Directive 94/19/EC of the European Parliament and Council, any bank operating in the single market must be covered by a deposit protection scheme, which all member countries must ensure is provided in their territory (Article 3 of the directive). This scheme has to guarantee at least 90% of the aggregate deposits of each depositor in the same bank up to an amount no less than €20,000 (Article 7), regardless of currency or location, within three months of their deposits becoming "unavailable" (Article 10). A bank's home country deposit protection scheme covers its branches in host countries (Article 4.1), but with a view to promoting cross-border competition, the directive allows for branches to join a host country's deposit protection scheme where this provides a higher level of protection (Article 4.2). In such a case, the host country guarantee is supposed to supplement ("top-up") the home country guarantee, and should be charged for accordingly (Annex II).

What is the nature of the British claim?

Landsbanki was covered by the Icelandic Depositors and Investors Guarantee Fund (DIGF) guaranteeing 100% of each customer's deposits up to €20,887, and in addition, Icesave was a top-up member of the British Financial Services Compensation Scheme (FSCS), which until the Icesave collapse covered 100% of up to £35,000 per depositor. This meant that, when Landsbanki, and hence Icesave, was put into administration by the Icelandic and British regulators on the 7^th and 8^th of October 2008 respectively, the British authorities were bound to ask the Icelandic authorities (theoretically the FSCS would deal with the administrators of the DIGF, although in view of the importance to both countries the matter was raised to government level) for (1) payment within three months, of an amount equal to the lesser of either the value of their deposit or €20,887, for each depositor qualifying for DIGF compensation among the over 200,000 Icesave UK depositors, and, (2) on behalf of all UK depositors with a claim on the FSCS, a pari passu allocation of eventual Landsbanki liquidation distribution to all depositors and their representatives including the FSCS (not to mention the Dutch deposit protection scheme).

A common but misguided criticism of the British claim has been that it seeks to recover an excessive level of compensation that the British authorities unilaterally promised to UK Icesave depositors. Certainly, the FSCS guarantee for £35,000 was already more than double the DIGF guarantee, and, as they closed Icesave, the British authorities actually increased the guarantee to an unlimited amount for retail depositors. This action was taken with the aim of forestalling any runs on other questionable banks, in the light of Britain's experience of the run on Northern Rock the year before, which demonstrated the fragility and critical importance of depositor confidence. But note from the preceding paragraph that the value of the FSCS guarantee does not affect the size of the aggregate British claim on Iceland anyway, because the claims of the FSCS and uncompensated depositors have equal rank; as far as Iceland is concerned, the only difference is that the larger the FSCS guarantee, the more UK depositors claim through the FSCS rather than in their own right.

Note, however, that the size of Britain's claim does depend on the value of DIGF guarantee. Like the British, the Icelandic authorities chose, as Landsbanki collapsed, to extend their deposit guarantee to the entire value of domestic deposits – in their case including wholesale deposits too – to stabilise the domestic banking system. According to Directive 94/19/EC (its third "whereas" recital, to be precise), "depositors at any branches situated in a Member State other than that in which the credit institution has its head office must be protected by the same guarantee scheme as the institution's other depositors", a principle of non-discrimination enshrined in Article 4 of the EEA Agreement which states that "any discrimination on grounds of nationality shall be prohibited". Strictly, therefore, the DIGF ought to offer the same level of compensation to depositors in UK branches of Landsbanki as it did to domestic investors. The implication is that the British claim on Iceland is actually smaller than it could be, because the UK has a case to ask the DGIF (as opposed to the Landsbanki liquidator) for the entire value of all UK deposits in Icesave.

Many commentators have objected to what seems to be a demand on behalf of "greedy" depositors attracted by the relatively high rates of interest offered by Icesave and who should have associated this with greater risk. In fact, Icesave's attractive interest rates were attributed to its low operating costs as a largely online bank, and were not viewed with particular suspicion. Motivated again by the need to maintain confidence in the shaky banking system of late-2008, the British authorities began to settle compensation claims from depositors in British branches of Icesave within weeks of its closure, without waiting for money from the DIGF. This means that Britain is now asking Iceland for money to repay the British taxpayer, rather than to pay depositors. Not that the British taxpayer will escape anyway – even if Iceland pays what Britain asks, British taxpayers will still have to cover the cost of the British top-up component of Icesave depositors' compensation, and since the FSCS unlimited guarantee did not cover wholesale depositors like local authority treasurers, many of those taxpayers will have sustained uncompensated losses at local government level too.

How far can the State of Iceland be held responsible for compensation?

Unfortunately, when Landsbanki failed there was not nearly enough money in the DIGF to meet its guarantee obligations. While no official statement of DIGF assets at the time of the Landsbanki failure seems to have been made, its 2007 Annual Report showed a plan for the fund to reach ISK10.9bn during 2008, which would have been worth just €80mn or £62mn on the day that Landsbanki was closed (October 7^th 2008). This compares with Britain's claim on the DIGF alone for £2.35bn. Essentially, the Icelandic deposit guarantee scheme was ex-post funded, being mandated to hold just 1% of the Icelandic banks' average amount of guaranteed deposits over the previous year. In theory, the DIGF would have borrowed as much as required to compensate Landsbanki depositors, and recovered the money over time by raising the insurance fees paid by the surviving banks. In practice, this would have been hardly feasible, because Iceland's banking system was dominated by just three banks, Kaupthing, Landsbanki and Glitnir (each of which had a market share by assets of about 30%), meaning that the failure of one of them would leave a crippling burden on the other two even if they were not hit by the same problem. In such circumstances, a strictly privately-funded DIGF would have found a loan on commercial terms either unavailable or impossible to repay. The conventional assumption is, however, that deposit protection schemes have state backing, in the form of loans or loan guarantees if not government grants, in the event that the fund does not have the means to compensate depositors when called on. The British authorities therefore looked to Iceland's government to either fund the DIGF or provide it with a state guarantee to allow it to borrow enough money to provide its contractual level of compensation to Icesave depositors despite there being little chance of future deposit insurance fees from the Icelandic banking system being sufficient to repay that debt.

Some commentators have argued that, since the DIGF is supposed to be a private-sector-funded scheme, the State of Iceland cannot be held responsible for DIGF obligations. On this question, Directive 94/19/EC is ambiguous. It says (in its penultimate "whereas" recital) that "this directive may not result in.....member states.....being made liable in respect of depositors if they have ensured that one or more schemes guaranteeing deposits.....and ensuring the compensation or protection of depositors under the conditions prescribed in this directive have been introduced". Iceland undoubtedly ensured the introduction of a deposit protection scheme that promised to provide at least as much compensation as prescribed by the directive, but a scheme likely to require ex-post funding of compensation covering one third of the banking system by the remaining two thirds could not realistically be described as "ensuring" that level of compensation. It is true that no government commitment to back up Iceland's banks' deposit protection scheme existed when Icesave was rapidly accumulating deposits in 2006-7. But this absence of a formal government back-up is normal – it is understood that governments do not want to absolve banks from contributing enough to make their own deposit protection scheme robust, and, in Europe at least, a deposit protection scheme backed by a relatively wealthy state could be considered to give the banks it covers an unfair competitive advantage in attracting deposits (in the words of Directive 94/19/EC, it is "not appropriate" for deposit protection "to become an instrument of competition"). And Icelandic regulators never attempted to dispel the notion promulgated by influential advisers such as Moody's that the Icelandic banks would ultimately receive state support. To do otherwise would have disadvantaged Icelandic banks in the European market. Moreover, since deposit insurance exists primarily to deter runs on banks by reassuring the majority of depositors that their money is secure, the Icelandic banking system itself may well have been unstable or even unviable if depositors in Icelandic banks had believed that their protection was limited to the resources of a fund obliged to hold only 1% of insured deposits.

It has also been argued that it is not reasonable to expect a deposit scheme to cope with a collapse of the banking system it covers, as opposed to a single bank. In fact, the Q&A section of the DIGF website explains that if two banks (ie likely to mean about two thirds of the Icelandic banking system) became insolvent at the same time, a customer with deposits in both banks would receive compensation for both.

Nevertheless, as the problems facing the Icelandic banks became increasingly clear in Autumn 2008, various Icelandic government representatives were specifically asked whether the government would stand behind the DIGF and said that it would, namely Triggvi Herbertsson, an advisor to the Icelandic Prime Minister interviewed on the BBC Radio Moneybox programme on October 4th and Jonina Larusdottir of the Ministry of Business Affairs in a letter of October 5th to the UK Treasury.

Did Britain really brand Icelanders as "terrorists"?

Notwithstanding these Icelandic government officials' commitments to support the DIGF made just before the demise of Landsbanki, the statements of more senior officials as the bank was in the process of being closed were more equivocal. Interviewed on Icelandic television on October 7^th, central bank governor David Oddsson, a former prime-minister, said, according to the translation reported in the Wall Street Journal, "These players lent this money to make a profit.....and they must face the consequences and not innocent citizens.....we have made this rather drastic decision and say: we are not going to pay the banks' foreign debts". No doubt alarmed by such comments and being aware of the fact that the Icelandic government had fully guaranteed domestic deposits, British Finance Minister Alistair Darling telephoned his opposite number in Iceland, Arni Mathiesen, to verify that UK Icesave depositors would get at least the €20,887 (then equivalent to about £16,000) guaranteed by the DIGF and that the comprehensive compensation given to Icelandic depositors of Landsbanki would not be at the expense of depositors in foreign branches, but Alistair Darling did not get the categorical reassurance the situation demanded. According to the transcript of the conversation, when asked whether British depositors would get the DIGF compensation, Arni Mathiesen said "I hope that will be the case. I cannot visibly state that or guarantee that now.....", adding later that "We need to secure the domestic situation before I can give you any guarantees for anything else.".

While it is possible to interpret these comments to give Iceland the benefit of the doubt (eg that David Oddsson meant that the State of Iceland would not simply assume Landsbanki's foreign liabilities in full and that Arni Mathiesen was acknowledging Iceland's limitations but did not mean that the domestic depositors' guarantee would be paid even if the foreign depositors' guarantee was not), in the absence of unqualified reasurrance (the Financial Times report of this conversation puts the burden of proof on the wrong side), the British government used the legal powers at its disposal to freeze Landsbanki's British assets to ensure that UK Icesave depositors would get at least something back. Here, the attitude of the British government may well have been hardened by its experience in the previous month of the difficulty of recovering money transferred from Lehman Brothers' London branch to its New York headquarters immediately before Lehman was declared bankrupt. It so happened that the legislation enabling the freezing order had been most recently updated to cope with terrorist organisations, and so was included in the Anti-Terrorism, Crime and Security Act, 2001 (which amended legislation from the less startlingly titled Emergency Laws Re-enactments and Repeals Act, 1964). Use of this legislation did not, as some Icelanders have protested, brand Iceland as a terrorist regime, and in fact the freezing order applied to Landsbanki specifically, rather than Iceland or Icelanders generally. And the freezing order was soon lifted once it became clear that Iceland did not intend to preclude any losses for its own citizens before releasing anything for foreign Landsbanki creditors.

Shouldn't negligent British regulators share the blame?

Many critics of the British claim argue that the British authorities were partly responsible for depositors' Icesave losses, because they allowed a risky bank insured by an inadequate deposit protection scheme to operate in the UK, and failed to prevent or even warn investors about the danger of its collapse. This criticism is unfair; because Icesave was a branch of a bank from another EEA country, the single market regulations practically obliged Britain's bank regulators, the Financial Services Authority (FSA), to accept the approval of the bank's solvency by its home regulators, Iceland's Financial Supervisory Authority (FME), at face value (according to the FSA's review of the Icelandic banking crisis on page 19 of its 2009 Financial Risk Outlook 2009, the FSA had only limited powers to supervise Icesave's local liquidity and conduct of business). And it is not hard to imagine the outcry if the FSA had suggested that Iceland was too small a country to support a secure deposit protection scheme (Dutch banking regulators evidently felt similarly constrained). In fact, when the FSCS merely advised British depositors that there could be a delay in receiving compensation in the event of the closure of a branch of a foreign bank, Icesave complained that this warning was a "violation of European law". Clearly, to some extent, the EEA's single market regulations contributed to the Icesave problem, by clearing the way for some banks to operate in the larger European economies with minimal scrutiny from those economies' relatively well-resourced and experienced regulators, so there is a case for sharing the cost of compensating Icesave depositors across the whole EEA.

How costly could Icesave compensation be for Iceland?

According to recent press reports, the British and Dutch deposit insurance schemes have now compensated 229,000 and 114,000 Icesave depositors respectively. Many of these depositors will have had deposits of less than €20,887, so the British and Dutch claims total £2.35bn (reflecting the sterling value of the euro-denominated Icelandic guarantee when Landsbanki was closed) and €1.33bn respectively. Based on the January 2010 Central Bank of Iceland forecast of 2010 Icelandic GDP of ISK1316bn and present exchange rates, together these payments represent 44% of Iceland's GDP.

The final fiscal cost to Iceland, however, can be expected to be much less than this, because the liquidation of Landsbanki's assets will recover substantial value for its creditors. The latest information from the Landsbanki winding up board projects a recovery rate for priority claims (which includes the DIGF) of 89%. At that rate, the final cost to the Icelandic taxpayer of compensating Icesave depositors would be about 5% of GDP.

Some Icelanders, notably lawyer Ragnar Hall, contend that the DIGF should take priority in the Landsbanki liquidation over the uncompensated (by the DIGF) claims of foreign deposit protection schemes and unrepresented depositors, in which case the DIGF could expect to recover more than 89% of its claim. They consider that the British government, by asserting a right to a pari passu share of the Landsbanki liquidation proceeds on behalf of the FSCS in addition to compensation from the DIGF, is asking for two bites at the residual assets of Landsbanki. Giving the DIGF precedence would, however, mean that the smaller depositors would be effectively being partly paid off out of the wealth of the larger depositors, making the DIGF more of a redistribution scheme than a compensation scheme. Although European law defers to national bankruptcy law on this point, European law is clear (reportedly unlike Icelandic law) – Directive 94/19/EC (Article 11) states that "schemes which make payments under guarantee shall have the right of subrogation to the rights of depositors in liquidation proceedings for an amount equal to their payments". Indeed, in the light of this clause (which also appears as Article 12 of Directive 97/9/EC on investor compensation schemes) Britain removed the preference formerly given to its own deposit protection scheme when it introduced the FSCS in 2001 (see, for example, section COMP 7.3.2C of the FSA handbook).

It may also be significant that the way that the Icelandic authorities chose to protect domestic deposits was to take control of Landsbanki and abstract a new "good bank" Nyi Landsbanki, comprising domestic deposits and associated liabilities plus new capital contributed by the Icelandic government, leaving foreign branch depositors in a "bad" bank destined to be wound up (as described in pages 15 and 16 of Iceland's request for an IMF stand-by arrangement). Whether this is significant depends on whether the assets of the old Landsbanki are allocated equitably to the creditors of the good and bad banks. Any unfavourable allocation to the bad bank will reduce the value available to be distributed to its (predominantly foreign) creditors.

Defenders of Iceland's preferential treatment of its depositors and banks argue that this was justified to preserve the domestic banking system, which is vital to the whole Icelandic economy. No doubt this is true, but it has to be said that the reason why Iceland's economy was so dependent on domestic banks is that foreign banks found it difficult to enter the Icelandic market. According to Report 1/2006 of the Nordic competition authorities on Competition in Nordic Retail Banking (page 15), at the end of 2005, all 178 bank branches operating in Iceland were branches of domestic banks (the report suggests the explanation may be that the cost of transferring accounts out of the incumbent banks had been prohibitively high).

The disagreement about deferred payment terms

The impact of the financial crisis on Iceland's economy (not to mention its dispute with Britain and the Netherlands) damaged Iceland's credit standing and made it prohibitively expensive if not impossible for Iceland to borrow in the capital markets as much as might be needed to repay the British and Dutch before much cash could be realised from the liquidation of Landsbanki and raised from future deposit insurance fees. Those countries therefore offered to effectively lend the necessary amount to the DIGF, subject to an Icelandic sovereign guarantee, by deferring repayment until 2016, with the plan being that the debt is repaid in 32 equal quarterly instalments from 5^th June 2016 to 5^th March 2024.

The terms of this loan is one of the key points of disagreement. Iceland contends that the proposed interest rate of 5.55% is too high. Critics of the deal, including some who ought to be able to produce a more rigorous assessment, compare the interest rate unfavourably with the interest rates that the British and Dutch governments pay on their fixed interest rate debt. In fact, this is not a reasonable comparison, for at least two reasons. Firstly, unlike a typical government bond, Iceland is not required to make any payments for the first seven and a half years of the loan; a more appropriate comparison would be with zero-coupon rates derived from British and Dutch government bond (gilts and DSLs respectively) yield curves. The interest rate set apparently reflects market interest rates as at the beginning of January 2009 (ie allowing for the statutory delay of up to three months before compensation is paid), at which time, according to Bank of England yield curve data, seven-and-a-half to fifteen year zero coupon gilt yields ranged from about 3¼ to 4%. And gilt yields are quoted on a semi-annual compounding basis, whereas the 5.55% specified in the loan agreement is expressed as an annual rate (which accounts for about tenth of one percent on the loan rate). Secondly, since the loan allows for early repayment as the DIGF receives money from the Landsbanki liquidation, it effectively incorporates a call option (the right but not the obligation to repurchase the debt) for Iceland. In practical terms, this means that if interest rates fell and Iceland was able to borrow more cheaply than the cost of the loan, it could reduce its expenses by borrowing elsewhere and paying off Britain early, whereas if interest rates rise and gilt yields exceeded the cost of the loan, Iceland could make some money back by investing the liquation proceeds in gilts and repaying the loan as late as possible. It has to be said that the terms of the loan might have been less contentious if the British and/or Dutch had set out how the rate was determined.

Since proposing the original loan agreement in June 2009, the British and Dutch have offered some concessions that soften the terms of the loan. They agreed to an amended loan agreement in which annual repayments were capped at 6% of Iceland's GDP, with any such reduced repayments being recovered from one or more five year extensions of the loan (ie effectively giving Iceland a put option). This modified form of the loan was included in the bill which Iceland's President refused to ratify. In recent days, Britain and the Netherlands have reportedly offered loan terms involving a floating interest rate (based on terms Iceland has accepted for loans from other Nordic countries), which Iceland is said to have rejected on the grounds that the British and Dutch were not passing on their own lower cost of borrowing. If the loan terms are the only obstacle to reaching an agreement, one way forward might be for the three countries to agree a mutually acceptable loan structure, for Britain and the Netherlands to structure some of their own growing debt in this way, to auction it to obtain market terms, and pass these through to Iceland.

Is it reasonable to expect Iceland to bear the Icesave compensation burden?

Although most of Iceland's politicians may have accepted Iceland's obligation to repay the British and Dutch governments the amount of money due from the DIGF, and are now negotiating mainly about the timing of the outlay, a large fraction if not the majority of Iceland's general public apparently regard the British and Dutch claim as excessive and unjust, and are expected to vote against accepting it if the referendum goes ahead. Even in Britain, the dispute is commonly portrayed as two tight-fisted governments of relatively powerful countries bullying a small nation into accepting poverty to pay for the damage done by a few greedy compatriots for whom the majority were not responsible. In fact, many countries have had to meet the cost of fixing banking crises in the past, and several are suffering one now like Iceland, and if the Icesave compensation does end up costing Iceland 5% of GDP, and similar losses are generated by Glitnir and Kaupthing (which were also taken over by the Icelandic government), the fiscal cost of the Icelandic banking crisis would be in line with the average fiscal cost of banking crises which is 16% of GDP. The cost of Iceland's banking crisis is painful but not unprecedented or unbearable.

Of course, bank depositor compensation will only represent part of the cost of the financial crisis for Iceland, but comparison of the burden on Iceland of compensating Icesave depositors with the reparations demanded from Germany after World War One, which proved impossible to pay and led to the resentment that contributed to the Second World War, looks exaggerated. Under the London schedule of payments of 1921, Germany was required to pay 50bn gold marks (ie nearly 18,000 tonnes of gold) in reparations from 1921 to 1933, representing 125% of 1921 German GNP (and more later if possible, up to 132bn gold marks).

In reality, the fundamental cause of Iceland's present misfortune is that, especially in the early years of the current century, Iceland's financial services industry grew rapidly and came to dominate its economy. That high degree of concentration of economic activity meant that Iceland's economic fortune would be extremely good during financial market booms, as in 2007 before the financial crisis, when Iceland had one of the highest per capita incomes in the world, but suffer a relatively large decline during financial market busts. Iceland's leaders were not shy about proclaiming Iceland's success during the boom; reading the bragging May 3rd 2005 London speech by Olafur Ragnar Grimsson, including the, with hindsight, personally unfortunate claim that the Icelandic "style of entrepreneurship breeds leaders who know that they are responsible", provides an antidote to sympathy for Iceland. Similarly, Iceland's banking industry was itself highly concentrated, meaning that Iceland was unwise to adopt the kind of ex-post funded deposit protection scheme covering the larger European countries. Iceland is arguably the world’s most experienced democracy, and Icelanders elected the people who made these mistakes or allowed them to occur. They should accept their responsibility, and approve the bill.

Update on March 9th 2010

Sadly, the people of Iceland rejected RebelEconomist's advice to vote yes; of the 62.7% turnout of registered voters, 93.2% voted no, and only 1.8% voted yes. However, while the result is decisive, it is less clear what it means. Although there were undoubtedly some who voted against the whole idea of a perceived capitulation to British and Dutch bullies demanding payment for bailing out greedy depositors of reckless private sector bankers, the majority seemed to accept repaying the amount of DIGF compensation disbursed by the British and Dutch but to reject what were regarded as unfair terms of the loan from Britain and the Netherlands. Indeed Iceland's prime minister Johanna Sigurdardottir had described the poll as "pointless", on the grounds that nobody was in favour of the bill in question anyway, since a "more favourable solution" had been offered by the UK and the Netherlands. The problem that RebelEconomist has with this position is that he is not sure exactly what Iceland would consider fair, or even whether the new offer from Britain and the Netherlands really is better from Iceland's point of view.

Assuming that by "fair", Icelanders mean that the British and Dutch should just cover their own borrowing costs rather than adding some "profit" margin on top (although judging by credit default swaps, a margin of about 4% to cover Iceland's credit risk would represent "fair market" terms), it is not clear that the proposed interest rate of 5.55% was unreasonable, as explained in the original post. And even if no allowance is made for the duration and flexibility of the loan, a crude comparison of this interest rate and current swap rates of a similar duration – say eleven years – would suggest that in LIBOR terms, this interest rate represents LIBOR plus about 1½%. Yet the new offer reportedly involves floating rate interest of LIBOR plus 2¾%. Even though this may imply a current loan rate of less than 5.55%, market expectations that interest rates will rise from their present anomalously low levels would suggest that a new deal of LIBOR plus 2¾% would probably be worse for Iceland in the long run (although the reported offer of an interest "holiday" too would also need to be taken into account to make such a judgement). Iceland sought legal advice on the draft loan agreement with Britain and the Netherlands; perhaps Iceland should also seek financial advice on the loan terms from an impartial investment bank (if it has not already done so).

To quote H.L.Mencken, "democracy is a pathetic belief in the wisdom of collective ignorance".

Misdisinformation

2009-08-07T05:32:00.000-07:00

RebelEconomist values the NakedCapitalism blog for providing a digest of financial news and commentary, and admires its writer Yves Smith for her productivity and independence, but I am afraid that Yves got hold of the wrong end of the stick in her criticism today of Zero Hedge’s report of Chris Martenson’s observation that the Fed has been buying very recently issued treasuries in its open market operations (actually, this story had already been covered by Brian Benton a couple of days earlier). Maybe the Zero Hedge and Martenson posts are a bit sensational, but they do raise an important point.

The main reason why central banks are generally not allowed to buy government debt in the primary market is that the central bank is supposed to buy assets at market prices (to protect its ability to re-sell them when it chooses to tighten monetary policy without depleting its capital and therefore its independence from government). Although the Fed does buy treasuries at auction, it does so only to roll over its existing holdings. So when the Fed buys a large proportion of a new treasury issue from the primary dealers very soon after the auction, it raises the question of how meaningful the auction process actually was in determining a fair market price for the bonds. And, as Chris Martenson notes, the apparently successful sale of a larger volume of treasuries to the private sector gives the impression that demand remains robust despite the massive increase in supply.

I have not been involved in the US treasury market for a few years, but it does strike me as strange that the Fed would buy such a recently issued bond. Normally, the most recently issued (so-called "on-the-run"; "hot-run" if you trade with J.P.Morgan) treasuries are the most expensive on the yield curve as their liquidity (ie still lots of bonds in loose hands with active trading) gives them extra utility (eg for hedging purposes). Although John Jansen has offered the ingenious explanation that the Fed might buy the most recently issued treasuries because the off-the-run issues tend to be priced with reference to the on-the-runs and would therefore also be raised in price, I am sceptical. In my experience, the treasury market does re-price the off-the-runs to allow for the idiosyncrasies of particular on-the-runs (eg for repo squeezes). And contrary to John Jansen's response to the Zero Hedge post, I could believe that a tacit understanding between the key players could be reached that the primary dealers can bid up for the bonds in the auction with the reassurance that the Fed will endeavour to – ie with no firm guarantee – offer a modestly profitable outlet a few days later. After all, the Bank of England reputedly used to be able to discreetly (and unattributably) signal its view of the conduct of British banks by a mere twitch of the Governor's eyebrow.

Yves Smith incorrectly relates the issue to whether the Fed is adding or draining liquidity. In fact, the quantity of liquidity that the Fed adds (or withdraws) is determined by the monetary value of bonds it buys (or sells). In this case, the issue is about how the Fed adds the liquidity, and the impact of its operations on relative prices in the treasury market.

Is this really a great global recession?

2009-07-04T04:06:00.000-07:00

In a VoxEU column that attracted significant media attention, Eichengreen and O'Rourke (E&O) present evidence suggesting that the present global economic downturn is "every bit as big as the Great Depression shock of 1929-30" and "every bit as global". In contrast, this post presents an unconventional indicator of global economic activity that shows no sign of truly global recession yet. This indicator is the seasonally adjusted atmospheric carbon dioxide concentration at Mauna Loa, Hawaii. Admittedly, the rate of carbon dioxide emission varies between different industries, and atmospheric carbon dioxide concentration is affected by natural variables such as sea surface temperature, making it a noisy indicator of economic activity. Nevertheless, atmospheric carbon dioxide does have the advantage as an economic indicator that it covers the whole world equally well, including regions where official statistics may be unreliable, and it does seem to have reflected previous major global downturns, so the absence of such a signal so far should at least raise doubts about E&O's assessment of the present episode. The explanation for the disagreement with E&O may be that their analysis gives too much weight to activity in existing developed countries, and that the prominence of the downturn there belies an ongoing improvement in living standards of a vast number of people in poorer countries, especially in Asia, that is to some extent being sustained by stimulating domestic activity to substitute for reduced export demand.

Like many who end up working in finance, RebelEconomist studied science at university, which in his case culminated in research investigating patterns in climatic records. Part of this work involved analysing the seasonal cycle in the well-known Mauna Loa record of atmospheric carbon dioxide concentration established by C.D.Keeling. This seasonal cycle arises because of the net absorption of carbon by plants during the summer (eg as leaves on deciduous trees) and release during the winter months, so that at Mauna Loa (20°N 156°W) the atmospheric carbon dioxide concentration normally peaks in early May and reaches a minimum in early October. Being driven ultimately by astrophysical forces and modulated by global scale environmental influences, the seasonal cycle is relatively stable and easy to model, and subtracting the seasonal cycle from the series isolates the underlying rise in the underlying level of carbon dioxide concentration that is the cause of concern about global warming. Even then, before he took much interest in economic events, RebelEconomist was struck by the marked dip in the upward trend of the seasonally adjusted series during and after 1973, apparently due to the first oil shock triggered by the Yom-Kippur-war-related Arab oil embargo and steep oil price rises (which was all the more marked because it had been preceded by a period of rapid economic expansion), as well as a less distinct deceleration around 1981 associated with another relatively severe downturn. Therefore, when RebelEconomist recently went back to the series to update his PhD analysis for a seminar celebrating his supervisor's research career, he expected to see a similar if not larger slowdown in the rising trend of atmospheric carbon dioxide concentration over the last few months, on the assumption that the present economic downturn is the most severe since the Great Depression. Instead, to his surprise, the updated seasonally adjusted series, based on observations up to and including May 2009 (Figure 1), so far shows no sign of decelerating at all.

For the geeky reader, the seasonally adjusted series in Figure 1 was obtained by time-variable estimation of a trend plus seasonal cycle model. To be more precise, recursively updated least squares estimates of the model from a forward and backward pass through the series, with parameter variation modelled as an integrated random walk process, were combined to produce a series of smoothed parameter estimates without the lag in parameter changes that would exist in a series of estimates obtained from a single forward pass. More details of these techniques can be found in P.C.Young's "Recursive Estimation and Time-Series Analysis" (published in 1984 by Springer Verlag). However, the seasonal cycle in this series is sufficiently clear and stable that similar results could be obtained with almost any reasonable seasonal adjustment procedure. Although the analysis included the entire record back to 1958, the years since 1970 only are plotted, since over longer periods the relentlessly upward trend makes higher-frequency variations difficult to see.

What might explain the absence of a recent slowdown in the rise of atmospheric carbon dioxide, in contrast to the 1973-5 recession? One possibility is that it is too early to expect the effect of reduced anthropogenic carbon dioxide emissions to reach a place as remote as Mauna Loa yet. On the contrary, the atmosphere is actually "well mixed" around each hemisphere, as the seasonal cycle at Mauna Loa shows by reaching its maximum not long after the end of the northern hemisphere winter, and its minimum close to the end of the northern hemisphere growing season. Also, the inflection in the upward trend around 1973 was practically contemporaneous with the beginning of that recession.

Another potential explanation for the absence of a deceleration of the increase in atmospheric carbon dioxide now might be that variations of natural origin are either obscuring anthropogenic effects, or were the real cause of the dip in 1973-5. In particular, sea surface temperature (SST) has a notable effect on atmospheric carbon dioxide at Mauna Loa, because the solubility of carbon dioxide depends inversely on water temperature, although it is not exactly clear what sea area has the most influence on the air at Mauna Loa (situated in the north east trade wind belt), and whether in monthly average observations the SST effect should be most apparent in the level or the change in atmospheric carbon dioxide and with how much lag if any. It seems unlikely though that SST caused the 1973-5 deceleration – SST over the ocean around Mauna Loa (as represented by an average over a box from 0-60°N and 160-230°E of the US National Climatic Data Center’s Extended Reconstructed SST, version 3b) was not markedly lower in 1973 than earlier in that decade (Figure 2).

Moreover, a muted inflection in 1973 is also evident in the (less complete) record of atmospheric carbon dioxide concentration at the South Pole (Figure 3; the unadjusted series is not plotted in this case because the seasonal cycles are so small that they obscure the seasonally adjusted series).

Also, as already mentioned, other smaller decelerations seem to coincide with major downturns such as those of 1981-2 and 1990-1. This association is evident in a weak positive correlation (about 0.1) between annual global real economic growth rates and the corresponding year's increase in the seasonally adjusted Mauna Loa carbon dioxide series over the period 1970-2008 (a longer series of quarterly observations of global economic growth rates could not be found; the greater availability of quality-controlled data in the environmental sciences – which honour the contribution of data compilers like Keeling – compared with in economics – which hardly does – is impressive). Certainly, regional SST cannot explain the absence of a current slowdown in the increase of atmospheric carbon dioxide at Mauna Loa; as Figure 2 shows, SST in the region has been generally falling since about 2004, and has not recently (at least until the last two months) been anomalously (relative to the 1971-2000 monthly averages) high.

So, if natural processes and influences cannot readily explain the absence of a current deceleration in the increase of atmospheric carbon dioxide, could it be the case that the present recession is not as great and not as global as E&O would have us believe? Unfortunately, their attempt to compare this downturn with the Great Depression is restricted to variables for which observations covering both periods are available; namely, industrial or manufacturing production (their VoxEU column is not quite clear about which of these is presented), stock market prices and trade flows. Of these, only industrial production is a direct measure of economic output (and manufacturing production would exclude construction); stock market prices reflect expectations for future output as well as how that future output is valued by markets, and it is net trade that contributes to economic output (which matters more when different stages of production are carried out in different countries). In recent months, however, a wider range of domestic economic activity reports from developing countries in Asia, especially from China, have suggested that economic growth there has remained fairly robust, especially by developed country standards. In China, manufacturing for domestic consumption such as car production continues to expand rapidly, while fiscal stimulus has boosted infrastructure investment and it now seems possible that China will achieve its 8% target for economic growth in 2009. Recent economic statistics suggest that India's economy is presently stronger than expected, and next largest economy among the developing Asian countries, Indonesia, also seems to be performing relatively well.

In conclusion, the absence of a slowdown in the increase in atmospheric carbon dioxide at Mauna Loa at the moment is inconsistent with the view that the present recession is globally severe, and this cannot be readily explained by known natural influences. Perhaps, rather than being a recession of "great" and "global" scale, the key characteristic of the present economic downturn is a shift of activity from the developed to the developing countries, and, aided by fiscal stimulus, into non-traded production such as construction and infrastructure investment..

Update:

Commenter Joao Carlos points out that the Brazilian economy (now one of the ten largest economies in the world) has also proved stronger than expected. Indeed, Brazil's "resilience" was specifically mentioned by Moody's credit rating agency yesterday as one of the reasons why Moody's have put Brazil's domestic and foreign currency sovereign credit ratings on review for an upgrade.

Does China appreciate sterling?

2009-06-07T11:07:00.000-07:00

RebelEconomist has been surprised by the recent strength of sterling, especially against the euro and the yen, and this short post offers an explanation for this behaviour which, as far as RebelEconomist is aware, has not previously been suggested by forex analysts (at least not when RebelEconomist put the suggestion to Macro Man earlier this week). In brief, RebelEconomist suspects that the Chinese have been buying sterling as part of their efforts to diversify their foreign exchange reserves away from the US dollar. Disclosure: RebelEconomist concurs with Angela Merkel, and holds a significant fraction of his savings in currencies issued by more conservative central banks than the BoE or the Fed).

While sterling did depreciate by about 30% (in terms of the Bank of England effective exchange rate index) from the beginning of the financial crisis (marked by, say, the demise of Northern Rock in September 2007) to the end of March 2009, the almost 10% recovery since March is barely justified by fundamental factors. Rallying share prices, narrowing credit spreads and tentative signs of at least an end to the deterioration in macroeconomic conditions, such as the recent uptick in the UK manufacturing purchasing managers' index, have been offset by increasing concern about the mounting burden of UK public debt and a growing political crisis, while the Bank of England remains in the lead in quantitative easing. Moreover, this sterling appreciation has occurred not just against the dollar, which has had similar fundamentals to sterling and was arguably riding for a fall itself, but also against the euro and the yen.

So what makes RebelEconomist think that China may be driving the recent appreciation of sterling? It is not foreign exchange market reports of Chinese flows; as a former reserves manager who was sometimes amused by erroneous speculation about his own activity and who would have certainly cut off any dealer suspected of such leaks, RebelEconomist is sceptical of anecdotal flows "information" anyway. His reason for pointing to China is that diversification of China's reserves has been advocated by credible Chinese sources and it would make sense for China to diversify into sterling. Of the five reserve currencies separately identified in the IMF Currency Composition of Foreign Exchange Reserves (COFER) reports (the US dollar, euro, sterling, yen and Swiss franc), sterling is probably the only currency whose issuing authority would not resent supportive intervention by foreign central banks at the moment. And if quantitative easing does lead to inflation and renewed depreciation, sterling offers more exit routes (from exposure to further currency losses) than most other major currencies – Britain is one of the most open countries to inward direct and portfolio investment by China's state funds (meaning that China could easily switch from conventional fixed income reserves assets into real investments for protection against inflation) and in the longer term, especially if sterling declines in international importance, sterling may well become part of the euro.

A pictorial comparison of QE in Japan and the US/UK

2009-05-06T09:49:00.000-07:00

See paragraphs 27 to 40 of the previous post. In a nutshell, in its quantitative easing period from 2001 to 2006, the Bank of Japan focused on creating a certain quantity of reserves, and largely allowed the market to determine how this should support the price of less liquid and less creditworthy debt (although the BoJ did buy more long term JGBs in its rinban operations than usual, and also made some token purchases of commercial paper and equities). The Fed, and to a lesser extent the BoE, are, by contrast, targeting their asset purchases on particular markets in which they are not normally buyers, notably the markets for mortgage-backed and some other asset-backed securities, and creating reserves as a by-product that the banks are content to hold because it bears some interest.

Update on June 7th 2009:

In an incisive comment on this picture posted on the excellent Worthwhile Canadian Initiative blog, Nick Rowe noted that, since an increase in money supply is believed to eventually lead to an equi-proportional rise in prices across the entire economy (see paragraph 5 of the previous post), the glasses ought to be on a level, connected by straws. That’s right, but then a viscous fluid (like maple syrup) would be needed to represent the time taken for the money injected to spread through the economy, and viscosity is hard to represent in a picture. I guess analogies are rarely perfect!

Easing understanding

2009-04-28T14:33:00.001-07:00

Introduction

1.     As the financial crisis has developed and increasingly affected real economic activity, the US Federal Reserve and the Bank of England (BoE) have resorted to progressively more aggressive and unconventional easing measures. While these measures have been described in the media as "quantitative easing" and even "printing money", these terms have not been used rigorously or even consistently. Commentators often misunderstand the significance of issues such as the payment of interest on reserves and the growth in base (central bank) money. It seems that the confusion is at least partly explained by the fairly superficial coverage of monetary policy implementation in economics textbooks, which abstract from certain details that are key to appreciating the differences between conventional easing, the pre-crisis idea of quantitative easing (QE) as applied by the Bank of Japan (BoJ) from 2001 to 2006, and the unconventional measures currently being applied by the Fed and the BoE.

2.     This post is an ambitious attempt to provide an explanation of monetary policy easing that covers all the aspects necessary to understand both conventional and unconventional easing measures. Although there has been some such explanation in the media, RebelEconomist has not found it entirely satisfactory, and offers his own here. It is hoped that his combination of experience of central bank market operations and academic monetary economics might just produce an account of monetary policy that does not leave vital questions unanswered and expresses some ideas in a slightly different way that can provide fresh insight. The post classifies Fed and BoE easing policies as they have evolved through the crisis. It is argued that while both central banks' unconventional measures have always been specified in quantitative terms, they are more accurately described as quantitative liquidity, credit and term easing rather than quantitative monetary easing. Neither central bank has yet begun to print money.

3.     Given its objective, the post is long, so readers who are mainly interested in present policy may wish to fast-forward to the discussion of unconventional easing measures in the last section. And in view of the complexity of the issue, assessment of the effectiveness and merit of the various policy options is mostly left for subsequent posts. Therefore, in the style of the central banker he once was, RebelEconomist has numbered the paragraphs for ease of reference here and in subsequent posts on monetary policy.

Fundamentals of easing

4.     Modern money (as opposed to commodity money such as gold coins) is debt; a readily transferable and widely accepted type of continuously redeemable debt. Typically money is non-interest-bearing debt owed by a highly creditworthy borrower such as a central bank in the case of banknotes or, in the case of deposit money, a commercial bank backed by state deposit insurance.

5.     To avoid going into the complexity and mystery of the monetary policy transmission mechanism, suffice it to say that, other things equal, an increase in the stock of money (also known as the money "supply", which perhaps confusingly implies a flow) has a stimulating effect on economic activity for a few months at least, and that short-term interest rates play a key role in the process. Because money is a substitute for interest-bearing short-term debt (ie money available with a short delay), an increase in the money supply tends to increase the price of all types of short-term debt, and since the price of a unit of debt (ie a unit of money due to be repaid when the loan matures) is conventionally expressed in terms of a rate of interest, increasing the money supply lowers short-term interest rates. Naturally, the influence tends to be greatest on the shortest and most creditworthy forms of debt that are money's nearest substitutes. The relationship between the money supply and the interest rate on such debt is normally described as a money demand curve, but is equivalently a debt market supply curve (Figure 1), and the short-term debt market is known as the "money market". Perhaps because the transactions-facilitating function of money is often likened to the lubricating oil in a machine, increasing the money supply or lowering interest rates is described as easing, while contracting money supply is called tightening. The degree of easing or tightening is called the stance of monetary policy. In the longer term, say about two or three years, the interest-rate-lowering and activity-stimulating effect of easing dissipates as the additional money becomes distributed in a pattern similar, in the absence of changes in the structure of the economy, to that of the original stock of money, at which point the residual effect of the ease will be an equi-proportional rise in prices – in short, a completed round of inflation.

6.     The supply of money is, of course, regulated by the central bank. Although there is more than one type of money, elementary explanations of monetary policy often abstract from this complication by assuming that they are held in stable proportions defined by "multipliers", meaning that the central bank need only regulate the supply of one kind of money to control them all.

7.     The form of money that the central bank directly influences is commercial banks' current account balances at the central bank. Although central banks typically pay little if any interest on positive balances in these accounts, commercial banks nevertheless tend to keep their central bank current accounts in credit, for at least two reasons. First, these accounts are used to settle any transaction that the banks undertake with the central bank, and sometimes also to settle inter-bank payments and transfers between the government and the banks, mostly on behalf of the banks' customers. Since these payments are not entirely predictable and the central bank normally heavily penalises overdrafts, the banks maintain a positive current account balance to provide some margin for error. Second, as a liability of the currency issuer itself (Figure 2), credit in a bank's current account balance at the central bank is the safest of all monetary assets, so banks may use their central bank current accounts as a store of value if the extra return available on alternative investments is not enough to compensate for their greater risk. In view of the functions that they serve, banks' current account balances are also called "reserves".

8.     Banks' holdings of reserves for transactions purposes can be expected to be proportional to the size of their customers' demand deposits. An archetypal transaction that commercial banks undertake with the central bank is to buy and sell banknotes as their customers respectively withdraw and deposit currency (currency includes coins as well as banknotes, but coins are relatively insignificant by value and are not always a liability of the central bank). Transactions between bank customers generate inter-bank payments. In either case, it seems likely that the greater the value of customer deposits, the larger the maximum outflow that customer activity is liable to generate, which their bank must be prepared to cope with. The amount of reserves that a bank would choose to hold for investment purposes depends on the trade-off between the risk and returns on reserves and other available assets, but normally, the return on reserves is so much less than even other credit-risk-free assets such as treasury bills that commercial banks hold practically no reserves as a store of value. Left to its own devices, a bank will determine its holding of reserves according to the trade-off between the likelihood and cost of overdrafts and the relative risk-adjusted return on reserves. However, in many countries, the regulatory authorities mandate a minimum fraction of deposits that must be held as reserves, partly for prudential reasons, and partly to control deposit money growth via the effective tax on deposits imposed by the need to hold zero or low interest reserves. In such cases the regulatory reserve requirement is usually the binding constraint. Anyway, whether voluntary or mandatory, the reserve ratio means that central banks' control over the quantity of banking system reserves also implies some control over the stock of deposits and hence of broader monetary aggregates.

9.     Although reserves represent the interface of the central bank and the rest of the economy, the stock of banknotes is normally a far larger liability of the central bank. Commercial banks may exchange reserves for banknotes at par, freely and on demand, and together, reserves and banknotes comprise what is called base money. The central bank would be unwise to try to control the money supply via banknotes – restricting the supply of banknotes could trigger a panic run on any bank apparently having difficulty meeting customer withdrawals. Like reserves, however, the value of banknotes in circulation is related to the size of demand deposits. Just as reserves provide the basic type of money for banks, banknotes provide the most widely accepted and dependable form of money for individuals. The transfer of banknotes represents immediate, often unrecorded, settlement of a transaction, which makes banknotes most suitable for occasional, relatively small transactions outside of committed business relationships, and for this purpose individuals hold a buffer stock of banknotes representing some fraction of their deposits. This means that the central bank has some indirect control of banknote circulation via reserves.

10.     While the banking system as a whole can ultimately only acquire reserves from the central bank, commercial banks trade reserves between themselves by borrowing and lending for settlement in their central bank current accounts, generally from one day to the next. The interest rate in this inter-bank market for overnight reserves loans indicates whether the supply of reserves is adequate for the banks' collective needs. Assuming that no interest is paid on positive reserve balances and that the central bank's overdraft charges, or the penalties for insufficient reserves in a regime of statutory reserve requirements, begin with a heavy cost for a shortfall of any size, the short-term market demand curve for reserves can be expected to resemble that shown in Figure 1. When the banks are close to their collective reserve requirement, overnight reserves loans will trade at a high interest rate as almost as many banks are in danger of incurring shortfall charges as being left with excess reserves. If, however, reserves are even slightly in surplus the interest rate will drop steeply, until as the interest rate approaches zero, it becomes worth borrowing reserves for the security they provide, for example against accidental overdrafts arising from operational errors. Such surpluses, however, do not persist for long, because banks can make more profitable use of excess reserves by expanding their lending to non-bank counterparties, so the inter-bank market for reserves normally operates on the steep part of the demand curve. The practical implication is that the demand for reserves is normally highly inelastic with respect to interest rates, with the result that small changes in the supply of reserves lead to large changes in short-term inter-bank interest rates.

11.     Since it is a point that seems to cause some confusion, note that, although an individual bank does expend reserves when it lends to a customer, reserves are not consumed or transferred outside the banking system in the process, even if the borrower is a non-bank customer. When the borrower draws on the loan, for example to purchase a car, reserves are transferred from the borrower's bank to the car seller's bank. Although it is conceivable that the car buyer might withdraw banknotes to pay the car seller, generating a fall in reserves as the car buyer's bank purchases banknotes from the central bank (Figure 2), these would normally be quickly paid into the car seller's bank account and sold back to the central bank for reserves. A banking system surplus of reserves is absorbed by an increase in the value of bank lending up to the point that the banks are generally content with the allocation of their assets between reserves and loans, not because the reserves are used up in some way, apart from a slight drain of reserves to pay for the increased circulation of banknotes commensurate with the growth of bank deposits.

12.     Central banks manage the stock of reserves in pursuit of both macroeconomic and microeconomic objectives. Their macroeconomic task is to use the influence of reserves to adjust the money supply and short-term interest rates to regulate economic activity, subject to the constraint of holding inflation close to some target rate. The trick is to exploit the medium-term, activity-altering phase of the money transmission mechanism without allowing its long-run outcome to generate unacceptable results in terms of inflation. Central banks' microeconomic task is to offset unwanted variations in the stock of reserves as it is impacted by flows associated with events like tax payment deadlines and holiday surges in banknote circulation, while accommodating structural changes arising from economic growth and evolving payments technology. Although in principle a central bank could attempt to determine the size of the adjustment required and arrange one or more transactions to produce exactly that change in reserves, in practice, central banks calibrate the supply of reserves according to short-term interest rates. They operate in this way because of the key role played by interest rates in the money transmission mechanism, and because the inelasticity of the demand for reserves means that a small mistake in the central bank's estimate of the need for reserves can drive interest rates to extremes. Most commonly, the target is specified in terms of the overnight interest rate in the inter-bank market for loanable reserves (ie "Fed funds" in the USA).

13.     Note that interest rate targeting means that the textbook account of deposit money creation, in which the central bank supplies base money followed by an iterative process of bank lending and customers re-depositing base money that creates some multiple of the initial injection of base money, is unrealistic. Actually, money creation is generally initiated by bank lending, with lending generating deposits and deposits in turn generating a need for reserves which are reactively supplied by the central bank in order to fix its targeted interest rate. Nevertheless, the fact that banks are obliged to hold some fraction of their deposits as low interest reserves, plus an additional fraction as non-interest-bearing banknotes in the bank's safes and tills to cover withdrawals during the interval before its branches can be re-supplied, allows the central bank to exert some influence over deposit money creation. By restricting the supply of reserves to raise the (opportunity) cost of commercial banks' base money requirement, the central bank can curtail the marginally profitable expansion of banks' balance sheets. And the much-discussed difference between targeting interest rates and targeting money supply should not be exaggerated. Nearly all central banks maintain some economic model that links the interest rate they target with their macroeconomic objective variables like economic activity (as represented by GDP) and inflation. The relationships included in the model incorporate, implicitly if not explicitly, the role of the money supply in the transmission mechanism.

14.     In principle, the central bank could fix its targeted interest rate by adding or subtracting reserves through any type of transaction that settles in commercial banks' current accounts, relying on the substitutability of reserves and short-term debt to affect the relevant interest rate. However, as it may be necessary to withdraw as well as inject reserves, central banks typically buy assets with relatively stable value and which can be liquidated (ie sold or lent in return for money) with minimal transactions costs. Even if the bulk of the assets are unlikely to ever need to be sold because contractions of the base money supply by more than a small proportion are rare, the assets are normally retained by the central bank to ensure its solvency and hence public confidence in its currency, so central banks are famously conservative investors across their entire portfolio. Traditionally, central banks traded gold, but since convertibility has been abolished, they have been able to buy income-generating financial assets instead. Given the importance of security, central banks favour fixed income debt assets, and normally only debt of the most creditworthy borrowers or short-term secured loans to banks in the form of repurchase ("repo"; strictly, from the money lender's point of view, "reverse repo") agreements collateralised by creditworthy bonds. Since nearly all investors are willing to hold very safe debt, such debt is also highly liquid, and short-term debt is quickly self-liquidating anyway as it matures. In practice, therefore, debt has now become the standard tool for monetary policy adjustment. Conventional easing involves creating reserves to make repo loans or to buy government or quasi-government bonds (Figure 2).

From interest rate targeting to paying interest on reserves

15.     Naturally, when debt is used as a monetary asset, there is potential for confusion between the interest rate on the central bank's target debt instrument, such as overnight inter-bank loans, and on the debt it trades in pursuit of that target in its monetary policy operations. Moreover, using debt allows the central bank to influence interest rates through its assets as well as its liabilities, an idea which is key to understanding and classifying the unconventional easing policies being applied during the present financial crisis. It is therefore unfortunate that few textbooks make this potential distinction between target and operational interest rates entirely clear.

16.     Not all central banks buy long-term debt in their monetary policy operations, and even those that do, notably the Fed and the Bank of Japan, tend to use short-term debt to make their marginal adjustments to the supply of reserves and buy long-term debt occasionally for the stable core of their asset portfolio. In fact, as RebelEconomist noted in a previous post, it is not clear why a central bank that targets short-term interest rates only should buy long-term debt at all. In developed countries in normal economic conditions, the balance sheet of the central bank tends to be small compared with that of the whole banking system, so it would seem best to concentrate the influence of the central bank's asset purchases on debt that, if not actually the target debt instrument itself, is as similar to it as possible. It may be necessary to use a close substitute rather than the target debt instrument itself because the target debt instrument is not considered a suitable investment for the central bank. Usually, this is because the target debt type is unsecured, such as inter-bank deposits, and the central bank wants to avoid managing the credit risk involved in buying such debt (which besides running some risk of loss, may require the central bank to favour dealing with some banks over others). Also, if an overnight interest rate is targeted, the central bank may prefer not to renew its entire stock of assets every day, in which case it may choose to deal in, say, one-week debt instead. Another advantage for the central bank of specialising in short-term debt is that its short maturity produces a strong natural drain of reserves as the debt is repaid, which puts the central bank in a strong position to reset the stock of reserves and interest rates frequently.

17.     For an interest rate targeting central bank, its operational objective is to hold the rate of interest on its target debt instrument close to the target with minimal variability. To this end, central banks use two basic trading strategies. Their primary strategy is to attempt to estimate the change in reserves necessary to guide the interest rate to the target and arrange one or more transactions to engineer that change. The estimation problem is more one of allowing for scheduled flows like maturing central bank loans and anticipating the actions of institutions and people, known as autonomous factors, rather than identifying and using the money demand curve. Usually, the adjustment required is an injection of reserves to replace maturing debt held by the central bank. The central bank then establishes transactions to make that adjustment by offering to buy or sell as necessary the corresponding amount of debt, either at a fixed interest rate or by auction. Although the central bank usually deals with a limited set of counterparties, these may include non-banks, since transactions with them are settled using their correspondent bank's reserve account. This procedure is called an open market operation (OMO). Central banks' secondary strategy is to provide standing facilities which offer to take deposits at an interest rate some spread below the target and to lend reserves at an interest rate some margin above the target, in practically unlimited size. These standing facilities provide respectively a floor and ceiling to the targeted interest rate in case, even after OMO adjustment, it would otherwise miss the target by an intolerably large amount. Since the standing facilities are designed to be used only in exceptional circumstances, the spreads are typically prohibitively wide.

18.     In theory, the interest rate inelasticity of the demand for reserves means that a change in the target interest rate can be accomplished with a small change in the size of the next OMO, and also that a failure to make the correct size change could result in the new target interest rate being missed badly. In practice, because the central bank's money market counterparties know that the central bank has the market power to correct any persistent miss and is able to impose sanctions on any of them considered to be behaving unhelpfully, the process of setting interest rates is facilitated by a degree of cooperation. Normally, the mere announcement of a change in the target interest rate is sufficient to shift market interest rates to the new target.

19.     Note that the fact that the target and operational debt instruments may differ means that the bounds on the target interest rate may not exactly correspond to the rates at which the standing facilities are offered. In particular, because central banks generally only lend on a secured basis, unsecured inter-bank deposits such as Fed funds could conceivably trade at a slightly higher rate than the standing lending facility. Adding to the difficulty of summarising the stance of monetary policy in terms of a single target interest rate, the debt instruments used in OMOs and standing facilities may well differ, with the standing facilities normally being provided only for the shortest possible term of overnight, while the instruments used for the standing facilities themselves usually differ, if only because the central bank does not give collateral when it takes deposits but requires collateral when lending. Nevertheless, as they have refined their operational techniques to achieve greater control of interest rates, central banks have increasingly emphasised the interest rates they set directly rather than market rates, especially the interest rate in the short-term OMOs they use to make marginal adjustments. This key interest rate is generally referred to as the "bank rate", or "repo rate" if that is how the OMOs are conducted. The standing facilities are typically offered at an equal and rarely-adjusted spread above and below the bank rate to define a symmetric interest rate corridor that moves up and down with the bank rate. In fact, monetary policy is now routinely set in terms of the central operational bank rate rather than some target rate, with market interest rates serving merely as indicators of the effect of the policy and of market expectations of policy changes.

20.     As central banks have placed increasing importance on controlling, and being seen to control, interest rates, a natural development of their strategy has been to change the nature of base money itself to make their job easier. Since it is the interest rate inelasticity of the demand for reserves that makes market interest rates inherently volatile, and since it is the sharp difference between the return on adequate reserves – avoiding a penalty of some size – and on surplus reserves – zero – that causes the inelasticity, an obvious way to reduce the volatility of interest rates is to smooth this disparity. The opportunity cost of holding excess reserves can be reduced by paying interest on reserves. Effectively, this raises the dashed line in Figure 1, so that the money demand curve – or to be more precise, since the return on reserves now differs from the zero return on banknotes, the reserves demand curve – is flatter in the normal range of interest rates. Where there are mandatory reserve requirements, the sharpness of the shortfall penalty can be blunted by applying it to the average level of reserves over some maintenance period, so that a shortfall on one day can be offset against a surplus on another day. Assuming that an overdraft, even for one day, is still unacceptable to the central bank, reserves averaging works better when the reserves requirement is larger and the level of reserves varies around a level well above zero. Paying interest on reserves makes such a larger reserve requirement more acceptable to the commercial banks. For these reasons the European Central Bank and the Bank of England remunerate reserves, and the Fed had been asking the US Congress for permission to pay interest on reserves long before the financial crisis.

21.     To stabilise money market interest rates with maximum effectiveness, the reserves demand curve should be practically flat at the policy rate, which suggests that the interest rate paid on reserves should be close to the policy rate – but certainly not above it, which would establish an arbitrage opportunity. However, paying any interest rate approaching the policy rate encourages the use of reserves as an unbeatably secure investment. The solution adopted by the ECB and the BoE is to remunerate reserves holdings of up to the required size at their policy rate, but pay no interest on any amount above this.

22.     It is important to realise that, because, other things equal, banks can be expected to hold more reserves when they are remunerated, paying interest on reserves changes the relationship between the stock of base money and other economic variables, notably inflation. The introduction of voluntary reserve requirements and remunerated reserves by the BoE, which previously had no reserves requirements, provides a revealing case study of the effect of paying interest on reserves. Prior to the change in regime on May 18^th 2006, banks' current account balances at the BoE were normally much less than £1bn. When the BoE began to pay interest on reserves at their policy repo rate, banks' current account balances increased to around £20bn almost immediately – the BoE simply bought more repo debt in its OMOs, on which it charged its repo rate, to accommodate the notified increase in demand for reserves remunerated at the same rate. Since the increase in the stock of reserves was equal to about half the value of the stock of sterling currency in circulation at the time, the "velocity" of base money (essentially the number of times in a year that the money stock would need to change hands to sell annual economic output at prevailing prices) fell by a third, yet the regime change had no noticeable effect on inflation or real output. Analysts accustomed to using base money growth to assess the monetary discipline of a central bank, assuming that the ability to freely switch from reserves to banknotes and vice versa makes them macroeconomically indistinguishable, need to revise their approach when interest is paid on reserves.

23.     Paying interest on reserves represents the apotheosis of interest rate targeting. Market interest rates on short-term, highly creditworthy debt are closely shepherded towards the target by the existence of a large volume of similar assets in the form of central bank liabilities bearing a near-target rate of interest as well as the availability of a large volume of secured loans at a near-target interest rate. To see how remunerated reserves hold up market interest rates, consider the example of a large retailer flush with currency after an unexpectedly successful January sale. The retailer deposits the currency with its bank at its stipulated deposit rate, and the bank pays the currency into the central bank in return for an increase in its reserve balance. The retailer's bank then has the problem of somehow earning as much interest as possible on its additional assets in the interval before it can arrange a loan to another customer. In the absence of interest on reserves, the bank may have to offer to lend at a very low interest rate in order to induce another bank to hold the reserves, which one might just be willing to do if they are aware of the possibility of a large withdrawal by one of their customers and the opportunity cost of holding the reserves is sufficiently low. With interest paid on reserves however, even if the retailer's bank has excess reserves, it can either afford to hold the excess itself and wait for a shortfall later in the reserve maintenance period, or lend the reserves to another bank waiting for a shortfall, at a higher interest rate reflecting the lower opportunity cost of holding remunerated reserves. If a shortfall never emerges, at least one bank may be forced to use the standing deposit facility, perhaps at a modest loss. If the reserves requirements are voluntary, in view of the recent use of the standing deposit facility some banks may specify an increased holding of reserves for the next reserve maintenance period, in which case even a permanent increase in reserves can be accommodated without lower interest rates.

24.     The efforts made by central banks to strengthen their grip on short-term interest rates reflect what has become the mainstream approach of calibrating monetary policy according to short-term interest rates on highly creditworthy debt, rather than some measure of money supply or exchange rate for example. In normal economic conditions, central banks leave interest rates on longer-term debt to be determined by market expectations of the future path of short-term interest rates and the profile across the range of debt terms (ie the term structure) of market term risk premia. Although central banks may try to shape market interest rate expectations by committing to adjust short-term interest rates in pursuit of certain policy objectives and by giving their view of the macroeconomic situation and outlook, they do not normally use their monetary policy market operations to influence longer-term interest rates directly. Similarly, in normal economic conditions, central banks do not attempt to influence the liquidity and credit risk premia, and hence the interest rates, on debt that is less liquid and less creditworthy than the debt they ordinarily buy.

The zero lower bound and quantitative easing in Japan

25.     If the policy rate is a target for some money market interest rate such as the interest rate on overnight inter-bank reserves loans, there will exist some finite amount of zero or low interest reserves that the central bank can supply to bring down this market rate to a positive target, even if the autonomous factors make it hard to specify exactly what that supply of reserves will be. And if the policy interest rate is the central bank's own OMO repo rate, the central bank can of course establish any particular positive interest rate of its choice on that type of debt, provided that it is prepared to lend or borrow in sufficient size at that rate. It is, however, conceivable that in severe economic downturns, the prospects for economic activity and inflation become so weak that the central bank's macroeconomic model suggests that a zero or even negative interest rate is needed to meet its objectives, and in this case it is theoretically impossible for a central bank to engineer a precisely zero (nominal) interest rate using market operations alone. If reserves are available to borrow at zero interest either from the central bank or other market counterparties, a bank's demand for reserves will in theory be unlimited – if it costs nothing to borrow reserves, a bank might as well have a huge holding, just in case an opportunity arises to purchase an asset that offers a greater than zero risk-adjusted return over the same period as the reserves loan. In mathematical terms, in Figure 1, the dashed line is an asymptote, and zero provides a lower bound for the policy interest rate.

26.     In practice, central banks can succeed in lowering their policy rate to zero or even slightly less, partly because of real world limitations such as transactions costs, the convention of dealing in rounded interest rates and the finite capacity of the banking system, and partly because of the banks' willingness to cooperate with the central bank within reason. It might even be possible for a central bank to force its policy rate significantly below zero by imposing restrictions such as charging interest on reserves, but this has not so far been attempted, probably because it would generate undesirable distortions, such as driving banks to use banknotes instead of reserves wherever possible and to settle inter-bank payments outside the central bank.

27.     Once the policy interest rate reaches zero, however, it no longer provides a sufficient measure of the monetary policy stance, because the practicalities of fixing interest rates mentioned in the preceding paragraph combined with the flatness of the reserves demand curve at a zero interest rate mean that a zero policy rate is compatible with a range of sizes of the stock of reserves. This matters because any amount of reserves in excess of the supply necessary to sustain a zero interest rate on the policy debt instrument influences the interest rates on other debt types that are near substitutes for reserves. For example, if the policy rate is a target for the overnight interest rate in the inter-bank market for loanable reserves, when the stock of reserves has increased to the point that the overnight interest rate has been driven to zero (ie reserves available tomorrow trade at parity with reserves available today), a further increase in reserves supply affects the price of the next nearest substitute (eg two-day loans) entirely directly (ie no longer via the overnight interest rate). Similarly, if the policy rate is defined as the central bank's operating interest rate (eg an overnight repo rate), the central bank is able to add to its easing effort without relaxing its grip on the policy rate by, for example, undertaking supplementary OMOs which lend for a slightly longer term or accept lower quality collateral than usual. And when the interest rate on the nearest substitute to the policy debt instrument reaches zero, the central bank can turn to the next nearest substitute and so on, in a cascade of easing. Ultimately, the central bank can buy real assets and even goods and services with base money, so there is no question that a central bank can create inflation if that is considered necessary. As Fed Chairman Bernanke explained in his well-known speech of 21 November 2002, a central bank has not "run out of ammunition" when its policy interest rate has been reduced to zero. On the contrary, it seems reasonable to believe that easing is no less effective at boosting activity and prices after the interest rate on the central bank's primary target debt instrument has reached zero.

28.     Clearly, a precise description of the monetary policy stance when the policy rate reaches the zero lower bound could comprise a vector of interest rates on debt types that are progressively more distant substitutes of the policy debt instrument. A more straightforward approach, which is also consistent with a policy of leaving the market to determine how easing spreads beyond the policy debt instrument, is to express the monetary policy stance in terms of the quantity of reserves. The best-known example of such an easing campaign is from Japan, where between 2001 and 2006 monetary policy was (besides the virtually zero interest rate prevailing in the overnight inter-bank debt market – known in Japan as the overnight call rate) specified in terms of a series of increasingly large targets for the banks' current account balances at the BoJ, culminating in a target of ¥30-35tn (equivalent to about 8% of Japanese GDP). Monetary easing that is expressed in terms of the quantity of reserves held by the banks is, in RebelEconomist's opinion, the most appropriate definition of quantitative easing.

Unconventional policy and the financial crisis

29.     Although the unconventional measures now being applied by the Fed are often described as quantitative easing, Fed policy developed from the opposite direction to the BoJ's QE policy in the sense that the Fed policy started with the aim of easing risk premia and evolved into monetary easing, whereas the BoJ policy began as monetary easing and compressed risk premia as it extended. Fed and BoE unconventional easing began as a response to the financial crisis, at a time when they were holding their interest rates well above zero because of the potential inflationary threat posed by the high commodity prices sustained into last year. In fact, it is questionable whether Fed and BoE unconventional easing could until recently even be properly described as monetary policy, although of course, as the financial crisis has increasingly restrained the real economy, both central banks have also been undertaking conventional monetary easing by cutting interest rates.

30.     At first, the financial problem was seen as one of a lack of liquidity (liquidity being defined here as ease of transacting rather than as, for example, abundance of money). As the US housing bubble burst and it became clear that many marginal borrowers were likely to default, investors shunned mortgage-backed securities (MBS), especially complex structures including sub-prime mortgages, and the debt of any borrower believed to have a significant fraction of its (book) net worth tied up in them. Banks and money market funds that had funded holdings of MBS with short-term borrowing were faced with either paying ruinous interest rates to roll over their debt, especially for any term longer than a day or so, or else selling their MBS at such low prices that they would have become insolvent. The Fed took the view that market prices for MBS and for the debt of their holders were depressed more by an unwarranted rise in investor risk aversion leading to larger liquidity, credit and term risk premia than by a realistic assessment of greater risk, and acted to help the systemically important holders of MBS obtain funding through what was expected to be a temporary crisis. For this purpose, on December 12^th 2007 the Fed introduced the term auction facility (TAF), which provided funding for a longer period than the normal Fed OMOs, on the security of lower quality collateral, including certain types of MBS.

31.     The idea was that the TAF would reduce the spread between the interest rates on highly liquid debt such as treasury bills and on bank debt collateralised by lower quality bonds. Besides narrowing spreads on short-term debt, by providing a way of raising liquidity from MBS the TAF could also reduce the spread between MBS and treasuries of similar maturity. However, the Fed set no target for any spread, but instead announced a schedule to auction a fixed quantity of loans. In that way the TAF was a quantitative easing policy.

32.     Note that the TAF was not supposed to ease the credit risk premium. Contrary to what at least one academic has written, a repo loan is not free of credit risk just because it is collateralised by government bonds, and is not necessarily more risky when less creditworthy bonds are accepted as collateral. A repo loan suffers credit loss if the borrower defaults and the collateral is then worth less than the value of the loan, regardless of whether this shortfall arises from interest rate or credit risk. To ensure robust security, an initial margin or haircut is subtracted from the value of the bonds pledged as collateral in determining the amount of collateral required. When less creditworthy bonds are pledged, a larger haircut is applied to cover the expected value of the additional losses associated with credit impairment, so provided that the haircut is assessed correctly, a repo loan collateralised by mortgage-backed securities is no more risky than a repo collateralised by government bonds. Note further that the TAF funding was not ultimately provided by the Fed itself in the form of base money, because the Fed raised the money it lent by either selling or not rolling over maturing treasury bills from the assets it had bought in supplying the existing stock of base money. In other words more commonly associated with central bank intervention in currency markets, the operation was sterilised. In fact, some of its spread narrowing effect was due to the additional supply of treasury bills keeping treasury bill yields higher than otherwise as the Fed reduced its holding. The Fed effectively substituted one asset on its balance sheet for another less liquid asset of similar maturity and credit risk, without changing the size of its balance sheet. The operation might be most appropriately described as substitutional quantitative liquidity easing.

33.     As the financial crisis grew through 2008, with the Fed increasing the size and maturity of the TAF and adding new programmes like the Primary Dealer Credit Facility lending against a wider variety of collateral, the Fed reached the point where it was running out of treasury bills. The Fed could no longer continue to increase its lending against illiquid securities without either selling longer-term treasuries, and thereby probably raising longer-term interest rates including the economically important mortgage rates, or expanding its liabilities and balance sheet. At the time, however, persistently high commodity prices made the Fed reluctant to deliberately expand its non-interest-bearing, monetary liabilities (expansion on the scale required would have driven the Fed funds rate to zero) and limited borrowing powers prevented the Fed issuing securities without permission from Congress. The solution adopted was for the US Treasury to issue and sell new treasury bills and deposit the proceeds at the Fed to fund further lending, in a scheme called the Supplementary Financing Program introduced on September 17^th. Now, extra lending by the Fed was matched and funded by a liability in the form of a Treasury deposit, and the Fed had progressed to what may be termed expansional quantitative liquidity easing. As unconventional easing continued apace, the Fed's balance sheet began to grow much faster than previously.

34.     A similar programme, called the Special Liquidity Scheme, had already been introduced by the UK authorities on April 21^st 2008. This allowed banks to exchange existing mortgage-backed securities for UK treasury bills with the BoE, although the treasury bills were not owned by the BoE but were specially issued by HM Treasury and loaned to the BoE for the purpose.

35.     Following its discussion with Congress mentioned in paragraph 20, the Fed had in 2006 been granted authority to pay interest on reserves from 1 October 2011. This effectively allowed the Fed to borrow money by issuing interest-bearing liabilities, which offered a more straightforward way to raise funding for liquidity easing, since it avoided the need to continuously coordinate operations with the Treasury. After the demise of Lehman and AIG intensified the financial crisis, Congress allowed the Fed to bring the date from which it could pay interest on reserves forward to October 6^th 2008. From then on, Fed purchases of less liquid assets were increasingly unsterilised with the stock of reserves allowed to grow. This new approach could be described as money-financed quantitative liquidity easing.

36.     Previously, creating a large amount of base money to fund expanded asset purchases would have been regarded as dangerously inflationary, but with interest paid on reserves, whose risk-free nature was even more highly valued during a time of financial turmoil, the banks were happy to hold the reserves. The interest-bearing reserves were effectively self-sterilising and providing the funding for the Fed asset purchases that injected them. Since Fed credit is practically the same as US government credit, paying interest on reserves is economically like selling a daily-resetting floating rate note instead of a treasury bill. In short, extra reserves are being created to allow easing rather than to cause it.

37.     Some analysts define quantitative easing as something like "an increase in the size of the central bank's balance sheet through an increase in its monetary liabilities". Under this definition, the Fed had begun quantitative easing once it began to use remunerated reserves to fund its continued balance sheet expansion. But this would be a poor definition of quantitative easing anyway, because in theory any easing involves some expansion of the central bank balance sheet and increase in monetary liabilities, even if the inelasticity of the demand for unremunerated reserves allows this change to be small.

38.     The next easing step taken by the Fed was to start buying lower quality securities outright (ie beyond only taking them as repo collateral), albeit cautiously at first. On September 19^th 2008, the Fed announced that it would begin buying short-term debt of the Federal housing agencies. Initially, the Fed limited itself to only indirect exposure to the debt of less creditworthy issuers. The Commercial Paper Funding Facility was established on October 14^th 2008 to buy commercial paper via a special purpose vehicle funded and owned by the Fed. On November 25^th 2008, the Fed presented a plan for a Term Asset-Backed Securities Loan Facility (TALF) to lend on a collateralised but non-recourse basis to buyers of asset-backed securities comprising student, car, credit card and small business loans – the non-recourse funding effectively involving selling a credit guarantee. With these programmes, the Fed had graduated to credit easing.

39.     Also on November 25^th 2008, the Fed announced that it would begin outright purchases of $100bn of longer-term agency securities and $500bn of agency-guaranteed MBS, specifically mentioning its desire to lower mortgage interest rates by this action. At its monetary policy meeting on December 16^th, the Fed cut the Fed funds target to 0-¼%, meaning that it had practically exhausted its ability to ease conventionally anyway, and the post-meeting statement said that purchases of longer-term treasuries would be considered. A programme to buy $300bn of longer-term treasuries as well as a further $200bn of agencies and $750bn of agency MBS was duly announced on March 18^th 2009. The Fed's easing efforts now included term easing, and were specified in quantitative terms, so it does not seem unreasonable to describe Fed policy as quantitative easing. Although the Fed did not state an intention to deliberately increase the quantity of reserves, the relatively stable demand from the public for banknotes means that, in practice, the proceeds of these asset purchases as they are made through 2009 can be expected to increase reserves by a similar amount. Fed policy has now reached the same point as BoJ QE a few years previously, with the quantity of reserves held at the Fed standing at $925bn (about 6% of US GDP) at the time of writing.

40.     The BoE meanwhile had already adopted money-financed quantitative easing on March 5^th 2009, when it cut its repo rate to ½% and undertook to purchase £75bn of longer-term UK government bonds (gilts) and corporate bonds financed by an increased stock of reserves. The BoE suspended reserve requirements and undertook to manage its OMOs so that the stock of reserves would increase above the aggregate of the banks pre-existing voluntary reserve requirements by an amount corresponding to the proceeds of its asset purchases. It is interesting to note that the policy rate was not cut to zero despite the BoE's commitment to increase the stock of reserves. This suggests either that the BoE will accept market interest rates significantly below ½% if necessary (perhaps moving the repo rate down for appearances sake) or that the BoE believes that are sufficient rigidities in the sterling money market to allow the stock of reserves to be increased without OMOs at ½% becoming redundant. The BoE evidently prefers to keep its repo rate sufficiently far above zero to allow some inter-bank lending to continue – if the central bank lends at a rate that does not cover administrative costs and expected credit losses, it would not be viable for a private sector bank to lend surplus reserves.

41.     Although it might seem that every conceivable easing measure has by now been brought to bear on the financial and economic crisis, one, arguably desperate, tool remains. This is the convergence of monetary and fiscal policy, involving the central bank lending directly to the government to fund public expenditure on goods and services. Base money is created when the government draws down the loan. Monetary financing of government expenditure is the traditional definition, and RebelEconomist's preferred definition, of the term "printing money". It is unfortunate that this term has been devalued by being used during the easing campaign to express how readily central banks seem able to create resources to buy valuable assets in general, which is actually no more than the normal function of a monetary authority. Printing money to finance government expenditure would, however, be a big step, because it would mean that the central bank had given up its monetary policy independence and ability to prevent inflation when the need for easing has passed. When a central bank buys assets in the markets, because it pays the market price in base money, it should be possible for a well-capitalised central bank to reverse this position by re-selling these assets if and when it considers this necessary to bolster the value of its currency. When the central bank prints money, however, the exchange of base money for government debt is typically off-market, meaning that the debt assigned to the central bank is unlikely to be marketable and is not guaranteed to have a value as large as the base money credited to the government. So far, during this crisis, no developed country central bank has yet been obliged to print money.

Guaranteed to be no better

2009-02-12T15:12:00.000-08:00

Just a quick post to record an opinion on the idea of dealing with banks' troubled assets by writing insurance against their most extreme losses, a solution which has been applied in the UK, and is being considered in the US and EU as an alternative to buying the troubled assets outright. So far, proposed troubled asset purchase schemes like the TARP have been stymied by the problem of valuing the assets, which are typically mortgage-based complex structured products, at the right level to induce the banks to sell them while avoiding losses to the taxpayer.

RebelEconomist has never tried to value structured products (as a fund manager, he always avoided them), but he would imagine that the key to realistic valuation of them is their left tail (extreme loss) risk, for two reasons. First, he suspects that the structuring was often designed to shape the securities' return distributions to minimise the probability of default as defined by the rating agencies, while accepting the maximum risk given default (not to mention accepting the maximum risk short of default too) as far as such risks attracted a return premium. In other words, structured products were built to arbitrage the naïve reliance of risk management on credit ratings. The left tail of their return distribution may well be very different from regular fixed income securities. Second, by definition returns in the tails of a return distribution are seldom observed, so the tails are the most uncertain parts of the distribution. And unfortunately, in securities involving credit risk, the left tail is typically long. It is the left tail of their return distributions where the difficulty of valuing structured products resides.

This view of the troubled asset valuation problem suggests that pricing insurance against their worst losses, which essentially means buying the left tail of the return distribution only, does not represent a significantly easier task, and that writing such guarantees is not necessarily a better deal for taxpayers than buying the assets. Guarantees look cheaper (ought to generate fee income up front, in fact) because they do not involve buying the bulk of the return distribution, over which the average return should be clearly positive and which will have a relatively well-defined value like a regular bond. The danger is that this minimal initial cost makes an insurance scheme enticing to politicians who can be seen to "do something" without asking voters to make an immediate tangible sacrifice, even if there is some attempt by the official accountants to estimate the expected outlay on the guarantees. Moreover, the fact that the cost arises later, as and when the guarantees are called upon, perhaps even under a different administration, reduces the government's incentive to drive a hard bargain on the fee.

RebelEconomist still believes that something like the PRAT scheme is the right approach.

US economic policy shot in the foot #3: Gold

2008-12-31T14:06:00.000-08:00

When RebelEconomist began writing this blog a year ago, he planned to write a series of three posts criticising obsolete US economic policies that by needlessly sticking to, the US economic authorities "shoot themselves in the foot". The problem with the third of this series, however, has been that the policy concerned has proved (inadvertently) richly financially rewarding during the last year. Nevertheless, RebelEconomist still considers the policy to be questionable, especially looking forward, and wishes to fulfil his promise to write three shot-in-the-foot posts anyway, so here is the third. The subject of this post is America's massive holding of gold bullion, which dominates its foreign exchange reserves. The post concludes that the main reason why the USA holds so much gold seems to be policy inertia, and argues that for investment and presentational motives, a substantial fraction of the gold should be sold with the proceeds reinvested in reserve currency government debt.

As of December 12, the market value of the US foreign exchange reserves including gold amounted to $281bn, with gold valued at the 12/12/2008 LBMA pm fixing of $826.50 per fine troy ounce (instead of the historic value of $42.2222 used in the US Treasury and IMF reports) and reverse repo investments valued according to the cash invested (rather than the value of the collateral assets held). Of this, gold accounts for 77%, compared with the all-country average gold share of reserves of 8.5%. Gold's share of the non-SDR reserves (which is arguably more relevant because the amount of SDRs held presumably reflects US international economic policy rather than a portfolio management decision) is 82%.

While the proportion of the dollar market value of the US reserves accounted for by gold has changed with market prices, the US has held much the same physical quantity of gold – just over eight thousand metric tonnes, presently 8133.5 metric tonnes or 261.499 million troy ounces – since the early 1970s. This was the amount of gold that the USA had left when the dollar peg to gold (at a rate of $35 per troy ounce) that provided the anchor of the Bretton Woods fixed exchange rate system finally collapsed in 1973 (a process beginning in 1971 with the suspension of dollar convertibility by President Nixon) under the strain of persistent US fiscal and current account deficits. As far as RebelEconomist knows, unlike other countries which have sold gold, such as the UK, the US government has never reviewed the purpose of its gold reserve, and it seems unlikely that any rigorous secret review would have concluded that the existing holding just happened to be about the appropriate size. Perhaps the US authorities considered that raising the possibility of selling the country's gold would be too controversial, especially given the strength of the US tin foil hat brigade.

The obvious problem with holding gold is that it pays practically no interest. It is possible to lend gold, but not normally to sovereign borrowers, and even the unsecured gold loan ("lease") interest rate is relatively low. Naturally, a real asset like gold can be expected to hold its real value over the long run, but in most convertible currencies, real debt interest rates tend to be positive. As a result, conventional asset allocation techniques tend to give gold a low portfolio weight.

Figure 1 shows the mean-variance efficient portfolio weights optimised for various design portfolio returns for the four non-dollar reserve currencies separately identified in the IMF currency composition of official foreign exchange reserves (COFER) reports, plus gold. At present, the USA holds just euro and yen debt instruments in its currency reserves, plus effectively some sterling via its SDR accounts at the IMF (the present sterling weight in the SDR is 11%). On the assumption that the US authorities would not short-sell other countries' currencies, the portfolio weights are constrained to be non-negative. The analysis is based on quarterly real returns for the period 1990 to 2008 inclusive, with deutschmark returns being used for the nine years before the introduction of the euro. For each currency, each quarterly dollar return comprises the interest return on that currency plus the capital gain into dollars. Three month LIBOR rates were used to calculate interest returns, as these are readily available for the whole of the period; in practice, central banks tend to hold mostly medium term government securities with less credit risk premium and more term premium, so three month LIBOR is not unrepresentative of the return on reserves investments. For gold, a LIBOR-equivalent unsecured bank lease rate is derived from dollar LIBOR minus the gold swap (Gold Forward Offered or GOFO) rate. To obtain real returns, the dollar returns are deflated by the US import price index on the grounds that the real value of the US foreign exchange reserves in terms of their foreign purchasing power is most relevant (using real returns rather than dollar returns slightly favours gold, but the results are not greatly different).

Despite the more than doubling of the dollar gold price over the 1990-2008 period, gold is given at most a weight of 36% in mean-variance efficient portfolios for low design portfolio returns. This is mainly because gold has the second lowest real return (an annualised rate of 4.2%) of the currencies (ranging from 3.6% in yen to 5.0% in sterling), without its returns being outstandingly stable or uncorrelated with the other currencies (which would give gold a diversification advantage). However, because the optimal portfolio at high returns is dominated by sterling, and hardly includes euros at any design returns, it could be argued that the results are unrealistic because it would not be feasible for America to invest such a large proportion of its reserves in sterling. The Swiss franc's low return means that it is not included at all, although no US reserves are presently invested in Swiss francs anyway, and that market would presumably have an even more limited capacity than sterling. The analysis is therefore repeated with the weights being capped at 10% for sterling and fixed at zero for Swiss francs, to see whether such constraints would imply a larger gold holding. As Figure 2 shows, they do not; while in the restricted analysis more gold is appropriate at medium design returns (up to 45%), at higher returns the euro is now favoured for its real return of 4.8% and most stable real return of the remaining currencies.

The analysis strongly suggests that, even given the strong appreciation of gold in recent years, the present proportion of gold in the US foreign exchange reserves is far too high. That conclusion appears to be robust to using different methods and other reasonable assumptions. Optimisation was tried using a mean loss measure of portfolio risk instead of variance, and gave similar results. It could be argued that the sample estimates of return means, variances and covariances are unreliable, but it is unlikely that reasonable alternative estimates would give gold a much greater weighting. In particular, it would be difficult to justify using a similarly high capital gain on gold in the near term without a tinfoil hat scenario for the value of fiat currencies (which, needless to say, the US authorities would not want to use as a working assumption). Critics of mean-variance analysis sometimes argue that an evenly weighted portfolio is just as good, which would imply a non-SDR weight of 33%.

It is instructive to examine the efficient frontiers in mean / standard deviation space corresponding to the unrestricted and restricted currency allocations, which are shown in Figure 3. The fact that the portfolio risk is actually minimised towards the highest design returns suggests that, in terms of risk at least, there is little to be lost by choosing a high return portfolio. For a design real return of 4.5%, the restricted reserve portfolio weights are 42% euros, 4% yen, 10% sterling and 44% gold. This compares with the present non-SDR allocation of approximately 9% euros, 9% yen (it is impossible to identify the precise currency allocation in the US reserves because investments in reverse repo are not broken down by currency, but the remaining currency reserves are roughly evenly split) and 82% gold. Comparing the optimal and actual portfolios, the cumulative opportunity loss over the 1990-2008 period has been $26bn in interest income foregone, reduced to $5bn by offsetting capital gains of euros, yen and gold against the dollar (of the currencies considered, only sterling depreciated against the dollar). The gap between the unrestricted and restricted efficient frontiers gives some idea of the cost in return foregone or risk taken of the limited range of currencies in which the US invests its foreign exchange reserves. While sterling and Swiss franc debt markets would not have the capacity to absorb a large fraction of the US reserves, the allocation could be broadened to include other convertible currencies like Canadian and Australian dollars and Swedish krona.

There is of course more to the case for holding some gold than just standard portfolio optimisation. History suggests that gold can provide a reliable store of value in times of extreme financial stress, such as during wartime; actually, this property of gold could be allowed for in quantitative asset allocation by using a more sophisticated description of the gold return distribution than just its central tendency (eg mean) and spread (eg variance) - in particular, with more information on the tails of the distribution. Unlike currency, gold is no country's liability and so is not subject to credit risk as long as it is physically under the control of its owner. Indeed, one reason why the USA held the majority of the world's gold bullion at the beginning of the Bretton Woods era was that the UK had been forced to pay in gold for the armaments it purchased from America in the early years of World War Two, as sterling would have presumably been rendered worthless if Britain had been defeated and occupied by the Nazis. As gold has been prized since prehistoric times, gold would probably still be valuable even if civilisation collapsed. Being of high value for a given quantity, valuable quantities of gold are easily and discreetly transported and stored. Of all countries, however, the USA has perhaps the least need for such robust security. The USA is militarily strong, has no land borders with hostile neighbours, and is a stable democracy without violent social conflict. Moreover, as one of the world's largest gold producers, America has a replacement supply and a large holding of unmined gold anyway. There does not seem to be enough justification for America to hold four fifths of its foreign exchange reserves in gold.

Another issue is that by holding so much gold, America is sending some perverse signals. When the US Treasury advises emerging market countries to minimise their holding of foreign exchange reserves on the grounds that the typically low interest rates paid by reserve assets makes them expensive to keep, holding so much gold itself makes the USA look hypocritical. In fact, given that, other than a small exposure via SDRs, none of the US reserves are held in higher yielding currencies like sterling, the USA may well have earned less interest income on its reserves than any other country in recent years. And now, at a time when the US authorities are endeavouring to revitalise the market for "troubled" risky assets by effectively exchanging them for safe assets such as treasuries, it looks incongruous to be retaining a massive holding of the most conservative investment of all; even more so when the US Treasury's share of America's foreign currency reserves have been pledged as the backing for a money market fund guarantee scheme. Worst of all, as the Federal Reserve's ongoing aggressive easing has expanded the US monetary base and raised fears of inflationary repudiation of America's massive dollar-denominated foreign debt, holding real assets like gold undermines the Fed's inflation credibility. The tinfoil hat brigade can do without more grist for their mill!

In conclusion, there is a strong case on investment and policy credibility grounds for the USA to substantially reduce its holding of gold. Even on the most conservative analysis, America should sell about half of its holding, or about four thousand tonnes of gold, and reinvest the proceeds in its normal euro and yen debt instruments, or even better, in government bonds denominated in an expanded set of currencies.

A right PRAT

2008-11-09T05:47:00.000-08:00

Henry Paulson's Troubled Assets Relief Program (TARP) is designed to alleviate the disruption of the US banking system caused by its holdings of various assets of dubious value (ie "troubled"). In RebelEconomist's opinion, the TARP tackles the problem the wrong way round by trying to remove the troubled assets from the banks. As an alternative, this post proposes the Partitioned Residual Assets Trust (PRAT) scheme, which approaches the problem from the opposite direction by selling off the safer parts of the banks.

The troubled assets comprise various structured products, typically including mortgage debt, which the banks mostly came to hold by accident, either when they were left with securities created for sale just before the market dried up, or when they took them back from off-balance-sheet investment vehicles that could no longer attract funding. At first, the banks' problem was seen as a lack of liquidity, with the complexity of the troubled assets making them hard to value and therefore difficult to sell to raise cash to repay creditors or for new lending. More recently, however, it has begun to appear that the problem is that the banks' existing and potential creditors are refusing to renew or increase lending to them for fear that some banks are insolvent. The creditors suspect that the troubled assets' realisable market values, and maybe even their "hold-to-maturity" values (ie adding back any illiquidity discount), are significantly less than the book values at which they are recorded in the banks' published accounts, not least because mortgage debt has become more risky as US house prices have fallen.

In its original form, the TARP was supposed to restore confidence in the banks by buying their troubled assets, partly to remove them from the banking system and partly to revive the market for the troubled assets by establishing transacted prices and guaranteeing a backstop bid. In doing so, however, the TARP faces the same valuation problem as potential private sector buyers. It has been suggested that the TARP could determine market prices by reverse auctions, offering a progressively higher price for troubled assets until willing sellers emerge. Unfortunately, the securities concerned are typically highly idiosyncratic, partly because of the large number of different pools from which mortgages may be drawn, and partly because they were individually structured to achieve designated credit ratings and to appeal to particular buyers, so there may well be only one seller of any particular security. And their complexity would make it difficult to design a formula to reduce several variables to a single common standard of value (eg as yield is used to compare bonds with different cashflows) that would allow a range of assets to be admissible in each auction without giving any an inherent advantage. The danger is, therefore, that the TARP would pay more for individual assets than the minimum price that a bank would accept in each case.

Even if a way of determining competitive market prices for troubled assets could be found, the outcome might not raise confidence in the banks holding them. Although the availability of transacted prices should reduce uncertainty, any bank that had been assigning higher book values to such assets would have to report a revaluation loss and correspondingly reduced capital, and it is not inconceivable that using market prices for many assets would show some banks to be insolvent. It could be argued, however, that the TARP should pay more than market value for troubled assets, because it can hold them indefinitely and could therefore forego the illiquidity discount reflected in their present market values, which would give the banks some extra help. In fact, the TARP could afford to pay up to hold-to-maturity value before it would be expected to lose money on each purchase. Unfortunately, the complexity of many of the troubled assets makes it difficult to determine their fair (ie properly allowing for default risk) hold-to-maturity values too. Also, paying more may give some banks more help than they need to return to reasonable health, meaning either that the cost to the public is greater than necessary or that fewer banks can be helped with a limited amount of money.

An alternative way for the authorities to help the banks cope with bad assets, as used in previous banking crises in other countries, is to recapitalise troubled banks by buying common or preferred shares in them. This gives each bank involved additional assets to absorb losses, in return for which the public gets some claim on the bank's future profits if the recapitalisation is successful. Preference shares rank above common stock in the creditor pecking order, ensuring that losses are borne first by the banks' existing shareholders, but typically pay a fixed dividend, so that unless they are convertible into common stock their return does not increase with the profitability of the bank. The TARP was amended during its passage through Congress to include the option to buy stakes in the banks as well as their troubled assets, and following the British government's lead in taking stakes in British banks, the facility was used in the USA. The main problem with capital injections is how to set the terms to be fair to both taxpayers and existing bank shareholders. To be more precise, for a given amount of cash, how many shares should the TARP receive (note that it would not be appropriate to pay the market price of existing shares, because injecting cash makes default less likely and therefore reduces the value of the implicit option represented by the shareholders' limited liability), and, in the case of preference shares, what dividend should they pay? Only in the extreme case where a bank is definitely insolvent would it be reasonable to simply write down the value of the shareholders' equity to zero before injecting fresh capital – in other words, to nationalise the bank – as Sweden did with some banks during its banking crisis in 1992. If there is any doubt that the nationalised bank was insolvent, its shareholders can be expected to claim that the government is appropriating their property. Also, taking a public stake in a bank is a blunt instrument to deal with problems emanating from a troubled minority of assets. If the stake is held in the form of common stock, it is necessary for the government to decide whether, and if so how, to exercise shareholders' control rights, and owning shares of any kind exposes the public to all kinds of fresh business risks not necessarily arising from the troubled assets.

A better solution, it occurs to RebelEconomist, would be to combine a market-value separation of the troubled assets from the parts of the banks that provide banking services with preserving the existing bank shareholders' interest in the troubled assets. The basic idea is that, since it is the troubled assets that are hard to value, the existing bank shareholders should keep these while the rest of the bank is sold.

The details of the plan are as follows. In order to decide which banks ought to be partitioned, and which of their assets should be retained by their existing shareholders, a rough conservative valuation of each bank's assets and liabilities would be made, together with an estimate of how uncertain these valuations are. If this valuation suggests that the bank is, or has a significant probability of becoming, less capitalised than some minimum standard, the bank would be partitioned. The assets with the most uncertain values (ie the troubled assets) would be assigned to a trust fund to be passively managed on behalf of the existing bank shareholders by government-appointed managers. In other words, after partitioning the bank, the residual assets are placed in a trust, hence the acronym PRAT. Each bank share would be converted into one share in the trust. PRAT shares would be non-voting, but marketable to allow its shareholders to liquidate their stake if they wish. The gap remaining in the bank's balance sheet remaining after removal of the troubled assets would be filled by an injection of government bonds of sufficient size to bring the bank up to some highly prudent capital ratio. This safe bank, which should be relatively straightforward to value accurately, would be floated, ideally by auction, with the government receiving the proceeds to defray some of the value of their debt injection. The remaining liability, owed to the government, would then be assigned to the trust fund.

The PRAT scheme has the following notable features:

(1) The safe bank should be regarded as highly creditworthy, and be trusted by the public to provide typical banking services. While subject to banking regulation and supervision as normal (albeit probably tightened in the light of recent experience), it would be free of government control. Beyond the standard deposit insurance, it should not be necessary for the government to guarantee any of the safe bank's liabilities.

(2) Because the safe bank should be readily marketable, the existing bank shareholders should receive a fair value for it, meaning that they cannot claim that they have been cheated by the government. The value of the government debt injected into the bank to make it safe should be reflected in its flotation price, and so its generous capitalisation should not increase the debt burden on the PRAT. Although the valuation of the troubled assets used in the process was rough, these values determine only whether and how to partition the bank and are not used as transactions prices.

(3) Since the existing bank shareholders retain the troubled assets through their equity in the PRAT, they bear any losses these generate in future. Besides being cost-efficient from the public point of view, this solution also minimises moral hazard. This is not unreasonable, given that the shareholders were supposed to be in control of their business and therefore ultimately responsible for its mistakes, and were well rewarded during the boom years, not least for bearing the risk associated with being at the bottom of the pecking order. And if the troubled assets do come good, the PRAT shareholders benefit fully. In effect, the trust concentrates the risky part of the bank's balance sheet in a vehicle which, unlike a bank, does not perform a vital function in the financial system.

(4) While the PRAT should begin with positive equity based on the book values of the troubled assets, if their market values are more realistic, the trust might actually be on the edge of insolvency. This is why the PRAT is established as a trust rather than under shareholder control – to prevent the shareholders "gambling for redemption" in the hope of generating enough return to cover the trust's liability to the government. The potential cost to the taxpayer is limited to the PRAT's debt, plus its administrative expenses. Since separation from the troubled assets can be expected to give the existing bank's junior creditors a windfall gain in the value of their claims, it would be appropriate for them to bear some of the cost of the solution, which could be achieved by swapping some of their claim for PRAT equity. Bank employees' unvested stock bonuses from previous years could also be converted to PRAT shares.

To sum up, instead of removing the troubled assets from the banks, it would be better to remove the banks from the troubled assets. The PRAT scheme could achieve this in a way that is fair to both existing bank shareholders and taxpayers.

Just say no

2008-10-29T09:45:00.000-07:00

Although RebelEconomist has previously argued that it would be possible for the USA to neutralise or even take advantage of the so-called "mercantilist" policies of its trade partners that have contributed to America's large trade deficit, the prospect of increased political support in America for a more protectionist trade policy and the special problems of dealing with China's exchange rate regime make it sensible to consider how to block mercantilism if it really is regarded as unacceptable. This post suggests a simple counter-measure which works by impeding modern mercantilism's central mechanism, the mercantilist country's liberty to accumulate foreign exchange reserves in the currency of the target country for their exports.

Americans worry about their trade deficit for at least two reasons. For most people, their immediate concern is the loss of jobs and wealth generation involved when domestic demand is satisfied by imports rather than domestic production. A longer-term problem is that the imbalance of imports leads to an accumulation of financial claims on the USA that the holders expect to be able to redeem for goods and services sometime in the future, obliging Americans to forego some consumption for a period. If the USA continues to have a large trade deficit into a nasty recession, there will probably be increasingly loud calls from industrialists and labour unions to restrain imports. And with Barack Obama (the leading US Presidential candidate at the time of writing) having expressed reservations about free trade agreements such as NAFTA during his election campaign, the possibility of America adopting some protectionist trade policies has to be seriously considered.

Naturally, the countries with the largest trade surpluses with the USA are the focus of American disapproval, especially those whose governments apparently promote trade surpluses by their exchange rate regime or by import tariffs and other trade controls, policies labelled as "mercantilist" by their detractors. At present, the most prominent of these countries is China, which pegs its currency to the US dollar at a rate that makes its exports relatively cheap to Americans. To fix the renminbi/dollar exchange rate at the peg level, the Chinese authorities offer to exchange as much of their currency for dollars or vice versa as the foreign exchange market requires at that level. In practice, since the peg level chosen generates more exports than imports, while the Chinese government restricts capital account transactions including both investment abroad by Chinese citizens and foreigners' investment in Chinese assets, the renminbi exchange rate regime obliges the Chinese authorities to steadily buy dollars. These dollars are then invested by the authorities in financial assets to add to China's foreign exchange reserves. If the reserve currency authorities – the US government in this case – are unhappy with the appreciating effect of reserves accumulation on the exchange value of their currency, they could respond in kind by buying foreign currency themselves, most directly by buying the currency of the reserve-accumulating country. Such opposing action is not necessarily hostile, as it does allow countries to continue accumulating dollar assets as contingency reserves (and America to acquire foreign exchange reserves itself), albeit while neutralising the exchange rate impact. China's restrictions on capital inflows, however, rule out offsetting intervention by preventing other countries from accumulating renminbi reserves.

An obvious solution to America's problem of unwelcome persistent trade deficits with countries which restrict capital inflows is to simply limit the amount of dollar assets that their governments and their agents are allowed to own. Alternatively, foreign government holdings of dollar assets could be penalised by levying a special withholding tax on their returns. By tackling the problem at source using an instrument (control of trade counterparts' reserves accumulation) that directly influences the objective (the trade deficit with a particular country), this approach – call it Reserves Control – provides an efficient solution in the spirit of Mundell's Principle of Effective Market Classification, which should recommend it to macroeconomists. The sanctioned country would either have to allow their currency to appreciate against the dollar, select certain exports to be given priority access to the American market, or buy more American products of some kind. Unlike conventional trade restrictions, such as tariffs or import quotas, Reserves Control would affect all industries the same, with no opportunity for lobbying by firms and trade unions etc to obtain favourable treatment for their particular interests. Reserves Control would be difficult to evade, given the volume of dollar asset purchases necessary for a country to sustain a significant trade surplus with the USA. Existing money laundering regulations and supervision should make it impossible for countries to evade Reserve Control by disguising government acquisition of dollar assets, such as by using agent fund managers, on anywhere near the scale necessary to affect exchange rates. And not enough offshore dollar investments exist with sufficient size, liquidity and security, or independence from the US authorities to offer a significant alternative to US assets for reserves accumulation.

The difference between Reserves Control and Warren Buffett's clever Import Certificates scheme is that Reserves Control exclusively targets intervention by specific foreign governments in support of their country's exports to the USA. In brief, the Import Certificate scheme would grant US exporters tradable certificates to the dollar value of their exports, which importers need to present to the US authorities to be allowed to import goods and services of the same value into the USA, and would therefore need to buy from American exporters. This would act like a variable tariff that automatically adjusts to maintain a zero balance of trade while giving priority to the most valuable imports, regardless of their country of origin. Under Reserves Control by contrast, a trade deficit could still exist, but only to the extent that the foreign private sector is willing to hold financial claims on the importing country, and countries that are not considered to be mercantilist need not be penalised. In fact, Reserves Control is not trade restraint per se, and the restriction it does impose is a matching response to a trade partner's closed capital account.

In truth, it is not hard to think of ways around such controls – for example, government guarantees for export credit in the case of Reserves Control and transfer pricing in the case of Import Certificates – that would undermine either scheme before long, so RebelEconomist sees them both as second-best, temporary solutions. As he has previously argued, if a country is apparently using reserves accumulation to effectively subsidise its exports, it seems sensible to try first to accept and exploit this by matching the implied financial liabilities with assets that yield as least as much. But if the reserves accumulation is being driven by the trade deficit at a not unreasonable exchange rate that is being maintained for monetary stability purposes, the real problem may lie in the productivity or pricing policies of domestic producers of tradable goods and services.

Beware rising custody holdings

2008-09-26T08:09:00.000-07:00

As RebelEconomist has previously discussed, the US financial system lifeboat (now officially known as the troubled asset relief program, or TARP) ought to damage US sovereign creditworthiness, and - because the easiest way for America to lighten its growing debt burden is to allow inflation to reduce its real value - increases the likelihood of dollar depreciation. Not surprisingly, there has been speculation that Asian and oil-producing country central banks and sovereign wealth funds, which are some of the largest holders of US public sector debt, will start reducing their dollar reserves. Since many of these national institutions do not publish details of the currency denominations and types of assets they own, skilled observers of international capital flows like Brad Setser study the weekly Federal Reserve balance sheet report for details of the Federal Reserve Bank of New York custody holdings on behalf of other central banks, which include US Treasury and agency bonds, for clues about changes in the size and composition of dollar reserves.

As Brad Setser noted overnight, Fed custody holdings have been increasing in the last couple of weeks, which suggests that the foreign central banks are not reducing their holdings of dollar reserves, but RebelEconomist suspects that the custody holdings may be a misleading indicator at the moment. This is because the custody accounts are probably being used in the dollar lending operations conducted by various developed-country central banks cooperating with the US authorities to cope with the present elevated global demand for dollar liquidity.

The dollars being lent by the participating central banks (the European Central Bank plus the central banks of Britain, Switzerland, Japan, Canada, Australia, Sweden, Denmark and Norway) are lent to them by the Federal Reserve, in return for a loan of their own currency, under a reciprocal swap lines arrangement. Being risk-averse institutions, central banks normally lend only against relatively good collateral when conducting liquidity-providing operations. When lending dollars to their own commercial banks, although central banks may be happy to take domestic currency bonds, they are likely to request additional collateral to do so, to provide additional protection against the currency mismatch. For example, the Bank of England requires 4% more collateral if non-dollar securities are pledged. In view of this, some of the central banks’ counterparties may pledge dollar bonds, including US Treasury and agency securities. If so, like the Bank of England, the central bank may request that the collateral be delivered into its Fed custody account for safekeeping. As it appears that the Fed custody holdings are reported on a settled basis (as opposed to a done basis), to the extent that the foreign central banks do take treasuries and agencies as collateral, their custody account holdings can be expected to increase.

Since the reciprocal swap arrangements have been expanded three times already this month, on the 18th, 24th, and 26th, and because the central banks involved have increased their dollar lending, other things equal, it would not be surprising to see an increase in Fed custody holdings at the moment. But this would not necessarily mean that central banks are accumulating dollar reserves, and may conceivably be concealing a reduction in dollar reserves holdings.

Addendum: how the swaps work:

The question of how the swaps work has arisen in the comments on this post.

Initially, I had imagined, for each increase in the reciprocal swap programme, a single foreign exchange swap between the Fed and each central bank involved, which effectively loaned the stated amount of dollars to the foreign central bank until April 30th 2009 (the programme's planned horizon at present) against collateral of their own currency, to be lent by them as the need for dollars arose from their commercial banks. I therefore thought that the swaps must be off-balance sheet, because there was no item on the Fed's H.4.1 report sufficiently large (ie $290bn from September 26th) to account for either side of the swap. After further consideration and discussion elsewhere, I now think that the announced size of the swap programme (which has since increased to $620bn) actually represents the maximum size of a portfolio of swaps. My guess is that, for each dollar loan auction by a foreign central bank, the dollars are drawn from the Fed via a matching currency swap of the same size and term as the loan. These dollar loans from the Fed are probably included in the “Other Federal Reserve Assets” line of H.4.1, but since they have yet to build up to their limit, that item remains much smaller than the reported size of the reciprocal swap programme.

I had been wondering about the pricing of the swaps, which would be a huge issue if the swap is for seven months and the dollar lending is for shorter periods, but I would expect that the terms of the swap are arranged so that their pricing reflects the dollar interest rate achieved in each auction. Nevertheless, it must be said that this kind of detail should be given in the notices (including from the foreign central banks involved) that announce these operations. Now that the swap programme is so large, the potential interest differentials (depending on how the swaps are arranged) are in the order of billions of dollars over the planned life of the programme.

Selling the family silver

2008-09-24T07:17:00.000-07:00

On the road to financial ruin, an oniomaniac may cross a series of boundaries into increasingly desperate, previously unthinkable behaviour in order to carry on spending. Having exhausted their credit, they may raid their children's savings, or pawn their wedding ring. It seems that, in its attempt to stave off bank closures and even a mild recession following perhaps the greatest boom in history, the USA will soon cross such a line by starting to sell off its foreign currency reserves.

Last week's announcement of a government guarantee for money market mutual funds stated that the backing for the guarantee would be provided by the $50bn Exchange Stabilization Fund (ESF). Essentially, this is the fund which the US Treasury would use to fund intervention in the foreign exchange market if required, and includes the Treasury's share of the US foreign currency reserves (the rest being held by the Federal Reserve in its System Open Market Account). According to Michael Bordo, this is the first time in the ESF's history that it has been used for domestic purposes.

To RebelEconomist, this initiative begs the question, how can this foreign currency fund be used for domestic purposes? Well, the ESF does currently hold about $17bn in dollar securities, to provide dollars in case the US government wanted to sell dollars in the foreign exchange market, but the size of the guarantee accounts for the entire ESF, including its euro, yen and SDR assets. The implication is that, if the $3tn+ money market mutual fund industry suffers losses in excess of $17bn, the US Treasury will be forced to sell foreign currency assets to buy dollars. Since the USA has historically tended to disdain holding foreign currency reserves itself, it (ie the Treasury and Fed combined) owns (ie not counting foreign currencies held temporarily through reciprocal currency swap arrangements with other central banks) only about $47bn of euro and yen reserves. Even moderate losses sustained by money market mutual funds arising from bankruptcies such as that of Lehman, which caused the Reserve Primary Fund to become the first money market mutual fund to "break the buck" (in other words, lose some of its investors' capital and not just interest) since 1994, could quickly deplete the USA's foreign currency reserves almost entirely. Moreover, it is not clear that the drawdown of the ESF has not begun already. The US authorities have also undertaken to buy short term agency debt and lend money to money market mutual funds to help them meet redemptions, with the first $2bn of these operations being done yesterday, and reports so far do not make clear that this support for money market mutual funds is not also being funded from the ESF.

For now at least though, no plans have been announced to draw on the much larger, and more iconic, US gold reserves.

The end of the beginning

2008-09-19T11:02:00.000-07:00

The news that the US authorities are devising a lifeboat for banks along the lines of the Resolution Trust Corporation of the 1980s – let's call the impending scheme the RTC2 – called to RebelEconomist's mind the words of Winston Churchill after the Battle of El Alamein: "this is not the end; it is not even the beginning of the end; but it is, perhaps, the end of the beginning". If media stories are correct, the idea is that RTC2 will buy unsaleable assets from the banks to allow the banks to clean up their balance sheets, and thereby restore the confidence in bank solvency necessary to allow banks to perform their normal business function. It seems to RebelEconomist that this initiative represents the logical conclusion of the accelerating sequence of bailouts that the US authorities have been conducting since at least the start of the present crisis, if not for longer. Since the debt of every American financial institution smaller than the government is now effectively government-guaranteed, attention will now turn to the solvency of the state itself. In RebelEconomist's opinion, the RTC2 initiative represents a last throw of the dice by the present administration to avoid the unpopular policies that are needed to properly fix the US economy.

In the ideal outcome, the true value of the assets bought by the RTC2 will exceed the price it pays, and with the time granted by the deep pockets of the state they will eventually prove to be profitable holdings so that the scheme costs the American taxpayer nothing. There are various reasons, however, why RebelEconomist doubts that this ideal outcome will be realised. First, reports suggest that the RTC2 facility will be a voluntary facility for the banks. Since the banks will be required to give up an equity stake in their business as well as their assets when they sell to the RTC2, they will be reluctant to go to the RTC2 unless it is their best remaining option. The danger is that the banks, which should have at least as good information about the value of their assets as the RTC2, will tend to deal with the RTC2 only when it offers more than their assets are worth. Using reverse auctions to establish a fair price for these assets will not generally be feasible, because the idiosyncratic nature of the most troublesome structured products on the banks' balance sheets means that there will often be only a single potential seller of a particular security, as well as the one RTC2 buyer. Second, the bailout culture, of which the RTC2 itself is the apotheosis, may well undermine the value of the assets it acquires. If borrowers are aware that their mortgage debt is now owed to the government, they could argue that they deserve a bailout as much as the banks and refuse to pay, emboldened by the knowledge that the government will be sensitive to the bad publicity that foreclosure and eviction would generate.

At the time of writing, there has been little information given about how the RTC2 would be funded. Presumably, it will be funded by increased issuance of treasury bonds in some form (perhaps as dedicated, labelled, RTC2 issues). Besides the effect of additional supply in terms of lower bond prices and higher yields, at some point, after the bailouts of Bear Stearns, the housing agencies and AIG, and now the RTC2, the AAA rating of the US government must be in jeopardy. The major rating agencies S&P and Moody's cannot afford renewed accusations of conflict of interest, this time as American companies rating their own government. Although the case can be made that the US government would never default on debt payments in its own currency, this argument did not dissuade the rating agencies from downgrading Japanese government yen debt, despite the fact that Japan's reliable public administration compares favourably with the US history of debt ceiling scares. The US sovereign rating of AAA by S&P and Aaa by Moody's looks increasingly out of line with Japan's ratings of AA and A1 (ie two and four notches below triple-A) respectively. CDS protection against default by the US government has been trading more expensively than Japan since at least the housing agency bailout. Any downgrade of the US sovereign credit rating will reduce the range of investors permitted to buy US government debt and can be expected to raise treasury yields. While the RTC2's demand for mortgage debt, and the reassurance it provides to financial markets, can be expected to reduce spreads between mortgage and treasury yields, some of the resulting reduction in mortgage rates could well be given back in the form of a higher underlying level of US bond yields based on treasuries.

In RebelEconomist's opinion, the US already has too much debt to take on more to finance a bailout of the whole banking system. Since there is going to be limited scope to cut public expenditure without social unrest in the developing downturn, the US government should spend more wisely, and raise taxes, especially on windfall gains remaining from the boom. Instead of spending money forestalling bankruptcies and foreclosures, the government should allow them to occur naturally, and concentrate on facilitating the adjustment and limiting the distress involved. Expand the bankruptcy administration to expedite foreclosures, but provide grants to move and re-house those dispossessed who leave graciously, and assistance for new owners to take over, especially when they have been renters, so that houses do not remain empty for long. Provide retraining for those whose jobs are permanently lost as a result of the restructuring, such as realtors and mortgage brokers. Raise taxes first on those who have benefited from the activities that led to the present bust. Even if it does not raise a large fraction of the money needed, it would be salutary to levy a retrospective income tax on financial workers' bonuses in excess of, say $10mn in the last five years. Increase inheritance tax, since much wealth bequeathed nowadays will represent unanticipated capital gains on houses and stocks during the boom years. America, it is time to stop rolling the dice; roll up your sleeves and clean up the mess!

Mad about mercantilism

2008-09-15T02:53:00.000-07:00

Many critics of China's exchange rate policy label it as "mercantilist", meaning that its purpose is to promote net exports in order to increase the country's financial wealth at the expense of its trade partners. Countries running trade deficits with China complain (without a trace of irony about the bounded – ie up to balanced trade – mercantilism that their own position represents) about losing industry and employment to China. Although RebelEconomist does agree that it would be in China's own interest to allow its exchange rate to float increasingly freely, he would question whether complaints that China's currency policy is mercantilist and disadvantageous to its main trade partner, the USA, above all are justified.

First, it is hard to characterise China's exchange rate regime as mercantilist. While China does seem to have adopted an export-led economic development strategy, and is undoubtedly now worried about the impact on employment of a slowdown in exports if it allows its currency to appreciate sharply, China has not adjusted the exchange value of its currency to stimulate exports. The original motivation for the peg to the US dollar was to augment China's monetary stability following currency reform at the beginning of 1994, with a practically fixed exchange rate of 8.28 yuan to the dollar being maintained from then until 2005. This peg was held despite substantial real renminbi appreciation in the first few years due to relatively high Chinese inflation and pressure for a nominal devaluation in line with other Asian currencies during the Asia Crisis of 1997-98. And since July 21st 2005, when the renminbi was re-pegged to a currency basket apparently dominated by the US dollar, involving an immediate 2.1% appreciation, the renminbi has been allowed to steadily appreciate against the dollar. China's increasing competitiveness and consequently large trade surplus has been driven by productivity growth and the pricing strategies of its exporters rather than its exchange rate regime. This presumably explains why the US Treasury has declined to brand China a "currency manipulator".

Second, whatever the motivation for China's exchange rate policy, RebelEconomist is sceptical whether it necessarily gives China any economic advantage at the expense of the USA. On the contrary, RebelEconomist can think of two arguments why China's currency regime actually ought to be a disadvantage for China, and by implication, potentially advantageous for the USA.

To appreciate the first argument, a brief reminder of the operations involved in pegging an exchange rate may be helpful. Initially, in order to hold the exchange rate at the peg level, the authorities undertake to exchange as much of their currency for the peg currency as the market requires at that level. In China's case, this intervention usually obliges the authorities to buy foreign currency, mainly because, at the peg exchange rate, Chinese products are cheap in foreign markets, meaning that the supply of foreign currency from exporters selling their foreign currency revenue for renminbi outweighs demand for foreign exchange from Chinese importers needing to pay for imports. Also, the fact that the Chinese government restricts its citizens' freedom to buy foreign currency financial assets reduces Chinese demand for foreign currency. Then, in order to accommodate the currency flows generated by their intervention, the authorities normally buy and sell financial assets, typically bonds. In China's position, this entails selling bills to domestic banks to raise renminbi to sell, and buying mostly US government and agency bonds to invest the dollars that China buys. The bonds purchased are retained as foreign exchange reserves, allowing the foreign exchange intervention to be unwound if the market flows reverse. In theory, now that China holds more than enough foreign exchange reserves to meet any foreseeable need for reverse intervention, the Chinese government could spend some dollars on American products instead of bonds, but for strategic reasons, the US government bans American companies from selling China many of the type of defence and technological goods that the Chinese might like to buy. Naturally, the concentration of Chinese dollar investment in US government debt raises bond prices and therefore lowers the interest rates payable by the US government. In short, China's intervention involves under-pricing the goods that it sells to the US, and paying an excessive price for the US assets that it buys. This hardly seems like grounds for the Americans to complain.

The second argument against the idea that China's exchange rate policy gives them a competitive advantage applies regardless of how the policy is implemented. This argument, which appeals to RebelEconomist's mathematical pretensions, is simply that the currency peg imposes a restriction on the Chinese economy, and calculus teaches us that a constrained optimum cannot be superior to the unconstrained optimum.

The idea that mercantilism is a disadvantage to the mercantilist is not new. The British economists who did most to discredit mercantilism, such as Adam Smith and David Hume were arguing against the advocates of mercantilist policies for their own country, such as Thomas Mun. They drew their conclusions from somewhat different reasoning, however. Smith explained that the proceeds of trade are generally better spent on enhancing the productive capacity of a nation rather than being saved at low interest rates (admittedly, the key reserve asset when Smith was writing in the 18th century was gold) and Hume described how accumulated trade wealth could be expected to bid up domestic prices so that a trade surplus would prove unsustainable anyway.

Provided that America can organise itself to exploit this apparently irrational behaviour by China, such as in the ways that RebelEconomist has suggested in a previous post, China's exchange rate policy need not be a problem for the US. Even if particular American industries suffer from under-priced Chinese competition, the overall gain to the US economy from cheap imports and low-cost funding should provide the resources necessary to compensate or reassign people involved in those industries.

It’s a wind-up

2008-08-19T10:58:00.000-07:00

As the credit crisis has unfolded, several vicious circle processes have come to light which have contributed to its magnitude and persistence. Such positive feedback loops – which in this case are sometimes wrongly called negative feedback loops because they reinforce the credit crisis – act to increase the response of a system to a change in an input variable. On the assumption that these mechanisms are intolerable, analysts of the credit crisis have suggested various financial system reforms to eradicate them. RebelEconomist, however, questions whether such positive feedback loops really are a major problem, and considers that some of the proposals to get rid of them might create their own perverse effects.

One such positive feedback mechanism that has been much discussed recently is bank capital adequacy regulation. The existing fixed capital ratio rule has the effect of amplifying the business cycle, because during a period of elevated credit losses like the present, banks may prefer to contract lending and sell existing assets to reduce any resulting capital shortfall rather than sell additional shares at depressed prices or cut dividends to raise more capital. To the extent that selling and buying less assets reduces asset values in general, the asset side of the banks’ balance sheets contracts further, and forces further asset sales, and so on in a vicious circle. In order to reduce this inherent pro-cyclicality, Goodhart and Persaud propose that a bank’s capital requirement should depend on its recent asset growth, so that bank capital coverage automatically rises during credit booms to restrain the expansion, and falls in busts. The trouble is, who would lend money to a bank that was being allowed to run down its capital cushion against losses at a time of financial turmoil? You might as well propose that gravity be reduced at the bottom of hills. One lesson that should have been learned from the credit crisis is that, if there is the slightest doubt about a bank’s solvency during a time of stress, it will be shunned by lenders. Unless the scheme introduces counter-cyclicality by forcing banks to hold excess capital at all times except the very worst, which would certainly be strongly resisted by the banks and may well be inefficient, it might even exacerbate a credit crisis.

Another positive feedback mechanism is the requirement for financial businesses to report realistic market, or “fair”, values for a large proportion of the assets they hold (the alternative being to value the assets at their historic cost when acquired). This requirement (eg as specified in FASB statements 157 and 159 in the US) has been applied increasingly extensively to financial businesses. Since fair market valuation reveals the effect of falling asset values on firms’ solvency, it raises their cost of funding following such losses and so exacerbates their problems. In this case, proposed remedies include restricting the scope of fair value accounting to assets that are intended to be held for a short period only, or at least suspending further introduction of fair value accounting until the credit crisis subsides. No doubt a firm in difficulty would be grateful for the opportunity to try to trade its way out of trouble with money owed to its creditors, under the cover of accounts that do not reflect creditors’ exposure to a potential default, but such obfuscation could be expected to discourage future commitments and raise the cost of new credit. In fact, economic theory suggests that, in the absence of full disclosure, creditors might well assume that the danger is worse that it really is. Apart from providing some short-term relief at the expense of already committed creditors, abandoning fair value accounts might also exacerbate a credit crisis.

Perhaps the concern about positive feedback mechanisms in the financial system is misplaced. Positive feedback is quite common in nature, such as the amplifying effect of sea ice on global temperature or the cascade of neutrons in nuclear fission. No doubt, as discussed, many of the positive feedback mechanisms in the financial system exist for good reason. Provided that a feedback process is convergent, or is interrupted or counteracted by some other process before it progresses too far, it is not necessarily a problem. It can simply be seen as playing a role in determining the path and amplitude of the system’s dynamic response to changes in input variables. What really matters is that the influence of any such feedback mechanisms is taken into account when predicting the response of the system to shocks. In short, a reasonable answer to coping with financial system positive feedback mechanisms like capital adequacy requirements or fair value accounting is for firms to allow for them by either further reducing their exposure to risk or building in more protection.

To peg is not to hold

2008-07-31T13:39:00.000-07:00

It is often assumed that a country which pegs its currency to another must intervene in that currency pair to fix their exchange rate, and will therefore hold foreign exchange reserves in the peg currency for that purpose. This presumably explains why, although US Treasury Secretary Paulson has urged China to change its exchange rate policy (a crawling peg to an apparently dollar-dominated currency basket), he has accepted the Gulf Cooperation Council (GCC) countries’ pegs to the dollar. In both cases, the weakening of the US economy which led to easier monetary policy and incipient dollar depreciation has obliged the pegging countries to buy a lot of dollars. These dollars are invested in dollar securities, especially bonds, and held in those countries’ foreign exchange reserves (or, in a growing number of countries, their sovereign wealth funds). While this has had the welcome (since the credit squeeze began at least) effect of holding down US long-term bond yields and hence mortgage rates, the US authorities would have liked the Chinese to let the renminbi appreciate against the dollar, since many Chinese exports, such as steel, compete with American products to some degree. By contrast, the US does not produce as much oil as it requires and has actively called for more oil from the GCC countries, and oil is generally priced in dollars anyway, so Paulson would prefer US mortgage rates to be reduced by reserve accumulation by GCC countries rather than by China. In fact however, unless the exchange rate regime is a rigid fix in the form of a currency board (where by definition the domestic currency is fully backed by holdings of the peg currency), currency intervention need not involve the peg currency at all, as this post explains.

Foreign exchange intervention in an exchange rate pair works by augmenting the market supply and demand for assets denominated in the two currencies involved. When a central bank intervenes in the foreign exchange market, the domestic asset traded is always, in the first instance, domestic base money. In the case of sterilised intervention though, this flow of base money is offset, either by selling bonds to recover the base money sold, or buying bonds to replenish the money supply when base money is purchased. Effectively, sterilised intervention trades domestic bonds against foreign bonds, but the exchange rate is a factor in their price difference (for the purposes of this post it is assumed that sterilised intervention does affect the exchange rate).

The mechanism by which intervention affects the two currencies involved may be understood by analogy to a physical system governed by Newton’s third law of motion “every reaction has an equal and opposite reaction”, such as the boats on an ocean shown in Figure 1.

The boats represent currencies, and the distance between any pair represents their relative value or exchange rate. The position of any boat on the sea represents the wider value of the corresponding currency relative to all other currencies (and indeed anything else that the currency can buy, including goods and services). By pulling or pushing against another vessel, a sailor in one boat can shift its position relative to the other, just as trading between two currencies can affect their exchange rate. Consistent with Newton’s third law, applying a force on one boat from another will also shift their absolute positions on the sea, by an amount for each boat that is inversely proportional to its mass. If a light boat such as a dinghy pulls on a heavy ship, for any given change in their separation, the absolute position of the dinghy moves further than that of the ship. Here, the mass of a boat is analogous to the total volume of transactions in a currency; if a currency is heavily traded, a foreign exchange transaction of given size accounts for a small fraction of the market turnover involving that currency and can therefore be expected to have proportionately little impact on its overall exchange value.

Typically, a currency peg involves fixing a minor - ie comparatively lightly traded - currency to a major one like the US dollar. This means that intervention to maintain the peg works mainly by changing the exchange value of the minor currency and has relatively little effect on the overall value of the major currency. A corollary is that the peg could be operated almost as effectively via foreign exchange transactions against another major currency to which the minor currency is not pegged. To use the boat analogy, a sailor in a dinghy wanting to move towards, say, the SS Dollar (Figure 1a) could move almost as far towards the SS Dollar by pulling against another large ship lying alongside it, such as the SS Euro (Figure 1b). The practical implication is that it is not necessary to deal in, and therefore not necessary to hold, assets denominated in a particular currency in order to peg to that currency, although it would be most efficient (in terms of the volume of transactions required) to deal against the peg currency, especially if it is not far more heavily traded than the pegged currency.

There could be various reasons why a country that pegs its currency to another might not want to deal in or hold that currency in its reserves. One explanation might be that the peg currency is not freely traded on the foreign exchange market (ie it is not fully convertible). This may be the case when the peg currency is that of a key trade partner such as a neighbouring country and is itself a minor currency. It could be preferable to hold assets denominated in non-peg currencies for investment motives, such as because they are expected to offer a higher return, more stable value, or greater liquidity than the assets available in the peg currency. Another reason might be that a country’s foreign exchange reserves serve several purposes, and the other purposes are better served by holding a currency other than the peg currency.

The relevance of this discussion to the present international macroeconomic situation is that, if, in the light of the apparent willingness of the US Federal Reserve to jeopardise the value of the dollar by keeping interest rates low to stimulate economic activity and by taking on large contingent liabilities like those incurred in the rescue of Bear Stearns, dollar-pegging countries fear a sharp depreciation of the dollar and a consequent loss on their reserves, they can cap or even reduce their exposure to the dollar without relinquishing their dollar pegs. Ironically, because the GCC countries' currencies are lightly traded, the necessary changes in intervention strategy (ie somewhat more active intervention, against a different major currency, most likely the euro) would be easier for them to make than for China.

The Greenspan Put

2008-06-30T14:34:00.000-07:00

As an alternative to the savings glut explanation for the expansion of spread product in the US that ended in the sub-prime bust, in his previous post RebelEconomist suggested that investors’ belief in the existence of the so-called Greenspan Put may have played a role in encouraging them to buy more risky assets. This post presents some evidence that investors do seem to have come to expect the Fed to at least behave as if there is a Greenspan Put.

The idea of the Greenspan Put is that the Federal Reserve provides protection for investors against sharp falls in the value of US risky assets (strictly, a put option hedge would be paid for and exercised by the investor, but it is the protection principle that matters here). By cutting interest rates in response to such developments, the Fed can support asset prices, both directly by lowering the discount rate applied to anticipated future cashflows, and indirectly by boosting economic activity which decreases the likelihood of debt defaults and, in the case of stocks, enhances company earnings. While it can be argued that easing monetary policy is an appropriate reaction to a large fall in asset prices anyway, because such events inhibit economic activity and hence restrain inflation, under Alan Greenspan's leadership the Fed made a series of eases in response to financial crises which appeared to be disproportionately aggressive considering either the severity of the shock or the amount of easing in each case.

Within a few weeks of Greenspan taking over from Paul Volcker as Fed chairman, the Fed cut the Federal funds target by half a percent to bolster damaged confidence in the wake of the “Black Monday” stock market plunge of October 19th 1987, even though this roughly 25% correction merely cancelled out the increase of the preceding year of boom. Fed funds were held at 3% from September 1992 to February 1994 to assist the resolution of the “thrifts crisis”. Interest rates were cut when Long Term Capital Management’s disastrous bets on continued convergence of yield spreads caused trouble in Autumn 1998, despite the fact that Greenspan had specifically warned that “caution also seems warranted by the narrow yield spreads” in his Humphrey Hawkins testimony of February 1997. Greenspan subsequently explained that the easing was intended “to address the seizing-up of financial markets”. This cut in interest rates, and the various liquidity-ensuring measures taken in case of disruption associated with the turn of the millennium, seemed to accelerate the persistent rise of the stock market from the mid-1990s that had prompted Greenspan’s famous “irrational exuberance” remark. Nevertheless, when the dotcom boom turned to bust, the Fed reduced the Fed funds rate to a historic low, though the subsequent recession turned out to be mild and inflation remained comfortably positive. Although Greenspan retired in January 2006, the rapid lowering of interest rates by the Fed since the current financial crisis began with losses on US sub-prime mortgage debt, especially the apparently panicky 75bp emergency cut on January 22nd this year, suggests that the pattern continues with new chairman Ben Bernanke, and there is now discussion of a Greenspan-Bernanke put.

As Figure 1 shows, these episodes seemed to change the link between interest rate expectations and risky asset prices. If the central bank is mainly concerned with inflation, then interest rate expectations will tend to drive risky asset prices, and bond yields which discount short-term interest rates will tend to be negatively correlated with stock prices, because, other things equal, higher interest rates are bad for risky assets and low interest rates good. Alternatively, the more the central bank is inclined to ease to mitigate falling asset prices, the more frequently asset prices drive interest rate expectations, in which case the correlation between short-term interest rates and asset prices will be positive. Figure 1 shows the correlation between daily changes in yield on the two year treasury note and in the S&P500 stock index from August 6th 1979, the day that Volcker became Fed chairman, until June 26th 2008. The two year note yield tends to be highly sensitive to near-term policy interest rate expectations without, as a “risk-free” rate, being disturbed by changes in creditworthiness. The S&P500 index represents the main risky asset class.

In the early years of the period covered by Figure 1, the blue line, which shows the rolling one hundred (working) day correlation between interest rate and stock price changes, indicates generally negative correlation. Its first sustained move into positive territory is linked with the 1987 stock market crash - note that, as each point in the hundred day sample contributes equally to the correlation and the correlation value is plotted at the point corresponding to the centre of the sample, sharp changes in market behaviour will appear fifty days before the event that drives them, and last for fifty days afterwards. Stock market sentiment was fragile for several years after the 1987 crash, and there was a brief scare when stocks fell sharply again on Friday 13th October 1989, which again drove correlation positive, although the Fed did not actually ease on that occasion. By going ahead with tightening in February 1994 despite being doubted by the market, causing considerable stress in fixed income markets, Greenspan acquired a more hawkish reputation, and the correlation reached its most negative in the summer of 1994. The Fed’s response to the 1998 LTCM crisis, however, generated a break in market expectations, since when the correlation has been mainly positive, and presently stands only just below the high reached in late 2002 in the stressful period after the 9/11 attacks and leading up to the Iraq War.

The red and green lines show the correlation for the Volcker and Greenspan-Bernanke eras respectively (practically the average of the blue line within each sub-period). Under Volcker, a celebrated inflation-fighter, the correlation was clearly negative (-0.283) and much lower than during the tenures of Greenspan and Bernanke so far (+0.065). Shifting the interest rate and stock price changes by one day sheds additional light on market behaviour during the two regimes. In all cases, the correlation between the shifted series is nearer zero, but under Volcker the negative correlation shrinks by far the most when stock price changes are shifted one day forward, whereas under Greenspan the positive correlation is only slightly lower when stock prices are shifted forward one day. This is consistent with the theory that monetary policy tended to drive stock prices in the Volcker era, whereas stock prices have more often driven monetary policy expectations since then.

In conclusion, while not necessarily responding to risky asset price changes per se (because, say, the Fed governors wish to be popular), the fact that the Fed has eased during times of market turmoil against a background of generally stable economic activity and comfortably positive inflation has conditioned the market to expect the Fed to any mitigate sharp fall in risky asset prices. The danger is that investors have come to rely on such a response and therefore allocate more of their wealth to risky assets. Then, if the Fed fails to live up to investors’ expectations following some sharp fall in risky asset prices, that fall will be exacerbated as expectations are revised. In short, the Fed seems to have created a moral hazard trap. The present conjuncture of financial market turmoil, weakening US economic activity and rising inflation may well bring matters to a head. So far, while investors have begun to recoil from particular types of spread product, such as asset-backed commercial paper (ABCP), their continued inclination to respond to savings shortfalls by increasing exposure to risky assets rather than saving more suggests that investors continue to rely on the Greenspan Put. Either the Fed will allow higher inflation or investors in risky assets are going to be disappointed.

Addendum:

In response to a good question from an anonymous commenter, I checked that the two era correlations are statistically significant from zero. Despite the fact that the correlations are not large, they are highly statistically significant, because of the huge number of daily observations in each era. There are 2026 points in my Volker era and 5266 in my Greenspan/Bernanke era, so the correlations of -0.283 and 0.065 have z-scores of -12.7 and 4.7 respectively. These are both statistically significant from zero even at even the most stringent level like 0.1% (two-tailed). Actually, it is arguably the difference between them that matters, which is of course even more significant since the two correlations have opposite sign.

For anyone who is interested in the technical details of this analysis, I transformed the correlations using Fisher's z-transformation. This yields a variable that is approximately normally distributed with known mean and standard deviation, which can then be checked for significance using tables for the standard normal distribution.

An enigma inside the conundrum

2008-05-31T14:14:00.000-07:00

It is sometimes argued that foreign exchange intervention in support of the US dollar by dollar-pegging Asian central banks, which was especially heavy from 2002 onwards, contributed to the ongoing financial crisis which began in the US last summer. The idea is that the investment of the proceeds of this intervention in dollar bonds represented a "saving glut" that depressed bond yields (by up to 60bps in the period up to May 2005, according to Warnock and Warnock's Federal Reserve International Finance Discussion Paper 840). The fact that this fall in yields occurred despite tightening US monetary policy from 2004 was described at the time by Federal Reserve Chairman Greenspan as a "conundrum". In an attempt to maintain their returns in the face of lower yields, the argument goes, investors became more willing to buy bonds which offered a relatively high yield to compensate for higher risk, including risks of default, illiquidity and operational problems such as legal ambiguity. This increased demand for "spread product" (so-called because the relatively high yield of these bonds is characterised as a yield spread over benchmark government bonds) "crowded in" additional supply, including bonds involving previously almost unsaleable risk such as marginally creditworthy borrowers and complex contracts. It was the eventual realisation of these risks, notably in collateralised debt obligations (CDOs) constructed from mortgages owed by sub-prime borrowers, that precipitated the crisis.

The problem that RebelEconomist has with this explanation is that, if the growth in spread product had been driven by central banks, which tend to buy relatively safe government or government-sponsored agency bonds, the yields on this safe debt should have been depressed the most. It would be expected that some relative decrease in yield would be required to induce other buyers of safe bonds, such as pension funds and insurance companies, to switch out of safe debt into riskier and less liquid substitutes. In other words, spread product spreads ought to have widened. On the contrary, until the crisis hit, spreads narrowed, as exemplified by the five year (a maturity representative of central bank foreign exchange reserves portfolios) swap spread (ie representing commercial bank debt) shown in Figure 1.

Of course, it may well be the case that, rather than simply representing the expected value of credit, liquidity and other losses suffered by investors in spread product, yield spreads depend on investor preferences for risk, which they trade off against expected return, as in the classic mean-variance model of portfolio selection. If so, however, it seems reasonable to expect the spread to shrink in line with yield levels. But this was not the case either; even expressed as a proportion of the yield on the corresponding treasury benchmark, spreads narrowed, also as shown in Figure 1. Moreover, if buying of riskier bonds had been motivated by inadequate yields on safe bonds, investors might have expressed concern about having to take these risks, whereas in fact surveys of investor sentiment, such as the Gallup/UBS investor optimism index, indicated a gradual recovery of confidence following the dotcom bust which culminated in the bankruptcy of Worldcom in 2002.

My conclusion is that the idea that central bank buying of the safest debt displaced existing investors reluctantly into spread product is implausible. Perhaps there was some less direct link between central bank dollar purchases and the growth of spread product, such as a surge in US economic optimism that encouraged Americans to both consume more, including imports from dollar-pegging countries, and regard investment risks like default as less likely to be realised. Alternatively, a growing perception that a "Greenspan Put" existed (ie that the Fed would ease in response to financial crisis) may have led investors to regard spread product as less risky than previously and no longer requiring such a wide yield spread. Whatever, it seems that the explanation for the narrowing of spreads associated with the conundrum is itself an enigma worthy of more detailed investigation.

US economic policy shot in the foot #2: An exorbitant privilege squandered

2008-04-30T15:15:00.000-07:00

As RebelEconomist was asked by a commenter on his previous post (about the ascendancy of the euro as a reserve currency) to expand on his remark that America could have handled the reserve status of the dollar better, it is opportune to post the second in his trilogy of criticisms of US economic policy in recent years, which happens to concern that issue.

Although it is easy to get a different impression from reading some US macroeconomic commentary, having a reserve currency gives a country like the USA a potential economic advantage. Indeed, to the countries that feel obliged to hold reserve currencies without their own currency being equally held by other countries, issuing a reserve currency seems like an “exorbitant privilege” as Valéry Giscard d’Estaing (not Charles DeGaulle, to whom I mistakenly attributed the quote before) described the US dollar. The key advantage of having a reserve currency is that the country can borrow in its own currency at a relatively low interest rate, because the demand for interest-bearing reserve assets from other countries drives down its interest rates, especially on the government debt in which foreign currency reserves are typically invested. In fact, after allowing for expected exchange rate movements, a reserve currency issuer can normally pay less on its domestic currency liabilities than it receives on its own foreign currency assets (see for example, Gourinchas and Rey, 2005). A reserve currency issuer also has the option to create an excessive amount of money to reduce the real value of its outstanding debt and help finance its government, but exercising this option is likely to deplete its reserve currency status.

So why do some US analysts complain about the accumulation of dollar reserves by foreign countries? Mainly because the reserves accumulation has been a consequence of foreign countries' intervention, particularly by East Asian and Gulf Cooperation Council (GCC) nations, to stop their own currencies appreciating against the dollar. By implication, this has kept the dollar stronger than otherwise and thereby at least contributed to an unwelcome US trade deficit and the decline of some US industry. A more controversial complaint, which RebelEconomist will question in a future post, is that the reduction in US treasury yields caused by the investment of the intervention proceeds, famously characterised by Ben Bernanke as a "saving glut" fostered a market for riskier alternative investments which contributed to excessive housing construction and the sub-prime crisis. It is also argued that the currency policies of countries like China hurt their own people, but for the purposes of this post, let us take their choice as a given and focus on how the US can make the best of it.

A link between reserves accumulation and reserve currency appreciation leading to industrial decline is plausible. It is like the problem of "Dutch disease" faced by countries enjoying a surge in income from the exploitation of a natural resource, named after the impact of a natural gas boom on the Dutch economy in the 1960s and 70s. In brief, Dutch disease develops as the increased spending of the resource owner in their national economy drives up the prices of non-traded items such as labour, while the prices of tradable items like manufactured goods are fixed by international competition. An overall rise in domestic prices relative to foreign prices represents an appreciation of the real exchange rate, and assuming fixed money stock, the increased transactions demand for money as the economy expands to include resource exploitation activity drives up the exchange value of the domestic currency, meaning an appreciation of the nominal exchange rate too. Domestic producers of tradable items that use non-tradable inputs face higher costs than their foreign competitors, and being unable to raise their prices, are forced to contract, meaning that some of the resource windfall can end up paying for increased unemployment.

It is understandable that reserves accumulation can produce an effect like Dutch disease as it effectively transfers real resources to the sellers of the reserve currency debt in which the intervention proceeds are invested. To coin a phrase, the US economy is suffering a bout of “American ague”. In fact, American ague is a more serious ailment, because the resources that flow into the reserve currency economy do not represent unencumbered wealth like a natural resource windfall; they oblige the debtor to pay back resources in the future. If the reserve currency country fails to prepare for this eventuality, it may come as a nasty shock. Given their similar mechanisms, could the treatments that have been applied for Dutch disease work for American ague?

There are two standard treatments for Dutch disease. One is to intervene in the foreign exchange market against the appreciation of the domestic currency, selling domestic for foreign currency to absorb the additional inflow from resource exports. In most cases, the government already receives the domestic currency needed for this purpose through state-owned resource producers and/or from royalties on resource sales, but if not, the government should be able to increase taxes on the private sector to tap the export boom. In fact, if the resource exports and associated taxes are payable in foreign currency, the government can purchase foreign assets directly without intervention. Besides immunising the economy against Dutch disease, buying foreign currency assets spreads the benefits of the export boom into the future, perhaps permanently, which enhances national welfare if the marginal utility of consumption is declining. Where foreign currency assets are acquired by intervention, they are typically included in the country’s foreign exchange reserves managed by the central bank, but they can equally well be entrusted to the care of a specialist sovereign wealth fund (SWF) management institution, as in Norway for example. The other remedy for Dutch disease is to use the export revenue to import capital goods, and if necessary foreign labour too, to invest in the domestic economy like the GCC countries do. The government can build infrastructure such as roads, railways, electricity supply, schools etc that can be expected to yield future dividends, including to the government itself in the form of enhanced taxes. Alternatively, the government can buy stakes in domestic enterprises or use tax breaks to encourage investment by the private sector.

To adapt these treatments for American ague, in the absence of a resource windfall, the authorities need another source of domestic currency to fund their investment in foreign exchange reserves or public infrastructure. The obvious answer is to sell more government debt into the demand from foreign reserves managers. Provided that these debt sales do not eliminate the price premium on reserve assets, it should be possible to realise the exorbitant privilege as the risk-adjusted spread between the outlay on servicing government debt and the income from reserves or infrastructure assets. Such asset-liability matching also prudently sets aside the funds required to repay the government debt when due.

Obviously, the US government did not adopt such policies. Dollar reserve accumulation accelerated first as Asian countries built their foreign exchange reserves following the Asia crisis of 1997, and then as rising oil prices in the last five years or so boosted the incomes of oil producing countries. In the meantime, the US Treasury was actually buying back its debt from 2000 to 2002, while the Federal Reserve continued to steadily accumulate treasuries until recently to back its base money. Apart from a couple of symbolic interventions in coordination with other central banks (in support of the yen in June 1998 and the euro in September 2000), the US authorities have not intervened in the foreign exchange markets since 1995. The proportion of US GDP accounted for by government activity, including investment, is low compared with other countries. US economic policy did not change in response to the reserves inflows. The result was that foreign countries’ purchases of treasuries reduced the supply available to other investors and lowered treasury yields, “crowding in” other kinds of debt and reducing US saving. Reserve inflows have therefore effectively financed increased consumption and the US net international investment position (NIIP) has become increasingly negative. Collectively, America has behaved as if the exorbitant privilege was not the cost of funds, but the funds themselves. The exorbitant privilege has been squandered.

Why were remedies like those for Dutch disease not tried by the US authorities? It was certainly not because there was a lack of opportunities for investment in US foreign exchange reserves or public infrastructure.

Judged against the yardsticks that the US Treasury uses to measure the reserves adequacy of other countries, America's foreign exchange reserves are unequivocally inadequate. A paper by the US Treasury Office of International Affairs suggests that countries should hold reserves sufficient to pay for three months’ worth of imports, 100% of short-term external foreign currency debt (a minimal interpretation; the paper does not specifically exclude domestic currency debt, which accounts for most US external debt), or 5% of M2 money stock (again, a minimal interpretation; a range of 5-20% is mentioned) depending on the type of emergency that is most likely to generate a call on their reserves. The present holding of $277bn worth of US foreign exchange reserves (including gold, which accounts for 82%) provides 22%, 97% and 72% of the suggested cover respectively. It could be argued that US currency intervention would not have been welcomed by the Eurozone and Japan, in whose currencies America exclusively holds its foreign exchange reserves at the moment. Perhaps so, but these countries should accept that official inflows are a corollary of the international role they have actively promoted for their currencies. And there were occasions when more substantial US intervention in support of their currencies would have probably been welcome, by the Eurozone in Autumn 2000, and Japan in Spring 1998 (maybe June 2007 too). To reduce the impact of such reserves accumulation, the US could have broadened the range of currencies it holds in its reserves to include sterling and Canadian dollars for example, and added other instruments such as equities. America could have even created its own SWF.

It also appears that the US government could usefully invest more in public projects (unless the invasion of Iraq is regarded as an investment in energy security). To European and Japanese visitors, the poor state of US public transport is striking; few major airports have a railway connection to the centre of the city they serve. The tragic consequences of inadequate levees near New Orleans and a decaying bridge in Minnesota show how worthwhile some infrastructure projects might have been. The American Society of Civil Engineers 2005 report card assessed the condition and capacity of US infrastructure as grade D, and estimated that expenditure of $1.6tn was needed to bring it up to scratch.

Nor has the US government been constrained from issuing more treasuries by the size of the government debt. By European, let alone Japanese, standards the US net government debt to GDP ratio of 31% (or 60% including debt assigned to the social security trust fund) is relatively low.

No doubt the main reason why the US government has not increased its borrowing and investment in foreign exchange reserves and public infrastructure to absorb official capital inflows is that both policies would conflict with Americans' traditional aversion to, in the case of intervention, interfering in financial markets, and, in the case of investing in public infrastructure, taxing and spending and "big government". Regrettably, now that a rise in US long-term interest rates would be hard to bear, and now that the dollar has depreciated and the dollar pegs of some of the largest reserves-accumulating countries are showing signs of strain, it is probably too late for the US to change its approach to dealing with official capital inflows. If the euro does succeed the dollar as the world’s principal reserve currency, however, the Europeans would presumably not be restrained by such views from using official capital inflows for public investment. Perhaps a dedicated EU institution could be established to isolate and manage the exorbitant privilege, by both issuing euro debt designed to appeal to reserves managers and acquiring a range of broadly liability-matching investments from non-euro financial assets to European public infrastructure projects.

Euro schizophrenia

2008-03-13T02:34:00.000-07:00

One of the key motives for the creation of the euro was European (especially French) envy of the US dollar’s position as the dominant global currency. Besides being a symbol of America’s political, economic and cultural supremacy, dollar ascendancy granted the US an “exorbitant privilege” (as DeGaulle put it) of low-cost loans in the form of foreign central bank holdings of foreign exchange reserves. The euro was intended to rival the dollar.

Now at last, it seems that the European dream has come true. The dollar is depreciating steadily against the euro as the US is apparently debasing its currency deliberately to ease its burden of debt and resource misallocation. Countries with largely dollar foreign exchange reserves and currency pegs are beginning to question whether the dollar provides the currency stability they desire. The dollar looks set to decline as a reserve currency, and with few other currencies offering the necessary combination of widespread use, deep and reliable financial markets and a trustworthy central bank, the euro is gaining much of the status that the dollar is losing. Talk of countries leaving the euro has receded, and even outside the EU, the euro has been adopted by some countries such as Montenegro, and, despite some government resistance, is gaining ground in Iceland.

But the Europeans are still not happy. Trichet is concerned about "excessive" euro appreciation, while Juncker argues that the euro/dollar exchange rate “does not reflect fundamentals”. President Sarkozy complains that the strengthening euro is a “shock” to France’s economy and for Airbus, a strong euro is “life-threatening”. Politicians like Sarkozy call for more “dialogue” with the ECB about monetary policy.

Unfortunately, sustained euro appreciation is probably an inevitable part of the handover process, as both faith and wealth shift from the dollar to the euro. Moreover, if a driver of the change is US-generated inflation, and the Europeans hold to the Deutsche Bundesbank central banking model, with price stability as the clear priority of monetary policy, nominal appreciation is likely to be secular. As sterling was supplanted by the dollar as the dominant reserve currency, it fell from nearly five dollars to the pound in 1914, to under three in 1949, to just over one in 1985. The Europeans are going to have to choose between a prevailing but strong currency and an also-ran but competitive one. And, with the euro reaching new highs against the dollar almost every day lately (over 1.55 at the time of writing), and eurozone inflation standing at 3.2% in February compared with an ECB objective of "below, but close to, 2%", it looks as if decision time is nigh.

RebelEconomist hopes that Europe chooses hard money (disclosure: although I am British, I do hold a minor but not insignificant fraction of my modest wealth in euros, and no more dollars than a few nickels, whose value is fortunately underpinned more by their metal content than Ben Bernanke). Germany and Japan have shown that it is possible to have a thriving economy with a strong currency. And of course, reserves currency status bestows the exorbitant privilege of cheap capital inflows. Official capital inflows need not be the problem that they became for America, provided they are not used to finance unsustainable consumption. They can be invested to advantage, either in domestic capital stock or foreign financial assets (including Europe’s own foreign exchange reserves in the absence of sufficient private sector saving abroad).

China can privatise to sterilise

2008-02-21T13:56:00.000-08:00

The news that Chinese inflation reached an annual rate of 7.1% in January provides some support for critics of China’s exchange rate policy like Ken Rogoff who warn that selling renminbi to hold down its value against the US dollar is expanding the money supply and fuelling inflation. Although the People’s Bank of China (PBoC) sells sterilisation bills to absorb the base money (ie banknotes plus commercial banks’ settlement balances at the central bank) created by its currency intervention, the market for these central bank bills could be reaching saturation point. It may have become impossible to sell enough bills to fully sterilise ongoing intervention without driving short-term interest rates up to a level which makes the renminbi more attractive and hence the task of preventing its appreciation even harder. This could explain why, as reported on Bloomberg, the inflation report was accompanied by a PBoC statement that it will “increase innovation in monetary policy measures”.

As readers of the comments on Brad Setser’s blog may recall, RebelEconomist suggests an alternative sterilisation tool: the Chinese authorities could sell some stakes in state-owned enterprises (SOEs) instead of sterilisation bills.

Privatising SOEs would be consistent with other Chinese economic policies. The authorities would like to brake economic growth, and the Chinese stock market has probably been a more important source of economic stimulus than low interest rates. Increasing the supply of stock could be expected to lower stock prices and raise yields. While the stock market has fallen back since last year, it does arguably remain over-valued and the authorities would probably be content to see a controlled decline continue. It is known that the Chinese government wants to list most large SOEs, which presumably means floating a significant proportion, if not the majority, of their shares. Privatisation is supposed to increase economic efficiency, and may improve corporate governance.

In fact, because Chinese stocks are so expensive, given present yields on stocks and central bank bills, selling state shareholdings instead of bills would lower the current cost of sterilisation.

The state has no shortage of shareholdings to sell. The State-owned Assets Supervision and Administration Commission (SASAC) is responsible for several hundred SOEs which made a combined profit of about $100bn in 2006, which would suggest that their current collective market value is of the order of several trillion dollars. The state holding of PetroChina alone is worth over $500bn; more than enough to completely sterilise another year’s reserves accumulation at the recent pace.

Since base money is of indefinite duration, equities are arguably a more appropriate sterilisation instrument anyway than bills, which need to be rolled over until the economy grows sufficiently to hold the excess stock of base money created by intervention without inflation.

Apart from vexing existing holders of Chinese stock (which may be inevitable anyway if the authorities want to restrain the boom), the main obstacle seems to be coordinating the various state institutions involved, from the central bank to layered holding companies, but this should not be insurmountable, given the political will.

Mrs RebelEconomist's view of global imbalances

2008-02-20T05:26:00.000-08:00

Japan does not need a sovereign wealth fund

2008-01-31T06:54:00.000-08:00

Sovereign wealth funds (SWFs) are a hot topic at the moment, and it seems that most countries with large foreign exchange reserves are creating their own SWF, so it is no surprise to hear that some Japanese politicians, sitting on the world’s second largest reserves, held mostly in US dollars and worth $973bn at 31/12/07, want a Japanese sovereign wealth fund.

Various arguments have been made for and against SWFs, which may or may not justify their existence in general, but there are two reasons why RebelEconomist considers that a SWF would be a bad idea for Japan in particular:

(1) Japan’s reserves are not sovereign wealth. In most countries with a SWF, the fund represents the accumulation of persistent current account and government surpluses. The foreign currency held in the SWF is typically acquired by the government either directly as revenue from the sale of natural resources by state-owned producers (eg oil producers in Norway), or indirectly by selling domestic currency obtained from taxation of a prospering economy (eg Singapore). Japan does have a current account surplus, presently amounting to about 4% of GDP, and its monetary authorities did build their foreign exchange reserves by intervening against the resulting appreciation of the yen, but, as is well known, the Japanese government has a large budget deficit, of about 4% of GDP, and the yen that has been sold by the authorities was borrowed. In fact, Japan’s net international investment position (ie its overseas wealth), worth about 40% of GDP at the end of 2006, of which about half is accounted for by its foreign exchange reserves, is small in relation to its government debt, worth about 150% of GDP. While it is true that China, which has even larger foreign exchange reserves than Japan, also borrows the domestic currency it uses to intervene, China’s budget deficit and government debt, at about 2% and 20% of GDP respectively, are comparatively small, and the Chinese government retains huge marketable stakes in state-owned enterprises (its stake in PetroChina alone is worth a substantial fraction of its reserves). In short, Japan's foreign exchange reserves are funded out of government debt, and Japan cannot afford to take unnecessary investment risks with its reserves that could leave their value insufficient to cover that debt.

(2) Contrary to the reasoning of many advocates for a Japanese SWF (eg “Japan mulls investment fund to tackle ageing crisis”, Financial Times 23/4/07), conventional investment wisdom suggests that an ageing population makes it appropriate to take less investment risk not more. For example, John Bogle (founder of Vanguard Mutual Funds) recommends that the percentage of bonds in an individual’s pension fund should be equal to their age. This is because a person with many years to retirement can allow time to average out the return fluctuations of more risky assets, whereas someone close to retiring needs more certainty about what they will have to live on. If the state reckons that it does not have sufficient assets to meet its social security obligations, the prudent (as opposed to politically easy) response should be to either save more or for the government to explain that it will be unable to be as generous as expected, not to switch into more risky investments in the hope of making up the shortfall by increasing return.

The usual precautionary motive for holding foreign exchange reserves certainly applies to Japan, and at a stretch could even justify the existing level of reserves (for example, Wijnholds and Kapteyn suggest that a level of reserves representing about 5-20% of M2 is adequate to cover capital flight; Japan’s reserves represent about 15% of M2+CDs). To serve such a purpose, however, reserves must be held in a liquid form like government bonds rather than the equities, corporate bonds, property and “alternative investments” characteristic of a SWF.

A bad argument for Japan to have a SWF, as made by Morgan Stanley's Stephen Jen, is that Japan's reserves need to make a high return to offset prospective appreciation of the yen. The obvious solution to this problem, if Japanese economic policymakers believe that they have more reserves than required for precautionary purposes, is of course to sell some reserves and repurchase yen whenever the yen is on the weak side, like last summer (on July 6th, the day that Jen’s argument was published, ¥/$ stood at about 123, compared with 107 at present, implying a rate of return from switching back into yen that cannot have been matched by many risky US dollar investments in this period). And the yen proceeds of such reverse intervention should be used to pay down government debt and shrink Japan’s swollen government balance sheet – as recent events at SocGen show, risks exist even in a balance sheet that is supposed to be well-hedged.

US economic policy shot in the foot #1: The SOMA portfolio

2008-01-13T12:29:00.000-08:00

This week’s news of the death of the UK corporate troubleshooter Sir John Harvey Jones reminded RebelEconomist of a piece of advice he gave on his television programme back in the 1990s. The gist of it was that, in business, doing nothing is almost certainly the wrong choice, because the business environment evolves continually so that yesterday’s best practice is today’s handicap. This post is the first in a series of three describing aspects of US economic policy that may have once been reasonable, but, without rigorous review and reform, became ossified and increasingly unsuitable as the economy changed. In each case, I shall argue that failure to update the policy has represented a wasted opportunity for the US.

Low long-term interest rates and their effect on US mortgage finance undoubtedly contributed to the recent US housing boom and the associated development of complex debt instruments, which led to the present disruptive housing bust and financial turmoil. It is commonly argued that long-term interest rates were driven down by the purchase of dollar bonds, especially treasuries, by Asian and oil-producing nations’ central banks investing their foreign exchange reserves. As Brad Setser put it in his blog this week: “the surge official outflow from asia and the oil exporters led to a surge in demand for US debt and specifically "safe" treasuries and agencies. that pushed yields on these instruments down. US investors didn't like the yields and sold, often to foreign central banks. they then invested their funds in higher yielding instruments -- often MBS or CDOs that included repackaged subprime debt.”

While Fed board governors are not known for plain speaking, it does appear that they were aware of and concerned by these developments during the boom. Greenspan famously described falling long-term interest rates during a period of rising short-term interest rates as a “conundrum”, while Bernanke suggested that the explanation for the relatively low long-term interest rates was a “savings glut”. It is not unreasonable to infer that around this time, the Fed would have preferred long-term interest rates to be higher and understood that either less buying or more selling of long-term treasuries would have the desired effect.

In the light of these concerns, it is remarkable that, during the period in which the Fed was raising short-term interest rates from June 30th 2004 to June 29th 2006, the Fed itself was almost certainly the largest holder, and one of the biggest buyers, of US treasuries. As Chart 1 (reproduced from the New York Fed’s latest annual report on domestic open market operations) shows, the outright holdings of its system open market account (SOMA), which comprise exclusively treasuries, grew from about $670bn to $750bn nominal over the tightening period.

Despite the fuss about currency intervention and reserves accumulation by Japan and China, their central bank holdings of US treasuries appear to be smaller than the Fed’s. Neither country publishes full details of its reserves holdings, but according to the most recent US Treasury survey of foreign holdings of US securities, as at end-June 2006, Japan and China held $706bn and $556bn respectively of non-ABS long-term debt securities and $85bn and $17bn ofshort-term debt securities. Given that it is unlikely that all of these bonds are held by the monetary authorities in each country or that they include treasuries only, the SOMA holding is probably the largest. Moreover, foreign exchange reserves are typically held mainly in short-term securities, whereas the SOMA holdings deliberately represent a roughly even proportion of the outstanding issue of treasuries across the maturity range, as evident in its present (January 2nd 2008) holdings (Chart 2).

An obvious question is, therefore, why does the Fed hold such a large proportion of treasuries, and why did they continue to increase their holdings even when they were concerned that other buyers were fuelling the boom by driving down long-term interest rates?

In a fiat money system, the central bank supplies, distributes and collateralises its money (mainly banknotes) by buying debt. In order to maintain confidence that the central bank remains solvent and able to redeem banknotes if the demand for money falls, this debt tends to be highly creditworthy and liquid. Clearly, government bonds have these properties, so the Fed buys treasuries, and as bonds mature and the underlying demand for central bank money expands with inflation and real economic growth, the Fed is a regular buyer. These treasuries are held in the SOMA.

But government bonds are not the only suitable monetary asset; the Fed accommodates short-term, seasonal fluctuations in money stock using collateralised short-term bank debt in the form of repurchase agreements (“repos” in Chart 1). In fact, repo is arguably a better asset than long-term bonds for monetary policy operations, for at least two reasons. One reason is that, while trading any asset (eg gold) for money gives the central bank some control of short-term interest rates (since money is a close substitute for bank deposits), which is of course how central banks set the tightness of monetary policy, dealing in short-term debt itself ought to give the closest control. Another reason is that using non-government debt supports central bank independence by separating central bank and government finances. For these reasons, monetary authorities that have more recently (re)developed their monetary policy operations, like the European Central Bank and the Bank of England, use largely repo rather than government bonds.

So the Fed could have countered the fall in long-term interest rates that occurred as they tightened monetary policy in 2004-6 by substituting repo for SOMA holdings of long-term treasuries, which would have brought the Fed into line with more modern practice anyway. The fact that Bernanke had previously (in 2001) discussed the possibility of the Fed buying more treasuries to reduce long rates if short rates hit zero suggests that the Fed did not doubt that reducing SOMA treasury holdings in 2004-6 would have meant higher long-term interest rates. And by recently running down its treasury bill holdings and expanding its repo operations to temporarily allow banks to raise liquidity against securities of lower quality during the ongoing credit squeeze, the Fed has demonstrated its ability to substitute repo for treasuries. If the Fed had substituted repo for long-term treasuries in 2004-6, US mortgage rates might not have fallen so low, and the housing boom and growth of high-yield debt securities might have been more muted.

The most likely explanation why the Fed did not do this is simply that they are not looking to change what works. The annual reports on open market operations describe how the Fed avoids distorting the market for specific treasury issues, but do not discuss the possibility of responding to changes in the behaviour of other investors and its impact on the yield curve, let alone whether treasuries are the most suitable debt instrument to provide the mainstay of the SOMA. A less favourable explanation might be that the Fed board governors were unwilling to take action that might have been seen as targeting the housing market specifically.

A warning for the US; reassurance for China

2008-01-05T14:24:00.000-08:00

It is often asserted (eg in Brad Setser’s blog http://www.rgemonitor.com/blog/setser) that:

(1) The growing US foreign debt is manageable because it is denominated in dollars

(2) China will sustain a loss on its reserves when the dollar inevitably depreciates

The chart below suggests that such thinking may be unwise. It shows the logged dollar return on high-quality short-term debt (ie representative of reserves investments) in the US and UK (FRBNY discount or Fed funds rate and Bank rate respectively) from 1914 to 2006. 1914 is chosen as the start date because it marks the outbreak of the First World War, which arguably began the process by which the US dollar supplanted sterling as the main global reserve currency.

Although, as would be expected, the dollar appreciated against sterling over this period, from nearly five dollars to the pound in 1914 to about two now, the consequently higher interest rates required to retain debt capital in the UK fully compensates for this depreciation, despite the existence of exchange controls in the UK until 1979. It seems that uncovered interest parity (UIP) approximately holds in the long run. In fact, if anything, sterling debt has provided a slightly higher return, presumably reflecting the risk premium of holding a declining currency managed by a weak central bank.

Although sterling debt lost ground from 1914, the interest rate penalty was sufficiently large that sterling had caught up as early as 1925. And a similar pattern was seen after successive sterling devaluations, including those of 1931 (the suspension of gold convertibility), 1949 and 1967.

To conclude, easy money and dollar neglect can delay, but not reduce, America’s debt burden. While China may report a mark-to-market loss on its dollar reserves over the next decade or so, this is practically irrelevant, because, assuming that China will not want to actively reverse its exchange rate policy for the foreseeable future, its reserves are stuck in dollars for a while anyway. And, as evinced by Zhou Enlai’s 1972 comment when asked about the impact of the French Revolution – “it’s too early to tell” – the Chinese are famous for taking the long-term view!