Sunday, 30 October 2011

Regulatory omissions - the paradox of an oversight body

Note: this blog post was also published at the Adam Smith Institute blog titled: "The paradox of regulation"

Apart from the policymakers in the EU summit, the regulators across Europe are designing their reform proposals on how to improve the financial system and make it more robust to future crises. One of the main proposals on banking regulations in Europe is done by the Basel Committee on Banking Supervision. In addition to Basel I and Basel II, the previous banking reforms that substantially influenced the changes in banking regulation worldwide (I briefly touch upon the Basel Accords in my paper on the crisis) the new proposal, Basel III goes a step further. It is seen as a comprehensive response of the Basel Committee to the financial crisis of 2007-2009.  

The Basel III agenda is based around three key elements aimed at making banks more resilient to future instabilities. Banks need to have core tier one capital equal to 7% of their risk-weighted assets; top “systemically important” institutions need to carry an additional 1 to 2,5% in capital, generating a total of up to 9,5% of top quality capital as part of their risk-weighted assets; the banks need to keep enough liquidity (cash and easy to sell assets) to survive a 30-day crisis.  

The liquidity requirement can actually prove to be quite welcomed, but what will happen after 30 days, and is that time enough for the banks to recuperate and find additional sources of liquidity to cope with the temporary liquidity setback? The current levels of instability in the eurozone seem to be running for three years, and there’s still no sign of recovery.

Disregarding the liquidity requirement, the first two elements of the Basel III regulations are particularly important and can prove to be harmful by setting a trigger for the next big crisis. How so? First of all, can regulators really assess what is tier one capital supposed to be? What are ‘safe’ assets in the eyes of the regulators? In the wake of the current crisis, assets that were considered safe were those backed by the world’s wealthiest governments such as the US, UK and German Treasury bonds, or even better Mortgage-based securities (MBSs) backed by the US Government Sponsored Enterprises (GSEs) (see recourse rule), and sovereign debt of peripheral eurozone countries backed up by all eurozone economies (the peripheral eurozone sovereign debt was assigned the zero risk weight status by Basel I and II).  

All of a sudden, sovereign debt is no longer a safe asset since it could very well lead to the next big depression if all the European banks that hold peripheral debt go bankrupt. The securities that led to the downturn of American financial institutions, MBSs, are also no longer considered safe assets, and are in fact considered “toxic”. However, all of these assets were highly rated (AAA) and government backed making the Basel Committee on Banking institute them as a ‘must have’ for every financial institution. So if they made this mistake before, who is to guarantee that the regulators will pick up good assets now? The regulators can’t and never will be able to anticipate which assets are safe and will stay safe. They always do have the best intentions – keep the system stable, but they don’t have perfect foresight and they don’t posses perfect knowledge of the financial system, no matter how smart they (think they) are.  

Information in the economy is widely dispersed among a huge amount of consumers and businesses which posses local information that enables them to set prices and determine quantities of goods to be bought and sold. The market price aggregating billions of choices and decisions every single day is the best way to express real value. No central regulatory body can do a better job, simply because they cannot physically posses all the necessary information.

The same line of reasoning is applied in the financial market. The complex matrix of information and market participants is somewhat smaller in the financial market and rather global (as the decisions and financial products are run globally) but they are far more complex than regular goods and services and are thus far more difficult to control and have oversight on. Even if the regulators fully understand the complex derivatives and quadrupled securitized loans they cannot process how market participants will react and sometimes cannot even see the obvious consequences of their actions. The current financial crisis is the best example. By steering banks into buying MBSs, they were creating anartificial demand for these securities and henceforth an artificial demand formore mortgages which led banks into lowering their lending standards in order to create more and more AAA-rated MBSs

The regulators need to understand the consequences their actions may incur on those being regulated, they need to anticipate their reactions, but have failed to do so continuously. They may fail again, as their desire for finding new safe assets may end up creating another asset bubble. There were some suggestions that the new safe assets should be debt of businesses backed up by government guarantees (in order to have an AAA rating, of course) and re-packaged into new types of securities (see blog post). Others have proposed to do the same with eurozone peripheral sovereign debt – have highly solvent nations pull the debt into securities, back them up the usual way and sell them on the market, thereby creating new, huge, safe bonds and resolve the sovereign debt crisis in one blow. Some banks have already started to issue covered bonds (debt made up of high quality mortgages and loans) backed up by collateral and secured by bank’s other assets in the event of bankruptcy. No matter what the new safe assets look like, by exaggerating their use and forcing banks to fill up their assets with them can only lead to another asset price boom, higher debt burdens (as these safe securities are in fact debt-tied securities) and consequently another recession. 

As far as the impact on the current recovery, an increase of bank capital-asset ratios, even if announced at a future date (in the Basel III case this is 2019), due to negative future expectations will work towards the decrease of lending, unprofitable business lines for banks that will drive costs for bank customers, and finally shift the businesses to seek support on high investment projects with the so-called “shadow banking system” – hedge funds, money market funds, SIVs, and investment funds, the unregulated financial industry. Furthermore, even if we disregard expectations of future contraction by the banks which may lead them to contract today, the European Commission (EC) plans to institute the 9% capital standard as soon as possible to prevent financial contagion from a Greek default (see previous post), making the reaction on the lending market immediate.

The paradox of the regulatory oversight body arises in the following – by striving to make the system stable, they end up increasing the systemic risk and fueling artificial demand that can lead to an asset bubble. By creating incentives to invest in certain types of assets, the regulators send distorted signals about the demand for these assets and hence distort its prices. The effects of their actions are usually counterproductive and the reason this is so is because they think they posses enough data and information to make them control the market economy and the behaviour of market participants. Never was this possible before and has always proved to have disastrous consequences, since the market will always have more information than a few individuals, depicted by the term asymmetry of information. The regulators call upon the asymmetry of information in their desire to overcome it, but they paradoxically become its victims.

Friday, 28 October 2011

Eurozone regulatory responses – or, How the policymakers are steering us into another depression

Well, all my hopes were in vain. The decision of the policymakers is obviously to destroy lending on the European market and consequently any hope of a recovery any time soon.

The European leaders decided in the early morning hours on Thursday to let private investors (mostly EU banks) to take a 50% cut in theface value of their bond holdings – something that would reduce the Greek debt to 120% of GDP by the end of 2020, combined with a 130bn more for bailout of Greece by the EU and the IMF.

What a strategy!

This is how I would sum it up: let’s destroy the banking system and freeze lending in Europe again (and possibly endanger every other strong economy in the World) in order to keep Greece on life support just a bit longer, and offer them a huge relief – they will decrease their debt to only 120% of GDP by 2020 (!?), more than any eurozone economy (and any world economy besides Japan) has at the moment.

Maybe they should have all rather had a good night sleep instead. 

Let’s take a closer look at their response to the crisis.

First of all is the Greek ‘rescue’ plan. It’s hard to see how this plan can actually help Greece stabilize. Keeping the status quo is not going to make investors ready to invest into the Greece economy. Pushing more money into an insolvent country and keeping it on ‘life support’ will make its economy more and more vulnerable and dependent on foreign aid. The policymakers are turning Greece into a long term problem for Europe. This will have negative implications on all fronts – it will ruin confidence around Greece for a long time, disabling it to achieve any growth whatsoever, it will create massive social instability in the country, and it will give further rise to euro-scepticism around the continent. The country’s future seems to be a lock-down in debt, social turmoil and inability to create growth. Greece at this point doesn’t only need a debt restructuring, it needs a restructuring of its entire economy, starting from the labour market, public sector, industrial policy and so on. This is what the policymakers should have focused on, instead they choose to short-fix Greece until 2020. According to all of this, I fail to see how Greece will be able to grow at all until 2020.

The second great idea was to impose a 50% loss on banks holding Greek debt. Apparently it was the banks’ fault to invest into ‘safe’ assets such as the peripheral sovereign debt and MBSs, while being instructed to do so under Basel standards. Buying AAA rated securities with low yields isn’t quite a quest for profits. It is more likely a sound investment since every bank has a responsibility against its depositors and strives on keeping a good reputation for itself; otherwise, all its depositors will switch to another bank. This is something that the Wall Street “99%” protesters and all alike don’t understand. Investing into MBSs and Greek debt at the beginning of the decade looked like a decent investment, since the securities were heavily backed up by governments. Blaming the banks of making risky investments and forcing them to undertake huge losses on the same investments they were encouraged to buy by the regulators, is absurd. I can see the policymakers blaming the banks again in 2 years from now, when we’ll still be in a recession, that they refused to suffer bigger losses on Greek debt and this is why the situation got worse. I wouldn’t be surprised to stumble upon such an opinion.

The outcome of such a contractionary policy will be just that – a huge contraction of lending as the Euro banks will most likely shrink their balance sheets causing a lack of support for the real economy. I have pointed out earlier in the blog that 80% of Europe’s companies depend on bank loans to run their business (compared to only 30% of American companies). The recovery is obviously postponed by the policymakers, and I can’t think of a good reason why this is so. 

Tuesday, 25 October 2011

Restoring confidence

There is a lot of money in the world economy currently (rising monetary bases worldwide, quantitative easing, declining interest rates – see Graph and Table below - click to get a better view). However, none of the newly created money has had any effect on restoring confidence or economic growth.

The investors are in a lock-down, they invest into safe assets with low yields which is a typical sign of an uncertain environment. What is there to be done in order to unblock the money holdings of banks and institutional investors and make them move it into undervalued assets and equities? Once the investors start investing, money will start flowing into the economy – the government can only do so much to try and create incentives for an upsurge in demand, but so far, their efforts remain futile. Only an increase in confidence and reducing of uncertainty will work towards releasing the vastly created money into the system. Once banks and high profile investors feel safe enough to start investing again and supporting more and more projects, the money will start flowing back to the businesses. This will incentivise businesses to invest into new production which will finally increase their earnings and eventually the businesses will start hiring again. Decreasing unemployment rates will work towards increasing consumer confidence and as more jobs are created, more people will be bringing home higher incomes. At first the consumers, still careful, will start paying off their mortgage and other debts, piled up during the crisis, and after a while they will feel confident again to start buying consumer goods. The recovery, like everything in economics (except panics), is a slow process and one needs to be patient in order to see its full effects. Investor and consumer psychology plays an important role in recovery, just as much as it does in a boom. The same forces operate, only in inverted ways.

Having all this in mind, what is there to be done in order to boost confidence? It’s hard to say for sure, as every economy is different and there is no ‘one size fits all’ approach, but there are some things that should be considered.

The first thing to focus on is the source of major uncertainty in the world economy currently – the eurozone and Greece. The Greek debt should be restructured and if necessary Greece should be allowed to default. Before doing that the rest of eurozone countries should somehow be protected from their exposure to Greek debt – unfortunately, the only way to do so is through the EFSF, which bears with it a lot of unwanted consequences – see previous blog post. The policymakers still haven’t found ways to resolve this important issue and are hoping that something will happen that will somehow restart growth and resolve them of their worries. In an unlikely event of that happening, there are things to be done in order to boost confidence, but these are no short-run solutions. Since the politicians were so impatient to call for the end of the previous recession, they are now even more aggravated that nothing they do seems to be working. 

Uncertainty is rising high due to the inability of the policymakers to provide plausible solutions. This is becoming even more noticeable in the European banking sector which is seeing an increase in overnight deposits placed within central banks (see graph below). The banks feel uncertain and don’t know where to place their excess liquidity. They don’t want to borrow between each other under rising fear of default of various banks exposed to sovereign debt. 

This is obvious evidence that the banks aren’t illiquid, they are just uncertain and don’t know where to invest their money in as they are constrained from all angles (previous blog). They chose the safest option of putting the money overnight within the central bank and getting a safe return. The central banks should start thinking how to discourage banks from leaving too much overnight deposits by charging banks for placing their deposits with the central bank overnight. Giving banks negative rates for overnight deposits is an unconventional method but it might just work. However, there is no guarantee this will drive them into increased business lending, as uncertainty will still be high and confidence low, despite low interest rates and new lines of quantitative easing. Liquidity is present in the system, but is not encouraging lending.  

This means that something else needs to be done to move the excess liquidity into other assets and loans. Printing new money and using it to buy Treasuries and clearing banks’ balance sheets off from bad assets isn’t going to start growth or employment. It is more likely to devalue the currency and monetize the debt while having a huge inflationary effect. Therefore, besides discouraging banks to keep money at the central bank there is not much to be done via monetary policy to increase investor confidence – what is needed is a boost of confidence via stabilizing the system and creating incentives to increase production and therefore increase demand. 

What should be done

The first necessary policy is keeping taxes low long enough to create a credible environment for businesses expectations. This can be done only by credibly committing to keeping the budget deficit low (fiscal consolidation) so that businesses don’t create expectations of increasing future taxes. The EU economies and the US should seriously consider introducing flat tax, or at least a tax reform to reduce marginal tax rates on investments, corporate profits, capital gains and personal income, while broadening the tax base. Tax incentives should also be created to stimulate investments through, for example creating low-tax entrepreneurial zones to attract and encourage businesses for new investments and hiring. Another good way to stimulate investments would be eliminating taxes on capital investment in order to encourage businesses and manufacturers to start buying new equipment. Although this might generate an initial loss in revenues, it will pay back through newly created demand for investment into equipment and a boost of sales and earnings.

Second, any existing employment regulation should be reduced substantially and it should be made a lot easier for businesses to hire. One way to do this would be to eliminate income tax on newly employed for the first year or two. This would particularly be aimed at young people seeking their “first job”, in order to reduce high levels of youth unemployment. Businesses would welcome a cut in hiring costs. However, they can only start hiring if they start producing and investing. Therefore, the tax incentives have to come first in order to support business production. This will eventually be followed by higher production levels (higher supply) and will lead to firms start hiring more. With more people having new, safe jobs, they will increase their consumer goods consumption which will all together lead to a rise of aggregate demand. What is important to note is that this is a gradual process and one needs to be patient in order to see its full effects. A credible promise of fiscal sustainability, signals of tax incentives for businesses and changes in the labour market will send positive reinforcement to banks and investors and will work towards increasing their confidence. 

The final step, from the US perspective, should be to stop blaming China and their ‘deliberate’ currency devaluation on the US current account deficit. It is not the Chinese fault that a vast majority of US companies decided to cut costs by moving all the production to China due to smaller labour costs and higher overall productivity. This is a perfectly welcomed move by a profit maximizing company – it will choose the best way to decrease costs and increase revenues by still maintaining the quality of their product or service in order to maximize their profit – Apple is the perfect example. The politicians and economists should therefore lay off China and start thinking about the inter instabilities of the US system of why the US current account is so large. The current account deficit by itself isn't a problem when the capital inflows are used to finance investments instead of consumption as it will boost production and increase growth. When the capital inflows are used to finance consumption, this will very likely be used to finance an asset price boom. In addition, the US received a lot of capital inflows from other countries’ central banks instead of private investors which also weakened its trade position. Another way to think about the deficit was to take it as an effect of globalization – the US will continue experiencing high capital inflows as it did before the crisis as it is considered a country worth investing in. The savings of surplus countries will continue to flow in the most productive assets, such as the ones in the US. For further insight on the subject I recommend an excellent explanation of the US current account deficit by Ben Bernanke in 2005.

In short, the US should stop inducing protectionist policies, remove any barriers to trade (while not imposing the tariff for Chinese goods which will only start a trade war with China – something neither of the countries want) and promote free trade to increase specialization, competition and benefit from economies of scale. Every crisis so far resulted in a high trade contraction worldwide (see Reinhart and Rogoff) and it was not until trade was restored to previous levels that the economies started to grow again. 

Saturday, 22 October 2011

Eurozone crisis and Greek default – summary and suggestions

Last few weeks saw a decline in banking shares throughout the markets, huge uncertainty regarding political responses on whether to recapitalize the banks and set higher capital standards, the privatization of another bank highly exposed to peripheral eurozone debt Dexia, and further questions on what to do with the eurozone system – to resolve the issues by boosting cash reserves of the EFSF, by higher political integration or something else.

Fears are rising concerning the possibility of a Greek default to bring down with it Italy, Spain and Portugal as well as sovereign debt infected European banks. All the countries in the EU could be exposed, if not directly via common currency or through losses of domestic banks and another credit squeeze, then indirectly through declining trade and a severe blow on confidence. The financial linkages would spread quickly worldwide, just as they did after the fall of Lehman Brothers in 2008. Read about the effects of the euro break up worldwide in the previous post.

In order to prevent such an outcome, the European summit held tomorrow, 23rd October should find a way to resolve the following issues: agree on private sector Greek debt holders’ losses and figure out what to do with Greece; create a credible recapitalization plan for European banks exposed to peripheral countries sovereign debt; and protect other countries from the effects of a possible Greek default or debt restructuring.

The general plan is to push higher losses on private Greek debt holders (a ‘haircut’ of around 50%) in order to restructure the Greek debt. In order to do this, precautionary steps need to be taken. The European Commission (EC) wants to step in and protect all the banks exposed to peripheral eurozone debt by recapitalizing banks and giving more firepower to the European Financial Stability Facility (EFSF) to stop contagion and protect other European countries in threat of sovereign default. 

The first thing to make clear is which eurozone countries are insolvent (unable to repay its debts) and which are illiquid (temporary unable to settle its liabilities) in order to back up the illiquid ones by offering more lines of credit and restructuring the debts of the insolvent economies. A lot of policymakers already agree on this as Greece is pictured as the only insolvent country so far, since the current austerity measures are crippling its growth and its economy. Italy and Spain are illiquid and need temporary signs of liquidity in order to pay its liabilities.

The next step is ensuring which European banks will be able to endure and withstand a potential sovereign default of the country they were invested in. This should be done by a credible stress test - not like the one done in July 2011 by the European Banking Authority (EBA). Even though that stress test pointed out to serious instabilities and 8 potential bank defaults, it didn’t account for a potential sovereign default. The new stress test should take not only the potential losses from the default into account but also the possible reactions on the capital markets, policymakers’ reactions, and the hit to consumer and investor confidence. The idea of the stress test is to find out what capital-asset ratio (core tier one capital to risk-weighted assets) is sufficient enough for the exposed banks to survive the default and all the turmoil that will follow it. The EC has signalled a 9% ratio to which the banks responded by rather selling assets than raising new expensive capital in order to meet the target. Dangers were also a further credit contraction to the eurozone small and medium sized businesses, which are highly dependent of bank loans (accrding to FT, European companies rely on banks for 80% of their funding, compared to only 30% of the US companies). Furthermore, the FT reports, the bankers are unwilling to raise new capital knowing that the newly raised money will only be used to cover up sovereign debt writedowns. This is why the banks would rather chose selling assets to reach their target, so that the result might be a decrease of lending – something that a recovering economy does not need!

The policymakers will go around the banks and fill them up with capital coming from governments, i.e. they will raise capital through solvent states or via the EFSF. After the stress tests are initiated and the capital ratio reached the policymakers will use this to assess which banks require recapitalization. Here is where the powered up EFSF should step in.

The EFSF should act as an enforcer of stability in the eurozone banking system. It has the role of creating a ring-fence around Spain and Italy after a potential Greece default and will use its increased funds to recapitalize exposed banks and reduce future risks to the banking system, and furthermore to restore confidence. EFSF was created in order to avoid seeking parliamentary approval for every decision on bailouts and to reduce the risk of credit rating downgrades of Germany and France.

Recapitalization of banks and sufficient liquidity into the system to prevent panic and contagion

The EFSF should inject capital into banks and purchase bonds from weakened countries on the open market lowering borrowing costs to these countries. The EFSF should therefore ‘isolate’ Greece in order to protect European banks highly invested in the peripheral eurozone debt and other countries from possible sovereign default.

The fund is however no longer big enough to complete the new tasks. It should borrow money from the ECB or from the market. It could also issue guarantees instead of loans in order to offer more leverage. The fund currently has 250bn firepower but this may need to be increased to at least 440bn by most estimates or even to 1000bn or more.

There still isn’t consensus on how the recapitalization should be done. The idea to impose more commitments of countries to the EFSF isn’t likely due to several reasons – fear of a credit rating downgrade, political opposition in many eurozone countries (Slovakia’s prime minister already lost her vote of confidence in Parliament during a decision on further support for Greece) and simply the fact that some countries can’t afford to put in more money (Spain, Italy) since it would be absurd to use highly leveraged vehicles backed by weakened countries to rescue those very same countries and their banks.

Another option is to have the EFSF guarantee losses up to 20% on sovereign bonds rather than buying them off Italy or Spain. This could increase their power by not raising extra money. There is also an option of making the EFSF a bank so that it can borrow unlimited amounts from the ECB, a solution Germany finds unacceptable. Another idea is for the ECB to keep buying bonds and having the EFSF guarantee them. Finally, there is still the idea of creating Eurobonds which could prove to be a good vehicle to raise liquidity but very hard to set up immediately as there is a need to build a good oversight system in order to prevent potential misuse by reckless member states. This requires a much closer integration into a full fiscal union with coherent and strict rules which would apply for everyone.

Even though the policymakers still do not agree how the recapitalization should be enforced one thing is certain – any solution will require huge amounts of money to be funded, printed or guaranteed in order for the EFSF to restore confidence, financial stability and growth in the eurozone.

Without even knowing how they plan to initiate the action, possible (negative) consequences can already be recognized and anticipated. The first thing a highly leveraged EFSF would do is create a temporary rise of investor confidence, meaning that the markets would react positively to the plan. After the positive reinforcement, problems will arise. The first one that comes to mind is moral hazard as the banks and governments that become dependent on outside funding may find it hard to return to their old ways which could result in further instability for the eurozone in the form of political concessions and a switch of balance of powers within the eurozone. The private sector will not react immediately and may wait for some time before increasing investment, which is a bad sing for the policymakers who hope to see immediate results, before they run out of “ammunition” to fight the banking crisis. The uncompetitive countries won’t see their problems solved by the EFSF and would still need a radical restructuring of their economies and removing high political interference in the economy. There is a need now to prevent peripheral countries from future instabilities and misbehaviour. Here is where the idea of a full political European Union, an idea imbedded in the Mastricht treaty and a long desire of European policymakers, comes to mind and one can expect more and more arguments for a tighter fiscal Union, even though this will be extremely hard to initiate especially due to big opposition in euro sceptic countries like the UK.

Greece is ready for default

The idea of bank recapitalization and a huge financial injection into the banking system should hardly come as a surprise. The uncertainty over Greek’s ability to implement the enforced austerity measures has increased severely and Italy’s credit downgrades haven’t helped either. The austerity package enforced upon Greece is not working. Investor confidence surrounding Greece is close to nothing as every sign that its government is not fulfilling the austerity measures further decreases faith in Greece and raises its bond yield, which is now at a whopping 78%, not to mention its CDS spreads. Unwillingness to accept that Greece needs to go under only adds up to the uncertainty around banks and undermines the austerity measures even further. Not to mention the vast protests and social instability currently going on in Greece. A default is the only plausible option and the only way Greece and the eurozone could be saved from this vicious cycle of uncertainty and threat to economic recovery. The whole set up around the new role of the EFSF and different ideas on how to carry out the recapitalization can mean only one thing – the eurozone leaders are preparing to default Greece.  

The policymakers are hoping they could forestall investors and create a credible plan now in order to avoid a mass panic and slipping into another recession after the Greek default. They wish to secure the system with enough capital so that the banks can endure another systemic crash. In short, the policymakers seek to ease the burden of Greek default and isolate it from hitting other troubled countries and exposed banks.

Final step – a shift to growth?

The shift of macroeconomic policies from austerity towards a new agenda for growth can only be done by setting a stage to spur back investments into the economy. Kick-starting investments in order to increase production and employment and thus boost demand requires restoring confidence back into the economy – something the regulators have in mind but have no clue on how to approach it (based on their proposals).

Regulators are making serious omissions in their proposals. They require more capital to be held by the banks and are willingly letting the banks cut their assets in order to reach the capital standards and therefore reduce lending. On the other hand they expect their plan to restore confidence and lead the eurozone back on the path to growth. The two desires of the policymakers are in contradiction one with the other. Stiffing bank lending, upon which European businesses strive on, is not a way to restore growth. A strive for fiscal consolidation is one thing, but discouraging banks from lending by imposing higher capital standards won’t help anyone and is very likely to push Europe and consequently the entire world into a double-dip recession. 

Furthermore, designing a new system to stop future crises of confidence isn’t a guarantee against future recessions. No matter how prudent the new regulation will be it is very likely that it won’t be able to cope with a new future crisis. We cannot anticipate what will happen in the future and we cannot be certain how will the economies react and which part of the economy will be taken down – which asset price bubble. All we know is that the debt crisis is likely to cause a new economic downturn – just like so many times before. Due to animal spirits it’s only a question of time when another asset bubble tied with rising debt levels will decrease consumer and investor confidence and increase the prospects of a new recession. Unless the regulators are going to constrain the long term debt and maintain a balanced budget that will ensure the credibility of the sovereign as a borrower, the situation may (or better yet, will) repeat itself, only under different circumstances and causes but with the same impacts and outcomes. 

Wednesday, 19 October 2011

Wolfson Economics Prize

The debate around the eurozone problems is reaching new levels.
As of yesterday there is a prize assigned for any economist that is capable of creating a painless scenario for the demise of the euro and the eurozone.

The prize is named after its sponsor Lord Wolfson, chief executive of Next, and it presents the second largest prize in economics after the Nobel Prize, a total of £250,000. What an incentive!

The conditions and more details on the prize can be found here.

Monday, 17 October 2011

Euro break-up – effects beyond the eurozone

During the past few weeks the centre of economic discussion worldwide has been the Greek default issue, the euro break-up and numerous possible solutions to this problem.
Today, I begin with a series of comments on the eurozone crisis and its possible remedies and consequences. I will start backwards with the worst case scenario – what if the euro falls? What are the possible consequences to the world economy? Inspired by an interesting article from the Financial Times that looked at consequences of a euro break-up on the UK, I use a similar method to paint the global causal effect picture.
A euro break-up won’t only create adverse effects to the eurozone economies; it will yield a significant spillover effect to any countries with strong trade ties with the eurozone. Negative trade linkages will present the direct impact while financial ties and loss of confidence will present an even stronger indirect impact to the world economies.
The first effect is a decrease of exports to any country outside the eurozone which is its significant trading partner. Examples include the UK, US and China in particular. Also, a fall in the value of the euro will result in appreciation of the trade partner currencies, the sterling, the dollar and the renminbi respectively which will come as an additional constraint to exporters.
An even more significant effect will be the financial linkages since all the banks invested in the eurozone will experience significant losses by sovereign defaults and euro banks defaults. A contraction of credit on the domestic market is a natural consequence not only due to huge losses of banks, but also due to a significant decrease of investor and consumer confidence. Loss of confidence will spill over to the real sector and growth will start deteriorating while unemployment may rise even further. The already fragile recovery will be shattered as the final effect may be a deep depression due to a lack of solutions to bring up consumer confidence again. Banks that find themselves in trouble will once again have to be bailed out, only now it is a question where will the money come from. Deficits and debts are on historically high levels and further stimulus will create an inflationary effect, not to mention a significant decrease of investor confidence and country ratings due to ever rising debt levels. The stimulus will not increase demand as investors will be frightened with uncertainty and loss of confidence and thus hold on to their assets. The policymakers will simply run out of options in dealing with the failing system. Nothing they do will create any effects and nothing they do will be enough to start economic recovery. The downward spiral could lead the world into another terrible depression that will again manifest itself through deteriorating trade levels, significant loss of confidence and uncertainty regarding the future, further credit squeeze and decrease of demand.

Credit easing explained

Note: this blog post was also published at the Adam Smith Institute blog titled: "Credit easing won't deliver growth"

Upon observing gloomy reports on the UK economic growth figures last month, panic spread through Westminster. The conservatives in power are getting anxious and cannot seem to wait until their long term growth plan starts yielding its first results. Due to public pressure the governing politicians wan't to see growth rising immediately, i.e. they wish to see their reforms yield results now, as their popularity is decreasing at approximately the same rate the unemployment levels are increasing. The latest action proposal, besides quantitative easing, has been a call for credit easing. 
Credit easing implies that instead of a central bank, the government should buy corporate bonds from small and medium-sized businesses and therefore provide them with enough money so that they can start investing and hiring again. It is supposed to be a swift way to deliver credit to businesses and start up economic growth in the short run until the long run stabilization reforms start to yield their expected effects. The idea comes as somewhat revolutionary for the system where the government wishes to create a market for loans and bonds of small and medium-sized businesses (SMBs) thereby removing the dependency of the SMBs to the banks. In times of slow growth, rising unemployment, no signs of a full recovery and record low consumer and investor confidence comes an idea that is supposed to alter the financial sector by decreasing the role of banks in the economic recovery and leaving it up to the government to kick start lending – not with a fiscal stimulus, but with something very similar but yet very unconventional – credit easing.
Since the UK chancellor of the exchequer George Osborne who made the proposal hasn’t yet found a way to enforce the idea several ideas emerge on how this is supposed to be done; (i) buying loans and bonds directly from the SMBs by a government agency; (ii) buying SMB loans from the banks (either by the government or by private investors via government subsidies), securitizing them and selling them off to private investors; (iii) buying the banks’ corporate bonds and thereby reducing their funding costs and creating an incentive for the banks to increase lending; (iv) offer a guarantee on SMBs loans creating confidence so that the banks could be encouraged to lend money to SMBs.
I will go through each of the proposals in order to evaluate the effectiveness of the credit easing plan.

The first proposal implies a simple fiscal stimulus to certain businesses who found themselves in problems and need recapitalization. The problem arising, among many others, is adverse selection. There is no way for a government bureaucrat to determine which companies should get the necessary funding and which companies will have the strength to invest it in potentially prosperous projects. Due to rising uncertainty surrounding the world economy it is questionable why would the firms start increasing production and start hiring again if they anticipate more contraction in the future and higher taxes due to unsustainable deficit and debt levels. Furthermore, can any government bureaucrat honestly provide a better evaluation of who should get government funding? They don’t have any responsibility on distributing the funds and they don’t have any obligation (or knowledge for that matter) to make an effective decision over who gets the funds. This is something that the Keynesists don’t understand. According to Keynes’s theory, more money into the economy from the government will increase aggregate demand since investors will now have enough money to start investing, businesses will use the stimulus they receive to hire more workers and increase production and consumers will be encouraged to start spending on consumer goods, creating more demand for the businesses, and hence restoring economic growth. However, it is unlikely to imagine that by creating a temporary job for a fireman or a teacher will make them spend their salaries on buying a new car or a washing machine. The money will more likely be used to pay off household debts. The consumers will be careful in taking new loans and the banks will be careful in issuing them as long as confidence in the economy is low. On the business side there is a similar effect; the money they receive will be spent on paying off their debt, not an increase in production or higher employment. The stimulus in the form of bond purchases will thus only result in a form of social transfer from the government to politically prominent firms that found themselves in troubles.
The second proposal has similar implications to the quantitative easing policy where someone is supposed to artificially clean the riskier loans off the banks’ balance sheets. There is an additional clause to securitize these risky loans and sell them off as “safe” assets. The government will simply be the middle-man that pools the securities together and gives them a government guarantee which will result in a high rating for the security. These sorts of securities will soon enough become a desirable asset and their demand will increase. An increasing demand will yield more and more securities and more and more credit to businesses – an effect that is in theory a good one. However, due to an increasing demand for these low risk securities it is very likely that the banks will start to decrease lending standards and offer loans to high risk business projects. Knowing the typical regulatory train of thoughts I dare to say the regulators will encourage banks and other institutions to fill up their assets with these securities in order to re-capitalise themselves and become safer.
The idea is strikingly similar to the past decade of mortgage-based securities trading and is very likely to have the same drastic impact on the financial markets once the bad loans start defaulting. Previously it was the government-sponsored enterprises who packed the mortgages into highly rated securities which were sold on the market. More and more of these securities were sold and the demand for their creating became even bigger. The banks decreased their lending standards in order to produce more mortgage loans which were all successfully bought by the GSEs, repackaged and sold back to banks or other institutional investors. The downward spiral was created. Artificial demand for housing brought down the financial system. The artificial demand for business loans might even be more dangerous since the impact on businesses will, unlike the previous crisis, be direct and swift.
The final two propositions sound more plausible than the first two, but still cannot guarantee that the banks will start lending. Buying the banks’ corporate bonds will only have an inflationary effect, similar to the one already done by the central bank (see post on quantitative easing). The effect of buying corporate bonds from banks is very similar to a fiscal stimulus described earlier, only now the money is flowing to the banks, instead of SMBs. It is questionable how wise will such a move be politically, as the public is fired up on banks and demand the government punishes them, not reward them. Government guarantees, despite offering a far greater leverage, are of a similar effect – they cannot persuade banks to start lending and will result only in rising moral hazard. 
In conclusion, credit easing is not very different in effect to a fiscal stimulus or quantitative easing. What is peculiar about the policy is that it’s being proposed by the only government in the West that strictly committing itself to austerity, long-run growth and restructuring of the economy. It is interesting to note here the political economy implication in how poor current economic performance can undermine even the most credible plans made by a government so much that the very same government is ready to take a completely different approach than the one they have advocated so much. This would be a completely missed policy coming from the conservative government as it will undermine their credibility – the basis on which they expect their austerity plan to work. The conservatives are worried about the results of the economy and - typically for politicians – seek immediate impact of their recovery plan. This won’t come so soon. The Treasury has made accurate predictions of when the deficit will start to decrease – in 2014. Commiting every budget until then towards this goal will send a signal to investors that the plan is credible and that the government isn’t looking for short-term fixes but rather a long-run stabilization path. This will sooner than expected (but certainly not in the next few months) yield positive expectations on the UK economy and will increase confidence, which will lead to a gradual increase in investments, consumption, employment and consequently economic growth.

Friday, 14 October 2011

Tobin tax - a tax on financial transactions

The European Commission has recently proposed a levy on financial transactions, as little as 0.1% for equities and bonds and 0.01% for derivatives. Both parties of the transaction would be entitled to it even for transactions where one trader would be out of EU. It is estimated that the tax could raise about 55bn euro a year for the EU. The idea behind it according to Jose Manuel Barosso: “it is time for the financial sector to make a contribution back to society”. However, the very same Commission has estimated that such a tax could severely harm derivatives and bond trading in Europe (up to 90% of derivatives trading will disappear) and cause a 2% decrease on average of the European GDP in the long run.
The tax is named after a Nobel Prize winning US economist James Tobin who proposed the tax with the idea of an efficient and fair way of raising revenue for the government. In theory the tax is supposed to discourage speculation. In practice, however, it is unlikely to persist.
The main problem behind the Tobin tax is selective implementation. Either everyone has it, or no one has it. A Tobin tax issued in Europe will simply drain the money out of European markets and push it towards off shore financial centres. The traders on the derivatives and bond markets are usually big multinational companies (banks included) who will have no problem of transferring the derivatives trading and currency hedging transactions into some of their international centres such as Hong Kong or New York.
The tax is likely to hit pension funds and middle sized companies which use derivatives to hedge against swings in commodity prices and currencies, rather than other financial institutions. Unlike multinational companies, middle sized companies cannot pass their trading to other markets and will be the only ones left to bear the burden of the tax. This is therefore a tax that will stiff economic recovery even further as it will impose additional costs to the already troubled middle-sized companies which are according to the widely accepted paradigm – drivers of economic growth. It will harm all those manufactures, retailers and import-exporters that use derivatives to hedge against currency and price swings, even for low rates such as these ones. The imposed costs on companies who will have no choice but to bear the burden of the tax will reflect on the prices and competitiveness of these companies and finally the burden will fall on consumers.
As a final consequence, volumes of trading will decrease rapidly, spreads will increase and trading will inevitably move on to offshore “unregulated” markets. Europe won’t benefit at all as the revenues it collects from this tax will be substantially smaller than expected, while the effect on GDP growth will be devastating.
Some estimates say that the market which will suffer the hardest blow is the UK market and London as one of the world’s biggest financial centres. The loss of trading volumes will be up to 33% just on bonds and stocks for the UK, 23% for Spain, 13% for Germany and 12% for France (according to Financial Times). The derivatives market, although with a much smaller tax, is estimated to be completely wiped out from European markets. No wonder that the UK stands firmly against such a proposal. This time, a stubborn stance from the UK is welcomed as the tax can only go through if verified by all 27 EU countries. According to its adverse effects (huge negative impact and a negligible positive impact) it is very unlikely for this to happen.

Overlooked effects of quantitative easing

Last week the Bank of England issued another £75bn of quantitative easing (QE) in addition to the £200bn in 2009. Quantitative easing essentially means buying government bonds with newly printed money to drive down long-term interest rates due to the inability to lower the interest rates in a conventional way. A central bank creates incentives for the bankers to loan money to businesses instead of buying treasury bonds as the yield on the bonds goes down. The central bank also buys bad assets from banks to clear their balance sheets and decrease their borrowing costs. The immediate effects are devaluation of the national currency, lower gilt yields and higher inflationary expectations. 

It appears that QE became a simple solution for politicians to try and quick fix the economy, while bearing no responsibility if it doesn't work. Central banks are pumping money into the economy at every sight of a growth slowdown. Their hope is that by buying government bonds and clearing banks’ bad assets they will decrease gilt yields and drive down long term interest rates in order to create incentives for banks to start lending. The immediate effect of such an expansionary monetary policy is the devaluation of the national currency and higher inflationary expectations. Decreasing long term interest rates isn't only dangerous for higher expected inflation, they can also lead to an asset price boom, just like the one recently experienced in the US and many European countries. 

The graph below specifies the relationship between annual changes in housing prices and the Fed key interest rate, where it shows an interesting negative correlation between housing price changes and interest rates. A decrease of the interest rate will trigger a rise in housing prices while an increase of the interest rate will move the housing prices downwards. This mechanism was straightforward even in the years preceding the 2008 recession but it certainly wasn't the only factor that led to a steep rise and in the end of 2005 to a rapid decline. The inverted relationship is nonetheless still rather obvious.

Source: Vukovic (2011) “Political Economy of the US Financial Crisis 2007 – 2009” Financial Theory and Practice 35(1).
Even if the inflation and asset price boom fears are sustained and somehow the central bank manages to restore recovery so that it can start increasing interest rates again and lowering inflation, there is no guarantee that another round of QE can start-up economic growth. The policymakers seek an immediate impact in order to ease the pressure from the voters concerning a bad state of the economy and avoid reducing investor confidence. When a central bank buys the Treasury bonds to decrease their yields this will decrease borrowing costs but it is not enough to encourage banks to start lending money to businesses. In theory an incentive to behave in such a way is evident, since the banks can earn higher returns from loans to businesses instead of buying safe Treasury bonds and since their bad assets are being ‘cleaned’ by the central bank. But the theory disregards the role of confidence, uncertainty and future expectations in the economy that will more than anything influence banks’ lending decisions and businesses’ hiring and investment decisions. 

The regulators and the Bank of England (or any central bank in the recovering economies) send mixed signals and opposite incentives to banks and businesses. On one hand, regulators seek to steer banks into buying safe investments (consisting mostly of US and German government bonds with low yields) and on the other hand expect them to increase lending to businesses and start up economic growth. If a bank if forced to increase its capital reserves and discouraged into risky investments a climate of uncertainty is created in the bank as it has no incentive to offer risky loans again due to fears of another recession and due to pressure from the regulators and policymakers. Lower borrowing costs to encourage lending will not yield the effect the policymakers are hoping for when regulatory policies are contradicting each other. 

Lending to businesses and the support for innovation is highly discouraged, especially to small and medium sized businesses who don’t have enough credibility for any bank to support them on lucrative projects and investments. In the environment of mixed signals sent by the central banks on one side and the regulators on the other, no wonder the banks and the economy are in a stand still. No bank is ready to start lending in an uncertain environment. While the entire business world is waiting to see how the Greek and euro zone issues are to be resolved, the recovery plans are not showing good results, economic growth is still not improving and there are rising threats of a double-dip recession, no investor is going to invest, no bank will be willing to take on higher risks and the businesses will still be out of money and not ready to start hiring. 

Quantitative easing will therefore, due to uncertainty, low confidence levels and mixed regulatory policies only result in higher inflation and a devalued currency, while any of its possible positive effects will be crowded out.

UK banking reform - Vickers report

I will open the blog with a regulatory topic - the ICB banking reform in the UK and its effects on competitiveness, growth and recovery of the UK economy.

In September 2011 the UK Independent Commission on Banking (ICB) announced its proposal of a banking reform that was to transform the British banking system and make it less vulnerable to outside shocks of liquidity and more responsive in their risk-taking behaviour. The initial concern that drove to the setting up of the ICB in 2010 was the notion that Britain will never again uphold a system in which a financial institution is considered too big to fail and that never again will the government have to bailout large banks at the taxpayers’ expense. The very essence of the Commission was to design a regulation that will reduce the likelihood of failure of important financial institutions and mitigate the effects on the economy of their possible defaults. The Commission was also supposed to tackle the problems of reducing systemic risk of the economy while keeping in perspective that it shouldn’t disturb the financial system from maintaining its main role of supporting the economy.
The Commission focused their report around two central issues: financial stability and competition of the banking system. Financial stability implies setting up a loss-absorbent position for the banks by increasing their capital requirements along with a structural reform of the universal banking system in the form of a ring-fence. A ring-fence implies partial separation of retail and investment branches of a bank so as to assure that the retail branch shouldn’t be responsible for its investment branch’s risky decisions and would be able to absorb the losses and protect the deposits of its clients. The partial separation means that in case of balance sheet problems incurred by either of the bank’s branches the other branch could still step in and provide the needed funds to absorb the losses and avoid another public bailout. The ring fence should discourage the banks from risky investments making them more robust and highly unlikely to fail. It will also make resolution simple in case of a bust of either branches and it won’t incur any cost to the taxpayers.
In addition to the ring-fence the banks are to be required to hold more equity than before primary to avoid imposing losses to the taxpayers. Higher capital requirements will lead to the creation of a ‘bail-in’ fund where the bank’s private creditors will be responsible to cover the losses. Instead of the international standard of 7% capital requirement the UK banks should hold a 10% capital, while the retail banks should hold another 7 to 10% in order to mitigate possible future losses. The intuition behind such higher capital standards claims they would have been enough to protect the banks if initiated before the crisis. 

The ring-fence proposal recognises the retail part of a bank as too important to fail and seeks to protect it from losses imposed by the bank’s other subsidiaries. The retail branch will also be discouraged from investing into risky assets by limiting the scope to where it may invest. Such a proposal is based on faulty assumptions. Firstly, there is no clear pattern that an investment part of a bank drove to illiquidity of the retail part (Northern Rock and Wachovia are clear counter examples since they were retail banks, while other universal banks had balance sheet problems in both branches). Secondly, higher capital standards and an incentive to invest into what the regulators perceive as safe assets will not increase stability or the resistance to future financial crises. The effect will be exactly the opposite – it will lead to an increase of systemic risk to the economy. The ring-fence will stiff lending and make credit more expensive on the domestic market. The perception of safety will be achieved for the retail banks, but it is only a question until when, since future threats to banks assets are impossible to predict. The only plausible argument in entailing a ring-fence is to satisfy the public’s desire to be strict to banks as they are found as the main culprit due to their over-extensive risk taking and greed. It is therefore not convincing how a ring-fence should impose more stability into the system. The causal relationship between a ring-fence and financial stability is not proven, it is merely a possibility.  
Although the Commission does anticipate effects of future liquidity crises and asset shocks as well as the effects on bank behaviour once the reform is implemented, it fails to recognize the immediate impact the reform will have on the economy. They have set 2019 as the deadline to when the banks should adapt to the new reform, but the impact on expectations of banks and investors is immediate. Rational expectations and confidence are formed today with regard to expectations of the future. The banks will anticipate higher future costs and capital requirements which could lead them to a possible credit contraction now. If the banks anticipate a more hostile environment in the future, they will be reluctant to support long term projects today. The Commission should have included in one of its Annexes the anticipated immediate reaction of the banks and the markets, especially concerning the delicate situation the UK economy is currently in.
The second crucial focus of the Commission, competitiveness of the banking industry, is somewhat in contrast with the ring-fencing and capital requirement propositions. In the domestic market, higher capital requirements will result in less credit and deposit creation which implies less money for businesses to invest. Higher costs for banks will make loans more expensive and interest rates higher in the UK, therefore discouraging investments. On the international front, there is no guarantee that British banks will increase their competitiveness, since the banks’ subsidiaries abroad will continue operating under the same standards as before. Perhaps the regulators had in mind that by making banks safer at home would boost their international credibility as they become a more confident lender. This sort of reasoning is questionable, as there are many factors that influence the performance of domestic banks abroad, where the situation in the domestic market contributes only a small part in evaluating this performance.
The Commission requires that banks start investing into safe assets, but it fails to recognize that this sort of behaviour and economic thinking initiated the balance sheet problems of the banks. It also fails to realize why the banks started lowering lending standards. The regulatory obligations set forth in the US and Europe were steering bank’s investments into ‘safe’ assets such as mortgage based securities (MBSs) and were creating adverse demand on the housing market. The banks lowered lending standards because of an artificially created demand pushing them to invest into mortgage based securities. This drove the banks into issuing more and more mortgage loans to risky borrowers, as they needed to respond to the rising demand for MBSs. Filling up banks’ assets with risky securities wasn’t caused by competition but a lack of competition combined with overprotective regulatory confinements. The banks didn’t undertake risky investments due to greed and misbehaviour; they were simply following what the regulators enforced. The regulators had only the best intentions but made mistakes in evaluating the full consequences of their actions – the main one being what will happen if the mortgage based securities were to suddenly default. The only way for that to happen was for the housing market to crash simultaneously across the nation, which is exactly what happened. The housing bubble burst led to a series of defaults of MBSs, leaving all the banks that complied with government regulations with ‘toxic’ assets. The regulators are again repeating the same mistake. They feel they have the wisdom to repair the system and point out to obvious mistakes no one else before them was smart enough to observe. However, they omit to realize the following:
"The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design."
F.A. Hayek, The Fatal Conceit
Steering investment decisions of banks and imposing capital restrictions isn’t a way to boost confidence and will not result in a safer and more stable system. Regulators have designed reforms in the past that were supposed to protect the economy against adverse banking crises and defaults, but crises still occur, despite all their promising efforts.
I don’t mean to create a pessimistic forecast over the newly designed proposal but I would suggest caution in implementing the reform in this stage of the recovery. A vital task in this stage is to start up economic growth by restoring investor confidence. This will depend on many factors, mostly on resolving the Greek default issue and recoveries of the euro zone and the US, both huge UK trading partners. All the actions of the government and all newly legislated policies should therefore be focused on reducing uncertainty and enabling long term credible promises, such as the Treasury growth plan. While many countries chose short term fixes, Britain chose a long term path to recovery and restoring financial stability. It should stick to that path, not amend it along the way at any signal of poor performance of the economy. It takes time for the reforms to kick in. The UK is in a good position regarding its near future; it hosts the Olympic Games in the summer of 2012, which will bring in a huge inflow of foreign currency and assets into the country. An event such as that one will spur optimism back to the consumers and send a credible signal to the investors that the UK is capable of servicing its liabilities even with deep budget cuts. By roughly the same time, upon observing the new budget proposal the investors will receive a signal that the government is sticking to their long term path and will adjust their expectations accordingly. This will create incentives for businesses to start investing again and for consumers to start spending again as they will realize that the tax cuts are sustainable and that they shouldn’t expect any future tax increases that will stiff spending due to rising deficits. Reducing regulatory confinements to businesses is also a step in a right direction in reducing uncertainty. The ICB Report isn’t of such effect, at least not at the moment.


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Through this blog you are entering the interesting world of economics. I hope you find my posts thought provoking or just interesting enough to leave a comment.

The blog will mostly be about economics and political economy and will cover the issues regarding Western economies and when necessary certain Asian and Latin American countries. Topics will range from macroeconomic issues such as the current crisis and recovery and its regulatory responses, monetary policy, fiscal policy and a range of political economy issues.

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