Anthony Painter » Bank of England

Osbornomics- the triumph of hope over reality

anthonypainter — Wed, 04 Nov 2009 10:03:00 +0000

Don’t worry there will be some Obama later. However, the piece I’ve written is more a reflection on where we are than a celebration of the victory itself. There was plenty of that last year and the early part of this year. Interestingly, looking back at the blog at that time I didn’t write anything about his victory at all. I think that I’d just had enough, focusing instead on finishing the book. I still had a conclusion to write….

Anyway, the more prosaic business of the economy: people’s jobs, homes and businesses.

Giles Wilkes at CentreReform has run some separate scenarios on the Conservative approach to solving the fiscal deficit and extracting the economy from recession. The Osborne strategy is to lift the burden from fiscal supports and let exports and capital investment take the strain.

It could work. It’s just highly unlikely. In Slash and Grow. Spending cuts and economic recovery. Wilkes points out:

“Several organisations, from the CBI to the Bank of England, predict that the UK can only grow sustainably through net exports and business investment. Consumption, both by households and the government, needs to fall. But if these two elements (which tend to comprise 80-85% of the economy) are to remain stagnant, the other two will be left with a huge burden to carry. The highest 5 year contribution that capital investment and net exports have ever made was in the mid 1990s, when they added an average of 1.1 percentage points to annual growth.

An even more extraordinary performance will be needed if a future Conservative administration is to achieve budget sustainability by 2015. This is because, even with spending flat in real terms for five years, the gap will need to be closed by higher revenues, which require economic growth.”

And remember, such a strategy would require there to be sufficient growth in world demand to take up the slack of the loss in domestic fiscal support. Other countries would also have to be pursuing strategies that were not similar to ours (everyone can’t devalue all at once.) And the business sector would have to gear itself towards export markets very rapidly- this is in an economy that has a largely non-tradeable sector (Ocado can’t deliver in Brussels.)

Moreover, capital investment- the second Tory anticipated economic recovery driver- is highly volatile. There is no way of predicting where it will head. It is one reason for a degree of caution in the imposition of tougher capital reserve requirements for banks- that may drain the markets of liquidity just as the recovery is gaining some pace. I must emphasise this is absolutely a short-term consideration. And you really have to wonder just how capital investment can expand at the 9% rate needed in Wilkes’ Osborne scenario to get the deficit back to sustainability. The Government is not having to force Lloyds TSB and RBS to lend because they are desperate to anyway…..

This also assumes that there is a huge appetite for corporates to leverage themselves up again. There will be caution both with households and corporates if we look at, say, what happened in Japan in the 1990s and 2000s which bears some similarities to our current situation, i.e. it is a credit recession rather than an inflationary adjustment.

So what is likely to happen when fiscal supports are withdrawn?

Well, time to dust down my trusty old friend, Richard Koo, once again. Japan tried a premature fiscal consolidation in both 1997 and 2001 as I discussed a few weeks back. What was the result? Well, fiscal deficits actually increased and they precipitated a credit crunch and multiple banking failures as well.

What this means in practice is for George Osborne’s highly optimistic, high risk scenario to work he needs an enormous amount of luck.

For what it’s worth, my prediction? Should the Tories win and begin cutting expenditure immediately, Osborne will be forced to reverse his policy within a year or face a new economic/ fiscal crisis.

Taking on City excess

anthonypainter — Mon, 26 Oct 2009 10:24:00 +0000

Will Hutton pitched into the discussion about whether we should look at fundamental structural change within the banking industry. Last week, I signaled agreement with Mervyn King’s suggestion that we should split commercial banking from investment banking. Hutton is clear about the scale of the challenge:

“But reforming big finance ranks alongside climate change and the Middle East conflict as one of the great policy challenges of our time.”

However, he doesn’t follow King’s desire to see banks split down the middle. He accepts Lord Adair Turner’s line that such a split would be impractical and undesirable; better instead to manage capital requirements and, perhaps, think about some form of transactions tax if that was insufficient to curb riskier behaviour. Hutton does go much further than Lord Turner in suggesting:

“Britain should now break up its banks that are too big to fail as the US once trust-busted Standard Oil in 1911 when it got far too large – the King solution. The impact on British finance and the powerful financial oligarchs would be irreversible and unforgettable. We could create more than a dozen banks where we now have four – NatWest, Bank of Scotland, and the Halifax should be given their independence again – and new banks created to specialise in infrastructure and innovation financing, where there is a gaping hole. There could be a genuinely competitive banking market, fighting to increase lending in all parts of the country and driving a sustained recovery. No single bank could pose a systemic risk because none would be large enough.”

So how does Hutton’s trust-busting proposal stack up?

There are three questions for me: does it actually reduce systemic risk, does it eliminate moral hazard, would there be banks that were still be ‘too big to fail’?

On the first of these, the proposal fails. The risk inherent in the system (sorry to get all Monty Python on you) is what is risky. Sounds tautological? Well, let me throw another tautology your way. The systemic risk is the system.

Having scattered tautology all around, let me hit you with an oxymoron (stick with this, serious point coming.) John Cassidy sees the financial meltdown in terms of ‘rational irrationality.’ What he means is that while the medium term consequences of decisions are irrational, short-term decisions are entirely rational. So, for example, a Wall Street CEO who invests in a risky class of financial products knows that he (almost all are ‘he’) may be jeopardising his firm’s future, and knows that if other CEOs are making the same calls then the entire system may be jeopardised. However, he can’t but make the investment or his company’s stock will forgo growth, his reputation will suffer and he will lose his job.

Over to Cassidy:

“The same logic [rational irrationality] applies to the decisions made by Wall Street C.E.O.s like Citigroup’s Charles Prince and Merrill Lynch’s Stanley O’Neal. They’ve been roundly denounced for leading their companies into the mortgage business, where they suffered heavy losses. In the midst of a credit bubble, though, somebody running a big financial institution seldom has the option of sitting it out. What boosts a firm’s stock price, and the boss’s standing, is a rapid expansion in revenues and market share. Privately, he may harbor reservations about a particular business line, such as subprime securitization. But, once his peers have entered the field, and are making money, his firm has little choice except to join them. C.E.O.s certainly don’t have much personal incentive to exercise caution. Most of them receive compensation packages loaded with stock options, which reward them for delivering extraordinary growth rather than for maintaining product quality and protecting their firm’s reputation.”

Herein lies the problem with the Hutton proposal. The dynamic of ‘rational irrationality’, far from reducing the risk within the system, could actually increase it. Many banks chasing scarce capital will compete with each other to make ever greater returns. That in itself will increase risk taking. Ah, but aren’t these investors wise to risk? No. That’s the problem. The whole thing is opaque and riddled asymmetries of information. Goodness, people within firms don’t know what is going on let alone investors on the outside.

So the Hutton proposal wouldn’t reduce systemic risk and may indeed increase it.

Now, the moral hazard question. While none of these smaller banks would be theoretically too ‘big to fail’, they would certainly be ‘too politically damaging to allow to fail.’ Northern Rock was not a big High Street bank but it was inconceivable that it could have been allowed to fail; indeed, it had to be nationalised. This was partly due to the fact that confidence in the system would be shot (remember, the hour by hour monitoring of ATMs…..) but also the political fallout would have been devastating.

So while none of the new ‘mini-banks’ would be ‘too big to fail’ as long as their failure didn’t undermine trust in the entire system, the reality would be different. What’s more, contagion spreads quicker in financial markets than myxomatosis in a rabbit warren. What this would mean in practice is that any executive would still be in a position where they knew they had a taxpayer guarantee. Moral hazard would still apply. Moral hazard and ‘too big to fail’ are, in reality, two sides of the same coin.

On the basis that I don’t see that Hutton proposal- and he has some other ideas for the creation of banks to support infrastructure and innovation which are excellent- reduces systemic risk, eliminates moral hazard, or really solves the ‘too big to fail’ issue I’m sticking with Mervyn King.

Only by having a commercial banking sector that is very boring, very regulated, and transparent can we shield the UK taxpayer from shouldering the burden of loss while others reap the grotesque rewards. I do not think the system is transparent enough for capital requirements to resolve the issue. The only way is to de-risk commercial banking. I do not think any of Lord Turner’s objections are really convincing. There is no reason why the more sophisticated services like hedging could not be offered by regulated commercial banks. They could simply become agents for such services.

Where I absolutely 100% do agree with Will Hutton is that this is one of the big questions of our time. It is one that I fear we are ducking exposing the UK- given the the ratio of the banking sector to our GDP- to perhaps greater risk than any other European economy.

Post script: George Osborne has delivered a speech on these issues today. It contains lots of ‘this should happen, that should happen’ without much this is how it will happen. Intriguingly, he reiterates his proposal to hand banking regulation to the Bank of England. Yet he doesn’t state whether he agrees with Mervyn King’s proposal to break up the banks. Well, to support one measure is to support the other so what is it? Vince Cable is explicit in his support.

The rest of the speech is the normal mix of deregulation, rhetoric about red tape (as if the issue facing the British economy was supply side and not demand side!) and his usual stuff about Britain facing a ‘debt crisis’:

“It is the soaring national debt that sits like a vulture poised to swoop on a sustainable British recovery.”

Unfortunately, shoot that bird too early and you shoot down recovery which is what will happen, of course. To his credit, George Osborne is completely honest about his intentions. If we vote for it, then we will only have ourselves to blame.

Tory cuts- a second credit crunch?

anthonypainter — Thu, 17 Sep 2009 11:21:00 +0000

Giles Wilkes at CentreReform and myself have been having a discussion about cuts, the economy, etc on his blogsite (highly recommend.) Sunder Katwala has also blogged on this.

Giles made an important point that should the Tories pursue a strategy of radical cuts in public expenditure with the aim of provoking a depreciation of the pound then it is likely that the Bank of England would have to step in.

My column for LabourList this week argued that cuts in public expenditure at this stage could be disastrous. Now imagine cuts and interest rate rises. With all those people on variable rate and tracker mortgages now and businesses likewise, the results could be devastating.

It would be possible that a second credit crunch could be provoked (again, that is exactly what happened in Japan in 1997 when they prematurely cut public expenditure.)

This Tory economic approach is mad, bad and very dangerous. Labour must communicate that.

Tories risk economic calamity

anthonypainter — Mon, 06 Jul 2009 11:43:00 +0000

Two pieces caught my eye over the weekend. Both deal with the gnarled topic of government borrowing and debt. I covered this issue a few weeks ago when discussing the project initiated by President Sarkozy to re-think debt chaired by Amartya Sen and Joseph Stiglitz. Some debt is good as it raises the productive potential of the economy.

Of course politicians are engaged in a semi-bogus debate about cutting public expenditure. The issue is not who is tougher. It is when the necessary fiscal stiffening should be initiated.Economically, we are most definitely not out of the woods yet. Both the supply of capital and the demand for capital appear to be declining. If the investment is not undertaken then that harms growth, employment, etc. What can fill the gap? Well, it’s public expenditure or nothing. The latter is terrifying and that is why I find the Tories’ line on debt and fiscal rectitude so concerning. They may be in government in a year. Watch the double dip recession- or worse- become a real possibility.

By focusing the debate on the level of debt, they have made short-term political capital but they are creating a irresponsible dialogue. The major issues facing the economy currently are the continuing risk of financial collapse and the associated decline in demand. Richard Koo, through his experience of the Japanese economy which has sustained a series of shocks over a decade and a half, cautions us not to become too cautious when it comes to debt. I would be encouraged if all front line politicians read his book as a matter of urgency. Will Hutton picked up his arguments in his Observer column yesterday (I will say it again, Hutton has become a must-read commentator once more.)

The debate that has been going on about debt and cutting spending simply ignores thefundamentals- the British economy is facing serious structural weakness and we still don’t know how that is going to pan out. Debate about what the spending and capital expenditure will be in 2013 are, frankly, irrelevant. All we can say is that when the economy shows signs of sustained recovery and growth, the stimulus can be withdrawn and we can return to normal times again. We do not know when that will be. If we try to return to orthodox economics too early then we could face calamity. That is the more powerful argument against the Tories’ approach to the economy.

They are facing exactly these challenges in the USA. Krugman, Stiglitz (yes, him again), Nicholas Nassim Taleb appear to have vindicated. Vice President Joe Biden in a characteristic display of honesty admitted that the administration may have underestimated the scale of the economic malaise. In terms of the urgency of the stimulus and the required magnitude it may have undershot. The aforementioned economists and commentators argued this at the time. They won’t be coy in coming forward with a brutal ‘I told you so.’

Congressional Republicans are quickly assuming an attack formation. But their assertion that the economy will self-correct is taken from the playbook of depressions past. They seem to want to play the Herbert Hoover card with a Panglossian flourish.

Thank goodness for the world economy that they are not in control of either the executive or legislative branches. Nor will they be until at least November 2010. The risk that their political bed-fellows in UK will come into office earlier is greater. What the Tories may do to public services seems to be a relatively blunt political attack. What they may do to the economy is far more scary and potent.

The problem with this is that it requires a degree of honesty about the risks facing the economy even if we start to see more convincing green shoots. Labour’s strategy seems to be to demonstrate that it turned the economy round. And the right moves have been played. However, why de-prioritise the economy when it remains the most important issue facing us for the foreseeable future? Instead, the better way to force the Tories onto the defensive- rightly- is to say that weaknesses persist, risk abounds, and the last thing we need is to drag the economy back into the mire through naivety and ideology. A head-strong ideologue is the last thing Britain needs and David Cameron has that air.

One final thing. To do what needs to be done the tennis loving Governor of the Bank of England, Mervyn King may well have to be taken on. He is continually parroting the Tory line on debt. Nobody wants high levels of debt and we must display to international markets that there is a grip on public expenditure and that borrowing is a crucial component of returning the economy to growth. However, if the economy rocks and jerks any more then debt may be a lesser of two evils. That was certainly the Japanese experience (as Tim Geithner the US Treasury Secretary knows only too well.) Why are we incapable of even peering back at recent history?

Dan Hannan and the ‘modern’ Conservative party

anthonypainter — Thu, 09 Apr 2009 14:50:00 +0000

Dan Hannan is the gift that just keeps on giving. Using nothing more explosive than mere facts, Sunder Katwala of the Fabian Society demolishes Hannan’s argument on Fox News that the NHS has been a “mistake for 60 years.” Surely this guy is just a media savvy crank and can be ignored? Well, David Cameron would certainly like it to be that way. The problem is that the Dan Hannan problem just will not go away because it’s revealing of something rather more fundamental: the degree to which the Conservative party hasn’t changed.

Right wing blogs such as Iain Dale, Guido Fawkes, and ConservativeHome were quick to laud Hannan’s speech to the European Parliament where he assailed the Prime Minister and was rewarded with spots on US cable news and 2million YouTube hits. His speech was an articulate expression of extreme free market philosophy as his comments about the NHS were. ConservativeHome polled Conservative party members on the speech. 88% had seen it and 87% thought that Dan Hannan should get a prime spot at the Conservative party conference. Scan the 418 comments on the speech on Guido Fawkes, 50+ comments in each of a series of posts on Iain Dale, and scores in response on ConservativeHome, and you will see that Hannan’s extreme free-market views have warm support amongst Conservative members and supporters.

This is David Cameron’s Hannan problem. His core support is considerably to the right of where David Cameron positions himself in public. This explains why he has been unable to genuinely re-position himself on the centre-ground of British politics. He has not had a Clause IV moment because he can’t have it and not shed significant chunks of support to either UKIP or the apathy party.

What this means in practice is that any Conservative government would most probably default right given any political dilemma. This needs to be understood. The difference between David Cameron and his re-positioning and Tony Blair’s could not be greater. David Cameron has been noticeably quiet on Dan Hannan- see Jim Pickard in the FT on this. Tony Blair took his party with him and where it did not follow he took it on. David Cameron has done no such thing. How can you be a reformer without reform?

This is one of the reasons why the Tories have been so out of step on the economy and earlier this week George Osborne suggested that a Tory government may re-open pay deals for nurses, teachers, and police before have to beat a quick retreat. In practice, what it would mean is that a Conservative administration would be quite brutal in cutting public expenditure even as the economy may only be in the early stages of growth. They would repeat the Japan error once again- cutting too much too early leading to a double or treble dip recession and ultimately a greater level of public debt. The negative social impact of the early 80s increases in interest rates and indirect taxation and reductions in public expenditure in the midst of a recession are still felt today. The Bank of England is now independent but a Tory government could do an immense amount of damage with the wrong fiscal policy.

David Cameron will do everything within his powers to prevent Dan Hannan getting his speaking slot at the Tory party conference. That is partly to do with what he says. But more importantly, it will reveal exactly the ideological position of the modern Conservative party which remains Thatcherite to its very core. And that is the direction in which David Cameron will inevitably be pulled because he has done nothing to take it on either politically or intellectually.

The Dan Hannan problem- like the Rush Limbaugh problem that the Republicans have in the US- is very grave indeed. Dan Hannan will continue to get all the exposure he could ever wish for. That will communicate the reality of the modern Conservative party.

Vince Cable’s perverse economics

anthonypainter — Tue, 29 Jul 2008 09:46:00 +0000

I have an enormous amount of respect for Vince Cable, not least because he’s the only current front-line politician who had a published chapter on my international political economy course reading list when at university. A very good piece it was too, covering the inconsistent pace of globalisation. However, his argument on the Today programme about how the mortgage market should proceed was irresponsibly conservative and, quite frankly, perverse. The audio file is here.

What Cable is essentially arguing is that the housing market has been growing largely because of the availability of cheap mortgage finance. He castigates lenders for allowing borrowers to secure mortgage finance for up to an amount that is five times their annual income. Such lending is irresponsible in his view, and mortgage values should be limited to three times of annual income. By pursuing this more conservative course, we will begin to open up the market for first time buyers. The economics underlying this argument are plain wrong.

If the house sale market existed in isolation then he may have an argument. It doesn’t. It exists in parallel to the rental market. If people aren’t buying houses they are renting them instead- they’ve got to live somewhere! What this means in practice is that as house prices decline, the risk-return ratio alters in the rental market. In other words, rents go up, capital costs (i.e. house prices) go down so that spurs investment in rental property. So our first time buyer still does not own a house, but they are paying more rent to support the profits of private landlords.

This point was illustrated in report published yesterday by the National Housing Federation which forecasts a 25% increase in house prices by 2013. House prices will decline in the short term but will then continue their upward trajectory because the main driver of the market is demand. We live alone for longer, live longer, and get divorced more. Whether people are renting or buying, more people need properties and supply is not keeping pace with that. What’s more, unless the mortgage market is kick-started even fewer houses will be built making the situation worse.

So Vince Cable’s position actually puts first time buyers in a much worse position. The market fundamentals won’t change but the ability of people to get on the property ladder will be devastated unless good mortgage finance becomes more readily available.

Turning to Vince Cable’s contention that the banks have been lending irresponsibly and that we should return to a three times income rather than five times income norm, this is unduly conservative. Let’s do the sums using the BBC’s mortgage calculator.

‘Kate’ has an income of £40,000 and is looking to buy in the South East where a one bedroom flat is likely to cost her £200,000. She has £20,000 savings. If she can get a mortgage for £180,000 over a 25 year time frame at 6%, it will set her back £900 for interest only, £1173 for repayment per month. Her monthly disposable income is £2300 or so. Either option is affordable. At 12% it would be unaffordable (leaving her with a monthly post-mortgage income of £400 or so.) 12% interest rates would only be seen in an economy facing collapse so exceedingly unlikely.

Now let’s move Kate to Cableland. Her income is still £40,000 but she can only get a mortgage worth £120,000 now. With her £20,000 savings that means she can get a house worth £140,000. That means that house prices will have to fall by £60,000 before she can buy. That’s a fall of 30%!!!!!!!!!!!!!!!!!

Of course, that won’t happen because assuming that wholesale markets do recover, finance will be in plentiful supply to allow private landlords to purchase the flat that Kate dreams of before it gets anywhere near £140,000. Poor Kate unless she gets a £20,000 pay rise- a 50% increase- is stuck in the rental market indefinitely. How frustrated she will be that she can’t get a mortgage even though it is completely affordable with her income and she is paying the same amount, if not more, in rent as she would be in a five times income mortgage.

Now to Vince Cable’s final argument that there should be no kick-start for the mortgage markets lest we repeat the mistakes of creating a house price bubble again. His argument against the Bank of England underwriting mortgage debt because it means that the public sector will take the risk and the banks will get the rewards is curiously out of date. The Bank of England has a scheme already in operation called the Special Liquidity Scheme which protects existing high-quality assets in a manner that contains the risk in the private sector. The UK housing market is not like corporate bonds or equities. It can’t suddenly junk- the basic underlying assets, i.e. houses, have a pretty sturdy value whatever the short term fluctuation may be.

Sir James Crosby’s report into the mortgage market to be published today does not envisage permanent government support for the mortgage market as exists in the US through Freddie Mac and Fannie Mae. That is right but an extension of the special liquidity scheme to new as well as existing mortgage assets could be advisable. Any extension would be time bounded until wholesale markets recover.

I’m afraid Vince Cable’s arguments would have a devastatingly detrimental impact: house prices would continue their decline, the economy would suffer, and first time buyers, other than the very few at the margins, would actually be harmed rather than helped. Looking seriously at providing more liquidity to the system, but in a way that prevents the public sector assuming the private sector’s risk, is the way to go. And hopefully, those five times salary 90% mortgages, at good interest rates, will become readily available again and Kate gets the pride and investment potential of her first flat.