Tuesday, 26 February 2013

Corporate cash reserves are far from a myth

The Telegraph's Jeremy Warner has written a piece questioning whether the story about corporate cash hoarding holding back an economic recovery in the UK stands up to scrutiny.

Although he acknowledges that corporates have been steadily increasing their reserves over recent years he suggested this trend may not suggest that there is a tsunami of investment waiting in the wings. According to the ONS total cash reserves held on private non-financial company balance sheets accounted for £672 billion in the third quarter of last year, but Warner claims the figure is only "£50bn higher than they were before the crisis began and hardly enough to explain the great “compensating” leap in public indebtedness".

He goes on to say that the evidence for this being purely a reaction to the crisis and therefore easily reversible is not as strong as many, including members of the Coalition government, have suggested. Rather than a response to short-term uncertainty higher cash balances could instead prove to be "a semi-permanent corporate phenomenon". Only through serious entitlement and supply-side reforms, Warner concludes, can the government hope to pull the economy out its current malaise.

It seems only fair to start with an important point in which I agree with the piece. Firstly, it is absolutely true that the increase in corporate currency and deposit holdings began some time before the crisis. Below is a chart of the ONS data:

As you can clearly see, even a decade ago corporate reserves were on an upwards trajectory. Indeed the rate of increase in reserves was far faster in the five years before the start of the crisis than in the last five years. This suggests that, whatever the underlying causes of corporate cash hoarding are, they are not simply explained by pointing to uncertainty caused by the crisis.

This, however, is where is where I part ways with the author.

It is quite clear that irrespective of the drivers of the trend corporate cash balances remain high on historical standards, despite Warner's claim otherwise to me on Twitter. Moreover, it seems to me that either high reserve balances are a "semi-permanent corporate phenomenon" or they are not high by historical standards - they cannot be both.

Now the confusion here might well have arisen due to the impact of corporate borrowing. If corporates are running large capital reserves and taking on debt then net liabilities may not look unusually high. Indeed there does appear to be evidence that this is in fact the case:

The reason for this rise in borrowing can, in my opinion, be traced to a combination of ultra-low interest rates and the desire by corporates to improve returns on equity to keep management and investors happy (e.g. it could be understood as an unintended consequence of the central bank's response to the crisis). As Andrew Smithers, head of Smithers & Co, says:

"The data from the Office of National Statistics show that debt is high, compared to output or assets, whether measured gross of net of cash type assetsBonds are raised and repaid in lumps. Individual companies therefore tend to have high cash balances when they have just borrowed or are just about to repay debt. On average therefore companies will tend to have more cash when they have more debts."

In itself raising debt at low interest rates is not a big problem. The issue is that this money does not appear to be going to productive investment but instead funding corporate share buybacks:

As a recent Ernst & Young ITEM Club report suggests, while investment grew by 5.1% in the year to the end of Q3 2012 it was still some 11.6% lower than the peak of Q4 2007. This poses some potential problems as rather than invest in improving efficiency, for example through investing in new technology, or expanding business operations the figures suggest managers are instead focused on massaging equity returns. If the trend continues it could mean that profitability becomes increasingly squeezed and that firms are ill-prepared to take advantage if a recovery sets it.

It could also mean that companies with large debt piles could struggle to refinance if interest rates were to move upwards, leaving the central bank with the uncomfortable choice of leaving rates lower for longer risking further debt increases or raising rates risking disorderly deleveraging.

The falls in capital reserves since Q3 2011 may well point to a slight improvement in corporate investment, although we have not yet seen this reflected in the GDP numbers. Of course, they could also reflect falling profitability as firms dip into their reserve to meet current obligations.

I cannot fathom why Warner would wish to paint such a gloomy picture of the UK economy where a cautious, risk-averse private sector indefinitely holds back investment necessary for sustainable growth when the evidence suggests that good policy could alleviate many of the present barriers to recovery. Perhaps the UK's sovereign debt downgrade by Moody's has had the same effect on commentators that doomsayers suggested it would have on markets.

Yet if he is right that corporate cash hoarding represents a structural rather than a cyclical shift in corporate behaviour, it argues all the more strongly for the government to help plug the shortfall in investment rather than continue to cut capital spending as the Coalition has done.

Monday, 18 February 2013

The Price of Safety

In my latest feature "The price of safety", co-written with Frances Coppola, we take a look at an issue I have been closely following over the past few years - the economic impact of corporate cash hoarding. To my mind the story is a crucial one to help explain why more than five years since the start of the financial crisis Western economies are still struggling to achieve meaningful growth.

For me the key to understanding this point is an appreciation of sectoral balances. The concept was eloquently summarised by Martin Wolf in 2011:

"If the government wishes to cut its deficits, other sectors must save less. The questions are 'which ones' and 'how'. What the government has not admitted is that the only actors able to save less now are corporations."

Since the onset of the crisis executives of cash-rich firms (along with a number of commentators) have argued that they have good reason to build up capital buffers. Macro threats such as the eurozone crisis, heated debates over the federal budget in the US and a possible hard landing in China have all been offered as sources of existential risk.

When I first looked at the issue I was tempted to accept this analysis. The overwhelming desire for safety in the face of these risks appeared both to explain rising cash reserves and below inflation yields on government debt instruments. In effect management of businesses running a cash surplus were focused solely on downside protection even at the medium term cost to profitability and the wider economy.

Yet Andrew Smithers, head of Smithers & Co, had a different interpretation. He noted that while cash reserves were indeed high so too were corporate debt levels. With interest rates at historic lows profitable businesses found an extremely cheap source of financing in debt markets and appeared to be using them to fund, among other things, large scale share buybacks and dividend payments. Smithers says buybacks alone were equal to 3% of UK GDP in 2011.

Unsurprisingly equity investors have broadly supported these moves with many actively agitating for them. Some have even filed law suits to that effect.

While I understand their motivation, I think the argument that companies should simply hand their reserves back to investors or reduce the stock of risk-absorbing equity may well be misplaced. This is because in large part these capital stockpiles have been built on businesses slashing their capital investment. The lack of organic investment may be part of the explanation for falling productivity and over the medium term could also have serious consequences for the profitability of these firms (even if the trend can temporarily be masked by a boost to investor returns through buybacks).

Falling manufacturing profitability, as show by the ONS chart below, could suggest that this squeeze is already starting to happen. It might also demonstrate that corporates are having to try to protect margins by bleeding existing assets to a greater extent and leaning on suppliers - neither really offering a long term solution.

Furthermore, while the private sector remains focused on its search for safety the public sector in the UK is attempting to cut spending in an effort to improve the longer term trajectory of government finances. This is helping to drive a toxic cycle whereby fears of the impact of government cuts on demand can be used as a pretext for increasing capital buffers - or as Wolf puts it: "The government's - not surprisingly, unstated - policy is to demolish corporate profits."

In "The price of safety" we conclude that although it may not be the government's intention to undermine aggregate demand, nor the private sector's desire to hold back economic growth (although with large and growing debt piles they may have some motivation to keep interest rates low!) the lack of investment is nevertheless having that effect. Frances writes:

"It is unreasonable of the private sector to withhold risky investment in potentially productive activities themselves and refuse to allow government to do so. If private investors will not take risks, and the government cannot for fear of upsetting private investors, the economy is doomed to stagnation."

For me, this is an excellent summary of the game of chicken that has been initiated. Ultimately either the private sector will have to balk at falling profits or the government become shy of driving output lower if we are to break free of the current economic malaise. On current signals from both sides it seems that realisation may take some time yet.

Thursday, 14 February 2013

Why this time IS different

Usually I try to avoid engaging in spats on social media – they’re time consuming and invariably end up with both sides all the more convinced of their original positions. Nevertheless last weekend I found myself engaged in one with Ryan Bourne of the Centre for Policy Studies over a recent post on ConservativeHome by Andrew Lilico.

In it Lilico claimed that the very idea that government transfers could boost aggregate demand and, as a consequence, GDP is a “fallacy”. He writes (emphasis mine):

“The naive idea behind this is the intuition that if people spend more of their money, rather than saving it, that will boost growth.  Except that's just wrong.  In orthodox macroeconomic models, money that isn't consumed is invested.  And investment boosts GDP as well as consumption.  So when the economy is operating properly, even if we could costlessly transfer money from high savers to high consumers and would not distort their incentives by doing so, there would be no effect upon GDP - it's just that a bit more of that GDP would be consumption and a bit less investment.”

Now I think it’s important to address this point. Yes, at the most basic level orthodox economic models demonstrate that savings always equal investment. As Simon Wren-Lewis explains:

“In the most simple model of a closed economy without government, income (Y) = consumption (C) + saving (S), but also expenditure (Y) = consumption (C) + investment (I). So S=I by definition.”

The problem here is the so-called “paradox of thrift”. That is, if there is an external shock a reduction in consumption reduces output (and therefore incomes), offsetting any temporary rise in saving.

This fall in output can be exacerbated because people decide not to invest their excess capital but instead park it in bank accounts as money. During “normal” times this should not pose much of a problem as the bank can then lend that money out but this may not happen if, for example, the financial sector is in the process of deleveraging and de-risking.

Instead that additional capital could simply sit on the bank’s balance sheet in order to improve its loan-to-deposit ratio. Or as Wren-Lewis puts it – “the bank may just decide to hold on to the cash”.

During these periods there could be good reason for a government to seek to reallocate idle capital from those with a low marginal propensity to consume (MPC) to those with high MPC. As The Economist’s Daniel Knowles suggests, this should increase the velocity of money (eg what GDP is designed to measure).

To be fair to Lilico his central case is slightly more nuanced than the classical savings = investment model. He states that even if a government were able to transfer money to those with high MPC it may still fail to improve output:

“[It] isn't the amount of saving that counts here, but the amount of over-saving.  The fact that one person saves a lot doesn't mean that she over-saves - it might be optimal for her to save a lot.  And the fact that someone else hardly saves at all doesn't mean he doesn't over-save - ideally he might save even less!  So transferring money from low MPC folk (say, "the rich") to high MPC folk (say, "the poor") might increase over-saving, rather than reducing it.”

Now this looks like a valid point. If we are saying that an external shock can make saving the overwhelming priority for people, then we should assume that it applies as much to those on low incomes as those on higher incomes.

But here is where this time really is different.

As the chart below shows, during almost all recent recessions prices have fallen much further than average earnings. During this latest downturn, however, the opposite has happened.

Household costs in particular have held up during the recent recession, shrugging off falling incomes to post in many cases inflation-busting price increases.

What this suggests is that, unlike during a traditional recession, those whose incomes were already hitting up against their expenditure before the crisis would have struggled to cut costs even if there was an overwhelming pressure to save. Many would have had to raid savings, sell investments or borrow against fixed assets just to meet current spending commitments.

Yes, this could also apply to those at the higher end of the income spectrum but they are likely to have been far less impacted by increases in household costs and would be in a far better position to adjust their finances towards saving (liquidating assets, cutting down on discretionary spending etc). Simply put, under current circumstances with the overwhelming incentive to save it is doubtful whether the concept of "optimal saving" is really relevant to the policy discussion.

Bourne, however, claims that people’s spending decisions are not based on short-term factors. In his recent blog post on the CPS site he writes:

“Those advocating redistribution now usually do so by advocating one-off transfers because of the current state of the economy. But economic analysis generally finds that people’s spending decisions tend to be based on permanent income, so this sort of one-time transfer is unlikely to have any significant effect even if you believe all of the assumptions above hold.”

Yet that was not what was suggested by the work of Christopher Carroll and Miles Kimball in their 1996 paper “On the Concavity of the Consumption Function”. In the paper the authors conclude that “adding income uncertainty to the standard optimization problem induces a concave consumption function in which, as Keynes suggested, the marginal propensity to consume out of wealth or transitory income declines with the level of wealth”.

Or, as Carroll later described in a NBER article:

“[In] the presence of uncertainty, households with low levels of wealth will respond more to a windfall infusion of cash than households with ample resources”

As such there is good reason to believe that precisely because of the current state of the economy transfer payments could increase aggregate demand. While during normal times savings held as cash in bank accounts may have made their way into productive investments, the dysfunction within the banking system at present makes that highly unlikely.

Now, simply because transfer payments could increase aggregate demand does not make them ideal policy. Both Bourne and Lilico rightly point out that there are significant deadweight costs to such policy moves. My preference would, instead, be for government to increase spending on infrastructure, which would have long-term benefits for the economy as well as the short-run boost to aggregate demand.

However, simply because it is not ideal policy does not make it a “fallacy”. The question Lilico, Bourne et al need to answer is whether the economic status quo is really better than the alternative that they attack?

How monetary policy can help explain the employment puzzle

So over the past few days I’ve found myself in two debates over the impact of automation on jobs with the New Statesman’s Alex Hern and the inimitable Frances Coppola.

In both I wanted to discuss the demand impact of automation, which has thus far been largely ignored in the “robots ate my job” discussion. Basically my point is that the consequences of high unemployment on demand would ultimately be enough to offset the case for automation. Or looked at another way, businesses might choose to retain employees even if the cost per unit is higher than with an automated alternative.

For me, this has important implications. In the short term the fear of demand destruction is likely to do little to dissuade individual businesses from trying to increase productivity through automation – so some of the fears about job destruction are at least theoretically justified.

In the longer term, however, the costs of rising unemployment should help to erode profit margins faster than automation can maintain them. As persistent mass unemployment would be intolerable for both sides – either government transfer payments would have to be significantly increased or circumstances would risk profound social upheaval.

One response to this could be a temporary expansion in the public sector as the private sector adapts to technology “shocks”. There are still plenty of long-term productivity gains that can be achieved through large-scale infrastructure improvements and meanwhile it would allow new types of industry to form.

Alternatively, the private sector may seek to stagger investment in new technology in order to avert a demand shock. To an extent this appears already to be happening, particularly in the energy sector, and has been abetted by protectionist measures by governments (usually at the behest of lobby groups). As Frances points out, this type of labour hoarding comes very close to the Luddite argument.

It is fair to say that both Alex and Frances were sceptical of the demand picture I was painting. I concede that the reality could be much more disruptive and far less smooth a process than it suggests, but I still believe it could ultimately become an important factor – if it’s not already so.

And yet even if you accept the thesis is does not seem a sufficient explanation for what is actually happening in UK labour markets. Figures out from the ONS earlier this week showed that unemployment fell again between September and November, even as early GDP estimates suggest growth was pretty much flat over 2012.

Ben Broadbent, External Member of the Monetary Policy Committee, gave a speech last September on productivity and the allocation of resources. In it he laid out the current debate on the causes of the surprising resilience of Britain’s labour market:

“One explanation for this is labour hoarding. Because it is costly both to fire and to re-hire employees firms may have hung on to staff in an expectation that demand will pick up. Another is that underlying productivity growth has slowed. In that case, weak output may not be the result purely of weak demand. It may instead reflect an independent hit to supply, one that explains why employment and inflation have been relatively high.

As extremes, these two hypotheses can have very different implications. If the first is true, then without a strong pick-up in economic activity, employment and inflation are likely to decline. Finding themselves in the position of a cartoon character that has run off the edge of a cliff, but is not yet aware of the fact, firms will at some point have to face reality and trim their under-employed workforce. Cost growth and inflation will then fall. If, instead, supply is (and remains) the problem, we could continue to see below-par output growth without any such implications for employment or inflation.”

Broadbent’s claim is that there is an element of both at play, as the fundamental problem is a misallocation of capital. While labour has proven itself flexible in the aftermath of the crisis, ironically capital has proven sticky.

This has been caused, he contends, by a combination of uneven demand between sectors and an impaired financial system unable to efficiently reallocate capital - hence the growing number of stories about “zombie companies” kept going simply to service debt. Although this would have a negative impact on productivity and output in the short run, it should also mean that there are good reasons to expect these to ultimately recover.

However, I think here there is also an issue that Broadbent does not address. In its efforts to avert a systemic collapse in financial services the Bank of England, along with the other major central banks, has in effect given an open-ended commitment to support asset prices.

In doing so they may be exacerbating the causes of misallocation of capital, in particular through a mispricing of risk. If central bank action is helping keep unproductive areas of the economy on life-support then default risk is effectively taken off the table for investors, encouraging unproductive investment.

Unfortunately this has left successful companies unable to gain access to capital, which is holding back investment in making their businesses more efficient (eg investing is new technology). Employing more workers to meet demand is a partial solution to this, but the current trend could quickly run out of steam if the underlying economy continues to stagnate and real wages continue to fall.

As such while it is understandable that central bankers have focused on the problems within the financial sector to prevent a system-wide collapse, it is not a costless strategy. The problems of “zombie” loans and the rebuilding of shattered confidence between institutions are likely to take many more years to resolve themselves. In the meantime Britain’s economic potential is being squandered.

Perhaps it is time to take seriously the idea of a sovereign wealth fund for developed countries, as suggested by Miles Kimball and hinted at by Simon Wren-Lewis, to help free up productive capital.

The uncertain course of debt deflation

This post is written jointly with Frances Coppola.

I have been re-reading Irving Fisher's "Debt deflation"[1]. Short and immensely readable, it remains one of the best explanations of financial crashes and depression in economics literature. But I am puzzled. What is going on at the moment doesn't quite fit, somehow.

On the face of it, much of what has happened over the last six years fits all too well with Fisher's description of debt deflation. He identifies two prime causes of booms and busts - what he calls the "debt disease" and the "dollar disease". Over-indebtedness before the crash results in debt deflation after the crash - the "debt disease". And shortage of money in circulation leads to apparent over-production and crashing prices - the "dollar disease". The disastrous deflationary spiral experienced by the US in the Great Depression, and by several Eurozone countries at present, can be adequately explained by these two factors. 

But what is happening in countries such as the US and UK is much less straightforward. We had a crash, followed by sharp deleveraging in the private sector, distress selling, price crashes and bankruptcies. But then we propped it all up. Governments intervened to arrest the deflationary slide by taking distressed private debt on to public balance sheets, and central banks flooded the place with new money to prevent catastrophic price falls. The sharp deleveraging stopped and the price level stabilised - in fact in the UK the general price level actually rose. And yet we seem to be experiencing a number of features of Fisher's debt deflation spiral. 

Fisher identifies a chain of nine linked stages in debt deflation:

1) Debt liquidation causing distress selling leading to
2) Contraction of deposit currency as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
3) A fall in the level of prices, in other words a swelling of the dollar. Assuming....that this fall of prices is not interfered with by reflation or otherwise, there must be
4) A still greater fall in the net worths of business, precipitating bankruptcies and
5) A like fall in profits, which in a capitalistic society leads the concerns which are running at a loss to make
6) A reduction in trade, in output and in employment of labour. These losses, bankruptcies and unemployment lead to 
7) Pessimism and lack of confidence, which in turn lead to
8) Hoarding and slowing down still more the velocity of circulation.
The above 8 changes cause
9) Complicated disturbances in the rates of interest, in particular a fall in the nominal (money) rates of interest and a rise in the real (commodity) rates. 

Now it is easy to see where in this sequence governments and central banks intervened. Clearly it was between stages 2 and 3 - exactly where Fisher says that reflation might interfere with the process. Bernanke and Geithner may not have read Fisher, but they did what he suggested. Consequently we have not seen a general fall in the price level and we have not had a spate of bankruptcies. But that's where the good news ends. 

There is no doubt that the financial crisis did severely disrupt trade, output and employment, despite the reflationary efforts of governments and central banks. And it is still doing so. Employment in Western nations is well below what it was before the crisis: in the US this shows itself as a stubbornly high unemployment rate, while in the UK it takes the form of substitution of full-time employment with part-time, short-term and casual work. Output is also significantly lower than before, to the extent that the UK's OBR pessimistically forecasts that it cannot return to its previous level. And both domestic sales and exports are reduced. The feeble nature of the economic recovery is the reason why Western central banks are still reflating their economies six years after the crisis. 

Evidently the reflation did not fully prevent stage 6 from occurring. And it seems to have had no effect at all on the subsequent stages. Pessimism and lack of confidence is evident throughout the economy: people are worried about their savings, their jobs and their incomes. People and businesses are cutting spending and saving like crazy: they are paying off debt and hoarding cash and other assets. Investors are moving their funds to safe havens - highly-rated government debt, traditional safe haven currencies such as the Swiss franc, government-insured deposit accounts. Even UK local authorities are under-spending their budgets and building up reserves. Yet the crisis itself is long over and did not cause the catastrophic deflation of the 1930s. What on earth is going on?

There is no doubt the prompt intervention of the authorities prevented a repeat of the 1930s disaster. We did not repeat the mistakes of the early 1930s, except in the Eurozone where the Euro straitjacket forced countries to maintain tight monetary and, latterly, fiscal policy, precipitating the classic deflationary spiral. Or - did we? Six years on, monetary policy is so loose it is practically in pieces and central banks are resorting to increasingly esoteric and untested tools to find ways of depressing interest rates further (actually this amounts to the "complicated disturbances in interest rates" that Fisher mentions, though not for the same reasons). But fiscal policy is another matter. In contrast to 2009, when governments worldwide collaborated to give substantial fiscal stimulus to the global economy as a whole, the general policy stance of Western governments now is that fiscal policy must be progressively tightened in order to reduce public deficits and - as the IMF puts it - "get public finances on to a more sustainable path". In other words, we are VOLUNTARILY undertaking debt deflation in the public sector. The only Western government that hasn't so far adopted fiscal austerity as a general policy is the US. But it clearly intends to. Even Obama talks about reducing the deficit , though whether he means short-term spending cuts or longer-term structural reform is unclear. 

The prevailing view appears to be that fiscal "reforms" - i.e. public debt deflation - can be conducted despite difficult economic conditions if monetary policy is supportive. But this ignores the fact that fiscal and monetary policies affect the economy in different ways. Monetary policy primarily affects the financial system: fiscal policy primarily affects the "real" economy. Or in US parlance, monetary policy influences Wall Street, fiscal policy Main Street. Obviously there are indirect effects: monetary easing depresses interest rates on variable-rate mortgages and on savings and investments, benefiting homeowners: taxation policy affects the nature and direction of money flows around the financial system. But the direct effects have more impact - and the direct effects of ANTICIPATED fiscal austerity and government spending cuts are sufficient in themselves to explain pessimism, lack of confidence and hoarding among the general public. Never mind that governments actually haven't done much fiscal tightening yet. All that matters is that people think they are going to. Public sector workers are worried about losing their jobs - and with reason, as there have already been significant job losses and further cuts to government departments are planned. Working-age people on low to middle incomes worry about tax rises and benefit cuts. US pensioners worry about cuts to Medicare: UK ones, about means-testing of benefits such as the winter fuel allowance. And there is clearly more to come. The UK government responded to the news that it would miss its deficit reduction target by announcing a further 3 years of cuts and austerity. Really they are stupid. Did they think people would react to that by going on a spending spree? Anybody with any sense surely could have foreseen that people would respond by increasing their savings level. The effect of the UK government's announcement must have been to depress the economic activity of average UK households. 

Perversely, the effect of monetary easing can also be to reduce spending and increase savings rates. Pensioners on fixed incomes cut their spending in anticipation of poorer returns on their investments due to depressed interest rates. And people who are suffering erosion of their capital due to negative real interest rates don't necessarily spend the money instead - certainly not if it is money they are saving up for their old age. No, they try to make good the difference. They cut discretionary spending and save even more. 

The effect on businesses of anticipated fiscal austerity is slightly different. Businesses generally don't suffer directly from fiscal tightening, unless governments raise corporation taxes. They suffer indirectly, because of demand reduction caused by households suffering reductions in real income and/or opting to save instead of spend. Resilient (or even improved) private sector profitability has been the surprising story of this financial crisis, but it has largely been driven by the ability of some businesses to bleed existing assets (increasing rents) while cutting investment in future projects (holding back innovation causing artificial scarcity). Unfortunately because incomes are being squeezed by a combination of inflation and corporate cost cutting this will likely prove a temporary state of affairs. Indeed we are already seeing a growing number of corporate profit warnings.

The problem then is what companies do with their surpluses. If fiscal policy is still a driver of uncertainty then there is very little incentive for them to start investing as they rationally assume demand will be further undermined. But the alternatives are not very compelling either – sitting on cash (or cash-equivalent assets) with interest rates around zero and above-target inflation mean they are already losing significant amounts in real terms. Moreover, contrary to what a number of investors have been advocating for, committing to paying it out as dividends is also problematic as at best it can only buy time unless the business can achieve meaningful organic growth.

Yet their reluctance to spend is helping to intensify the economic downturn and undermining central bank attempts to reflate. This has created a destructive cycle whereby businesses try to anticipate the demand impact of government cuts by building up surpluses, increasing the actual impact of the cuts when they occur. The burden is then shifted onto central banks to mitigate the shortfalls by trying to reflate the asset base, even as the spillover effects of unorthodox monetary policy erode returns on safe assets and prop up inflation above average wage rises. It hardly makes a compelling case for banks, which are under regulatory pressure to de-risk, to start increasing lending to the real economy.
They too are sitting on what little profits they are able to make, refusing to take on risk and lobbying government in the hope of reducing regulatory threats.

Debt deflation doesn't follow a predictable sequence: it meanders in an uncertain and unpredictable manner, depending on the situation of each economic agent. So the relationships between Fisher's nine linked stages are complex, and the effect of later stages can be to recycle earlier ones. So, for example, the effect of private sector hoarding is to reduce economic activity, depressing trade, output and employment and causing bankruptcies. Businesses that aren't highly indebted and are able to cut costs may survive depression of customer demand, but businesses that have significant amounts of debt and/or high fixed costs may go right back to stage 1) - debt liquidation, distress selling and bankruptcy. This includes banks. There have been calls for banks to reduce "forbearance", where they do not foreclose on bad loans, because it maintains businesses that should be allowed to fail, preventing growth of new, more viable businesses. But when the banks have balance sheets stuffed full of loans to zombie businesses and underwater homeowners, their own solvency is at risk if they foreclose on those loans. Forbearance is a self-protective hoarding strategy on the part of banks. Without it, banks would go bankrupt. 

The effect of banks desperately hanging on to bad loans in order to avoid bankruptcy is that new lending, particularly to business, is severely curtailed - as Fisher forecast. They cannot afford the risks that these businesses represent. They have quite enough risk on their balance sheets already. But the effect is that small and medium-size businesses, particularly, are starved of the essential finance they need to grow. And as Fisher also forecast, debt deflation in general and hoarding behaviour in particular (including forbearance and lending restriction) has disruptive effects on interest rates. Interest rates on assets perceived as "safe" crash through the floor, while interest rates on finance for productive activity head for the moon. 

So the picture we have is one of continuing, though slow, debt deflation and significantly disrupted price mechanisms despite - and to some extent because of - central bank attempts to reflate. It seems that the supportive effect of monetary easing is cancelled out by both the reality and the threat of fiscal austerity. We are locked into the same deflationary spiral as the US of the 1930s, but at a much slower pace. Now, slow may be better - it may avoid the appalling hardship described by Steinbeck and evident in reports from today's Greece. But it does mean that recovery is not going to happen for a very long time. 

Whether softening the fiscal stance, delaying public sector financial reforms and allowing reflation to do its job would stop the debt deflation spiral and allow economies to recover I don't know. There are a lot of very worried people out there. It may be that the biggest problem now is not the debt, not the economic problems, but people's hearts and minds. The world is a frightening place at the moment. Everyone is desperately trying to protect what they have rather than risking it in the hopes of better to come. But risk-taking is essential for economic growth. While risk aversion remains the dominant paradigm, there can be no lasting recovery. 

[1] Irving Fisher – Debt Deflation: http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf

The dangerous game of monetary policy primacy

There is a growing trend, particularly among US economic commentators and bloggers, to stress the importance of the policy choices facing central bankers. While monetary policymakers will undoubtedly be crucial in achieving and sustaining an economic recovery, ignoring the impact of fiscal policy choices on fear-driven economies is wrongheaded.

Of course, many will argue that it was ever thus. Writing on the CrookedTimber blog, John Quiggin explains (emphasis mine):

“Clearly there was a consensus as of early 2008. The differences between “saltwater” (former New Keynesian) and “freshwater” (former New Classical/Real Business Cycle) economists had blurred to the point of invisibility. Everyone agreed that the core business of macroeconomic management should be handled by central banks using interest rate adjustments to meet inflation targets. In the background, central banks were assumed to use a Taylor rule to keep both inflation rates and the growth rate of output near their target levels. There was no role for active fiscal policy such as stimulus to counter recessions, but it was generally assumed that, with stable policy settings, fiscal policy would have some automatic stabilizing effects (for example, by paying out more in unemployment insurance, and taking less in taxes, during recessions)… This broad consensus was destroyed by the Global Financial Crisis and the Great Recession, but it wasn’t replaced by anything resembling a real debate.”[1]

That is to say mainstream economic models assumed that the role of fiscal policy during a recession was to act as a stabilising force as increased spending on social welfare acted to mitigate falling economic activity. Monetary policymakers could then use their interest rate levers to lower borrowing costs, push interest down on savings (decreasing the incentive to hoard capital) and improve growth expectations.

As Quiggin suggests, however, these traditional policy channels proved insufficient to cope with the impact of the Global Financial Crisis and its aftermath. Instead a combination of massive fiscal stimulus alongside a range of new monetary policy tools, including large-scale central bank asset purchases and looser inflation targets, were brought in to counter systemic threats to the financial system.

Whether these new tools have proven successful is the subject of much debate. What is increasingly apparent though is that subsequently central bankers have proven far more responsive to changing circumstances than politicians on both sides of the Atlantic.

Given the political gridlock in America and austerian fervour across the European Union it is understandable that focus has been driven towards areas where meaningful policy decisions can still be achieved (i.e. the Federal Reserve and the Bank of England). Yet while central bank policy loosening (even the unorthodox variety) undoubtedly has an impact, it is being diluted by the threat of fiscal tightening hanging over developed economies.

This point could prove crucial. If the West is facing a period of persistent demand weakness with current output significantly below potential (see Roger Bootle[2] and Gavyn Davies[3]) then the private sector has little reason to invest in trying to grow their businesses, and a large incentive to hoard capital. Indeed this is what we have seen.

Slate’s Matthew Yglesias says that the best way in which to shake these reserves loose is through leaning on monetary policy measures. He writes (emphasis mine):

“That's why a real strategy for bringing corporate cash off the sidelines doesn't have anything to do with tax reform (though tax reform might be nice), it has to do with monetary policy. Specifically an NGDP targeting strategy or an "Evans Rule" strategy would work on both of these dimensions. That's because both the Evans Rule or a reasonable NGDP target amount to a promise that either real growth will be faster-than-expected or else inflation will be faster-than-expected or else both. That doesn't give you "certainty" about the future, but it gives you a rational basis for shifting assets at the margin out of low-yield high-liquidity strategies and into more aggressive ones. That more aggressive business investment posture should, in turn, produce both more real output and somewhat higher prices thus creating a credible virtuous circle.”[4]

I think Yglesias is missing something here. I agree with him that profitable firms must decide what to do with their excess cash. Yet when faced with existential threats, such as a eurozone collapse, or the prospect of wilful demand destruction carried out by governments they have good reason to seek insurance in “safe assets” like sovereign debt rather than put capital at risk.

Looked at another way the US debt ceiling debate – much as the fiscal cliff debate before it – is not really about a threat of sovereign default but about the future of fiscal policy. If the Republicans succeed in exacting harsh spending cuts then the country could quickly find itself in a similar position to the UK – with a government wedded to both upfront cuts to spending (including slashing investment) and reducing countercyclical benefit payments.

You need only look at Britain’s recent economic performance to illustrate just how successful those policies have been.

That Obama appears sympathetic to the argument that his administration needs to rein in spending[5] should be a concern. As Jonathan Portes, director of the National Institute of Economic and Social Research, has suggested[6] the danger with this type of thinking is that it risks self-fulfilling pessimism even as debt markets are effectively paying governments to borrow.

I would not argue against the point that there are a number of necessary reforms to put both Britain and the US onto sustainable fiscal trajectories, including dealing with contentious issues such as healthcare and pensions. But lumping these in with short-term efforts to reduce the deficit, as the Coalition is doing and as the GOP are threatening, looks increasingly counterproductive.

Denying the need for fiscal and monetary policy coordination simply because the political classes have become dysfunctional rather lets politicians (and their economic advisers) off the hook. We should instead be vocal in pointing out their folly in the hope, if not the expectation, that they will realise there is still time to change course.

[1] http://crookedtimber.org/2013/01/01/the-failed-state-of-macroeconomics/
[2] http://www.telegraph.co.uk/finance/comment/9701668/OBRs-supply-pessimism-could-be-the-ruin-of-this-government.html
[3] http://blogs.ft.com/gavyndavies/2013/01/13/how-much-spare-capacity-does-the-world-have-left/
[4] http://www.slate.com/blogs/moneybox/2012/12/11/cash_on_the_sidelines_has_nothing_to_do_with_uncertainty.html
[5] http://www.washingtonpost.com/blogs/wonkblog/wp/2013/01/14/obama-wants-1-5-trillion-in-deficit-reduction-what-about-the-gop/
[6] http://www.publications.parliament.uk/pa/cm201012/cmselect/cmtreasy/uc1691-i/uc169101.htm