Tuesday, 19 March 2013

Cyprus - Beware False Equivalence


Empathy: The ability to imagine oneself in another’s place and understand the other’s feelings, desires, ideas, and actions.

When faced with an example of injustice it is a common psychological trait to relate the suffering of others to our own experiences. While this can be helpful in fostering greater insight into the personal hardships they may be undergoing it can also cause people to prioritise the similarities of their situations and underplay the differences.

It is in this light that I view attempts to liken the haircuts to Cypriot depositors to ultra-low interest rates in Britain. Yet to my mind this false equivalence does a disservice to understandably panicked depositors in Cyprus and causes undue concern for savers in the UK.

I first came across this particular line of argument on twitter in a tweet from Ros Altmann, former director general of Saga and pensions expert. She wrote:

“UK vs. Cyprus - Sterling devaluation +inflation +ultra-low rates have been stealth tax on savers, to help borrowers and banks”

Altmann went on to point out that UK monetary policy has cost savers more than 20% in real terms since 2008 inflation peak. And she is far from alone in her concerns. Many joined her in her staunch defence of savers against the clawing hands of the Bank of England.

Now I’m not actually disputing the facts as presented. Both savings and real incomes have been clobbered since the crisis by a combination of near-zero interest rates, modest wage rises and above-target inflation. The question is whether this combination of factors can be compared with a sudden seizure of deposits by the state.

This is an important question to answer as the critics are bringing into question the legitimacy of policies brought in to address the crisis. So is the UK really taking money from savers in order to pay for the pre-crisis excesses?

It is certainly true that saving and incomes have fallen sharply in real terms over the crisis. To my mind, however, the question misframes the problem and obscures the purpose of current monetary policy.

During “normal” times when the economy is growing interest rates are certainly higher. Yet the reason for this is not simply to reward savers for their frugality but to incentivise holding back cash in bank accounts and disincentivise heavy borrowing in order to prevent the economy from overheating and driving up inflation.

As a consequence of the so-called “Great Moderation” savers got used to these higher interest rates. This was understandable with politicians unwisely boasting that they had ended boom-and-bust economics. But the fundamental truth remained that high interest rates reflected the central bank’s attempt to hold inflation around target, not to protect the purchasing power of savers.

When the Great Recession struck, therefore, central banks responded to the economic shock by dropping interest rates. This had a number of potential benefits. Initially low rates prevented a cascade of disorderly defaults by allowing struggling companies to refinance at lower rates and encouraged stronger firms to take on more debt.

However, they also caused the rate of interest paid on cash held in people’s bank accounts to fall. This is quite a deliberate aspect of the policy as it should prompt savers to move some of their money either into current spending or investments, which helps boost the velocity of money in an economy (and therefore GDP).

That it is an intentional effect of monetary policy does not make it a Machiavellian plot to steal people’s savings. Instead it should be viewed as a good reason to move money into a portfolio of financial assets that should benefit in the case of an economic recovery or to bring forward already planned spending.

In fact some academics, including Professor Miles Kimball of the University of Michigan, believe that current interest rates remain too high. Kimball has advocated negative nominal rates whereby central banks could in effect impose a charge on cash holdings.

In a recent post on her blog FT Alphaville’s Izabella Kaminska says the Cyprus bank levy represents a harsh example of a negative interest rate. She writes:

“This is the ultimate negative interest rate because it shows that the privilege of having deposits (delaying spending) is associated with principal loss, from the offset.

Which is why negative interest rates, as I have long argued, are a bad omen for the banking model. They show banks have become redundant and that sound equity is more desirable than deposits or weak equity.

Deposits have always represented a store of value. Rather than spending (redeeming your money, which is national equity) on goods or assets which are consumed or depreciate or perish over time you can artificially extend the life associated with your share or the real economy’s wealth by turning your stake into deposits (loanable funds).

The fact that deposits are now depreciating more quickly than real assets only implies there is no longer any sense in delaying spending.

Better to spend now on good equity or goods than be lumped with disappearing equity.”

In terms of the implications of negative rates for the banking sector, Kaminska certainly raises some fascinating points but I don’t agree on the particular charge that the Cyprus levy is representative of what the policy would look like in practice. And this goes to the heart of the debate about UK monetary policy.

With a mix of above-target inflation and ultra-low interest rates UK savers are facing an environment negative real rates. Yet unlike their Cypriot counterparts British savers have the choice of where, when and whether to move their money out of their bank accounts. That they have not been doing so on a larger scale is indicative of a failure to explain the consequences of the current policy mix to the public.

Raising rates while the economy is still weak and companies (including banks) are in the process of deleveraging could raise the spectre of disorderly defaults and an increase in bankruptcies. Those campaigning for policymakers to protect savers need to look at the systemic implications of their proposed solutions.

Of course none of this should reduce our sympathy for Cypriot depositors who have found themselves caught up in a political standoff that they have no control over.

Monday, 11 March 2013

Weak sterling is a reflection of a weak economy, not a policy objective


As sterling hits another new low against the dollar many have started question whether the supposed benefits of a weak currency have been overstated.

Among the voices within the sceptic camp is Andrew Sentance, former Monetary Policy Committee member and currently senior economic adviser at PWC. In a recent blog post Sentance suggests that while Britain’s economic weakness and reduced fear over a eurozone collapse have both played their part in lowering the value of sterling, there has also been a concerted effort by policymakers to “talk down the pound”.

He writes:

“[A] weak pound appears to be an important ingredient of official economic policy. Government ministers, including the Chancellor, have talked of rebalancing the economy and emphasised the role of a competitive currency in achieving this. The Governor of the Bank of England has argued along the same lines. In his major speech earlier this week, he argued that the 25% fall in the value of the pound was “certainly necessary for a full rebalancing of our economy”.”

In order to understand his point we need to look at the measures taken by the government and the Bank. It is certainly the case that under normal circumstances a central bank issuing £375 billion of new money into an economy might be expected to lower the exchange rate value of a currency.

However, this idea relies on the notion that the Bank of England has somehow managed to outcompete other central banks through its easing programme. The figures would suggest that this is far from the case.

It is undeniably true that the Bank’s balance sheet has swelled to around £400 billion but this is dwarfed by the Federal Reserve’s $2.92 trillion (£1.96 trillion) or the European Central Bank’s €2.77 trillion (£2.42 trillion). Moreover, unlike its American counterpart, the Bank has resisted increasing its stock of asset purchases since the £50 billion boost last July.



In fact sterling’s recent falls against the dollar have predominantly been a 2013 phenomenon, after the latest batch of asset purchases had already ceased (see chart below).



To claim that Mervyn King has managed to influence its trajectory you have to believe that foreign exchange markets are reading the tea leaves of future policy rather than responding to central bank actions. Otherwise the dollar would surely be in freefall after the Fed’s announcement of “Unlimited QE” in September last year that will see the balance sheet grow by $85 billion a month until unemployment falls below 6.5%.

For those who support the notion of rational markets is it not more likely that markets are instead responding to repeated demonstrations of Britain’s economic fragility?

Official figures suggest the UK saw a meagre 0.2 per cent growth last year versus a 2.2 per cent rise in the US’s national output. This disappointing economic performance has undermined government efforts to improve the national finances and, much to the chagrin of the Chancellor, cost Britain its AAA rating from Moody’s last month.



Here a report from the International Monetary Fund (IMF) last week could perhaps shed some light on why the UK has fared so badly in the post financial crisis environment. Building on the Fund's earlier work on fiscal multipliers, it suggests that key forecasts for the effects of government cuts may have been optimistic and that the actual impact of fiscal tightening policies have been much more severe than anticipated:

“The negative impact of fiscal tightening on economic activity in the near term is indeed amplified by some features of the current environment, including the proportion of credit-constrained agents, the depressed external demand, and the limited room for monetary policy to be more accommodative…It may also lead country authorities to engage in repeated rounds of tightening in an effort to get the debt ratio to converge to the official target. Not explicitly taking into account multipliers or underestimating their value may lead policymakers to set unachievable debt targets and miscalculate the amount of adjustment necessary to bring the debt ratio down.”

It should be noted that the paper is not a critique of the UK government’s plan and indeed the authors are keen to stress that it does not make a comprehensive case against fiscal consolidation. Rather it serves as a warning that under current circumstances cutting government spending can significantly lower output in the short term and worsen a nation’s debt dynamics before it improves them.

From this line of argument one could perhaps conclude that if George Osborne chooses to continue with current policy in his Budget then he is indeed targeting weaker sterling in the short term in order to prompt a sharp boost to the UK's trade balance. If so he might consider listening to Sentance’s warning that “exporters in a mature industrialised economy like the UK do not respond to short-term currency movements in this way”.

As he says, businesses need the longer-term reassurance of strong, stable demand for their products in existing markets before they look to expand operations elsewhere. If the fiscal multiplier is high then far from promoting an export-led recovery government cuts may be helping to erode confidence and force the private sector into its own bout of consolidation.

Weak sterling is not a policy objective, save as a get-out-of-jail-free card for politicians wedded to the dogma of austerity. So far it has failed to provide even that.

Monday, 4 March 2013

The Collapse of the Soviet Union: A Warning for Europe


On June 5, 1989 the attention of the world was grabbed by the image of an anonymous man standing in front of a column of Chinese tanks in Tiananmen Square. Elsewhere, however, in the People’s Republic of Poland an equally momentous event was unfolding in the narrative of the Cold War.

Solidarity, a Polish labour union movement born in the Gdansk shipyards at the start of the decade, was poised to shake the Communist stranglehold on power for the first time since 1944. In the first multi-party elections since the country’s liberation from the Nazis the party, led by shipyard worker Lech Walesa, won between 70-80% of the vote and shattered the semblance of Soviet political invulnerability.

The impact across the USSR’s expansive empire was seismic. By the end of 1989 Azerbaijan, Hungary and Czechoslovakia had declared their sovereignty and these were soon followed by Georgia, Lithuania, Estonia, Latvia and ultimately Russia itself the following year. Over 12 months the Eastern European bloc that had been one of the defining features and central obsessions of the 20th Century imploded at a pace that confounded politicians and commentators alike.

This was the inglorious endgame for Europe’s last monetary union. While its significance to the global balance of power and to political discourse can hardly be said to have been underappreciated, its relevance to the current woes of Europe’s single currency has been largely ignored.

A great deal has been written on the numerous failings of the Soviet system by the 1980s. The USSR was overstretched, haemorrhaging money to its vassal states and fighting an increasingly costly proxy war in Afghanistan, and was quickly becoming victim of its own closed economy.


Theoretically it was impossible for the Soviet Union to run a budget deficit. If its liabilities exceeded its revenues the state could simply raise the costs of the goods and services it provided to compensate. Nevertheless when Mikhail Gorbachev took office in 1985 he took on a social system that was struggling to pay its bills.

“The heaviest burden we have inherited from the past is the budget deficit, which was carefully concealed from society, but nevertheless existed,” Gorbachev acknowledged in 1989. “And, of course, the deficit has a pernicious influence on the entire economy…at the practical level the most urgent and immediate task…is to restore a balanced market and normal financial relations.”

No doubt many of today’s politicians trying to untangle the complex financial history of southern European economies will have sympathy with the former General Secretary.

Yet the Soviet Union’s deficit appeared a manageable 2% in 1985. Even by 1989 as it neared collapse the deficit of the Soviet bloc amounted to only around 9%. Furthermore fiscal transfers, which have proven such a point of contention between euro member states, were an inherent part of the USSR’s structure. Kyrgyzstan and Uzbekistan, for example, would receive over 10% of annual gross national product (GNP) from other republics while more developed countries such as Belarus would traditionally pay out a net 15-20% of its GNP.

Of course within this system Russia was the largest source of credit for its satellite republics. Just as Moscow was the political centre of the Soviet project so too it became the biggest regional investor.

“The Soviet Union was a peculiar empire in that it didn’t simply exploit its colonies for material gain but actually provided for them,” says Gabriel Stein.

Increasingly there are voices calling for Germany to follow the Russian example and play a similar role for struggling eurozone countries. Gavyn Davies, chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners, wrote last year in his column for the FT that it could be more informative to view troubles in the eurozone not as a public debt crisis but as a balance of payments problem.

The struggling eurozone periphery, made up of Italy, Spain, Portugal and Greece, are running a combined budget deficit roughly equal to the current account surplus of Germany. Davies contends that what needs to happen is not some external bailout but the annual transfer of around 5% of German GDP from the eurozone core to the periphery.

This does not mitigate the pressing need to reform uncompetitive economies but it should provide the breathing room for these reforms to happen without exacerbating the economic slowdown. Neither a condition-free bailout nor a simple policy of enforced spending restraints are likely, by themselves, to return these countries to a sustainable growth path.

For European politicians, however, the concept of fiscal transfers has provided them with something of a mental block. A number of politicians, with Angela Merkel, the German chancellor, foremost among them, have proven wary of sleepwalking into a fiscal union under the pretext of addressing the crisis.

“A necessary but not sufficient condition for the survival of the euro in its current form would be fiscal union,” Stein says. “But everyone knows that it would be political suicide to attempt it.”

The alternative route is to go the way of allowing a limited break-up of the monetary union. By allowing Greece to leave policymakers would be free to focus their attention on the more strategically significant economies of Spain and Italy, while the Greeks could allow their domestic currency to devalue against the euro to plug its competitiveness gap.

Here the Soviet example offers a pertinent warning. On the face of it as the USSR’s main creditor the country that stood to gain most from its disintegration was Russia. Equally those with most to lose were the less developed republics that had become accustomed to central handouts.

A quick glance at how these republics have fared over the past two decades offers us some stark truths about this process.

Figures from the World Bank show that while per capita income in Russia has almost trebled since 1991 many of its neighbours have failed to keep up. The Kyrgyz Republic, for example, has seen per capita income grow by only 29% over that time, and it took the country almost 15 years for average incomes to return to 1991 levels.

Indeed excluding the Baltic countries, most of the former Soviet states have suffered since the break-up. A number of them were drawn into bloody wars over territorial disputes and huge swathes of their populations emigrated to the West. In the case of Armenia it is estimated that almost a quarter of its people were lost after it declared its independence.

The Russian Federation, however, was far from immune to the turmoil. The average life expectancy for men fell from 65 years in the mid 1980s to 57.6 years in the early 1990s. This exacerbated nascent demographic problems in the country and the population, having peaked at 148.7m in 1992, has declined to under 142m today.

Chris Weafer, the chief strategist at Troika Dialog, says the central problem was the failure of governments across the region to establish themselves:

“The reason we saw such a severe economic decline in the 1990s was that there was a sharp decline in government control. It may have marked the end of the Soviet command economy but the reason it took so long to recover was the lack of political leadership.”

Despite Merkel’s oblique reference to Europe’s troubled history, military disputes are highly unlikely to erupt as a consequence of the eurozone crisis. Yet it is surely of note that cutting Greece off risks forcing the country into years or even decades of economic and social strife.

It is important to remember that much of the German productivity miracle has been based on the disparity between faster growing southern Europe and the sluggish central European countries. While the austere Germans berate the profligacy of their neighbours now, it was this same consumption boom that fed directly into the country’s savings glut.

Moreover members of the single currency would be unwise to split its members between an expendable periphery and a necessary core. If Greece is forced to exit it could set a precedent that would encourage bond markets to look for the next vulnerable candidate.

This domino effect is precisely what was observed in 1989. Once Poland had been effectively allowed to separate from Moscow the rest of the “outer empire” fragmented and eventually shook the core until it shattered. With Portugal, Italy and Spain all potentially next in the firing line such a prospect would surely be unwelcome.

Certainly the underlying economic inflexibility of the USSR propelled it towards its demise but that in itself is only part of the story. Ultimately, the key lesson from the Soviet Union’s collapse is that the decision to break-up a monetary union is first and foremost a political and not an economic one.

As Gorbachev himself put it:

“The Soviet model was defeated not only on the economic and social levels; it was defeated on a cultural level. Our society, our people, the most educated, the most intellectual, rejected that model on the cultural level because it does not respect the man, oppresses him spiritually and politically.”

It is therefore imperative that policymakers convince the majority of people within the eurozone to remain supportive of the single currency if it is to survive. This is one reason why depriving the Greek people of a referendum on membership was such a poor judgement. Above all else they must maintain the cultural legitimacy of the European project.

Already we have seen a rise in the popularity of the extreme right on the Continent. A research paper from Demos concludes that many of these movements tend towards a fear that immigration and multiculturalism are destroying national...values and culture. Finland, the Netherlands and Slovakia all boast strong far-right parties while the National Front in France and Italy's Northern League have been gaining ground.

These nationalists are taking advantage of economic weakness and the understandable fears of the voting public to thrust their regressive ideas of ethic nationalism back on the agenda. Just as in Russia after the default of 1998, the opinion is growing that liberal politicians have failed to address a system in crisis. Attempts to absolve themselves of responsibility by blaming market behaviour is only likely to accelerate this process.

“History is against European leaders that the fundamental weakness [in the eurozone] is economic rather than political. They absolutely must have leadership if they are to convince people that the euro will survive,” Weafer says.

Abandoning a weak link may make pragmatic sense in the short term but it sends a message that the commitment to the euro is far from absolute. Those calling for its dissolution should think again about the both the human and the economic cost that such an act could entail. Europe needs a combination of renewed political resolve and trust in its citizenry if it is to avoid the Soviet outcome.