May 16

Sir Mervyn King as Governor of the Bank of England – Marks out of 10

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Banking reform, British monetary policy, Quantitative easing, Sir Mervyn King's record as Governor of the Bank of England

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May 16, 2013

As Sir Mervyn King enters his final days as Governor of the Bank of England, the time is right to assess his overall record over the past 10 years.

1. Monetary policy before the credit crunch. The initial phase of his tenure, between 2003 and 2007, appeared at the time to be a period of monetary stability. But as events transpired, serious problems were beginning to build up in the monetary system. The Bank of England presided over rates of monetary growth well in excess of the growth of output, with the increase in two standard measures of money supply – M3 and M4 – accelerating from approximately 6% per annum when Sir Mervyn took the reins to 15% per annum by 2007. The Bank of England could and should have taken measures to restrict monetary growth, most obviously by raising the Base Rate, but failed to do so. Mark for Sir Mervyn = -1.

2. Banking regulation before the credit crunch. The consequence of rapid monetary growth was an increase in leverage throughout the banking system, a bubble in asset prices, and an escalation in the UK’s external Balance of Payments deficit from less than £1 billion in 1997 to more than £50 billion by 2007. In a public statement in 2012, Sir Mervyn acknowledged that the Bank of England had failed to take account of the dangers of rising bank leverage, let alone take any measures to restrain it. Mark = -1.

3. The Bank of England’s immediate response to the credit crunch of late 2007 was badly fumbled. The first victim of the freeze in international money markets was Northern Rock, but Sir Mervyn vetoed a “white knight” approach from Lloyds TSB to rescue it, opting instead to spend his time lecturing the City on the dangers of moral hazard. Technically he was correct, but his timing could not have been worse. To take an analogy from the world of cricket so beloved of the Governor – it was rather as though the batsman had executed a cover drive that was technically beautiful, but appallingly mistimed, with the result that, instead of the ball flying to the boundary, it lobbed gently up into the air to offer an easy catch to the fielder.

Mark = -1.

In this case, the fielder did not take the catch. Sir Mervyn was fortunate indeed not to be sent back to the pavilion, and to have his mandate renewed. He was a beneficiary of the “camel in the tent” syndrome. The Prime Minister, Gordon Brown, apparently decided that it was safer to retain Sir Mervyn as Governor than to have him as a disgruntled ex-Governor outside the tent criticising the Labour Government’s own distinctly mixed record.

4. Banking regulation after the crisis. In his second term, Sir Mervyn’s record on banking issues improved. He was a strong advocate of the separation of investment banking and retail banking. He recommended restructuring the broken banking behemoths, in particular RBS – “if a bank is too big to fail, it is too big”, as he quite correctly stated. The Bank of England was also reasonably supportive of the entry of new banks into the market, increasing competition and customer choice. Mark = +1.

5. Monetary policy after the crisis. After 2008, the Bank of England aggressively cut Base Rates to an historic low of just 0.5% in early 2009, where they have remained ever since. In my view, quite correctly. Mark = +1.

6. The Introduction of Quantitative Easing. In early 2009, the Bank of England introduced a new measure to stimulate recovery – Quantitative Easing (QE) – in simple English, printing money. I would not criticise the initial decision to attempt QE in the context of early 2009, when there was a general desire that “something must be done”. Mark = 0

7. Later rounds of QE. Where I do criticise the Bank of England, however, is that it persisted with QE long after its damaging effects became all too evident. The mechanism by which QE reduced the real incomes of savers, pensioners, the low-paid and those on fixed incomes and stifled economic recovery has been set out in other comments on this site and in The Golden Guinea, and will not be repeated here. Yet, like an alcoholic who can’t keep off the drink, Sir Mervyn persisted in repeating the dose again and again. In late 2012, he seemed to accept that QE was not stimulating the recovery in output and jobs for which its advocates had hoped, but by early 2013 he was again pressing for a further round. Fortunately, he found himself in a minority on the Bank of England’s Monetary Policy Committee, so it didn’t happen.

As I wrote in my forecasts for 2013 on December 28th 2012

“If the Bank of England responds with yet more quantitative easing, my prediction is that it will have precisely the same effects as QE has had already – driving down real incomes, driving up inflation and sending the British economy back into a stagflationary recession. However, if QE is consigned to the dustbin of history, then there is a realistic prospect for a recovery in the UK economy in 2013.”

Such has indeed proved to be the case, but no thanks to Sir Mervyn.

Mark = -3 for each round of QE supported by Sir Mervyn after the initial round.

In summary, Sir Mervyn King’s tenure at the Bank of England has been distinctly mixed. Yes, it has been a period of turbulence and not all the problems were of his making. But having said that, he presided over an excessively loose monetary policy before the credit crunch, fumbled his response to Northern Rock crisis, and persisted in pursuing the economically destructive policy of Quantitative Easing despite its comprehensive failure to achieve any of the objectives that the Bank of England set for it when it was introduced in March 2009.

Applying a starting mark of 10 – by definition, his record as Governor on taking up the post was unblemished – by my reckoning he finished with a mark of 6 (= 10-1-1-1+1+1-3). A 9 or 10 would be the mark of a great Governor. A 7 or 8 would mark a “safe pair of hands”. A mark of 6 must be judged as only fair.

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May 13

The Reinhart-Rogoff Controversy and predictors of sovereign debt default

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Indicators of sovereign debt default, Mr Micawber, Reinhart-Rogoff

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May 13, 2013

There has been much debate in the financial press recently about the implications of new evidence that seems to contradict the Reinhart-Rogoff rule.

The strong version of the rule states that, once the ratio of national debt to GDP rises above 90%, it has a significant negative impact on the rate of economic growth.

The implication is that sovereign governments should take whatever measures are necessary – including extreme fiscal tightening – to ensure that national debt remains below this level.

But an American Ph.D. student who tried to replicate the RR results discovered that there seems to be no simple relationship between debt levels and growth rates – thus apparently undermining the case for fiscal austerity. In a slightly sheepish article in the Financial Times in April, Reinhart and Rogoff argued that the occasions when high economic growth occurred with national debt greater than 90% of GDP were exceptions to the general rule, typically after major wars. In the UK, national debt was significantly above 90% of national income in 1815, at the end of the Napoleonic Wars, 1918 after the First World War and 1945 when the Second World War ended. In all three cases, the British Government of the day had borrowed heavily to finance the war effort. Once the war was over, demobilisation released human and financial resources to rebuild the private sector, stimulating economic growth and generating taxation revenues sufficient to bring debt levels down.

What is different about the current situation is that national debt has risen to levels unprecedented in peacetime, with no prospect of demobilisation or the release of pent-up demand to stimulate private sector growth.

In The Golden Guinea, I cite a weaker version of the RR thesis – “historically, governments have struggled to service national debt once it exceeds 90% of national GDP” (p. 183). The reason that I was happy to put my name to this weaker version was that it was borne out by research that I did thirty years ago, never published or reported, as a sanity check for an internal policy debate at the European Investment Bank.

At that time, the EIB lent to African countries from two windows – risk capital, which were grant funds that the Bank managed on behalf of the European Community for investment in equity and soft loans in Africa, and own resources, or funds that the Bank itself raised on international capital markets. Understandably, the EIB was very cautious in placing its own capital at risk. I was the Loan Officer for Malawi at the time, and advocated supplementing risk capital operations in the Republic through the use of our own resources. Other colleagues cautioned that Malawi was not sufficiently creditworthy for the EIB to lend from its own resources.

I pored over IMF statistics of sovereign debt defaults to identify whether there were general indicators of sovereign solvency, and discovered a very interesting relationship. Drawing a graph of sovereign debt default rates on one axis, and a nation’s external debt service obligations as a percentage of its export earnings on the other, I discovered to my surprise that the relationship was not linear. Rather, an inflection point occurred when the debt service/export earnings ratio rose above approximately 20%. Below that level, in general, sovereign governments in Latin America, South Asia and Africa seemed able to service dollar-denominated debt. But once the ratio rose above 25%, the risk of default was very high indeed.

I remember looking up from my graph and gazing for some moments through my office window to the fields of the Kirchberg and the woods beyond, and experiencing a growing realisation that my more cautious colleagues had a point. For at that time, the external debt service/ export earnings ratio of the Republic of Malawi was almost exactly 20% – the inflection point at which it might struggle to service additional hard currency debt.

On reflection, the result was not perhaps as surprising as I found it at the time. Nor does it uniquely apply to governments. Households and businesses may be able to service their debt up to a certain critical point, yet experience severe distress above that point. As Mr Micawber observed,

“Annual income twenty pounds, annual expenditure nineteen pounds nineteen shillings and sixpence, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”

The danger is that the empirical weakness of the strong RR thesis that growth is always low once national debt exceeds 90% of national income – which I agree is far too simplistic – will lead highly indebted governments to relax their efforts to bring their borrowing levels under control. That would be a big mistake. For in my view the weak version of RR still holds. If national debt rises beyond 90% of GDP, there will inevitably come a point where a sovereign government will struggle to meet its debt servicing obligations, and ultimately default.

As I wrote in The Golden Guinea, “The trigger (for default) is likely to occur when bond investors start to lose confidence in a sovereign government’s ability to service its debt. It is impossible to define precisely the moment at which this may happen, as it depends upon interplay of many factors, including investor psychology.”

However, at a time when the national debt of the southern EU Member States has risen to over 100% of their GDP, it is difficult to avoid the conclusion that further borrowing is likely to lead to debt servicing problems in the future.

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Apr 03

Are Sterling Bond Prices in a Bubble?

Categories:

Bond bubble, Coutts, Quantitative easing, Sterling Bond Prices

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April 3, 2013

The news that Coutts, the private bank for high net worth clients, has just warned its clients against investing in high yield bonds brought to mind the analysis of a paper published many years ago in an Italian academic journal (“Dilemmas in Development Banking”, Savings and Development, Milan, 1985).

Coutts is warning its clients against exposing their fortunes to a potential collapse in the high-yield debt market, and are reported to be instructing their managers to be wary of extending credit to clients who propose using borrowed money to buy bonds. “If and when yields rise, the impact of these bonds, magnified with leverage, could lead to serious losses,” one Coutts investment manager was quoted as saying in the Daily Telegraph yesterday.

Are the manager’s words of warning justified?

My Savings and Development paper, written almost 30 years ago when I was a Loan Officer at the European Investment Bank (EIB) in Luxembourg, set out a general mathematical model of banking in 15 equations. It provided the framework I applied to analyse the collapse of Northern Rock and RBS in “The Golden Guinea”. Although the paper was written in the search for an answer to another question – namely, how multilateral institutions such as the EIB could cost-effectively channel credit to finance the growth of the SME sector in Africa – 20 years later, in 2005, the model of banking solvency that it set out suggested that major banks were sailing into uncharted and dangerous waters.

The equation that defines the fundamental condition for banking solvency is:

[r – i] = a + p + pr

This equation states that, in order to break even, a bank’s on-lending margin – the difference between the rate at which it lends [r], and the rate at which it raises money for lending [i] – must be equal to the percentage costs of administering the loan [a] and the assessed probability of loan default [p + pr]. If it is not, the bank will accrue losses and ultimately become insolvent.

This simple equation can be used to explain the banking crisis of 2008/09. During the credit boom of 2004-07, banks globally chased new business far beyond the minimum point defined by the Fundamental Equation of Banking Solvency:

• accepting a decline in on-lending spreads [r – i];

• absorbing a rise in administrative costs [ a ] – not least because banks were prepared to pay ever greater sums, in both basic remuneration and bonuses, supposedly in pursuit of the best talent in the global financial marketplace (who, as events transpired, often turned out to be no more than prime examples of the old adage that in a high wind even turkeys can fly); and

• advancing new loans on lower security to borrowers of deteriorating quality, leading to a rise in the probability of default [p + pr].

This appears fairly self-evident now, but it still seems remarkable that these three clear signs of looming problems were completely overlooked or ignored by financial regulators and Central Banks.

After the credit crunch and collapse of Lehman Brothers, I reworked the equation to calculate the probability of default implied by the yields offered on good quality bonds, assuming administrative costs are zero for a retail bond investor. The equation then becomes:

p = [r – i] / (1 + r)

I subsequently discovered that the same equation had been derived by other economists, e.g. David Xu & Filippo Nencioni in their paper, “Introducing the JP Morgan Implied Default Probability Model: A Powerful Tool for Bond Valuation”, JP Morgan Securities Inc. Emerging Markets Research, New York, September 20th 2000.

My analysis assumed a risk-free rate of interest and cost of funds [i] of 3.5%, being the social rate of discount set in HM Treasury’s Green Book and also close to the long-term rate of interest on UK gilts at that time.

An analysis on the basis of this second equation led to the conclusion that bond yields in 2008/09 implied a risk of default significantly greater than actual default rates for all bonds at the trough of the Great Depression in the 1930s. The inference was that, provided the entire capitalist system did not implode, Sterling corporate bonds represented good value. Corporate bond prices in early 2009 were much lower (and yields much higher) than justified by their true probability of default.

Since then, corporate bond prices have recovered strongly and yields have fallen – so that now the gross redemption yield on, for example, Marks & Spencer’s 5.625% bond maturing on March 24th 2014 is only 1.7% – well below the 3.5% Treasury Green Book discount rate and below the rate of inflation – implying a negligible (or even negative!) probability of default and offering negative real returns. Similarly low yields are offered by other corporate bonds.

So the model suggests that the concerns expressed by Coutts are valid. Quantitative easing has led to an artificial bond bubble. Investors should be very cautious in committing new funds to UK fixed-income securities. Their risk / return profile is distinctly unappealing – none moreso than gilts issued by the UK Government itself.

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Mar 28

Sad Cyprus

Categories:

Cyprus exit from the euro, Emile Durkheim, Eurozone crisis

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March 28, 2013

As banks in Cyprus reopen for business after 10 days, it would appear that international currency and securities markets have taken the latest Eurozone crisis in their stride – “a tempest in a teacup” to quote Jamie Dimon on another occasion.

But just as Mr Dimon’s observation failed to sweep JP Morgan’s problems under the carpet, so current market reactions may under-estimate the longer term fallout from the Cypriot banking collapse.

German Chancellor Angela Merkel is determined to maintain the single currency at least through to the German Federal elections in September. But she has only succeeded by, metaphorically speaking, holding a gun to the heads of the Government of Cyprus. Furthermore, the write-down of Cypriot bank deposits, imposition of capital controls and limitation of bank withdrawals to just €300 per day marks the first step in the fragmentation of the single currency – two years ahead of my prediction that the euro would start to fracture between 2015 and 2017. The reality is that a euro in Cyprus is now no longer the same currency, or with the same value, as a euro in Germany.

Many Cypriots are questioning whether they were right to surrender their sovereign currency for the euro, and they are right to do so.

If the Government of Cyprus is properly serving the interests of its citizens, it should now as a matter of urgency be putting into place a contingency plan for its withdrawal from the Eurozone and the orderly restoration of the Cyprus Pound. The governments of Portugal, Ireland, Italy, Greece and Spain should be doing the same.

So also, in my judgement, should the Government of France. As the economic situation there deteriorates, it is far from clear that it is in French national interests to remain part of the single currency indefinitely.

This would leave a core Eurozone of Germany, Austria, Finland, the Netherlands, Belgium and Luxembourg, and possibly some of their neighbours – although it is clear that the Scandinavian countries other than Finland do not currently wish to be part of what would in effect be an enlarged Deutschmark zone.

It would be extraordinarily naive to believe that the reopening of the Cypriot banks marks the end of the Eurozone crisis and the restoration of a stable equilibrium. As Emile Durkheim wrote in “The Division of Labour in Society”,

“If the conquered, for a time, must suffer subordination under compulsion, they do not consent to it, and consequently this cannot constitute a stable equilibrium.”

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Mar 26

The longer term consequences of the Cypriot banking crisis

Categories:

Cyprus exit from the euro, Eurozone crisis, Flight to gold

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March 26, 2013

As the Cypriot banking fiasco stumbles towards a resolution, some financial commentators have noted the comparatively modest impact it has had on bond markets elsewhere in the Eurozone. The conclusion they draw is that the situation in Cyprus poses no systemic threat to the euro and, once their banks reopen, things will continue much as before.

While this may be true in the short term, over the longer period such a view may prove too sanguine.

The Cypriot crisis has marked a new and worrying development. As the headlines in today’s Financial Times state, “Eurozone shifts burden of risk from taxpayers to investors”. For the first time, bank losses are being absorbed directly by the write-down of bank deposits. True, the write-downs only apply on deposits of more than €100,000, but this concession was only elicited after the Cyprus Parliament decisively rejected EU proposals to impose a levy on all deposits.

Ordinary depositors are not in a position to assess the financial stability of the banks in which they place their savings. In the past, they had the assurance that these banking institutions were supervised by regulators who would protect their interests. In the event of failure, their deposits were guaranteed by their national governments. One way or another, their money was safe.

This has now been thrown into doubt.

Added to that, there is uncertainty about the extent to which banks elsewhere in the Eurozone are exposed to the bad debt problems that brought down the Laiki Bank. Laiki’s senior management could be forgiven for feeling slightly aggrieved by the turn of events. And in particular, their response to appeals from Europe’s leaders to show solidarity with their neighbours by investing in Greek sovereign bonds, on the assumption that these bonds would be honoured, if necessary with the support of the ECB. When Greece defaulted on its sovereign debt, Laiki was left dangerously exposed.

But Laiki was not the only bank that invested heavily in Greek sovereign debt. Many banks across the Eurozone did the same, including, reportedly, a number of leading French banks.

The problem is that there is no way that an ordinary depositor can gauge the exposure of the bank in which their savings are deposited.

The real threat to the Euro is not a sudden and catastrophic collapse, but rather the gradual erosion of trust in the system’s financial and political institutions. It doesn’t take Nostradamus to foresee that the longer-term consequences of the Cypriot banking collapse is likely to be a loss of confidence among depositors, leading to the gradual withdrawal of funds from banks, in preference for cash kept under the mattress or converted into gold and silver.

This in turn will lead to a further decline in the rate at which money circulates around the economy, and further reductions in economic activity and employment.

As I wrote in The Golden Guinea:

“The case put by supporters of the Euro for maintaining the single currency is that the alternative is so much worse. Yet the narrative put forward by apologists for the European single currency completely discounts evidence of the damage done by the Euro. The Eurozone authorities have sought to address this damage by successive bailouts, adding to the national debt of sovereign states that are already over-borrowed. This has led onwards to attempted fiscal consolidation on a scale that has plunged the continent of Europe into the most severe and prolonged recession seen since the Great Depression, causing mass unemployment and social distress on a scale not experienced in living memory.

This is the legacy of the failed Euro experiment.

Throughout the Euro’s prolonged and painful death throes, Europe’s political elite have asked the wrong question. The question they are asking is, “How can we save the Euro?”

In reality, the ultimate fate of the Euro is already sealed by what Tolstoy described as “the slow shifting of the registering hand on the dial of the history of mankind.”

The question that needs to be asked is “How can we dismantle the Euro in an orderly manner, to minimise its negative impact?”

And, following from this, “What should be put in its place?””

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Mar 18

How long can Cyprus stay in the Eurozone?

Categories:

Cyprus exit from the euro, ECB Policy, Eurozone crisis, Flight to gold, Howard Buffett, Ponzi schemes

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March 18, 2013

The decision of the Government of Cyprus to impose a one-off levy of up to 10% on Cypriot bank deposits has sent shock waves across Europe.

When Mario Draghi announced last year that the European Central Bank was committed to do everything in its power to stabilise the single currency, it was widely assumed that he meant that the ECB would buy the sovereign bonds of Eurozone Governments and take other measures to support sovereign debt markets. This assumption was confirmed by the announcement on August 2nd 2012 that the ECB would be willing to engage in “outright monetary transactions” – in simple English, to buy the bonds of sovereign EU governments to keep their prices up and their yields down, provided they were meeting their budgetary targets.

But the Cypriot Government’s pre-emptive announcement of a tax on bank deposits brings a new, unanticipated and potentially highly destabilising factor in the equation. Those who designed this proposal may have been attracted by its theoretical elegance – the funds that the Government of Cyprus would raise through the levy could be injected into ailing banks, improving their capital ratios by reducing their liabilities (bank deposits) while simultaneously increasing their equity.

The problem is that it sends a disastrous signal out across the Eurozone. The message is that, henceforward, Eurozone governments may opt – or be forced – to confiscate bank deposits without warning as one mechanism to fulfil Mr Draghi’s commitment to “do whatever it takes” to save the euro. So hard work and thrift could be penalised in an arbitrary and unconscionable manner, while profligacy, waste and fecklessness would be rewarded.

The likely response to this signal is easy to predict. Savers will become more wary of placing their savings in banks, and instead opt to “keep cash under the mattress” or hold their savings in physical assets such as gold that cannot be easily sequestrated by the government.

I do not regard gold as an investment, but rather as an insurance policy. As Congressman Howard Buffett of Nebraska, the father of Warren Buffett, observed in 1948, “I hold here what is called a $20 gold piece. Before 1933, if you possessed paper money, would could exchange it at your option for a gold coin. This gold coin had a recognizable and definite value all over the world. It does so today. In most countries of the world, this gold piece, if you have enough of them, will give you much independence.” He also wrote that, “When you recall that one of the first moves by Lenin, Mussolini and Hitler was to outlaw individual ownership of gold, you begin to sense that there may be some connection between money, redeemable in gold, and human liberty.”

In a stable world, there is little point in holding gold, as it pays no interest or dividends. But in volatile times, it makes eminent sense to hold an asset which is universally accepted as a store of value and means of exchange, cannot be damaged by fire or vandalism, is easy to store (and hide) and is easily portable. If you were a White Russian in 1917, or a German Jew in 1938, or a Tutsi in Rwanda in 1994, converting your assets into gold coins could literally have saved your life. Stitched into your money belt, gold coins would have offered a means of escape from political oppression and the chance of a new start in a free country.

Cypriot savers could be forgiven for coming to the same conclusion after the events of recent days. Across the Eurozone, the value of gold as an insurance policy has now risen as a consequence of the Government of Cyprus’s actions, reportedly at the behest of the German authorities.

This is bad news. It is likely to lead to a net withdrawal of deposits from banks – reducing the funds they have available for lending to new enterprise. It is also likely to result in greater hoarding by individuals and families. The consequential reduction in total spending will adversely affect economic growth.

It is reported that the Government of Cyprus may now be having second thoughts about the wisdom of its proposed savings levy. It is to be earnestly hoped that the levy will be rescinded. But even if it is, considerable damage has been already been done in further undermining trust in banks and politicians. It will also leave unanswered the question of how the Government of Cyprus can hope to tackle its sovereign debt problem within the stifling embrace of the euro. In essence, Cyprus – along with the other peripheral economies of the Eurozone – is trapped in a Ponzi Scheme. As I commmented on August 6th 2012,

“There is a term for a plan that involves drawing down ever-increasing amounts of money to finance existing obligations. It is called a Ponzi scheme.

A remarkable feature of Ponzi schemes is that they can endure for quite a long time. A surprising number of new investors can be drawn into the scheme to keep it going because they want to believe the false prospectus of its promoters.

But, sooner or later, they all inevitably end in collapse.”

My forecast remains that the Euro Ponzi scheme will start to disintegrate sometime between 2015 and 2017, with one of the smaller peripheral member states – Portugal, Cyprus or Greece – likely to be the first forced out of the single currency to avoid social disintegration. The crisis in Cyprus may have brought the day of reckoning a little closer.

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Feb 23

QE and the Downgrade of Britain’s Sovereign Debt

Categories:

British monetary policy, Quantitative easing

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February 23, 2013

The news that Britain’s sovereign debt has been downgraded comes as no surprise to those of us who have followed the Bank of England’s monetary policies over recent years with growing bewilderment.

The job of a Central Bank is to maintain monetary stability. It is not to print money. It is not to manipulate the exchange rate. It is not, above all, to stoke up inflation or debauch the currency.

The Bank of England has been culpable of all three. And incredibly three members of the Monetary Policy Committee, including Mervyn King himself, are now reported to have voted for yet more money printing at their most recent meeting.

Let us seek to be scrupulously fair to them. Back in March 2009, with the world economy reeling after the collapse of Lehman Brothers, and the British Government battling against a credit meltdown following the collapse of Northern Rock, RBS, Lloyds HBOS and several smaller financial institutions, a case could be made for the Bank of England’s announcement that it would try to revive the economy through Quantitative Easing. Against such a desperate backdrop, taking this leap into the unknown was defensible.

But now experience has told us that, not only does QE not work, it is seriously hampering economic recovery.

Half a century ago, in a classic essay on “The Methodology of Positive Economics” (1953), Milton Friedman wrote that “the only relevant test of the validity of an hypothesis is comparison of its prediction with experience.”

The Bank of England made the following predictions about the impact of QE:

1. It would kick-start economic recovery – the Bank forecast that the UK economy would grow by 1.7% in 2010, 3.4% in 2011, and 3.5% in 2012. It didn’t – UK GDP has stagnated.

2. It would boost bank lending to business and stimulate business investment. This has also not occurred.

3. It would ease consumer credit and drive retail sales upwards. That hasn’t happened. Retail sales remain flat with a succession of insolvencies among high street retailers.

4. QE would also ease the flow of mortgage finance and stimulate the revival of the housing market. This hasn’t happened either. House prices remain flat, mortgages are difficult and expensive to secure, especially for first time buyers, and there seems little prospect of a significant revival in the housing market in the foreseeable future.

5. These positive effects would be felt against a backdrop of low and falling inflation. Again, the Bank of England’s forecasts have been consistently wrong on this count, and inflation has continued to run well ahead of the Bank’s 2% target.

The reasons for the failure of QE were set out in my comment on “Why Quantitative Easing Hasn’t Worked” on this site on August 13th 2012. My own predictions of the likely impact of QE have been fully vindicated by experience.

So on the Friedman test, the Bank of England’s hypothesis – that QE works – has been shown to be invalid. The alternative Golden Guinea hypothesis – that, not only does QE not work, but it has hampered economic growth and driven the UK into a stagflationary recession – has been fully validated.

Experience has revealed the consequences of QE only too clearly. It has driven down the real incomes of small savers, pensioners, the low-paid and those on fixed salaries. As a result, it has driven down consumer expenditure and harmed the retail sector. It has increased the unfunded pension liabilities of the corporate sector, forcing companies to divert their resources away from new investment that would have generated growth and jobs. In some cases, these liabilities have driven otherwise sound companies into insolvency, resulting in a rise in bad debts. It has choked off bank lending to new enterprise.

As all these effects became increasingly evident, hopes rose last year that the Bank of England would call a final halt to their failed policy and consign QE to the dustbin of history. The news that three members of the MPC voted for more quantitative easing in January threw this into doubt, causing turmoil on the financial markets, sending the value of Sterling tumbling, and resulting, a few hours ago, in a downgrade of Britain’s sovereign debt.

And so, in a final, cruel irony, a policy designed to drive down the cost of UK government borrowing has instead resulted in a debt downgrade that will cause gilt yields to rise.

It is to be earnestly hoped that the majority of the Bank’s Monetary Policy Committee will resist the folly of more quantitative easing being urged upon them by an irresponsible minority led by Sir Mervyn King.

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Feb 15

An “Expensive Experiment” – An End to QE in the UK?

Categories:

Bank of Japan, Public Accounts Committee, Quantitative easing

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February 15, 2013

Congratulations to the Treasury Accounts Committee, which in a trenchant critique has condemned quantitative easing as an “expensive experiment” which has failed to deliver any of its alleged benefits or to stimulate economic growth. It has resulted instead only in inflation and lower returns on savings. It has significantly cut the real incomes of savers, pensioners, and those on low incomes, causing genuine hardship and stifling the recovery of consumer expenditure.

All these criticisms have been made in comments on this site over recent months. Hopefully, the fact that the Treasury Accounts Committee has now given them wider airing will give pause to the siren voices calling for yet more doses of money printing.

But while it is to be hoped that the Bank of England will now call a final halt to QE, there are worrying signs that central banks in other leading nations still labour under the misapprehension that printing money offers a cheap and easy route to economic prosperity. The latest to embark on this exercise is the Bank of Japan, apparently with the objective of driving down the external value of the Yen, which has fallen by almost a fifth against the dollar in recent months. The Bank of Japan’s actions could mark an escalation in competitive attempts by different nations hoping to stimulate export growth by driving down the external value of their currencies. If so, the world economy may be entering a worrying phase of “beggar my neighbour” economic nationalism where competitive currency depreciations cause further instability, harming trade and cross-border investment, with the result that all nations are left worse off.

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Feb 04

The “electrified ring fence” – does it go far enough?

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Banking analysis, Banking reform

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February 4, 2013

The announcement by the Chancellor of the Exchequer that the UK Government will introduce an “electrified ring fence” around core retail banking activities, with draconian sanctions for any banks that breach it, is to be welcomed.

However, it begs the obvious question. If it is so desirable to keep retail banking activities separate from investment banking – as I firmly believe that it is – why did Mr Osborne not go the full mile and introduce a British Glass Steagall Act requiring a statutory separation of the two? In other words, any retail bank accepting savings and deposits from the man and woman in the street should be formally prohibited from using these funds to underwrite or trade in financial securities or their derivatives. Depositors’ funds should only be used for lending to households and businesses who, after having undertaken a proper due diligence appraisal, are assessed as having sufficient capacity to service their loans, and are capable of offering adequate collateral should they fail to do so.

Merchant and investment banking have a long and honourable tradition, and are a vital part of the dynamic operation of any market economy. But their functions and incentive structures are completely different from those of a deposit-taking banking institution. Moreover, the risks taken by an investment bank in sponsoring new ventures are typically greater than those taken by retail bank, and therefore require higher capitalisation – typically at least 30% to 40% of assets under management, rather than levels of between 5% and 10% required for a retail bank.

The decision to end the clear delineation between the two banking functions that occurred with Big Bang in the UK in 1986 and the abolition of the Glass Steagall Act in USA 1999 were major contributory factors to the financial crisis that followed.

Reintroduction of the delineation – ideally on an international rather than merely a UK level – would represent a significant building block in the restoration of international monetary stability.

The concern is that the “electrified ring fence” is a rather unsatisfactory halfway house, which may be difficult to monitor and regulate, and which, one fears, will only result in the growth of a self-serving regulatory empire.

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Feb 01

Margaret Hodge and the tax accountants

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UK Taxation, VAT and fiscal policy

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February 1, 2013

I must admit to having a sneaking regard for Margaret Hodge as a tribune of the people and defender of the taxpayer in her role as Chair of the House of Commons Public Accounts Committee.

Until yesterday, that is.

In a blatant attempt to score a few cheap points by exploiting her position, she cut off a response from a tax partner from KPMG, who was explaining that the firm’s “main purpose was to help our clients pay their tax”, stating that it was a “laughable” response. The clear implication was that companies across the UK only pay fees to their tax advisers to help them engage in dodgy tax avoidance schemes.

Here I feel I must stick up for my former firm, Deloitte, where I worked as a management consultant for eight years in the 1990s. Although I wasn’t directly involved in the firm’s tax advisory services, their role was exactly as described by Jane McCormick of KPMG in her testimony yesterday – namely, to ensure that their clients’ tax affairs were dealt with in a way that complied with the law and that they paid the taxes due under the law – no more, certainly, but no less. I would be extremely surprised if Deloitte as a firm had actively promoted the use of aggressive tax avoidance schemes. It would have been entirely contrary to the firm’s culture. Quite apart from any other considerations, the partnership would have been most concerned about possible reputational damage that the firm could have suffered had it been implicated in any transactions that were legally dubious.

Things may have been different at Price Waterhouse, whose shilling Margaret Hodge apparently had no difficulty in taking when she herself worked there in the 1990s – apparently in those days not suffering from the synthetic moral outrage expressed yesterday – but I suspect not.

Ultimately, those who are to blame for the anomalies that exist in the British tax system are not tax accountants, but rather the legislators who have, over the years, devised a system of labyrinthine complexity and Heath Robinson inefficiency.

The way to resolve these anomalies is not to adopt a demagogic “shoot the messenger” approach, but rather to take a red pen through the entire tax code, with the aim of replacing it with a simple 20:20:20 structure – 20% income tax, 20% corporation tax and 20% VAT – with a higher rate of income tax (40%) on incomes above £50,000 and a lower rate of VAT (5%) on price sensitive labour-intensive services such as hairdressing, home repairs and prepared food. Such a system would raise broadly the same level of tax as at present, provide a stimulus to growth and productivity by ending the distortions inherent in the current system – and achieve a further goal that I suspect both Margaret Hodge and I share. Namely, to release the army of tax advisers and accountants to other sectors, where their undoubted talents could be deployed for more socially useful purposes.

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