BBC BLOGS - Stephanomics

Archives for February 2009

The big borrowers

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Stephanie Flanders | 16:21 UK time, Friday, 27 February 2009

If you're wondering where the epicentre of the global financial crisis might be in 2009, I suggest you look somewhere east of the Danube.

Today's 24.5bn euro ($31bn; £21.8bn) joint rescue package for Central and Eastern European banks shows that the dire figures coming out of the region are starting to focus minds. But this is just the beginning.

Why are these economies in a particularly painful bind? Well, you knew that big borrower nations like America and the UK were hit first by the credit crunch. As I discussed recently, countries that relied on exporting to the rest of the world are now also being thumped.

The very bad news for the Central and Eastern European economies is that over the past few years they've been big borrowers and big exporters. Now they're suffering the worst of both.

You might think that "horrendous" is a rather emotive term for an economist. But it's the only word that comes to mind when you look at the figures. Until very recently, exports accounted for 80-90% of GDP in the Czech Republic, Hungary and Slovakia.

Meanwhile, US and British borrowing in the lead-up to this crisis was chicken feed compared to what these countries were hoovering up, relative to the size of their economies.

I've brought together the most striking figures in a chart (see below).These are the IMF's figures for net capital inflows in 2007 as a share of GDP.

Capital flow bar graph

I must confess that I was astonished to see that Bulgaria sucked in flows worth nearly 40% of GDP in 2007. America wasn't the only place where you had very risky imbalances hiding in plain sight. Trust me, there are plenty more where that came from, and I'm leaving out the likes of Tajikistan and Ukraine - they're a subject for another day.

As Graham Turner of GFC Economics points out, these inflows are far larger than anything seen in the lead-up to the Asian financial crisis of 1997-8. Thailand had net inflows of just under 11% of GDP in 1996, the year before its currency peg collapsed and investors in emerging markets started running for the door.

European governments last week called for a doubling of the IMF's lending resources to £500bn, in the hope that a lot of that money might find its way to the likes of Romania and Bulgaria.

But there's no getting around the fact that many of the economies in trouble are in the European Union. This Sunday's special European summit in Brussels will be an opportunity for the likes of Germany and France to declare their solidarity with the East.

So far, solidarity has been in fairly short supply. Czech officials were understandably outraged earlier this month by the French President Nicolas Sarkozy unveiling support for French car makers which was dependent on keeping French plants open - and appearing to suggest they close their Czech plants down instead. Not a lot of fraternité there.

Though all have been under pressure in the foreign exchange markets, not every country is in the same straits.

Poland and the Czech Republic, while poorly, are in better shape than most of their neighbours. Slovakia and Slovenia also face a hard slog, but at least they are in the euro.

They don't have the problems of Romania or Hungary - where a large chunk of the population, incredibly, now has mortgages denominated in Swiss francs. (I guess it seemed like a good idea at the time, much as 125% mortgages seemed to make sense in Britain in early 2007.)

The situation for the Baltic economies is dire, too (sorry, it's a long list). A few weeks ago Latvia officially became the first country in this crisis to have seen a 10% drop in GDP.

The Baltics are all pegged to the euro. Some say they should go ahead and join - which would at least give them the benefit of lower rates and stop the one-way bet to the speculators who think the pegs will break.

Riding out the storm inside the eurozone is no quick fix. Ask Spain. But if you're on the edge of a full-blown current account crisis from the drying up of capital flows, being outside the euro won't be comfortable either.

Whichever way they go, many of these countries are going to need support from EU and other multilateral institutions but also, probably, individual countries (several of whom, like Austria, have discovered their banks have a lot vested in the East).

Eurozone economies may have to rely on that kind of bilateral help: the Maastricht Treaty explicitly forbids bailouts among euro members.

For EU members that are outside the euro, there are some funds available: the pool of available European Community assistance was doubled to 25bn euro ($31.6bn; £22.3bn) recently when the EU joined an IMF support package for Hungary and Latvia. But that's pretty small change compared to the scale of the problem. Knee-deep in bank bailouts, Western European governments will hardly relish the job of explaining to voters why they should bail out profligate East Europeans as well. But they didn't want to bail out the banks either.

Don't mention nationalisation

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Stephanie Flanders | 12:08 UK time, Wednesday, 25 February 2009

President Barack ObamaIn his speech to Congress yesterday, President Obama wanted to remind us of his steely resolve. You can see why.

To judge by the polls, voters still hold Mr Obama in high esteem. But when it comes to the economic crisis, steely resolve has not been the message of the administration's first month.

Fixing the US economy and the banking system was always going to be hard. No-one expected the Obama team to wave a magic wand. And, to underscore the point, it has only been one month.

But here's what many find troubling about the record so far. The Obama White House will almost certainly never have more political capital than it has now - more room to think the unthinkable,and do it.

Yet to many economists, the policies that the administration has announced so far are in some respects, the bare minimum. They're what the country will need if everything works. And the White House is having trouble with even those.

Yes, the fiscal stimulus package was large, but no larger than most think the economy will require. To get it, the president had to struggle much more than he would have liked.

He has also given the public the impression that this will be the last stimulus package Congress will have to pass. We'll find out more when he unveils his new budget tomorrow, but that's the implication of the president's pledge last night to halve the deficit by the end of 2012.

To believe there won't be need for any more, you have also to believe that the private sector will be able to take up the baton of growth by the middle of next year, when the bulk of this stimulus will have run its course. To many economists, that sounds optimistic, at best.

As Goldman Sachs analysts have pointed out, the American private sector is moving from a period of historic deficit to one of surplus - from net borrowing of 3.5% of GDP in 2006 to net saving of around 1% of GDP last year.

To judge by the Japan experience, that shift has a long way to run. The same team reckons the private sector could be saving to the tune of 10% of GDP by 2012.

Theoretically, the rest of the world could take up that slack; exports could soar, and the US could start lending all that private saving to the rest of the world. But that's not what you would call the baseline scenario. The much, much more likely outcome is that government borrowing will not only rise to around 10% of GDP this year (as projected) but will also stay in that vicinity for several years.

The only question is whether that happens by choice, through government stimulus, or by default, as a deeper recession takes its toll on the federal budget.

You can see why the President would not want to raise these issues in his address last night. In a world of problems-for-right-now, next year's fiscal stimulus package is one of the few that can wait.

But the same cannot be said of the Financial Stability Plan and fixing America's banks.
The Administration has said it will be resolute in stress testing the banks and acting on the findings.

Nearly everyone agrees that this kind of reckoning will be required to finally rebuild confidence in the nation's financial institutions.

Surprisingly, perhaps, most now also believe that the end conclusion of this exercise ought to be the nationalisation of several important banks. That's because, even to many Republicans, the uneasy middle ground we have now exposes the taxpayer to all of the risk on the banks' balance sheets but none of the potential gains.

But in its extraordinary joint statement on Monday with the major financial regulators and the Fed, the Treasury Department once again re-iterated that "the strong presumption is that banks should remain in private hands".

That is certainly the strong presumption for normal times. Just as nationalisation, in normal times in America, is the policy that dare not speak its name. But these are not normal times. If the Administration dare not speak its name now, many are wondering what else it will not have the courage to do.

It might not be you

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Stephanie Flanders | 11:55 UK time, Monday, 23 February 2009

For those who missed it, there was some good news from the statistical trenches in Saturday's FT from the Undercover Economist, Tim Harford.

Crowds on busy streetWe are used to thinking that nearly everyone suffers financially from a recession. But he asked an economist at Bristol University to check.

Using data from the regular survey of British households that began in 1991, Lindsey MacMillan found that at the end of the last recession in 1993, more than half of households were earning more than they did in 1991.

Amazingly, one in six had seen their income rise by more than 50%, despite meagre growth in the economy as a whole. And the results during the latter recovery were much the same.

"In other words," says Harford, "the variability in individual experience completely drowned out the distinction between growth and stagnation in the underlying economy."

We all know that some industries do better in recessions - after last week's flurry of new jobs announcements from KFC and others, the fast food industry comes to mind. The same goes for Poundland and discount supermarkets.

But this new finding goes a lot deeper than that. It reminds us that even in parts of the economy that are adversely affected by recession, most people will not suffer a big decline in income as a result of this recession.

The National Institute of Economic and Social Research expects British households' real disposable income to grow by 3.3% in 2009. That would be the fastest growth in years. In 2007, the peak of the boom, real incomes didn't grow at all.

It's a paradox we're getting used to. In a year of rising real living standards, households are going to save more because they are understandably fearful about the future. But back in 2007, when their income was flat, they saved less - 2.2% of their income compared to 4.2% in 2006.

But, as our undercover friend would remind me, those, too, are simply macroeconomic aggregates, far removed from the actual experience of real families and households.

People still get promoted in recessions. They still retire - not necessarily earlier than planned. And I can personally attest that they still have babies.

All of those changes can have a bigger impact on a given family's finances than the fact that the UK is in recession. That's not much consolation to households where one or both earners have recently been laid off. But it is true.

The cost of taking over the banks

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Stephanie Flanders | 15:30 UK time, Thursday, 19 February 2009

Reading today's public finance figures [pdf] is a bit like finding out that a team fighting relegation has just lost another match. Disappointing, but not exactly a surprise.

The truly momentous change in Britain's fiscal prospects came last November, in the pre-Budget report. That was when we discovered that the picture of the public finances painted year after year by the Treasury had been fundamentally, unforgivably wrong. Compared to that, today's poor numbers almost seem like small change. Net borrowing in January was about £2.3bn more than the city had predicted.

And the Chancellor looks set to miss his £77.6bn borrowing forecast for the entire fiscal year - the Institute for Fiscal Studies now reckons it will be £87bn.

Alistair DarlingBut what's a £9bn or so overshoot compared to the £80bn jump in the forecast for the fiscal deficit between last year's Budget in March and the pre-Budget report. Nearly all of that enormous revision was due to the fact that the underlying (structural) budget was far weaker than the Treasury had thought. And it probably had been for years. Bumper revenues from the financial sector are one of many supposedly fixed features of the fiscal landscape that has turned out to be all too transient.

Corporation tax revenues in January were nearly 25% down on the same month last year. And much of that may be gone for good.

Does the reclassification of RBS and Lloyds by the Office National Statistics change things one way or another? Basically, no. After all, we knew that the taxpayer was a majority shareholder in these institutions. This would just formalise the obligation.

The public debt figures may change - quite spectacularly. When the ONS completes the change, Britain's net public debt could rise from just under 50% of GDP to 150%.

But that does not tell you much about the eventual cost of the bank rescues to the taxpayer. We'll only know that when these banks are back in the private sector. There's much debate about what the eventual cost of all the government's financial sector interventions will be.

Some say £120bn - 8% of GDP. Others think it will be higher. Still others suspect we taxpayers will make a small profit. We can all agree the cost will not be 100% of GDP.

But there is one way in which the government's ownership of these institutions does make a difference to our fiscal position, even if that ownership is temporary. It gives Her Majesty's Government a lot more foreign currency debt than it did before.

I wrote a few weeks ago about the health of the country's balance sheet - public and private. As I said then, the government is not subject to an emerging market-style debt crisis because it does not issue foreign currency debt.

But our banks do have significant foreign currency liabilities - around £1.5tn. And with the arrival of Lloyds and RBS a fair chunk of those are on the government's balance sheet.

There are plenty of foreign currency assets to put against those liabilities, so the government's net position has not changed.

But, as David Miles, economist at Morgan Stanley, has pointed out, the fact that the liabilities are more liquid than the assets could pose a short-term liquidity problem if there were a run from the pound and people pulled out their cash. Right now, the Bank of England doesn't have enough reserves to deal with that kind of run.

If there were some kind of run and the Bank faced problems, other central banks would certainly rally round. But it would be embarrassing, to say the least.

As Miles says, talk of the UK "running out of money" is far-fetched. But with so many banks now on the government's books, the Treasury has one more reason to preserve at least a modicum of confidence in the pound.

Is quantitative easing really just printing money?

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Stephanie Flanders | 12:59 UK time, Wednesday, 18 February 2009

And the sound you heard was the sound of a printing press being warmed up.

Bank of EnglandThe release of the minutes from the February meeting of the MPC confirms that the committee which sets UK monetary policy wants their power to go beyond interest rate cuts, with direct purchases of assets by the central bank, also known as quantitative easing (QE).

The big questions are: what happens next? Is it really printing money? And, finally, will it work? The first two are easier than the last.

What happens next (if it hasn't happened already) is that Mervyn King will write a nice letter to the Chancellor asking "please can we use the Asset Purchase Facility (APF) to buy a range of securities on the Bank's own account, using money we've created for ourselves?" We can be fairly confident that Alistair Darling will say yes.

At the MPC's next meeting, there may then be two votes - one on the level of Bank rate (base rates), and one on the level of any Bank-financed purchases through the APF. If it doesn't happen in March it will surely happen soon.

If they decide to go ahead with QE, that will be a change of policy, and we can expect a statement recording that fact. But unlike a change of Bank rate, QE is an ongoing process not an event. So the MPC may vote to authorise purchases over an extended period rather than month to month.

Traditional "QE" involves buying just government securities, or gilts. However, the minutes indicate that the MPC will be looking to buy high quality corporate securities as well, just as the Bank bought commercial paper on the government's behalf last Friday (the first official use of the APF).

If and when we go to QE (and it surely is now a matter of when), I think we can expect significant purchases of both gilts and commercial securities.

Large scale central bank purchases of government debt make people nervous, for reasons I'll get to in a minute.

But purchases on the £50bn-plus scale we're probably talking about would quite simply swamp the corporate debt market. There isn't enough to go around.

You'd also be taking a lot of higher risk assets on to the public balance sheet (via the Bank), which could raise the risk premium on government debt and send long-term interest rates in precisely the wrong direction.

So, we can expect the Bank to buy a lot of gilts as part of this policy. Is that "printing money"? The politicians will say no. But any economist would say yes.

A few weeks ago I discussed one definition of printing money, which was a deliberate expansion of the central bank's balance sheet and the monetary base (the narrowest measure of the money supply). Ben Bernanke, among others, has associated himself with this definition.

But the most popular definition of printing money - the one the politicians are terrified of - is simply central bank financing of government deficits. Also known as "monetizing the government debt".

Since the Bank will be purchasing gilts on the secondary market, not from the government directly, the government will almost certainly say that this is not monetizing the debt. To say otherwise conjures up vision of Weimar and Zimbabwe.

To preserve this distinction, the Bank of Japan was legally forbidden to buy debt directly from the Ministry of Finance when they undertook QE in the 1990s.

Funnily enough, the Bank of England faces the same legal constraint: Article 101 of the Maastricht Treaty (of all things) forbids direct central bank financing of deficits.

But it is a distinction without a difference. When the Bank of England buys up gilts, one arm of the government is buying up debt owed by another arm of the government in exchange for money created by the central bank. Whether the gilt is brand new, or issued the day before, is quite simply irrelevant.

That said, there are big practical differences between this policy and Zimbabwe-style money financing. The most important is that the Bank is choosing to buy gilts as a means to an end. It is not being forced to buy them because the government has nowhere else to go.

Also - and crucially - the Bank has every intention of unmonetising the debt when the storm is past. In other words, it's going to sell it all back.

So in that sense, QE will not directly affect the stock of government debt one way or another. (Certainly there won't be any direct change to the amount of debt on the Treasury's books.)

It may even make the debt management office's job harder, by putting a lot of extra gilts back into the market, at a time when issuance of new debt is still running high.

But if QE works, the government will clearly benefit from a faster upturn in the economy - and so will all of us. I will tackle that thorny question in a later post.

Has Goldilocks gone for good?

Stephanie Flanders | 15:09 UK time, Tuesday, 17 February 2009

Should we be more scared of deflation - or of inflation? Anyone who's been living on planet Earth the past few weeks will choose deflation.

It's fear of falling prices that's driving policy by the Bank of England and the Federal Reserve right now. And rightly so. We saw what happened in Japan and we don't want it here, thank you very much.

The CPI (Consumer Prices Index) measure of inflation fell to 3% last month, and the Bank of England now expects it to fall close to zero by the middle of next year. But they don't rule out the possibility of a negative CPI. And they see little chance of CPI above 2% before 2012.


The City takes a slightly different view. If you look at market measures of inflation expectations, investors seem to expect moderate deflation in the next year or so, but significant inflation after that - of the order of 3 to 4%.

But as usual, those market expectations hide a lot of disagreement. And right now, the sheer range of views on the inflation/deflation spectrum is wider than anyone can remember.

There are those who fear a Japan scenario - a decade of self-reinforcing deflation. But there are also those who think that high inflation - even hyper-inflation - is not very far off.

That's because the more successful the central banks are in preventing deflation, and in persuading us all that prices are set to rise, the greater the chance of excessive price growth down the road.

The middling, "base-case", scenario built into most city economists' economic forecasts is what the bond market is reflecting: two years of low inflation, possibly mild deflation, with a moderate uptick in inflation after that.

But then, the base-case scenario a year ago was for a modest slowdown in the advanced economies, and consistent growth everywhere else. Look how that turned out.

I suspect that, in their heart of hearts, many city folk think we are living in a more binary world - that it will be bad deflation, or high inflation (maybe even one followed quickly by the other).

What seems strangely unlikely is a "just right" outcome in between. The Goldilocks economy really has gone for good.

That poses a challenge to policy makers and all of us. But spare a thought, too, for the fund managers charged with investing our fast-diminishing pension pots.

After all, if you think that deflation is the big danger, the traditional advice would be to pile into cash and bonds. If you think that inflation is enemy number one, then history would suggest that shares and gold are a safer bet.

But what do you do if you think that there's a roughly 50% chance of each?

It sounds like one of those peculiarly unhelpful weather forecasts. But that may well be the world we're in.

Innocent victims?

Stephanie Flanders | 12:59 UK time, Friday, 13 February 2009

After today's appalling growth figures from the eurozone, I'm starting to think that the UK will lose the competition to be the worst hit by the credit crunch.

Earlier this week, I said that this recession wasn't going to be fair. Looking at their fourth-quarter GDP figures, the Germans would surely agree.

When drawing up a list of those unfairly penalised in this recession, it's tempting to add the world's exporters to the list.

BERLIN - DECEMBER 15 2008: A worker moves parts for high-voltage circuit breakers at a factory of German engineering company Siemens on December 15, 2008 in Berlin, Germany.  Sean Gallup/Getty ImagesAmong European economies, Germany stood out as one that had risen to the challenge posed by globalisation. It saved. It invested. Against the odds, through reunification, through the downs and ups of the euro, it had stayed at the top of the league of global exporters.

Now, like savers and exporters all over the world, it's being hammered. Output fell by 2.1% of GDP in the fourth quarter - the worst fall since reunification in 1990.

That's worse than the UK, and far worse than France. It's even worse than Italy, for goodness' sake.

Germany was the first major economy to officially go into recession last year. The forecasts are now for another decline in 2009, of around 2%.

Like Japan, Korea, and the rest, Germany is being punished for its heavy dependence on exports.

So, another list of innocent victims to add to the roll-call? Well, yes and no.

In the parable of domestic savers versus borrowers, it's easy to see who has prudence and justice on their side. But when you're talking about countries, things are less clear-cut.

It is true that these countries did what they were "supposed to do" - they saved and produced rather than borrowed and spent. But they did an awful lot of saving and producing. And not very much spending.

That meant they had a lot of extra savings and products they needed to offload on everyone else - also known as an enormous current account surplus. And as we all know, the flip side of their collective surplus was a big deficit in countries like the US and UK.

In an ideal world, those imbalances would have gone away over time, as the currencies of the exporting countries got more expensive, and currencies like the dollar went down. But, as we all also know, that didn't happen.

The big Asian exporters accumulated a mountain of spare cash instead, which they invested in dollars to keep their currencies low.

Germany didn't go in for all of that. But, as Martin Wolf points out in his excellent book, Fixing Global Finance, it has long been among the world's leading excess savers. We just haven't noticed quite so much, because its current account surpluses have been offset by deficits elsewhere in Europe.

In 2006, it had a surplus of savings over investment of 5% of GDP. Germany's current account surplus that year was around $150bn, the third largest in the world after China and Japan. The US deficit that year was over $850bn.

Sooner or later, those imbalances were going to have to be unwound. And the longer they lasted, the bigger the chance that the "great unwinding" would come with a giant thud.

I noticed in Davos that the (few) Americans there didn't like to think they were victims in all this - the poor innocents who kept an imbalanced world going by force of credit cards alone. They'd prefer to be cast as the global imbalances villain, if those are the alternatives on offer.

But, as Keynes said many years ago at Bretton Woods (and as Mervyn King reminded us in his press conference earlier this week), the responsibility should cut both ways.

Back then, Keynes said the world needed a system where surplus countries had an incentive to adjust - not just deficit ones. He didn't get one. And the world never has.

The result is a system much more prone to boom and bust cycles - which ultimately hurt the saver/exporters as much as the borrowers.

Germany, Japan, and others are now learning that lesson the hard way. There's plenty of blame to go around. But don't think they are immune.

From optimism to pessimism

Stephanie Flanders | 17:26 UK time, Wednesday, 11 February 2009

In its latest Inflation Report, the Bank of England has moved from being a relative optimist on the UK economy to becoming a serious pessimist - at least when it comes to this year.

But the governor wants us to know that the old lady of Threadneedle Street will do whatever it takes to get the economy moving again - and also that "whatever it takes" might start even sooner than we thought.

bankchart.jpgWhen it comes to the immediate outlook, the change is such that the Bank has had to alter the scale on its famous fan chart for projected growth. Back in November, the bottom of the range of possible outcomes was minus 4% (year-on-year). Now the worst outcome is approaching a scary minus 7%.

They hate translating these charts into a single forecast for growth. But a rough calculation suggests that the Bank's central forecast is now for the economy to shrink about 2.9% in 2009.

That would be the worst decline in a single year in the UK since comparable records began in 1949. The worst year in recent memory was 1980, when GDP shrank 2.1%.

Mervyn KingAs the Governor Mervyn King admitted at today's press conference, the Bank is now more pessimistic than the consensus (although the consensus is falling fast). And of course it's hugely more pessimistic than the midpoint of the Treasury's November forecast, which was a fall of 1%.

So far, so gloomy. But the most striking thing about these projections is the outlook for 2010. The same caveats apply, but they seem to be looking at a central forecast for positive growth next year of more than 2%. That compares to a consensus of just 0.6%.

In many ways, their 2010 optimism is the flipside of their 2009 gloom - usually a steeper decline into recession means a steeper climb out. Mervyn King and his colleagues seem to think this time will be the same, with growth picking up sharply next spring.

After all, we have seen an extraordinary effort by policymakers in the past six months to stop this recession in its tracks, not just in the UK but around the world. And the governor confirmed that we could see even more extraordinary efforts by the Bank's Monetary Policy Committee in a matter of weeks.

On the basis of his comments today, I wouldn't be surprised if the MPC discussed full-scale quantitative easing - the creation of central bank money to buy up public and private assets - at their meeting last week.

We'll find out for sure when the minutes are published next week. But it is now a racing certainty that they will discuss it at their March meeting. Before the meeting we can expect another exchange of letters between the governor and the chancellor explaining that the Bank thinks it might be time to take that step, but that is a mere formality.

The Bank has cut interest rates three times since its last report, and inflation measured by the consumer price index is still forecast to be below target until after 2012. That alone makes the move to quantitative easing a foregone conclusion.

Two big messages from the Geithner plan

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Stephanie Flanders | 18:40 UK time, Tuesday, 10 February 2009

There are two big messages from the latest US bank rescue plan announced by Treasury Secretary Timothy Geithner.

Timothy Geithner with Barack ObamaOne is that, if anything, the Obama administration is even more neurotic about nationalising banks than its predecessor. The other is that right now it needs to be seen to stretch every taxpayer dollar as far as it can go - even if that might increase the final cost to Uncle Sam.

George Soros has said that the US faces a choice: between partly nationalising the banks themselves, or nationalising just their bad assets. Today's plan suggests that the administration doesn't want to do either.

What started as a "Bad Bank" and then later became an "Aggregator Bank" is now a "Public-Private Investment Fund" which would help private investors take on toxic assets rather than have government buy them directly itself.

As is true of the entire package, the emphasis is on providing a "bridge" to private capital and generally avoiding anything that smacks of public control.

This arms-length-and-even-that-only-when-necessary approach to the dirty business of getting toxic assets off banks' books has another supposed advantage: if the government's not buying the assets, it doesn't have to value them either.

But it's not clear how the valuation issue will be avoided in practice - if you "leverage" a private purchase of an asset, for example, by underwriting the borrowing to buy that asset, that itself relies on some implicit valuation of the asset. The government could still overpay.

It may be that the US Treasury has devised a way round this, but if so, Mr Geithner's speech suggests that it's a work in progress. The objective is to "use private capital and private asset managers to help provide a market mechanism for valuing these assets". Precisely what that mechanism will be is still being discussed.

Of course not buying assets is also cheap - at least at first. As I said, that is the other big lesson of this plan: the administration is trying to spend as little as possible up front. In that sense, the "Public-Private Investment Fund" is attractive to the US Treasury for the same reason that the UK's Private Finance Initiative was attractive to Gordon Brown.

The new Consumer and Business Lending Initiative to promote lending across the economy will be based on a pre-existing Federal Reserve lending facility for exactly the same reason. The Treasury will provide the minimum amount of capital to leverage the maximum amount of lending by the Fed.

There's nothing wrong with trying to get the most lending at the least cost. It's already been harder to pass the fiscal stimulus package than the administration had hoped. It doesn't want to go back to Congress any sooner than it has to.

But there is a risk that penny-pinching now will cost the taxpayer more in the end.

That's true in the narrow sense that these kinds of guarantees leave the government liable for more of the losses on these assets and fewer of the gains.

But there's a more general risk in these minimum-cost, maximum-private involvement approaches. That is that this plan will fail to do what the administration desperately needed it to do: to instill confidence, finally, that the world's most important government will do whatever it takes to put its financial system right.

There was plenty in Mr Geithner's speech that was good. But the market's negative reaction suggests that so far, at least, he has not achieved that goal.

Update Wed 0926: From the comments: "your description of a $1.5 trillion dollar package as 'penny-pinching' and 'minimum cost' really does beggar belief" (Adam C).

But there's a huge gap between that headline number and the upfront cost to the Treasury. And that is precisely the problem.

When you look at the small print, nearly all of that $1.5 trillion is supposed to come from private investors - suitably "leveraged" by a small amount of public capital, or guarantee. At least in the initial stages of the plan, the Treasury doesn't seem to be planning to spend more than the $350bn or so left in the original TARP.

The administration was dealing the hand it was given - if you assume that you can't raise much more money from Congress in future, you get a proposal that looks like this.

But the risk is they will end up with the worst of all worlds - a plan that looks to the average voter like another giant cheque to the banks, but on close inspection by investors looks like too little, too late.

Unfair? We may have to hope so

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Stephanie Flanders | 15:30 UK time, Monday, 9 February 2009

If you think bank bonuses are unfair, then hold on to your hats. It's a sad fact about life after the crunch that the best-case scenario now for the global economy may be the unfairest.

The most obvious example is that of savers versus borrowers. Already savers are getting some very unjust deserts. But for the world to recover, that may have to continue.


If you saved for the future during the boom years, the chances are you are now being hammered. Indeed, the Spectator just dubbed savers "the new underclass". Your pension may well be worth less than what you've contributed, and the interest rate on your savings account is now barely visible to the eye.

Even before last week's interest rate cut by the Bank of England, half the variable rate savings accounts were paying interest of less than 0.5% - while many borrowers are seeing a big cut in their monthly costs.

Of course, prudent home buyers who didn't take on enormous mortgages can enjoy the fact that they are not now sitting on negative equity. And the shrewd renters who saw this all coming know that their reward is on its way in the form of lower house prices.

More generally, net savers might hope to gain from the deflationary future now being painted for the major advanced economies. It's not just houses that are getting cheaper. In a world of generalised price falls, every pound of savings will go that much further. And every pound of debt is cause for that much more regret.

That's when savers do get their just rewards, and borrowers are sent to deflationary hell because the real value of their debt keeps on going up.

But, lest you forget, this deflationary scenario is precisely the one that the major central banks are all hoping to prevent. The authorities are (understandably) scared of a repeat of the 1930s - or Japan in the 1990s - when falling prices led to a prolonged period of stagnant demand.

So in the best scenario savers will not get much reward in this life, while borrowers will enjoy extremely low interest rates and even some erosion of the value of their debt by inflation. (If they're really lucky, they could even get hyperinflation, which would wipe out savings and debt alike, but that's a subject for a future post).

And there's likely to be plenty more injustice to go around.

We don't yet know quite how the fiscal costs of cleaning up this mess will be distributed - but it's a fair bet that young people will end up paying higher taxes to clean up after a boom they didn't enjoy.

When it comes to the financial system, it is possible that the banks who were prudent in the boom years will come out ahead. But those same prudent banks could question whether the institutions who took colossal (and foolish) risks are going to come out sufficiently behind.

It's been the same problem since the credit crunch began. If governments are going to restore confidence in the financial sector and so revive lending to the broader economy, they're going to end up 'rewarding' a lot of bad behaviour and effectively punishing those who abstained from it.

Seen in that broader context, the mega-bonuses for bankers might look like a drop in the ocean.

Yes, it's all very unfair. But it may be our best hope.

Just follow the money

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Stephanie Flanders | 13:01 UK time, Friday, 6 February 2009

A lot of economic policy is easier said than done. But quantitative easing is one that's easier done than said.

It's such an ugly phrase - you can see why news editors would do everything they can to avoid it. But the governors of the British and American central banks hate it as well.

Both have tied themselves in knots over the last few weeks trying to show how their policies differ from quantitative easing - or (because I can't bear to repeat it again) QE.

king_bernanke203.jpgIn his speech last month at the LSE (13 January), Ben Bernanke said that the Fed was doing "credit easing", and that it was "conceptually distinct" from QE. A week later, Mervyn King said [63Kb PDF] that the Bank purchases of assets under the new Asset Purchase Facility would be "unconventional unconventional policies", as distinct from the more "conventional" QE. [See update below for more on the Asset Purchase Facility.]

I get it. Things are complicated - especially monetary policy things. Central bankers, of all people, have to be precise.

But it's odd that two former teachers, previously known for their crystal clarity, should decide now is the time to be wilfully complex.

I suspect that the real reason they want to distance themselves from QE is that from there, it's only a small leap for commentators to a phrase that people understand only too well: printing money.

But here's the funny thing: they may not be doing QE. But they are very definitely printing money.

Here's the simplest way of looking at all of this. (I'm afraid it's not the shortest.)

In normal times, monetary policy is about indirectly controlling the supply of credit in the economy by controlling its price. Cheap money means more lending by banks; having higher interest rates encourages less.

There is no direct targeting of the amount of money banks have in their accounts, or lend out to customers. You simply set the base rate at what you think is an appropriate level and see what happens.

But when interest rates are at or close to zero, everything changes. You can't make money cheaper any more, so you have to target the amount of cash more directly: in classic "QE", by targeting the amount of cash the commercial banks have in their accounts with the central bank.

That's (mainly) what the Japanese central bank did from 2001 onwards. Instead of targeting the interest rate, they adopted a target for the banks' balances with the Bank of Japan, which they attempted to meet by purchasing government securities from the banks, paid for with freshly-minted cash.

The more bonds the banks bought, the more cash they built up in their accounts with the BoJ. That, in turn, expanded the monetary base, also known as "high-powered money" (or M0).

By itself, that didn't do much to help the economy. As I pointed out yesterday, banks have to do something with it to increase "broad money" and get it out into the economy. In Japan's case, a lot of the money just sat in the banks' accounts and didn't achieve much at all.

Right. So that's QE. What about "credit easing"? That is what the Fed is now doing. It involves buying a mixture of bonds and securities in different markets with the direct goal of increasing liquidity in those markets, pushing up prices and cutting yields (the price being inversely proportionate to the yield).

Now that expands the Fed's balance sheet - just as with QE. To the extent that bank balances with the Fed go up, it also increases the monetary base. But, says Bernanke, it's not QE - because the rise in the monetary base is a side effect of the policy, not the goal.

If you think that sounds like a distinction without a difference, you're not alone.

Mervyn King is on slightly stronger ground when he says that purchases by the Asset Purchase Facility are not QE, at least under current arrangements. That's because they'll be bankrolled by the government.

Every pound spent by the Bank on corporate assets will be matched by the sale of an equivalent amount of Treasury bills. So, theoretically, M0 will not change and there'll be no quantitative ease.

But, as my colleague Robert Peston has pointed out, the T-bills that are supposedly offsetting the cash created by buying assets are pretty cash-like themselves.

Banks, in particular, are likely to treat them like cash. Which would suggest that even the initial non-monetary use of the facility would in practice have monetary implications.

The gnomes of Threadneedle Street will protest that it's the formal expansion of the monetary base that matters for QE. But if that's the way they want to play it, you could argue that all their many efforts to provide liquidity to banks have effectively been a form of QE.

As a result of those policies, the monetary base grew by 35% in the second half of 2008 alone. And the Bank's balance sheet expanded by around 160%.

The Special Liquidity Scheme and the decision to provide cash against a wider range of collateral have explicitly encouraged banks to build up more central bank reserves. The Fed's special operations have done likewise.

As I mentioned last week, one result of all these liquidity operations has been to push overnight rates below the official interest rate - in fact, not just in the US but also in the UK. Even though keeping that overnight rate close to the Bank rate is supposed to be their number one goal.

In other words, they have been concerned about the quantity of money sloshing round, not just the price. That sounds awfully like QE.

By now, the three people still reading this will be asking: "and the point is...?" The point is: forget about QE or not QE. Just follow the money.

Both the Fed and the Bank of England have been pushing money at the banks for the past 18 months - and for good reason. In the process they have massively expanded their balance sheets. And that, in the words of Ben Bernanke, is "effectively printing money".

Printing money may or may not be the same as QE. It may or may not be "unconventional". What matters is whether it works.

Update 1620: The Bank of England now has a news release and a Market Notice [76Kb pdf] about the Asset Purchase Facility.

Pushing string

Stephanie Flanders | 13:00 UK time, Thursday, 5 February 2009

It is hurting. But so far it isn't working.

The Bank of England has now cut interest rates from 5% to 1% since October. Savers say they are being punished for nothing - rate cuts are hitting their income, while having less and less impact on the economy at large.

Bank of EnglandThey have a point. The Bank's Monetary Policy Committee clearly thought this rate cut was worth doing. In its statement it reminded us of its view that "although the transmission mechanism of monetary policy (is) impaired, the past cuts in Bank Rate (will) in due course nevertheless have a significant impact".

It's possible it will cut again before thinking further out of the box than it already has. But there is a rising clamour among some City economists for the Bank to think and act more quickly.

I said yesterday that the major accepted cause of the US Great Depression was the Federal Reserve's failure to prevent a collapse in the money supply after the stock market and financial panics of 1929-31.

For at least a year now, the Bank of England has been trying to avoid that mistake - by pumping liquidity into the banking system and slashing interest rates.

That policy has expanded the narrowest measure of the money supply - cash balances held by banks - and dramatically expanded the balance sheet of the Bank itself.

But, as Jamie Dannhauser at Lombard Street Research has pointed out, all these efforts have not had much effect on growth of the broader money supply.

That is the measure - known as M4 - that matters if you want to get money moving around the economy and prevent deflation.

Dannhauser says that, once you take account of some big distortions in the figures, the broader stock of money was actually shrinking in real terms in the second half of the year. And it's moving in the wrong direction.

By the Bank's own reckoning, M4 was growing at an annual rate of 3.7% in the third quarter of 2008. It should publish its own estimate of what happened in the last quarter of the year in next week's Inflation Report. But based on the bank deposits and lending figures released today, Dannhauser thinks the annual growth rate for the fourth quarter will be around 1.7% - negative in real terms.

Why do these arcane figures matter? Well, for starters, they help explain why the situation for British companies has deteriorated so much faster than people expected.

Survey after survey finds firms worrying about a lack of cash and working capital, and the figures bear them out.

Money balances in the non-financial corporate sector have fallen nearly 10% in real terms over the past year - despite all the efforts of the Bank.

Today's Bank figures show that the deposits of non-financial companies fell by £6.9bn in the fourth quarter, while lending was essentially flat

It brings us back to the old Keynesian phrase about "pushing on a piece of string". The money is going into the banking system but it's not getting through to the broader economy.

Until that happens, the threat of deflation will loom large over Threadneedle Street. And there'll be more calls for the Bank to bypass the banking system, with a big "unconventional" yank on the string from the other side. I'll say more about that big subject in a later post.

Protectionism wasn't the problem

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Stephanie Flanders | 08:50 UK time, Wednesday, 4 February 2009


Politicians and commentators keep warning that "protectionism is what made the Great Depression Great". It's a good line. Pity it isn't true.

Before you ask, I'm not endorsing protectionism. Or suggesting it could be a route out of our economic troubles. But it didn't cause the Great Depression.

If that sounds too heretical for the BBC Economics Editor, I should tell you that the US Federal Reserve chairman, Ben Bernanke, agrees.

Academics have been arguing over the causes of the 1930s slump for decades. I can't do justice to the arguments here. But I've been going back over the competing theories. Protectionism and the infamous Smoot-Hawley legislation raising US tariffs in 1930 are surprisingly low on the list.

A crude summary of the state of academic thought in this area would be "Friedman & Schwartz meet Eichengreen, in a world of bank panics and John Maynard Keynes".

Let me explain. In a classic work, Milton Friedman and Anna Schwartz say the US downturn of the 1930s was the Fed's fault, by failing to inject cash into a fragile banking system after the crash of 1929.

At a party for Friedman's 90th birthday, Bernanke (then a Fed Governor), said: " I would like to say to Milton and Anna: Regarding the Great Depression - you're right, we did it. We're very sorry. But thanks to you, we won't do it again."

But didn't protectionism help transmit America's problems around the world? Well, not really. Bernanke, Barry Eichengreen and other distinguished economists have established pretty convincingly that it was the gold standard that helped turn a mismanaged US stock market crash into a global slump - by causing a prolonged and devastating period of falling prices.

It was the gold standard - in effect, a fixed exchange rate system anchored by the price of gold - that led the world's leading economies into a deflationary spiral. That was because the only way for deficit countries to stem the resulting flow of gold - money - out of the country was by shrinking domestic demand, which led to a further downward spiral in prices and incomes.

Since everyone was doing the same thing (and surplus countries like the US were not allowing inflows of gold to stimulate demand), this didn't help countries out of their hole - they just collectively dug themselves deeper and deeper. The first countries to dump the gold standard were also the quickest out of deflation and the quickest to recover.

The depression certainly did see a collapse in global trade and capital flows, and a descent into protectionist tariffs and laws. But a fair reading of the evidence suggests these were more the result of the global downturn than the cause.

According to Peter Temin, a distinguished economist at the Massachusetts Institute of Technology, exports were 7% of American GDP in 1929. They fell by 1.5 percentage points in the next two years.

Given the fall in world demand in those years, not all of that fall can be attributed to other countries' retaliation against the US tariffs. And even if it were - overall, GNP over the same period fell by 15%.

So, on any reasonable assumptions, Temin says "the fall in export demand can only be a small part of the story." And, as he points out, even that loss in foreign demand from the tariff would have been partly offset by the fact that the tariff diverted demand from foreign to home-made goods.

His conclusion? "Any net contractionary effect of the tariff was small."

This shouldn't come as a surprise. Even the greatest fans of free trade would admit that the benefits of lower tariffs - or costs of higher ones - are fairly small beer when compared to the kind of collapse in incomes and employment we saw during the depression.

To repeat, I'm not endorsing protectionism, or a policy of "national self-sufficiency" (though intriguingly for his modern admirers, that's what Keynes supported in 1933).

The world is more interconnected than in the 1930s, and in the financial realm, especially, the crisis is going to require international cooperation to fix. That's not going to happen if countries are at each other's throats.

But in constantly warning against overt protectionism, governments may be once again overstating their capacity to affect events.


The better lesson of the 1930s may be that you don't need tariffs or a revolt against foreigners to cause a collapse in world trade and capital flows. A fully-synchronised global downturn can do that all by itself.

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