The Best Laid Schemes

The plan to give the president of the European commission an electoral mandate has fallen at the first hurdle when the group of European socialists and democrats failed to attract interest from major political figures.

Political circles in Brussels have been buzzing with the idea that the next commission president, to be appointed next year, should be elected through the European parliament elections in June. The plan was that each major political group would identify its candidate for the post in advance and the candidate of the leading party would be elected commission president at the parliament's first session. The plan would make the commission president more like a prime minister than a bureaucrat.

To this end the socialist bloc had set a timetable for primary elections to run from November to February, with the candidate formally chosen at a congress on 1 March. Unfortunately when nominations closed there  was only one name, Mr Martin Schulz, a Brussels insider with no ministerial experience. Currently president of the European parliament, Schulz's only executive experience is as mayor of Würselen in 1987-98.

Since the 1990s the president of the commission has been chosen from among former prime ministers. (The current president was PM in Portugal and the president of the European council was PM of Belgium.) No socialist former (or current) prime minister was willing to stand as the socialist candidate. Nor indeed was any senior minister from any of Europe's recent socialist governments.

The reasons for the lack of strong candidates will be the topic of much analysis and debate. Is the job of commission president no longer attractive enough, now that the council also has its high profile president? Is there a lack of confidence in the process, given that the council still has to nominate the candidate before the parliament can elect him or her? Or are there other reasons?

Having made a commitment to put the candidate at the head of their campaign for the European parliament, socialist parties are now saddled with their uninspiring choice.

Banks: Collecting the Rent

Since the start of the crisis I have been trying to understand how it is that banks (and the finance sector more generally) extract rent from the economy. I once quoted Simon Wren-Lewis asking the right question:

Did innovation and deregulation in that sector add to social welfare, or make it easier for that sector to extract surplus from the rest of the economy?

To explain how far I've got in my thinking, I will need to make some gross simplifications about how banks work. Bear with me, it help to gain an insight into the subject.

The first step is to see that banks profit margin comes from the difference between the interest they pay (to depositors or bond holders etc) and the interest the charge to borrowers. Out of this margin they pay their running costs and the rest is net profit.

The next step is that banks make money from all the loans they have issued, which are recorded as assets on the banks balance sheet. So as a first approximation its rate of profit can be seen as its total net profit divided by its total assets:

profit/assets 

 

Banker however do not pay much attention to this ratio. They are more interested in maximising the return on equity, that is the highest profit for the shareholders' capital.

profit/equity

 

An interesting analysis piece in the FT explained why bankers have an incentive to watch ROE:

...return on equity... is a benchmark that investors use to compare stocks and it is also used in the calculation of bankers’ bonuses.

Now comes the clever bit. We can analyse ROE with this equation:

 profit/equity = (profit/assets) x (assets/equity)
 

The first term in the equation is return on equity (ROE). The second term can be considered to be the rate of profit on its loans or "profit margin". The final term is a measure of how much the bank funds itself through debt rather than equity. So the equation says:

ROE = profit rate x leverage
 



Here is an example. Before the crisis, a high street bank might have had profits of 4 billion on assets of 800 billion and equity of 20 billion. So its ROE was 20%, its profit margin was 0.5% and its level of equity at 2.5% of assets gives a leverage of 40:

20% = 0.5% x 40
 

Notice first how tiny the rate of profit is. For a non-financial company its total profit is the rate of profit times the amount of sales. So to make a decent level of profit banks need to sell lots of loans. That is what happened. Banks turned from being prudent institutions safeguarding our money and making loans to good customers to become selling machines pumping out loans to the next mark customer.

Next look at the level by which ROE is boosted by leverage. A small profit is boosted to a large profit (40 times larger) by using debt. If the bank increased its equity from 2.5% of assets to 4% of assets, it leverage would be 25. In the example above its ROE would fall to  about 12.5%. (Actually not quite as it would need to pay less in interest on the equivalent of 1.5% of assets so its rate of profit would rise slightly.)

The problem is that this level of leverage is dangerous. If it makes loses in one year equal to 2.5% of assets then the equity is wiped out and the company becomes insolvent. For any other type of company it would drive up its cost of debt. Banks by contrast have had an implicit guarantee that the state would come to the rescue.

This then is how banks extract rent, by expanding the amount of loans they make beyond what is prudent, and using debt to magnify the return on equity. In the process they create a highly unstable economy where the public ends up paying the bill.

Two final points. The equation profit/equity = (profit/assets) x (assets/equity) is one of the three equations to explain the crisis that I promised some time ago. The others will follow later. Secondly, I've avoided discussing the Miller-Mogdliani thoerem, partly to keep it simple and partly because I want to post a review of Admati and Helliwig's The Bankers New Clothes before getting into that one.
 

Essex Economics

Definition:

Essex economics is an approach to economics which relates all economic topics or news to the impact on house prices. It is widely followed in early 21st century England.

Example:

Newsnight sent a team to Essex to investigate the impact of low interest rates on people living on fixed incomes including savings. They returned with a report on home ownership in one Essex town and buy-to-let in another.
 

Key concepts:

In Essex economics the only investment considered is purchasing a house; commercial investment means purchasing a buy-to-let property. Interest rates are a major topic as it affects the cost of mortgages. Economic crises are synonymous with falling property values. The most watched indices for Essex economics are known as the Nationwide and the Halifax.

 

The related political economy requires politicians to promise to ensure ever increasing values for residential property. (See eg Help to Buy)

Forever Blowing Bubbles

From time to time it is good to look at the Nationwide's index of house prices to see how overvalued housing still is. I tend to follow the ratio of prices to earnings for first time buyers. This time I have put the long run average on the chart. The long run average for house prices is 3.4 times average earnings for first time buyers.

Source: Nationwide

I'm not sure that the long run average is the right measure of where a sustainable ratio should be. About 18 months ago when I looked at these figures the long run average was 3.3 times. The longer prices remain high the higher the long run average becomes. I once used a trend line from 1983 to 2003 and projected it forward. This gave a flat trend close to 2.9 times.

I previously pointed out the irresponsibility of a government boosting house prices in these conditions. It is pleasing to see that this view is widely shared, at least outside the government's supporters.

I worry more about the consequences of the next fall in prices. The best we can hope for is that house prices stagnate while earnings catch up. Unfortunately at present the opposite seems to be happening.

Update: small correction to improve clarity.

Some Last Thoughts on Saving

I have a few final thoughts on the subject of saving, before I get back to my promised posts on the three equations to explain the crisis.

Firstly, here is the World Bank series on real interest rates, posted for no other reasons than it is interesting to see, and because someone asked about the more recent data.

Source: World Bank

My other thought is what do we mean by saving. A lot of comments concern incentives to save. One idea of saving is someone putting money away for a later date. I think that is what Frances Coppola had in mind when she talked about savers complaining about low interest rates.

The savings data I have used is aggregate saving and so includes negative saving as well as positive. Positive saving happens when people consume less than their income and put the difference in the bank. Negative saving occurs when someone consumes more than their income and fills the gap by borrowing or running down their capital.

So when we think of incentives it is important to see both sides. There is perhaps here a difference of perspective. Looked at from the point of view of banks what incentivises their customers to save or to borrow is an important question. Indeed saving and borrowing are seen as very different activities. To an economist who thinks in aggregates, they are two aspects of the same thing.

The difference between banking and economic perspectives is a big topic and one I would like to explore, when work and family life allow.

One point I haven't touched on is investment, by which I mean the purchase of real capital assets. (The purchase of financial assets is a type of saving.) I tend to look at these things from a simple Keynesian perspective where income is split between consumption and saving; and saving is used to finance investment.

Savings and Real Interest Rates

Following up on yesterday's post, do higher interest rates incentivise saving? Do lower interest rates encourage people to save more to meet a savings target? Or is saving unaffected; people save what is left over after paying for everything else?

It is an empirical question, and so I have tried to find data to provide an answer. I was not happy with my first go because the data I had was for nominal interest rates. To strip out any effects of inflation I have found data on real interest rates from the world bank. Combining this with the ONS data on savings rates (via the BoE) for 1967-2009, I have produced this scatter chart.



Source: World Bank, ONS via BoE

Is there a correlation? I have put a trend line on the data, but don't take it seriously. The R squared is less than 0.01, which means that the savings rate is independent of the interest rate.

On a loanable funds model this implies a vertical supply curve, just like my old textbook said.

The same caveats as yesterday apply. This is one country over one period and done in a rush. Other empirical analyses are welcome.

Savings and Interest Rates

Frances Coppola has been writing about what determines the interest that savers earn on their accounts. On Twitter she asked what do we mean by savers, people who save out of current income or people who hold savings accumulated over time. During the discussion we got into how interest rates affect decisions to save.

To me that is an empirical question. Do higher interest rates incentivise saving?  Do lower interest rates encourage people to save more to meet a savings target? Or is saving unaffected; people save what is left over after paying for everything else?

When I studied macro we had a diagram which showed the loanable funds theory of interest rates. (The interest rate is the price that matches the number of borrowers to the number of savers.) In this diagram the supply curve was vertical, meaning that the level of saving was independent of the interest rate. I always wondered if that really was the case. As I say it is an empirical question.

Using some data I have to hand (The BoE's useful three centuries of data series). I have done a scatter chart.

Source:BoE and others

I have used long run government bond yields as an index of interest rates and the savings rate in the UK from 1948 to 2009. This data is not ideal, but it gives a quick and dirty answer. Other countries and time periods might give a different result.

The answer is that the savings rate is higher when interest rates are higher. The R squared is 0.59 suggesting that interest rates explain 60% of the increase in savings. In the loanable funds model the supply curve would be upward sloping.

The one issue I am aware of is that I have not controlled for inflation. It would be better to use real interest rates, which I will do when I can look for another data series.

Say It Again, Sam

I tweeted, early this morning, a piece by Samuel Brittan in today's FT. I quoted:

No so-called banking union will suffice while these imbalances remain

 Which chimes with my own scepticism that banking union is neither necessary nor sufficient to deal with the Eurozone's problems. Now I am fully awake I have second thoughts. Did I fall into a rhetorical trap? Here is what he meant by "these imbalances":

Since the euro was inaugurated in 1999, German unit labour costs have risen by less than a cumulative 13 per cent. During this time, Greek, Spanish and Portuguese labour costs have risen by 20 to 30 per cent, and Italian ones by even more.

Of course, banking union is not meant to deal with the problem of competitiveness diverging between Eurozone countries. You see the trap. It reminds me of a recent article by Ken Rogoff where he argued that Keynesian stimulus to demand would not work in the Eurozone; what was needed was to fix the banks. So fixing the banks will not resolve the competitiveness problem and boosting demand will not fix the banks and, I suppose, sorting competitiveness will not boost demand.

There are in fact three problems in the Eurozone:

• a financial crisis, in which many banks' solvency is questionable;
• a recession caused by a lack of demand; and
• imbalances in competitiveness (by which I mean misaligned real exchange rates).

A solution for one is not the solution to all. Banking union is intended to deal with the financial crisis, not the competitiveness crisis, and boosting demand is meant to deal with the recession. Where Sir Samuel and Mr Rogoff are correct is that solving only one problem is not sufficient as the three issues interact. So we need to stimulate demand and fix the banks and somehow deal with the effects of different rates of inflation in the Eurozone.

In the heading of this blog, I say that Equals, as in equations, will not fear algebra. I actually have in mind an equation to explain each of the problems. When I find the time I will blog on each.

Economic Policy or Business Policy

A story in today's FT illustrates something I have been thinking about recently. Policies which are good for business are not normally good for the economy. Too often governments present their business friendly measures as boosting the economy. Policies to promote business usually serve the interests of the incumbents. The upstarts and the new businesses which economy friendly policies would encourage have no voice, because they don't yet exist.

The Economist newspaper understands this distinction, although it tends to couch the argument in free market terms. Governments, it argues, should promote competitive markets; businesses prefer markets distorted to give them the sort of advantage that allows them to collect extraordinary profit.

Today's story concerns a falling out between the telecoms industry and Neelie Kroes, the European commissioner trying to update telecoms regulation.

Chief executives from some of the biggest telecoms groups in Europe will meet Ms Kroes today to give their views with Etno, the trade body for the incumbent operators.

Ms Kroes wants to end roaming charges in the EU (an obvious single market measure) and make changes to the way network operators sell space to other phone companies. The industry is furious. I should say "the corporations who benefit from the current arrangement are having a tantrum." They claim that without the profits the current setup provides they will not be able to pay for investment in new generation networks.

(A economist would point out that it is not current profits which incentivise investment but the prospect of future profits as a return on the investment. The source of finance for the investment - retained earnings, new equity or borrowing - is irrelevant. If the incumbents don't want to do it they should move over. New entrants will make the investment and reap the reward.)

What caught my eye was this comment by an unnamed EU official:

"One of the things that is very hard for us to illustrate is that this package will be helpful for thousands of companies that don’t exist yet – even will help them come into existence."

Ms Kroes was particularly blunt:

“There are several stages of grief – from denial to anger to bargaining to acceptance. That applies equally to a person facing a divorce or a company facing the loss of a cash cow," Ms Kroes told the FT. “What will improve investment are measures to improve wholesale price stability and regulatory certainty and measures to remove single market barriers.” 

Neelie Kroes gets the difference between a policy for business and a policy for the economy.

My reasons for thinking about the subject have more to do with British politics. The Conservatives are firmly in the camp of business friendly policies. This should open an opportunity for Labour to position itself as pro-economy not pro-incumbent. Sadly it seems that this opportunity is being missed. I would argue, for example, that the BIS department should become the department for economic development. I favour a dynamic economy of change, challenging the monopoly power of incumbents, removing barriers to entry, facilitating the access of upstarts and mavericks and increasing consumer power in the market.

If a Dutch liberal can get it, can't Labour?

Will TTIP Create Jobs?

Last Monday the prime minister gave enthusiastic backing to the proposed EU-US trade deal, known as TTIP. Among other things he proclaimed:

Two million new jobs

 According to theory trade has economic benefits, but job creation is not one of them. The reason why trade doesn't reduce unemployment is quite simple. The Bank of England and other central banks watch the unemployment rate. When it gets too low (below the "non accelerating inflation rate of unemployment") they tighten monetary policy and so push unemployment back up. So trade deals don't push unemployment below the NAIRU. Of course unemployment fluctuates with the business cycle, but trade impacts the long run, not short run fluctuations.

So where did Mr Cameron get his 2 million figure? I found this study which gives the same number. It claims a sophisticated methodology for its analysis of the employment benefits of  TTIP. Here is where they give themselves away:

the numbers presented below are to be considered long-term results or equivalent to changes in employment independent of the economic cycle. That means, for example, that a 1 percentage point drop in the unemployment rate reduces the unemployment rate during both an upswing and a downswing of the economy by 1 percent.

So if the central bank thinks that full employment (NAIRU) is 6% will TTIP mean that it will accept unemployment at 5 %? No, it will raise interest rates when unemployment falls to 6%.

In the long run all economies can reach full employment with or without TTIP.  Of course cyclical unemployment remains, which even this study accepts is not affected by trade deals.

The Economy Is Not a Race

I've mentioned before the new Tory narrative - that Britain is in a race and the economic challenge can be reduced to its ability to compete. The fact that I hear the same rhetoric from different ministers convinces me that this is a coordinated message.

Of course it is nonsense. One country's economic success can benefit other countries. Stronger growth in the eurozone would generally support growth in Britain.

Samuel Brittan goes off message to demolish the narrative in today's FT, "Politicians should stop their talk of competitiveness" He points out:

for a country or area with its own currency... its competitive position is entirely a matter of its exchange rate

His point not only undermines Mr Cameron's cozy story, it also flatly contradicts the view Mrs Merkel pushes on the Eurozone. For example:

The competitiveness of countries depends on many more issues than just weighing up imports against exports.

Samuel Brittan is right, politicians who see the economy in terms of competitiveness are capable of doing great harm.

The Euro Crisis Can Be Solved

The only solution to the Euro crisis is more Europe, for example* Joschka Fischer said:

The price of the monetary union’s survival, and thus that of the European project, is more community: a banking union, fiscal union, and political union.

 There is not the political will for more Europe, and the longer the crisis goes on the more support for Europe evaporates:

Support for European economic integration is down over last year in five of the eight European Union countries surveyed by the Pew Research Center in 2013.

The only conclusion is that the long grind of austerity in the periphery will continue , or the Eurozone will fall apart.

The pessimism is congealed in this post by James Haley . There are two paths, he says, banking union or grinding internal devaluation. When I read it I thought, no there are other paths. The point of this post is to illustrate one.

The key to fixing the Eurozone crisis lie in repairing its broken banking sector. European banks have yet to recognise the losses on their dubious loans. European countries have not the funds to bail out their banks nor nor to pick up the tab for closing them down. Ireland tried and found itself in a sovereign debt trap.

On the whole, the Eurozone can afford to bailout or close down insolvent banks. That is why banking union is seen as a solution. There is enough room to raise the funds to pay for a programme to resolve and recapitalise Europe's banks.

Here is my proposal. Instead of new permanent institutions we could look to a one-off solution. The institutions for assessing the needs of banks for fresh capital or for closing down insolvent banks already exist. Bank stress tests have been conducted. They can be done again, but this time for real. The ESM has the power to invest directly in banks rather than forcing their home country to take on the debt.

The remaining problem is that this exercise will be costly. The solution is a one-off bond issue jointly guaranteed by all Eurozone countries. The EU already raises funds this way, but on a much smaller scale to support for example the European Investment Bank. Making the exercise a one-off can be used to create incentives for banks to come clean on their problems.

Let me anticipate two objections. One, why would Germany go along with this plan? Two, if it is done once it can be done again.

Germany has been reluctant to see Eurobonds, mainly because of moral hazard. This is different because it would be for a specific purpose, not directly funding individual governments but solving a Europe wide problem. Germany's own banks would benefit, both from recapitalisation and by removing the risks of default by some of their borrowers.

On the second objection. It would be necessary to follow up by making financial supervision more national. This would mean rolling back the single market for this sector so that banks which want to offer services in another Eurozone country would need to create a subsidiary which was separately capitalised and under the supervision of the host country.


*Joschka Fischer is not alone. Yesterday I picked up El Pais in a cafe and found Javier Solana, Felipe Gonzalez and Jacques Delors making the same point.

Exit By Accident

As Mr Cameron loses control of his party, the country is once again heading towards leaving the EU by accident. It is evident that Brexit is supported by a minority of the country's political class. None of the leaders of the main political parties favours the idea, nevertheless we could find ourselves on the outside before the end of the decade.

Mr Miliband has been too astute to fall into the trap of matching the Conservative pledge of a referendum. Not only would that increase the risk of exit by accident, it would legitimise the Tory right and embroil Labour in an issue which is best left to the fanatics, rather than keeping the focus on jobs and growth.

Labour needs a line on Europe that allows us to watch from the sidelines while the other lot tear themselves to pieces. The line should remain that Europe is changing and we should not make a decision until the Eurozone crisis is finally resolved.

We could add that the Euro may not survive another five years. Mr Kai Konrad, who chairs the advisory panel of the German finance ministry, recently declared that

I would only give the euro a limited chance of survival.

The break up of the Eurozone would be immensely disruptive and costly, not just to its members but also to its trading partners. At the same time it would present Britain with a new challenge to help rebuild Europe in a different form.

A European Union after the Euro would be a very different proposition from the present set up. The key lesson of the failure of the single currency would be that integration needs a more cautious and pragmatic approach.

Which is very much what Britain wants from the EU; a sharing of power where there is a clear benefit while avoiding grand schemes driven by dreams of unification for its own sake.

Now is not the time to talk of leaving the EU. It might be worth thinking about how to help the EU backtrack on its single currency.

Umm... Well... Uh... Bye then.

One in Four African Countries May Double GDP This Decade

For a change here is some good economic news. From the World Bank's latest Africa's Pulse:

About a quarter of countries in the region grew at 7 percent or better, and several African countries are among the fastest growing in the world. Medium-term growth prospects remain strong and should be supported by a pick-up in the global economy, high commodity prices, and investment in the productive capacity of the region’s economies.

Seven percent is pretty good. It is not a threshold, or a tipping point, but as a growth rate it has the neat quality that 7% is about what you need to double in size in ten  years. 

Growth alone does not guarantee development, and the report points out that poverty reduction lags behind the economic performance. This is basically good news; for many people the world is becoming an easier place to live.

Moving the Threshold

It seems that the tipping point for the decision by Fitch to downgrade the UK credit rating was their forecast that gross government debt would pass 100% of GDP. FT Alphaville reports:

Fitch now forecasts that general government gross debt (GGGD) will peak at 101% of GDP in 2015-16 (equivalent to 86% of GDP for public sector net debt, (PSND) and will only gradually decline from 2017-18. This compares with Fitch’s previous projection for GGGD peaking at 97% and declining from 2016-17 and the ‘AAA’ median of around 50%.

It looks like: 97% good, 101% bad.

It comes at the end of a week when we have been celebrating the demise of the myth of the 90% threshold for debt to GDP beyond which lay catastrophe.

A 100% the threshold doesn't make any better sense than 90%. In fact as Frances Coppola pointed out yesterday, the debt ratio is a poor way to predict the health of an economy. It is even a poor way of looking at the health of public finances. She explains it like this:

Debt/GDP is a pretty confusing metric, since it compares a stock and a flow. It would be more meaningful to compare fiscal deficit/GDP. But even that is not ideal, since GDP measures activity in the economy, not government income, and the government income figure is netted with spending to give the deficit. The reality is that governments do not have to pay all their debt off in one year - in fact most governments pay off little or no debt. What they have to do is service the debt. And their ability to service the debt is governed by two things: 1) the interest rates prevailing on outstanding debt stock and on new issues during that period: 2) revenue from taxation and other income.

What does it mean to say that national debt is 100% of a country's annual income? It means  that debt is 50% of two years income, 25% of four years income or 10% of ten years income. That is what happens when you mix a stock and a flow. I've talked before about how government's can run deficits forever, provided the economy is growing.

The reasoning behind Fitch's downgrade is flawed and we should take no notice. Unless, like Ed Balls you want to add to Mr Osborne's discomfort.

Begging the Queston

Yesterday's post was a bit long winded (by my standards) but the fuss over that paper has helped me refine my critique.

Never mind the economics or the maths, the problem I see in Reinhart and Rogoff is an error of logic. The idea of a 90% threshold is an assumption. It cannot therefore be a conclusion.

I can expose the logic using an old fashioned syllogism:
High debt correlates to low growth
The threshold for high debt is 90%                        
Therefore 90% debt is the threshold for low growth

If the premises are true so is the conclusion. R&R put a lot of effort into establishing the first premise but none at all into the second. It is an assumption.

Assuming your conclusions is the logical fallacy of begging the question, or as the ancients called it petitio principii. I have long supported the idea of teaching logic in schools. I now think it should be a compulsory subject for economists.

The 90 Percent Solution

Economic growth slows when public debt passes a threshold of 90% of GDP.

This factoid (or as economist prefer "stylised fact") had become part of the armoury of those defending austerity. It is now officially nonsense.

The idea came from a paper by Reinhart and Rogoff, the authors of an acclaimed book on financial crises, This Time Is Different: Eight Centuries of Financial FollyThe 90% myth however is from a different paper. That paper has recently been found to contain some errors of arithmetic which when corrected makes the 90 threshold disappear.

The paper has been criticised before, for example by Krugman , but now it is discredited. However I have always argued that the methodology, or the logic, was flawed. The two economists examined a vast dataset of countries with various levels of debt to GDP ratios. Here is how I explained the error of logic in an earlier post:

The paper simply slices the data into four sets where the debt ratio is below 30%, 30%-60%, 60%-90% and above 90% and then compares median and mean growth rates. So the 90% "threshold" is manufactured by the methodology. It does not emerge from the data.

In other words they chose 90% and so cannot conclude that 90% is a threshold. As an error of logic it is known as petitio principii or begging the question or a circular argument. What if they had cut the date into 20 % chunks instead. Would we have had an 80% threshold or a 100% threshold?

Indeed looking at the footnotes of the original paper we find that the authors were aware of this problem, (although it didn't prevent them boldly stating their conclusion):

The four “buckets” encompassing low, medium-low, medium-high, and high debt levels are based on our interpretation of much of the literature and policy discussion on what is considered low, high etc debt levels. ... Sensitivity analysis involving a different set of debt cutoffs merits exploration ...

At last, the notion of a threshold can be junked because of a mistake in a speadsheet. But don't let that put you off the book. It is in a different class altogether.

Mr Osborne's Tangential Relaionship With Truth

After quoting from Mr Osborne's budget speech in my last two posts I am left a little queasy. As usual his words don't connect to reality in a direct way. Look at his claim that:

In places like Edinburgh and London, we have a world beating asset management industry.

Well, if you read to the end of my post you will have noticed that Britain's fund industry is only world beating in a world where Dublin and Luxembourg don't exist.

Take this example from my last post:

Many observers of the British tax system complain that it has long biased debt financing over equity investment.

The point he is referring to is that dividends are paid out of profits after tax while interest is paid from pretax profit. So it is cheaper for companies to raise funds from bonds than shares. We are talking about 20% corporation tax, not 0.5% stamp duty.

So how much difference does stamp duty make to the cost of capital? while corporation tax is paid every year, stamp duty is only charged if shares are sold and it is not charged when a company first issues its shares. So basically, not much. It is a tax on speculation rather than companies seeking finance. The effect of the cut will be an incentive to speculation.

It is tempting to propose Mr Osborne for the Pontius Pilate "What Is Truth" award. But at least Pilate was interested in truth.

Stamping Out Duty

While we are on the subject of stamp duty, this is a tax where I would favour extending the base. Stamp duty is charged on the sale of shares at 0.5%, however it is not levied on the sale of corporate bonds or other forms of securities. This seems unfair. As the chancellor said in his budget speech:

Many observers of the British tax system complain that it has long biased debt financing over equity investment.

So today I am extending stamp duty to apply to debt financing through bonds on an equal basis to shares. No he didn't say that. He said this:

So today I am abolishing altogether stamp duty on shares traded on growth markets such as AIM.

So while the rest of the world thinks that taxing financial transactions will help to stabilise their economies, Britain has a different approach.

In parts of Europe they’re introducing a financial transaction tax. Here in Britain we’re getting rid of one.

Labour should promise to extend stamp duty to sales of all traded securities equally, including shares, bonds, derivatives, mortgage backed securities, collateralised debt obligations ...

Island Nation Financial Centres

The Cyprus tragedy should also inspire us to think about its business model for banking. The island is a recent arrival to the world of offshore banking. Just like Ireland and Iceland the rapid growth of its banking sector spurred on by light regulation and low taxation left the islands vulnerable to the fragility of finance.

One concern should be the competition between jurisdictions to attract financial business. Competition for example over tax.

Which brings me to Mr Osborne's recent budget. Banks are not the only firms in the finance sector.

Financial services are about much more than banking. In places like Edinburgh and London, we have a world beating asset management industry. But they are losing business to other places in Europe.

We act now with a package of measures to reverse this decline – and we will abolish the schedule 19 tax which is only payable by UK domiciled funds.

Schedule 19 didn't make the headlines. It is the 0.5% stamp duty paid by asset management firms when investors sell out of the funds.

According to the FT:

Scrapping the so-called ‘schedule 19’ tax will bring the UK in line with Dublin, which also charges no tax, and make it more competitive than Luxembourg, which charges a small fee. Dublin and Luxembourg are the UK fund management industry’s main offshore rivals.

There are around £700bn-worth of UK domiciled funds, compared with about €2tn registered in Luxembourg and €1tn registered in Dublin.

I had thought that the government's policy was to re-balance the economy away from finance and towards other sectors, such as manufacturing. Now it seems tax cuts and regulatory reform are being used to boost the finance sector.

"An Approach We Should Take"

To answer my own question, I don't think that Britain will go the way of Cyprus. My argument is that Cyprus and its tragedy is a better pointer to the real problem than Greece and its troubles. While I wonder how much Russian money there is spinning through British banks, the real worry is the instability of the finance sector.

Not so long ago some commentators were proclaiming the end of the eurozone crisis. I was sceptical; the crisis was in remission, not cured. My opinion was based, not so much on the capacity of eurozone leaders for policy errors, but my awareness that the fundamental problems in the banking and finance sector have not been resolved.

There had been a plan for a European fund to recapitalise failing banks. When the time came for the fund to act in Cyprus, it didn't happen.  So when Mr Dijsselbloem, the Dutch chair of the Eurogroup committee said that the Cyprus solution "is an approach that we should take," he was right.

The shareholders and bondholders of failing banks should be the ones to take the loss, not the taxpayer. This is the approach that should have been taken when Ireland's banks got into trouble. Instead the ECB forced the Irish government to underwrite the banks turning the banking crisis into a public debt crisis.

The fear back then was that losses in Irish banks would undermine banks in other places whose failure in turn would lead to more failures with a cascade of banks collapsing like a line of dominoes. It could happen like that. The problems in Cyprus's banks were triggered by the losses on Greek bonds included in Greece's bail out package.

That is where my question could becomes serious. How are the dominoes set up and where does Britain's banking sector stand in the line up?


Mr Dijsselbloem implies that each country will be responsible for its own banks if they fail. While he has been forced to "clarify" his comments, we should still ask how big is the banking sector compared to a country's national income? I have found some ECB figures for the aggregated assets of banks and compared them to Eurostat figures for GDP.



Source: ECB, Eurostat

As you can see, Luxembourg and Malta are ahead of us in the queue.

Could We Be the Next Cyprus?

Back in 2010 the drive for austerity was driven by a fear that we could all go the way of Greece. The country's high level of government debt led to a crisis in which government could not raise funds from the market and was forced to accept an EU-IMF bailout with harsh terms and savage cuts.

Of course we in Britain, and most of Europe, were in a very different position from Greece. A financial crisis has caused the economic crisis and countries were badly affected even if they had low public debt before 2008. (Ireland and Spain had lower debt than Britain which was less indebted than Germany or France.)

Despite the fact that the problem lay in the banks, the narrative turned to public debt with Greece as the exemplar. The banks are still the problem and fixing the finance sector should be the priority.

Cyprus presents us with a new model. A small country whose banking sector towers over its economy. The aggregate balance sheet of the Cyprus banks is some 800% of the country's GDP. When the banks hit trouble can a small country cope?

Instead of worrying whether Britain could go the way of Greece, is this an opportunity to ask could we go the way of Cyprus? The aggregate balance sheet of banks in Britain is over 500% of GDP.

During the crisis the last government took action to stabilise the finance sector, recapitalising some major banks forcing others to recapitalise themselves and providing guarantees to keep them solvent. Since then the pace of reform has slowed. Each proposal has been compromised from the outset by fear of the power of the financial sector. Each proposal has been watered down further by financial sector lobbying.

Yet still the banks have failed to recognise the bad loans on their books, to raise their capital to a safe level, or to separate the activities which government should underwrite from those which should be at the risk of investors. Could Cyprus be the wake up call?

A Simple Keynesian Narrative

The coalition government has been remarkably successful in establishing its narrative that identifies the economic crisis with public debt. The falsehoods behind this narrative are well documented, but the success of this story will be halted not by argument but only when the electorate has grown tired of austerity which fails to lead to economic revival.

Recently, the prime minister has found a different narrative.We are in a race with other countries; emerging economies are catching up; we risk being left behind. Britain must be more competitive. This narrative is no more honest than the last. The global economy is not a zero sum game. One country's win is not another country's loss and new arrivals in the club of rich nations do not make the old members poorer.

I keep asking where is Labour's narrative?

The Tory narrative works because it deals with familiar ideas. Personal debt and household debt may be completely different from national debt but the Tory tale has a feel of familiarity. "Maxing out the national credit card" is an absurd notion, but it connects to how people feel when personal debt is out of control. Equally the global race sounds plausible not just to sports fans but to people whose only connection to racing is school sports day.

As a simple Keynesian I would like to see narrative which emphasises investment to boost effective demand and increase growth. The problem is that these terms lack the immediacy of the Tory metaphors. I want to propose one small step towards a more homely narrative.

Instead of talking about growth we should talk about income. The parallels between national income and household income may not be exact but it does open a way of connecting to people's experience. For example, if you are in debt one way out is to increase your income. Paying down the national debt will be easier if we increase national income.

Britain's economic problem is not debt, but the failure to increase national income. The government cannot increase national income itself, but it should remove the obstacles to increasing income. That is where the narrative turns to investment.  The language of investment should also connect to people's direct experience. We invest now to increase income in the future. We should avoid talk of "stimulus" and of tax cuts or deficit financing.

Investment is not just public, although that is needed. Equally important is removing the constraints on private investment, through reform of the finance sector including flagship projects like regional enterprise banks.

This is a small contribution towards constructing a coherent narrative to counter the Tory dominance of the political story.

The Pound in Free-Fall

There has been a bit of excitement in the last few days over the fall in the value of sterling. Here is The Sunday Times going over the top in a "news" story:

Experts warn there could be a major slide in sterling with the pound heading to parity with the euro for the first time since the financial crash of 2008-09.

Plenty of others have commented on the benefits of a lower pound, but my thoughts turned elsewhere. What is a reasonable value for the pound against the euro? Britain has experienced higher inflation than the eurozone in recent years and so you would expect the value of sterling to fall relative to the euro.

The OECD produces some figures on purchasing power parity (PPP), which compares the values of currencies in terms of what they can buy. This gives a quick was to estimate the fair value of the exchange rate (at least for the recent past). I have worked the figures to put them on a chart.


Source: OECD, author's calculation

So back in 2005 the PPP rate was 1.32 € per £. This fell rapidly to 1.15 in 2009 and has been at 1.13 € per £ since 2011.

A quick check of the FT shows the market rate is now 1.1655 € per £. So the current market value is probably sightly above the fair value, especially as inflation has continued to be higher in the UK than in the eurozone. The recent slide has in fact brought the market rate closer to reality.

Update: I could do the same for the pound against the dollar. The OECD figures suggests an PPP exchange rate around 1.47 $ per £ in 2011 and 2012. At the bottom of the recent slide the market rate remained above 1.50 $ per £.

1776 and all that

When Adam Smith said this, could he have foreseen Mr Osborne's policies:

To diminish the number of those who are capable of paying for it is surely a most unpromising expedient for encouraging the cultivation of corn.

Corn or anything else...

Prescient

Double Dutch

Only a few days of excited anticipation remain before the prime minister descends the chimney to deliver his carefully wrapped speech in the Netherlands. It is risky to offer a comment so close to the point when the ribbons come off and we all see what Mr C has for us. All the same, there is one point I think will be worth watching out for.

In all the build up to The Speech, it has been presented as focusing on the relationship between Britain and the EU. If that is its subject matter then I think the prime minister has already fallen into the trap of seeing the UK as external to the EU.

The alternative would be a speech on reforming the EU.  It is not just Britain who might seek a return of powers from Brussels. In the last two decades the French, the Dutch, the Irish (twice) and the Danish have all said no to some part of EU integration. Nor is the issue of a tighter eurozone group a concern only for the UK. Ten of the 27 EU member states (soon 11 of the 28) remain outside and risk losing influence if the inner core starts to dominate policymaking.

Comparisons with  the Bruges speech will be unavoidable. In that speech a previous prime minister set out an alternative vision for Europe, one in which sovereign states cooperated to their mutual benefit. In contrast the spinning of Friday's speech has prepared us for the opening bid in a Dutch auction.

Mr Cameron does not want to lead Britain out of the EU, but if his text really is as limited as we have been led to expect then exit by accident will become ever more possible.

The Fabian Pledge

The Fabian Society is asking its members to propose policies which could be included in a pledge card.

It is a nice idea, however once you start to formulate a pledge it becomes quite a complex task. On the one hand the pledge needs to describe the outcome, preferably in a concrete and measurable way. On the the other hand policy advocacy is concerned to propose the actions that would lead to the outcome. So "cut unemployment by 500,000" would be an outcome, but what policies would lead to that result?

The challenge forces you to look for a symbolic policy which provides an example of a deeper idea. Given my simple Keynesian approach I want to argue for more investment, but to what concrete result? I have settled on this idea:

We will build 100,000 affordable homes, sell them and use the proceeds to build 100,000 more.

It provides an example of a simple Keynesian policy. When the private sector is unwilling to invest the government can step in and undertake the investment itself. The resulting assets can then be sold to the private sector. It has the beauty that the initial borrowing can be repaid once the economy recovers simply by selling all the assets. In my pledge example, the government would borrow £3bn to build the houses which would be sold on the open market to households or housing associations, realising £3bn+ in revenue which can be used to continue constructing housing. Once the private sector begins to build again, the government scheme can be wound up and the money repaid.

I would advocate giving a government agency the responsibility of handling this fund. I would also back up the policy by creating compulsory purchase powers to allow the agency, or local government, to acquire any brownfield site which has had planning permission for housing for more than five years without the owner developing the site.

Conventional Folly

It is surprising how much of what passes for conventional wisdom is nonsense. Sometimes a quick check of the data is needed but often a moment's thought is enough to see through an idea which is taken for granted in the flow of a discourse, but is in fact not grounded in reality.

Europe's relative decline, which I wrote about recently is a good example. It should be obvious that if developing countries begin to converge economically with rich countries then Europe (or the US or the UK) will command a smaller share of global resources. Yet pundits fret about this change.

There are many other examples. On Twitter recently I encountered the familiar argument that when Britain joined the common market we were joining a trading block not the political and monetary union which the EU has become. You need to know a bit of history to refute that one, but the evidence is only a few clicks away on the internet.

Another one from Twitter was the claim that Britain's prosperity depends on the confidence of international investors. In fact the amount of foreign direct investment into Britain is a fraction of the flow of earnings into the country from British investments overseas.

It is not just in the new media free-for-all that this conventional folly is found. An opinion piece in today's FT claimed, "The eurozone countries are determined to move forward with political integration to save the euro." Everyone knows that political integration is what is needed to save the euro; but will it really and are the eurozone countries really so determined?

In each case conventional wisdom is used to support a political conclusion - in favour of a referendum on Europe, against quitting Europe, or taking a middle position on Europe. A rational debate deserves better.

I should take a bit of time on this blog to expose the folly of conventional beliefs.