Central Bank – Emperor's New Clothes

With the myth of its power having been shattered, central banks need to get nasty to win back respect

Central banks are looking a bit naked as if stripped of their power.  Previously, central bankers such as Alan Greenspan were held in awe and ruled over the hearts and minds of investors.  This position of power stemmed from the perceived ability to soothe the fire-breathing financial markets.  Yet, the global financial crisis and its aftermath have shown this to be but a myth.  Part of the problem was that central banks wanted to be liked and keep investors onside.  With its generosity proving its downfall, the naked emperor may need to stop being so nice.

Pretenders to the throne

This fall from grace has happened swiftly.  The powers of central banks reached their peak just before the crisis hit.  Quick to blow their own trumpet, economists talked of a “Great Moderation” – a prolonged period of steady and stable economic growth coupled with low inflation.   Central banks had also shown themselves willing to step in during moments of strife and prop up the stock market.  This won them a strong following among investors who could be sure that central banks would send in the cavalry if there was trouble. 

The proverbial crown slipped and fell dramatically with the global financial crisis.  Not only were central banks proved to be not suitable guardians of the economy but their capacity to rally at times of trouble was limited.  Low interest rates and quantitative easing offered little respite from the plague eating away at the economy.  The potency of central bank policy has been eroded as its primary source of power, the ability to print money, does not mean much in a world awash with money.

The problem was exacerbated by central banks not having the freedom to act as their almighty reputation might suggest.  Part of this was due to internal restraints such as a chronic (but misplaced) fear of inflation.  Such worries about rising prices keep central banks from unleashing their full firepower when faced with crisis.  In addition to this, politics also often acts to stifle central banks.  Germans’ heightened aversion to inflation has kept the European Central Bank from doing more.  The Federal Reserve has also had to be mindful that its actions did not draw ire from Republicans who are typically hostile to any government intervention. 

Cursed by hubris

It also became obvious with hindsight that central banks may have built their dominance on a dubious myth.  The “Great Moderation” may have just resulted from good luck rather than good management.  It is easy to keep inflation down when cheap goods are flooding in from China while money was cheap as China was sending a considerable portion of its earnings as reserves and sending it back to the US.  Yet, the misplaced belief in the rule of central banks over the economy lead to ignorance of risks that central banks thought they had slayed. 

Central banks were happy to live off this aura while also being generous in its dealing with investors.  Yet, this kindness turned out to have a cruel twist with the support shown by central banks to financial markets sowing the seeds of crisis.  Although lauded at the time, the reign of Alan Greenspan has instead been shown to be like a king trying too hard to please his subjects.  Over this period, the Federal Reserve kept interest rates too low while investors made merry amid a booming stock market.   

Better to be feared than loved

The unruly nature of financial markets coupled with the flood of cash sloshing around in global finance means that a guiding hand is needed more than ever.  Having been knocked from their high towers, central banks have to restore some assembly of order in a world where the pull of its ability to print cash is diminished.  It may be best to follow the words of Machiavelli, a renaissance philosopher who theorised on power struggles in Medieval Italy, in that it is better to be feared than loved. 

In this vein, if it was a need-to-be-loved that got central banks, and the rest of us, into trouble, it might be time to get nasty.  Taking a harsh line against any potential distortions in the economy (using macroprudential policies) would win more respect than being too friendly.  To rule with a firmer fist seems a better fit at a time when the consequences of financial excesses are so pertinent.  This would help to usher in a more peaceful period if combined with greater regulation to keep the banking sector from getting out of hand.  More stability may even get investors to appreciate the value of tough love.  

Monetary Policy – Losing its Power?

With the finance sector already awash with cash, we can no longer rely on central banks to help us out of trouble

After having worked like a charm for a long time, monetary policy now seems to be losing its mojo.  The source of power for central banks mainly comes through their tricks of printing money and controlling interest rates.  With many governments mired in debt, it has only been the wizardry of central banks that has stood between us and a greater tragedy.  It is of great concern that the capabilities of the once almighty central banks to manipulate the economy are under threat from the large amounts of liquidity in the financial system.  The spells with which central banks hold sway over the economy may amount to little more than illusion when there is already lots of cash around.

Where has the magic gone?

The power to create money seems nothing short of sorcery; however, the rise of digital cash means that it is in fact easier than ever.  Central banks have even lost their monopoly over generating electronic cash with normal banks able to pull off the same trick by making loans.  It was thought that control of interest rates would be sufficient to steer the economy through any ups and downs.  Yet central banks left interest rates too low in line with their narrow focus on keeping inflation in check and banks were free to churn out loans at an unprecedented rate.  The prices of assets such as property have surged upward as a result but only until the inevitable crash in prices.

Central banks stepped in with record low interest rates and new policy tricks such as quantitative easing.  Yet these measures lack potency considering that cash was already cheap and in abundance.  Both banks and businesses hoarded cash – the former worried about their own survival while the latter had few investment options available due to the weak economy.  To add to this, many emerging markets such as China had been building up massive reserves since well before the global financial crisis. 

With the international financial system already flooded with cash, it has been no surprise that monetary policy has not worked as well as expected.  It has been like trying to use sweets to modify the behaviour of a child that lives in a candy shop.  Instead of being much help, the extra funds from central banks have seen the financial markets deformed and distorted as if suffering from some form of voodoo.  Some emerging markets have also suffered from this black magic with their banking sectors unable to handle the volume of cash on offer.

Nothing up their sleeves

Central banks have been looking to develop new powers to influence different sectors of banking.  The Bank of England has been given greater scope to deal with a runaway property market.  Yet, the central bank seems ill at ease with its new policy options, such as restrictions on mortgages, and prefers to rely on its old act of manipulating interest rates.  If central banks no longer have the power to bewitch the economy, it will be tougher to clean up after a crisis like the one we have just been through.

This shifts the goal of policy to stopping problems forming rather than merely attempting to limit the ensuing trouble.  Restricting the dark arts conjured up by banks will be essential to preventing future disasters.  The fairy-tale time when we could believe in the magic of central banks may have passed – we will need to rein in the wicked elements of the economy now that there is nothing to save us from potential misfortune.

Banking – Let Financing Flourish

Banks have had to prune back their lending but other forms of finance have found space to blossom

Spring is in the air as a dark winter for the banking sector has allowed new forms of financing to take root.  A range of financing options has sprung up to service businesses left out in the cold by banks.  This is more than just a temporary reprieve from the current dearth of funds from banks.  It could instead be part of a bigger shift whereby banks are no longer the main source of lending.  This development appears to be a good thing for the economy but the full ramifications will only become clear with time.

Diversification in financing

Banks had long been the big trees in the financial jungle.  Their network of branches spread far and wide and claimed the bulk of the chances to provide funds to the economy.  Few opportunities filtered through to other forms of funding, which remained small in comparison.  The global financial crisis has opened up the possibility of change with banks having been poisoned by toxic debt.  Access to credit all but withered away after the crisis cut down a few banks and clipped many others.

The problems in the banking sector are mostly self-inflicted.  There is a glut of cash available for loans but banks are too concerned with their own survival to be in a position to facilitate lending.  A range of companies have sprouted up between the cracks to provide the funding needed to nourish the economy.  These new firms have been labelled as the shadow banking sector and tap into money from a range of sources such as pension funds and businesses outside of the finance sector, as well as from people like you and me through peer-to-peer lending sites. 

The diversity of routes for lending solves one of the problems with the banking sector.  Deposits were not enough to provide banks with all the money that was needed in the lead up to the global financial crisis.  Instead, banks sucked up funds from the money markets where it was possible to borrow for a few months.  This is not an issue when funds flow freely but the money dried up when the crisis struck.  On the other hand, the money being put to use by the new firms comes via an assortment of different arrangements and many, such as pension funds, are willing to offer up cash for longer periods.

When more is better

The growth of the many new sources of financing seems to be positive.  As in nature, higher levels of biodiversity help to build a more robust funding ecosystem.  Such funding operations are still just saplings.  Yet, there is the potential for a future forest of financing options.  Some parts of the new setup may even grow to rival the lending capabilities of banks.  This has only come about through the irony of banks jeopardising their long-term prospects and opening up opportunities for others due to their need to lend less to ensure short-term survival.

There is a further benefit in that any shrinking of banking operations should be beneficial over the long term.  This is because the current rules for banking mean that banks have too much scope to get themselves into trouble.  Not all is rosy however, with some of the new firms facing criticism from the public despite seemingly meeting a genuine need (such as Wonga).  The new range of financing options may also include potential problems lurking under the surface.  But this could be somewhat accommodated by central banks and other regulators broadening their oversight. 

The flowering of new funding options may be one of the few bright spots in the aftermath of the global financial crisis and could help to ensure that the economy won’t have to go through a drought in finance again.

Central Banks – false illusion of power

The Bank of England shows how little central banks can do with their limited resources

Everyone looks to central banks as the custodians of the economy.  Once upon a time, central banks were regarded as having almost mythical powers to control the forces of the economy.  However, this fairy tale was shattered by the global financial crisis and central banks have since been trying to regain their previous status as economic titans.  Central banks have fought back with extra powers such as quantitative easing which have helped bolster their popularity.  In contrast, the trouble that the Bank of England is having in dealing with the conflicting problems of a fragile recovery and a booming housing market shows central banks at their most impotent.

The myth and the reality

Much of what central banks do relies on creating a belief in their resolve and ability to call on seemingly unlimited resources.  Chronic inflation in the 1970s was reined in by central banks flexing their muscles and inflation has stayed low ever since.  Even in the throes of a crisis, the European Central Bank kept the Eurozone together merely by proclaiming that it was willing to do “whatever it takes” to do so.

With the power to print money, central banks have the godlike ability to create something out of thin air.  It is often only the ideas of economics that keep central banks from unleashing the full force of their powers.  The ability to summon money from the ether is of limited use when most economists are scared of rising inflation following an increase in the supply of money.  Economics has also restricted central banks to operating only in a small arena, which reduces their capacity to act as a power for good.

One example of this is quantitative easing which helped ease the pain over the downturn but came with side effects.  The purchases of bonds through quantitative easing helped to shore up the financial markets but did little to alleviate a chronic shortage of demand in the actual economy.  A slightly different way of using quantitative easing could have had more punch with less mess but also came with the possibility of some inflation. 

Like something from Greek tragedy 

The Bank of England operates in this world of possibilities, but with only limited options.  It has made use of what was available (low interest rates and quantitative easing) but the economic recovery has struggled to gain much traction even after five years.  Yet, the consequences of its policies have shown up as a housing market boom at a time when the Bank of England still has its hands full nursing the economy.

One thing that the Bank of England is missing is a bit of help from the government.  Not only is the government dragging down the economy with its austerity measures, but it is creating problems with policies such as Help to Buy which stoke up the property market just as the central bank is praying for it to cool down.  For all of their potential power, central banks still have to steer clear of politics putting any criticism of government policy out of bounds.  The government with all of its populist tendencies still trumps an institution established to look out for the long term health of the economy. 

Instead, the Bank of England and its governor, Mark Carney, have tried to use the media to communicate their concerns about the property market.  However, this is having little effect as the Bank of England can be ignored since there are few actions it could actually take to back up its words.  Its main weapon would be higher interest rates but the economic recovery is seen as not yet being strong enough.  It would be a shame to see the Bank of England fall from grace battling a wayward government and a run-away property market but it will take a heroic feat to stop that happening.

Banking – Back to Basics

Time for banks to return to their bread-and-butter operations after having almost poisoned the global economy

Banking is like food – best kept simple with as little processing as possible.  This is because, in their role as the intermediaries controlling flows of money in an economy, banks provide the nutrients which help the economy grow.  What was supposed to be a straightforward process became convoluted as banks cooked up ways to move loans onto others.  The resulting concoctions were devoured by investors around the globe, resulting in serious indigestion once the toxic nature of the ingredients was discovered.  Given that the packaging of dodgy debt was one reason for the scale and severity of the global financial crisis, the common sense move would be to change back to a plain vanilla variety of banking.

A recipe for trouble

We rely on food getting from the farms where it is grown to our supermarket shelves every day.  Too much or too little food would cause problems as would food ending up in the wrong places.  We also rely on banks to look after our money in the same way.  Savers leave their surplus cash in banks who make it available for others to borrow.  This simple analogy is how we tend to perceive the role of banks but, as with many things, the reality is more complicated.

Banks have access to a growing range of funds allowing them to lend as much as demand allows.  This gives them a substantial amount of control over how much money there is in an economy.  Central banks look to control lending using interest rates but the global financial crisis has shown that this is insufficient.  Interest rates tend to be too low when economic growth is booming, giving banks scope to lend more than is optimal.

This problem has been exacerbated with banks being able to sell on loans to investors in the form of bonds.  By passing on the risk associated with lending to others, banks circumvented the normal limits on lending and levels of debt exploded as a consequence.  Debt from banks was sold on as bonds such as CDO and MBS with this alphabet soup of financial instruments eventually proving sickening to the financial system.  Banks had our cake and ate it and the result has been years with the economy being starved of credit.

Creating these nauseating bonds was like using MSG to flavour food – an easy way to get an immediate boost but not good in the long term.  Most of us would steer clear of extra nasty additives in our food for fear of the future consequences.  Bankers, on the other hand, gobbled up any magic pills which boosted their profits in the knowledge that it would not be the banks themselves that would pay the price.  This is a problem which is endemic to banks operating without sufficient regulation.

Smaller is better

Considering the propensity for banks to poison the entire economy, their operations should be pared back to a more traditional and wholesome role.  One means to do this would be to limit the activities of banks and break up larger financial institutions that have parts which operate like conventional banks.  Banks should be limited to a scope within which they cannot get into trouble and need to rely on the government for support.  More speculative aspects of their business should be left to others who should be prevented from accessing our deposits.  Other forms of financing are flourishing and this is already replacing part of what banks do.

The basic idea behind this is already out there and is known as the Volker rule.  It has been endorsed in principle by many in politics including President Obama.  Yet, the implementation of this idea has stalled due to opposition from an unsurprising source - the banking sector.  This highlights another benefit of having smaller banks – a reduction in the dominance of the finance sector.  The wealth generated by banks has given them the political clout to push for more freedom to chase profits.  Banks have built themselves up to be the champagne in the economy (providing skilled jobs and lots of tax revenues).  Yet, since it is all too easy for the bubbles to go flat, a return to a bread-and-butter setup would be preferable.

No mystery behind banks behaving badly

Banks were misbehaving in the lead up to the global financial crisis but the blame lies elsewhere

Many fingers have been pointed (and fists waved) at the banking sector.  Bankers have been receiving massive pay-outs despite having acted irresponsibly in getting us into trouble.  While they deserve much of the blame for our current woes, it is like blaming students who are left in charge of running their own school.  Bankers were left to run their own affairs on the mistaken assumption that they could do so responsibly.  But the few rules in place to keep banks from acting out proved insufficient.  This raises the question – why were banks given so much leeway in the first place?

A recipe for trouble

Banks are in business to make money.  The most common way for a bank to do this is to loan out money at a higher interest rate than they pay to get access to the funds.  Given these basic guidelines, anybody running a bank would lend out as much money as possible.  This would not be a problem if there was only a relatively fixed amount of cash to go around.  To make more loans, a bank would have to get its hands on more cash which would involve higher costs if spare funds were in short supply.  The extra charges for banks would then result in higher interest rates and this would put off some potential borrowers.

Unfortunately, this is not how things work in finance.  Instead, using tricks such as electronic money, banks can create as much money as they want.  Any limits to lending have been further diluted as banks have come up with ways of getting loans off their books.  Financial wizardry has enabled loans to be repackaged as bonds and sold off to investors.  Such bonds (known as mortgage-backed securities) were popular due to a combination of a decent rate with seemingly little risk.  With lots of money sloshing around the global economy before the financial crisis, investors did not bother to delve into what the bonds actually entailed.

Banks had reduced their lending standards to include sub-prime borrowers as they no longer had to worry about whether the loans were actually repaid.  So what investors got were bonds that would drop in value once the debt-fuelled property boom came to its inevitable end.  The situation was made worse by the way in which bankers were paid.  Their substantial remuneration packages were linked to profits giving bankers an extra impetus to undertake risker actions.  Levels of pay got out of hand as it was easy to make money by tapping into the demand for credit. 

Even if bankers themselves were motivated to cash out after quick gains, it was thought that prudent business practices would keep banks running through thick and thin.  Yet, the number of banking bailouts showed that bankers favoured short-term profits (and big bonuses) over long-term survival.  With the government and the central bank expected to step in if banks got into trouble, it was worth taking extra risks as there were millions to be made and only the possibility of losing their jobs if things backfired.

No one in charge

With it seemingly obvious that bankers were heading for trouble, there was a glaring need for oversight and regulation.  Despite this, banks were increasingly given a free rein following a couple of decades of deregulation of the finance industry.  A wave of free market ideology had convinced a generation of politicians that any government interference would hamper the industry.  The result was that the finance sector was put on a pedestal and afforded the status of teacher’s pet as a source of tax revenues as well as jobs for skilled workers.

Any attempt at oversight typically succumbed to something known as “regulatory capture” where the government agencies designed to monitor the banking sector are too closely intertwined with the banks.  This is because personnel move back and forth between government and finance, always keeping the industry’s best interests at heart.  Even the central banks that were charged with ensuring financial stability did not find fault with the banks.

Instead of taking on the inherent problems in the banking system, central banks developed a narrow focus on inflation.  Interest rates were the main tool with which central banks attempted to rein in the vagaries of the finance sector.  But higher interest rates only target the demand for loans rather than the supply of credit from banks (who actually make more money when interest rates rise).  Interest rates went up too slowly to stave off the credit boom as easy loans from banks opened the way for us to get ourselves deeper into debt.  Given too much freedom, we can all get into trouble and banks have shown themselves to be no exception. 

Animal Spirits – Caging our Wild Side

Money can bring out the worst in people so it might be time to rein in the finance sector which offers ways for us to get into trouble

Economists tend to assume that we are all boring (and the feeling is likely mutual).  According to economic theory, we are thought to act in a rational manner, assessing how best to spend our cash like calculators with legs.  Not only is this an overly simplistic view but it has resulted in economists ignoring how our emotional sides affect the economy.  The global financial crisis is an example of what can happen when animal instincts such as greed and fear take over.  Economists need to take a closer look at how our emotions can drive the economy and how we can be saved from ourselves. 

Reality is messy

Economics is the study of allocating scarce resources.  It focuses on how consumers make the most from what they have.  At the same time, competition between firms ensures that products are priced efficiently so that as much output as possible can be generated from limited input.  Economists would like to think that our sober side helps keep everything running as it should.  But when money (and everything that money brings with it) is involved, our primal nature can take over with ugly consequences.

The worst of our traits kick in over booms and busts.  When times are good, we hear stories of people making easy money and we want in too.  Like greedy kids in a candy store, we buy a second or get shares in the latest stock market fad in the belief that prices are sure to rise further.  Prices will climb as the lust for more wealth attracts more and more victims.  But with gains in asset prices typically outpacing the rest of the economy, this can only last for so long. 

When asset prices start heading downwards, fear is the overriding response.  Companies slash plans for investment and lay off staff in order to stay in business.  Consumers also retrench by cutting back on spending and asset prices slide downwards as higher prices no longer seem sensible.  Assets often end up being sold off at bargain prices as cash is needed to pay off debt taken on during better times.  Fear also reached chronic levels among banks who would not even lend to each other in the aftermath of the global financial crisis.

How we get ourselves in trouble

Change is a necessary part of an economy developing over time as certain sectors expand while others wither away.  But what Keynes labelled our “animal spirits” result in periodic bouts of instability that can hamper the expansion of any economy over time.  Rather than dealing with our insecurities, most economists choose to ignore them.  A common argument used by economists is that financial markets constantly adjust to new information and reflect the true value of any assets.  Yet, sharp drops in stocks or house prices cannot be reasonably explained away with this line of thought.

The devastating effects of our emotions getting the best of us are evident in the wake of the global financial crisis.  Instead of ignoring base instincts, economists should be thinking of ways to rein them in.  One of the key ways for greed and fear to influence the economy is through the finance sector.   Banks are geared to generate as much borrowing as possible but their loans more often than not go toward speculative investments in property or stocks.  Such lending creates unnecessary instability with the economy as a whole suffering as boom turns to bust.

It is no coincidence that the worst recession of a generation comes at a time when the finance sector has grown to dominate many developed economies.  Limiting the scope of banks, with more rules following decades of deregulation, would be a good place to start improving the system.  Measures such as taxes on financial transactions would also take out some of the volatility from markets for stocks and bonds by pushing investors to take a more long term view.  Such policies may lead to higher fees for loans and lower returns from investing but the costs of continuing with the status quo will only mount up.  Better to save us from ourselves than to let our passions run wild and cause even more havoc.

China and its growing pains

The Chinese economy is treated like a problem child by the media but does not deserve its bad reputation

Growing pains have led to a lot of bad press recently for both China and Justin Bieber.  The development of both has been closely watched for any signs they are going off the rails.  Bieber has been much maligned for bad behaviour as he shakes off a boyish image.  China has been the driver of growth in the global economy but may not continue to fulfil this role.  Just like Bieber, much of the new stories on China are negative but China is different in that it does not deserve the harsh treatment in the press.

Big trouble in little China?

Like a spoilt kid growing up in front of the media, a developing economy can always expect a few troubles along the way.  Even more so when every step is analysed in detail as has been the case with the once-in-a-generation rise of a new superpower (China, not Justin Bieber).  The Chinese economy always seems to be on the cusp of a breakdown according to many experts.

The current concern with China is the high level of debt amid a surge in investment.  Some of the money has gone into projects that have not panned out as shown by empty housing apartments and dodgy infrastructure ventures.  The bulk of wayward spending tends to turn up in out-of-the-way places, such as the far-flung regions of China.  Here, both private and public investment is driven more by politics than by financial fundamentals.

Local politicians need a growing economy to please their masters in central government.  Large building projects are a convenient shortcut to achieve this and banks can be cajoled into lending to maintain their political connections.  Banks have limited room to move in China due to regulations which limit the level of interest rates on savings.  This encourages savers to stash their money in what is referred to as the “shadow banking sector”.  These offer higher returns on savings and provide firms who are shunned by banks access to loans.  But being outside the normal banking system means that this sector is harder to keep tabs on and influence through policy.

Bigger worries elsewhere in the world

Talk of politicians pushing projects and shady banks does not seem to bode well for China, but its banking sector is likely to be no worse than Western banks.  Banks in the US pushed dubious mortgages throughout the global financial system during their own lending binge.  At least any direct ramifications of a banking meltdown will be mostly contained within China.  Yet, such worries fail to take into consideration one crucial factor – the controlling influence that is the Chinese government.

The government in China has both the willingness and the ability to step in and shore up the banking sector if required.  The Chinese government intervened with a massive fiscal stimulus in 2008 and 2009 as the global economy slowed.  In comparison, most Western governments only managed a half-hearted response to the global financial crisis.  A sluggish economy with high unemployment is not something that the Chinese government would tolerate as its own existence would be under threat.

Another positive for China is that any potential problems with its banking sector are not symptomatic of bigger issues.  The financing for debt in China does not come from overseas but through China’s own reserves.  Neither is the surge in investment causing the overall economy to overheat as evidenced by subdued levels of inflation and a relatively low volume of imports.  The contrast with countries making up the “fragile five” could not be starker.  China is likely to ride out any bumps in the future as it develops but the same may not hold true for the turbulent career of Justin Bieber.

Global liquidity: have we created a monster?

Money in the financial system overwhelms all it encounters making it a growing threat that needs to be dealt with

We are being overrun – by money.  There may be worse things to have battering down one's door but a surplus of cash in the financial system can have scary consequences.  The financial system was set up to facilitate the movement of cash to parts of the economy where it is needed but has instead become a behemoth exerting a dominating influence over the creation of goods and services in the actual economy.

Quantitative easing feeds the beast by flooding the banking system with even more cash in the hope that a few crumbs will drop down into the actual economy.  However, not only is the financing no longer having the desired effect, but the extra money is becoming increasingly erratic and hard to control.  Policies are needed to yank banking back into line.

Money getting out of hand

Spare cash in the form of savings is the basis for economic growth.  Surplus from current production is invested to enable higher output later on.  Banks were first created to shift extra money elsewhere so that production could be expanded.  Yet, banks have gone beyond the basic operation of allocating money and moved into the business of making money from money.  This is a waste of resources considering our best and brightest could be put to better use.  But more than that, the colossal size of the financial sector is in itself a problem – it is like a giant trampling everything in its path.

Money is free to move around the globe on a whim.  Too much free-flowing cash turns into a menace in terms of stability.  The danger always seems close at hand – banks and others creating more cash out of thin air by increasing leverage when times are good while central banks unleash a mass of new money to shore up the economy when things turn bad.  Yet, money is not always forthcoming - the impact of the global financial crisis was exacerbated by a flood of cash fading to a trickle.

The money is out there lurking and waiting.  The skulking leviathan surfaces only in a few places but creates distortions wherever it emerges.  A clear example is the property prices in London and other places in the UK which are booming at a time when the underlying economy is stuck in a faltering recovery.  Emerging markets have also fallen victim to the ebb and flow of global finances due to their less developed financial markets and limited domestic savings.

Making money work for us

If massive money movements are causing chaos, it is only sensible to conclude that greater controls should be put in place to rein in the rampaging.  The current direction of policy on finance has turned to re-regulation after decades of deregulation gave banks the freedoms which allowed the phantom cash to wreak havoc.  The finance sector has railed against any restrictions, but the monster now rearing its ugly head cannot be left uncaged.

It is argued that free movement of money is essential despite the risks, as credit is cheaper as a result.  But even the cheap cash from central banks has not been enough to convince banks to lend which suggests that easy money does not bring the benefits previously thought.  This means that we should not fear the utilization of policies as controls over the movement of money, the separation of retail banks (which take in savings and give out loans) from investment banks (which deal in financial wizardry), or the introduction of higher standards for banks in each individual country.  Money in itself is not evil – it just needs to be kept in its proper place.

Another New Policy - Negative Interest Rates

Another unconventional policy measure may be trialled in Europe as its central bank struggles to revive the moribund economy

The on-going economic troubles have been demanding in many ways – including having to learn the meanings of an ever-increasing range of new economic terms.  This is due to central banks implementing a range of practices to breathe life into an economy which seems impervious to their best efforts at resuscitation.  The list of unconventional policies started with quantitative easing, which was soon followed with forward guidance.  The next piece of headline-grabbing jargon may be negative interest rates.  This latest innovation is expected to come from the European Central Bank (ECB) even as other central banks look to wind down their operations.

The What, How, and Why of Negative Interest Rates

The policy of negative interest rates is just as simple as it sounds – paying someone to hold money instead of receiving interest on any deposits of cash.  Fortunately, the humble blogger on the street will not be required to pay negative interest rates by his or her retail bank; instead, the banks themselves will be charged for their holdings at the central bank.  Banks tend to park any surplus funds with the central bank so the idea of negative interest rates is to spur banks into making better use of their reserves.  In particular, the policy is intended to boost lending by banks which has remained sluggish despite record low interest rates.

The policy is all about creating the right incentives.  The actual payments themselves would be small.  For example, the ECB is said to be considering an interest rate of -0.1% in place of its current rate of 0.25%.  Central banks have been frustrated by the failure of low interest rates to generate the desired result – more lending.  Both forward guidance and negative interest rates are policies aimed at achieving this.  

Timing – why now?

Now we understand the basics of negative interest rates, the final question is one of timing – why now?  The ECB is driven by two key factors – the changes to monetary policy in the US and fears about deflation in Europe.

The effects of the Federal Reserve printing money to buy bonds (known as quantitative easing) have reached far beyond the US borders with some of the money also finding its way to Europe.  Less loot leaving the US will likely lead to less liquidity in the European banking system.  Low levels of inflation (0.7% in January) have led to fears about consumer prices starting to fall, something already happening in places like Greece.  There are concerns that such deflation could further undermine demand and result in debts increasing in size relative to the economy.

The potential adverse consequences of these developments have pushed the ECB to act and negative interest rates are one of the few options available.  This is because the actions of the ECB are restrained by divergent views among the member countries of the European Union.  In particular, Germany has been adamant in upholding rules that limit the ability of the ECB to purchase bonds. 

Negative interest rates would also bring their own complications.  European banks may struggle to deal with negative interest rates which are not the norm.  The extra costs may weaken banks by lowering their profits, making them more cautious lenders and exacerbating the problem.  Low lending rates have had only a muted effect so the benefits of going negative may be limited.  Even if the policy is seen to be effective, Germany would be loath to offer more help to struggling countries in the periphery of Europe as it may encourage them to put off crucial reforms.

It is too early to say whether negative interest rates will ever make it into our everyday lingo.  Either way, we can only hope that it does not take many more new policies until we can shake off the current economic stupor.

UK economy is growing but not yet in recovery

Some good news at last for the UK economy but don’t expect the tough times to be over

The outlook for the UK economy is finally beginning to brighten following a harsh recession and weak recovery.  The Office for Budget Responsibility raised its forecasts for the UK economy with growth of 1.4% expected in 2013 up from a previous estimate of 0.6% in March while 2014 is expected to see growth of 2.4% instead of a prior March forecast of 1.8%.  While the government was keen to publicise this as good news, much of the improvement is due to factors that are likely to be temporary.  Government measures along with monetary policy are behind the perkier economy but the effects will not last and a proper recovery may still be some time away.

The unexpected boost to the economy has come through higher spending by households.  Many UK consumers are feeling better off with UK shares near record highs and the UK property market going through a period of resurgence.  Stock markets in many developed countries have been providing stellar returns as extra cash being printed by central banks flows into shares.  House prices have benefited through a range of government schemes aimed at increasing the availability of mortgages.  This has translated into more consumer spending through a mechanism known as the wealth effect which is the notion that people will spend more if the financial assets which they own are worth more.  The UK government has tried to tap into this effect on spending using schemes such as Help to Buy to lift house prices as a means to boost the economy due to few other options (such as higher government spending) being available. 

The wealth effect relies on growing levels of financial wealth which can be lifted by different measures but which ultimately rely on the health of the economy.  As such, temporary boosts are possible but asset prices (and wealth) can only be pushed up so far and may involve potential negative effects for the economy.  Higher prices for financial assets now come at the cost of price gains in the future  (such as a weaker property market in the future) with a reduced wealth effect.  This may be a necessary price to pay with few other avenues for generating growth but the tactic of pushing up property prices has also been used by the UK government to provide cover for its program of austerity measures. 

With public debt reaching around 75% of GDP in 2012, the government has given priority to cutting back its spending but this is controversial coming at a time when the overall economy is weak.  The government claims that the cuts are necessary as investors would not buy UK government bonds (resulting in the government having to pay higher interest rates) were government debt to get even more out of hand.  Concerns about debt levels have eased considerably since reaching near frantic proportions during the Eurozone crisis, but the government remains unrepentantly committed to slashing spending levels.  Cuts to government spending are going to continue for years to come with the stated goal of reaching a budget surplus by 2018 despite calls for a change in policy.

Other areas of the UK economy also have little to offer in terms of growth.  Exports from the UK have failed to pick up despite a weaker pound and the value of the currency has begun to rise again which does not bode well for UK exporters.  Investment is also weak with lending to businesses in decline.  It is proving tough to come up with an engine to drive growth in the UK – a recovery is long overdue but we may still have to wait.

British banks gone AWOL

The banking sector is in dereliction of its traditional duties in the economy and quick fixes will not be enough to make amends

After nearly collapsing and bringing the economy down with them, UK banks are further adding to their bad name by holding back the economic recovery.  Banks are either too weak or too caught up in making easy money to fulfil their traditional role in the economy.  The situation is made worse because monetary policy works through the financial sector and banks are crucial links through which money is fed into the actual economy.  Instead, bank lending to UK businesses has been falling, thereby dampening the impact of lower interest rates and pushing the Bank of England to pump more and more money into the economy (which is not healthy).  Why have banks seemingly abandoned their posts?

Banks have traditionally acted as intermediaries between those with money to spare and those in need of financing.  There is a surplus of funds at the moment due to quantitative easing by the central banks which is aimed at getting more households and companies to borrow.  But this money is not getting to businesses - partly because the weak economy has hit demand for loans but also because of the reluctance of banks to lend.  A large amount of debt, which could go bad due to the weak economy, is making banks cautious while new banking regulations are restricting banks’ capacity to take on fresh loans.  Small businesses have been hit hardest as there are few other options for getting cash.  As a result, there has been a large knock-on effect on the economy as small businesses are a significant source of jobs and innovation.

Other parts of the finance sector have failed to pick up the slack.  Investment banks (which are different to retail banks who carry out the functions above) have long had only weak links with the actual economy and continue to generate profits through their ability to make money from money while also attracting some of the best and brightest who could offer more in other sectors (see previous blog).  Firms such as Wonga, which offer lending services now shunned by retail banks, are being hounded for their trouble.  The only bright spot has been mortgage lending but that has been targeted by government initiatives along with monetary policy to the extent that the Bank of England has had to apply the brakes due to concerns about a housing bubble.

The failure of banking to facilitate the circulation of funds around the economy has resulted in surplus cash flowing into financial assets such as property or the stock market rather than being put to productive use in the actual economy.  The Bank of England has tried a scheme of providing banks with funds for lending but more needs to be done to clean up banks and change their behaviour.  One of the reasons why Japan took so long to recover from a financial crisis more than two decades ago was that it allowed problems in its banking sector to stagnate.  Let’s hope that it doesn’t take that long to learn the same lesson.

UK Property Market – Prudence over Politics

Why we should be happy that the Bank of England is putting the brakes on the government’s efforts to boost the property market.

It is the job of politicians to get elected, but it does not follow that governments always do what is in the best interest of voters.  This might be the best explanation behind the actions of the current UK government with regard to the housing market – angling for voters (and an economic recovery) by pumping up property prices with little concern about the long term health of the economy (for more on this, see rebound in UK house prices is not all good news).  Many expressed a sigh of relief when the Bank of England stepped in to put the brakes on a booming real estate market by taking away incentives promoting mortgage lending among banks.  It is something new to see a central bank taking a stance which puts them at odds with the government but it provides a good case for arguing for greater oversight of government policy.

The current understanding of the role of a central bank is as an independent body which watches over the economy with powers to intervene if there is too much or not enough growth.  Central banks are kept separate from politics where policies are aimed at winning over voters within a time frame of a few years.  Some aspects of government where a longer time frame is required such as monetary policy could be influenced in a negative way by political calculations and it is thought that central banks are better positioned to administer monetary policy in order to achieve goals such as warding off inflation.

The global financial crisis highlighted that low inflation in itself is not sufficient for financial stability with aggressive lending by banks combined with excessive gains in asset prices also shown as big threats.  Central banks have been given greater scope to oversee the overall health of the financial sector and this is behind the latest policy actions by the Bank of England.  The UK government was hoping that a buoyant property market would increase spending and create a feel-good factor propelling it back into power in elections scheduled for 2015.  Yet any gains in real estate prices without higher wages would be unsustainable and put home ownership beyond the reach of many, ultimately requiring weaker prices in the future to bring house prices back in line with the economy. 

Governments and central banks had previously been operating in their own separate spheres of influence but the extended remit of central banks may bring them into conflict.  This has the potential to work in a positive way to provide greater oversight for government policies shown to be at fault in the past (for example, high government borrowing in the UK in the run up to the global financial crisis).  Another example of how the European Central Bank did the most to save the euro while the various governments in Europe squabbled.  It is not hard to argue for giving more power to economists (see previous blog) when politicians provide so many reasons for doing so.  

Wonga - Do we need to be saved?

Politicians are questioning our ability to make the right choices but that is not the real problem.

Criticism of Wonga recently reached a new nadir with the rather ridiculous claim by Ed Miliband, the Labour Party leader, that children have been “targeted” throughTV ads.  There does seem to be something unethical about a firm which charges almost 6,000% interest on loans.  However, this hasn’t prevented Wonga from prospering.  With wages stagnating for many people, there is strong demand for extra cash at times of need even if it does come with a big chunk of interest payment.  Yet, many in the media have been critical of a culture of borrowing with Wonga as the new pied piper (see my previous blog on Wonga).  Are Wonga’s loans useful in times of trouble or a snare for the unwary?

One of the key elements of a capitalist economy is that firms will sell any product where profits can be made.  This drive for profits pushes companies to innovate and create things that we didn’t even know we wanted.  The short-term loans from Wonga are one such product allowing quick access to cash that was not previously available.  Their popularity suggests that many find such loans useful, but it also prompts concerns that people are not making the smartest financial decisions.  Politicians among others target the source of supply (the firms offering the loans) rather than the source of the problem which is too complicated to deal with.

This paternalistic way of thinking is the basis for government action on a range of our “bad habits” from smoking (where policies have worked out for the best) to alcohol and fast food (which have been controversial).  Government policies such as these which try to modify the behaviour of adults sometimes seem like a replacement for a decent education system.  The world is growing in complexity and we are faced with an increasing range of choices at the same time as education is becoming increasingly focused on test results.  This leaves teachers with little time to teach important life skills such as a healthy diet or financial literacy.  Politicians could do us all a favour by asking the bigger questions rather than jumping on the latest bandwagon – if only there was a way to improve the behaviour of politicians.

Wonga – the new bad boy of finance?

Wonga has been grabbing headlines for the wrong reasons but who is really to blame?

It is not a good time for finance firms of any guise to be making too much money at the moment.  So the British short-term lender Wonga attracted the wrong type of attention when it announced record profits of 65 million pounds for 2012.  Everybody from Ed Miliband, the Labour Party leader, to the Archbishop of Canterbury have lined up to vilify Wonga for making money out of people who have fallen on hard times.  Wonga, who offer loans of small amounts for a period of up to 30 days, have hit back with a slick new promo video telling the stories of some of its customers.  Is Wonga as bad as they say or is the recent controversy just a bit of name calling to grab some headlines?

Among the numerous criticisms, perhaps the most commonly heard are to do with the eye-wateringly high interest rates which work out at 5,853 percent (as stated clearly on the website).  Yet the short periods of borrowing mean that interest payments are typically small compared to the amounts involved - a typical loan of 200 pounds for 15 days incurs fees and interest of just over 36 pounds.  But 200 pounds would explode out to over 10,000 pounds over 12 months so any mishaps which delay repayment have the potential to spiral out of control and result in massive debts.

So why would people risk this in the first place?  A bit of extra cash when we are short might save us even more money than the cost of the loan when caught in a spot of trouble or might stop us from missing out on a big night out with friends just before payday.  The choice to borrow or not to borrow is one that each of us is free to make (with full disclosure of charges from Wonga).  What the long line of Wonga critics are instead condemning is the fact that so many people are choosing to take out loans through firms such as Wonga.

Wonga is a symptom of and not a cause of a society that spends at will and may not always have money left at the end of the month in case of emergencies.   Life was not always so free and easy - access to any extra cash used to be limited to only those on good terms with their bank managers.  But new ways of getting cash, such as credit cards and short-term loans, have provided money to the masses.  We should be thankful to have it if we need it but better management of our finances might mean that we would be thankful not to need it.

Same low interest rates but for longer

The central bank in the UK pledges to keep interest rates low for years to come but that still might not be enough to achieve the desired result.

The current slump in the global economy is proving frustrating for economists who had come to think of themselves as bastions of sound economic management.  Tried and tested policy tools such as changing the level of interest rates have only had a limited effect, as have new ideas such as quantitative easing (for more, see Why is the economy still in a rut?).  Mark Carney set out to begin his stint as the new governor of the central bank in the UK with a bold fresh approach to monetary policy but his timid initial parley seems to be a rehash of existing measures.  The new stance taken by the Bank of England aims at making low interest rates more attractive but it does not seem as if anyone is interested.

The not-so-new policy concept announced by the British central bank was that of forward guidance which entails providing greater clarity in the future direction of interest rates.  This is expected to improve the intended effects of interest rates which are set by the central bank depending on the state of the economy.  The Bank of England has set its base interest rate (which determines most other interest rates in the economy) at 0.5% since May 2009 but what is different with forward guidance is that Carney has stated that the base interest rate will stay at this level until the unemployment rate falls from 7.8% to 7.0% which is not expected to happen until the middle of 2016. 

In other words, the Bank of England is promising three more years of record low interest rates.  But this pledge comes with a big caveat – the central bank may raise interest rates if inflation looks set to stay above 2.5% over the medium term (economists are a bit neurotic about inflation – for reasons why, see Time to rethink Inflation?).  So Carney has tried to provide as much clarity as possible on the future of interest rates while leaving himself leeway to change interest rates earlier if necessary.  The Bank of England already gave some guidance on interest rates but linking the interest rates with unemployment makes this more explicit.  A similar policy framework has been tried elsewhere – most notably in the United States where the Federal Reserve has also committed to low interest rates until the job market improves.  But it is as yet unclear whether the forward guidance has had any notable effects.

The theory behind low interest rates and forward guidance is as follows – low interest rates when the economy is on a weak path are intended to entice firms and consumers into borrowing more and spend this extra cash to help make up for any shortfall in demand.  But this has not worked out so far as lending by British banks has been falling since the global financial crisis.  Guidance whereby low interest rates are pledged for an extended period of time is meant to fix the aversion against taking on debt by easing concerns that any borrowing now will be penalized with higher interest rates once the economy picks up – thus adding to any impetus to take out a loan.  But Your Neighbourhood Economist does not hold much hope for forward guidance to add much punch.

For forward guidance to work, economists are relying on a piece of theory known as rational expectations.  This assumption is that companies and consumers respond not only to current prices (including interest rates) in an economy but also expectations of these prices in the future.  Since low interest rates have not had the intended effect, economists have seemingly come to the conclusion that it is because of worries that the low interest rates will not last.  And so the hope is that by alleviating these concerns with forward guidance this will spark the borrowing that is meant to spur the economy into life. 

But to Your Neighbourhood Economist, it seems like trying to tempt shark attack victims back into the water by convincing them that the water is shallow.  This is because lots of companies went bust in the aftermath of the global financial crisis due to having borrowed too much.  Consumers too are still overburdened with excessive debt no amount of low interest rates ever seems destined to fix at this point in time.  The notion of rational expectations does not match up with what could be deemed as irrational fears of debt – hopes for borrowing our way back to economic growth seem too scary for most.

Why is the economy still stuck in a rut?

As the last hope for an economic recovery, monetary policy has proven lacklustre at best and here is why things have not turned out as planned.

It has been more than five years since the onset of the global financial crisis but it still seems as if we are stuck cleaning up the mess.  The task of getting the economy back on track has been made even trickier with policy makers being side-tracked by a number of misadventures such as the Eurozone crisis and the fiscal cliff in the US.  Governments everywhere have been shackled by large debts and central banks have been relied on to save the day.  Despite having a better track record in the past, the inability of central banks to use monetary policy to fix the problems created by the unique circumstances of our current dilemma have prolonged the economic stagnation.  Your Neighbourhood Economist looks at why the central banks had to try new things and why even this fresh approach has not improved the outlook for the future.

Monetary policy had always provided a road map back to economic recovery in the past.  The directions were simple – lower interest rates would help get the economy back on the right path. The theory behind this was that making it cheaper for firms or households to borrow would give the economy a boost at a time when other sources of growth were flagging.  Interest rates could be topped up again once the economy had been kick started with inflation used as a gauge on the strength of the economy (i.e. low inflation suggests weak demand with rising inflation seen as a sign of an overheating economy). 

However, even interest rates close to zero have failed to gain traction amid the consequences of the global financial crisis.  There are two main reasons for this which relate to borrowers and lenders.  On the lending side, banks have shrunk their operations due to chronic uncertainty that pervaded both the financial well-being of the banks themselves and any borrower they might lend to – banks were unsure of the potential for losses on their own books, let alone those of other business which they may lend to.  A wave of new regulations also acted to hamstrung banks who reacted by lending less to lower the level of risk on their balance sheets with other options such as selling shares not available (this problem was most pronounced in Europe – see Another reason not to bank on Europe for more). 

Borrowers too weren't in the mood with many companies and households having already taken on too much debt during the years of cheap credit which led up to the crisis.  Uncertainty was another factor as wage earners worried about their jobs while firms were more concerned with their own survival rather than borrowing to expand their operations.  Rather than borrowing, the opposite was more likely to be the case as consumers paid down their credit cards while firms repaid their debt and kept cash for a rainy day.  A lack of willingness on both sides (lenders and borrowers) meant that more debt was out of the question no matter how low interest rates would be set.  This put pay to conventional notions of monetary policy and required a fresh approach.

Quantitative easing was taken on-board as a possible solution.  This involved central banks buying bonds to provide funding for banks and companies wanting a different source of cheap funding.  The bond buying also lowered the returns on these safer assets and pushed investors to put their money into more risky assets such as buying bonds of struggling countries in Europe like Greece or Spain.  The extra money in the global financial system was expected to help grease the wheels of banking which had seized up.  But little of this additional cash has reached the real economy and has been hoarded by banks or companies or has gone to pump up share prices.

The limited extent to which their policies fed through to the economy prompted central banks to throw more and more funds at the problem with the Federal Reserve in the US buying US$85 billion in bonds each month and the Bank of Japan pledging to double the money supply in two years (for more on this gamble, see All bets are ON).  The acceleration of monetary policy has not driven the economy much faster through the slowdown.  However, even just the notion of an eventual retreat by central banks has caused jitters among investors who have benefited most up to now from the real-world consequences of monetary policy (refer to Caution - Windy Road Ahead to see how monetary set the tone of stock markets).

So the outlook for the stagnating economy is not good.  Governments remained mired in their debt with even relative bright spots such as the recovery in the US economy in peril when factoring in likely cuts to government spending in years to come.  Central banks have dug themselves into deep holes by trying to do too much and even the limited effects of monetary policy will be difficult to maintain (for more on why thus might be the case, see The perils of doing too much).  The result being that problems in the economy such as a shortfall in demand and uncertainty over the future continue to drag on consumer and business sentiment.  All it would take to ignite economic growth again is a commonly held belief that the future will be brighter.  But, considering all of the above, it is proving a hard sell.  

Recessions, Ice creams, and the UK economy

The UK economy is set for a triple dip recession but it may not be the last.

Children love ice cream cones but a chocolate coating makes it even better.  Ice cream can be covered in chocolate not once but twice and a double-dip ice cream cone was a real treat.  It is a pity that recessions don’t work the same way.  This is particularly true in the case of the UK which may be in the midst of a triple-dip recession after real GDP fell in the last three months of 2012.  Even worse than this is that the fear that a weak UK economy may dip into negative growth a few more times this decade. 

A double-dip recession is a relatively common flavour of recession.  It occurs when an economy rebounds after a recession but the ensuing growth is not strong enough to be sustained and the economy weakens again before an upward trajectory is finally achieved.  The reasoning behind such a growth path is that businesses and households will hold back on spending during a recession due to heightened cautiousness and uncertainty about the future but spending will pick up again once the economy seems to be improving.  If the delayed burst of spending is premature or small in size, the boost to the economy is only temporary and growth stalls until the economy has worked through the issues that caused the first recession.

Investments by companies in new factories or equipment are essential for an economy to return to sustainable growth.  But such investments fluctuate considerably depending on the business mood and companies will delay or terminate investment plans if the economy is not strong enough for the companies to earn a suitable return.  So growth will remain feeble with short periods of weak recovery followed by similarly short and shallow recessions.  Such is the background behind the triple-dip recession and why the third consecutive recession in the UK may not be the last.  This weak business cycle with minimal investment in the UK will continue until business confidence is revived.

 

What makes the state of the economy after a deep recession in the UK different from the plain vanilla type is the hard-to-digest problem of a banking crisis and the bitter tonic of austerity measures.  In the build-up to the global financial crisis, the UK economy was more reliant on its banking sector than most other countries.  High wages earned by employees in the finance sector helped boost spending and a willingness by banks to lend fuelled a real estate boom.  The excesses of the finance sector in the good times amplify the problems that need to be sorted when times turn bad.  The result in this case is that the UK economy is currently suffering from weak consumer spending and a decline in lending by banks.  Reregulation of banking activities has added further complication to sorting out the finance sector. 

The effect of the banks adding to the swings in the economy is further heightened through the government.  The buoyant finance sector provided extra income for the government when the economy was booming.  Not only did this boost of funds to the government quickly dry up after the global financial crisis but the government also had to use up valuable resources to step in to rescue the banking sector.  Having already spent the cash bonus, the government is now having to take money out of the economy in a manner which is the opposite of a fiscal stimulus through its austerity measures.  This is also not a problem that will be easy to sort out and government cut backs are expected to continue through to 2018.

Considering that a “triple-dip recession” is relatively new term, what comes next?  A quadruple-dip recession?  Even if the UK economy manages to survive without slumping to two consecutive quarters with negative growth (the common definition of a recession), years of slow growth are ahead.  The worst case scenario is Japan.  The extent of the economic stagnation in Japan is not measured in the number of recessions but in the number of decades for which there has been no substantial growth.  Japan also suffered a property bubble which triggered a banking crisis but on a larger scale.  Yet, like Japan, the UK still has a lot to do, such as finding the right balance between regulations and increasing lending at banks along with government measures to boost the economy.  Until this happens, hopes for recovery are likely to melt away like an ice cream cone on a hot day.