Wednesday, 17 September 2014

Splitting the Bank

Faisal Islam reports that Alex Salmond has demanded “Scotland's share” of the assets of the Bank of England, namely its gold, FX reserves and its holdings of UK debt built up through two rounds of QE:
Salmond didn't mention the liabilities, which is unfortunate since if you take a share of an institution you must take both the assets and the liabilities. The liabilities of the Bank of England are the monetary base of the United Kingdom – sterling notes & coins and sterling bank reserves.

There is a very good reason why Salmond didn't mention the liabilities. He wants to use Scotland's share of the Bank of England's assets to write off Scotland's share of UK debt, leaving Scotland with a debt-free balance sheet at independence:
Neil Wilson, in a good though flawed post, explains how this would work:
On a population proportion of 8.38%, Scotland owns/owes £186bn of HM Treasury's balance sheet, and so the question is how best to deal with that.
The TL;DR version is that £186bn of the shortest dated Gilts from the Asset Purchase Facility are uplifted to HM Treasury and written out there - reducing both the Gilts outstanding and the Taxpayer Equity figure by £186bn and creating an asset adjustment at the Bank of England.
That then settles the Scottish share of the UK National Debt, and the Scottish claim over the Bank of England in one neat accounting journal. Scotland's government owes nothing in GBP, and the UK has no outside entity with any claim over its central bank.
I should explain that the Asset Purchase Facility is the off-balance sheet vehicle actually used for QE purchases. It is a wholly-owned subsidiary of the Bank of England, so any adjustments to its balance sheet will consolidate into the balance sheet of the Bank of England. Wilson has a neat chart, which I've borrowed to show here:

What Wilson is suggesting is that £186bn of the gilts at the APF, representing Scotland's share of the UK national debt, should be written off. If this were done as a balance sheet writeoff, that would mean an immediate reduction in the sterling monetary base of £186bn, wiping out nearly half of the QE expansion at a stroke. As the monetary base is made up mainly of bank reserves, it would be bank balance sheets that took the hit. Done in this way, the price of writing off Scotland's debt would be either instant insolvency for the UK's banks or an undignified scrabble for whatever gilts remained in circulation. Clearly this is a non-starter (though it would reduce gilt yields to something nicely negative).

But that isn't what Wilson is suggesting. What he has done is rather cleverer. In his model, the gilts are written off against something called “Taxpayers' Equity” on HM Treasury's books, which is actually expected future tax revenues (and therefore sits on the asset side of the balance sheet). The monetary base remains untouched. In effect he has written off part of the asset side of the Bank of England's balance sheet, rendering it technically insolvent, then recapitalised it with an asset transfer from HM Treasury's balance sheet. 

Writing off QE gilts in this way would mean that nearly half of the QE expansion of monetary base could not be unwound through normal open market operations, since it would no longer have tradeable assets backing it. In effect, the UK would have monetised Scotland's share of its debt.

The trouble is, this makes Wilson's proposal legally impossible. The UK is a signatory to the Lisbon Treaty which forbids monetisation of government debt. Scotland would not have monetised anything, since it would simply have written off gilts on both sides of its balance sheet with no monetary expansion involved. But the UK would have broken Article 123.

Monetising Scotland's share of the UK debt also raises serious questions regarding the conduct of UK monetary and fiscal policy post-independence. In the integrated central bank/government model that Wilson uses, tax revenues sterilise monetary expansion (government spending): government spends money into the economy, and money is recycled back to government in the form of taxes. The sale or loan of gilts to the private sector by the Bank of England acts like a windfall tax, since it drains money from the private sector: this is how normal monetary operations work. In the absence of gilts to sell or lend back into the market (open market operations), the only way of draining reserves would be to raise taxes: this might be dressed up as interest rate rises (to preserve the fiction of central bank independence), but it would amount to the same thing. 

Wilson concludes that because “Taxpayers' equity” is the net savings of the private sector, there would be no cost to the UK taxpayer from monetising Scotland's debt. If the monetary base expansion were both permanent and non-inflationary, this would be true. But books have to balance. Considering the central bank and government as an integrated unit, if the monetary base (liability) shrinks, so must taxpayers' equity (asset). QE was only ever supposed to be a temporary expansion of the monetary base: at some point, the plan is to unwind it. If half the gilts purchased under QE were written off in settlement of Scotland's share of UK debt, unwinding QE would inevitably mean tax increases (or equivalent interest rate rises) – which would fall wholly on the reduced UK population, since post-independence Scotland's population is not going to contribute taxes to HM Government.

Salmond would no doubt argue that as Scotland intends to continue to use sterling, there would be no need to reduce the monetary base to reflect the smaller size of the UK economy. But as the only fiscal backing for the UK's monetary base comes from the UK government, the Bank of England would be irresponsible if it considered Scotland's needs when determining an appropriate size for the monetary base post-independence. The size of the monetary base should be appropriate to the size of the UK economy: it would not be unreasonable for the Bank of England to conclude that it must shrink. To be sure, there are other gilts that could be sold to drain the reserves: this model wipes out less than half of the Bank of England's holding. But it would make it impossible to return to pre-2008 monetary policy in the long run without somehow obtaining higher tax revenues.

Of course none of this would be remotely appropriate in Salmond's preferred option, a currency union. If the UK were to enter into a currency union with an independent Scotland, HM Treasury would issue Scotland with shares in the Bank of England. If Scotland repudiated them in favour of its share of Bank of England assets, it would de facto have rejected the currency union. It cannot have both a currency union AND a share of Bank of England assets. Currency union means sharing the institution, not stripping its assets.

And I'm not convinced that using the gilts at the Bank of England to write down Scotland's share of debt is sensible anyway. After independence Scotland would be cut off from Bank of England currency issuance. If it continued to use sterling without a currency union or used its own currency backed by sterling it would need substantial sterling reserves. Scotland would do better to keep the gilts as sterling reserves - they wouldn't be enough, but they would be better than nothing.

Alternatively, Scotland could claim the value of its share of the Bank of England's assets in the form of physical cash, in which case we would presumably give them Giants and Titans to the value of their claim on Bank of England assets. The accounting for this would be different from Wilson's model, of course: since the Bank of England is the issuer, these would remain on the Bank of England's balance sheet as a liability, and the gilt holdings would be untouched. 

But in fact Scotland cannot eliminate its share of UK debt by writing it down against the value of its share of Bank of England assets anyway. The market value of Scotland's share of the assets of the Bank of England is less than the market value of its share of UK debt. Wilson assumes that Scotland's debt would be entirely monetised from Bank of England holdings of gilts. But this is a larger share of the Bank of England's assets than Scotland should have, whether judged on population or GDP. If a “fair share” of Bank of England gilt holdings were written down against Scotland's share of national debt, there would still be debt left over. I fail to see why the UK should monetise the whole of Scotland's debt simply because the Bank of England is wholly owned by HM Treasury.

And all of this will be immaterial if the Scots vote “No”, anyway. For a few years, at least. 

Related reading:

Salmond's QE grab - Long & Variable (good post by Tony Yates)

Tuesday, 16 September 2014

Independence and union

I have been very reluctant to write more about the Scottish independence question. Earlier this year I wrote a couple of pieces about the currency question, and one about the implications for the rest of the UK. But since then I have become very aware of how painful this is for many people, including me. This piece is not easy for me to write: I have strong personal and family ties to Scotland, and have always seen my Scottish friends as part of my British "family". My own identity is more British than English, and I am deeply hurt by people who say "the United Kingdom is not a country" or "there is no such thing as British". That may be how they feel, but it is not how I see myself. For me, I am British first.

I am also concerned that anything I write now would be inevitably seen as taking a political stance. The economics of what is being called "independence" are horrible, at least in the short term: but if I write a piece explaining that, it will be seen as "anti-independent" and feed into the SNP's "Project Fear" rhetoric. But nor do I want to contribute to Yes campaign euphoria. The economics are horrible for the people of Scotland. They are not being told the truth.

I do not like the way in which the facts are being skewed, changed or omitted to suit the political stance. And I should emphasise that BOTH sides are guilty of this.

There have been actual lies from the SNP, such as Salmond's false claim that a Scottish government would be unable to prevent the Scottish NHS suffering spending cuts if Scotland remained in the union. The Scottish government already has full control of SNHS spending, so any cuts would be its own decision, Nor does the argument that SNHS spending would have to be cut due to reductions in the Barnett formula stack up: Scotland's receipts under the Barnett formula have actually risen by 3% under the Coalition government and it now receives more in fiscal support than any other region of the UK.

The SNP has also made many claims that cannot be substantiated. It continues to state that Scotland would remain part of the EU, despite clear statements from EU member states and officials that Scotland would have to apply for membership and meet Maastricht criteria. It also continues to insist that the UK government will eventually agree to a currency union which would be highly detrimental to both sides and probably would not survive anyway. And the SNP conceals important facts, such as that leaving the UK could mean temporarily losing EU support for Scottish farmers. .

Telling the Scottish people things that are untrue, making claims that have been rejected by the other parties concerned and concealing facts is unfair. The people of Scotland cannot make an informed decision if they are not being told the truth about what leaving the UK would mean. I call upon the SNP to come clean about what leaving the UK would mean for Scotland in the first few years. There would be a deep recession, possibly a currency crisis, and a substantial loss of capital and trade. It would be grim.

But in its way the approach taken by Better Together is more poisonous. Better Together's approach has been to paint a completely negative picture of an independent Scotland in order to frighten people into voting "No". This is just wrong. Scotland is perfectly capable of surviving as an independent country. It would suffer serious hardship for some years, but independence would enable it to rebalance its economy away from risky financial services and declining oil, and become a well-diversified, successful market economy. I have no doubt that the determination of the Scots, and their ability to endure difficulties for the sake of the future, would enable them to do this. They have every right to manage their own affairs and are more than capable of doing so.

And that brings me to the real problem at the heart of this debate. When I looked at the ballot paper for the vote on Thursday, I was surprised by the wording:

"Should Scotland be an independent country?"

My immediate response was "Yes of course it should!". Why would anyone want to be a citizen of a country that was not independent? If this were a vote about English independence, I would be very tempted to vote Yes and damn the economics. But that would cause me a problem. I said at the start of this post that I am British first, English second. Why should my desire to see England independent mean that I have to give up my British identity? Similarly, for those Scots who also see themselves as British - and there are many of them - why should they have to give up part of their identity in order to achieve independence for Scotland?

This is the dilemma that has been created for Scots by the way in which this vote has been framed. It was reiterated by David Cameron yesterday: he said Scotland has to decide whether it wants to remain in the union.  But that is not the question the Scots are being asked! Scots are being asked whether Scotland should be independent, not whether it should leave the Union. Independence and membership of a successful supranational union are not mutually exclusive.

The SNP leadership do seem to grasp this, which is more than can be said for Better Together. But they explain it extraordinarily badly. They call for "a share" of UK institutions and insist that there must continue to be a currency union. This won't do: all it does is annoy the other side, who then close ranks and refuse to co-operate at all. It would be far better if the SNP explained clearly that although they want Scotland to be an independent country they do not wish to leave the Union: they want to reinterpret the Union in a way that works for them. They want, in short, to be treated as equals. Welsh nationalists have much in common with this view. And so do I.

I would like to see the UK recognise its constituent parts as independent countries in their own right, united in a federal model. I would like to see the anomalies of the Westminster system, such as the West Lothian question, resolved once and for all by creating a system of governance for the United Kingdom that truly recognises that its citizens really have dual nationality - they are British, but they are also Scottish, English, Welsh and Northern Irish.

I wouldn't like anyone to interpret this piece as endorsing a "Yes" vote. I fear that the intransigence of the UK side is such that a "Yes" vote would indeed mean, as Cameron put it, a "messy divorce" - a divorce which, as far as I can see, neither side really wants. I actually have a problem with both "Yes" and "No" votes: "Yes" because it could result in a costly and unnecessary breakup, and "No" because it could entrench existing governance and lead to an even more painful separation further down the road.

We do not have to sleepwalk into this. Both sides must change their stance before it is too late.

I called above for the SNP to come clean about the costs of this potential divorce for the people of Scotland. Now I call upon the Better Together side to state plainly that a "No" vote would not be a vote for the status quo but would be followed by real changes to the way the Union is constituted, recognising the legitimate demands of the constituent countries of the UK for self-determination and self-government.

Sunday, 14 September 2014

The Co-Op story: a tale of two banks

Over at Pieria, I've posted the text and some of the images from the presentation I gave at the UK Society of Co-operatives conference on September 7th 2014 at the University of Essex. It's the full story of the decline and fall of the Co-Op Bank. Well, not just the Co-Op Bank.....we often forget that there were two banks involved in the Co-Op disaster. One of them was a mutual, but perhaps not the one that you might expect.

The post can be found here.

Monday, 8 September 2014

United Queendom

Oh, this is fun. Bob Denham of EconFilms has turned the economics of Scottish independence (and, let's be honest, the politics too) into what he describes as a "romantic comedy". Cue Rachmaninoff, please...

The mini-series ‘United Queendom’ tells the story of a gay couple on the verge of separation. The couple argue over oils (for the bath), who controls the credit card, membership of ‘The Club’ and whether they should aspire to be like their neighbour, the Scandinavian Model.

With 10 days to go to the referendum and polls showing it will go to the wire, the series is an attempt to get more people engaged in the debate – particularly those who can’t vote but are affected, such as people in the rest of the UK.

Here's what Bob has to say about it:
‘The more people can relate to the debate, the better – and nowhere is that more true than on the economics of a possible break up.’  
He adds:
‘This series is universal. I want everyone in the world to be able to watch and take part.'
I should add that this is not the first time Bob has lampooned a Very Serious Subject. His last online comedy: 'A Very European Break Up' on the European debt crisis has received over 300,000 views and featured in national and international press in countries such as Germany, Greece, the Netherlands and Spain.

The trailer for 'United Queendom' can be found here:

If you'd rather jump in at the deep end, the whole mini-series is here

Enjoy. (I did...)

Thursday, 4 September 2014

Don't pin all your hopes on SME asset-backed securities

Here's a neat chart from JP Morgan (h/t @debtnerd)

(larger version here)

What it says, essentially, is that although the total amount of Euro SME loans currently in issue looks sizeable, by the time you have removed all the loans that would be ineligible for securitisation and purchase by the ECB for one reason or another, there is not much left. Securitising and purchasing 10.3bn Euros worth of SME loans is not going to make a great deal of difference to the distressed periphery.

So the idea must be that the presence of the ECB in the SME ABS market would spur loan issuance. To make a significant difference to credit conditions in the periphery and repair the broken monetary policy transmission mechanism, that loan issuance would have to be simply huge and concentrated in periphery countries. There are several problems with this, to my mind.

Firstly,it makes a huge assumption about the scale of potential demand for credit in the periphery from creditworthy SMEs. Is discouraged demand really that huge - or is there actually a problem with the creditworthiness of potential borrowers, because of the widespread destruction of physical and human capital in the periphery? Distressed corporate loans in the periphery are far higher than in the core. That's why spreads are so high. Why would an SME ABS programme improve the creditworthiness of borrowers?

If the underlying problem is borrower creditworthiness, then it is difficult to see how the SME ABS programme could generate the huge additional loan issuance required to kickstart growth, even with ECB purchases. Unless.....we saw in the US that demand for ABS could encourage lenders with no "skin in the game" to reduce lending standards and even indulge in outright fraud to increase the volume of loans for securitisation. Although the ECB says it is planning to limit purchases to the highest quality SME loans, how would it ensure that this was the case in practice, especially if there turned out to be not very many high-quality SME borrowers in the periphery? I'm sure Blackrock, which is advising the ECB on the design of this scheme, won't have forgotten about the problems in the US - but is it familiar enough with the very different European marketplace to avoid creating opportunities for fraud and sharp practice?

It's also worth remembering that mortgage-backed securities in the US were first created by the GSEs (the first was issued by Ginnie Mae) and were originally designed to be packages of prime mortgages only. Including subprime in the mix was a later development intended to raise returns on junior tranches. If the Eurozone's SME ABS are to be tranched, presumably the ECB would only buy senior tranches - in which wouldn't there potentially be a similar temptation to include poorer-quality loans in the mix to improve the returns to private sector investors?

And what about the regulators? The Eurozone does not have full banking union: supervision particularly of smaller lenders remains at national level. One of the problems in the US was the fragmentation of the regulatory infrastructure - and a fragmented regulatory infrastructure is exactly what there is in the Eurozone, too. National regulators could be under pressure to cut corners from governments anxious to kickstart growth, and from lenders and securitisers anxious to prove they are doing their bit (and improving profitability). Tight regulations are useless if the institutions are too weak or too captive to enforce them. The flawed institutional design of the Eurozone is itself a serious risk to this programme.

So as far as I can see, the SME ABS programme is either going to be too small to make much difference, or is likely to encounter serious problems with loan quality at some point, putting the ECB's balance sheet at risk. I'm particularly worried by the way in which SME ABS purchases by the ECB is being promoted in some quarters as the primary means of "fixing" the periphery (though Draghi himself does not make this mistake). If only we can get credit flowing to periphery SMEs, the thinking goes, all our troubles will be over. This is simply not true. SME ABS purchases cannot substitute for flawed institutions and inadequate fiscal and monetary support. And even more importantly, they cannot compensate for a lack of creditworthy borrowers.

Central support for hard-pressed SMEs in the periphery would probably help to repair those economies. But the ABS issuance and purchase programme alone will not be enough. In the absence of other measures, reliance on such a programme would simply create moral hazard for lenders, securitisers and regulators.

Without German support, QE in the Eurozone remains a distant dream

Q. What further monetary easing measures do I expect the ECB to announce?

A. Maybe a few basis points off interest rates.

Q. Will they announce QE?

A. No.

Q. Why not?

A. Because the ECB needs the Germans to co-operate, and at the moment they aren't co-operating.

There's a fuller explanation at Forbes here.

And the deeper story behind Draghi's Jackson Hole speech at Pieria here.


Wednesday, 3 September 2014

Draghi's Jackson Hole speech has been misunderstood.

At Pieria, I dissect what Draghi actually said at Jackson Hole on 22nd August, and conclude that he has not called for short-term monetary and fiscal stimulus to kickstart growth, as some have argued:
"Some analysts have claimed that this speech was Draghi's “Abenomics” moment. Nouriel Roubini argues that Draghi has outlined a similar “three arrows” approach:
  • structural reforms in periphery countries
  • fiscal easing focused on investment and on demand stimulus in the core
  • quantitative and credit easing
But Roubini, like others, ignores the context of this speech. It is not fundamentally about restoring growth in the short term. Nor is it about the balance of monetary and fiscal policy, or about the responsibilities of core versus periphery. In fact it is not about short-run economic policy at all. It is about unemployment."
Specifically, it's about cyclical unemployment becoming structural, and the prospect of permanently elevated unemployment, a lower participation rate and lower trend growth. A whole generation thrown on the scrap heap.....

Draghi's proposals for addressing this are radical. Read more here.