Preventing Repossession

Sarah Teather MP has said that the government should do more to protect families from repossession (LibDems). Some caution is necessary. This doesn't seem to be a specific policy proposal. But the idea seems to be to tighten up the law to make it harder for lenders to repossess homes (there's a lot of reading between the lines here). This is probably cheap in terms of public money but someone will have to bear the cost of any eventual policy. Banks are a convenient scapegoat.

There are two problems with a purely legal solution. Repossession is generally a last resort anyway, particularly in a depressed property market. In which case, the policy doesn't amount to much more than formalising existing practice. In other words, it's a populist gimmick.

Assuming though that it does genuinely dissuade lenders from repossessing homes, this still carries a cost. Principally, it makes mortgages less secure from the lenders perspective. It is harder and more costly for them to get their capital back. Arguably, it is desirable for banks to exercise more prudence about who they lend money to, but it is naïve to think that these costs won't be passed on to the beleaguered home-owners. Credit will become more difficult and more expensive to access. They will find it harder to refinance their mortgages. They will eventually find it harder to sell their houses as buyers find financing more expensive.

So either there is no real value to such a policy or the cost will ultimately be borne by the people the policy is intended to protect.

This is not to say that the government shouldn't be protecting some home-owners. The important thing though seems to be to allow people to remain in their homes, not necessarily to remain the owners of them. We should use public money (we're borrowing enough of it) to buy up the houses and bring them into public ownership. Any equity the delinquent borrower had built up could be wiped out - but that is as it should be - and the lender may have to write off some of the value of the debt - but they lent unwisely in the first place. The ex-owner would then continue to live in the property and pay rent to the government.

It would have to be financed with public borrowing, but that borrowing would be secured against tangible assets, moreover which are bought at a trough in the market. The government's obligation to the lessors could be capped, say at five years, after which they would have to either buy the property back, move or see the property pass to a private letting company. This would allow the principal (and potentially some return) to be recovered in a reasonably short term.

Andrew Rawnsley in the Observer

Andrew Rawnsley has written a rather good op-ed in the Observer about the need to invest fiscal stimulus in public works rather than trying to pump it through consumer spending.

Steinbrück Reductio

Peer Steinbrück, Germany's finance minister, has received uncharacteristic attention in the British press for his claim that Gordon Brown has been "crass" in abandoning fiscal prudence (BBC). In the UK, the Tories have been entirely characteristic in jumping on the bandwagon.

I suspect that Gordon Brown is not too far off the mark when he claims that this is just "internal German politics". However, Mr. Steinbrück's criticism probably has more to do with Eurozone politics. At the moment the Euro is balanced on the Franco-German fulcrum of President Sarkozy's newly minted Keynesianism and Chancellor Merkel's fiscal restraint. The decline of sterling probably weighs heavily on the minds of Germans worrying what happens if that axis tilts too far Sarkozy's way. It's also worth observing that Germany currently has substantially higher level of public debt than the UK, even if it is currently running a surplus and paying that down.

Mr. Steinbrück is wrong (as are the Tories). A dramatic loosening of fiscal policy is required to stimulate the economy. But he is right, as Vince Cable has pointed out, that a VAT cut is a very poor way of implementing that loosening.

I've harped on about this before but it is not enough to run up a public deficit. Government spending to stimulate the economy should always be an investment in the future. Running up liabilities on the public balance sheet must be offset by creating public assets. If this isn't done, the custodians of the public purse are storing up a heavy tax burden to weigh down any recovery later on. As concerning is the fact that the Labour government is using the stimulus to postpone reckoning with some pretty serious structural problems in the British economy - an over-reliance on cheap credit and on the financial services sector. This, rather than the mere fact of the fiscal stimulus, is what is bringing the pound down and concerning German fiscal hawks.

Protectionism revisited

Before the hiatus for NaNoWriMo I intimated that I was in two minds about the virtues of protectionism. Now that I've had some time to think about it I think I've unpacked the dilemma a bit. Euro-sceptics be warned, this post assumes a rather European perspective. This choice is due to the facts on the ground. The removal of trade barriers across Europe means that it would difficult to implement any sort of protectionist policy on a smaller scale.

The problem is that here (at present) in Europe there are tough standards around labour conditions. These standards do not apply more widely across the world. The 'need' for protectionism comes from the need to maintain the competitiveness of European labour against countries that derive an advantage from not recognising those standards. They can produce goods more cheaply by (from a European perspective) mistreating their workers. Protectionism is one solution to the problem of how we safeguard European jobs and European labour standards at the same time.

But if we stood up for those rights for all workers across the world than no country would enjoy a competitive advantage over European workers who do enjoy those rights. So we should be legislating to bolster those rights for all workers and introducing tariffs where those rights are not recognised and honoured – both to eliminate the competitive advantage to not doing so and to incentivise doing so. To frame it a slightly different way, the present situation is one where we do not enforce labour standards for workers outside of Europe. This means that to remain competitive either European jobs must be exported or Europe must import the laxer labour standards of the developing world. Neither is politically palatable. What we should be doing is exporting our own labour standards. We can do that by using tariffs to create a competitive advantage to adopting them.

Such a scheme would need a broad base of support from developing markets to legitimise it, otherwise it would not escape the charge of European protectionism. But it should be politically saleable. It is not a naïve protectionism – the tariffs would apply equally to European products and non-European. Developing economies, including much of Latin America, China, to an extent India, are governed by parties employing left-leaning rhetoric. An economic treaty 'for the workers' would be something they may find harder to argue against than previous laissez-faire free trade treaties (which have had a corrosive effect on labour standards by exporting jobs to those countries with the weakest standards). The purpose is not to generate revenue from the tariffs so they could be channeled back into development aid for emerging economies to motivate them to come on board.

The price is that it would be inflationary. It increases the costs of producing just about anything. And it increases the spending power of the working classes. In the long run, there is a limit to that inflationary potential but in the short-term it will create economic tumult. Recalibrating an economy is never painless. But the end result hopefully will be that Europe has a more diversified economy and a more equitable distribution of wealth.

Apologies for the hiatus

Apologies for the (over a) month long hiatus. I've been wrestling with NaNoWriMo for the last month. No I didn't make it.

I'm currently back in the UK and flicking through the press here. More content to follow soon.

Redistribution

In the presidential election campaign over here in the States, Senator Obama has been repeatedly criticised for telling Joe "the Plumber" Wurzelbacher that he wanted to "spread the wealth around" (NYT). Dr. Bernanke hasn't actually started the printing presses rolling yet so it is unlikely that plumbers in Ohio actually do make $250,000 per annum. But socialism is still a cuss word over here, so that idea that extraordinarily well compensated plumbers should see the government appropriate some of that compensation and pass it onto the less well compensated is on a par with all of Stalin's other atrocities. I don't want to harangue Americans for their inexplicable phobic reaction to "socialism" though. I would, however, like to say a bit about the redistribution of wealth.

There are three possible motives for redistribution: equality, improving the lot of the poorest section of society or a belief that it promotes overall economic growth. Obviously these are not mutually exclusive. Personally, I am not of the opinion that equality is in itself good. I do believe that society should place a priority on improving the worse conditions in which its members live over improving the average conditions. If greater wealth equality does promote overall growth then that is a happy corollary.

Redistribution doesn't imply anything about how an economy is run, at least up to a point. It is just as possible to redistribute wealth in a free market economy as it is in a dirigiste economy. If you are so aggressive about redistribution that you completely disincentivise gains in efficiency or production then you cannot maintain a free market. But as long as you limit redistribution to a proportion of gain - that is, it is still worthwhile to realise a gain because you will always be better off individually if you do so, even if you don't get to keep all, or even most, of it - then a free market remains an effective way of allocating capital.

Secondly, long term growth is still necessary. This is obvious really. If the overall economy is shrinking but the poorest members are getting richer, eventually they will catch up with richest. At that point, every one gets an equal share. But because growth is negative, the wealth being shared is diminishing, so those equal shares will get smaller. So perhaps my original contention needs some qualification. I want to improve the lot of the poorest part of society sustainably and in the long term.

The goal is clearly some sort of equality. But what sort? I think my desire is quite a British one: what we should be striving for is equality of opportunity, rather than equality of wealth. That is, we want people to be able to benefit from their own industry and innovation. Indeed, the only way to generate those benefits is to allow the people who a generate them a greater than general share in them. Otherwise the tragedy of the commons will ensure that they are not generated.

But there is still a strong argument for some significant level of redistribution. The playing field is currently highly uneven. Unless we ensure greater equality of wealth, we will not be able to create greater equality of opportunity.

There is a second, slightly more subtle, reason for wanting to create greater wealth equality though. By creating more equal consumers, you create an economy that is more geared to those consumers. By commanding more spending power, the poorer part of society can allow the supply-side to realise greater efficiencies and economies of scale as it competes for that spending. On the other hand, human nature being what it is, wealth disparity creates a sort of illusory "exclusivity value". This is real market value, but it exists because people are willing to pay a premium for something because others are not able to pay that premium. This is, I think, a component of GDP that should be minimised.

Now I can see that this argument could be stretched to support the idea that equality promotes growth. The more homogenous the level at which individuals within a society consume, the greater the efficiencies that can be realised in providing for that demand. I've no idea if this works in practice or not though. As I say, it would be a happy corollary if it did.

Responsible borrowing

So Gordon Brown said today (still today here Stateside) that he will allow borrowing to rise to help restore demand; essentially, in order to finance a Keynesian stimulus. Even the Tories recognise the need to allow the deficit to grow to finance counter-cyclical measures, even if they didn't resist the opportunity for a dig at Brown's lack of prudence in the good times.

Meanwhile the Economist has argued that the downturn and consequent need for stimulus has re-awakened an old ideological divide: should public borrowing be used to finance government spending or tax cuts?

It boils down to this - what characterises responsible borrowing is less how much we borrow than how we spend it.

I would like to suggest a few criteria for deciding whether we are employing our borrowed cash responsibly.

Public spending on the public good
If public money is being spent, then it should be spent on things that the public need. This isn't normally a problem for governments; there's normally a backlog of public works that need financing. Nevertheless, the exercise cannot simply be a matter of pumping money into the system. You have to get something for that money.

Value for money
Developing the point, the government are still the keepers of the public purse. The need to generate demand in the economy does absolve the government from the duty to ensure the public gets value for the money being spent. In the short term, the money being spent is being borrowed, but it will have to be paid for by the taxpayer eventually.

Plan to pay
Even economic stimulus must be thought of as an investment. There must be some sense of how it will eventually be paid for, even how it will pay for itself. That payment can be deferred, running a deficit demands this, but it must be planned for. This may be as simple as hiking taxes or cutting spending in better times, but this must make it into the policy before the money is spent. Better yet are those infrastructure investments that will generate revenue themselves in the future. The green investment proposed in the Liberal Democrat recovery plan feels like a good example this.

Focused and efficient
The stimulus must actually stimulate. It needs to be injected into those parts of the economy where it will be "spent on", rather than being lost to paying off debt or saving. Spending aimed at job creation, for instance, should look to create more lower paid jobs (although obviously paying a fair wage) rather than few highly paid jobs.

Minimise leakage
However borrowing is disbursed, the government needs to ensure, as much as possible, that it is the national economy that is stimulated. Within EU, and indeed with any reasonably open economy, this is a difficult task. How does the British government, for instance, ensure that the money it spends on creating jobs is not "wasted" stimulating Eastern European economies via remittances from labourers from those countries? This is not an argument for tighter immigration controls, but it is a real problem with classic Keynesian stimulus in an era of globalisation and open markets. I suspect this may be a strong argument for a co-ordinated, Europe-wide response although I suspect setting up such a thing would be a diplomatic nightmare.

Progressive, not regressive
This one, I guess, is more subjective and ideological than the others. But all public spending should primarily benefit the worse off, and the expense should primarily be borne by the better off. Tax cuts for the rich, the cost of which will eventually be paid by the less well off, either in terms of future tax increases or, more likely, reduced public spending or inflation, do not constitute responsible borrowing in my book.

I doubt the list is comprehensive. But I think it does point to a conclusion (inasmuch as a series of unjustified assertions can) that a properly thought out program of public spending is more likely to be a "responsible" use of public spending than the more haphazard approach of tax cuts - which effectively amount to borrowing money to give away to private spenders. Although, that said, there's probably more scope for ill-considered spending programs to score worse as well.

In summary, the right spending program is a better solution than tax cuts, providing we can work out what the hell it is.

Soft protectionism

Nick Clegg has called for British consumers to "Buy British" to help boost small businesses and thus the local economy (story here). This strikes me as a sort of soft protectionism.

Protectionism is a subject I need refine my opinion on. Orthodoxy has it that it's a bad thing. It slows growth and leads to trade wars. It was a factor that exacerbated the Depression. Nevertheless, there is a clear need to diversify Western economies that that have previously been overly reliant on credit-fulled consumerism and innovative financial services. It is hard to see how this can be done without initially shielding our somewhat atrophied industrial sectors from the rigours of the global economy.

What I don't like about this pronouncement though, is not that it amounts to protectionism, but that if the Lib Dems think protectionism is a good idea, they should say so, rather than pleading with the British consumer to do their dirty work for them. If nothing else, it is simply ineffectual.

One possibility, that may be politically feasible, is to introduce green tariffs. If importers were taxed on fuel miles this would create an advantage for local businesses, but on diplomatically acceptable terms. Of course, British exporters would then be likely to face similar tariffs in other countries. But, aside from the ecological benefits (which are good case for such a tax policy anyway), it would create an impetus towards diversifying the economy and aligning production more closely with consumption.

What happens in Corfu

Just a quick post this.

Matthew Norman's piece in The Independent is a wonderful precis of just how the Tories have screwed themselves. They have probably done nothing illegal but they've tried to play with big boys and shown themselves to be catastrophically unequal to the task.

Bretton Woods: the Revenge

So there is to be an international summit to discuss the reform of international finance. Already comparisons are being made to the Bretton Woods Agreements. These are probably inaccurate. While anything could happen, as currently billed, the intention of the future summit is to address financial regulation, not trade or monetary policy. Nevertheless, it's a plausible excuse to assess the legacy of those agreements at the end of the war.

The US was in a position of considerable financial strength after defeat of Germany and Japan. Europe was in ruins and needed capital to rebuild. The US offered this capital in exchange for Europe accepting a movement from imperial trade blocs towards free international trade and a de facto currency peg to the US dollar (although this was initially by virtue of a peg to gold, for which the dollar was exchangeable). This allowed the US economy to gain access to new markets in which it compete on favourable terms. And although the dollar peg did not survive the massive deficits the US incurred during the Vietnam War, the US dollar remains (for now) the world's reserve currency. The other major legacy, the movement towards free trade, has gather steam to become the globalisation of today.

I don't want this to read as an anti-American spiel. The gold peg was a widely accepted mechanism of avoiding the tit-for-tat devaluations of the Depression, intended to gain a trade advantage. Free trade, when it has genuinely been a reciprocal opening up of markets, has on the whole been a force for good in the last fifty years.

However, both the dollar's status as a reserve currency and the increasingly integrated global economy have contributed to the present financial malaise. The dollar's status as reserve currency resulted in a flow of easy credit to American house-buyers and consumers from savers in the Far East. When that flow, and the resulting property bubble, broke down, the interconnection of the global economy made the contagion very difficult to contain.

So I would suggest that we need to move away from the need for a reserve currency, and away from view that globalisation is an unqualified. Clearly both carry risks.

One idea that it may be worth resurrecting, that first came about during the collapse of Bretton Woods, is the Tobin tax, a marginal levy on foreign exchange transactions. This would encourage developing economies to rely more on their monetary and fiscal policy to support their currency and less on maintaining large foreign currency reserves to fight of speculators. In turn, this would make imbalances of payments in the developed world more immediately apparent.

The problems with globalisation are harder to addess without straying into policies contrary to free trade - tariffs and subsidies. For now, I shall just frame the problem.

Globalisation allows different countries and companies to pursue their comparative advantage. This leads to greater efficiency and greater specialisation. But it removes redundancy and creates a tightly coupled global economy. This global economy is not immune to the market cycle and destructive exuberance of the markets, indeed by allowing these patterns a bigger field, it allows them to play out for longer and come apart more destructively than on a national scale. The globalised world economy is too specialised, too tightly coupled and it lacks firebreaks. When one element fails, it brings the rest crashing down with it.

We should be prepared to sacrifice some economic efficiency to create economic resilience. The global economy is in need of decoupling, and national economies in need of diversification. In particular, it seems desirable that national economies should to some extent try to match their production to their consumption. This is the old protectionist mantra of "self-sufficiency". How to realise this without veering into protectionism, maintaining most of the advantages of free trade, seems to me to be an economically and politically vexed question though.

Nick and Vince's economic recovery plan

As I've recently signed up with the Liberal Democrats back in the UK, and my new membership card arrived yesterday, this would seem to be an apposite time to review what my party is considering to heft the British economy out of recession. So you know what I'm talking about, the plan can be found here. I may look at Labour and Tory plans as well, time permitting.

So the first thing to observe is that it is a spectacularly unfocused document. 4 out of 9 of the action points are geared towards helping people survive the recession (points 1, 5, 6 & 7). A further two (3 & 4) are more geared towards "How can we stop this happening again?" than "How do we fix it now?" These are all good intentions but are being missold as prescription for the economy.

To take them in order:

1. Action on the housing crisis – stop unnecessary repossessions and provide more social housing
The UK clearly needs more social housing. The lack of it has undoubtedly been a contributory factor to the property bubble. The present straitened times may offer an opportunity to acquire it cheaply. Unfortunately, the taxpayer is now on the hook to make good any losses the banks make on their exposure to an overvalued property market. I like the idea of building up social housing stock. I also like the idea of realising the losses in the property market rather than leaving them in an uncertain limbo, even though the taxpayer may end paying for it.

Now I'm not sure that this is actually what comes out of the details of this part of the plan. It seems far more geared towards forcing banks to let people keep homes that they couldn't afford in the first place. I think a lot of the loan restructuring will happen anyway. It makes financial sense for the banks to restructure (i.e partially write-off) the debt rather than foreclose and sell the collateral at the very bottom of the market. But applying government pressure to distort those decisions is going to prolong the process of correcting the inflation in the property market, painful though it is.

2. Action to put more money in people’s pockets - tax cuts for people on low and middle incomes
I have to be honest, I am automatically skeptical of any policy suggestion that claims to be revenue neutral by virtue of cutting unnecessary costs. I just don't think Britain's governments are ever that keen on wasting taxpayers money. So any policy that assumes that they are is suspect. Keynes would be suspicious of revenue neutral methods of counteracting a downturn anyway. You actually need to pump more money into the system by running a deficit.

So on the good side, this will reallocate money to people who are more likely to spend it. However, upping taxation on pollution, worthy though it is in the long run, is unlikely to encourage investment in the British economy. Similarly, rich people tend to have more mobile money. The taxation loopholes I don't doubt are unfair, but the Inland Revenue takes what it can without driving them to take their money overseas.

This one strikes me as a gamble. But I don't think it is primarily intended as an economic stimulus so much as a populist measure to support "ordinary British families".

3. Action to limit the excesses of the City & 4. Action to deliver future economic stability
I don't want to go too much into these. I will make a few general points. I think the question of how to reform and re-regulate the financial sector and monetary policy is a rich subject in it's own right.

As I said earlier, nothing here is particularly geared towards helping the economy recover from recession. The suggestions don't seem terrible, apart from an irrational antipathy to short-selling. Nor do I think City bonuses per se were a contributory factor (objectionable though they are to a sense of social justice) so much as the fact that they incentivised the wrong sorts of behaviour. But I think that the financial sector is in need of far more radical reform than suggested here.

Really though, these measures are simply too late. The horses have already bolted. To deliver economic stability you need to anticipate, or work out how to anticipate, the next crists, not explain how you could have prevented the last one.

5. Action to cut energy bills and fight fuel poverty
Undoubtedly, improving fuel efficiency in British homes is a good thing. This would be an ideal area to perform some Keynesian stimulus. Financing it through a de facto windfall tax on energy companies (the word "re-invest" fools nobody) is a categorically bad idea. Allowing this sort of instability into corporate taxation and regulation will do nothing to encourage investment in the UK economy. If there are market inefficiencies that allow these companies to make exploitative profits they should be identified and addressed directly.

6. Action to help people with debt problems
The reason, generally, people end up paying a high rate of interest on their debt is because are perceived as a credit risk. Extending cheap credit to such people at the taxpayers expense is not a solution. But education is.

Asking the financial sector to help finance that education is a windfall tax on a sector that hasn't had a windfall (and indeed in which the taxpayer now has a substantial stake). So, yes, help people understand how to manage their finances. Again, if nothing else, this would create jobs and act as economic stimulus. Some public funding, with appropriate strictures, might not then be inappropriate in helping people to restructure their debt.

But the overall effect here is pro-cyclical. It encourages people to spend less and pay off debt. This is the opposite of an economic stimulus. It is a necessary process, no doubt, but it is not part of an economic recovery package.

7. Action to help people who lose their jobs
Yes. Our infrastructure to support the unemployed is going to need some new investment in a recession. Most of this is sensible, if obvious stuff.

However, the idea that raising the minimum wage, in an economic downturn, is going to help create jobs is foolishly optimistic. I think in terms of incentivizing people to get back to work (which is not usually the problem in a recession) they have got it half right by continuing to provide benefits once someone has found employment. I would go further. My suggestion would be to scrap the minimum wage completely and instead continue to pay "unemployment" benefit, minus some fraction of salary (say two thirds). This would essentially be a government-sponsored "make-work" scheme but it would keep people in employment and it would mean that they were better off in cash terms by working. And it would maintain some sort of market mechanism to ensure that the work they were doing was as productive as possible.

8. Action to deliver ‘green-collar’ jobs and energy independence
The headline is great. It is only when you read the detail that you see what is actually being proposed is a tax hike. I don't have a problem with using taxation to steer the country but now is not the time to do so and it is wrong to present it as an economic stimulus.

By all means, invest in green mortgages and the railways. But borrow (or print money) to do so and start taxing lorries once the stimulus kicks in, when the economy is better positioned to weather an anti-commercial policy and when the infrastructure to replace them is already in place.

9. Action to reinvigorate global trade
Freeing up international trade can only be a good thing for the economy. Quite how you do that when the economy is in a slump and the clamour for protectionism across the world is growing louder, the paper neglects to mention.

However, I don't think that high commodity prices are a bad thing for the UK in the long run. They make it more and more economic sensible to start rebuilding the UK's manufacturing industry, the agricultural sector and those areas which have fallen out of favour with a highly skilled, services-biases economy of the sort which is particularly vulnerable to a downturn. Diversifying the UK economy is going to be key to a long-term recovery and diluting the cost of the higher wages demanded by Britons is beneficial to that end.

Leverage - What is it good for?

We all know by now that the process of deleveraging is causing a sizeable deflationary pressure. And that the process - when it occurs systematically - creates a devastating feedback loop. Banks, predominantly, see the market price of their assets fall, their debt-to-equity ratio swings up into the red/danger sector of the gauge, they are forced to sell assets to pay off debts, depressing asset prices further, leading to even more deleveraging. It is painful medicine.

What about leveraging though? How did we get so leveraged in the first place?

If we look at the economic and financial theory - which of course is based on a number of unrealistic assumptions about the efficiency of the market - then there is no reason for investors to prefer debt to equity. An efficient market should ensure that the risk and likely return are in line. Of course, debt carries a preferential claim on the assets of the business. Debt is lower risk than equity, but that gets priced in. So in an efficient market the market value of debt and equity is the same.

In practice, there are often strong tax incentives to finance through debt rather than equity. A common inefficiency is the taxation of dividends but not interest paid on debt. Companies have already paid corporation tax by the time they get around to servicing their debt. But so they have when they get around to paying dividends to shareholders. The market is then skewed in favour of debt financing.

The main textbook purpose of leverage is to improve shareholder returns. If a company needs to raise finance for a new venture they have two options: they can issue new shares or borrow money, either directly from the bank or by issuing bonds. If you are a shareholder which would you prefer? You shouldn't mind issuing new shares. Your equity will be diluted but the capital of the company is increased by a like amount. But it means that you have to share future returns with the new shareholders. Conversely, debt usually involves fixed payments. If the company outperforms the market then rather than having to share that with the new investors you only pay them a fixed coupon and you keep more for yourself. If it goes pear-shaped, of course, you only get what's left over after the creditors have taken their dues.

But here's the thing. You hold shares in a company because you think it's a good investment. Shareholders are already of the opinion that the company will outperform, otherwise they'd sell up and invest elsewhere. They have inbuilt bias towards leveraging the company to get new long-term financing.

In the short term, leveraging up usually looks like a good idea. Businesses tend to finance new ventures when the economy is on the up. Profits go up because of generally increasing prosperity (so-called 'beta') rather than any special magic ('alpha'). Leverage makes mediocre companies look good in good times. This pushes up share prices, thus massaging leverage ratios downward, encouraging the company to take on even more leverage. In other words, it's the reverse of the deleveraging feedback loop described earlier.

Let's take a step back at this point. From the macroeconomic point of view, what is the effect of leverage. In the first instance, it doesn't really generate greater return on capital. It apportions the profits in different amounts to different investors. There may be a marginal effect of getting cheaper finance by catering to different risk appetites but leverage is one of the reasons that equity values are so volatile in the first place. The two most significant effects of leverage though are negative.

In the first place, leverage makes business less agile, less able to change direction with the economy. They go full steam ahead in good times, and when the downturn comes and the brakes come on, you end up with a train wreck. Arguably, this would not happen if investors discounted future contingencies properly but recent events have shown quite conclusively that the market is often quite short-sighted.

The second problem with leverage is that it obfuscates the real performance of business ventures. In good times, leveraged equity performs better and is valued higher. Again with entirely efficient markets this would not happen. But we must deal with the system as it is, rather than how we would wish it to be. This obfuscation interferes with the purpose of the financial system, which is to allocate capital to where it provides the best return. Leverage creates (or at least exacerbates) market inefficiency.

The conclusion is this, leverage - long-term debt financing of business - carries hidden costs for the economy that real world markets do not adequately price in. On top of that, tax regimes often skew the market in favour of leveraged finance. Policy-makers should do the opposite. There should be disincentives to leverage.

A quotation

This one rather caught the temper of the times for me...

The rulers of the exchange of mankind's goods have failed, through their own stubbornness and their own incompetence, have admitted their failure, and abdicated. Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men.

True they have tried, but their efforts have been cast in the pattern of an outworn tradition. Faced by failure of credit they have proposed only the lending of more money. Stripped of the lure of profit by which to induce our people to follow their false leadership, they have resorted to exhortations, pleading tearfully for restored confidence. They know only the rules of a generation of self-seekers. They have no vision, and when there is no vision the people perish.

Franklin D. Roosevelt

Reconsidering Value

Here is something of a Socratic question: Does advertising something increase its value? I'll come back to it in a moment.

Some economists like to distinguish between market price and market value. The former is simply how much you could get for something, selling it today, no matter how inefficient, ill-informed or plain scared the market actually is. Market value on the other hand is what someone would pay for it if they were acting "knowledgeably, prudently, and without compulsion". When the two coincide you are said to have an efficient market. The fact that the two are, supposedly, not coinciding at the moment is what is leading to calls for the suspension of mark-to-market accountancy rules, which after all rather depend on a certain amount of market efficiency.

Back to the original question. Assuming that advertising is not making fraudulent claims about a product, so that potential buyers remain able to act knowledgeably and prudently, can it increase market value? We'll assume that there is no compulsion involved either although let's caveat this depends on your assumptions about the psychological efficacy of advertising in persuading people to buy. Let's say, in fact, that all advertising does is associate a product with a certain sort of lifestyle, giving it a certain cachet, a certain desirability. Classic branding stuff. Well the answer is that if advertising is successful in making a product more desirable then, yes, there is more demand, people are knowledgeably, prudently and without compulsion prepared a higher price, the market value increases.

Or let's take another example: I spend a lot of money on a house. A good part of the money I spend is discounting the supposed future value of the house. What does this mean? House prices are going up, they've been going up for a while, the prevalent assumption is that they will keep going up. I am prepared to pay a lot now because I will be able to make more selling later. And of course, one effect of this assumption is that it will keep driving prices up.

Arguably, the problem here is that the market is not knowledgeable. It assumes that prices will keep going up, whereas in fact they cannot. But this is a strained definition of 'knowledgeable'; in fact what is demanded at this point is omniscience. Even then, even if I realise that house prices cannot keep going up, the fact that the view is prevalent means that the seller of the house would not knowledgeably, prudently and without compulsion sell the house to me. He'd get better money from someone else.

What's the point here? Well in recent years a lot of economic and political discourse has been haunted by a belief that markets determine value. For instance, the advocates of globalisation point to increased growth which is attributed to the removal of trade barriers and tariffs, and developing countries opening up to markets and investment. But growth here means a growth in GDP, which is the market price (not even the market value) of what the country does. There is also a wider discussion to be had about whether that growth is really attributable to reducing barriers to trade but I don't want to address that here.

So here's the anti-thesis: The market doesn't determine value, it discovers it. Sometimes it distorts it. I suspect this is not controversial position to adopt and that even free market ideologues would agree. The market is a field into which our values - personal, cultural, ethical - are projected. It is a mechanism for realising those values efficiently. It is a way of achieving consensus and collaboration towards achieving and attaining what we place value on. But it does not enact valuation.

A sidenote - I'll confess that my usage here is a little muddy. Things have value, people have values, and we are talking about possibly very different things. To try to clarify, one's values in this context are the motives - be they personal, cultural, ethical, spiritual - that inform a process of valuation when determining the value of a product. As a corollary, it is precisely the fact that people have different values, leading them to assign a different value to that same product, that means we have to invoke market value in order to make value objective and measurable.

Market forces then, like those that drove the speculative property/credit bubble of recent years, are not a pure, reified, inevitable energy. They are the abstracted agenda of profit-seeking individuals and organisations. When we found ourselves in a situation where people were forced to take on more debt than they would be able to ever pay off, it was not the market that determined that, but the irresolve of our own values. If we had been prepared to place a higher value on social housing, more equitable distribution of wealth, reduction of personal debt then the market would have responded with ever more efficient ways to realise those values instead.

Instead we went with what the advertisements told us we should value.

Karl Marx's Revenge

Today has seen what is effectively the partial nationalisation of the financial sector in the UK, but also in the US.

To start with the UK, although it is not strictly speaking chronologically correct to do so, Her Majesty's Government is reportedly contemplating buying a £50 billion stake in British banks (BBC). Apparently it will follow the Buffett model of getting very preferential shares and warrants for common equity.

Ben Bernanke seems to have come up with something slightly different. He is proposing that the Federal Reserve will buy commercial paper from cash strapped firms directly (transcript on the Washington Post). To finance this without printing dollar bills, or Treasury bonds which in the short term amounts to much the same, he is proposing to take advantage of new powers to pay interest on deposits - and thus encourage those them to write off assets. You can't dofirms with spare cash to deposit it risk-free. In other words, he is going to be running a bank. Rather than buy equity in the banking sector, which is politically unpalatable in the States, he is going into competition with banks, who are in no position to compete.

Of the two schemes, I prefer the US one. Rather than effect a partial nationalisation of the whole banking sector, Dr Bernanke is proposing what is effectively a total nationalisation (albeit with a time limit, unfortunately) of the money markets. The benefits of having private money markets have always seemed marginal. In normal markets they are very closely correlated to policy rates anyway. When they deviate from policy rates (like now) it is cause for alarm rather than a celebration of the efficacy of the market. And it is an area that is too vital to the economy to abandon to the markets. By nationalising the money markets, the Fed is removing a level of indirection from its policy rate-setting and does not make a vast contribution to capital efficiency anyway.

Alistair Darling's scheme, on the other hand, invests taxpayers' money in a failing industry. I've been consistently making the point that the banks are not principally under-capitalised so much as over-leveraged. Yes, an injection of capital will allow their balance sheets the flexibility to write off junk assets without bankruptcy. But what does this actually mean? It means that they have debts which their assets don't cover. It means that they need someone to give them equity capital to pay off those debts. Then they can write down those assets. It effectively means HM Treasury is paying off their debts, and, by way of a sweetener, receiving equity a fraction of the value of the money they have actually invested. Politically palatable but hardly a sound investment.

Of course, the Fed won't actually be allowed to undercut the banks and drive them out of business. That just isn't politically tenable in capitalist America. But that's a pity because it's the closest we've seen to the right solution.

Deposit Insurance

The US "bail-out" bill that passed over the weekend included a measure to extend deposit insurance from $100,000 to $250,000. There are also moves in the UK to extend it from £35,000 to £50,000. In Ireland and Greece they have removed any limit whatsoever. This is sad. It is a very regressive form of government intervention.

Ostensibly, the impetus is not to safeguard the finances of the well off. It is prevent runs on teetering banks. But the effect is essentially to use public money to insure the deposits of the rich. The poor simply do not have so much saved. So it ends up being a subsidy of the rich by the poor. It is not even clear that the various governments can afford it. Ireland, for instance, has guaranteed deposits equal to twice its GDP.

And there is a limit to how effective merely extending the insurance can be? What motivated the run on Northern Rock was fears about having accounts frozen rather than losing deposits. The process in the UK for making a claim against the insurance is somewhat bureaucratic. That is one of the reasons why the rescue of Bradford & Bingley bypassed the process altogether and handed the deposits over to Banco Santander.

In any case, bad banks deserve runs. Even good banks have no right to depositors' confidence. And, in the long term, depositors moving their money to better banks is what the industry needs. It's been a consistent message in this blog that it is not that the banking sector is under-capitalised, but over-invested (although too small a proportion of that investment is equity).

We need to allow banks to fail and if, necessary, to allow depositors to lose some of their funds.

That said, depositors should be first in line to recover money from the bankruptcy. And I think there is an argument for structuring deposit insurance better. The real social purpose of deposit insurance should be to ensure that "ordinary people" are not impoverished by the collapse of banks. But that could be better implemented by providing the insurance to individuals, across all their accounts, even when they are with institutions. This would also remove some of the incentive for moving deposits to new accounts at other banks. At present if I $100,000 with one bank and $100,000 with another I am fully insured; whereas if I have $150,000 at one bank I am not. There is also an argument for providing more insurance to those who are older. Most of us save over the course of lives, and we save for retirement. Therefore, the older we get, the greater need we have for deposit insurance.

With deposit insurance scheme more geared towards protecting individuals, rather than failing banks, there probably is a stronger argument for raising the overall headline figure. But overall, the government would not be insuring that much more (disclaimer: I've done no analysis of the statistics here but the intuition seems sound) because it would not have to insure multiple accounts of one individual in full.

Quick note

I'm entertaining a guest from the Old Country this week. This is my current excuse for this blog being a little more sporadic than I would like. Next week I will revert to blaming it on being overworked.

Ann Pettifor

One voice that seems to be getting a lot of airtime in left-wing British press on the "credit crisis" is that of Ann Pettifor of Advocacy International. She also has a blog.

Her analysis is interesting, even if her solutions are a little extreme. Cancelling debt would mean cancelling the population's bank accounts at the same time. This would be politically unfeasible.

But her "credit pump" theory, I think is astute. Essentially, because credit has been easy asset prices have become inflated and thus people have been forced to borrow beyond their means in order to get by. To be honest, I think even those people who haven't borrowed extensively, have still probably derived a good part of their income indirectly from the credit-fuelled consumption. In other words, our economy has become "addicted to credit" to use a trope, which has in turn widened disparities wealth.

I don't think that so extreme a Jubilee as she advocates is going to be the answer. But it is wrong to talk of systematic at risk at this stage. The system was self-destructive from the outset. As we dig our way out of the hole, we do need to be thinking about what a better system would look like so we can dig in the right direction.

John Gray in the Guardian

And more on the politico-cultural ramifications of the Paulson plan, an excellent essay by John Gray in the Guardian.

The Paulson Plan - a brave new world

So the final draft of the Paulson Plan is out. I find my copy at the New York Times (PDF).

It's obviously quite a lengthy document so I'll refrain from too much analysis until I've had chance to read it and catch up on some of the press response. My initial impression is that it has absorbed a lot of the different ideas that were milling around Congress, provided authority to the Treasury Secretary to implement all of them, but left it to his discretion on which of them actually do get implemented and how, along with a set of stated aims for the intervention and a substantial framework for oversight.

In other words, we need to wait and see how it is implemented. This is simply the legislative groundwork for the Paulson plan. We don't actually know what his plan is yet.

To shift focus from the economics of the package, the equity warrants are the most significant aspect. They are non-voting but this is still, in a sense, a mandate to nationalise the finance sector. Given the USA's ideological commitment to a free market capitalism where the Government watches from the wings, this is a substantial coup. A philosophical Rubicon has been crossed here.

This is a test too, not for free market capitalism which has already flunked, but for the sort of partnership of State and commerce that predominates in most of the rest of the world. The provisions against excessive executive compensation and the requirements to use the rights over the mortgages to effect a kind of Jubilee on foreclosure could be (maybe) the seeds of an ideology where the public sector acts as the political conscience of industry. We should welcome this warily.

Unblocking the pipes

I've just seen this article on Bloomberg. It is actually rather reassuring.

I said before that the financial sector needs to contract substantially. To do this, it needs to deleverage and it seems increasingly likely that this is going to be hard because, once its trash mortgage portfolios are marked at a realistic price, large chunks of the sector are going to be insolvent. If you are insolvent, the value of your assets is not sufficient to meet your debts. The only way to resolve this impasse is through bankruptcy, passing the shortfall on to your creditors. This is what needs to happen to unwind the leverage and restore credit-worthiness to the system. It is good to see this is happening, and that the mortgage portfolios are being marked more realistically in the process.

It looks like the US legislature will be able to pass the Paulson plan in some form this weekend. Hopefully, it will be discretionary enough, and its managers will be astute enough, to use it to cushion this process of deleveraging rather than as a wholesale recapitalisation of the system. This latter action would only serve to transfer the gap between the value of assets and liabilities onto the public balance sheet rather than liquidating it. In other words, rather than allowing the banks' creditors to suffeer the consequences of their unwise investments, those consequences would be met by the US taxpayer.

Consolidate your loans!

Unsurprisingly, this has been a rather tense and tough week in the financial sector. So this post may end up being pithily concise.

This article by David Leonhardt in the New York Times is one of the better analyses I've read.

Personally I'm wavering on the plan. The legislature have done a better than expected job in improving the bill, but I'm very doubtful that bringing these debts onto the public balance sheet is the right thing to do. It would be better, if the damage could be limited, to allow the banks to go bust and the debt to be written off. The plan that is being proposed is the equivalent of taking out a mortgage to pay off a credit card.

In the short term, this may be the only way to keep America solvent. But unless something is done to address the imbalance in what the US economy produces and what it consumes the root problem will only be postponed and eventually exacerbated. But I don't think there are leaders who have the courage to tell American consumers that they have to change their spending habits. So once the immediate crisis is averted I see things carrying on much as before... until the mortgage is foreclosed on as well.

In other words, this plan is only a good idea if someone can persuade Americans to give up their addiction to easy credit in the long term.

What is wrong with Western banking?

I said in an earlier post that the banking sector needed to shrink. And I promised an explanation of this. Well here it is.

According to the BEA's figures, in 1987, the contribution of the banking and insurance industries to national GDP was 5.79%. In 1997 it was 7.17%. In 2007 it was 8%. The financial sector is becoming a larger and larger part of the US economy.

This shouldn't be the case. The wider economic value of the banking sector (yes there is one!) is in the efficiency it creates in the allocation of capital. A working financial system channels money to those parts of the economy where it provides the greatest return on capital. Banking does this by facilitating direct investment; insurance does it by turning small, catastrophic risks into more likely but less impacting ones, making returns more predictable and thereby encouraging investment.

But the point is that finance doesn't produce capital; It allows it to be employed more efficiently. So if the financial sector were improving - rather than simply growing - you would expect it to become a smaller part of the economy over time rather than a larger one as it became a more efficient mechanism for deploying capital. Even in good times you would expect, if not absolute contraction, then certainly to see finance becoming a smaller and smaller proportion of overall GDP.

How has Western finance escaped this reckoning?

The first ploy is simply by leveraging 'beta'. The economy has been growing. By borrowing and investing you can make money as long as things keep going up. Things go up, you go up faster. The flipside is of course that you go down faster too. The simplicity of this ploy has largely been disguised by developing increasingly complex and opaque derivatives.

As an aside, contrary to reports in the press, derivatives are not intrinsically ruinous. They are by definition a zero sum game. If one counterparty loses money, it is only because someone else has made it. But by and large, they are a not much more than a punt on the markets. As such, they don't (intrinsically) really help to realise the macroeconomic efficiencies in capital allocation I mentioned before. And the more exotic and complex they are, the more opaque and illiquid they become, and arguably the less efficiently they allocate capital. And banks have devoted a lot of resources to developing, trading and hedging these things. This represents an abandonment of the core purpose of finance and a failure to create a macroeconomic return in capital efficiency.

Derivatives can, I believe, create liquidity and enhance capital allocation, but to do so they must be simple, transparent and not generate long-term counterparty risk. Creating ever more complex, bespoke, over-the-counter products rather than moving derivative markets onto exchanges represented a move in the wrong direction for the financial sector.

To return to the main thread: The other, more significant, engine for the imploded growth of the financial sector was charging what were effectively brokerage fees for the supply of credit to the consumerist West. It hardly needs to be said, but consumption on credit is a really bad idea. It is fundamental misallocation of capital. It produces no return at all. The mechanism is opaque but by now well studied. I won't bore you with yet another essay on the bursting of the property bubble.

But a consideration of how banking went wrong wil be vital once the dust has settled. It is clear that the cost of their catastrophic failure is society's loss confidence in Big Finance to manage the economy. It was of course always suspect to imagine that a regime run for the self-interest of employees and shareholders would, in the long run, prove more competent than a political establishment accountable to population at large. But in future, the banks will be subject to a lot more government regulation - and rightly so. What is vital is that government regulation is well thought out and intended to realise the value of a well functioning financial sector as well as just curbing the excesses. That means it needs to be about realising efficiencies, promoting transparency and liquidity, formed around principle rather than bureaucracy. This will be a difficult thing to accomplish.

Somewhat preoccupied

I have, I confess, been somewhat consumed with the Paulson Plan. It will become a little broader going forward... but this is the seismic event of the moment. The focus is likely to remain for a little longer.

The Paulson Plan - why not equity?

Along with a growing multitude, Sebastian Mallaby, in an article in the Washington Post has mooted the idea of forcing banks to raise capital directly by issuing new equity. Aside from a need for political expediency, I don't think this one will fly.

It looks like Mr. Paulson has taken the view that the problem is not that the banks are under-capitalised. The problem his plan is trying to resolve is that the banks have assets on their books for which there is no market and hence no reliable market price. This bailout is not, or at least certainly shouldn't be, about getting more capital into the banking sector. It is about removing that uncertainty from bank balance sheets.

Simply providing more capital to the banks won't remove that uncertainty, however it is done. The assets of unknown price stay on their books. What is needed, as the Treasury has diagnosed it, is to quarantine the assets. I think this is probably right.

Moreover, it is not as if banks haven't tried to raise new equity capital. Certainly they have in the UK with a number of rights issue. Largely these have not been all that successful. There just isn't an appetite for banking equity at the moment.

That would leave the taxpayer to buy the new shares. And, indirectly then, those "toxic" securities are still on the public balance sheet because they are owned by banks in whom the Treasury now has an equity stake. It's hard to see the benefit apart from some dilution of the risk. But the cost of that is that those mortgage-backed securities are still creating large uncertainties about banks' balance sheets.

The Paulson Plan - business as usual

So the response of a Democratic Congress to Paulson's bailout is in (New York Times and Washington Post).

Some things are sensible: the plan as originally drafted, clearly needed more oversight. And I think Mr. Paulson is wrong about executive pay. It's necessary to make the bill palatable to the public and any CEO who takes the golden parachute while his firm goes bust rather than participating is frankly going to have to get a new identity in Latin America.

Sadly, they didn't stop there and the thing risks becoming a political football. The push "for assistance for distressed homeowners" (NYT) is wrong-minded. Not because they shouldn't get assistance but that this does need to be a "clean bill". As a sidenote, I think 'focused' is probably a better word here. There's nothing clean about it. But the US Congress needs to curtail its usual dysfunction and get a bill passed. If it needs to be fixed later, so be it.

I'm doubtful this will happen though. Both parties are going to play to the gallery with this one.

The Paulson Plan - First Take

The profound disquiet I felt on Friday when the news broke about a massive bailout of the financial sector by the US Government bordered on physical nausea. It seemed utterly corrupt. Undoubtedly it has become necessary. But the derivatives spivs have been allowed to profoundly endanger the economy with their hubris and greed. They have been allowed to get away with it. And the US taxpayer has had to take on debts of $700 billion to salvage the situation. It seems contrary to any sense of justice.

Having spent today keeping up with the details emerging from the cabal on Capitol Hill I am feeling slightly better about it. I would have preferred to see the banks recapitalised by a government purchase of equity - that would have ensured that the taxpayer got to see the eventual benefits of the rescue as well as the cost. But I suspect, pleasantly vindictive though it would be to dilute the capital of these reckless companies, this would not be all that pragmatic. So no partial nationalisation, richly deserved though it is.

In the first place, that equity will probably not hold its value. The banking sector needs to shrink substantially (more on this in a subsequent post). Secondly, the subprime instruments on their balance sheets have attained a rather totemic quality. To restore market confidence this "toxic waste" needs to be isolated.

So the US Government is left trying buy the stuff, sticking it in quarantine for a few years, and seeing how much money the taxpayer gets back. The problem is, nobody has a clue what it's worth. The Paulson gambit seems to be that it actually does have some value, but that it is impossible to realise it in the present market. That is, the problem is one of liquidity. The alternative is that the banks are still lying about, or at least inventing, the valuation to keep their balance sheets from falling apart. This doesn't strike me as unlikely. So it is quite a big, and desperate, punt by the Treasury.

The final judgment will have to depend on how much Paulson pays. The banks and the government are both over the barrel on this, but the government can probably afford to drive a hard bargain. This will take nerve; and even with nerve it won't be easy. The difficulties in valuing this complex, toxic instruments are precisely what has led to their illiquidity and the attendant market panic. But if Paulson is right and the problem is liquidity and he gets a good price, in the long run the taxpayer shouldn't be too much worse off. So it may turn out that this is not the heist of the century after all.

I'm not sure how hopeful to be that it turns out not to be though.

About this blog

So I'm starting a new blog. Why? The week just gone has seen a near meltdown of the Western financial apparatus. It is difficult to rationalise this as a freak anomaly. Fukuyama had it that the defeat of communism by Western capitalism marked the End of History; even 9/11, despite its enormous cultural impact, did not really call into question the West's ideological commitment to free market capitalism. The Economist asks: What next? That's what I want to know too.

I work on Wall Street. I am one of the villains of the piece. But this week has pricked my political conscience. I want something better than the corrupt poisonous hubris of... well my lot. If not to put into practice then at least to believe in.

I don't know what that is yet. This is a space for me to think about that.