Archives for August 2012

Resurrecting the world’s first economic policy idea

The Old Testament gives specific instructions to the Israelites as to how they should organise their society. One of the most intriguing from a modern-day economist’s perspective is that of the Jubilee. Every 50th year, all debts between Israelites were to be wiped clean, all land returned to the families that owned it 50 years previously and slaves freed. In today’s parlance, it was pushing the Reset button and starting afresh. There is little evidence that the Israelites followed this revolutionary idea, most probably because those who would benefit most were the poor and downtrodden and those who would benefit least were the rich and powerful!

Recently some economists such as Stephen Green have been proposing the idea of a Modern Debt Jubilee ( as having merit for solving today’s economic problems. The world is currently experiencing a balance-sheet recession rather than a standard cyclical recession. This is where individuals, governments and especially banks believe themselves to be over-indebted and seek to reduce their liabilities (debts) – there is a much reduced desire both to borrow and to lend. This inhibits overall demand in the economy, leading to slower growth which in turn holds back confidence in companies who defer investment.

The policy of Quantitative Easing (QE) is the printing of money to make banks balance sheets more liquid and thus encourage them to lend once more. An alternative Modern Debt Jubilee policy would be to print money and use it to repay some of the debt outstanding which is inhibiting economic growth – so returning to the concept of Jubilee. For example the government could decide to give every adult in the country £10,000 in a special account, which could at first only be used for the repayment of their debts. In this way, individuals could repay their most expensive debts (typically consumer credit), and banks would become both more liquid and have smaller balance sheets. For those who do not have debts use of the money could be restricted to paying for tertiary education, for buying a home for them to live in or providing a pension – all of which can be regarded as personal long term investment.

At the cost of a large amount of money, £450bn for the UK – (compared with the £375 billion of QE so far approved by the Bank of England) this Modern Debt Jubilee policy would significantly reduce consumer debts, provide better-funded pensions and boost the amount of equity in people’s homes. Though the use of this money would be restricted to “worthy” areas, there would certainly be a consumer wealth effect both from consumers just feeling less indebted and from the boost to disposable income from reduced interest payments. Demand in the economy would pick up and if the Bank of England feared inflation then they could easily reverse the QE as banks would not need the extra liquidity as consumers repaid debts. A little inflation, however, would be rather welcome as it would break the economy out of the deflationary mindset that it has fallen into currently.

If we do need to print more money to boost the economy, then this idea is a far more powerful way of ensuring it happens than replacing government bonds with cash in the banks’ balance sheets, the current QE policy.

Jubilee – the oldest and least used economic policy idea in history is definitely worth considering today in a modern form. For those at the bottom end of the income distribution, it would rid them of debts that burden their lives thereby pushing the Reset button on their personal finances. For the middle classes it is a way of either ridding themselves of expensive debt or encouraging long term savings.

A layman’s guide to the LIBOR scandal

LIBOR stands for London InterBank Offered Rate. It has become the global benchmark for market interest rates – these are related to but different from the official interest rates set by Central Banks at their policy meetings, eg Bank of England Base Rate.

Each day at 11am, a group of banks (a different group for each of 10 currencies, generally those who are considered most active in each currency) submit to the British Bankers Association (via Reuters) the rate of interest at which they believe they could borrow from other banks over 15 different maturities ranging from 1 day to 1 year. For each currency and maturity, the BBA exclude the top quartile and the bottom quartile and calculate the average of the middle two quartiles. This average is then published as the daily LIBOR fixing. Over time this has become the benchmark used for market interest rates (similar to the FTSE 100 Index used as the market benchmark for UK stocks), and has thus become the reference for nearly all derivative contracts relating to interest rates and many other loan contracts. Estimates as to the total value of contracts outstanding in LIBOR-related contracts vary since much of the trading is carried out as transactions directly between banks and not on market exchanges, but $300 trillion (12 zeroes in a trillion) is probably a conservative estimate – equivalent to more than $40,000 for every human being on the planet. A change of 1 basis point (0.01%) for 1 day on that nominal exposure results in $120 million of cash flow difference moving around the global financial system.

Arguably there are 3 scandals (so far).

  • From 2005 to 2007 when light-touch regulation was in vogue and banks proprietary trading desks were making enormous profits with consequent internal political power, it has become apparent that traders at Barclays and other banks sought to influence the rates that were contributed to the BBA by the rate contributors both at their own bank and in at least one case in other banks too. They were doing this to suit their own trading positions (by trying to get LIBOR to be marginally higher or lower so that they would make greater trading profits)
  • During the 2008 crisis, when lending between banks broke down and the entire financial system came close to collapse, there were no actual trades on which to base the numbers that the banks sent into the BBA. Further many banks did not wish to disclose the weakness of their positions to the wider world and so told their contributors to bias downwards their expectations of what interest rate they would have to pay in the market should they have been able to.
  • In 2007 the New York Federal Reserve were sufficiently concerned by what they felt was a weak process for such an important market price, that they wrote to the Bank of England about their worries. Mervyn King and Paul Tucker appear to have done very little in response to this warning, a fact that has already been picked up by the Treasury Select Committee.

Of these three scandals, the first is criminal if true and can be proved. However the method of calculation is designed to throw out entirely the very high and the very low inputs – it would require an enormous conspiracy between many banks to actually alter a LIBOR rate. The third is a political loss of face for the Bank of England and King and Tucker in particular – it will probably cost Tucker the chance of succeeding King as BoE Governor. The second is almost certainly true but equally contributed to keeping the whole financial system alive – the world was so chaotic at that time and no actual interbank trades were taking place that every LIBOR rate input was a judgement without any evidence to support it. It will be difficult to prove in a Court of Law that a knowingly wrong number was submitted. It is entirely possible that had banks contributed less optimistic judgements of their ability to borrow at the time, then the higher LIBOR rates this would have created could have made the crisis worse

Note that the 2005-2007 scandal involved only dollar and euro interest rates but not sterling rates, so no sterling borrower or lender will have been damaged by it. However this scandal reinforces the long-running narrative of politicians that banks have become forces of evil and must be increasingly heavily regulated. Sackings and resignations of the interest rate traders and many of their superiors right up to CEO level have and will continue to occur. A new system for calculating market interest rates is likely to be brought in in due course, one that will be based on actual transactions rather than best guesses. In the meantime compliance departments will be scrutinising very carefully every input to the BBA.

Mario Draghi – boiling the German frog!

The anecdotal boiling frog story holds that if you throw a frog into a pot of boiling water it will immediately jump out, but if you place it in a pot of cold water and slowly boil the water, it will not perceive the danger and will be cooked to death. The recent announcement by Mario Draghi, the President of the ECB, of how the ECB believes it can bring the Eurozone crisis under control, smacks of these tactics.

By the end of July, as many of Europe’s leaders had set off for their holidays, Spanish bond yields hit critical levels, which if maintained would shortly leave Spain unable to raise money in the financial markets and requiring a full-scale bailout from the other governments. Spain is however too big for the other Eurozone countries to bail out without considerable help from the ECB in the form of printing money.

Mr Draghi has carefully constructed a plan of action that garners just enough political support to be workable. First, a country must ask for assistance from its fellow Eurozone governments, which must be approved (thus achieving full political buy-in) unanimously. They and the ECB will then set out the conditions for such assistance (achieving the strict conditionality criterion demanded in particular by Germany) and the ECB will then be free to buy short and medium-dated debt in any amount in the secondary market.  That should, in theory bring down yields and enable the country to continue to fund itself in markets. Draghi has promised that he would also deal with the issue of ECB priority in the repayment of debt which bedevilled the Greek bailouts.

As an idea this has the support of the “moderates” within the Eurozone, essentially most of the political leaders and Central Bankers with the sole exception of the Bundesbank, which firmly opposes any Central Bank buying of government debt. The Bundesbank though is a greatly weakened institution today. On the ECB it has only vote out of 17, and only has influence to the extent that the German government agrees. In this case, both Merkel and Schaeuble have come out in favour of the Draghi plan – the Bundesbank is therefore rather isolated. Draghi has successfully driven a wedge between the Bundesbank and the German government

The realpolitik logic of such a plan however is where the boiling frog appears. Once one starts buying up the debt of credit-challenged countries, one begins to incur a large cost should it cease. Since the ECB can create money at will, the cost to it of buying more debt (if conditions do not improve) is zero, but the cost of stopping buying more debt will be considerable if the country defaults on the debt already owned. The German politicians may choose to believe that by imposing conditionality on a country before the ECB starts buying its debt, they are not creating an inflationary problem, but they are the frog being placed into tepid water. Every successive purchase of debt will be the equivalent, in the eyes of the Bundesbank, of raising the water temperature another notch.  

Europe continues to march ever closer to a denouement to its crisis, but the ultimate choice to be made is still the same. Germany has to decide very soon between the lesser of two very large evils.  Should it maintain its foreign policy objective to be a good European and keep the euro together, it will have to accept massive money printing to bail out the sovereign debts of the other countries, and suffer the consequent inflation. Alternatively, should it maintain its key economic policy objective of a sound currency with tight control of the money supply, it will have to accept the break-up of the euro and possibly of Europe as other countries find themselves politically unable to cope with the resultant economic depression..