Devaluing the pound won't do what its advocates want it to do

Civitas this week released a pamphlet, written by import-export businessman John Mills, arguing that the UK government should target an exchange rate a third lower than the current one, in order to boost demand and UK manufacturing by raising net exports. In turn, this would lessen the burden on the welfare state, allow the government to extricate itself from the economy, alleviate long-term unemployment, improve the self-help ethos and traditional work ethic, and even arrest the UK’s international relative decline, Mills argues.

While making this case Mills ties himself up in a few apparent contradictions (e.g. a strong pound is terrible because it is bad for purchasing power) and with no argument dismisses hundreds of years of economic consensus (with a very crude mercantilism) but I will try to distil the most coherent and convincing argument out of the monograph, in order to make the fairest possible critique.

While China has wound its exchange rate policy down, and Japan does not explicitly target the price of the Yen, Civitas founder David Green holds up Switzerland as a good example of how a country can target its exchange rate. Switzerland buys up foreign currency with newly-created money from the central bank in order to keep Swiss Francs at the desired target. While a Civitas blog post from a third author, Daniel Bentley, comes out against a similar money printing means of achieving a lower rate, it’s unclear what else Mills would propose, since he doesn’t suggest any mechanism at all.

In any case, the price of a pound is governed by demand and supply. Economic authorities could either cut demand or boost supply. Since the whole point of the scheme is to raise the demand for British goods by cutting their price a demand-cutting plan would have to be careful. Green thinks that investment into UK housing and gilts is “artificially” propping up sterling, so perhaps he’d like to ban or limit these. Presuming this outrageous interference with trading freedom was legal; it’s unclear if the pound could actually be cheapened by the desired third by cutting these demands.

Still, foreigners hold about 30 per cent of gilts and foreign buyers have recently been responsible for a majority of transactions in prime London property. If previous investments could be hit as well as new activity, sterling would surely come under serious pressure. This would slash home-owning Londoners’ wealth and hike the government’s borrowing costs, but it should also make UK manufactures (and services) cheaper.

However, even with this printing-free mechanism there should be inflation. Any import business will face higher prices on its imports. Presuming margins are already competitive, the entirety of the exchange rate driven cost hike should feed through into prices. Depending on demand elasticities – the responsiveness of consumer choices to price rises in all the different affected markets (the UK currently imports about £570bn of goods, services and oil per year) this might produce some substitution in demand for these goods, along with a secular fall in demand. But it seems highly likely that this demand dip will not be enough to bring prices back to where they were – and bear in mind if it did this would mean a big fall in consumption for the same prices.

The necessity to bluntly interfere in investment and housing decisions make the above method a very unpleasant one, and we have seen how Mills’ promise that there will be no inflation (based on the dip in the pace of price rises seen after the exit from the Exchange Rate Mechanism) appears very unlikely. Of course, as suggested, the above demand-based scheme is highly distortionary aside from its philosophical issues. So the supply-based method of cheapening the pound – money printing, and inflation – starts to look much more attractive.

But – aside from going against Bentley’s blog post, and Mills’ promise not to create inflation – printing has very clear problems as a means of boosting exports. If $1 buys £1 when the money supply is £100, and we print £100, we’d expect – all things being equal, for the dollar to now buy £2. But since all things are equal, UK factories are still only churning out 100 widgets. These originally went for £1 (and hence $1), but now they will go for £2, so despite the fact the pound is cheaper, the widgets still cost $1. We get all the costs (and benefits) of inflation and none of the supposed benefits (and costs) of cheaper sterling.

Here’s where it gets interesting. Printing extra money is futile if your goal is to boost UK net exports past the very shortest of short runs. But it is by no means futile if your goal is to boost UK inflation to overcome the nominal rigidities (cash prices that won’t fall) particularly wages. UK unemployment is still well above the natural rate, even though employment recently hit an all-time record. One of the key reasons it reached the 29.75m peak is that real wages have been falling throughout the crisis.

A further bout of inflation would give the space for relative real prices to adjust to clear markets and bring the UK much closer to full employment of all resources. So while the paper is muddled and wrongheaded, I would actually support an exchange rate target as a misguided way of getting the extra demand we need.

Monetary policy still has teeth

A storm has erupted over the past few days in a lot of the economics blogosphere, over an article by Mike Konzcal, backed by Paul Krugman, which claimed that current economic developments were evidence that monetary policy wasn't all-powerful and boosting demand sometimes required fiscal intervention. The claim faced convincing push-back from Scott Sumner, Matt Yglesias, and Ryan Avent. Before I look at the specifics of the claim, I’ll outline a (heavily oversimplified but still broadly true) model of the economy to help us to understand the debate.

In economists' simplest model of the macroeconomy, aggregate demand (AD) and aggregate supply (AS) interact to produce the price level. At the onset of the financial crisis and recession, AD crashed. Usually a crash in demand would produce a movement along the supply curve until price and supply have both fallen to produce a new equilibrium.

But the biggest market in the economy is the labour market, and many nominal prices (especially one of the most important prices, wages) are sticky-downwards. This means that prices do not fall enough to equilibrate the market, and output stays far below where it could be (this is what economists call the output gap).

This is where fiscal and monetary policy come in. Since prices are stuck, we need extra AD to get back where we were before, at the original pre-recession level of output. In theory, both monetary policy (here I will just look at interest rates) and fiscal policy (cutting taxes or boosting spending) can have the same effect on AD.

As far as I know, pretty much every mainstream economist agrees with everything I've said so far. But a key Keynesian claim – which the Konzcal article was arguing for – was that monetary policy is ineffective in special situations. Nominal interest rates can only go to zero – beyond that point savers will simply stash their cash in their mattress. Real interest rates (taking into account inflation) can only go to zero minus inflation. This is called the zero lower bound.

Konzcal said the Federal Reserve’s ‘Bernanke-Evans Rule’ – which promises to keep interest rates low until unemployment falls below 6.5 per cent – has failed to outweigh the $85bn (£55bn) federal cutbacks as part of ‘sequestration’. His evidence is Friday’s GDP release, showing that the US economy grew 0.6 per cent in the first quarter (2.5 per cent sped up as if the quarter were a year) below expectations it would expand 0.7 per cent. Konzcal said this GDP report showed the US economy was stagnating, and that the B-E rule failed to outweigh the sequestration.

But his critics pointed out that this was a big jump in growth over the previous quarter, when government spending hadn’t been cut and the Bernanke-Evans rule had barely taken effect – and growth was under 0.1 per cent (or 0.4 per cent on an annual basis). They point out that by creating inflation – and future expectations of inflation – a central bank can boost AD with monetary policy even when at the bottom bound, reducing real interest rates even when nominal rates can’t fall further. And they argue that monetary policy is dominant; it can always overrule fiscal policy.

If Konzcal's critics are right, it has at least two major implications for the UK. One is that Ed Balls’ plan to slow the pace of austerity further while keeping the Bank of England’s two per cent inflation target would only shift output to the government sector, not boost growth. In fact, if he pressed the Bank into actually achieving their target (consumer price inflation has been above target for 39 successive months) it would mean lower demand and perhaps even a triple-dip recession, as they would have to roll back QE and hike interest rates.

A second upshot is that spending cuts have not harmed growth (though the distortions from tax hikes may have). This is because any fiscal austerity has been offset by the central bank. If the government had not cut spending, the central bank would have had to rein in inflation with less quantitative easing (electronic money printing that can be rolled back) – unless it wanted inflation even further above target.

I dreamed a dream of the FCA

Last week, I dreamed of Financial Authorities that were good for Britain. Unlikely, I know, but in this fantasy The Financial Conduct Authority had given up on its mission to eviscerate the UK’s financial services and embarked on a crusade to make them stronger.  This Paulene conversion had begun with the Treasury’s brief to strengthen competition, particularly in the banking sector.  This was puzzling for them as they had previously been trying to standardise everything.  But competition is about choice and choice means allowing businesses to be different.

Albeit fewer than before the regulators started interfering, we still have four big banks but customers mostly do not transfer because they think they are all the same.

Economics is not just the dismal science; it is the dead science.  In the world of economics everything is standardised except the price.  The mortgage market is a bit like that.  Either firms match and therefore do not compete, or they compete, prices are driven down and they go bust.  The science of the living, however, i.e. biology tells us that firms compete through evolution.  They change and adapt and the ones that best adapt to the environment, i.e. the market, thrive.  They compete by better meeting customer needs, that allows premium pricing and that in turn prompts innovation and further growth.

Contrast that with the FCA view that premium pricing is wicked and should be stopped at once.  In almost every consumer market the brand leader is also premium priced.  That is not because consumers are stupid but because they want what they consider to be best.  They are the judges, not some arbitrary quango in Canary Wharf.

When the FCA woke up to the need to promote differences, not destroy them, they changed their working lives.  No longer did them spend them inventing new regulations to inflict on financial services, they began removing the ones we do not need.  That turned out to be almost all of them.  The FCA staff had never been so busy.

Fired up with enthusiasm, they took their crusade to Brussels.  “Either,” they said, “we need the regulations in which case the whole world does.  Or the rest of the world does not need these regulations, and therefore, nor do we.”  Joy broke out across the regulators’ offices and also those of the financial services sector.  And consumers were the happiest of all.

Then I woke up.

Osborne bungles banks – again

It will be a while before the inside story of the Co-op’s pull-out from the Lloyds HBOS deal emerges, if it ever does, but some aspects are immediately apparent.  The HM Treasury has failed, at least for now, to achieve their twin goals of downsizing Lloyds HBOS, as required by Brussels, and bringing competition to the retail banking sector.  The deal could have transformed the Co-op from a small player to a serious retail bank.

Any deal would be a commercial issue, but surely HM Treasury played some part.  Apparently excessive regulation is a major reason for the pull-out, a direct government responsibility. Whatever happened to de-regulation?  Yes the Financial Services Authority was eliminated but it was replaced by two further monsters, the Financial Conduct Authority and the Prudential Regulatory Authority.

As the IEA has pointed out, we do not need capital ratio regulations, or not now anyway and as this institute has pointed out, financial services markets are now global and therefore need global, not local, regulation.  The UK simply hobbles itself by adding its own unilateral regulations and regulators.

Capital Ratio regulation is a good example of the right medicine at the wrong time.  It was needed in the boom times up to 2008 but is counterproductive in recession: more capital means less lending.  It is like going to the doctor, asking for a cure for a throat infection and being given a prescription for piles because the doctor has suddenly realised that he should have provided that when you last visited.

Osborne also bungled by handing out cheap money for the banks to lend out only to find they put it in their own pockets.  The fact is that he does not understand banks, bankers or banking.

The Co-op has effectively told government that the climate is unattractive for this deal.  And since it has been in the works since last year, they must have been saying so for some time.  The collapse tells us that HM Treasury failed to deliver.

Lloyds HBOS won’t mind too much.  Yes they are under pressure to dispose of the packaged up TSB but they’d rather sell to a newcomer or a tiddler than create a serious competitor as the Co-op could have become.  It is nonsense to say that HM Treasury cannot manage the market since they contributed to the current mess and own, in effect, two of the big four. HM Treasury could have leaned on Lloyds HBOS to sweeten the deal to make it attractive to the Co-op but they evidently did not.  Another bungle.

Maybe some white knight will ride in and save the situation.  Let us hope so but I would not bet on it.   

Chart of the week: Japanese monetary base and inflation

Summary: Kuroda’s efforts may work through yen, not through monetary base

What the chart shows: The chart shows the Japanese monetary base and Japanese inflation, both set as an index with February 1993=100.

Why is the chart interesting: The new Governor of the Bank of Japan (BoJ), Mr Haruhiko Kuroda, has announced that the BoJ intends to double the monetary base – that is to say, notes and coins in circulation plus banks’ reserves with the central bank – over the next two years. The hope is that this injection of money will finally cause inflation to rise to the new 2% target. Mr Kuroda’s policy also includes a substantial weakening of the yen, which – through higher import prices – should help boost Japanese inflation. This part may work. However, as the chart shows, the relationship between the monetary base and inflation is tenuous at the very best. Mr Kuroda should aimed at boosting broad money – essentially, the bank deposits held by the non-bank private sector – the relationship of which with inflation is much more clear.

Charts and comments provided by Stein Brothers (UK) www.steinbrothers.co.uk

Disqualifying the architects of failure from holding office

Business Secretary Vince Cable is reportedly looking to see if there is sufficient evidence to justify an action to ban the HBOS 3 named in the Banking Commission's report from serving as company directors again.  He is reportedly "outraged" by the situation.

A Department for Business, Innovation and Skills spokesman said: "The business secretary has instructed officials at the Insolvency Service to look into the Financial Conduct Authority report when it is published to see whether there are matters that could lead to further action."

In general it is seen as a good thing that those who break the rules should suffer some consequences.  Laws and rules usually set out what will be considered a transgression, and they normally set out the range of punishments that will follow.  It has to be a breach of the rules, however.  Simple incompetence or inability is not, in itself, a punishable offence.  Failing to show due diligence can be, however, where the rules specify that it is required.  If the HBOS 3 broke the rules, of course they must be called to account.

The same could apply to the guilty politicians who presided over it, encouraging and enabling behaviour that led to the crisis, and recklessly flooding the market with money and credit.  They did this because they were addicted to spending and stood to gain personally from the electoral support that it helped to produce.  They tried to manipulate the economy by 'smoothing the Business Cycle' to avoid the electoral unpopularity that an economic downturn would have engendered.  Gordon Brown and Ed Balls and others stood to make personal gain of popularity and office from their actions, and certainly failed to show due diligence for the welfare of the nation and of its citizens. 

An investigation could establish whether they broke rules in doing so, and whether there is enough evidence to have further action taken against them.  Did they, for example, engage in systematic deceit?  Did they knowingly lie about the true state of the nation's finances?  The most likely outcome is that the finding would be one of simple incompetence on an overwhelming scale, a finding that would not justify debarring them from office, but whose publication might make if difficult for any of them to do so again.  It is worth an investigation, though, if only to put on record what they did.

Go after the real culprits of the crisis instead of just bashing bankers

Every child learns at some stage that a good way to divert blame is to point the finger at someone else.  Now the politicians on the Parliamentary Commission on Banking Standards have discovered the trick.  They hope that as the lynch mob pursues the HBOS trio of Sir James Crosby, Lord Stevenson and Andy Hornby, the role played by politicians in the financial crisis will be quietly overlooked. 

If so, they reckoned without Fraser Nelson.  The Spectator Editor, writing in today's Telegraph, exposes the accomplices who should share their guilt.  Politicians were "infatuated with bankers," he writes, largely because financial services provided two-fifths of all corporation tax collected for a government that over-dosed on spending. 

"Financial greed is always dangerous, but when paired with political vanity it becomes lethal. By working hand-in-glove with the financial sector, Labour ran a form of crony capitalism – and allowed the banks to have loans of up to 35 times their assets. Brown’s government was so dazzled by the tax haul, so swept up in the party spirit, that it left the teenagers with the car keys and a case of tequila. The crash was inevitable."

Correct, as we have said before on this site.  By all means point to the greedy bankers taking reckless risks, but don't overlook the people behind them, the politicians and central bankers who facilitated this and egged them on for political gain.  Fraser's piece should be required reading for those involved in public finance, not least because the lessons have not been learned.

"Government still thinks it can rig the banking system. It still places its faith in dangerously underpriced debt. It still thinks that the remedy for our hangover is some salt, some lemon and another round of tequila. Even bankers are looking on aghast. The financiers, after all, did not cause this downturn. They added to the drama, but the basic problem was (and remains) one of overspending."

Before people can work on a remedy, they should first work on their understanding of the wrong.

Why you really don't want capital controls even in extremis

There are, to a useful level of accuracy, two forms of capital controls. The first is the type we're seeing in Cyprus today, limited and supposedly shot term controls in order to stave off imminent disaster. Even the OECD and the IMF tend to say that these are OK in the right circumstances. The second sort of capital controls comes from the grottier end of the  fascist economic spectrum. Capital, in some manner, belongs to the country not the individual so it's just fine for the country to deny the individual the right to send it where they wish.

The problem with this distinction is that the former tend to end up transforming into the latter:

The authorities said at the time the controls would be temporary and limited in scope – lasting a few weeks or, at worst, a month or two. Half a decade later, the capital controls are still in place and getting more and more restrictive. This was the second time Iceland had implemented `temporary’ capital controls.

The first time it did so, in the 1930s, led to the controls being in place until 1993. This is in line with the historical evidence; once capital controls are imposed, they are really hard to abolish, and a temporary arrangement usually ends up being permanent.

The reason is that when a country implements capital controls, it signals the authorities have lost control over the economy, needing to employ desperate measures. That is does not exactly build confidence, so anybody with money will seek to abandon the sinking ship as quickly as they can, persisting in that desire until things look better. While the controls last, however, it is unlikely that things will look better because the abolition of the controls can become a necessary condition for improving economic conditions. This is why the official pronunciations on the duration and the scope of the capital controls in Iceland were always too optimistic.

If you look around the UK at present you will see the usual suspects quite slavering over the new consensus that the short term controls are OK. For exactly this reason: they know that short will become long. It even popped up in the Green New Deal from NEF and other economic ignorants. The idea was that if British capital could be stopped from leaving Britain then there would be more capital to invest in their lunatic plans. This doesn't really work for:

The Icelandic capital controls have proven to be highly damaging for its economy; investment has collapsed and is just about the lowest in Europe at 14.4% of GDP in 2013, compared to the EU average of 18%. The reason is that foreign direct investment almost completely dried up...

It most definitely wouldn't work in the British situation. You may have noticed that we're running a trade deficit. We have been since, ooh, the early 80s I think? What often gets missed is that if you're running a trade deficit then you are, by definition, running a capital account surplus. That is, more foreigners have been investing in Britain than Britons have been investing in foreign. This is simply an identity, it's not an arguable point.

So, institute capital controls in order to increase the amount of capital available for investment and.....suddenly Britain has less capital as Johnny Foreigner no longer sends his capital here for people to enjoy.

We really don't want to let them reimpose capital controls you know. It's not just the vileness that accompanied them, the having to ask permission before taking more than £25 out of the country and all that. It's that capital contols would be hugely damaging to the economy of the country. Because, just for those who are in the Green New Deal and thus too stupid to notice, we import capital in Britain. And if we have capital controls then we cannot do that, can we?

Incoherent bank regulations

The Bank of England’s Financial Policy Committee has announced an increase in capital ratio requirements for banks and the FSA announces a reduction.  The former is, of course, for existing banks and the latter for new banks.  Higher capital ratios are intended to stop banks going bust so, on the surface, it is odd that those that are unlikely to be at risk now their days of profligacy are over, at least for the time being, are having further bolts applied to the empty stable door whereas those banks most at risk, namely the small new ones, are being encouraged to expose themselves further.

Maybe handicapping the big banks in this way is good, in the long run, for competition. Perhaps we should not care if small banks go under and worry only about the systemic banks.  That shows a misunderstanding of the economic cycle.  Cyprus was the last domino in the 2008 crash, not the beginning of a new one.  Whatever happens in Cyprus will not put large British banks at risk.

Some economists, and the Bank of England, fail to grasp an elementary piece of accountancy.  Capital adequacy ratios decline if cash is replaced by loans to small businesses. New small banks are going to have an insignificant effect, in the short term, on lending to small business and we need those loans to rebuild the UK economy.  It is the clampdown on lending by the big banks which is mostly to blame for the UK’s sluggish economic recovery.

The Chancellor nearly got it right when he arranged for big banks to borrow at subsidised rates.  He hoped they would pass it on with more lending at lower rates.  Instead they put the money in their pockets, widening their margins and bolstering their capital ratios.  Instead of sending them to gaol for defrauding the rest of us, the Bank of England is now patting them on the back.

Yes, of course Cyprus should go bust: or at least the banks

When an institution, person or country is bust then the obvious thing to do is say, well, yup, you're bust. Then clean up the mess and start again. So it is with the situation Cyprus is in (or at least, that it's in as I write, on Friday afternoon). The place is bust and someone is just jolly well going to have to take the losses that cannot be paid back. Paul Krugman (this is the Good Krugman, the economist, not the NY Times pontificator. Even if the economist is speaking through the NYT) says that Iceland did well when it simply agreed, yes, we're bust, and then dealt with cleaning up the mess:

Like Cyprus now, Iceland had a huge banking sector, swollen by foreign deposits, that was simply too big to bail out. Iceland’s response was essentially to let its banks go bust, wiping out those foreign investors, while protecting domestic depositors — and the results weren’t too bad. Indeed, Iceland, with a far lower unemployment rate than most of Europe, has weathered the crisis surprisingly well.

The Wall Street Journal points out that it doesn't actually have to go quite that far:

The European Central Bank on Thursday gave Cyprus until next Monday to reach a deal on restructuring its insolvent banks. Our suggestion: Let them go bust. Cyprus's two biggest banks, Laiki and the Bank of Cyprus, are deeply insolvent. While the EU, the IMF and Cyprus could spend the weekend trying to negotiate a deal to inject billions into the banks, the time would be better spent arranging for their bankruptcy. Here's how it could work: Shareholders, along with senior and subordinated debt holders, would be wiped out. Deposits up to €100,000 that are insured would be protected. Larger depositors would take a haircut in the range of 40%—somewhat more for Laiki depositors, somewhat less for account holders at Bank of Cyprus, reflecting the extent of the losses and the capital needs at the two banks.

Madsen made a similar point earlier in the week:

The bank levy punishes savers but leaves the bond-holders untouched, violating the principle that small savers should be protected, while the bond-holders who knew they were taking a punt should take a hit.

I was recommending something close to the WSJ solution last weekend elsewhere. And this leads me to two points I want to make.

The first is that all of us making these sorts of suggestions are the capitalist neoliberal running pig dogs (yes, Good Krugman qualifies for that). You know, the people who are supposedly only the apologists for the rich and powerful. And we're all singing from the same hymn sheet here: let the rich take the beating. We're all resolutely opposed to these bad debts being heaped on the taxpayers' shoulders for decades to come. Against small savers getting gouged. Entirely in favour of rich people losing their money. It's yet another example of what is the most underappreciated fact about this capitalist neoliberal running pig doggery: how incredibly, massively, pro-poor it all is. It is, after all, the only politico-economic system that has ever raised the average man and woman up above a subsistence level income. And I really cannot think of anything more pro-poor than that.

The second is still capitalist dog running: the defining point of the system isn't in fact the way that assets are owned, the competition red in tooth and claw. Rather, it's the way that it cleans up the inevitable failures.  For in any structure of human affairs there will indeed be failures. And I take bankruptcy to be one of the most valuable and defining points of this whole capitalist/market system that we've got. When failure does happen, when debts are unpayable, then we all agree, yup, those can't be paid. Oh dear, all you investors, you lost. Better luck next time. It's the quid pro quo that if the investors get it right then they make out like bandits. And if they put their cash into banks which then lend all the money to the Greek Government to default upon (which is indeed what the Cypriot banks did) then they lose large chunks of it.

So, the Worstall solution to Cyprus is that we should indeed be pro-poor and capitalist. Those banks are bust. OK, so, the large depositors lose much of their money, the small depositors were protected under law and so should be protected (yes, the rule of law is indeed important) and that's about the best we can do. Because failure really is failure and it has to be treated as such.