EZ problems are largely Germany’s fault?

Simon Wren-Lewis (Oxford economics prof) argues in The Independent that for the first decade or so of the Euro, Germany hammered down costs to an excessive extent and became too competitive. In particular he argues that Germany kept its unit labor costs too low.

Not sure about that.

The target that EZ countries are supposed to aim for is an INFLATION rate of just below 2%. And for the first decade of the Euro, Germany seems to have hit the target near enough, at least according to this source.

Incidentally Bill Mitchell also takes Wren-Lewis to task in a 3,500 word article today. But my 80 or so word criticism above is, needless to say, much more succinct and better value for money..:-)

FT article says bank capital is expensive – it’s not.

This Financial Times article repeats the myth that bank capital is expensive. As the author puts it, “New regulations mean all banks must hold more equity, and that means they have to earn higher profits to keep return on equity at the levels investors demand.”

Seems it’s necessary to keep pointing out the fallacy in the latter point, so here goes.

Shareholders only demand a higher return than debt holders (i.e. bondholders and depositors) because shareholders get a hair cut FIRST when problems arise. I.e. it’s only AFTER shareholders have been wiped out that bondholders have a problem.

Ergo if the bank’s capital ratio is say doubled, then the extent of that “first hair cut” problem per share is HALVED. Ergo the return shareholders will demand for undertaking risk is halved. Ergo if the capital ratio is doubled, there shouldn’t be any effect of the total cost of funding the bank.

I get the distinct impression from the above quoted sentence that the author (Laura Noonan) doesn’t get that point, because she talks about “keeping the return on equity at” a particular level.

To illustrate the point another way, suppose there are two banks which are identical except that one is funded entirely or almost entirely by debt, and the other is funded entirely or almost entirely by equity.

The return demanded by both types of bank funder will be the same in that they’re both parting with savings rather than spending those savings. They will also demand a return in respect of risk.

But the risk of the bank going under is the same in both cases given that the riskiness of the banks’ assets is the same in both cases. Thus the chance of shareholders and debt holders being wiped out or losing X% of their money is the same in each case.

So shareholders and bondholders will demand the same return for parting with savings, plus they’ll demand the same for accepting risk.

The only possible escape from the above argument is that bondholders UNDERESTIMATE risk. That is the more naïve bond holders may be under the impression that £X of freshly issued bonds means the bondholder is guaranteed to get £X back when the bonds mature.

That however is not a strong argument for funding banks via debt because it involves taking advantage of peoples’ ignorance or naivity.

As distinct from the latter “naïve” reason for thinking bondholders will get their money back, there is a more sophisticated reason, namely the calculation that governments will not in practice let bondholders be ruined come a bank crisis. That calculation paid off hansomely in the recent crisis. That is, large bondholders are often personal friends of politicians and regulators. And one doesn’t want to ruin people one regularly meets at cocktail parties does one?

The morality of that reason for bonds being a cheap way of funding banks does not stand inspection, of course.

And finally, Google is funded 90% by equity. And as we all know, Google is a total failure. A complete basket case…:-)    

Incidentally, I got that information about Google from a video by Anat Admati.

Video by Anat Admati.

She is an economics prof at Stanford.

John Redwood doesn’t understand helicopter drops.

John Redwood is often said to one of the Tory Party’s intellectuals. Normally I agree with much of what he has to say. But in the second paragraph of this article he says in reference to helicopter money:

“By this they mean the Central Bank creates new electronic money in an account (the modern version of printing notes or clipping coins) and gives it to people. The idea is they would then go out and spend. The sages think that if the economy is working below full capacity then the extra money spent will be more demand, and will bring more of the unused raw materials and labour into use. Clearly the conditions would have to be very unusual. Normally if a Central Bank prints more and gives it away or spends the cash it leads to more inflation.”

Perhaps John Redwood can then explain to us why we’ve had an enormous increase in government / central bank created money over the last two or three years thanks to QE (both in the UK, US and elsewhere), yet inflation is nowhere in sight!!!!

You might argue that QE has not put money in to the hands of the “people” referred to by Redwood, but rather into the hands of the government bond holders who were bought out thanks to QE. Hence (given that the tendency of the wealthy to increase their spending when their stock of cash rises is more muted than in the case of the less well off) that would explain the relatively muted rise in spending and demand and hence inflation. Unfortunately that argument is weak and for the following reasons.

What happened in the recent “QE years” was that governments boosted fiscal stimulus (i.e borrowed more than usual and gave bonds to those it borrowed from). That will have transferred money from the rich to the less well off. The state (i.e. the government / central bank machine) then printed money and bought back those bonds. Net result: cash in the hands of both the rich and poor will have risen, which comes to the same thing as helicopter drops.


Unusual conditions.

Moreover, what’s all that nonsense in the above quote from Redwood about conditions having to be “very unusual” for increased spending not to cause inflation? The only condition needed is that the economy has significant spare capacity, or put another way that unemployment is above NAIRU: which has been the situation over the last seven years or so.

If a firm gets increased orders for its wares and it advertises for more staff, and suitable applicants are two a penny, then wages in the relevant professions / skills / jobs concerned will not be pushed upwards. In contrast, if there are skill shortages in relevant jobs, then wages WILL TEND to be pushed up. Inflation  ensues.

Why I need to spell out this elementary stuff to a supposed intellectual is a mystery.


Are heli-drops desirable?

Having said that, I’m not actually advocating heli-drops (i.e. some sort of system via which every household gets the same amount of cash, or gets an amount inversely related to their income, or whatever). Reason is that heli-drops can be effected via the existing public expenditure system. That is, if you want to feed money into household pockets, why not just cut direct taxes, raise the state pension or something like that? Why set up an entirely new system, staffed by ten thousand bureaucrats to do more or less the same thing?

Great news: we don’t need to save in order to invest.

I’m thrilled to learn from Ann Pettifor’s letter in the Financial Times today that “investment is not constrained by savings”. So the UK can invest £30bn in the proposed HS2 rail project, and no one needs to save in the form of spending less on beer, home improvements, cars etc to pay for it? This is wondrous news. Instant wealth appears from nowhere.

The relevant paragraph in her letter reads “As Keynes explained and understood, in an economy based on credit, investment is not constrained by savings. Many of those who lay claim to his theories still do not accept this basic principle of a credit-based economy — applied in the UK since the founding of the Bank of England in 1694.”

I’d like to be the first to propose Ms Pettifor is awarded a Nobel Prize for this amazing insight.

The $1.6 trillion gift by taxpayers to banks.

Working out the exact size of the subsidy or gift that taxpayers were forced to make to banksters is not easy. The following is back of the envelope estimate.

It seems from this source that the total amount loaned by the Fed to banks was $16trillion and the loans were at a zero or near zero rate of interest.

Now what would have been a realistic or appropriate rate of interest? Well Walter Bagehot’s famous answer to that was a “penalty” rate of interest, and in exchange for first class collateral.

One of the reasons for that penalty rate is that a borrower who suddenly finds their cash flow calculations are nonsense, is incompetent. Commercial banks themselves charge penalty rates to borrowers who suddenly claim they need emergency funding, and quite right.

As to exactly what that penalty rate should be, Warren Buffet loaned $5bn to Goldman Sachs at the height of the crisis at 10%. So presumably 10% is a fair “penalty rate”.

So roughly speaking, those Fed loans to banks were at zero percent, when in fact they should have been at 10%.

As to the duration of those loans, I don’t have exact figures, but to keep things simple, let’s say one year. On that basis, banks were subsidised to the extent of $1.6trillion. Or at least they were subsidised to the extent of $1.6trillion PER YEAR for however long the loans lasted.


The money came from thin air?

Several members of the revolving door brigade, with a view to claiming they weren’t subsidised at all, have claimed the Fed created the relevant money out of thin air (which it  did), and hence that the whole operation didn’t cost taxpayers anything.

That claim is blatantly dishonest. Reason is that there was an alternative to rescuing banks: the Fed, or more generally “the state” (i.e. central bank and government) could have dealt with the deflationary or recession inducing effects of bank failures by simply dishing out billions to the country’s taxpayers, and citizens generally. And/or the state could have implemented a large rise in public spending (something a left of centre government might have chosen to do).

Now you might claim that largesse towards taxpayer / citizens would have been a subsidy of taxpayers just as much as lending $16trillion to banks at a near zero rate of interest was a subsidy. Well the answer to that is that it’s widely accepted that it is the state’s job to maintain demand at a level that keeps the economy at capacity or “full employment”, whether there’s a bank crisis or not.

Central banks and Treasuries do that ALL THE TIME: i.e. they cut interest rates when appropriate, adjust the size of the deficit and so on. And that activity is not normally regarded as subsidy, and quite right.

Moreover, dishing out money created from thin air to taxpayers during a recession simply immitates the free market’s own cure for recessions (which in practice doesn’t work very well). That is, in a totally free and perfectly functioning market, and given a recession, prices and wages would drop, which in turn would increase the value of the monetary base, which in turn increases the paper assets of the private sector, which in turn induces the private sector to spend more. And that cures the recession. That’s known as the “Pigou effect”.

Of course in the real world, the Pigou effect doesn’t work very quickly because as Keynes famously put it, “wages are sticky downwards”. That is, if you try to cut wages, you often get riots.

In short, if the state dishes out money to taxpayers during a recession (e.g. by cutting taxes), all the state is doing is to IMITATE or bolster the free market’s cure for recessions.

And a subsidy is a payment which does not take place under free market conditions. Thus, in a sense, having the state print and dish out money to taxpayers or citizens in general is not a subsidy.

In contrast, there is absolutely no way that having the state dish out trillions to a very small and select group of firms, banks or any other group, is not a subsidy.

__________

P.S. (11th Dec). David Andolfatto argues here that central banks should not charge penalty rates. In the comments, I stick to my view that the rate should be “penalty”.

_______

P.S. (5th Jan 2016). My above $1.6trillion estimate is way out. I've done a revised estimate here:

http://ralphanomics.blogspot.co.uk/2016/01/the-80-billion-gift-by-taxpayers-to.html

Changes in how household budgets are allocated since WWII.

Family spending by category 1953-2010 a product of today's old-school research in the library with @brickonomics pic.twitter.com/xdzRfWt2mb

— Neal Hudson (@resi_analyst) January 6, 2015