Monthly Archives: October 2007

Yes housing wealth is wealth, but corresponding to the housing asset is a housing liability. Under certain conditions, not all of which are too unreasonable, the value of the housing liability exactly equals the value of the housing asset, so housing wealth isn’t net wealth.

The fundamental value of the housing asset, FA, say, is the present discounted value of current and anticipated future rents from the stock of residential homes in existence in a given economy (the UK, say) at a given point of time. The rents can either be the actual market rents paid by those living in rented accommodation or the imputed rental value of the housing services consumed by owner-occupiers. The fundamental value of the housing liability, FL, say, is the present discounted value of current and anticipated future rents that the current inhabitants of the economy expect to pay (or impute to themselves if they are owner-occupiers) over their lifetimes.

The strongest version of the proposition is that the fundamental value of the housing asset equals the fundamental value of the housing liability, that is,


Therefore, regardless of whether a change in house prices is due to a change in risk-free discount rates, in risk premia or in anticipated future rents, the housing liability changes in value by the same amount as the housing asset. So housing wealth isn’t net wealth. When the price of housing increases, when you have re-budgeted the increased cost of living in your now more valuable accommodation, you will have no money left to spend on anything else.

If the increase in house prices is due to an increase in current and expected future rents (holding constant the discount factors), you may choose to switch your spending more towards other goods and services, away from the now more expensive housing services. If the increase in house prices is due to lower risk-free discount rates or lower risk premia, there is no reason to expect any spillover into spending on non-housing goods and services.

There are a number of reasons why the proposition that housing wealth isn’t net wealth could fail to be true.

  • Reasons consistent with rationality.

(1) Overlapping generations. The future rents discounted in the price of an existing home are not just those paid (or imputed) by those currently alive, whose present discounted value I denote by FAA , but also those that will be paid (or imputed) by those yet to be born; the present discounted value of the rents that will be paid by the unborn is FAU. So, if there is a positive birth rate, FAU will be positive. It follows that


Consumption today, of course, does not include the consumption of future housing services by the unborn, therefore


It follows that when the house prices rise, the value of housing as an asset goes up by more than the value of housing as a liability, so net housing wealth increases. This effect will be reinforced if there in net immigration into a country. If there is intergenerational caring, with bequests, and no-one dies childless, the consumption of the unborn is effectively internalised by those currently alive, and FL = FAA + FAU=FA.

(2) MEW. My earlier blog did discuss mortgage equity withdrawal (“Households-consumers can borrow against the equity in their homes and use this to finance consumption”), that is, using you home as collateral for consumption loans. This will boost consumption if and only if the homeowner is liquidity- and collateral- constrained. The boost to consumption is, of course, temporary, as the loan will have to be serviced and repaid; future consumption were therefore be lower in present value than it would have been without the MEW.

  • Reasons requiring irrationality.

1. “Feel good factor”. This is the argument that when house prices go up, home owners get a buzz, feel happy and go out and spend. It’s hard to know what to make of this. If there is a feel good factor for homeowners when house prices rise, there must be a feel bad factor for all those missing out on the capital gains because they do not own real estate – people for whom it may now have become harder to get a foot on the housing ladder. Also, does the feel good factor actually cause you to spend more? The feel good factor is not the same as consumer confidence, which is positively correlated with consumer spending. My wife spends more (mainly on shoes) when she feels bad – and she is a professor of economics.

2. Owner-occupiers don’t understand the concept of ‘opportunity cost’. Possible, but not likely. As soon as a the owner of a home that has gone up in price wants to cash in on this gain, he will find out that he will have to spend the entire sale price to purchase the right to equivalent housing services. If he is trading down, and the value of the house he is selling exceeds the present discounted value of the housing services he plans to consume over the remainder of his life, we are in the overlapping generations case discussed earlier, and there is no irrationality involved.


Falling house prices are viewed by many as a major contributor to the economic slowdown in the US. In Europe, a long run of years characterised by rapidly rising house prices appears to have come to and end in Ireland, Spain and in the UK. Lower house prices affect aggregate demand through two channels – investment in housing and private consumption demand. This blog deals with the effect of changes in housing wealth on private consumption. It uses a little algebraic notation as part of a scientific experiment to determine the impact of symbol use on blog readership.

The effect of changes in the prices of existing homes on investment in home improvements and on the construction of new homes is not considered, except for noting the differences between the current size of the residential construction sectors across the four countries just mentioned. In the US, construction accounted for about 5.0 percent of GDP in 2006. The corresponding 2006 figures for Ireland, Spain and the UK were, respectively, 9.9 percent, 12.2 percent and 5.4 percent of GDP.

On average, you live in the house you own

The bold statement that is the title of this blog was put to me about ten years ago by Mervyn King, now Governor of the Bank of England, then Chief Economist of the Bank of England, shortly after I joined the Monetary Policy Committee of the Bank of England as an External Member in June 1997. Like most bold statements, the assertion in the title of this blog is not literally correct, although the pithy statement trumps the literal truth as a vehicle for getting the message across. A more precise statement would be that an increase in house prices does not make you better off. The argument is simple and applies to any consumer durable.

Let’s consider coconuts instead of houses. When does an increase in the price of coconuts make you better off? Answer: when you are a net exporter of coconuts, that is, when your endowment of coconuts, E, say, exceeds your consumption of coconuts, C, say. If P is the price of a coconut, the amount, G, by which you are better off when the price of coconuts increases by an amount ΔP, is given by

G = (E – C) x ΔP .

A net exporter of coconuts is better off when the price of coconuts increases, a net importer of coconuts is worse off. Someone who is just self-sufficient in coconuts is neither worse off nor better off.

Houses are no different from coconuts in this regard. Assume for the moment that the price of a house (strictly of a unit of housing) equals its fundamental value, F – the present discounted value of the future rents it generates. These rents can either be the market rents earned by a commercial owner of property-to-let, or the imputed rental value of owner-occupied housing. So we have:

P = F .

The consumption value of a unit of housing is also the present discounted value of current and future rents. When the price of residential property increases, households-consumers whose endowment of housing exceeds their consumption of housing are better off. Those for whom the endowment of housing is less than their consumption are worse off. The next step is the assertion that, for a typical household-consumer, the endowment of housing equals the consumption of housing:

E = C .

It follows that, since the representative household-consumer is self-sufficient in housing, a change in home prices does not make it better or worse off:

G = 0 .

As long as your endowment is positive, your wealth obviously increases when the house price increases. However, an increase in house prices means that the present discounted value of future rents has increased. As a consumer of housing services, now and in the future, you are therefore worse off. On average, in a country like the UK, people consume the housing services they own. Hence an increase in house prices does not make them better off. For financial assets like equity there is no corresponding “present discounted value of future equity services consumption” whose cost increases whenever the value of equity goes up. An increase in stock market values therefore unambiguously makes you better off.

But as regards house prices, regardless of whether a change in price is due to a change in risk-free discount rates, in risk premia or in expected future rents, you are neither better off nor worse off as a result of that price change, if you consume, now and in the future, the same contingent sequence of housing services whose present discounted value is part of the wealth you own. In that case, despite the increase in your housing wealth, once you have paid for the consumption of your initial contingent sequence of housing services, there will be nothing left to spend on anything else.


Instead of the price a house, P, equalling its fundamental value, it could be equal to the sum of its fundamental value, F, and the value contributed by a speculative bubble, B:

P = F + B .

The consumption value of the house, PC continues to be equal to the present discounted value of current and future rents, that is,

PC = F .

It follows that the net financial benefit or gain you have from a change in house prices can be written as

G = (E – C) x ΔF + E x ΔB .

So, making again the assumption that E = C, the net gain from an increase in house prices is given by

G = E x ΔB .

Ironically, an increase in house prices therefore only makes you better off if there is a (positive) bubble.

Distribution effects
Some households-consumers have an endowment of housing that is smaller than their consumption of housing (call them renters). Others own more housing than they consume (call them landlords). Clearly, landlords-homeowners are better off when the price of houses increases, while renters are worse off. If the marginal propensities to spend of these two categories of households-consumers are different, such a redistribution will not be neutral as regards its effect on aggregate consumption. I have no empirical information on whether renters have higher or lower marginal propensities to spend than landlords.

Likewise, some current home owners may be planning to ‘trade down’ later in life, for instance when the family home gets replaced by a smaller property when the children leave home, following retirement or following the death of one’s spouse. For them the fundamental value of their endowment exceeds the present discounted value of their current and future planned consumption of housing services. Against that, there are also persons planning to trade up in the housing market.

Foreign ownership
Residential property in a country could be owned by households-consumers not resident in the country, in which case the fundamental value of the housing stock located in the UK and owned by UK households-consumers is less than the present discounted value of future rents from the stock of houses located in the UK. An increase in the price of UK property would make UK households-consumers worse off in this case. I have no information on how much UK residential property is owned by foreign households-consumers.

Assorted irrationalities
Consumers of housing services may be more myopic and/or may discount future expenditure on rent at a higher rate that the discount rates that are reflected in house prices. Home owners may fail to recognize the opportunity cost of the owner-occupied housing services that they are consuming. There may be a variety of other irrationalities and behavioural idiosyncrasies causing the consumers of household services to respond differently from the owners of homes to changes in the present discounted value of current and future rents.

What do economic models assume about the effect of housing wealth on consumption demand?

Most econometric models I am familiar with treat housing wealth like equity as a determinant of household consumption. They forget to allow for the fact that households consume housing services (for which they pay or impute rent) and that with properly functioning markets, the value of housing wealth in the consumption function would be cancelled out exactly by the present discounted value of current and future rents.

An example is the FRB/US model. It is used frequently by participants in the debate on the implication of developments in the US housing market for US consumer demand. A recent example is Frederic S. Mishkin, a member of the Federal Reserve Board, in a paper “Housing and the Monetary Transmission Mechanism”, NBER Working Paper No. 13518, October 2007. The FRB/US model a-priori constrains the wealth effects of housing wealth and other financial wealth to be the same. The long-run marginal propensity to consume out of non-human wealth (including housing wealth) is 0.038, that is, 3.8 percent. In several simulations, Mishkin increases the value of the long-run marginal propensity to consume out of housing wealth to 0.076, that is, 7.6 percent, while keeping the long-run marginal propensity to consume out of non-housing financial wealth at 0.038.

The argument for an effect of housing wealth on consumption over and above the pure wealth effect, is that housing wealth is collateralisable. Households-consumers can borrow against the equity in their homes and use this to finance consumption. If they are otherwise liquidity-constrained or credit-constrained, a boost to housing wealth would boost consumption by more than the pure wealth effect.

Housing wealth is, however, not the only form of financial wealth that allows one to overcome liquidity constraints or credit constraints. Many other financial assets can be used as collateral. In fact, liquid financial assets like stocks and bonds tend to make better collateral than housing equity. Indeed, one can finance consumption spending simply by running down holdings of liquid financial assets; unlike illiquid housing wealth one does not have to use them as collateral for a loan in order to turn them into current spending power.

You can, of course, get a larger aggregate liquidity or collateral effect from housing wealth than from other financial wealth, if housing wealth is owned to a greater degree by liquidity-constrained households than other financial wealth. To the extent that the ‘other’ financial wealth is liquid, it is obviously true that the owners of this ‘other’ financial wealth cannot be more liquidity constrained than the owners of residential property. This, however, does not constitute evidence that owners of residential housing are liquidity constrained. It could be the case that neither the owners of residential property nor the owners of ‘other’ financial assets are liquidity-constrained. On balance, however, it seems likely that at least some owners of residential property are liquidity constrained while, almost by definition, no direct owners of liquid financial instruments are liquidity constrained.

What this implies is that the ‘collateral’ or ‘liquidity’ effect of a change in house prices on consumer demand is likely to be larger than the ‘collateral’ or ‘liquidity’ effect of a change in other financial asset prices of equal magnitude. This does not mean, however, that the total effect on consumption demand of a change in house prices will be larger than that of an equal change in the value of other financial assets. This is because the total effect is the sum of the pure wealth effect and the liquidity/collateral effect, and the pure wealth effect of a change in house prices on consumption demand is zero.

If the argument in this blog is correct, the FRB/US model’s approach to the consumption effect of housing wealth is questionable. The pure wealth effect of housing wealth on consumption is zero (not 0.038). Mishkin then makes the further, untested, assumption, that the collateral or liquidity effect of housing wealth on consumption is greater (0.038) than the collateral or liquidity effect of ‘other’ financial wealth (0.000).


The arguments of this blog lead to the conclusion that the proposition that consumption is affected more by changes in housing wealth than by changes in other financial wealth is questionable, and that there is a distinct possibility that the net effect of changes in housing wealth on private consumption may be small or even negligible (if home owners are not liquidity- or collateral-constrained).

So, when considering the impact of housing price declines on aggregate demand, focus on the investment and home-improvement side, not on the consumption effects.

Consider the following scenario. Scientists determine that, following careful empirical study and the meticulous application of cost-benefit principles grounded in utilitarian ethics, men ought not to be allowed to live beyond the age of 86 and women beyond the age of 88. You can easily see how the utilitarian calculus would lead to this conclusion and policy recommendation. By the time people cross those age thresholds, they tend to be frail, infirm and doddery. Many no longer enjoy life and may even wish they were dead. Some have failed to "shuffle off this mortal coil" only through inertia and lack of commitment, others because of religious convictions that proscribe suicide, yet others because they are too decrepit even to attempt unassisted suicide and because assisting suicide is a criminal offence in most countries.

Because but few of these old folk still make a productive contribution as workers, home makers or child minders, they also impose a serious financial burden on the community. Many no longer pay taxes but are net recipients of government transfers. The medical expenses incurred by and on behalf of the very old tend to be high. In the UK, with its tax-funded NHS, the elderly impose a non-trivial health-tax on the rest of society. In addition to the financial/fiscal burden imposed by the elderly, they impose negative externalities. They drive too cautiously and fail to make due progress; they slow down other pedestrians on busy streets and during the rush to catch a bus, train or tube. Their Zimmer frames clog up passageways and entrance halls. They also are at times not very pleasant to look at, especially when they take out their dentures in a restaurant. Finally they can be highly irritating, because they tend to bang on about the good old days.

A utilitarian paternalistic government would know what to do in this situation. It would rewrite the intergenerational social contract to include mandatory involuntary euthanasia at age 87 for men and at age 89 for women. The week before my 87th birthday, I would receive a note informing me that in a week’s time I have to turn up at my local NHS hospital to be humanely executed by lethal injection. Those who have served in the armed forces could opt instead to be executed by firing squad. The penalty for failing to turn up would (of course) be death.

Professor Julian Le Grand, of the LSE’s Department of Social Policy, would not approve of this classical utilitarian paternalism. His libertarian paternalism (a poisonously oxymoronic expression) would instead prescribe the following government policy. The intergenerational social contract would be still rewritten to include involuntary euthanasia at age 87 for men and at age 89 for women. I would still receive, the week before my 87th birthday, a note informing me that I will be humanely executed in a week’s time by lethal injection. Those who have served in the armed forces could still opt instead to be executed by firing squad. The penalty for failing to turn up, however, would not be death but a fine of £200 (a Life Permit).

The arguments I have used to rationalise a fine or fee for being allowed to go on living, are no different in essence from the arguments used by Professor Julian Le Grand to rationalise his suggestion (offered for discussion and debate) that the sale of cigarettes should be banned except to holders of a Smoker’s Permit. Le Grand’s Smoker’s Permit would cost £200 and would also require the signature of a doctor. Similar proposals have been floated by him for the automatic enrolment of employees by their employer in exercise classes, subject to an opt-out clause (this time without a fine or fee).

Le Grand is advocating ‘soft compulsion’, that is, mandating (prescribing or proscribing) certain kinds of behaviour, subject to an opt-out clause. The exercise of the opt-out option can be made costly in a number of ways: by attaching a financial cost to it (£200 for the Smoker’s Permit), by making it time-consuming (the requirement of a doctor’s signature for the Smoker’s Permit), by making it embarrassing (overcoming peer-pressure not to opt out of workplace fitness activities) or by creating the presumption (or at least a suspicion) that future (career) prospects may be adversely affected should you opt out.

Le Grand is not the only highly visible advocate of an enhanced guiding and directing role for the government through ‘soft compulsion’. Another LSE notable, Richard Layard, Emeritus Professor of Economics at the LSE, and author of the book Happiness: Lessons from a New Science, published in 2005 and now available as a Penguin book, appears to believe all of the following (the seven proposition are mine; I distilled them as best I could from Layard’s Happiness volume):

  1. We know what makes us happy
  2. We want to be happy
  3. Therefore we ought to do what makes us happy
  4. The state knows what makes us happy
  5. The state knows how to make us happier
  6. The state wants us to be happier
  7. Therefore the state ought to take measures that make us happier

A number of strong and to me convincing arguments against propositions 4., 5. and 7. can be found in the useful tract Happiness, Economics and Public Policy by Helen Johns and Paul Ormerod, published by the  Institute of Economic Affairs in 2007. I believe all seven points are either dangerously misleading (or even deceptive), completely wrong or a threat to liberty and to all that makes life worth living.

Proposition 1. is true only if happiness is defined either as self-reported happiness (the verbal or written characterisation of their mood/state of mind/feelings by persons responding to questions in an interview or filling in some kind of questionnaire) or as a physiological or electro-chemical response to certain events or stimuli. None of this need bear any relationship to everyday notions of happiness. Using a value- and emotion-laden word like ‘happiness’ to label behaviour, actions, reported feelings and physiological or electro-chemical responses that bear little or no relation to the everyday concept, is misleading.

Proposition 2. is the happiness literature’s equivalent of ‘revealed preference’ in neoclassical consumer choice theory. People choose what they choose, because they prefer what they choose; and the proof that they prefer what they choose is that they choose it. It is a tautology. We want to be happy because if we wanted to be something other than happy, the happy we appear not to want to be cannot really be happiness.

Proposition 3. is a normative statement or value judgement that I reject utterly, regardless of whether Propositions 1. and 2. are correct. Many ethical system, some based on religious principles, others without divine underpinnings, would reject the pursuit of personal happiness as the main goal a person ought to pursue. The Christian tradition I belong to commands me to seek the Kingdom of God and to love my neighbour as myself. From this perspective, the pursuit of personal happiness is immoral, self-obsessed infantilism. Whatever one’s views on ethics, Proposition 3 isn’t science.

Proposition 4. is correct only if we define happiness in one of the peculiar ways prevalent in the pseudo-science of happiness; it also requires that the state and the government that manages it, has taken on board the views of Layard, Le Grand and their ilk. I hope this is not the case, even in the UK, on any wide scale. The worrying trends towards teaching pseudo-happiness in English schools will in all likelihood turn out to be yet another fad that does not outlast the incumbent administration. 

Proposition 5. is wrong, even if Proposition 4. were correct. The state/government knows at most only the ‘partial equilibrium’ direct determinants of ‘happiness’ (or even more likely just of few of the empirical correlates). No one and no institution, including the state, understands the dynamic general equilibrium effects even of those policies whose direct impact effects on ‘happiness’ are at least partially understood. Interaction effects, feedback effects (negative and positive), lagged effects, effects working through expectations and anticipations – no one has a clue.

Proposition 6  is wrong even if Proposition 5 were correct. Even if the government or some other state institution were to know how to raise our level of self-reported happiness, or how to lower hypertension, or indeed how to modulate the electro-chemical reactions in the cerebral cortex (or any other part of the brain) so as to give us a warm feeling or pleasant buzz inside, it would not follow that the government would want to pursue policies aimed at doing any of these things. 

The notion that governments are benevolent and competent makes for bad political economy. Governments are temporary coalitions of partly self-interested, partly altruistic, partly ideological, partly noble and partly evil people who happen to have got hold of the levers of control of the state. Each government represents the good, the bad and the ugly. It does some good and some harm. The primary objective of the governments I have observed is to hang on to power. If that requires making people happy (by any definition), the government may try to do so; its ability to achieve the objective should, of course, not be overestimated.. If it requires making people feel powerless, fearful, resentful and divided, then the government will instead pursue that objective. 

Proposition 7 is a normative statement about what the state ought to do. I strongly disagree with it. The defining property of the state is that it has the monopoly of the legitimate use of force in a society. The state can coerce, prescribe and proscribe behaviour; it can tax and it can declare some of its liabilities to be legal tender. It should only do those things that require this power of coercion. 

The fundamental responsibility of the government is to create institutions, laws and regulations that allow people the maximum freedom to make their own choices. This requires the funding of key public goods, such as defense, law and order, public administration, public health and the education of children. It will also require the public provision of those public goods and services that cannot be provided effectively through private or cooperative arrangements. Governments also have the duty, on behalf of the community and jointly with other private and cooperative institutions, to help those who cannot help themselves: the poor, the weak and the infirm; those too young to qualify as competent citizens; the mentally ill; the mentally handicapped; and those too old and frail to look after themselves any longer. 

Governments can try to correct market failures and failures of other non-government allocative mechanisms, as long as government failure is not likely to make things worse. The main causes of market failure are externalities (including informational asymmetries) and market power. Both regulation and taxation or subsidies can be used to address the causes of market failure. 

Externalities are any effect of the actions of one or more persons on the well-being (utility) of third parties. I prefer restricting the government’s role in addressing externalities to those instances where an action has a material (significant) adverse effects on the rights of others. Such material rights externalities would exclude, for instance, someone taking offence and getting upset at something I write or say, no matter how much this lowers their subjectively experienced wellbeing or comfort level. This is because, in my book, there is no right not to be offended. 

As I accord the government no automatic role in correcting externalities that are not rights externalities, it will not come as a surprise that I also oppose the government having any role in boosting people’s ‘happiness’ (in any and all senses of the word) when there are no rights externalities involved. Even if the government were to know what is good for me, it is not the government’s business to see to it that I (or someone else) undertakes the actions required to bring about that good. If my actions harm me (smoking tobacco, excessive alcohol consumption, smoking cannabis for non-medical reasons, using heroin for reasons other than pain relief) there is only a role for government if my actions also infringe on other peoples’ rights.

In the case of smoking, the health effects of secondary smoke inhalation are a prima-facie case for banning smoking in enclosed public spaces. If the only externality from smoking had been the fact that it causes the air to stink and to become irritating to some people’s eyes, this would not be sufficient grounds for the government to ban smoking in enclosed public spaces, although private clubs could do what they want. Putting further obstacles in the way of mentally competent adults who wish to smoke – things like Le Grand’s Smoker’s Permit cum doctor’s signature – is harassment and an assault on freedom. Excessive alcohol consumption is not a problem requiring government action if all it does is to cause my liver to rot. If I drive under the influence, or become drunk and disorderly in public, there are laws to deal with this. 

The wearing of seat belts by adults is another area where governments have no obvious role, other than an informational one (see below). Clearly, insurance companies may require seat belts to be fitted in cars they insure. Air lines have the right to refuse passengers who do not wish to tighten their seat belts. Mandating seat belts for children is also legitimate. Mandating the wearing of seat belts by competent adults is an unwarranted interference with individual sovereignty. 

The only legitimate role for the government in areas of private decision making where there are no rights externalities involved are (1) the provision of information and (2) framing. Information is an awkward commodity. Ex-ante the discovery of information can be costly. Ex-post, information is non-rival in use and should be disseminated as widely as possible. Governments therefore have a role in funding the provision of relevant information on health issues (even those without a public health dimension), seat belts, hygiene (which may also have a public health dimension) and food and product safety. Mandating the provision of information on the ingredients/materials in food, household products and drugs by the producer or seller can also make sense, with due allowance for the cost of providing different kinds of information. Therefore, pace Julian Le Grand, no ban on salt in processed foods, but clear labelling and information about the health risk of too much salt. 

Framing or presenting logically equivalent choices in different ways is a tool for influencing choices that relies on the violation of one or more of the conventional postulates of rational decision theory – often the independence of irrelevant alternatives. Framing matters if you feel different when I describe the bottle as half empty or half full. Framing is central to the opting in – opting out debates concerning trade union membership and participation in ‘second pillar’ company pension schemes by workers. When the ‘default’ is that workers are enrolled in the company pension scheme unless they actively opt out, 80% of the work force stays with the scheme. When the default is that workers are not enrolled but are free to opt in, only 20% of the workforce signs up. 

If mere framing, that is, mental window-dressing which does not have any effect on outcomes and payoffs in different states of nature, has a powerful effect on behaviour, the role of government becomes interesting. If we believe that there are areas of private choice for which the government knows what is good for us better than we do ourselves – if not all of the time then at least at those times when we actually decide to opt in or out of the company pension scheme – then we should grant the government the right to insist on a particular kind of framing of the choices in private pension schemes. If we don’t trust the competence of the governments and its experts, we should deny the government the right to frame choices in private arrangements. 

It is clear from Le Grand’s Smoking Permit example, that he does not trust the ‘soft compulsion’ of moving from opting in to opting out when it comes to many kinds of private choices. The cognitive distortions exploited by framing will in many cases have to reinforced with other incentives to get the outcomes preferred by Le Grand. Fines, taxes, mandatory waiting periods, time wasted in obtaining permits etc. are all part of the toolkit of the new Paternalists.

A true libertarian wants the state out of his life and out of his business. The camel’s nose unavoidably is back into the tent when one recognises the legitimacy of collective coercive action given the reality of rights externalities – when my actions impinge on your rights. There is, however, a huge difference between those who try to keep as much of the camel out of the tent as possible and those who are trying to push every inch of the beast into the tent. Le Grand and Layard are contributing to a dangerous ideology rationalising ever-increasing and ever more sophisticated attempts to steer, nudge, influence and in the limit completely override individual judgement and choice. One opt-out and fine at a time, it is moving us towards a nightmarish form of central planning not even attempted by the former Soviet Union – the micro-management of individual consumption, life-style and human capital management choices.

This ideology is fundamentally totalitarian, although the uniform of the familiar military dictator has been replaced by the tweed jacket and business suit of the expert and the technocrat, and the secret policeman has given way to the psychiatrist and behavioural therapist.

It is totalitarian because the state refuses to leave the private sphere alone.  Actions that have no external effects, and which therefore a-fortiori have no external rights effects, are nevertheless deemed legitimate concerns of the state.  Private actions can be nudged, influenced and incentivised by the state using any of the tools and instruments it possesses, for no reason other than that the state believes this to be in our ‘true’ interest. 

Well, thanks but no thanks.  I prefer making my own mistakes to having someone else, be it the state or another entity or individual, make the ‘right’ choices for me.

The London School of Economics and Political Science has moved a long way from the days when it counted among its economists such champions of liberty as Lionel Robbins and Friedrich von Hayek, to the present-day prominence of two champions of the intrusive, micro-managing, overweaning, overbearing state – Richard Layard and Julian Le Grand. Let’s just hope these things move in cycles.

According to a report in the Financial Times, "European nations are to draw up radical proposals to improve transparency in financial markets and to change the way credit rating agencies operate in an attempt to prevent any recurrence of the financial turmoil arising from the credit squeeze."[1]

Are transparency in financial markets and better rating agencies indeed key to preventing the recurrence of the kind of mess we have been experiencing in the world’s most developed financial systems for these past three months?  I intend to take a multi-part romp through the crisis to see what lessons it holds for policymakers and market participants.

The problems we have recently seen across the industrialised world (but not, as yet, in the emerging markets), was caused fundamentally by wanton securitisation, fundamental flaws in the rating agencies business model, privately rational but socially inefficient disintermediation, and competitive international de-regulation. Proximate drivers of the specific way in which these problems manifested themselves were regulatory and supervisory failure in the US home loan market and excessive global liquidity creation by key central banks.

In the UK, the problems were aggravated by:

  1. a flawed Tripartite arrangement between the Treasury, the Bank of England and the Financial Services Authority (FSA) for dealing with financial crises;
  2. supervisory failure by the FSA;
  3. flaws in the Bank of England’s liquidity-oriented open market policies (too restrictive a definition of eligible collateral and an unwillingness to try to influence market rates at maturities longer than overnight, even during periods of serious lack of market liquidity;
  4. flaws in the Bank of England’s discount window operations (too restrictive a definition of eligible collateral; only overnight lending; too restrictive a definition of eligible discount window counterparties). 

Both shortcomings in the Bank of England’s operating arrangements and procedures were due to a flawed understanding of the nature and determinants of market (ill)liquidity, of the Bank of England’s unique role in the provision of market liquidity because of its ability to create unquestioned liquidity instantaneously and costlessly, of the conditions under which there is a trade-off between moral hazard (bad incentives for future bank behaviour) and the ex-post provision of liquidity to (a) markets and (b) specific individual institutions, to prevent collateral damage to the financial system and the real economy. 

1. Securitisation


Traditionally, banks borrowed short and liquid and lent long and illiquid. On the liability side of the banks’ balance sheet, deposits withdrawable on demand and subject to a sequential service (first come, first served) constraint figured prominently. On the asset side, loans, secured or unsecured to businesses and households were the major entry. These loans were typically held to maturity by the banks (the ‘originate and hold’ model). Banks therefore transformed maturity and created liquidity. Such a combination of assets and liabilities is inherently vulnerable to bank runs by deposit holders. 

Banks were deemed to be systemically important, because their deposits were a key part of the payment mechanism for households and non-financial corporations, because they played a central role in the clearing and settlement of large-scale transactions and of securities. To avoid systemically costly failures by banks that were solvent but had become illiquid, the authorities implemented a number of measures to protect and assist banks. Deposit insurance was commonly introduced, paid for either by the banking industry collectively or by the state. In addition, central banks provided lender of last resort (LoLR) facilities to individual deposit-taking institutions that had trouble financing themselves. 

In return for this assistance and protection, banks accepted regulation and supervision. This took the form of minimum capital requirements, minimum liquidity requirements and other restrictions on what the banks could hold on both sides of their balance sheets. 

In the 1970s, Fannie Mae (Federal National Mortgage Association), Ginnie Mae (Government National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) began the process of securitisation of residential mortgages. Asset securitisation involves the sale of income generating financial assets (such as mortgages, car loans, trade receivables (including credit card receivables) and leases) by a company (the originator of the financial assets) to a special purpose vehicle (SPV). The SPV, which might be a trust or a company, finances the purchase of these assets by the issue of bonds, which are secured by those assets. The SPV is supposed to be bankruptcy-remote from the originator, that is, it has to be an off-balance sheet entity vis-à-vis the originator. Cash-flow securitisation works in a similar way, as when the UK government agreed to create the International Finance Facility which was supposed to securitise future development aid commitments.

Private institutions, especially banks, immediately took advantage of these securitisation techniques to liquefy their illiquid loans. The resulting ‘originate and distribute’ model had major attractions for the banks and also permitted a potential improvement in the efficiency of the economy-wide mechanisms for intermediation and risk sharing. It made marketable the non-marketable; it made liquid the illiquid. There was greater scope for trading risk, for diversification and for hedging risk. 


There are three problems associated with securitisation (and the generally associated creation of off-balance sheet vehicles).

  1.  The greater opportunities for risk trading created by securitisation not only made it possible to hedge risk better (that is, to cover open positions); it also permitted investors to seek out and take on additional risk, to ‘unhedge’ risk and to create open positions not achievable before. When risk-trading opportunities are enhanced through the creation of new instruments or new institutions, and when new populations of potential investors enter the risk-trading markets, we can only be sure that the risk will end up with those most willing to bear it. There can be no guarantee that risk will end up being borne by those most able to bear it.
  2.  The ‘originate and distribute’ model destroys information compared to the ‘originate and hold’ model. The information destruction occurs at the level of the originator of the assets to be securities. Under the ‘originate and distribute’ model the loan officer collecting the information on the creditworthiness of the would-be borrower is working for the Principal in the investing relationship (the originating bank). Under the ‘originate and distribute’ model, the loan officer of the originating banks works for an institution (the originating bank) that is an Agent for the new Principal in the investing relationship (the SPV that purchases the loans from the bank and issues securities against them). With asymmetric information and costly monitoring, the agency relationship dilutes the incentive for information gathering at the origination stage. Reputation considerations will mitigate this problem, but will not eliminate it.
  3.  Securitisation also puts information in the wrong place. Whatever information is collected by the loan originator about the underlying assets remains with the originator and is not effectively transmitted to the SPV, let alone to the subsequent buyers of the securities issued by the SPV that are backed by these assets. By the time a hedge fund owned by a French commercial bank sells ABS (asset backed securities) backed by US subprime residential mortgages to a conduit owned by a small German Bank specialising in lending to small and medium-sized German firms, neither the buyer nor the seller of the ABS has any idea as to what is really backing the securities that are being traded.


Partial solutions
The problems created by securitisation can be mitigated in a number of ways. 

1. Simpler structures. The financial engineering that went into some of the complex securitised structures that were issued in the last few years before the ABS markets blew up on August 9, 2007 at times became ludicrously complex. Simple securitisation involved the pooling of reasonably homogeneous assets, say residential mortgages issued during a given period with a given risk profile (subprime, alt-A or prime, say). These were pooled and securities issued against them were tranched, with the higher tranche having priority (seniority) over the lower tranches. This permitted the highest tranche secured against a pool of high-risk mortgages, say, to achieve a much better credit rating than the average of the assets backing all the tranches together (the lower tranches, of course, had a correspondingly lower credit rating).

However, second-tier and higher-tier-securitisation then took place, with tranches of securitised mortgages being pooled with securitised credit-card receivables, car loan receivables etc. and tranched securities being issued against this new, heterogeneous pool of securitised assets. Myriad credit enhancements were added. In the end, it is doubtful that even the designers and sellers of these compounded, multi-tiered securitised assets knew what they were selling, knew its risk properties or knew how to price them. Certainly the sellers did not. 

There is a simple solution: simpler structures. This will in part be market-driven, but regulators too may put bounds on the complexity of instruments that can be issued or held by various entities. 

2. ‘Unpicking’ securitisation. This ‘solution’ is the ultimate admission of defeat in the securitisation process. A number of American banks with (residential mortgage-backed securities on their balance sheet have been scouring the entrails of the asset pools backing these securities and have sending staff to specific addresses to assess and value the individual residential properties. This inversion of the securitisation matrix is, of course, very costly and means that the benefits from risk pooling will tend to be ignored. It is an ignominious end for the securitisations involved. RMBS

3. Retention of equity tranche by originator.  When the originator of the loans is far removed from the ultimate investor in the securities backed by these loans, the incentive for careful origination is weakened. One way to mitigate this problem is for the originator to retain the ‘equity tranche’ of securitised and tranched issues. The equity tranche or ‘first-loss tranche’ is the highest-risk tranche – the first port of call when the servicing of the loans is impaired. It could be made a regulatory requirement for the originator of residential mortgages, car loans etc. to retain the equity tranche of the securitised loans. Alternatively, the ownership of the equity tranche could be required to be made public information, permitting the market to draw its own conclusions.

4. External ratings. The information gap could be closed or at least reduced by using external rating agencies to provide an assessment of the creditworthiness of the securitised assets. This has been used widely in the area of RMBS and of ABS. This ‘solution’ to the information problem, however, brought with it a whole slew of new problems.

2. Rating agencies 

A small number of internationally recognised rating agencies (really no more than three: Standard & Poor’s, Moody’s and Fitch) account for most of the rating of complex financial instruments, including ABS. They got into this business after for many years focusing mainly on the rating of sovereign debt instruments and of large private corporates. They have been given a formal regulatory role, (which will be greatly enhanced under the about-to-be-introduced Basel 2 Capital Adequacy regime) because their ratings determine the risk weighting of a whole range of assets bank hold on their balance sheets. 

Their role raises a number of important issues because it creates a number of problems. 


 1. What do they know? This is a basic but important question. One can imagine that, after many years, perhaps decades, of experience, a rating agency would become expert at rating a limited number of sovereign debtors and large private corporates. How would the rating agency familiarise itself with information available only to the originators of the underlying loans or other assets and to the ultimate borrowers? How would the rating agency, even if they knew as much about the underlying assets as the originators/ultimate borrowers, rate the complex structures created by pooling heterogeneous underlying asset classes, slicing and dicing the pool, tranching and enhancing the payment streams and making the ultimate pay-offs complex, non-linear functions of the underlying income streams? These ratings were overwhelmingly model-based. The models used tended to be the models of the designers and sellers of the complex structures, who work for the issuers of the instruments. Models tend to be useless during periods of disorderly markets, because we have too few observations on disorderly markets to construct reasonable empirical estimates of the risks involved.

2. They only rate default risk. Rating agencies provide estimates of default risk (the probability of default and the expected loss conditional on a default occurring). Even if default risk is absent, market risk or price risk can be abundant. Liquidity risk is one source of price risk. As long as the liquidity risk does not mutate into insolvency risk, the liquidity risk is not reflected in the ratings provided by the rating agencies. The fact that many ‘consumers’ of credit ratings misunderstood the narrow scope of theses ratings is not the fault of the rating agencies, but it does point to a problem that needs to be addressed. First, there has to be an education campaign to make investors aware of what the ratings mean and don’t mean. Second, the merits of offering (and requiring) a separate rating for, say, liquidity risk should be evaluated.

3. They are conflicted. Rating agencies are subject to multiple potential conflicts of interest.

a. They are the only example of an industry where the appraiser is paid by the seller rather than the buyer.

b. They are multi-product firms that sell advisory and consulting services to the same clients to whom they sell ratings. This can include selling advice to a client on how to structure a security so as to obtain the best rating and subsequently rating the security designed according to these specifications.

c. The complexity of some of the structured finance products they are asked to evaluate makes it inevitable that the rating agencies will have to work closely with the designers of the structured products. The models used to evaluate default risk will tend to be the models designed by the clients. It’s not just the problem that marking to model can become marking to myth. There is the further problem that the myth will tend to be slanted towards the interest of the seller of the securities to be rated.

Partial solutions 

There is no obvious solution other than ‘try harder and don’t pretend to know more than you know’ for the first problem. The second problem requires better education of the investing public. The third problem can be mitigated in a number of ways. 

1. Reputational concerns. Reputation is a key asset of rating agencies. That, plus the fear of law suits will mitigate the conflict of interest problem. The fundamental agency problem cannot be eliminated this way, however. Even if the rating agencies expect to be around for a long time (a necessary condition for reputation to act as a constraint on opportunistic and inappropriate behaviour), individual employees of rating agencies can be here today, gone tomorrow. A person’s reputation follows him/her but imperfectly. Reputational considerations are therefore not a fully effective shield against conflict of interest materialising.

2. Remove the quasi-regulatory role of the rating agencies in Basel II and  elsewhere. Just as the public provision of private goods tends to be bad news, so the private provision of public goods leaves much to be desired (‘the best judges money can buy etc.’). The official regulatory function of private credit risk ratings in Basel I and II should be de-emphasized and preferably ended altogether.

I may get my wish here, because Basel II appears fatally holed below the waterline. It was long recognised to have unfavourable macroeconomic stabilisation features, because the capital adequacy requirements are likely to be pro-cyclical (see Borio, Furfine and Lowe (2001), Gordy and Howells (2004) and Kashyap and Stein (2004)). On top of this, the recent financial turmoil should that the two key inputs into Pillar 1, the ratings provided by the rating agencies and the internal risk models of the banks are deeply flawed.

As regards internal risk models, there are two problems. The first is the unavoidable ‘garbage in – garbage out’ problem that makes any quantitative model using parameters estimated or calibrated using past observations useless during times of crisis, when every crisis is different. We have really only had one instance of a global freeze-up of ABS markets, impairment of wholesale markets and seizure of leading interbank markets simultaneously in the US, the Eurozone and the UK. Estimates based on a size 1 sample are unlikely to be useful. Second, the use of internal models is inherently conflicted. The builders, maintainers and users of these models are perceived by the operational departments of the bank as a constraint on doing profitable business.  They will be under relentless pressure to massage the model to produce the results desired by the bank’s profit centres. They cannot be shielded effectively from such pressures. Chinese walls inside financial corporations are about as effective in preventing the movement of purposeful messages across them, as the original Great Wall of China was in keeping the barbarians out and the Han Chinese in – that is, utterly ineffective. 

3. Make rating agencies one-product firms. The potential for conflict of interest when a rating agency sells consultancy and advisory services is inescapable and unacceptable. Even the sale of other products and services that are not inherently conflicted with the rating process is undesirable, because there is an incentive to bias ratings in exchange for more business in functionally unrelated areas.  The obvious solution is to require any firm offering rating services to provide just that. Having single-product rating agencies should also lower the barriers to entry.

4. End payment by the issuer. Payment by the buyer (the investors) is desirable but subject to a ‘collective action’ or ‘free rider’ problem. One solution would be to have the ratings paid for by a representative body for the (corporate) investor side of the market. This could be financed through a levy on the individual firms in the industry. Paying the levy could be made mandatory for all firms in a regulated industry. Conceivably, the security issuers could also be asked to contribute. Conflict of interest is avoided as long as no individual issuer pays for his own ratings. This would leave some free rider problems, but should get the rating process off the ground. I don’t think it would be necessary (or even make sense) to socialise the rating process, say by creating a state-financed (or even industry-financed) body with official powers to provide the ratings.

5. Increase competition in the rating industry. Competition in the rating process is desirable. The current triopoly is unlikely to be optimal. Entry should be easier when rating agencies become single-product firms, although establishing a reputation will inevitably take time. 

3. Excessive disintermediation

There are no doubt solid economic efficiency reasons for taking certain financial activities out of commercial banks and out of investment banks, and putting them in special purpose vehicles (SPVs), Structured Investment Vehicles (SIVs, that is, SPVs investing in long-term, often illiquid complex securitised financial instruments and funding themselves in the short-term wholesale markets, including the ABCP markets), Conduits (SIVs closely tied to a particular bank) and a host of other off-balance-sheet and off-budget vehicles. Incentives for efficient performance, including appropriate risk management can, in principle, be aligned better in a suitably designed SPV than in a general-purpose bank. The problem is that it is very difficult to come up with any real-world examples of off-balance sheet vehicles that actually appear to make sense on efficiency grounds. 

Most of the off-balance sheet vehicles (OBSVs)  I am familiar with are motivated by regulatory arbitrage, that is, by the desire to avoid the regulatory requirements imposed on banks and other deposit-taking institutions. These include minimal capital requirements, liquidity requirements, other constraints on permissible liabilities and assets, reporting requirements and governance requirements. Others are created for tax efficiency (i.e. tax avoidance) reasons or to address the needs of governments and other public authorities for off-budget and off-balance sheet finance, generally to get around public deficit or debt limits. 

OBSVs tend to have little or no capital, little or no transparency and opaque governance. When opaque institutions then invest in opaque financial instruments like the ABS discussed earlier,  systemic risk is increased. This is reinforced by the fact that much de-jure or de-facto exposure remains of the sponsoring banks to these off-balance-sheet vehicles. The de jure exposure exists when the bank is a shareholder or creditor of the OBSV, when the OBSV has an undrawn credit line with the bank or when the bank guarantees some of the OBSV’s liabilities. De-facto exposure exists when, for reputational reasons, it is problematic for the bank to let an OBSV that is closely identified with the bank go under.

 Banks in many cases appear not to have been fully aware of the nature and extent of their continued exposure to the OBSVs and the ABS they carried on their balance sheets. Indeed the explosion of new instruments and new financial institutions so expanded the populations of issuers, investors and securities that many market participants believed that risk could not only be traded and shared more widely and in new ways, but that risk had actually been eliminated from the system altogether. Unfortunately, the world of risk is not a doughnut: it does not have a hole in it. All risk sold by someone is bought by someone. If the system works well, the risk ends up being born by those both willing and most able to bear it. Regrettably, it often ends up with those most willing but not most able to bear it.Partial solutions.

 Mitigation of the problems created by excessive disintermediation will be part market-driven and partly regulatory.

1. Re-intermediation. Either Conduits, SIVS and other OBSVs are taken back on balance sheet by their sponsoring banks, or the ABS and other illiquid securities on their balance sheets are sold to the banks. The OBSVs then either wither away or vegetate at a low level of activity.

2. Regulation. We can anticipate a regulatory response to the problem of opaque instruments held by opaque OBSVs in the form of reporting requirements, and consolidation of accounts requirements that are driven by broad principles (‘duck tests’) with constant adaptation of specific rules addressing particular institutions and instruments. For instance, if the Single Master Liquidity Enhancement Conduit (M-LEC) proposed by JPMorgan Chase, Bank of America and Citigroup ever gets off the ground, it is questionable whether the US regulators will permit the participating banks to keep it off-balance-sheet for reporting purposes, including earnings reports.

4. Competitive Global Deregulation

 Regulators of financial markets and institutions are organised on a national basis and are, in part, cheerleaders and representatives of the interests of their national financial sectors. While regulation is national, finance is global. The location of financial enterprises and markets is endogenous. A thriving financial sector creates jobs and wealth, and is generally environmentally friendly. So regulators try to retain and attract business for their jurisdictions in part by offering more liberal, less onerous regulations. This competition through regulatory standards has led to less stringent regulation.

There have been occasional reversals in this process. The Sarbanes-Oxley Act of 2002 was a response to the corporate governance, accounting and reporting scandals associated with Enron, Tyco International, Peregrine Systems and WorldCom. It undoubtedly contributed to a loss of business for New   York City as a global financial centre. Because Sarbanes-Oxley compliance is mainly a matter of box-ticking (like most real-world compliance, especially compliance originating in the USA), it has not materially improved the informational value of accounting or the protection offered to investors. 

Is this global competitive deregulation process a welcome antidote to a tendency to excessive and heavy-handed regulation or a race to the bottom in which everyone loses in the end? I believe the jury is still out on this one, although I am inclined, if pushed, to suggest that the following are likely to be true

  • Principles-based regulation (allegedly what we have in the UK) vs. rules-based regulation is an unhelpful distinction. You need both. You need principles that spell out the      fundamental ‘duck test’: (a) Does the institution lend long and borrow      short? (b) Does it lend in illiquid form and borrow in markets that are      liquid in normal times although they may turn illiquid during period of      market turbulence? Do banks have      substantial exposure to it? If so,      it should be either consolidated for reporting purposes with the bank or      treated as a bank it its own right. Then you need rules that are constantly adapted to keep up with      developments in instruments and institutions.
  • Self-regulation is no regulation unless backed up credibly with the threat that, unless effective self-regulation is implemented, external regulation will be imposed.
  • Voluntary codes of conduct are without      significance unless they can be and are used by the regulator (through ‘comply or explain’ rules) to impose and enforce standards. That means that if the explanation is  not to the regulator’s satisfaction, compulsion can be used.
  • The UK’s ‘light-touch’ regulation has become ‘soft-touch’ regulation and needs to be tightened up in a large number of  areas.


Partial solutions 

1. Greater international cooperation between regulators. This is a no-brainer, but very hard to achieve.

2. A single EU-wide regulatory regime for banks, other financial institutions and financial markets. National financial regulators in the EU should go the way of the dodo. An EU-level FSA would be a good idea, although the central banks (the ECB and for the time being still 14 national central banks) should collect more information about individual banks than the Bank of England has done since it lost banking supervision and regulation in 1997 when the Bank became operationally independent for monetary policy.

3. A crackdown on “regulators of convenience”. This requires tough measures towards ‘regulation havens’, some found in the Caribbean, others closer to the UK. One effective approach would be the non-recognition and non-enforceability of contracts, court judgements and other legal and administrative rules from non-compliant jurisdictions.



Borio, C., C. Furfine and P. Lowe (2001): “Procyclicality of the financial system and financial stability: issues and policy options”, in Marrying the macro- and micro-prudential dimensions of financial stability, BIS Papers, no 1, March, pp 1-57. 

Gordy, Michael B. and Bradley Howells (2004), “Procyclicality in Basel II: Can We Treat the Disease Without Killing the Patient?”, Board of Governors of the Federal Reserve System; First draft:

April 25, 2004. This draft: May 12, 2004.

Kashyap, A K and J C Stein (2004): “Cyclical implications of the Basel II capital standards”, Economic Perspectives, Federal Reserve Bank of Chicago, First Quarter, pp 18-31.

[1] Financial Times, October 8, 2007, EU plans market reforms to avert crisis.

What is behind the Single Master Liquidity Enhancement Conduit (M-LEC) aka ‘Superfund’ proposed by Citigroup, JPMorgan Chase and Bank of America, with the active verbal encouragement of the US Treasury?

Exploding amounts of opaque financial instruments held by growing numbers of opaque financial institutions made a significant contribution to the perfect storm that resulted in massive disruption of interbank markets, the drying up of many collateralised debt obligations (CDO) markets, collateralised loan obligations (CLO) markets and asset-backed commercial paper (ABCP) markets and the continuing upheaval throughout the OECD wholesale financial markets. Prominent among the opaque financial instruments are a wide range of complex structured finance products based on the securitisation, bundling, slicing and dicing, tranching, enhancement and recombination of securitised illiquid assets and cash flows like mortgages, car loans and credit card receivables. Leading examples of opaque financial institutions are the Structured Investment Vehicles (SIVs) and Conduits (SIVs closely associated with a particular bank) whose assets M-LEC is supposed to purchase. All these SIVs, Conduits and similar constructions are off-balance-sheet vehicles created mostly by commercial banks (some by investment banks), mainly to avoid regulatory burdens, including capital adequacy requirements, reporting requirements, governance requirements and other restrictions on the asset and liability sides of banks’ balance sheets.

This raises the obvious question as to whether the proposed sale by a number of opaque off-balance-sheet vehicles of between $75 bn and $200 bn of illiquid opaque asset-backed securities (ABSs) to a single huge opaque off-balance-sheet vehicle, M-LEC, funded by the three above-mentioned American banks (and any other institutions willing to join the venture) represents a move towards better functioning ABS and ABCP markets and towards fair-value or fundamental-value pricing of these securities? It is possible, but not likely.

Clearly, if SIVs and Conduits have to unload large quantities of illiquid opaque financial instruments on an unwilling market because these SIVs and Conduits can no longer refinance their short-maturity liabilities in the defunct ABCP markets, the ‘fire sale’ prices realised by such distress sales would indeed be distressing to the sellers. These same prices would, however, be exhilarating to the buyers – the vulture funds and other deep pockets/smart money investors that are always on the look-out for just such opportunities. Since these SIVs and Conduits have no systemic financial stability significance, their losses (which are mirrored by profits earned by their counterparties) are of no policy relevance, and even their bankruptcy (which would inevitably involve some net real resource cost) would be a second-order issue.

The ‘fire-sale’ prices that might be realised if these SIVs and Conduits had to dump their illiquid assets on a reluctant market could also impact adversely on holders of similar illiquid assets, even if these assets had not been traded at the same time and the same prices. ‘Fair value’ accounting may require marking to market of these assets using the distressed valuations achieved in the sales by SIVs and Conduits. Any institution holding such assets, including banks, could take a serious hit on their balance sheets as a result.

An obvious alternative to a fire-sale of illiquid structured finance instruments by the SIVs and Conduits to the market, would be for the banks either to purchase the instruments directly from these off-balance-sheet vehicles (at generous prices), that is to take the securities ‘on balance sheet’, or to purchase the SIVs and Conduits themselves, that is, to take the off-balance-sheet vehicles ‘on balance sheet’.  The argument against that, from the perspective of the banks, is the same as the argument for creating the off-balance-sheet vehicles in the first place: it would use up capital and impose commercial banking standards of reporting, transparency and governance on the securities/former off-balance-sheet vehicles.

If Citigroup, JPMorgan Chase, Bank of America and any other banks are exposed to such vulnerable SIVs and Conduits, whether as shareholders, as creditors or providers of (as yet) undrawn lines of credit, for reputational reasons or simply because they would not like to value their own holdings of opaque structured finance vehicles at bargain-basement prices, it is their right to try and limit the damage to their bottom lines through any set of actions that does not violate laws and regulations. It is possible that in doing so (especially if a wide cross-section of US and international banks were to participate in the venture) they would restore liquidity to a currently illiquid set of markets and do some social good as well.

Even if we grant this argument, is this the best that could be achieved from the perspective of the efficient functioning of the financial system? Hardly. If I am correct in my belief that the proliferation of regulation-avoiding off-balance-sheet vehicles has indeed been a major contributor to our current problems, scant progress would be made by the creation of M-LEC – yet another gigantic off-balance-sheet vehicle. If banks are going to bid for the opaque securities held by opaque SIVs and Conduits, they should do so directly, taking the illiquid securities onto their own balance sheets, rather than stuffing them into M-LEC at prices unlikely to be the result of arms-length transactions. With a bit of luck, the three (or more) M-LEC sponsoring banks will in any case have to consolidate their shares in M-LEC with their own accounts, but this issue is still unresolved.

In view of the widespread lack of enthusiasm among the rest of the US and international banking community for signing up for M-LEC, it seems likely that the three institutions that proposed the creation of this Mother of All Liquidity Enhancement Conduits are the institutions most exposed, directly or indirectly,  either to the SIVs and Conduits targeted by M-LEC – those  holding large portfolios of the most opaque and illiquid structured financial instruments – or to the fallout from any forced, rushed liquidation of these investments. The deafening silence of the Fed about the merits of M-LEC reinforces this impression.

From the Washington Times, October 19, 2007,  p. 15:

"KABUL The top U.S. general in Afghanistan said yesterday he estimated that Afghanistan’s rampant opium poppy cultivation was funding up to 40 percent of the Taliban-led insurgency.

Gen. Dan McNeill, head of the NATO-led International Security Assistance Force, added he had been told by an international specialist that his figure was likely low and could reach up to 60 percent…"

Nuff said.

This blog comes from Washington DC where the great and the good of the world of international finance –ministers of finance, central bankers, national and international financial bureaucrats, private financiers – and thousands of hangers-on have gathered for the 2007 Annual Meetings of the World Bank Group/IMF.

When you enter the main World Bank building, its Atrium is dominated by a huger banner proclaiming “These Meetings are Carbon Neutral”. Even a moment’s reflection makes it obvious that this statement cannot be true. Let’s take the counterfactual (the benchmark against which carbon-neutrality will be judged), to be an otherwise identical world in which the 2007 Annual Meetings are cancelled (well ahead of time) and not replaced with any other similar event or set of smaller-scale regional events.

For those attending the Annual Meetings who are normally based in Washington DC anyway, I will assume that the carbon footprint is unchanged. Actually, with the meetings cancelled there will be fewer meetings, less jumping in and out of taxis and less dining out on expense accounts, so even for the Washington DC crowd, cancelling the Meetings would, in all likelihood reduce CO2eq (Carbon dioxide- equivalent) emissions, but I am keen not to overegg my case.

For those coming to Washington DC for the Annual Meetings from elsewhere, the cancellation of the Meetings is likely to result in a reduction in CO2eq emissions when we compare their activities in Washington DC to their activities had they remained at home (playing with the children/grandchildren etc.). This is because expense-account living in DC (fine food and drink, air conditioned hotels and meeting venues, other official and unofficial activities) is likely to be more CO2eq-intensive than the activities likely to be pursued under the alternative scenario at home.

Finally, there is the carbon footprint associated with transporting many thousands of meeting participants to Washington DC. They come, literally, from all over the world. The vast majority travels by air. It is highly unlikely that the total number of flights is not higher under the Annual Meeting takes place scenario than under the Annual Meeting does not take place scenario. Likewise, the average load of passengers and luggage carried by a typical flight is likely to increase as a result of the Annual Meetings. CO2eq emissions are increasing in both the number of flights and in the load carried per flight.

So the statement “These Meetings are Carbon Neutral” is obviously untrue. That raises the question: are those who dreamt up this slogan lying, stupid or both?

The use “These Meetings are Carbon Neutral”, could be an application of the principle of lying attributed to Joseph Goebbels: “If you lie, lie big”. [1] With the Nobel for peace going to Al Gore and the IPCC, being green (or at any rate appearing to be green) is a good thing. If you can talk the talk but cannot walk the talk, just fake the walk.

Another possibility is that the World Bank’s definition of carbon-neutral is so ludicrously restrictive, that the statement is both correct and utterly misleading. It could mean no more than that the air conditioners have been turned down a few degrees, that the toilet paper is recycled and that so-called carbon offsets have been purchased by the organizers in an amount equal to the net CO2eq emissions created by the meetings. I have argued elsewhere that the carbon offset industry is a gigantic fraud and massive waste of resources.

The World Bank should take that banner down.

An earlier version of this blog appeared as a Letter to the Editor in the Financial Times of 18 October 2007.

Of course the UK Chancellor of the Exchequer is being attacked for abolishing taper relief (a capital gains tax rate of 10 percent on an arbitrary selection of capital gains and on other capital income items masquerading as capital gains) and setting a uniform capital gains tax rate of 18 percent. Those who complain are those who stand to lose. Special pleading always masquerades as the defence of the common good: the losers want us to believe that their loss is not only painful to them, but also unfair and damaging to the UK economy. The Chancellor should not listen. Taper relief has no more justification on grounds of efficiency or fairness than would tape worm relief. Further reform of the CGT is required, integrating it fully with the taxation of other forms of capital income, and indeed with the taxation of labour income. The main reasons are tax administration and the preservation of the tax bases for capital income and labour income.

Through trivially simple financial engineering (varying dividend pay outs, borrowing and share repurchases) listed companies can seamlessly transform dividends into interest or capital gains. The same can be achieved by unlisted companies when their owners sell the business. This means that, for simple tax administration reasons and to preserve the capital income tax base, only a common tax rate for all capital income, dividends, capital gains and interest, makes sense. Sector, holding period, type of capital, nature of ownership, size of firm, corporate form are all irrelevant.

That only leaves the common tax rate on all forms of capital income to be decided. Efficiency dictates that you tax things at a higher rate the lower its elasticity of demand or supply. In the long run, capital is in infinitely elastic supply. This suggests a zero marginal tax rate on capital income is optimal. In the short run, capital is given – a zero supply elasticity. This suggests confiscatory taxation is optimal. Are we in the short run or in the long run? You take your pick.

Furthermore, most labour income in the UK is in fact capital income, the return on risky investment in human capital – education, training and other skills acquisition. Therefore, to avoid distortions, labour income and all capital income should be taxed in the same way. There also is a tax administration and income tax base preservation argument for taxing labour income and capital income the same way. In small enterprises, where the same persons are both shareholders and workers, income can be transformed seamlessly from wages into dividends and vice versa.

Both efficiency and fairness would be served by taxing all labour income and all capital income the same way. There is no case, of course, for a separate corporation tax. Only natural persons – the beneficial owners of capital should be taxed. There may be a tax administration case for collecting some of the personal capital income tax at the level of the company, as a withholding tax, but there should be full offset of such withholdings.

So, to preserve capital income and/or labour income as a tax base, it is necessary to add together each person’s wages, dividends, interest income and capital gains and to apply a single tax schedule to the total. The highest marginal tax rate on capital gains would therefore be 40 percent, the same as it is for wages and dividends.

A final benefit of my proposed simplification of the capital taxation regime is that it would lift the burden of guilt of engaging in privately profitable but socially unproductive labour from tens of thousands of tax lawyers, tax accountants and other tax efficiency experts and free them for socially productive labour.

I would like to make a deal with the Right Rev Peter Selby, Bishop of Worcester from 1997 to 2007. I promise not to make public statements about the merits of the Trinitarian doctrine (a form of higher theological mathematics asserting that 3 = 1).  In return I would like the Bishop not to write any more nonsense about credit and debt. In today’s Credo column on the Faith page of the Times of London (It’s time to stop giving credit to our culture of debt", The Times, Saturday October 13, 2007, p. 83) the Bishop produces a number of canards about debt.  Unencumbered by logic or facts, the Bishop makes a slew of assertions that are, at best, unproven and at worst plain wrong.

Assertion 1: The Jubilee 2000 campaign, advocating debt relief for the poorest nations of the world, "was a remarkable achievement". Case unproven. The Bishop makes the common mistake of confusing poor countries and poor people. The debt relief in question is the forgiving of debt owed by the governments of the poorest nations. It is quite possible, and in a many cases indeed likely, that the vast majority of the citizens of these poorest nations may have been made worse off by the cancellation of part or all of the debt owed by their governments. Most of the poorest countries have appalling governments – repressive, corrupt, incompetent and inefficient. Unlike the vast majority of the population, the rulers of the poorest countries often are rich – their wealth stolen from the people. Debt forgiveness consolidates the hold of these disastrous governments on power and postpones the day that they can be held to account. When trying to help the poor ‘do no harm’ should be an overriding concern. Jubilee 2000 violated the ‘do no harm’ maxim.    

Assertion 2: The need to get across “a systemic analysis of the nature of runaway debt, its roots in the creation of money by lending and borrowing, and the potential dangers for the world of both domestic and international debt.” Here the Bishop makes a factual statement about runaway debt. Where is (was) this runaway debt? The UK The US Everywhere in the world? Clearly, one can point to specific instances of excessive borrowing. Some households in the US and the UK have undoubtedly engaged in this. Elsewhere there is too little debt and borrowing. In the People’s Republic of China, for instance, it would probably be welfare-enhancing for the government to raise spending on education, health and environmental investment, and to finance at least part of this by borrowing, thus absorbing the excessive saving of Chinese households and public enterprises. Apart from his factual errors, the Bishop also confuses money creation with credit and borrowing. One can have lending and borrowing without money creation and money creation without lending or borrowing. The Bishop is confused about what money is, how it is created and what it does. He is in good company. Most people haven’t got a clue about the meaning and modalities of money. But fortunately, most monetary ignoramuses don’t display their ignorance by writing about it in the Times.   

Assertion 3. “It is obvious that if you allow financial institutions to make huge profits by lending large multiples of the deposits they hold, you are allowing them to create money”. This is complete gobbledegook. For those who care, there are many operational definitions of money, ranging from narrow money (coin and currency plus commercial bank deposits with the central bank) to broader monetary aggregates, typically the sum of coin and currency in circulation, plus some subset of the deposits of certain deposit-taking institutions, plus some of the close substitutes for these deposits. ‘Creating money’ – an unfortunate and imprecise phrase that appears to attribute divine powers to the ‘money creating’ institutions – does not require financial institutions to make huge profits; neither do financial institutions that make huge profits necessarily create money.  If financial institutions lend huge multiples of the deposits they hold, they must be financing that lending out of non-deposit resources (the wholesale markets, for instance, as Northern Rock did). This may have been reckless, but has nothing to do with money creation.    

Assertion 4. “This failure of understanding has led to the use of debt as an instrument not just for uncontrolled personal consumption but also for building hospitals, schools and even prisons. The disciplines of living within your means, of allowing public functions to be provided by democratically accountable institutions, and of not using tomorrow’s resources today are forgotten as the young are trained in indebtedness as a condition of obtaining their tertiary education”. This is complete nonsense. The institutions and financial instruments that permit borrowing and debt (the cumulative total of all past net borrowing), represent a wonderful manifestation of human ingenuity – the Bishop might even call it a gift from God; I certainly would.
Without borrowing and debt, each household, each firm and each government could only invest what it saves itself. That would lead to gross inefficiency and a colossal waste of resources. The financial means for financing investment are not necessarily distributed in the same way as the capacity to come up with productive and profitable investment projects. Without debt and borrowing, each family, enterprise and government would have to be financially self-sufficient. The creation of enterprises on a scale larger than cottage industries would have been extremely difficult. Material standards of living would be at the level of India and China before the 1980s.    Consider the state of UK infrastructure (social overhead capital). Transportation infrastructure is sub-standard and clapped-out. Many hospitals are a disgrace; many primary and secondary schools are in need of further capital investment; there is prison overcrowding.
Clearly, there is a strong case for large-scale catch-up investment in infrastructure. To finance all of this temporary investment boom with a balanced budget would be inefficient, as it would require large temporary increases in average and marginal tax rates. It would also be unfair, because the benefits from the improved infrastructure will benefit future generations as well as current ones. These future beneficiaries should contribute towards the cost of the investment.    There is another reason why borrowing by governments may be fair. Government borrowing tends to shift the burden of financing the government from the old to the young and from current to future generations. If the pattern of the past 225 years persists, future generations are likely to be better off than us. Shifting the tax burden to future generations that are likely to be better off than ourselves, is something even the Bishop might not object to.     The same holds for student loans to finance tertiary education. It is efficient and can be made fair. The returns to investing in a tertiary education accrue overwhelmingly to the student in the form of higher future income and greater job satisfaction. It is only fair that those who benefit should pay. Taxing the average Briton to subsidize the tertiary education of persons who, after completing their tertiary education, may well be richer than the average Briton, is unfair. Clearly, the risk of failing to complete the tertiary education programme or of failing to achieve a higher income for some other reason should not be a deterrent to enter tertiary education for students from poor backgrounds. That’s why repayment of the student loans should only begin once the income of the former student is above some appropriate threshold level. Requiring students to pay for their own tertiary education, if necessary by borrowing, is both efficient and fair if income-contingent debt service is built into the programme.       
Finally, as regards “…not using tomorrow’s resources today..”, the only way to shift physical resources from tomorrow to today is by reducing investment and, in the limit, consuming capital. Investing in tertiary education, likely all investment, shifts resources from today to tomorrow, regardless of how it is financed. A closed economic system has to reduce current consumption (and possibly also early future consumption) temporarily in order to increase investment today and thus achieve higher future consumption in the longer run. By borrowing, it may be possible, in an open economic system, to avoid any absolute decline in consumption, today and tomorrow, provided the return on the investment is sufficient. Borrowing and then repaying principal and interest is a wonderful mechanism for achieving a more even, smooth consumption profile over the life cycle.

Assertion 5.  “Most serious of all, we fail to notice where the resources are coming from: all the talk in the world about climate change and the depletion of the resources of the planet will be fruitless if we do not limit our appetite for eating up tomorrow’s bread and burning tomorrow’s oil today.” The Bishop may well be correct that were are depleting exhaustible natural resources too fast. However, excessive resource depletion and destruction of the environment have nothing to do with the culture of credit and debt. The former Soviet Union had very little credit and debt. Its financial system consisted of a single monobank that provided virtually no consumer credit. Its government debt was low. Other communist countries, like Romania, paid off all their public debt (at great cost to the population alive at the time). Yet despite being as far removed from the culture of credit and debt as one could get, the communist countries depleted scarce natural resources and vandalised the environment on a scale never seen before or since (except for China today). 

Assertion 6. “The communities of faith – Jewish, Christian and Islamic – have a proud history of criticising the institutions of credit and debt”. Fortunately, that is not true now and never has been. There is a tradition in the Abrahamic faiths of periodic limited debt forgiveness. In the Old Testament, this takes the form of the Sabbatical year and the Jubilee year. A creditor could, following a borrower’s inability to service his debt, take possession of the debtor’s land and cultivate it in order to be paid. Sometimes the debtor had to sell his own and his family’s labour to the creditor – a form of slavery known as bondage.  Every 7th year was a sabbatical year in which the debt would be erased. The sabbatical also applied to the land itself, which was to be left fallow every 7th year. Every 7th Sabbatical, that is, every 49 years, was a Jubilee year. Debtors were released from both debt and bondage, and the land was restored to the debtor. The Sabbatical and Jubilee tradition limited the extent and duration of indebtedness. It did not do away with the institutions of debt, bondage (or other forms of slavery), or declare them ungodly.
There is also, in the Abrahamic tradition (and in even older traditions on the Indian subcontinent), a prohibition of interest, or usury – making money just by lending money. Today, only the literalist, fundamentalist followers of Judaism, Christianity and Islam consider the charging of interest to be sinful and ungodly per se. The best-financed and most vocal forms of Islam today come from the oil- and gas-rich theocracies of the Middle East (often taking the fundamentalist and literalist Wahabbite form of Islam found in and exported from Saudi Arabia). Today, therefore, the prohibition of interest (riba) is only an economically significant issue for Islamic finance. Sharia permits financial contracts, including securities, that involve the sharing of profit and loss. A stream of payments must be associated with an underlying real asset with risky returns or with an underlying risky productive activity. Collateral is also allowed.  From an economic point of view, interest (strictly the nominal interest factor), is just an intertemporal relative price – the price today of borrowing money. Prohibiting interest, or setting caps on interest rates to avoid ‘excessive’ interest rates is a constraint on exchange that limits intertemporal trade and therefore will tend to be inefficient and welfare-decreasing. It is true that in an economy where there also many other distortions in credit markets and insurance markets, and where the scope for targeted redistribution is limited by informational and administrative constraints, caps on interest rates can sometimes be rationalised as a second-best policy.
However, I have yet to encounter a problem to which the prohibition of interest is the solution. The prohibition of interest, a constraint on voluntary exchange and on the right to determine the terms of a contract freely, makes no economic sense. Religious fundamentalism and literalism, in economic and financial affairs as in all others, is obscurantism, based on a perverse mixture of fear and muddled thinking. Fortunately, the more enlightened Christianity that has evolved since Thomas Aquinas condemned usury, recognises the social value of the institutions of debt and credit and the welfare-enhancing potential of borrowing and lending.

The Bishop is more than 700 years behind his church. The explosion of wealth, much of it held in financial form, among oil- and gas-exporting nations, many of which adhere, at least notionally, to fundamentalist-literalist forms of Islam, has led to an explosion of financial engineering aimed at circumventing the Quranic ban on riba. Considerable ingenuity and vast amounts of resources are devoted to the construction of financial products that are economically equivalent to interest-bearing loans or interest-bearing bonds, but theologically equivalent to permissible Islamic risk-sharing instruments. The process of certifying financial products as Sharia-compliant is time-consuming and costly; those with the religious authority to provide the desired certification (typically Islamic scholar-jurists) often don’t understand finance. Financial experts tend not to be well-versed in Sharia law and its application to financial structures. Those with the power of certification can extract significant rents from the issuers and buyers of Sharia-compliant problems. From an economic point of view, it is costly theological window-dressing, in the sense that no Sharia-compliant product I have ever studied passed the interest rate ‘

duck test’: if it looks like interest, compounds like interest, imposes on both parties to the contract obligations equivalent to those associated with interest, and – the bottom-line test – provides the parties to the contract with equivalent contingent payment streams, then it is interest, even if it is stamped “profit sharing”. Take a car loan as an example. Under Islamic banking a conventional car loan is reproduced by the bank buying the car from the dealer, selling the vehicle at a higher-than-market price to the buyer of the car (with the buyer often paying in instalments), and with the bank retaining ownership of the vehicle until the car (i.e. the loan) is paid in full. This is functionally equivalent to a car loan with interest where the car is the collateral for the loan.

An Islamic mortgage loan would have the bank buying the property from the seller and reselling it at a profit to the buyer, allowing the buyer to pay the purchase price in instalments. In order to protect itself against default, the bank asks for the property as collateral until the ‘purchase price’ (loan) is paid in full. The property is registered to the name of the buyer from the start of the transaction. In sum: debt and credit are good. Borrowing and lending are good. Abuses and misuses are certainly possible. They ought to be addressed through legislation and regulation if the benefit from so doing exceeds the cost of the intervention. Ranting against the culture of debt and credit from a position of matching moral authority and ignorance is not good. The Bishop’s column is unmitigated twaddle.

It is a disgrace that such manifestly uninformed nonsense is put out on a ‘Faith page’. One of God’s great gifts to humanity was the brain. It behoves us to use it.

On 11 October 2007, I gave a presentation for the Bank of England’s Graduate Induction Programme, titled: “MPC Past Present and Future: the good, the bad and the ugly”. A pdf version of the Powerpoint presentation I gave is available here.

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Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

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