Monthly Archives: November 2007

Signs of overheating in the US economy?
The US economy grew at an unsustainable 4.9 percent rate in the third quarter of 2007, which includes almost two months since the ‘official’ start of the financial crisis on August 9.  Admittedly almost a full percentage worth of this growth was inventory accumulation. If his was unplanned, it may predict future planned inventory decumulation. Even 3.9 percent GDP growth, though, is still well above the Fed’s estimate of the growth rate of US potential output (recently revised down to 2.5 percent per annum) and even above the slightly more optimistic estimate of potential output growth of around 3.0 percent per annum of the Bush administration and many private forecasters.  So the recent evolution of the output gap makes for higher inflationary pressures. 

It’s true that the US housing market is a little shop of horrors, with further horrors to come.  Falling domestic construction activity cut about 1 percent off the economy wide GDP growth rate last quarter.  However, residential construction, at barely 4.5 of GDP is a small (and shrinking) contributor to economic activity.  Its weakness has been more than offset by the strength of the internationally exposed part of the US economy, boosted by the vanishing US dollar and a still-strong level of global economic activity.  Exports (about 12% of US GDP now), grew 19 percent and contributed 1.4 percent to economy-wide growth.  A further contribution to demand growth for US production will have come from the import-competing sectors. 

Domestic inflationary pressures coming from a growing output gap are reinforced by the decline in the US dollar and the increase in the dollar price of oil and gas.  The rise in the real price of oil and gas also increases the output gap, as it lowers the path of US potential output because of the role of oil and related energy inputs in US production. 

The rising inflationary pressures are reflected in elevated inflation expectations. On Thursday  November 29, US break even inflation (calculated from nominal and index-linked bond yields) were 2.32 at a 2-year horizon and 2.51 at a twenty-year maturity.

There are indeed many pointers to a slowdown of domestic demand growth.  Although there should be no significant negative wealth effect on US consumption from the decline in US house prices (what the average American consumer loses as a homeowner (s)he gains as a consumer of housing services), the decline in housing wealth will impact consumption negatively through the ‘housing wealth as collateral for consumption loans’ channel.  The financial turmoil has raised the cost and reduced the availability of external funds to the household sector.  Three-month Libor has recently stood more than 60bps above the official policy rate rate, and the spread of three-month Libor over such measures of the market’s expectation of the official policy rate over a three month horizon as the overnight indexed swap rate (OIS), is close to 100bps.  Because many loans to households and non-financial corporates are priced off three-month Libor, there has been a significant degree of effective interest rate tightening, countering the  relaxation of monetary conditions associated with the weakening of the US dollar.

The cost of external finance to the non-financial corporate sector has also gone up, but I doubt whether there has been a corresponding tightening in the availability of external finance for established non-financial corporates.  The balance sheets of the non-financial corporate sector are strong and they are, on average, saving more than they are investing.  Established non-financial corporates may well look like attractive borrowers to banks who are no longer willing to lend to other financial institutions because of the pandemic of mutual mistrust among the financial institutions. Of course, new businesses without a track record will be badly affected by the credit crunch.

Groans and moans from a bloated financial sector
Judging from the noise, moans and calls for policy relief coming from the financial sector, one could be forgiven for believing that the end of the world is nigh. It’s not.  There used to be a time when most financial institutions were intermediating directly between the ultimate private spending units in the economy – households and non-financial corporations. Most financial markets also had either households (or their direct representatives – institutional investors like pension funds or insurance companies) or non-financial corporates or the state as participants.  No longer.  Many, perhaps most, financial institutions are involved only very indirectly and peripherally with the intermediation between ultimate savers and ultimate investors or with the management of portfolios of ‘outside’ assets.  Their counterparties are other financial institutions.  Both sides of their balance sheets include mainly ‘inside’ financial instruments.

This layering or pyramiding of financial institutions and the explosion of new financial instruments created by them was to a significant degree driven by the twin motives of regulatory avoidance and tax avoidance.  Part of it reflected genuine institutional and technical innovation not driven by regulatory and tax efficiency.  This may well have contributed to more efficient risk trading during normal times and under orderly market conditions.  These developments also make abnormal times and disorderly market conditions more likely and the associated financial crises deeper. The failure of regulators to keep up with the proliferation of instruments and institutions, the lack of transparency of many of the new instruments and institutions (negligible reporting obligations, mysterious governance practices) has reinforced the periodic eruptions of euphoria and hubris that are inherent in financial capitalism.   

The good news in all this is that much of the financial sector has become quite detached from the real economy.  The implosion of much of this formerly privately profitable but never socially productive financial intermediation will have little if any adverse macroeconomic effect.  Many, perhaps most, financial institutions today are engaged in a gigantic, worldwide game of musical chairs in which vast fortunes are won and lost every day, but nothing of macroeconomic  significance happens.  Much recent financial intermediation amounts to the creation of vast artificial lotteries that are used not to hedge previously unhedgeable and non-diversifiable fundamental risk, but rather to allow the taking of larger unhedged positions by speculators with more resources (mostly other people’s money) than sense. Imagine, for instance, a world without hedge funds, SIVs and conduits.  That world would be somewhat more stable and transparent than the one we have now, but not significantly different. 

All the Sturm und Drang in the financial sector today only matters from a macroeconomic perspective, if it has a material effect on household consumption and on household and corporate investment.  In my view, rather little of it does.

Prospects for US aggregate demand
Direct effects of the financial crisis on investment are so far limited to household investment (construction) and investment in the financial sector.  While any decline in investment, no matter where it occurs, has a negative impact on aggregate demand, from a medium- to long-term perspective, a contraction in the size of both the residential construction sector and the financial sector is necessary and desirable, as both had expanded way beyond what made fundamental sense.  We will come out of this crisis with secularly smaller residential construction and banking sectors (I include in the banking sector: private equity funds, sovereign wealth funds, hedge funds, SIVs, conduits, other off-balance-sheet vehicles created by investment banks and commercial banks, as well as investment banks and commercial banks; after all, a hedge fund is just a bank without capital, reporting obligations, governance, supervision or regulation).

Corporate investment outside the financial sector should not, for reasons outlined earlier, be significantly adversely affected by the effect of the financial crisis on the cost and availability of external finance.  Retained profits are significant and strong balance sheets make established non-financial corporates attractive borrowers for financial sector lenders that no longer wish to lend to other financial intermediaries.  But a material contraction in aggregate demand would depress investment, especially if that weakness of demand were expected to last significantly longer than in the cyclical downturns of the recent past, which all were short-lived.

What can we say about the prospects for non-investment aggregate demand in the US?  Government spending on goods and services, especially at the Federal level, is unlikely to fall as a share of potential GDP in the run-up to an election year.  If anything, a fiscal stimulus of some kind, working either through public spending on goods and services or through the tax-transfer side of the Federal budget, and then through household disposable income, or through current and expected future business profitability, is likely.  The external  contribution to aggregate demand is likely to continue to roar along, both through export demand and through import-substituting domestic production.  That leaves private consumption.

There can be no doubt that private consumption expenditure (about 70% of US GDP and also by far the most stable component of GDP) is going to weaken significantly.  And so it should.  The long-overdue and necessary increase in the US private saving rate is a necessary domestic counterpart to the long-overdue and necessary reduction in the US external trade deficit, which is the  contribution of the US  (necessary and long overdue) to  global rebalancing.  Consumption growth will have to fall significantly and may well have to become negative for a year or two. 

The notion that higher private saving means lower private consumption, barring a disposable income miracle, is apparently news to such distinguished economists as Larry Summers and Martin Feldstein.  Both have argued for many years (in the case of Feldstein indeed for decades) that the US saving rate has to increase significantly.  While some of this increase in the national saving rate could occur through an increase in public sector saving, the bulk will have to come through an increase in the private saving rate.  Indeed, I have not heard any recent plea for tax increases or public spending cuts from either Summers or Feldstein.  So private consumption growth needs to weaken; indeed, the level of private consumption may well have to fall temporarily, to enable the real-exchange-rate-depreciation-assisted ‘crowding in’ of a smaller US trade deficit. 

However, as soon as there is any sign of weakness in consumer demand, both Feldstein (who mooted a 100bps Fed rate cut at the August 2007 Jackson Hole  conference) and Summers (who  wants the Fed to cut aggressively to forestall a recession brought about by weaker construction activity and consumer demand) run to the nearest exit from the home of intertemporal sustainability screaming for a Fed bail out.  Summers in particular appears to be willing to make any opportunistic sacrifice of economic good practice in order to minimise the risk of a short-term slowdown.  He has proposed, for instance, that the two GSEs (government sponsored enterprises) Fannie May and Freddie Mac be allowed to weaken their balance sheets further to make off-budget (from the point of view of the government) quasi-fiscal transfers to financially challenged home owners unable to service their mortgages. He has also argued in the FT’s Economists’ Forum of 25 November 2007, that "…fiscal policy needs to be on stand-by to provide immediate temporary stimulus through spending or tax benefits for low- and middle-income families if the situation worsens." 

Where is the logic in calling for a higher saving rate when whenever a higher saving rate threatens to materialise, policies and gimmicks are invoked to lower the saving rate again?  Summers’ recommendations for avoiding a downturn are an example of the kind of weak-kneed opportunistic approach to demand management policy in the US that has reinforced what appears to be structurally low private saving propensities in the US these past 40 years or so. There are serious consequences, both internal and global/external of this opportunistic myopia.  Domestically, private and public provision for old age and retirement is becoming progressively more inadequate.  Externally, the US has moved inexorably from being the world’s largest external net creditor to being the world largest external net debtor.  This has weakened and will continue to weaken the global power and influence of the US and its government. It is difficult to go against the wishes and interests of those who own a growing chunk of you.

Surely the time for a consumption slump in the US is now, when the weakness of the US dollar and the strength of global demand will mitigate the impact on aggregate demand and employment?  If not now, then when or under what circumstances? 

Is the Fed kak-handed or a captive of the markets – or both?
Throughout the crisis, the Fed’s communication policy with the markets has been atrocious.  My fear is that this communication policy mess reflects a deeper confusion/disagreement in the Fed about how to respond to the crisis, and about both the ultimate and the proximate objectives of monetary policy.

The speeches by Vice Chairman  Donald L. Kohn on November 28 and by Chairman Ben S. Bernanke on November 29 had as their sole purpose to clean up the mess left by careless speeches  earlier in  November by assorted FOMC members who had left the impression that  it would take a miracle (or a disaster) for the Fed to cut rates at the December 11 meeting.  The self-evident superiority of a strategy where FOMC members say nothing in public that in anyway anticipates future Fed rate decisions has obviously not occurred to anyone.  The Fed’s monetary policy actions (decisions on the Federal Funds target rate) and its liquidity policy actions (decisions on the discount rate, on eligible discount window collateral policy, on eligible discount window counterparties and on its open market operations, both through repos and through outright purchases) speak louder than any words.  The written statements released following FOMC meetings and other policy actions fill the rest of the information gap.  Anything else is, at best, cheap talk.  At worst, it confuses the markets and puts the Fed in the awkward position it has found itself in so many times recently. Too often, ambiguous signals extracted from unnecessary speeches by FOMC members force the Fed to choose between appearing to be a captive of the markets (by validating the markets’ expectations – which tend to be very close to the markets’ wishes – regardless of whether these expectations make any sense) or appearing to be desperate to re-establish its operational independence and room for manoevre by deliberately surprising the markets – ‘teaching them a lesson’.

There obviously are deeper divisions among the Board members and in the FOMC as a whole, than I have ever witnessed before.  The Vice Chairman, Kohn, is an unreconstructed anti-inflation targeting old-style dual mandate man.  Mishkin believes in inflation targeting and appears to be genuinely convinced of the merits of the dual mandate.  Bernanke is an inflation targeter who can live with the dual mandate, but only because he believes that the best, or even the only possible, way to stabilise the real economy is to pursue  a low and stable rate of inflation in the medium term.  Several of the Regional Fed Governors only pay lip service to the dual mandate and are lexicographic price stability targeters at heart.  Janet Yellen, however, is a committed dual mandate proponent. 

What is equally striking as the disagreement about the operational mandate is the fear of the financial markets among key Board members, regardless of their view on the Fed’s mandate.  They fear a large fall in the stock market; they fear  financial  market turmoil; and they can be moved to cut rates if there is a sufficient crescendo of anguished voices from the financial markets and money centre banks.  We all know that the Great Depression of the 1930s started with a stock market collapse and was aggravated by bank runs and a misguided monetary policy.  The collapse of the multilateral trading system was the final nail in the coffin.  Perhaps our central bankers have studied the 1930s too much.


Financial markets and private financial institutions deserve the attention of the policy makers. They are an important part of the transmission mechanism of monetary policy and an important source of shocks that could have implications for systemic stability; the information conveyed by asset prices and other market indicators must be monitored carefully and interpreted thoughtfully.  But they only matter to the extent that they impact on the real economy.  Today’s overgrown, bloated and highly vocal financial markets and institutions are getting more attention than they deserve. 

The Fed and other US policy makers appear to be constitutionally incapable of taking the long view.  Instead they are flailing about in a desperate attempt to minimize any short-run economic pain.  By doing this, they also prevent necessary and unavoidable medium-term and long-term adjustment.  This institutionalisation of myopia and resistance to change may well be an accurate expression of the unwillingness and inability of the US polity and public to take the long view in virtually any area that matters, be it monetary policy, fiscal policy, infrastructure investment, energy pricing and security or global warming.  It is probably the clearest evidence that we can expect an accelerated decline in the global role of the US.

To answer the question in the title of this blog: probably not yet.  But I would not cut the Federal Funds target rate either.


The financial crisis that erupted in earnest on August 9, 2007, has not yet run its course. The correction of the global underpricing of risk from 2003 till early 2007, will manifest itself beyond the US subprime residential mortgage markets, the instruments backed by these mortgages and the institutions exposed to them. Higher-rated residential mortgages in the US and in Europe will suffer similar corrections. So will commercial mortgages and securities backed by them, securities backed by car loans and credit card receivables, and unsecured consumer credit of all kinds. Unsustainable construction, housing market and residential lending booms occurred not only in the US, but also in the UK, Spain, Ireland, the Baltic states and other CEE countries like Bulgaria.

Until quite recently, industrial country equity markets continued to perform well, unaffected by the re-appraisal and repricing of risk that has shaken many of the other markets for financial instruments. In the past couple of weeks, equity markets in most of the industrial world have given up all of their earlier 2007 gains and many are now trading in negative territory.  No doubt some further equity market corrections are due, in the advanced industrial countries and certainly in some of the more bubbly emerging markets.

There remains pervasive uncertainty about the value of the credit ratings granted to complex structured products during the period 2003-2006, and about the value of the various enhancements the issuers grafted onto these products, including the credit risk insurance provided by the ‘monolines’. 

Sovereign risk too is beginning to be repriced. Even within the Eurozone, the spread of 10-year Treasury bond yields over Bunds has increased from the 10 bps to 20 bps range to the 30 bps to 40 bps range for highly indebted, fiscally fragile countries like Greece and Italy. These spreads are likely to widen further when the budgetary positions of these countries worsen as the Eurozone goes into a cyclical downturn.

Emerging market risk continues to be underpriced. This holds for non-sovereign emerging market risk almost everywhere, including hot favourites like China.  It holds for sovereign market risk at longer maturities for emerging markets without massive foreign exchange reserves, without significant production and export capacity in natural resources and with a history of weak fiscal discipline and populist policies.  Argentina would be an example.  This underpricing of emerging market risk is also due for an early correction. 

So much for the bad news. 

There are, however, also signs that the outline of a systemic stabilisation and recovery sometime in the second half of 2008 is beginning to take shape. Leading commercial banks are beginning to put their off-balance-sheet off-spring back on their balance sheets. HSBC’s announcement on November 26, 2007, that it was taking on its balance sheet $45bn of debt, much of it mortgage-linked, owned by SIVs it manages is, I believe, a harbinger of things to come.

The apparent failure of the Single Master Liquidity Enhancement Conduit, aka ‘Superfund’, proposed by Citigroup, JPMorgan Chase and Bank of America, with the active verbal encouragement of the US Treasury, to get off the ground, is another positive sign, because it supports the view that it is no longer acceptable or possible for private financial institutions to avoid the recognition of capital losses on assets held in SIVs, conduits and other off-balance-sheet vehicles, by selling them to each other at sweetheart prices. The enforced revelation of where the losses are, will reduce the uncertainty and fear about counterparty risk that have been killing liquidity in so many markets.

Money from the ‘New Global Moneybags’ – sovereign wealth funds from the Gulf and from other emerging markets – is beginning to find its way into some of the depressed financial markets and shaky financial institutions. Citigroup announced on November 26, 2007, that it had raised $7.5bn in new capital from the Abu Dhabi Investment Authority, albeit at near-‘junk’ rates of 11 percent. More deals like this will follow.

The monetary authorities that matter have learnt their lessons and are ready to provide liquidity on a large scale should the need arise. The announcement in late November 2007 by the Fed about its plans for year-end liquidity are an example of this greater official preparedness. 

Most importantly, the credit boom of 2003-2006 has not led to a massive bout of over-investment in physical capital, except in a few emerging markets like China. The only sectoral exceptions in the industrial countries are residential construction in the US, Spain, Ireland, the Baltics and a few other emerging markets in CEE, and overexpansion of the financial sector almost everywhere. In countries that have been riding a housing construction boom, the contractionary effects of lower residential investment is now being felt (the US) or will be soon (Spain). But in the most systemically important of these countries, the US, residential construction accounts for barely 4.5 percent of GDP. The damage even a complete collapse of house prices can do through the residential construction channel is therefore quite limited.

There is therefore little threat of widespread excess capacity from the ‘supply side’ of the economy. The financial position (balance sheets and financial deficits) of the non-financial corporate sectors throughout the industrial world is strong. The bulk of the financial excess has stayed inside the financial sector or has involved the household sector. 

The key question then becomes whether and to what degree the decline in housing wealth (in the US) and the general tightening of the cost and availability of credit will adversely affect household spending in the advanced industrial countries. While the sign of the effect is clear – consumption will weaken – its magnitude is not. The increasing cost and decreasing availability of household credit is likely to affect and constrain mainly those households wishing to engage in new or additional borrowing. The increased burden of servicing outstanding household debt, especially unsecured debt, is as likely to lead to higher defaults as to reduced consumer spending. Personal bankruptcy is, especially in the US, such an easy and relatively painless option, that it is the shareholders of the financial institutions that have made the unsecured loans rather than the households that took out these loans that will suffer the brunt of the financial impact of the increased cost and decreased availability of credit. If these shareholders are, unlike the defaulting borrowersty, typically not liquidity-constrained, the net effect on consumption should be mild. There can be further effects on spending through the credit channel if the financial institutions whose debt has been defaulted on become capital-constrained as a result and curtail further lending. As always, those most affected will be new would-be borrowers, households and corporates. 

It is still likely, in my view, that the economic fall-out from the financial crisis will be contained mainly within the financial sector and the residential construction sector. It is clear that, following the overexpansion of the residential construction sector in the US and in a few European countries, and following the massive overexpansion of the financial sector just about everywhere during the past decade, there is now likely to be a retrenchment in both sectors, through lower employment, lower profits and lower valuations. 

From the point of view of the efficient allocation of resources in the medium and long term, the relative (probably even absolute in the short run) contraction in the size of the financial sectors of the advanced industrial countries is a desirable development, as for a number of years now, the private returns in the financial sector have exceeded the social returns by an ever-growing margin. Too much scarce analytical and entrepreneurial talent has been attracted into activities that, while privately profitable and lucrative, were socially zero-sum at best. In the short run, this cutting down to size of ‘Wall Street’ and ‘the City’ will inevitably have some negative side effects for Main Street also. However, the entire financial sector in the UK accounts for only about 7.5 percent of GDP, and the banking sector for no more than five percent of GDP. A sectoral depression will be painful, but of limited macroeconomic significance.  In the medium and long term, moreover, a more balanced sectoral allocation of the best and the brightest will be beneficial.

The short-run pain, concentrated in the financial sector, and especially in the commercial and investment banking sector and its off-balance-sheet offspring, is not suffered in silence. There is an army of reporters and newscasters standing by to report each groan and moan from every CEO whose bank has just written down another chunk of careless CDO exposure. But as long as the monetary authorities take their mandates seriously – including their duty to act, at a price, as lenders of last resort and market makers of last resort – and as long as the growing financial market hysteria does not spread to the real economy, the financial market kerfuffle should result in no more than a mild cyclical downturn around a robust upward trend.

In a market economy where asset markets and expectations about the future can have such a major impact on current economic activity,  it is always possible to talk yourself into a recession or depression.  Reducing  the likelihood that a recession/depression born of fear and lack of confidence will take hold, when the fundamentals also support a  much more positive outcome as an equilibrium, is the task of  policy makers, especially central bankers, finance ministers and those  in charge of avoiding trade wars.  Let’s hope they are up to the challenge.

Denmark grows up

Denmark is likely to hold a referendum on its relationship with the European Union.  The referendum proposed by Anders Fogh Rasmussen, its newly re-elected prime minister, is not a referendum on the EU Reform Treaty (aka Constitution-lite), although it is possible that Denmark will also hold a separate referendum on the EU Reform Treaty. Instead, the Referendum proposed by Rasmussen concerns the four opt-outs Denmark negotiated as part of the Maastricht Treaty.  The four opt-outs concern Denmark’s participation in  (1) the common currency (full EMU membership); (2) EU defence policy; (3) EU cooperation on justice and home affairs and (4) EU citizenship.

The reasons for Denmark’s change of heart are obvious.  As regards Eurozone membership, the Danish currency is umbilically linked to the euro via a fixed exchange rate.  Danish interest rates follow those set in Frankfurt for the Eurozone with a lag of a few hours.  Might as well save the transaction costs of converting Danish kroner into euros, get a voice in setting monetary policy for the Eurozone (and for Denmark) and have access to a serious lender of last resort, rather than one which can only issue kroner.

Non-participation in EU defence policy means that Denmark has to stand on the sidelines with military actions it approves of, and even feels strongly about, such as the EU presence in Bosnia-Herzegovina, Macedonia and probably soon also in Kosovo.  Since 2002, the EU has engaged in sixteen operations outside the EU, using civilian and military instruments in several countries in three continents (Europe, Africa and Asia).

Justice and home affairs concerns issues like immigration, asylum and external border controls, and the European Arrest Warrant.  With free mobility of persons among the Nordic countries, Denmark of course had little capacity for a national immigration and asylum policy.

The European Citizenship exemption is of symbolic significance only.  I wonder how many British citizens realise that they are citizens of the European Union as well as of the UK.

The Danish prime minister wants Denmark to be a full player in the EU.  The only way to achieve that is to be a full member.  The opt-outs stand in the way.  Therefore, they have to go.

Are there lessons here for the UK?


Time for the UK to grow up

Under the existing Treaty, the UK has two opt-outs.  It is not required to join the common currency and it does not participate in the Schengen Agreement, which abolished border controls between member states (currently 13 EU members plus Iceland and Norway), and created the Schengen Information System for the purpose of maintaining and distributing information related to border security and law enforcement.

The Reform Treaty will, if ratified, add a number of further UK opt-outs, the famous ‘red lines’. They are:

  • Defence: the UK want to remain in control of its  defence and foreign policy; there must be no European defence cooperation which weakens NATO.

  • Treaty changes: the UK opposes the removal of the national veto for major decisions on the EU’s future.

  • Tax: the UK wants to retain the national veto on taxation mattes, including such matters as  cross-border tax fraud.

  • Justice and home affairs: the UK does not want majority voting to undermine its common law system. It also wants to continue to be able to carry out frontier patrols.

  • Social Security: the UK wants the national veto to be retained for changes in social security systems.

  • European resources: the UK wants any changes to the EU’s right to raise certain funds to be agreed by unanimity alone. This protects the British annual EU budget rebate, secured by Margaret Thatcher in the 1980s.

The UK is punching far below its weight in the European Union.  It is not listened to, has very little influence on the decision-making processes of the Commission or the Council of Ministers, and is not taken seriously most of the time.  The prevailing attitude of the other European members states varies between amusement, bemusement and irritation.

Reasons for giving up the two existing UK opt-outs

Some examples.  Ecofin, the council of the ministers of finance or of the economy of the 27 EU member states, has become an insignificant rubber-stamping body for decisions made by the Eurogroup, the council of the minsters of finance and the economy of the Eurozone members, currently 13 in number, with Cyprus and Malta joining on January 2008.  The Eurogroup doesn’t formally exist in the European Treaties to date.  The Reform Treaty will be the first ‘constitutional’ EU document to recognise its existence and to specify its competencies.  It will continue to do the job Ecofin did before the common currency was created, on January 1, 1999.  The EU is not an EMU member; it does therefore not participate in the Eurogroup meetings.  After January 2008, the UK’s influence on EU decisions in the monetary, fiscal, financial and macroeconomic areas will be less than that of Malta.  The only way to pull your weight in the EU is by belonging to the Eurozone.

This argument for the UK joining the Eurozone is reinforced by the growing recognition that there are no real benefits and some real costs to the UK of monetary independence. The notion that a small open economy like the UK, with unrestricted international mobility of financial capital, could use national monetary policy actively to stabilise the real economy, is a prime example of the ‘fine tuning fallacy’.  In addition, the manifest incompetence of the Bank of England in its liquidity management (both at its discount window (the standing lending facility) and through its open market operations), and the far superior, albeit still imperfect, liquidity management policies and practices of the ECB, suggest that it makes sense also from a financial stability perspective for the UK to contract out monetary policy to the ECB. 

The Bank of England’s superior procedural transparency and accountability would not necessarily be lost as a result of the UK joining the Eurosystem.  The Governor of the Bank of England could, as a member of the Governing Council of the ECB, insist on a vote being taken on the ECB’s interest rate decision (there never has been a vote on monetary policy at the ECB since it was created).  Failure to accommodate this request would result in a public statement by the Bank of England Governor expressing his/her belief that the reported interest rate decision was null and void because of procedural irregularities. 

When votes are taken, the UK Governor could and should make public his/her own vote.  Indeed, I would recommend that a UK Governor make public his/her recollection of all votes cast, and that he/she publish his/her version of the minutes of the Governing Council meetings.  It would not be long before the Governing Council would (a) vote, (b) publish the individual votes and (c) publish the minutes of the meeting.

The UK’s failure to join the Schengen agreement is an example of costly xenophobia.  With more than thirty million tourists each year making visits to the UK and with free mobility within the EU for citizens of all EU member states in no more than five years, it is clear that any hope of effective border control has gone out the window.  Freeing resources currently wasted on checking arrivals from the Schengen Area and allocating these resources intelligently and selectively (using Bayesian profiling) to vetting entrants from outside the Schengen Area would in all likelihood enhance national security, especially if it were accompanied by the effective sharing of information and joint policies drawn up and agreed by majority voting on selected justice and home affairs issues.

Reasons for giving up the proposed new UK opt-outs

The decision on how to assign political competencies – at the supranational level, at the national level or at the sub-national level – has been approached in two complementary ways.  The legal-constitutional-political science approach appeals to the principles of Federalism which, in the case of the EU, was renamed and given the rather unappealing sobriquet of ‘principle of subsididiarity’.  This means that a political competency is assigned to the lower level unless there are significant benefits from assigning it to the higher level.  This applies to the allocation of competencies between the supranational European authorities and the national authorities.  It also applies to the allocation of competencies between the national authorities and the sub-national authorities, provinces/counties/cantons and municipalities.  It applies to the allocation of competencies between a municipality and its wards.  Most importantly, it applies to the allocation of competencies between any of the organs of the state and the individual citizens: when in doubt, leave the government out.

The economic approach applies cost-benefit analysis to the assignment of functions and competencies to the different tiers of the state.  Economies of scale and externalities will favour centralisation of decision making and (possibly) of provision, that is, assigning a function or competency to a higher tier of government.  Diversity of views, preferences, interests and tastes and the speed with which the quality of information about all these relevant characteristics deteriorates as the government agency is further removed from the citizen or interest group (that is, heterogeneity and lack of information), will favour decentralisation – assigning that function or competency to a lower level of government.

For example, boundary-crossing environmental externalities should be handled at the level closest to the domain of the externality.  In the case of greenhouse gases, this is the world, but since the EU is as close as Europe gets to world government, the EU is the natural level at which decisions should be taken. Other environmental externalities are national or subnational (ground water pollution, cleanliness of beaches etc.). Border-crossing public health issues (foot and mouth disease, bird flu, CJD etc.) should be handled at the EU level.  Occupational health and safety issues should be left to the national authorities, as are most, but not all, social security issues and most tax matters.  Defence and foreign policy are obvious EU competencies.  Education is a national or subnational compentency etc. etc.  It is clear that, from this perspective there have been both Type 1 and Type 2 errors in the assignement as tasks to the EU level.  Working hours (as per the Working Time Directive) are not an example of returns to scale or border-crossing externalities.  They should be repatriated to the national level.   

Following this economic logic, foreign policy and defence should be the first EU member state competencies to be assigned to a supranational authority. This makes sense for the UK also. The last time any European nation (not counting Russia) tried to pursue an independent national foreign and defence policy was in 1956, when the UK and France undertook their last colonial adventure in Suez (the Falklands War falls into ‘The Mouse that Roared’ category and does not count). Since then, only Germany among European nations has had a foreign policy that matters at all.  And Germany has no military presence or significance.  Today, the nations whose foreign and defence policies make a difference are the US, Russia (much diminished but still  somewhat relevant to the many countries it borders) and, coming up fast, China and India.  Despite having but the most anaemic version of a foreign and defence policy, the (mainly) soft power of the EU is already more significant regionally and globally than the foreign and defence policies of the UK, France or Germany individually. 

Outside Whitehall, no-one much cares about or pays attention to UK foreign policy, and the UK’s armed forces are no  longer capable of independent action anywhere that matters.  When we try to visualise a indicator of  international political and military power that spans the range from the US down to,say, Denmark, the UK and France will be much closer to the Denmark end than to the US end. So the choice for the UK, as for the other European nation states, is either no foreign or defence policy, or an EU foreign and defence policy.  An independent national foreign or defence policy in Europe is an extreme example of a buck-naked emperor.

I am not sure what I prefer: no foreign or defence policy in Europe or an EU foreign and defence policy.  The last time foreign and defence policies mattered in Europe – in the first half of the 20th century, the European nation states made the most dreadful mess of it, bringing humanity two World Wars and unimaginable horrors. Perhaps soft power is all that Europe can be trusted with.  But regardless of whether one prefers an EU foreign and defence policy or no foreign and defence policy in Europe, it is key to recognise that even for the UK, France and Germany, the time of being significant players in the global diplomatic, military and economic arenas are gone.  They have become small countries.

As regards future Treaty changes, I believe the days of national vetoes are gone.  But so are the days of national votes or national referenda.  Future Treaty changes should be decided by the European Parliament (with a suitably qualified majority) and/or by a referendum of the EU electorate in a single Europe-wide referendum.  If national votes are to play a role in this (either at the national parliamentary level or through national referenda), the requirement should be that a qualified majority of the member countries vote in favour (say two third plus 1).  But no national vetos in European matters.

As regards taxes and social security, the economic principles of economies of scale and externalities on the one hand and of heterogeneity and incomplete information on the other hand, suggest that no blanket statements like: ‘all tax measures to be subject to national veto’ are likely to be wrong.  Most of social security should clearly remain at the national level.  But the cross-border portability of past national contributions and/or acquired national entitlements has to be ensured.  Otherwise we all will end up working in the country with the lowest takes and retiring in the country with the highest benefits.

Clearly, tackling tax evasion and avoidance will require supranational decision making that cannot be vetoed by tax havens like Luxembourg. Indeed, where the EU has the power, it should compel the co-operation even of non-EU member states like the Switzerland or strange entities like the Channel Islands, the Isle of Man and Monaco.

Justice and home affairs are an area where I very much hope the UK will rethink its opt-out.  Without a written constitution, with no separation of powers, and with probably the most toothless Parliament in the EU, the Executive branch of government in the UK has greater power than the Executive in any other European Country; indeed the UK government is not subject to any effective checks and balances except the blessed bloodymindedness of the British people.  I very much appreciate having the European Court of Justice between me and a UK government that emasculates the right not to make self-incriminatory statements to the police or in court, and that does more damage to habeas corpus than any government since Magna Carta was signed.  The notion that the UK will continue pre-1973-style border checks on visitors to the UK from other EU member states, when within 5 years we will have unrestricted mobility of people within the EU (and probably around 35 million visitors yearly to the UK) is extraordinary.  Even if the authorities were to be willing and able to inflict these indignities on the travelling public (British and non-British), such national control measures would be woefully ineffective.

Last and definitely least, the British Rebate.  Why the other EU members allowed Mrs. Thatcher to get away with that outrageous bit of cheek, I have never understood.  There is no justification for continuing it even for just another year.  If that means a larger net UK contribution to the British budget, so be it.  The reason for this increased budgetary burden will be that the UK government didn’t have the guts to veto the Common Agricultural policy compromise.  You break it, you own it, is a good principle.


It is time for the UK government (and a large part of the British public) to grow up and start making a difference in Europe.  Sure, the UK is unique and different.  So are the other 26 EU members.  The UK has much to offer the EU.  It has sidelined itself for too long.

A short list of dos and don’ts for the government to consider.

  • Adopt the euro as soon as you can.

  • Join the Schengen agreement immediately

  • Forget about the British rebate.  Veto the CAP budget instead, at the earliest opportunity.

  • Make up your mind as to whether you want a European foreign and defence policy or no foreign and defence policy.  Don’t daydream about an independent national foreign and defence policy.

  • As regards taxation and social security, apply the economic criteria of economies of scale and externalities vs. heterogeneity and incomplete information.

  • Let future changes in European constitutional arrangements be jointly decided by (1) the European Parliament and/or the European electorate (through EU-wide referenda), and (2) national parliaments an/or national referenda, with support of a qualified majority of the member states required for ratification.

Introduction: changes in the conduct of monetary policy at the Fed

It has taken a while, just under two years since Ben Bernanke took over from Alan Greenspan as Chairman of the Fed, but the deed now is done: the Fed has moved to de-facto inflation targeting. It will continue to be an inflation targeting that dare not speak its name. The Fed has introduced inflation targeting inside the twin Trojan horses of improved communications and greater transparency. An indeed, these proposals are likely to improve the clarity of the Fed’s communications to the market and the public at large and to enhance its transparency. But there is more that that involved. I discern a movement away from the Fed’s symmetric dual mandate to a greater emphasis on price stability as the primary objective of monetary policy. This reform will not take the Fed the whole way towards the lexicographic or hierarchical inflation targeting of the ECB and the Bank of England, whose primary objectives are price stability and without prejudice to, or subject to, the price stability target being met, output, employment and all things bright and beautiful. It does, however, represent a significant step in that direction.

The Fed’s modus operandi under Greenspan could be described as formally symmetric but in fact biased towards low unemployment, extremely flexible inflation targeting without a firm, let alone a numerical, inflation target. The existence of the ‘Greenspan put’, referring to the asymmetric reaction of the Fed’s policy rate to asset price increases and asset price declines (and specifically to increases and declines in equity prices) remains a hotly disputed issue. There can be no doubt, however, about another asymmetry in the reaction function of the Greenspan Fed. With unemployment at or near the best guestimate of the natural rate, when faced with the choice between a rate cut that would reduce the likelihood of an increase in the unemployment rate at the expense of a higher risk of excessive inflation, or tighter monetary policy that would increase the likelihood of higher unemployment but would lower the risk of excessive inflation, the Greenspan Fed would opt for lower unemployment. 

This is no longer true for the Bernanke Fed. This may in part reflect differences in the interpretation of the Fed’s mandate between the two Chairman, or differences in their view of the transmission mechanism of the Federal Funds target rate to inflation and unemployment. It may also reflect differences among the two Chairman in their willingness and/or ability to impose their own views on the majority of the voting members of the FOMC. I have the impression that the Regional Federal Reserve Bank Presidents have become more vocal, assertive, and influential than they were under Greenspan. While among the Regional Fed Presidents there is a range of views and objectives – there is at least one distinguished modern Keynesian among them, Janet Yellen of the Fed of San Francisco – the Regional Fed Presidents tend to give greater weight to maintaining price stability than to maintaining high levels of employment and output. While the time series of observations on the Bernanke Fed is still to short for meaningful statistical analysis, I believe we will be able to identify in due course this break in Fed behaviour in the direction of putting greater weight on price stability. 

The new ‘communication and transparency’ framework provides most of the ingredients for inflation targeting. As explained below, at the very least, the new three-year horizon for the forecasts will provide the equivalent of a numerical point inflation target. In my view it will do more than that. A de-facto numerical inflation target could just turn the Fed into a standard flexible inflation targeter, trading off deviations of inflation from its target against the output gap or the deviation of the actual from the natural rate of unemployment. It could also be just the first step on the road to something closer to lexicographic or hierarchical inflation targeting, which will be approximated more and more closely as the relative weight given to inflation in the objective function of the Fed increases over time. 

Governor Bernanke denies that the substance of US monetary policy making has been changed in any way: “The steps being taken by the Federal Reserve, I must emphasize, are intended only to improve our communication with the public; the conduct of policy itself will not change.” (Bernanke (2007)). I don’t know whether this is an example of what that well-known moral philosopher Mandy Rice-Davies referred to as “Well, he would, wouldn’t he”, or whether the statement is sincere.[1] In either case, I don’t believe it. 

The Fed will no doubt continue to pay lip service to what is deemed (both by the Fed itself and by Congress) to be its official, legal dual mandate – maximum employment and stable prices. Congress will continue to insist on parity for these two objectives, and Fed officials and Governors will nod and agree. As the least independent of the leading central banks, the Fed cannot afford to thumb its nose at Congress by openly admitting to having adopted inflation targeting, be it ever so flexible a variety of inflation targeting. Even under Greenspan, however, maximum employment was typically interpreted by the Fed as the highest level of employment that does not threaten price stability; the changes announced today move the Fed closer to making price stability the primary objective of monetary policy, as it is in the Euro area, in the UK and in Japan. Actions speak louder than words, and I expect that the weight given in future Fed rate-setting deliberations to the achievement of sustained low inflation will not only be greater than it was during the Greenspan years (such has already been the case in the past year or so), but will continue to grow in relative importance. 

Incidentally, the fact that the official monetary policy objectives actually specify a triple, not a dual mandate appears to have been forgotten: “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”[2] This is probably because (a) nobody knows what moderate long-term interest rates are, and (b) nobody knows why the Fed should care about them and target them. 

The move of the Fed towards de facto inflation targeting came in the form of an announcement of changes in the Fed’s forecasting and communication procedures, in a speech by Chairman Ben Bernanke (see Bernanke (2007)) at the Cato Institute in Washington DC on November 14, 2007. From the point of view of inflation targeting, there were three material changes[3]:

(i) A longer forecast horizon – three years rather than two for real GDP growth, the unemployment rate and inflation.

(ii) Forecasts for both headline PCE inflation (referred to by Bernanke as ‘overall’ PCE inflation) and core PCE inflation

      (iii) More information about the dispersion of individual forecasts 

The longer horizon matters, because, even allowing for long, variable and uncertain lags in the effects of monetary policy, over a three year horizon a monetary authority like the Fed should expect to hit its inflation target, if it has one. Second, the Fed forecasts are made on the assumption of ‘appropriate monetary policy’, that is, not on the basis of a constant Federal Funds target rate or on the assumption that the future path of the Federal Funds target rate is that implied by the market yield curve. This reinforces the presumption that at a three year horizon, if not earlier, the forecast for inflation should equal the inflation target. 

As regards the forecasts for the unemployment rate and the growth rate of real GDP, the influence of monetary policy has all but dissipated after three years. The unemployment forecast at the three-year horizon can therefore be interpreted as an estimate of the natural rate of unemployment in three years’ time. Likewise, the growth rate of real GDP in three years’ time can be interpreted as the estimate of the growth rate of potential output in three years time. 

Unlike the Bank of England, where the inflation forecast is, in principle, the forecast of the entire Monetary Policy Committee, and unlike the ECB, were the inflation forecast is a staff forecast rather than the forecast of the Governing Council, the Fed’s forecasting procedure involves each of the participants in the FOMC meeting — the Federal Reserve Board members and all the Reserve Bank presidents (not just those voting) — providing their individual forecasts. In the future there will be forecasts for growth, unemployment, core PCE inflation and headline PCE inflation. These forecasts will naturally differ, and in the future I expect us to see the entire joint distribution of the 19 forecasts (seven Board members and 12 Regional Fed Presidents) for each of the four variables. 

If inflation were the only objective, and if rate setting were a majority decision, the median voter theorem would apply and the effective or operational inflation target could be backed out of the distribution of forecasts as the median inflation forecast (that is, the one that has half of the forecasts below it and half above — number 9, if the forecasts were ranked).[4] With a dual objective, and with a non-majoritarian decision making procedure (the Chairman carries much greater weight than the rest of the voting members – there is an unwritten rule that no more than two votes are cast against the Chairman’s preferred action – and there is a strong desire to achieve a consensus if at all possible), the simple median voter result will not hold. Nevertheless, knowing the mean, the median and the modal forecast for inflation will provide the markets and other observers with essential information about the inflation target. We will also know the dispersion of the forecasts (that is, the extent of uncertainty and/or disagreement among the forecasters) and the skew, that is, the ‘balance of risks’. All these are key ingredients in standard inflation targeting. 

One element of conventional inflation targeting (both lexicographic and flexible) that we don’t have and are unlikely to get in the near future, is an announced numerical inflation target (typically a point target, although some countries, including New Zealand, have a target range). It would be helpful to have such a publicly stated numerical inflation target, to set alongside the target implied by the ‘central tendency’ of the two-year and three-year inflation forecasts, but for the moment, this would, politically, be a bridge too far. The Congress would no doubt insist on a dual target for employment, unemployment or output growth, and the Fed will not want to risk getting itself into a position where it is expected to target something that it will, in all likelihood, be unable to deliver.

Before he assumed the throne on 20th street and Constitution Avenue, Ben Bernanke made statements to the effect that 1.5 percent per annum was the centre of his comfort zone for core PCE inflation. This comfort zone was generally thought to range from 1.0 to 2.0 percent (see Bernanke (2005)).[5] Since becoming Chairman, Ben Bernanke has not made any statement that could be interpreted as implying a numerical inflation target. Recently, Frederic Mishkin, one of the Governors, has indicated that his comfort zone for core PCE inflation was more likely to be centred on 2.0 percent (Mishkin (2007a)). For sake of argument, let’s split the difference and assume that the centre the inflation comfort zone for the core PCE deflator is 1.75 percent. This is likely to reflect a slightly higher inflation target than the ECB’s below but close to 2.0 percent for the Harmonised Index of Consumer Prices (HICP) and the Bank of England’s 2.0 percent target for that same HIPC, which it calls the CPI. This is because the US HICP index (available only since 1997) behaves almost exactly like the US CPI index, and because the US CPI index has systematically increased faster than the US PCE index, as is clear from Figure 1.



During the 32-year period 1965-2007, the headline CPI increased 24 percent more than the headline PCE index, an average annual difference in inflation rates of around 0.67 percent.  the core CPI increased 28 percent more than the core PCE index, an average annual inflation rate difference of 0.77 percent. A core PCE target of 1.75 percent therefore would correspond to a core CPI target of 2.5 percent. If the US CPI is indeed not just similar in design and to the US HIPC but also to the European HICP (and the UK’s CPI), then the implicit Fed inflation target is about half a percentage point above the UK inflation target, and just over half a percent above the Euro area inflation target. 

As is clear from Figure 2, there has been a very slight increase in the ratio of the headline CPI index to the core CPI index since 1965, about 2.7 percent over almost 32 years, and an even smaller increase in the ratio of the headline PCE index to the core PCE index, about 2.3 percent over almost 32 years.


There have, however, been big long-term swings in the headline to core ratios over the period. The large increase during the first oil price shock, in 1973-74 and the peak in 1980 following the second oil price shock are clear from the date, as is the 20-year decline since then and the reversal of this decline because of the growth of the BRICs since about 2000. 

And the target is: headline inflation

Americans eat and drink (the first of these not infrequently to excess). They live in houses that are bone-chillingly air-conditioned in the summer and over-heated during the winter. They drive cars with lamentable energy inefficiency. So, yes, food and energy are part of the American consumption bundle, which makes low and stable headline inflation the proper objective of monetary policy. Because of the lags in the operation of monetary policy, inflation targeting means inflation forecast targeting. Anything that helps predict or infer headline inflation is therefore welcome and should be used in the headline inflation forecasting and targeting process. 

Core inflation – the inflation rate of a bundle of consumer goods and services that excludes food and energy.- may well, at certain times and under certain conditions, be a useful predictor of future headline inflation (see e.g. Mishkin (2007b) for a statement of this view). At other times it is likely to be a predictably dreadful predictor of inflation. This is the case since the beginning of the decade, as pointed out by Charlie Bean (2006) and myself (Buiter (2007a,b)) because globalisation has brought us a steady, secular increase in the relative price of non-core goods to core goods, as is clear from Figure 2.

It is true by definition that, if a forecaster is not predicting any future change in the relative price of core goods and services to non-core goods, then forecasting core inflation is equivalent to forecasting non-core inflation or headline inflation (and vice-versa). It may also well be factually correct that the Fed has, historically, not forecast any changes in the relative price of core and non-core goods. That would hardly have been consistent with optimal forecasting. There is a marked positive association between the global business cycle and the relative price of non-core goods, and intelligent forecasters should at times lean out of the window to make sure that there are no new developments under way (of a kind not captured in past statistics) that may be relevant to the relative price of core and non-core goods and services. Globalisation, with China, India and the other BRICs entering the global markets as suppliers of core goods and services (manufactured goods, back-office functions and call centres) and as demanders of non-core goods (food, energy and other commodities) is one such development. 

Both globalisation and the global business cycle have contributed to the strength of commodity prices since the end of the slowdown that followed the late-2000 tech bubble crash, as shown by the increase in the headline price indices relative to the core price indices in Figure 2. 

Because non-core goods prices tend to be flexible while the prices of core goods and services are subject to nominal rigidities caused by long-term incomplete nominal contracts, shocks to the relative global demands for and supplies of core and non-core goods will have short-run effects on headline inflation that would not be present if all prices were either subject to similar nominal rigidities or behaved as freely flexible ‘auction-style’ prices. Increases in the relative price of non-core goods to core goods and services therefore tend to be associated with higher headline inflation, as shown empirically in Figures 3 and 4. 






The announcement by the Fed Chairman of a new communications and transparency strategy for the Fed hides a decisive break with the way in which the Fed conducted monetary policy in the past. It amounts to the de-facto adoption of a flexible inflation targeting framework by the Fed, with the role of the numerical inflation target taken by the central tendency of the FOMC members’ inflation forecasts at a three-year horizon. It also represents another nail in the coffin of core inflation as the Fed’s preferred inflation indicator/predictor, and its replacement by a less mechanically statistical, more robust and thoughtful economic analysis of the fundamentals driving headline inflation in the medium term.


Figure 1 source: Bureau of Labor Statistics, Bureau of Economic Analysis

Figure 2 source: Bureau of Labor Statistics, Bureau of Economic Analysis

Figure 3 source: Bureau of Labor Statistics, Bureau of Economic Analysis

Figure 4 source: Bureau of Labor Statistics, Bureau of Economic Analysis


Bean, Charlie (2006), “Comments in response to a paper by Ken Rogoff – "Impact of Globalization on Monetary Policy" given at the Federal Reserve Bank of Kansas Symposium in Wyoming, USA on 26 August,

Bernanke, Ben S. (2005), “Remarks by Ben S. Bernanke at a Finance Committee luncheon of the Executives’ Club of Chicago”, Chicago, Illinois, March 8.

Bernanke, Ben S. (2007), “Federal Reserve Communications”, speech by Chairman Ben S. Bernanke at the Cato Institute 25th Annual Monetary Conference, Washington, D.C., November 14.

Buiter, Willem H. (2007b), “The Fed still hasn’t recovered the plot: core inflation versus headline inflation again”, .

Buiter, Willem H. (2007a), “The Folly of the Fed or: Why is the Fed so Hardcore?”

Mishkin, Frederic S. (2007a). "Inflation Dynamics," speech delivered at the Annual Macro Conference, Federal Reserve Bank of San Francisco, San   Francisco, March 23,

Mishkin, Frederic S. (2007b), “Headline versus Core Inflation in the Conduct of Monetary Policy”, Speech given at the Business Cycles, International Transmission and Macroeconomic Policies Conference, HEC Montreal, Montreal, Canada, October 20.

[1] Mandy Rice-Davies (born 21 October 1944) is famous mainly for her minor role in the Profumo affair which discredited the Conservative government of British Prime Minister Harold Macmillan in 1963. While giving evidence at the trial of Stephen Ward, Rice-Davies made the quip for which she is most remembered and which is frequently used by politicians in Britain. When the prosecuting counsel pointed out that Lord Astor denied having an affair or having even met her, she replied, "Well, he would, wouldn’t he?" (Source: Wikipedia). 

[2] Federal Reserve Act [12 USC 225a. As added by act of November 16, 1977 (91 Stat. 1387) and amended by acts of October 27, 1978 (92 Stat. 1897); Aug. 23, 1988 (102 Stat. 1375); and Dec. 27, 2000

(114 Stat. 3028).]

[3] In addition, the frequency of the forecasts was increased to quarterly from semi-annually, and there will be summary reports, containing explanations for the individual forecasts.

[4] This assumes that all differences in forecasts at a 3-year horizon reflect differences in inflation targets only, and not differences in models (views on the monetary transmission mechanism), or the (perceived) inability to achieve the inflation target (in expectation) at a three-year horizon, which could lead to different combinations of inflation and unemployment being targeted not because of differences in inflation targets, but because of different weights being placed on deviations of inflation and unemployment from their target values.

[5] “My own guess is that core PCE inflation in 2005 will be slightly higher than its 2004 rate of 1.6 percent, though likely remaining within what I think of as the "comfort zone" of 1 to 2 percent”, Bernanke (2005).

In 1971, the then US Secretary  of the Treasury, John Connolly told his European counterparts: the dollar is our currency but your problem. So far, Connolly’s statement continues to be true.  Every time the dollar weakens, US exporters and US import-competing industries are gaining competitive advantage and/or increasing their profitability.  The explosive growth of US export volumes (reaching 10 percent per year) is part of the reason that, despite the collapse of US housing construction, the US economy is still expanding at a reasonable albeit declining rate. 

The weaker dollar also improves the US net external investment position, regardless of what it does to the trade balance.  With so much of US external liabilities denominated in dollars, every time the dollar weakens, the world largest debtor feels a little wealthier.  The Chinese authorities, despite moves to diversify their foreign asset holdings, still hold over a trillion dollars worth of external assets in US Treasury bills and bonds and similar securities.  The Japanese authorities have a similar exposure.  Already they have re-confirmed their reputations for being among the world’s worst portfolio investors. If the dollar falls by another twenty or thirty percent, which is certainly possible, the Chinese and Japanese authorities would each be presenting their tax payers with a further $200bn to $300bn capital loss. That’s a heavy price to pay for access to US markets for your exports, especially for a poor country like China (around 40 percent poorer at PPP exchange rates than we thought until recently, once (or if) the latest World Bank GDP revisions are accepted).

I fear, however, that the good news about dollar weakness for the US is about to come to an end.  Sooner rather than later, the weakness of the dollar, and fear of its future weakening, will trigger a large increase in long-term US interest rates, nominal and real.  Today’s papers reported how at the OPEC meeting, the cartel members discussed making a statement to the effect that the weakness of the US dollar meant that higher dollar prices for oil and gas were justified.  The fact that it was Iran and Venezuela pushing for such a statement does not mean that this view is restricted to declared enemies of the US government, or that it has no merit.  Many of the oil exporters continue to be large holders of US government debt.  They want to get out of as much of it as they can, but perceive a steeply downward-sloping demand curve for rapid sales.  Nevertheless, all the incredients for a bond-run are in place, and at some point in the near future, the gradual sale of dollar-denominated securities will become a flood.  The stock of US government debt outstanding can, however, only be reduced  through  US government budget surpluses, and we are unlikely to see many of those.  So when the dust settles, the existing stock of US government debt will continue to be held, but at a much lower price (higher yield) and at a much weaker external value of the US currency.

The further weakening of the US dollar will continue to boost the tradable sectors of the US economy, but any sharp increase in long-term nominal and real interest rates will hit investment spending everywhere, and the non-traded sectors like residential and non-residential construction in particular.  It won’t be pretty.  Expansionary monetary policy measures will be limited because a collapse of the dollar will have non-trivial inflationary consequences.  That ugly word ‘stagflation’, will raise its ugly head.

With US long-term real interest rates now set largely by world markets rather than by domestic monetary and fiscal policy,  the US policy makers  will have to get used to operating in a setting that is quite unlike the closed economy paradigm that they grew up with, and more like like a small open economy.  On the financial side, it has, effectively, already happened.

The joy of pointing fingers and apportioning blame
There is now widespread agreement on how the collective actions and inaction of the three parties to the UK’s Tripartite Arrangement for dealing with financial stability crises contributed to the Northern Rock debacle.  There is also reasonable clarity about the individual mistakes and misjudgements of two of the three parties – the Treasury and the Financial Services Authority (the regulator).  There is less agreement on what errors the Bank of England has made.

Collectively, the Treasury, the Bank and the FSA failed to act, speak and appear jointly, cohesively and harmoniously, to reassure  the markets, depositors and the public at large. The absence of a joint appearance,  when the rescue facility for Northern Rock was announced, by the Prime Minister, who as former Chancellor created the Tripartite arrangement, the current Chancellor, the Governor of the Bank of England, the Chairman and the Chief Executive of the FSA , is incomprehensible. The continued sniping at the Bank since that day by the Treasury and the FSA, and the repeated covert briefing against the Bank by the Treasury further undermined public confidence in the ability of the authorities to manage the nation’s financial stability arrangements.

The FSA was asleep on the job.  The Treasury was responsible for the Memorandum of Understanding between the three parties.  This MoU institutionally separated information about individual banks, including their liquidity positions, from the financial means to address any problems faced by illiquid but solvent banks.  The Treasury was also responsible for the inadequate, indeed bank-run-inviting, state of the UK deposit insurance scheme. 

And the Treasury decided, even after the risk of a run on Northern Rock’s deposits had been eliminated, that the Liquidity Support Facility created at the Bank of England to lend to Northern Rock, at a penalty rate, against its illiquid collateral, would be kept in place until a private buyer for all or part of Northern Rock or its assets could be found.  The alternatives of (1) switching off the life-support system and letting Northern Rock live or die on the strength of its own resources, or (2) taking it into public ownership and re-privatising it or selling its assets when market conditions normalised, were not considered. 

Of these two options, letting Northern Rock sink or swim on its own, with no special access to public resources, would have been my preferred option.  This is because, with the risk of bank run contagion removed, Northern Rock (with between 2 and 3 percent of the assets of UK-registered banks) was small enough to fail; its failure would not have adverse implications for financial stability in the short run and would have a mightily positive impact on financial stability in the long run, because the cautionary tale of Northern Rock this would change the incentives facing banks inclined to excessive risk taking.

The Bank of England as LoLR and MMLR
The Bank of England’s failed as a provider of liquidity.  It failed in two distinct tasks; as a lender of last resort (LoLR) and as a market maker of last resort (MMLR). It is  key to distinguish between these two functions. (see my earlier contributions on the subject, many joint writings with Anne Sibert at (1), (2), (3), (4), (5).) The  lender of last resort provides liquidity to individual banks and other individual financial institutions in distress.  Following Bagehot it does so on demand, at a penalty rate and against collateral that would be good in normal times, when markets are orderly, but that may have become illiquid in abnormal times because of disorderly markets.  The market maker of last resort provides liquidity to markets for financial instruments that are normally liquid but have become disorderly and illiquid.  It does so either by purchasing the potentially illiquid assets outright or by accepting them as collateral in ‘sale and repurchase agreements’ or repos.  Since it corrects a market failure – illiquidity of a market is a public bad -  there is no need to impose a penalty rate on repos used to mitigate such illiquidity.  No adverse incentives (‘moral hazard’) are created as long as the securities that are offered as collateral are priced fairly and subject to appropriate liquidity ‘haircuts’ or discounts on these fair valuations.  I discuss how such fair valuations can be established when the securities offered as collateral do not have a relevant market reference price or benchmark because they are or have become illiquid.  The Bank of England mismanaged both the lender of last resort function and the market maker of last resort function.

The lender of last resort
As regards the LoLR function, the Bank of England should have lent to Northern Rock at a penalty rate, and against normally good collateral, provided the institution was illiquid but solvent.  While I have no first-hand knowledge of the asset side of Northern Rock’s portfolio, those who do (or who assert they do) assure us that most of its assets are sound.  Northern Rock should have been able to access the Bank’s LoLR facilities in that case.  The discount window of a central bank (called the Standing (collateralised) lending facility in the case of the Bank of England, the Marginal Lending Facility in the case of the ECB and the primary discount window in the case of the Federal Reserve System is the place where lender of last resort funds should be provided.

The discount window of the Bank of England is, however,  ineffective as a source of liquidity for two reasons.  First, it only provides overnight loans.  The Fed lends at up to one month maturity at its primary discount window.  Second and most importantly, the Bank of England only accepts as collateral securities that are already liquid: UK government securities, sovereign debt instruments issued by other European Economic Area governments, high-rated debt instruments of a few international organisations (e.g. the World Bank), and, under exceptional circumstances, US Treasury securities.  So the Bank of England’s discount window only does maturity transformation of long-maturity liquid assets into overnight liquidity.  This is useless in a crisis.  The ECB accepts as collateral at its discount window euro-denominated debt instruments (rated at least in the A category) issued by both sovereign and private issuers.  It can accept nonmarketable and illiquid assets, including asset-backed securities.  The Fed can accept as collateral at its discount window anything it deems fit, including cats and dogs. 

Stuck with an underpowered discount facility, the Bank of England and the Treasury had to create the purpose-designed Liquidity Support Facility for Northern Rock to be able to lend to Northern Rock.  In the Euro area and in the USA, Northern Rock would have been able to use its prime mortgages as collateral at the discount window.  Indeed, if Northern Rock had been more on the ball, it could have used its Irish subsidiary (which is in the Euro Area) to borrow at the ECB’s discount window, or to obtain liquidity in the ECB’s liquidity-oriented repos.  The Liquidity Support Facility would have been redundant  had there been a properly designed collateral and maturity policy at the Bank of England’s discount window.  The discount window is, in principle, anonymous.  The Liquidity Support Facility was in the public domain, because of the mistaken belief of the Governor that undercover, secret LoLR support for Northern Rock would have violated the Market Abuse Directive. That, of course, is nonsense, and it was contradicted the very afternoon the MAD assertion was made, by a spokesman for the European Commission.  The ECB is reported to have provided undercover support to troubled Eurozone banks without creating any MAD problems.  Obviously, the MAD was not created to rule out discrete, secret LoLR support where it is needed to limit unnecessary damage.

The market maker of last resort
The Bank’s provision of liquidity to disorderly financial markets was also flawed, and continues to be so.  Again, it accepted (until it changed its mind after Northern Rock hit the rocks and interbank markets remained in turmoil – as they continue to be to some extent especially at 3-month maturities; yesterday (November 16), the spread of 3-month sterling Libor over the market’s estimate of the UK official policy rate (Bank Rate) over the next three months, as measured by the Overnight Indexed Swap (OIS) swap rate one again crawled up to around 75 basis points.  The Bank of England accepts as collateral in repos only the same short list of highly liquid and highly rated securities that it accepts at its discount window.  The menu of securities it is willing to purchase outright in open market purchases is equally restricted.  The Bank only sets the overnight repo rate (using its restricted list of collateral) and used to intervene at longer maturities only ‘at market rates’, not seeking to influence market rates at longer maturities than overnight.  It attributed the gap between, say, 3-month Libor and the expected policy rate over that three month horizon as reflecting market participants perceptions of default risk.  The Bank did not consider it its business to address default risk of UK-registered banks through its repos and open market operations, and I fully concur.

However, to identify the gap between 3-month Libor and the expected policy rate over a three month horizon as reflecting mainly default risk represents a serious error.  That spread is the sum of the default risk premium and the liquidity risk premium.  In my view most of the spread (at least 60 basis points of yesterday’s 75 basis point spread, say), represents the market’s perception of liquidity risk.  There is a term structure of  liquidity risk which the Bank can and should try to address by intervening aggressively at longer maturities in the interbank markets (through repos at the appropriate longer maturities) to drive down the excessive spreads.  It should do so accepting as collateral in its longer-maturity repos a wide range of private sector financial instruments, including illiquid and nonmarketed instruments.  It announced it would do so in September, but the 3 interventions it announced at a 3-month maturity were subject to a penalty floor (the interest rate could not be below the policy rate plus 100 basis points).  Nobody came to the party.

The fact that the Bank made its proposed market support operation subject to a penalty floor shows it still does not get the distinction between assisting an individual institution that is in trouble and supporting an illiquid market or financial instrument instrument.  LoLR operations have to be at a penalty rate to mitigate moral hazard.  MMLR operations correct a market failure.  Illiquidity is a manifestation of a breakdown if trust and confidence.  Liquidity is a public good, subject to ‘intertemporal network externalities’ – even when I have liquid resources today in excess of my own requirements, my willingness to lend these resources to you today at three month maturity, depends on my perception of the risk that both you and I will be illiquid three months from now.  If I expect both of us to be illiquid three months from you, I will not lend to you today.  So fear of future illiquidity supports an inefficient equilibrium with lack of liquidity today.

If the authorities could credibly commit themselves today to provide unlimited liquidity in three months’ time, such liquidity crises would not arise.  But such a commitment is impossible.  The best substitute is for the monetary authority to provide the 3-month liquidity today.  The Bank of England is the only agency whose sterling liabilities have unquestioned and unconditional liquidity.  They can provide this liquidity instantaneously, continuously and at no cost. They should do so; they did not. So the Bank failed in its market maker of last resort role.  It is possible, but socially inefficient for private banks and other financial institutions to carry on their own balance sheets enough liquid assets to weather virtually any market illiquidity storm.  They should have enough liquid assets to manage their affairs when markets are orderly.  It is the job of the monetary authority to prevent or mitigate market illiquidity.  This permits banks and other financial institutions to perform their valuable social functions of borrowing short and lending long, and of borrowing in markets that are normally but not always liquid, and lending in the form of assets that are often illiquid.

To avoid creating adverse incentives for the would-be borrowers in the repos, borrowers who might offer illiquid, nonmarketable instruments as collateral, it is key that the collateral be priced in such a way as not to offer a subsidy to the borrowers.  The Bank need not have superior information about what mortgages are worth, or about the fair value of the underlying assets backing asset-backed securities that might be offered as collateral.  It can organise auctions that serve as reservation-price revelation mechanisms for the parties offering the illiquid securities.  The reverse Dutch auction, with the Bank acting as monopoly buyer, is one example.  To discourage unnecessary complexity in structured products, the Bank should have a positive list of financial instruments that it will make market in.  To avoid a situation where private holders of illiquid instruments prefer not to have them valued at these auctions, there should be a regulation that all securities in a class for which there has been an auction, should be marked-to-market at the prices established in the auction (in the case of the reverse Dutch auction, this could even be at something close to the highest  price in the sequence of prices established in the auction; as the sole buyer in the auction, the central bank should get enough of an advantage from its monopsony power to ensure that the tax payer would not lose on these transactions).

The Bank should carry these illiquid securities on its balance sheet.  If, subsequently, a transparent normal market is re-established, the Bank could sell the securities again.  Otherwise it can hold them till maturity.  It never has to develop an informed view as to how much these illiquid assets are worth.  After all, the Bank is never liquidity-constrained and is uniquely well-placed to take the long view.

So the Bank failed in its lender of last resort function and in its market support or market maker of last resort function, because it operated against too restrictive a list of collateral and at too short a maturity.

Quo Vadis, Northern Rock?
Of course, Northern Rock knew, or should have known, about the collateral policy of the Bank of England, both at the discount window and in its liquidity-oriented market interventions.  Northern Rock had to live in the real world, and its funding policy, and its low liquid asset holdings were therefore reckless. 

The creation of a one-off support facility for a specific financial institution (as opposed to a discount window open to all eligible counterparties on demand, given the right collateral) should only be considered for institutions that are systemically important. For such systemically important institutions, being taken into public ownership is also an option. Northern Rock, which accounts for 2 or 3 percent of the assets of UK-registered banks, is not systemically important–it is small enough to be allowed to fail. It should therefore not have any stronger claim on public financial support that a failing ball-bearings company in Coventry.  It could and should have been allowed to sink or swim on its own.  If the protection of retail depositors, or the prevention of a bank run, are deemed to be important, a decent deposit protection scheme would have been sufficient.  The UK deposit insurance scheme is a shambles.  But once the Chancellor guaranteed all deposits of Northern Rock (retail and wholesale) as well as most other unsecured creditors, the widows and orphans were safe and the risk of a run was ended.  The Liquidity Support Facility for Northern Rock could and should have been ended at that point.

The odds against Northern Rock ever paying a fair price for its access to public funds and for the Treasury’s provision of deposit guarantees are overwhelming. The continued operation of Northern Rock as a publicly subsidised private bank therefore distorts the competitive level playing field, and will lead to justified trouble with Brussels about illegal state aid if it goes on much longer.  The  option value to the rest of the  UK-registered banking system  of the Chancellor’s statements that the Liquidity Support Facility  and the Treasury’s deposit guarantee will also be made available to any other bank that gets into Northern Rock-type dire straits, is worth  less than the  actual subsidy  received by  Northern Rock.  In any case, the socialisation of  bank creditor  risk in the UK is not  a desirable feature of the financial landscape.  The Treasury should cut Northern Rock loose forthwith and not  extend any financial  largesse to potential private sector suitors.

For my appearance on Tuesday, 13th November 2007, before the UK Treasury Committee in connection with their Inquiry: Financial Stability and Transparency, I submitted the following background paper: Lessons from the Financial Crisis.  The first half of this paper is essentially my earlier blog Lessons from the Financial Crisis, Part 1.

First, the good news. The US housing slump is unlikely to drag the US economy down very much. It is true that up to now, the major source of weakness in the US economy has been the housing sector. At the end of Q2, 2007, the Federal Reserve Board reported the market value of the US residential housing stock $21.0 trillion and single family mortgage debt at $10.1 trillion. About 14 percent of the mortgage debt, $1.3 trillion, say, is sub-prime. According to the Case-Shiller data, since the end of 2006, the average US house price may have fallen by 5 percent or so, knocking about one trillion dollars of the value of the US housing stock. The brain behind these data, Bob Shiller of Yale University, believes a further decline, over a period of years, of 15 percent is in the cards.

The reason for the good news is that there is no first-order wealth effect from a change in house prices on private consumption; a decline in house prices is a redistribution from home owners to consumers of housing services, that is, from landlords to renters. The fundamental value of a home equals the present discounted value of the flow of housing services its yields, now and in the future. This is also what those who live in the home expect to pay for it, now and in the future, either as rents or, if they are owner-occupiers, as the opportunity cost of the imputed rental income they forego by living in their homes. The FRB/US econometric model used recently by Governor Frederic S. Mishkin of the Federal Reserve Board in his Jackson Hole Conference paper  to analyze the US housing market erroneously attributes the same wealth effect to housing wealth as to stock market wealth, and thus assigns it a marginal propensity to consume of 3.8 percent rather than zero, which would be the number suggested by economic theory.

The good news is qualified because housing wealth is collateralisable wealth and can therefore help to relax liquidity and cash-flow constraints faced by households. The scope for financing consumption through mortgage equity withdrawal is reduced when house prices fall and this may cause a temporary fall in consumption. To allow for this collateral effect, Mishin raises the marginal propensity to consume from 3.8 percent to 7.6 percent.  Emulating this, I will raise my estimate of the combined wealth and collateral effect of housing price changes from zero to 3.8 percent. The impact on annual consumption of the 5 percent decline in house prices would then be $38 billion. With a $ 12 trillion annual GDP, this is a decline in demand of just over 0.31 percent of GDP – not quite the stuff recessions are made off. Even if, over the next three years, house prices were to continue to decline at a 5 percent rate, this would give us a further cumulative decline in demand of just over 0.9 percent GDP.

The decline in home prices, and the increased cost and reduced availability of finance for homebuilders and home purchases will no doubt further depress the demand for new housing. However, construction is a smallish sector in the US – only about 4.5 percent of GDP in 2007. Since 1975, the share of construction in GDP has not fallen below 3.7 percent (in 1992 and 1993). It seems unlikely that the construction sector will decline by as much as an additional one percent of GDP.

The sub-prime crisis, like any financial crisis, is first and foremost a distributional question

The sub-prime crisis, the write-downs by commercial banks and investment banks of CDO and other ABS exposures, the ABCP meltdown and related financial kerfuffles are first and foremost a redistribution of financial wealth from creditors to debtors. All these derivative claims are ‘inside’ financial claims – for every creditor there is a matching debtor. These write downs and write-offs do not in and of themselves destroy any net wealth.


The only assets for which there are no liabilities – ‘outside assets’ – are, in a closed economic system, the stocks of natural resources, physical capital, human capital and goodwill. We can take the value of equity as the best approximation to the value of the stocks of privately owned physical capital, of goodwill and of natural resources owned by private corporations. The value of the housing stock owned by households can also be measured reasonably accurately. Publicly owned infrastructure capital and human capital cannot be valued using readily available market prices.

All other financial instruments, including sub-prime mortgages, ABCP and all asset-backed securities are inside instruments for which changes in valuation do not change aggregate wealth but just redistribute it. That does not mean that such changes (and the precise circumstances under which they occur) don’t matter for aggregate demand or supply. In general they will not be neutral. But it is important to recognise that for every unhappy banker who writes off $200,000 of mortgage debt, there is one happy mortgage borrower who now will no longer have to service that debt.

Where the redistribution involved is from investment banks (and ultimately from the shareholders in these investment banks) to sub-prime borrowers the net redistributional effect on aggregate consumer demand may well be positive. Of course, defaults, personal bankruptcy, foreclosures and other reassignments of property rights involve real resource costs. A single foreclosure on a sub-prime mortgage has been estimated to cost as much as $50,000. With as many as 2.2 million families with a subprime loan made from 1998 through 2006 who expected to lose their home to foreclosure in the next few years, a real resource cost of $110 billion will be incurred.

Furthermore, the losses suffered by the banks will lower their regulatory capital. So will the need to take back on balance sheet a whole range of illiquid assets that had been parked in a variety of off-balance sheet vehicles like sivs and conduits. Ratios. How large could these numbers be? Banks have currently written down sub-prime backed assets to the tune of about $40bn, and assorted pundits estimate this number will rise to $60 billion soon. Ben Bernanke, during his testimony before the Joint Committee of the House and Senate on Thursday, November 9, gave a guestimate of $150 bn for the total losses suffered eventually by the financial system because of the subprime debacle; earlier this summer he had mentioned a figure of $100 bn. Even $150 bn seems low. New subprime issues in 2004, 2005 and 2006 were $363, $465 and $449 bn respectively. By 2004, any attempt at quality control in subprime origination had already gone out of the window, so I would expect that most of these loans will default before long, unless there is a major bail-out by the Congress. How much of the almost $1.3 trillion of subprime lending during these three years is covered by the value of the properties held as collateral is unknown, as there is no prior experience of lending to such a large subprime population. A loss of $150 bn would be just be under 12 percent; that seems low, and one could easily conceive of it being as high as 20 or 25 percent. In addition, losses will be made on subprime loans made before 2004 and after 2006, and on higher-rate loans, including Alt-A and prime loans. A $250bn to $300bn eventual loss on all mortgage-related exposure would seem to be in the ball park.

At the end of October 2007, the net worth of commercial banks in the US (as reported by the Fed) stood at just under $ 1.1 trillion (against assets of $10.7 trillion). Tier 1 capital stood approximately at $964 bn. While quite a significant share of the mortgage-related losses will be born by financial institutions other than commercial banks, such as investment banks, commercial banks’ capital will take a significant hit. In addition, US commercial banks have, through unused liquidity commitments, obligations of up to $350bn to sponsored conduits that used to fund themselves with ABCP; they also are exposed to the risk of having to take back and hold up to $140bn of loans taken out for failed leveraged buy-out type deals, and are warehousing, at a loss. an indeterminate but significant amount of loans and other assets that were intended for securitisation, or packaging into other complex structures. The combination of losses and unintended asset accumulation may depress the banks’ capital ratios to the point that dividends and share repurchases are threatened and even rights issues may have to be contemplated. All that does not do much for their willingness to engage in new lending, including to the real economy.

Possibly more serious than the objective magnitude of the losses that banks will ultimately have to face is the uncertainty, indeed ignorance, about where the losses are likely to hit. The opaqueness of many of the new financial instruments and the lack of transparency and minimal reporting obligations of many of the new financial institutions, is that we still don’t know who is exposed to what – who owns what and who owes what and to whom.

If all banks were required to mark to market or mark-to-model their assets and off-balance-sheet exposures using a common, verifiable methodology, we would not have the current situation where everyone is either trying to pass possible badly impaired illiquid hot potatoes on to a less well-informed counterparty, or trying to delay recognising the losses on those assets they cannot get rid off, in the hope that something will turn up and make all the bad things go away. It has even led to a proposal to create a kind of private market maker of last resort (the Single Master Liquidity Enhancement Conduit aka ‘Superfund’ proposed by Citigroup, Bank of America and J P Morgan Chase). There is a real risk that a facility of this kind would permit on a much larger scale the reciprocal taking in of each other’s dirty laundry at sweetheart prices that is rumoured to take place already among some banks. There is a grey area, with a thin line hidden somewhere in the middle, between wanting to prevent panic sales at fire-sale prices and trying to manipulate the market to as to avoid the recognition of the true magnitude of the losses that have occurred. In the mean time, lack of trust combines with ignorance about the true value of what’s being offered for sale to produce a de-facto buyers strike.

If the progressive reduction we are seeing in the willingness and ability of banks to lend, extends to lending to the non-financial sector (households and non-financial corporations), there could be further effects on the real economy. I believe households in the US are vulnerable to this, because they are highly indebted by historical standards and have been running financial deficits for many years. Non-financial corporates, however, are in rather good financial shape, both as regards the leverage in their balance sheets (low) and as regards their financial surpluses (adequate). In addition, non-financial corporates have the option of bypassing the banking system altogether and going to the domestic and international capital markets directly. I expect to see more disintermediation by the non-financial corporate sector at the same time that we see re-intermediation of the off-balance-sheet non-financial vehicles into the banking sector.

Other credit risk mis-pricing problems

Subprime mortgages were not the only area of credit where lending and borrowing discipline collapsed. Similar reckless behaviour could be observed in unsecured consumer lending, including credit card lending, and with car loans. Both credit card receivables and car loans have been securitised on a large scale, and indeed both assets have been combined with mortgage loans in CDOs and other complex structures. 

Good news and bad news from the rest of the world 

The major source of demand strength is the US economy is the external sector. This is not surprising, as the rest of the world is growing faster than the US and the real effective (that is, trade-weighted) exchange rate of the dollar has dropped like a stone. Exports are a much more important source of demand in the

US (12.0 percent of GDP in 2007Q3) than they were in 1975, for about 8.5 percent of GDP or in 1965, when they were 5.2 percent of GDP. From its peak in 2002Q1 the broad effective real exchange rate of the US dollar had depreciated by 25 percent by 2007Q3. The precipitous decline of the nominal and real exchange rate of the dollar since September can easily have added another 5 percent to the cumulative real depreciation rate. In real terms, the dollar today is as weak as it has been at any time since 1970.

It is therefore not surprising that the growth rate of real exports has been pretty spectacular recently (9.6 percent in 2007 Q3 on a year earlier). There is no doubt that, if the dollar stays weak (let alone weakens further) and if global growth slows down only modestly, the growth of export demand can easily more than compensate for the decline in residential investment. 

Since the last quarter of 2003, the US terms of trade (relative price of exports to imports) has declined by eight percent, that is about two per cent per year. The US trade balance deficit averaged about 5.4 percent of GDP. As a result of the terms of trade deterioration since 2003 Q4, the US has suffered an annual real income loss equal to two percent of 5.4 percent of GDP, that is 0.11 percent of GDP, which is tiny.

An index of the real oil price (West Texas Intermediate divided by CPI) peaks at 48.8 in the first half of 1980, following the second oil price shock. The latest official data, for September 2007, have the index at just over 38.4, after a trough of 6.9 at the end of 1998. Since September, the oil price has risen by a further 25 percent while the increase in the CPI has been negligible. The real price of oil today therefore again stands at around 48 – its all time peak. This oil price shock will have a marked negative effect on potential output, and will increase future inflationary pressures through the output gap channel. This adverse potential output effect of an increase in the relative price of oil is over and above any general price level effect from an increase in the dollar price of oil. If potential output weakens more than aggregate demand, the ugly word ‘stagflation’ will have to be dusted off. Inflationary pressures in the US have for a long time been higher than acknowledged by the Fed. Headline CPI inflation for the 12-month period ending September 2007 was 2.8 percent, while core inflation, the will-0’-the-wisp that used to be viewed by the Fed as a good predictor of headline inflation in the medium term, was 2.1 percent. There is no doubt that the collapse of the dollar and the explosive increase in the dollar price of oil will give further momentum to US inflation, just at the time that the growth rates of both actual and potential output are declining.

For the Fed, these are interesting times indeed. 

A final feature of the contribution of the rest of the world to the economic prospects for the US is that growth in the rest of the world, including the key emerging markets of China, Russia, Brazil and to a lesser extent India, is much more fragile than is generally appreciated. The mis-pricing of credit risk extended to the emerging markets. While sovereign risk in China and Russia is virtually absent, credit risk and other risk attached to private financial instruments is high. Neither China nor Russia benefits from the rule of law. There is no minority shareholder protection, creditor or bondholder protection, nor do we find any of the other institutions and fora for the resolution of property rights disputes taken for granted in the advanced countries. Administrative or regulatory expropriation has been a common phenomenon in Russia, Kazakhstan, Venezuela, Argentina and may also become a recurring phenomenon in resource-rich African countries and in other South-American countries. In my view these non-sovereign, private risks are significantly underestimated and underpriced.

There is also more sovereign risk than is priced in by the markets affecting emerging markets that do not have huge foreign exchange reserves and whose external surpluses are either vulnerable or absent altogether. Argentina and the Philippines are examples, and even a reasonably well-managed country like Turkey is more vulnerable to internal and external shocks than its ratings suggest.

The risk to global growth outside the US is therefore higher than generally recognised, and skewed to the downside.


The destruction of value and wealth thus far in the US as a result of the housing sector crisis is manageable. Its effects are mitigated and could well be more than offset by the strength of the export sector. However, the sub-prime crisis is but the tip of the credit risk mis-pricing iceberg. Unsecured consumer loans and car loans, and the large stock of ABS backed by credit card receivables, are waiting to join the credit risk-repricing party.

The single best thing that could happen would be for the true magnitude of the losses suffered by banks and other exposed parties to be revealed and put in the P&L. Until what happens, fear of getting stuck with the hot potato makes banks unnaturally unwilling to extend credit against the kind of collateral that they would not have thought about twice accepting at the beginning of the year. 

Continued global economic growth and dollar weakness are a necessary condition for the US to avoid a serious slowdown, or even a recession. While both may continue to materialise, the risks to global growth are higher than generally recognised and rising.


Frederic S. Mishkin (2007), “Housing and the monetary mechanism”, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C. 2007/40, August.


Tapir relief

Like many other animal lovers, I support tapir relief.  All four species of tapir are endangered.  Subsidising the bodily functions of this prehensile-snouted odd-toed ungulate (closest living relatives horses and rhinoceroses) is obviously a worthy use of public funds.


True animal libertarians may argue that tapirs can perfectly well relieve themselves, without government assistance or special incentives. The sign below, found in the Belize City Zoo, supports this argument.

Tapirsign_2Nevertheless, I am convinced that a sound utilitarian case for tapir relief can be made. There are bound to be positive tapir externalities meriting a subsidy or regulatory intervention (e.g. tapirs are considered cute, and not just by other tapirs).  In the unlikely case  that  an externalities-based case for granting fiscal favours to the tapir cannot be made, the proponents of the new (or indeed the old) paternalism can no doubt find failings in the cognitive skills of the tapir, or weaknesses in his capacity for long-term commitment, that would warrant a tax break.

Taper relief


There is, however, no case in fairness, efficiency or paternalism for the continuation of taper relief in the UK capital gains tax regime.  Chancellor Alistair Darling deserves brownie points (he won’t get any Brown points) for attempting to simply the unholy mess that is the UK income tax and capital gains tax regime.  Taper relief is a singularly pointless and distortionary feature of the UK capital gains tax, one which benefits not the tapir, but a different collection of mammals, ranging from owners of small businesses to owner/managers of private equity funds. Although, like the tapir, often pig-like in shape and keen to put their snouts in the trough, they are in no way endangered or in need of special tax advantages, either for efficiency reasons or because of fairness concerns.

I have argued elsewhere that, because of considerations of fairness, efficiency, tax compliance, tax administration, evasion and avoidance, the only  income tax, capital gains tax and corporate profits tax regime that makes sense would have the following features: (1) It adds all labour income, capital income (dividends, interest etc.) and capital gains together and applies a single tax schedule to this total, regardless of its composition; (2) It abolishes corporation tax or makes it into a pure withholding tax.  This means that taxes paid at the level of the company can be fully offset against the personal capital income (interest, dividends) tax liability. 

I would add the following: (3) It fully indexes the entire income tax structure (allowances, bands and capital gains); (4) It consolidates employers’ and employees’ national insurance (social security) contributions into the personal income tax; this could both raise the average income tax rate (across all income tax payers) and lower the highest marginal income tax rate;  national insurance contributions themselves would, of course, no longer exist as a separate tax; (5) It makes all interest income taxable, and allows all interest paid (on mortgages, credit cards, other loans) to be deducted from taxable income (in view of (3), only real interest payments should be deducted); and (6)  It imputes the implicit rental value of owner-occupied accommodation as income.

It would be possible, by deducting the value of inflation-corrected saving from taxable income calculated according to (1) through (6), to turn this into a consumption tax, but I would be happy with either.

Chancellor Darling’s proposals unfortunately took one step backward at the same time that he took a step forward by proposing the abolition of taper relief and its replacement by a single 18 percent capital gains tax rate. That is because he also proposed the abolition of the last remaining bit of indexation of capital gains, which means that you now pay capital gains taxes even if the nominal capital gains that are taxed do no more than make up for the erosion by inflation of the real value of your assets. 

But the abolition of taper relief can be viewed as a helpful first step on the road towards a promised land where all income is taxed according to the same tax schedule.  If nothing else changed, this means that in a sensible world, the highest marginal tax rate on capital gains would be the same as on labour income and dividends (assuming corporation tax is abolished).  Currently this would be 40 percent, but with the other changes I am proposing, the highest common marginal rate could be lower.

The two key features of taper relief are that the capital gains tax rate is (1) lower the longer an asset has been held and (2) lower for business assets than for other assets.  Neither feature makes any sense.

Should the owner of an asset be encouraged to hold it as long as possible?
The answer is a clear and unambiguous: ‘no’.  Especially when it comes to business assets whose effective deployment requires entrepreneurial and managerial skills, there is no presumption that the current owner is the best owner/manager.  Bad owners (that is, owners who either are poor entrepreneurs and managers themselves or who are poor at selecting good managers) should be encouraged to sell as soon as possible.  Good owners should hang on to their assets.  Governments have no way of knowing who the good or bad owners are.  There is no presumption that the current owners are the best possible owners -  something that is a necessary condition for encouraging long-term ownership of (business) assets. I would have thought that when the current owners are bad owners, both they themselves and the market of possible interested buyers of their business assets would be at least as likely to figure this out as the government or some government-sponsored agency.  The presumption underlying taper relief that, left to their own devices, owners of assets, and especially owners of business assets, would dispose of these assets too soon is not based on a single thread of evidence.

Should business assets be taxed more lightly than non-business assets?
The answer is again a clear and unambiguous ‘no’, based on the absence of any efficiency or equity argument in favour of this feature of taper relief.  A building owned by a small firm owned by an owner-entrepreneur  is not more or less  valuable from a social point of view that a similar building owned by  a ‘natural’ person, or indeed that same building owned by an investment fund specialising in property.  This feature of the tax system distorts investment decisions and decisions on whether or not to incorporate.

A number of other spurious arguments in favour of the continuation of taper relief have been made:

"We were promised….".
The then Chancellor Gordon Brown introduced taper relief in 1998 with the declared purpose of encouraging entrepreneurship, long-term investment and risk-taking in the UK.  Abolishing it now would be unfair, a breach of promise, and amounts to confiscation of profits resulting from a commitment to investment that took place only because the investor trusted the promise of the Chancellor.

Well, tough luck and/or more fool you.  Clearly it would be better if the structure of taxation, benefits, regulations and other factors relevant to investment decisions and under the government’s control were (a) sensible and (b) stable over time.  Stability of tax structures matters.  Sometimes it is better to have a second-best tax system that is stable over time than a first-best one that is at risk of getting changed frequently.  However, the distortion associated with taper relief is such that its elimination makes welfare-economics sense, provided that it is not followed by a sequence of further changes in the opposite direction.   

Furthermore, governments act on behalf of the sovereign. This means, in non-legal language, that they can do what they jolly well like.  A government cannot credibly commit itself to a specific course of future actions.  It can certainly not commit its successors.  Anyone who believes that any particular government decision or legislative act is irreversible, is terminally naive and should not be in business.  In the case of the 1998 Chancellor Gordon  Brown, this applies with special force.  Gordon Brown was pretty good at ensuring overall macroeconomic and financial stability.  He was also a maniacal micro-structural tinkerer.  There wasn’t a single economic or social problem or Gordon Brown was addressing it with a handful of tax incentives, a few subsidies and some regulatory measures.  Each budget would contain literally hundreds of such micro-tinkering measures.  And there would be different ones each budget, often reversing or neutralising other measures contained in the same budget or in earlier budgets. 

Any change in any feature of the tax system, the subsidy system or the regulatory framework will be, at least in part, a surprise to the private economy.  It will benefit some and hurt others, including persons, households, small and large firms, that had made investment decisions on the basis of guesses about the future tax, subsidy and regulatory regimes that were falsified by the government’s subsequent actions.  Unfortunate, painful and inefficient, perhaps unfair.  But an intrinsic feature of the the political landscape since the beginning of time.  The notion that the UK small business community is entitled for the rest of time to the most favourable tax treatment bestowed on it at any time in the past, is rather silly.

Encouraging risk taking
Then there is the notion that low rates of capital gains taxation encourage risk taking and that risk taking needs to be encouraged.  Let’s take the last one first.  Risk is bad.  Other things being equal, we want less of it.  More risk makes sense only if it is offset by a(n at least) compensating increase in expected returns.  To say that the government should encourage risk-taking is as silly as to argue that the government should encourage the pursuit of lower expected returns.

Is there too little risk taking in the UK economy?  Features of the corporate legal environment, especially limited liability, create incentives for excessive risk taking, because losses that would, with unlimited liability, result in negative equity, are not in fact borne by the entrepreneur under a limited liability regime,  Do businesses  overestimate risk and underestimate expected returns?  Entrepreneurs are congenial optimists who tend to overestimate returns and underestimate risk.  Managers of quoted companies that have but a limited equity stake in the firm, face a large number of incentives affecting their behaviour towards risk, not all of which point towards excessive caution.  The net effect will depend on the capital structure of the firm, the governance structure of the firm, including the relationship between management and the board(s),  the remuneration package of the manager, the market for corporate control in which the firm operates, and the nature of the managerial market place.  The case that there is too little risk taking in the UK economy, relative to the expected rewards on offer, has not been made effectively by anyone.

There may be too little risk capital available for launching new firms or new ventures by existing firms.  Capital gains taxation, however, is a very inefficient instrument (both from the point of view of its ability to correct the distortion that is targeted and from the point of view of the revenue effects for the tax authorities) to address the problem of the inadequate availability of external finance.  Capital gains taxation means taxing capital gains on the existing stock of capital assets.  Reductions in capital gains taxes benefit owners of existing capital assets.  Expectations of future low capital gains tax rates will have a favourable effect on investment today, but lower capital gains taxes today only increase the returns to investment decisions already made.

If governments want to boost investment, the revenue-efficient way is to work at the margin of new investment, say through a marginal investment subsidy, or through an investment tax credit, accelerated depreciation of new investment etc.  If governments want to encourage the availability of external finance for new firms and, more generally, for those enterprises whose access to external finance is inefficiently constrained, lower capital gains taxes (which come at the end of the investment process) are a singularly ineffective means to achieve this.  Measures to encourage venture capital funds that can pool the risk of many (hopefully imperfectly correlated) investment projects are one.  So are measures to strengthen the rights of external financiers vis-a-vis the owner-entrepreneurs. 

Encouraging small business
After the incredible lobbying power of the agricultural sector in advanced industrial countries, the cult of the small business is, to me, the second most incomprehensible feature of the industrial political-economic landscape.   Small businesses are ‘the seed-corn of economic growth’, ‘the backbone of the economy’, ‘the engine of growth’, the ‘well-spring of innovation and dynamism’, the ‘life-blood of the nation’.  Perhaps.  To me, the key feature of small businesses is that they are small.  And small is small.  Other things being equal, I would rather have a lot of medium-sized businesses, and much rather a lot of large businesses than a lot of small businesses.

Most small businesses stay small.  A lot die quite soon following their birth.  A few grow and become medium-sized businesses.  Very few grow and become large businesses.  Then, every 30 years or so, there is a Microsoft or Google. 

Are small businesses discouraged from growing and becoming medium-sized or large by capital gains taxes?  Most small businesses probably want to stay small.  I have a very small business, with two shareholders, two directors and two employees – my wife and myself.  I definitely neither expect nor want the business to grow significantly.  It does what I intended it to do.  I don’t expect to retire on the capital gains I will make from selling the business.  Most small businesses I am familiar with fall into that category.

There is a chronic tendency to romanticise and dramatise the role of the small business and the solitary entrepreneur.  Let’s face it, business is mostly boring; very little of it is glamorous, creatively challenging or intellectually exciting.  It’s mostly hard work – grinding and grafting.  Rather like farming or paid employment, in fact.  There is a small chance that an entrepreneur will be quite a bit worse than the wage slave, and an even smaller change that (s)he will make a staggering fortune and end up creating a lot of jobs for other people.  There is no clear evidence that, in the field of small business, the private risks are significantly greater than the social risks or the private returns much lower than the social returns.

Again, if there is a problem facing small businesses, it relates not to the taxation of capital gains, but to the cost and availability of external finance.  Much of this is due to the fact that new businesses have no track record on which to base a request for a bank loan or an injection of equity from a venture capital fund.  That problem should be tackled right at the point where the distortion arises. Subsidising small loans to small businesses that have never received a loan before, might help.  So would the possibility of postponing for a number of years the payment of business-related taxes by start-ups, while ensuring that in present discounted value terms, all taxes get paid in due course. But the selection criterion would be not size, but being new.

Granting small businesses special privileges (such as the rumoured proposal for a £100.000 tax-free allowance for capital gains from the sale of a business on retirement) is putrid pandering to the lobbyists from the UK small business community.  It is a waste of public money and unfair to those retirees who have only non-business assets to sell.  To belabour the obvious: assets are assets; the identity of the owner, whether they are business assets, personal assets, assets held in the investment portfolio of  an insurance company, or state-owned assets is irrelevant.  And small is small.  Not inherently good. Certainly not better than medium-sized or large.  And most definitely not obviously deserving of capital gaints tax breaks. 

I hope the current Chancellor will be able to see off his predecessor in this matter.  If we are ever going to get an income tax structure in the UK that is transparent and understandable, let alone simple, the original reforms proposed by Alistair Darling are a good place to start.    

<!– @page { margin: 2cm } P { margin-bottom: 0.21cm } A:link { color: #0000ff } –>

This post is a slightly amended version of a comment I published in Martin Wolf’s Economists’ Forum on 02/11/2007, in response to Martin Wolf’s column "Why immigration is hard to tackle", in the Financial TImes of 01/11/2007.

I have to declare an interest in the subject of immigration.  I am an immigrant (born in the Netherlands), and so are my wife (USA), my son (Peru) and my daughter (Bolivia).  We have currently 8 operational passports between the four of us (two British, two Dutch and four American).  Even our two cats are foreign breeds – Maine Coon and Norwegian forest cat.  Only the newts in our garden pond are truly British (I think). 

I feel about nationalities/citizenship and passports the way I feel about underwear: always carry plenty of it, and change it regularly. I have been fortunate indeed in that nationality or citizenship have never been a constraint on what I have been able to do.  I served as an external member of the Monetary Policy Committee of the Bank of England before I became a British citizen.  I became Chair of the Netherlands Council of Economics Advisers when I no longer held Dutch citizenship.

From a normative point of view, I am with Philippe Legrain who believes that freedom of movement is a human right.   For me, when it comes to the rights of nations and countries, libertarian political instincts combine with religious convictions: The earth is the LORD’s, and the fullness thereof; the world, and they that dwell therein.  Not: Britain for the British or Scotland for the Scots, or even British jobs for British workers.  I do not recognise national property rights.

Indeed, I would go further than that, and admit to a visceral dislike of and contempt for all forms of nationalism and patriotism.  I consider them regrettable historical accidents – manifestations of communal mental corruption that has too often exploded into collective madness, including  violent confrontations and war.  I recognise the historical reality and continuing  significance of the nation state and the notion of ‘country’, just as I recognise the reality and continuing significance of the HIV virus and of AIDS.  I allow for their existence, while hoping for and striving for their elimination.

I disagree with Martin when he says that a country is not just a set of institutions, but also a home, and that people have a right to decide who enters their (collective) home.  I view a country as a club with a set of institutions and membership rules.  The rules cannot be different for those born in the country (or related through kinship to people born in or resident in the country) than for those contemplating emigrating to that country. Anyone who is willing to abide by the membership rules has the right to join.  Anyone also has the right to leave and to join any other club. 

Under certain circumstances, exit taxes may be appropriate. These are, however, easily abused for opportunistic political ends, or to abrogate the right to leave.  It is clear that, despite remittances and the prospect of eventual return to the country of origin, certain forms of emigration (a brain drain, the departure of qualified doctors and nurses, the exit of the most dynamic and youthful age cohorts) can do serious damage to the rights of those left behind.  Whether compensation is due from the emigrant or from the government of the destination country is an interesting question.

Citizenship  is, in my view, purely residence-based, and residence is a personal choice.  It clearly makes sense, to avoid certain obvious free-rider or collective action problems, to link entitlement to some of the benefits of citizenship in a country to the duration of one’s residence there and/or to the magnitude of the contributions in cash (taxes) or in kind (compulsory military service, jury duty) one has made to the country.

I disagree with Mr. Legrain as regards some of his positive or factual statements about the consequences of immigration on the native population.  There are certainly plenty of instances where these effects can be negative.  Unskilled immigration into the UK may well bring in labour that is complementary to the labour of native skilled workers; it is likely to lower the wages of native unskilled workers, or to displace them altogether if wages are rigid downwards. 

When immigrants are different from natives in appearance or speech, the diversity they bring can as easily become a problem as a benefit.  On the Isle of Dogs in the London Borough of Tower Hamlets, where I lived for many years, the old native population, working class white Englanders left behind and marginalised when the docks left, co-existed badly with the large Bangladeshi immigrant community.  The resulting resentment let to the first election of a BNP Councillor in a local election (in the ward where I lived, Millwall, in 1993). The two communities are brought together only by their shared dislike of the affluent yuppies that are the most recent immigrants into the area.

This is a huge topic and there are many loose ends.  A key question for the ‘countries as open clubs’ view concerns the kind of membership rules that are legitimate.  Clearly a rule for citizenship in a country that reproduced the BNP’s party membership requirement – restricting it to "indigenous British ethnic groups deriving from the class of ‘Indigenous Caucasian’" - would not be my cup of tea.  I would begin by accepting only those clubs as legitimate whose membership rules (in theory and practice) respect the 1948 Universal Declaration of Human Rights. Beyond that, as long as immigrants impose no adverse rights externalities on natives (that is, as long as they do not infringe these same human rights), they should have the right to settle in the country.  Absence of negative rights externalities is compatible with negative conventional externalities (adverse effects on the standard of living of natives, for instance). So it would not be an argument against immigration that it makes (some or even all) natives worse off.  I recognise that, given the political governance realities of nation states, this moral argument will carry little practical weight.

If this policy of free migration were adopted by the EU, this could mean that, say, 150 million people might be queuing up to escape the low-lying areas of the Indian subcontinent and move to western Europe in less than a decade or so.  In addition to great cultural gains and economic benefits for some of the natives (European landlords and those native European workers with skills complementary to those of the newcomers), this would no doubt also create massive disruption, congestion, overcrowding, urban decay and growth of shanty towns in parts of Western Europe, and to drastic declines in the standards of living of native European workers whose skills are rival with those of the immigrants.  The immigrants themselves would on average be significantly better off, or they would not choose to come. 

My position that the wellbeing and rights of actual and potential immigrants count neither more nor less than those of the native-born is of course not exactly the brick with which the house of modern nationhood is built.  In the UK, as in the Netherlands and the US, vile and virulent anti-foreigner and anti-immigrant sentiment is never far from the surface.  The pages of most of the UK tabloids drip with poison when they address immigration-related matters. The flames of xenophobia, racism, anti-foreigner hysteria and anti-immigrant psychosis are also regularly fanned by opportunistic and spineless politicians from both government and opposition parties, oblivious of the damage they do to the social fabric.  Large-scale immigration has often provoked communal violence, and at times enduring civil conflict (as in Northern Ireland, Palestine/Israel, Sri Lanka, Tibet, and Assam). 

Peaceful coexistence and mutual tolerance among diverse communities, and a significant degree of integration and assimilation are necessary for a ‘country as an open club’ to thrive.  The British and Dutch models of multiculturalism, which have encouraged ethnic and religious apartheid, have failed.  Something closer to the original American melting pot model is more likely to be successful.

Despite the shock and horror about the recent UK immigration numbers (and yes, it is a scandal that the data are so poor), the scale of recent immigration into the UK (4.8 million gross and 1.6 million net over the last 10 years according to the (unreliable) official figures) has certainly been manageable from the point of view of the natives.  The net immigration of about 2.1 million expected between 2006 and 2016 also looks manageable, although it will exacerbate pressure on certain key scarce resources (housing, transportation infrastructure, health and education).  We will have to pay somewhat higher taxes to provide the necessary infrastructure and public goods and services.

Immigration has made London the most interesting, diverse, exciting and creative city in the world.  It is no longer be an English city, a British city, or even a European city in anything except a geographical sense, but it is the first true ‘worldcity’ or global city – an open city which belongs to all the people of the world.  This is no doubt why the enemies of the open society, including the suicide bombers that have targeted it and may to so again, hate it so much.  Those who don’t like what immigration has done and will continue to do to London or who feel threatened by it can, of course, under the ‘countries as open clubs model’,  always move somewhere else in the European Union.

The late Harry Johnson, professor of economics at the LSE and the University of Chicago, used to say that the whole ‘aid vs. trade’ debate about how to promote development and eliminate poverty was just shadow boxing.  If the rich, economically developed countries were serious about development and the elimination of global poverty, they would simply open their borders to all comers. He was right.

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.

Willem Buiter's website