Quantitative easing – expanding base money in circulation (mainly bank reserves with the central bank by purchasing government securities) – isn’t working in the US, the UK or Japan.  Credit easing – outright purchases of private securities by the central bank, which can either be monetised or sterilised – is achieving little in the US or the UK, although it has not been pushed too hard yet.  Enhanced credit support in the Euro Area – providing collateralised loans on demand at maturities up to a year at the official policy rate – is not working either.  These policies are not improving the ability and willingness of banks to lend to the non-financial sectors.  They have had little positive impact on the corporate bond market. It is not surprising why this should be so, once we reflect on the actions and the conditions under which they are taking place.

In a nutshell: quantitative easing (QE), credit easing (CE), and enhanced credit support (ECS) are useful when the problem facing the economy is funding illiquidity or market illiquidity.  It is useless when the binding constraint is the threat of insolvency.  Today, liquidity is ample, even excessive.  Capital is scarce.  Capital is scarce first and foremost in the banking sector.  A panoply of central bank and government financial interventions and support measures have ensured, at least for the time being, the survival of most of the remaining crossborder banks.  It has not done enough to get them lending again on any scale to the household and non-financial enterprise sector.

Like most authors, I tend to cringe when I read something I wrote more than a few years ago.  But while engaging in some authorial auto-archeology recently when preparing the index for a new paper (after all, if I don’t cite myself, who will?), I was pleasantly surprised with a few bits from a paper I wrote in 1999 and published in 2000 in the Bank of England’s Quarterly Bulletin, titled “The new economy and the old monetary economics”.

The paper takes aim at the assertion, rampant in 1999, that the behaviour in recent years of the world economy, led by the United States, could only be understood by abandoning the old conventional wisdom and adopting a ‘New Paradigm’. Prominent among the structural transformations associated with the New Paradigm were the the following: increasing openness; financial innovation; lower global inflation; stronger competitive pressures; buoyant stock markets defying conventional valuation methods; a lower natural rate of unemployment; and a higher trend rate of growth of productivity.

I argue, first, that the New Paradigm has been over-hyped. “…Unfortunately, the ‘New Paradigm’ label has been much abused by professional hype merchants and peddlers of economic snake oil.”

Second, I argue that, to the extent that we can see a New Paradigm in action, its implications for monetary policy have often been misunderstood.

I was particularly pleased that I had written following about financial innovation:

Last week the Eurosystem performed a €442bn injection of one-year liquidity into the Euro Area banking system.  They did this at the official policy rate – the Main refinancing operations (fixed rate) – of 1.00 percent, against the usual collateral accepted for Longer Term Financing Operations, effectively anything euro-denominated, not based on derivatives and rated at least BBB-.  It was a fixed-rate tender, that is, the ECB was willing to meet any demand at the 1 percent interest rate, as long as eligible collateral was offered; 1121 banks participated in the operation.

You will not be surprised to hear that this was the largest one-day ECB/Eurosystem operation ever.  Even more remarkable than its scale are the terms on which the one-year funds were made available.  There can be no doubt that this operation represents both a subsidy and a gift from the Eurosystem to the banks that participated in the operation.  I hope to clarify the distinction between a subsidy and a gift in what follows.

As long as the financial stability role of central banks remained in the background, the notion of central bank independence appeared to have something to recommend it.

The too big to fail problem has been central to the degeneration and corruption of the financial system in the north Atlantic region over the past two decades. The ‘too large to fail’ category is sometimes extended to become the ‘too big to fail’, ‘too interconnected to fail’, ‘too complex to fail’ and ‘too international’ to fail problem, but the real issue is size.  The real issue is size.  Even if a financial business is highly interconnected, that is, if its total exposure to the rest of the world and the exposure of the rest of the world to the financial entity are complex and far-reaching, it can still be allowed to fail if the total amounts involved are small.  A complex but small business is no threat to systemic stability; neither is a highly international but small business.  Size is the core of the problem; the other dimensions (interconnectedness, complexity and international linkages) only matter (and indeed worsen the instability problem) if the institution in question is big.  So how do we prevent banks and other financial businesses from becoming too large to fail?

Whenever the cumulative effect of the daily observation, looking out of my window or into the mirror, of human inequity and wretchedness brings me to the point that I am convinced the human race is an evolutionary dead end, something incredible happens to restore my faith that a hunger for freedom and an unquenchable thirst for justice and fairness are part of our genetic code. Crowds often become mobs and mobs are mostly ugly and destructive. The sight of large numbers of unarmed people, most of them young, facing heavily armed police, regular army, militia or other armed thugs is awe-inspiring.

To think I believed I had seen it all as regards creative uses and abuses of credit default swaps (CDS).  But then came Amherst Holdings.

A credit default swap written on a security (a bond, say) is a contract that pays the owner a given amount when there is a default on that security. In the simplest case, the owner of the CDS receives from the issuer or writer of the CDS the face value of the bond that is in default.  The writer of the CDS sells insurance against an event of default.  The insurance premium is the price of the CDS.  The buyer of the CDS buys insurance against default.  If the default does not occur, the writer of the CDS wins, because he has received the insurance premia, but has not had to pay out on the insurance policy.

To those of you prone to apoplexia gravis, a word of caution: this post does not advocate smoking anything, other than possibly herring.  Nor does it represent a defence of tobacco companies or other enterprises dedicated to the challenge of profiting from the sale of highly addictive toxic substances.  It is instead a plea not to abandon reason and the careful use of language when writing about stuff we strongly disapprove of.  Overstating a strong case often hurts it. It is also dishonest.

I am fortunate in that my kids, when they were mere tots, bullied me into giving up smoking.  As soon as I lit up in their vicinity, they would cry out “daddy, you are going to die!”.  Worse than that, they used to rat me out to my wife when I snuck outside for a quick smoke behind the shed.  It was a battle I could not win, so I quit.  Filthy habit.

You must have seen headlines stating something like “Smoking ‘kills five million a year’” (the year in question was 2000).  What does this mean?  Is this a bad thing or a good thing? Does it mean that five million people who died in 2000 would not have died when they did?  That they would not have died ever, if only they had not smoked? That they would have died later (if so, by how many years or months), and that the manner of their dying would have been more comfortable that their smoking-caused deaths?

The headline in question really ought to have read: “Smoking-related illness and disease caused the premature deaths of five million people worldwide in the year 2000.  Average life spans were -reduced by N years. If they had not smoked, the five million would not have died of smoking-related illnesses and diseases – cancer (lung, throat, mouth, larynx oesophagus, lung, kidney, bladder, pancreas, stomach, blood and cervix), diseases of the cardiovascular system (atherosclerosis, stroke, heart disease, aneurysms of the aorta and peripheral vascular disease), diseases of the respiratory system (emphysema, bronchitis and pneumonia), increased health risk and risk of death to the unborn from smoking pregnant women, periodontal disease, brittle bones, cataracts, ulcers.  Instead they would have died, had they not smoked, at some later date, of cardiovascular diseases, infectious and parasitic diseases, ischemic heart disease, assorted cancers, strokes, lower respiratory tract infections, respiratory infections, respiratory diseases, unintentional injuries, HIV/AIDS, chronic obstructive pulmonary disease, perinatal conditions, digestive diseases, diarrheal diseases, intentional injuries (suicide, violence, war, etc), tuberculosis, malaria, road traffic accidents, neuropsychiatric disorders, diseases of the genitor-urinary system, cirrhosis of the liver, nephritis/nephropathy, Alzheimer’s disease and other dementias, musculoskeletal diseases, hepatitis B, Parkinson’s disease, alcohol use, drug use, upper respiratory infections, skin diseases, hepatitis C, Huntington’s disease, multiple sclerosis, motor neurone disease or some other condition.

In my discussion of the Cap & Trade scheme for carbon dioxide equivalent (CO2E) emissions (greenhouse gases) proposed by U.S. Reps. Henry Waxman, D-Calif., and Edward Markey, D-Mass. (the American Clean Energy and Security (ACES) Act of 2009), I argue that the two key issues are (1) the size of the overall quota and (2) the enforcement of the rule that without a permit, you cannot emit.

Prima facie, the scheme looks tough.  The Discussion Draft Summary of the American Clean Energy and Security Act of 2009 reads: “The draft establishes a market-based program for reducing global warming pollution from electric utilities, oil companies, large industrial sources, and other covered entities that collectively are responsible for 85% of U.S. global warming emissions. Under this program, covered entities must have tradable federal permits, called “allowances,” for each ton of pollution emitted into the atmosphere. Entities that emit less than 25,000 tons per year of CO2 equivalent are not covered by this program. The program reduces the number of available allowances issued each year to ensure that aggregate emissions from the covered entities are reduced by 3% below 2005 levels in 2012, 20% below 2005 levels in 2020, 42% below 2005 levels in 2030, and 83% below 2005 levels in 2050.”

In fact, the scheme is a total con.  It permits the US to increase CO2E emissions until 2020.  The escape mechanism used – carbon offsets or carbon credits – suggests that for the period 2020 – 2050 also, the supposed intent of the Act – to reduce CO2E emissions in the US – will be neutered. 

Standard and Poor’s on Thursday, May 21 2009, issued the following statement: “Standard and Poor’s has revised the outlook on the United Kingdom to negative from stable. — The  AAA’ long-term and  A-1+’ short-term sovereign credit ratings were affirmed. — The outlook revision is based on our view that, even factoring in further fiscal tightening, the U.K.’s net general government debt burden may approach 100% of GDP and remain near that level in the medium term.

Is this good news for the UK or bad news? Both the UK’s long-term sovereign credit rating (reflecting the probability of sovereign default in the medium and long term) and its short-term sovereign credit rating (reflecting the probability of sovereign default during the next year) remain at the highest possible levels, AAA and A-1+ respectively. However, the negative outlook is bad, even if it is not bad news. Based on past behaviour, there is a one-in-three chance of a sovereign moving from a negative outlook to a one-notch downgrade.

The fact that one of the three leading credit agencies is publicly hinting at less than complete confidence in the solvency of the British sovereign is not in and of itself terribly significant any longer. Following their incompetent and deeply conflicted performance in rating structured products, the credibility of the rating agencies is badly impaired even in those domains – sovereign debt and the debt of large corporates – where they have not made complete asses of themselves.

Even though the credibility and reputation of the rating agencies is in tatters, the fact that they have not yet been written out of the regulations and rule books governing the investment behaviour of many institutional investors means that a downgrade would still affect market demand for UK sovereign debt. This will probably raise the funding cost of the UK sovereign somewhat.

But even without the input from the rating agencies, it would have been clear that the UK is about to exit its AAA status. It shares this fate with most of the other G7 countries. In two or three years, Canada  may be the only G7 country left to have an AAA rating. France could conceivably join Canada.  There is nothing too shocking about this.  Not that long ago, Japan’s sovereign rating was on a par with Botswana’s (I thought that was rather unfair on Botswana).

I will expand on the case of the UK in what follows, saving a more detailed consideration of the US fiscal predicament (which is much worse than that of the UK) for a future post.

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