The UK Treasury are reported to be working on plans to reform the two fiscal rules introduced by Gordon Brown. These are the ‘Golden Rule’, that over the cycle the government’s current account be in balance or in surplus and the ‘Sustainable Investment Rule’ that the ratio of net general government debt to annual GDP be no more than 40 percent.

Before reforming the substance of the rules, the UK government should think about how it would enforce whatever rule or rules it comes up with. Both the ‘Golden Rule’ and the ‘Sustainable Investment Rule’ were respected only as long as they did not bind. When they became binding constraints on the government’s ability to borrow they were bent, fiddled and now ‘reformed’, that is, ignored. The fiscal rules of the EU’s Stability and Growth Pact - the general government financial deficit should not exceed three percent of GDP, and over the cycle the general government financial deficit should be close to balance or in surplus - to which the UK also signed up, have been ignored/violated with equal equanimity. With zero credibility as regards its willingness to respect its own fiscal rules or those of the EU, why would anyone pay any attention to a new set of rules that the Treasury may come up with? (more…)

How far will the real price of oil and other carbon-based resources rise? Experts (I am not one of them) differ widely in their medium-term and long-term predictions, but my reading of the evidence suggests that there is a fair chance that the sky is the limit. In the short run (the next 2 or 3 years) a global cyclical slowdown may provide some temporary relief from rising commodity prices in general and rising oil prices in particular. This temporary cyclical energy price comfort will be deeper and longer-lived if the key emerging markets that have let inflation get out of control (effectively all of them except for Brazil) tighten monetary and fiscal policies to bring inflation down to politically tolerable levels. The resulting cyclical slowdown in emerging market growth will be bad news for economic activity in the industrial world, but will put downward pressure on commodity prices. We will be unemployed but able to afford petrol.

Once global growth returns to its underlying trend, however, say three or four years from now, I expect the relentless upward march of commodity prices, including oil, gas and agricultural commodities, to continue. The reason is simple. Global demand growth is heavily biased towards energy-intensive production and consumption in emerging markets. Even if common sense breaks out in India, China (perhaps even in the Middle East and other oil and gas producers) and domestic oil and energy use is priced at its global opportunity cost, the energy-intensity of global production and demand will be rising for quite a while. At a horizon of a decade or more, high energy costs may reduce the energy intensity of production, investment and consumption, but total energy demand is still likely to rise even if global real GDP growth averages only 3 or 4 percent per annum. (more…)

With a slight modification of the all-time classic referee’s report,  I can say the following of the Treasury’s recently released consultation document Financial stability and depositor protection: further consultation: this document contains much that is new and much that is good.  Unfortunately, what’s new is no good and what’s good is not new. (more…)

The effective fulfillment of the lender-of-last-resort function of the central bank requires that during a liquidity crisis the central bank lend freely to an institution that is illiquid but not  insolvent (if assets can be held to maturity), against collateral that would be good during normal times but that may have become illiquid during disorderly market conditions, and at a penalty rate.  The requirement that lender-of-last-resort facilities are only offered on punitive terms is key to the minimisation of moral hazard and thus to discouraging future imprudent, reckless lending and borrowing.

The same principle of providing assistance to illiquid but solvent institutions only on punitive terms applies when market illiquidity rather than funding illiquidity is the problem facing the troubled private financial institution and the central bank intervenes as market maker of last resort.

Any illiquid assets the central bank accepts as collateral in repos, at the discount window or at any of the more recently created special liquidity facilities, such as the Term Securities Lending Facility and the Primary Dealer Credit Facility in the USA or the Special Liquidity Scheme in the UK, must be valued or priced in a way that ensures that the transaction does not involve a subsidy from the central bank to the borrowing institution.  The repo, collateralised loan or swap should earn the central bank an appropriate risk-adjusted rate of return.  The same would apply if the central bank purchased illiquid private securities outright from a financially challenged private financial institution.  There is nothing wrong in principle with the central bank taking credit risk onto its balance sheet, as long as it earns a rate of return that adequately compensates it for that risk.

There is a growing suspicion in the markets that the ECB is subsidizing some euro area banks that are eligible counterparties at its discount window (the Marginal lending facility) or in repos, by overvaluing or overpricing illiquid collateral offered to the Eurosystem by these euro area banks. (more…)

French President Nicolas Sarkozy has blamed Peter Mandelson, the EU trade commissioner, for the Irish ‘no’ vote in the referendum on the Lisbon Treaty.  I yield to no one in the strength of my belief that the EU commissioners have super-human powers.  Even so, Sarkozy’s has to be an unusual mind to reach that conclusion. Why not blame the French and Dutch voters who in 2005 rejected the Treaty establishing a Constitution for Europe?  Without their ‘no’ vote there might not have been any need for a Lisbon Treaty - and it would have been such fun to have a referendum in the UK. (more…)

The voters of the Republic of Ireland have rejected the Lisbon Treaty (officially the Treaty of Lisbon amending the Treaty on European Union and the Treaty establishing the European Community) in the referendum held on June 12. According to the rules of the EU, as found in the Nice Treaty, this means that the Lisbon Treaty cannot come into effect, as the unanimous ratification of the Treaty by all EU member states is required for this.

No point moaning that 4 million Irish cannot be permitted to thwart the will of 490 million other Europeans. That argument is bogus and dangerous, even if the 8 remaining EU member states that have not yet reached a formal decision on the Lisbon Treaty were to ratify it - something that is by no means a done deal. The rules for ratification of the Treaty were clear. To change the rules when you are losing is a violation of the rule of law. Respect for the rule of law is even more important than the fate of the Lisbon Treaty. (more…)

The UK Treasury is considering the creation of something I shall refer to as an FSC (for Financial Stability Committee/Council) to advise/assist/overrule the Governor of the Bank of England and the other four executive members of the Bank of England’s Monetary Policy Committee (MPC) who currently deal with and decide on financial stability matters.

This could be a good idea or a bad idea, depending on how it is implemented. (more…)

The ECB, through its President, Jean-Claude Trichet, is back in the game of pre-announcing future interest rate changes. I would have thought that the experience of August 2007 would have cured them of this urge for a bit longer. On August 2, President Trichet flagged a rate rise for September by using the ‘strong vigilance’ code words: “… strong vigilance is therefore of the essence to ensure that risks to price stability over the medium term do not materialise.” Then events, dear boy, events intervened in the form of the August 9 eruption of the financial crisis, and the pre-announced rate hike was hastily shelved.

The wordsmiths at the ECB appear to have been busy in the mean time coming up with a new collection of code words. Strong Vigilance is no longer with us, and neither is his weakling half-brother, Mere Vigilance. Instead the Governing Council is reported in the Introductory statement of June 5th to be “… in a state of heightened alertness…”. Taken at face value this means no more than that the majority of the members were awake during the meeting, because the President had removed the decaf. (more…)

Unless Chairman Bernanke’s recent statement about the US dollar signals either a greater willingness to raise rates (or not to lower them) than before, or a greater readiness to conduct foreign exchange market intervention to stop the US dollar from falling further, it was cheap talk.

I can see two plausible sets of circumstances that would permit a test of the cheap talk hypothesis. The first would be a sharp weakening of the external value of the US dollar (as measured by its effective or trade-weighted nominal exchange rate) not associated with an obvious further weakening of domestic activity. An increase in oil prices caused by a negative shock to oil supply would be a possible trigger for such a configuration of economic outcomes. (more…)

The case for the UK shedding sterling and adopting the euro has never been clearer.

From a conventional macroeconomic perspective (asymmetric shocks, cyclical convergence, the 39 tests or whatever), there is no reasonable argument for a small, highly open economy like Britain to retain monetary independence. The belief that an independent national monetary policy allows you greater greater scope for effective macroeconomic stabilisation is an example of the monetary fine-tuning fallacy. With a high degree of international financial integration, the exchange rate does not function as a buffer against asymmetric shocks, permitting a less costly adjustment of international relative costs and prices than would have been possible at an irrevocably fixed nominal exchange rate. Instead it becomes a source of extraneous, uncessessary noice and volatility and of at times persistent misalignment. (more…)