Daily Archives: July 26, 2011

The latest figures show that Britain’s economy grew by only 0.2 per cent in the second quarter, which the Office for National Statistics says was equivalent to 0.7 per cent after taking account of the extra bank holiday for the royal wedding, and the effects of the Japanese earthquake. One excuse after another! Taking a slightly longer view, the economy has barely grown at all, according to the official statisticians, over the past three quarters. What should be done about this?

The answer depends on why growth has slowed down so sharply in the official statistics. One strong possibility is that the ONS is significantly underestimating the true level and growth rate of gross domestic product, as it has done for long periods during previous economic recoveries.

Alternative  economic indicators continue to look more buoyant than the GDP figures. For example, business survey data indicate that the economy may have grown by about 1 per cent in the first quarter, and by 0.6 per cent in the second quarter. Furthermore, labour market data have not weakened in the manner that would be expected if the economy had stagnated.
On these alternative estimates, the slowdown in UK growth would be in line with the pattern in other major economies this year. Growth would now be roughly in line with trend, with the path headed slightly downwards. That would provide no cause for complacency, but no cause for panic either.

The next question is how much of the growth slowdown has been caused by supply side factors, which cannot be addressed by conventional demand management. The shrinkage of the financial and construction sectors has certainly affected the economy adversely, but these effects need not be permanent, since resources can be redeployed in other industries.  More recently, however, the rise in oil prices has clearly acted as an adverse supply shock, simultaneously raising inflation and cutting output growth. There is nothing that fiscal or monetary policy can do about that, if the inflation target is to be respected.
However, once the commodity shock has passed, and assuming the economy stays subdued, there will be a strong case for a boost to demand through macroeconomic policy. Should this come from the fiscal or the monetary side? The government’s budgetary regime allows the fiscal stabilisers to work, and they are already doing so with the overshoot of the budget deficit relative to target in the new fiscal year. But this will only amount to around 0.5 per cent of GDP, which is fairly negligible.

Other ideas for fiscal easing include a temporary cut in VAT on the Labour side, or an early elimination of the 50 per cent income tax rate on the Conservative side. The Chancellor George Osborne continues to argue against this kind of emergency fiscal action, which would undermine the confidence effects he hopes to see from the control of public debt.

There is no doubt that the fiscal tightening has slowed the economy. The idea that the budget deficit could be cut by 2 per cent of GDP per annum without this affecting GDP was always a pipedream. But these effects were intended to be cushioned by expansionary monetary policy and a lower exchange rate, and that still remains the best route to easier demand policy.

Inflation is still too high for the Bank of England to ease policy immediately. The headline rate of consumer price inflation in June was 4.2 per cent. But underlying inflation rates are now falling sharply, with some measures of core inflation having dropped below 1 per cent. This is consistent with the very subdued behaviour of wage increases and labour costs, which will determine inflation in the long run.

The Bank’s monetary policy committee looked set to increase interest rates earlier in the year. We now know that this would have been a serious mistake. The case for another round of quantitative easing is growing.

The writer is chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners


Response by Jonathan Portes

Calls for more QE are passing the buck to the Bank

As Gavyn Davies says, the idea that the very sharp fiscal contraction now in train in the UK would not be contractionary was always a pipe dream, and there is now a strong case for a boost to demand. Like Vince Cable and the International Monetary Fund, he argues that monetary policy – in particular, another round of quantitative easing – should pick up the slack.

But there are several reasons to believe that  monetary and fiscal policy are far from being perfect substitutes in current circumstances.  Monetary policy works, in Milton Friedman’s famous phrase, with “long and variable lags”, while fiscal policy, if it takes the form of changes to government spending, can work quickly. Simulations using the National Institute of Economic and Social Research’s model suggest that, in the UK, the contractionary effect of spending cuts is offset in the short term to a very limited extent by a monetary policy response. 

Moreover, one main channel through which monetary policy could, in theory, boost demand is via a lower exchange rate.  But we’ve already seen the trade-weighted exchange rate fall below trend, and we have been importing inflation; while this fall is welcome, and things would definitely be even worse without it, a further significant fall would be of questionable benefit. 

And finally, while QE has clearly helped, it is likely to be subject to diminishing returns, with long term interest rates at historic lows. This is the result not of “confidence”, as the Chancellor has misleadingly argued, but, as in the US and Japan, economic weakness; UK long-term interest rates have fallen as expectations for future economic growth have been reduced.

Calling for more QE is understandable, but it amounts to passing the buck to the Bank of England at a time when it has limited room for manoeuvre.  Instead, calls for action should be directed at the government.  A more comprehensive growth strategy would include action on fiscal policy in the short-term – slowing the pace of spending cuts – and measures to boost the supply side over the medium term. 

The writer is director of the National Institute of Economic and Social Research

Since the devastating Japanese earthquake and, earlier, the global financial tsunami, governments have been pressed to guarantee their populations against virtually all the risks exposed by those extremely low probability events. But should they? Guarantees require the building up of a buffer of idle resources that are not otherwise engaged in the production of goods and services. They are employed only if, and when, the crisis emerges.

The buffer may encompass expensive building materials whose earthquake flexibility is needed for only a minute or two every century, or an extensive stock of vaccines for a feared epidemic that may never occur. Any excess bank equity capital also would constitute a buffer that is not otherwise available to finance productivity-enhancing capital investment.

The choice of funding buffers is one of the most important decisions that societies must make, whether by conscious policy or by default. If policymakers choose to buffer their populations against every conceivable risk, their standards of living would almost certainly decline. It is no accident that earthquake protection of the extent employed in Japan has not been chosen by less prosperous countries at similar risk of a serious earthquake. Those countries have either explicitly, or implicitly, chosen not to divert current consumption for such an eventuality. Buffers are largely a luxury of rich nations. It does not matter whether we perceive an increased buffer as part of a nation’s capital stock, or part of the net equity of the country. They are the same magnitude from different perspectives. Consolidated, the net capital stock of a nation must equal the sum of the equity of households, businesses and governments, adjusted for the nation’s net international investment position.

How much of its ongoing output should a society wish to devote to fending off once-in-50 or 100-year crises? How is such a decision reached, and by whom? In the 19th century, when caveat emptor ruled, such risk judgments were not separable from the overall price, interest rate and other capital-allocating decisions struck in the marketplace.

Today, while the decisions of what risks to take remain predominantly with private decision-makers, the responses to the global financial and, of course, the Japanese earthquakes have been largely government scripted. In the immediate aftermath of such crises, it is very difficult to convince people that the recent wrenching events are not likely to recur any time soon, because, with a (very) low probability, they might. This is especially the case having just been through the brunt of a financial crisis that is likely to be judged the most virulent ever.

In the wake of the Lehman bankruptcy in 2008, private markets and regulators are requiring much larger capital, ie buffers, to support the liabilities of financial institutions. Had banks and other financial entities maintained adequate equity capital-to-asset ratios before the 2008 crash, then by definition, no defaults or contagion would have occurred as the housing bubble deflated. A resulting recession, though possibly severe, would almost certainly not have been as prolonged or required bail-outs.

Bank managements, currently repairing their demonstrably flawed risk management paradigm, have been moving aggressively to build adequate capital to enable them to lend. For the moment they are expanding their loan portfolios only marginally. Most of the new capital appears to have buffer status, rather than being directly involved in spurring day-to-day lending. Deep uncertainty about our economic future, as well as the potential level of regulatory capital, has unsettled bank lending. More than $1,600bn in deposits (excess reserves) at Federal Reserve banks are lying largely dormant despite available commercial and industrial loans that, according to the Fed, entail “minimal risk” and are yielding far more than the 25 basis points reserve banks are paying on such deposits. The excess reserves thus seem to have taken on the status of a buffer, rather than actively participating in, and engendering, lending and economic activity.

The “frozen” reserves appear the result, at least in large part, of the unexpected sequence of bank bail-outs in 2008. Had Bear Stearns failed in March 2008 (without government intervention), Lehman Brothers, and possibly AIG, would have been induced to take capital-building actions during the subsequent six months to fend off insolvency. But Bear Stearns was bailed out, creating a widespread perception that if it was “too big to fail”, so were all its larger competitors. Lehman’s fear of insolvency was dangerously assuaged. What sequence of events would have emerged had Bear been left to fend for itself will always remain conjectural.

What is not conjectural, however, is that American policymakers, in recent years, faced with the choice to assist a major company or risk negative economic fallout, have regrettably almost always chosen to intervene. Failure to act would have evoked little praise, even if no problems subsequently arose; but scorn, and worse from Congress, if inaction was followed by severe economic repercussions. Regulatory policy, as a consequence, has become highly skewed towards maximising short-term bail-out assistance at a cost to long-term prosperity.

This bias leads to an excess of buffers at the expense of our standards of living. Public policy needs to address such concerns in a far more visible manner than we have tried to date. I suspect it will ultimately become part of the current debate over the proper role of government in influencing economic activity.

The writer is a former chairman of the US Federal Reserve and is now president of Greenspan Associates LLC

Response by Howard Davies

Risk averse regulators must be clear how much capital and liquidity is enough

Counter-factual history can be thought-provoking: Niall Ferguson has revived it usefully in recent years. Now Alan Greenspan threatens to undo all his good work, arguing that if only the US authorities had allowed Bear Stearns to expire, rather than handing it over to Nurse Jamie Dimon at JPMorgan Chase, the crisis would not have escalated. Of course it is impossible to be sure, as Mr Greenspan recognises, but it seems unlikely that Lehman Brothers and others would have been able to find enough new capital to survive. By the early summer of 2008 I suspect the die was cast.

But Mr Greenspan, while he dislikes rescues, is surely right to reassert the value of the lender of last resort role of central banks. Without that backstop banks would be obliged to be far more liquid, and bank borrowings would be prohibitively expensive. Some advocates of tougher regulation seem to argue that banks must be recapitalised to such a level that they will survive unaided in all conceivable circumstances. That amounts to reckless prudence: those who argue for capital ratios of over 20 per cent are in that dangerous territory.

Nonetheless, in the light of the crisis we can see that banks, especially those with large trading books, were too thinly capitalised, and capital providers are themselves demanding more equity. Without it, bank debt would be more expensive. We do not need to believe that the pure milk of the Modigliani and Miller theorem (which asserts that the overall cost of capital cannot be changed by altering the balance of debt and equity) to see that with more equity banks will be safer. The trick is to strike the right balance. We must fatten the geese, without damaging their ability to lend golden eggs. The current Basel proposals strike me as a reasonable stab, though I would be hesitant about going further.

Mr Greenspan does score a palpable hit when he points to the damage of continued regulatory uncertainty. For some regulators, no amount of capital and liquidity seems enough. As soon as banks digest a new regime there is talk of another, even tougher than the last. Basel 2 gave way to 2.5 and soon to 3.0. Buffers proliferate, as in a Pall Mall club. We should now accept that this is an imperfect science, and let the new system bed in, with a moratorium on further change until we see whether the new dispensation delivers a banking system which can support a dynamic economy.

The writer is former chairman of the UK Financial Services Authority, former deputy governor of the Bank of England and former director of London School of Economics. He is now a professor of practice at Sciences Po in Paris

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