In this morning’s blog post, Brian Keeley mentioned quantitative easing (QE) as one way governments can stimulate the economy, and (in an unrelated move) the European Central Bank has just announced it is launching a QE initiative amounting to 60 billion euros a month until September 2016. But what is quantitative easing?
First we have to understand the role of interest rates, the main weapon in central banks’ armouries. The rate set by a central bank is soon followed by other banks, thereby influencing the “price of money” – how much you have to repay on a loan, how much the bank will pay you for your savings and how much the government will pay to borrow money.
Central banks set different rates, depending on the type and length of the loan. In general, the shorter the payback period, the higher the rate. The rate most often referred to as “interest rates” is the so-called base rate or prime rate used to calculate the other interest rates.
As Brian said, central banks use interest rates for two main reasons. First, rates may be raised to “cool” the economy when there are fears about inflation. The idea is that by making credit more expensive, demand will be restrained and prices will not rise so quickly. Second, when economic growth is too slow, a cut in interest rates makes it cheaper to borrow money to purchase goods or to invest in a business, thereby stimulating growth.
In April 2009, the average interest rate set by the central banks of the Group of Seven nations fell to 0.5% and has been hovering around this level since. What happens when money is so cheap it can’t get any cheaper? In other words, what can governments do when interest rates can no longer be cut because they are so low already?
Quantitative easing is one possibility. The central bank injects money into the economy by buying certain financial products, notably government bonds (also known as gilts). The sellers are expected to use the money to lend to businesses and households or to invest (although they may just leave it in bank deposits or send it offshore). The US Federal Reserve applied quantitative easing during the banking crisis that followed the 1929 Wall Street Crash, and the Bank of Japan adopted a similar approach to dealing with the crisis in the 1990s following the crash of the property market.
The media often present this as “the government printing money”. The reason is that instead of borrowing money in the usual way by issuing new bonds, the government, through the central bank, simply creates the money and uses it to pay the banks and other financial institutions it intends to help.
We’ve become so used to describing the crisis in terms of trillions of dollars that the ECB’s 60 billion euros a month, seem modest by comparison (and it is compared to the $3.7 trillion the Federal reserve spent buying bonds in the US QE programme). But to put that into perspective, in March 2009 when the Bank of England announced it was making available £75 billion to buy gilts and corporate debt as part of its QE strategy, that was one and a half times the total value of all banknotes and coins circulating in the UK at the time.
If quantitative easing succeeds in making government bonds more attractive, the interest paid on these bonds does not have to be as high as it was previously. As I write, that seems to be happening. The Financial Times’ latest headline is “Eurozone bonds on fire after ECB launches QE”, with the paper reporting drops to record lows in the interest rates on 10-year government bonds in Eurozone countries.
That’s good news for governments who have to borrow money and to finance the debt they have already accumulated. But it may not be good news for everybody, pensioners for instance. Pension funds are massive holders of government bonds, so a drop in the interest paid on them (the yield) translates directly into a loss of income to the funds. And since the pensions industry uses bond yields to calculate pension payments such as annuity income, pensioners will be affected. Company pension schemes could be affected too. The yield on government bonds is an important element in calculating the future liability of pension funds, and when yields fall, liability increases.
After Monday’s post about how bad things could get, I thought an article on the OECD’s interim global economic outlook released today would cheer you up. It won’t. English prepositions being what they are, “cheer you down” doesn’t exist, but if it did, down you would be cheered. A quick glance at the early reactions from the international media gives you the flavour, even if you don’t speak the languages: Rezession, récession, recessione. The OECD projects that the euro area’s three largest economies – Germany, France and Italy – will shrink at an annualised rate of 1 percent on average during the third quarter of this year and at 0.7 percent in the fourth.
The euro area crisis is dragging down the rest of the world economy through its impacts on trade and business and consumer confidence. The outlook thinks that “durable” changes are taking place in the geographical composition of global imbalances, with the euro area trade surplus rising on soft domestic demand and fiscal consolidation. China’s exports to the euro area are being hit hard. This may affect China’s ability to invest in the US in the longer term, although that aspect is beyond the scope of an interim outlook. In the US itself, an increasing non-oil deficit is offset by an improving oil balance. This is another area where longer-term developments will be interesting. Oil production from deepwater sites and unconventional sources such as oil sands or the Arctic will grow, and most of the potential fields are outside the Middle East. The Japanese surplus is falling because of rising energy imports and sluggish exports. Business investment is holding up, but mainly due to post-disaster reconstruction.
Could it get even worse? Yes it could: “Risks to the outlook remain significant”. Apart from the euro area crisis, the report mentions the US heading for a “fiscal cliff”. Even if you’ve never heard that expression, you probably suspect that it’s the kind of cliff you fall, jump or are pushed off. The outlook explains that current legislation implies an extremely sharp fiscal tightening in 2013 (the fiscal cliff) that would probably push the US economy into recession. It then urges the political parties to agree on detailed medium-term consolidation plans to avoid this. Perhaps one of our American readers could tell us what the chances are of the parties doing this.
Fiscal policy poses problems elsewhere too. Rigour, austerity, tightening or whatever it’s called is a medium-term policy, but it’s acting as a drag on short-term economic activity. Some countries may actually be caught in a negative feedback loop whereby activity is weaker than expected when planning the budget, so less tax comes in and there is overspending and then the need for more consolidation, which acts as a drag…
The outlook suggests actions to address feedback loops that undermine the euro’s stability. Speculation that Greece or others might leave the euro are pushing up sovereign bond yields, making it more expensive for some governments to borrow, further reinforcing fears of a break-up. The OECD argues that exit fears could be soothed if the ECB intervened in bond markets to keep spreads (the different interest rates paid on sovereign debt of one country compared to another) within ranges justified by the fundamental economic conditions.
And in a move that will no doubt enrage euro sceptics, the Organisation also calls for further progress towards banking union to increase the availability of public funds to recapitalise banks, along with full recognition of non-performing loans enforced by common supervision.
This just in. Mario Draghi, the European Central Bank’s president has announced a plan whereby the ECB will buy unlimited quantities of government bonds to help countries facing high interest rates. Critics say it will discourage governments’ efforts to balance the books and that it would fuel inflation. That’s not the opinion of OECD Secretary-General Angel Gurría who backed such a move a month ago. “Speculators will lose their bet against the euro, because the ECB will then pull out all the stops,” he told the Neue Osnabruecker Zeitung, adding that he saw no risk of inflation in the short term.
So far, the announcement has boosted stock markets and helped Italian and Spanish bonds, so maybe the gloom will not become doom. Watch this space.
On September 5th 1661, Louis XIV ordered D’Artagnan and his musketeers to arrest Nicolas Fouquet, the “Surintendant des finances”, for the capital offences of embezzlement and crimes against the state (or Louis XIV as it was known in those days). Fouquet was accused of ruining the king through exorbitant interest rates on sovereign debt as well as diverting some of the financial flows from lenders to the royal coffers into his own pocket.
Fouquet defended himself well though, and after a three-year trial was exiled rather than executed. However today he’s mostly remembered for parties that even the Sun King found a tad extravagant (although Louis did build the Palace of Versailles as a bigger, blingier version of Fouquet’s château at Vaux-le-Vicomte).
There’s a lot of truth in the popular image, but it doesn’t tell the whole story. Fouquet tackled problems that would be familiar to any European finance minister today, using means that are still part of the policy response to the current crisis such as cutting public spending, rescheduling debt and raising taxes and improving their collection. (He also used a few that aren’t so common or so blatant anymore such as selling public offices to his cronies.)
Fouquet understood something that is key to the present crisis: the need to restore confidence and get the economy moving. He did this thanks to a number of instruments including reassigning to solvable funds sovereign debt that had in today’s terms become junk bonds and even providing collateral himself for sovereign borrowing.
So, restore trust, fix the financial system, stimulate growth. Three and a half centuries later, you can read a similar argument in a paper by Adrian Blundell-Wignall, Special Advisor to the OECD Secretary-General on Financial Markets. In Solving the Financial and Sovereign Debt Crisis in Europe, Blundell-Wignall looks at why the crisis is worse in Europe than elsewhere and what can be done.
Monetary union means that euro members can’t devalue their currencies to help exports, and pressures on international competitiveness are transmitted directly to the labour market, leading to increased unemployment. Some governments responded by allowing their deficits to grow, and debt with it. Moreover, monetary union has resulted in high levels of debt in the household and corporate sectors in many of the countries that are in the worst competitive positions, leaving little hope that savings can be spent to stimulate growth.
The crisis and recession have increased indebtedness, contributing to underlying financial instability. One of the main reasons the situation is worse in Europe is the nature of its banking system. European banks mix traditional business such as loans to firms and households with activities in capital markets. Countries with large capital markets banks are heavily exposed to the sovereign debt of larger EU countries like Spain and Italy. Traditionally, holding this dull but dependable debt was a safe form of collateral for other activities, but the sharp price fluctuations that are now typical of sovereign debt trading affects the true value of this collateral and the price that shares in this debt could be sold for at any given time.
Deregulation and innovation in financial markets are to blame too. Apart from capital market banking, “re-hypothecation” has grown massively – the practice of reusing the same collateral repeatedly. This increases risk, given that the value of this collateral can drop suddenly, plus the fact that the banks are doing deals for themselves using collateral originally pledged by clients. As the number of deals using the same collateral multiplies, so does counterparty risk, the risk that one of the parties involved can’t meet their obligations.
Blundell-Wignall argues that underpricing of risk is the core cause of the financial crisis and that excessive risk in banking can always be traced to two basic causes: too much leverage, and for a given leverage, increased dealing in high risk products. Far from acting to contain the risk of the proliferation of these products, such as derivatives, regulators cleared the way for them, for example by removing barriers to mixing different types of banking business such as those in the Glass-Steagall Act in the US.
At one time, derivatives were used for practical day-to-day business operations, such as an airline hedging against a big rise in fuel prices, but they rose from 2.5 times world GDP in 1998 (already a staggering figure) to 12 times world GDP before the crisis.
Derivatives trading needs collateral and the price shifts we mentioned above can result in calls for collateral the banks can’t meet. This provokes a liquidity crisis, and the banks don’t have time to recapitalise through earnings, so they stop lending to businesses, especially small and medium-sized enterprises, adding a further twist to the downwards economic spiral.
It’s easy to feel helpless in the face of such arcane and seemingly uncontrollable forces, but solutions exist. Fracturing the eurozone would be one, but while this may lead to a short-term improvement for certain countries, it would weaken the status of the euro as a global currency, increase pressure on countries that stayed in the euro, and create legal uncertainty about financial contracts in euros.
A more coherent approach would include solving the Greek crisis via a 50% or bigger “haircut” on its sovereign debt (reduction in its stated value) and granting the European Financial Stability Facility a bank license. The European Central Bank should continue to support economic growth and investor confidence via funding for banks and putting a lid on sovereign bond rates in key countries. Private banking should be reformed too, with investment banking separated from traditional retail and commercial banking.
That said, sending musketeers to arrest the financiers would appeal to many people.
Ineffective, Inconsistent and Dangerous: The OECD-backed fiscal consolidation plans to deal with the looming sovereign debt crisis
Today’s post is contributed by Pierre Habbard of the Trade Union Advisory Committee to the OECD (TUAC)
In 2010 in the wake of the recession, the policy consensus at the OECD – alongside the IMF, the European Commission and many G20 Finance Ministries – shifted away from support for stimulating global demand to near-term fiscal consolidation. Their priority became reducing sovereign debt through unprecedented budget austerity programmes, the costs of which will be borne almost entirely by workers and their families: cuts in public services and in social protection, regressive tax reforms, and downward wage flexibility. At the same time, the much needed re-regulation and downsizing of the financial sector, which triggered the crisis in the first place, was either scaled back or postponed until “better days”.
This policy response is ineffective, inconsistent, and ultimately dangerous.
It is ineffective because the fiscal consolidation programmes that are advocated ignore the causes of the crisis: the combination of rising inequality, excessive leveraging and de-regulation of the financial sector. To bring government debt back to pre-crisis levels, public budgets should contract by -9.5% on average in the near future, and remain in surplus afterwards.
Considering the enormity of the social crisis spreading across OECD economies, the cuts in public services and in social protection that are foreseen, as well as, concomitantly, the regressive tax reforms which the OECD is pushing for will hit households and the lower income people front on. The OECD concedes that the massive public expenditure cuts it is advocating “may have adverse consequences for equity outcomes” – but its response to this concern appears thin, to say the least, and this, in spite of its recent work in that field.
It is suggested that social protection and unemployment benefits be “revisited in terms of their effectiveness in reaching envisaged policy goals”. The OECD lives with the hope that while the inputs will effectively be cut down, the output levels (including quality of public services) could be maintained thanks to “efficiency gains”, better “targeted” services and restructuring: “doing more with less”, we are told. Trade union experience with public sector restructuring would rather point to the opposite effect: “doing much less with less”. Any restructuring involves substantial upfront costs. Importantly, the notion that social protection could be better targeted in times of social crisis appears rather illusory with unemployment at 10% and under-employment at 20%, rising poverty and social deprivation.
It is inconsistent because, as OECD experts are well aware, the most effective way to deal with the unsustainable rise in sovereign debt is to put an end to the unhealthy relationship between private sector finance and government balance sheets. If public budgets have become more vulnerable following the crisis, it certainly is not due to any badly managed or inefficient public services or social protection, or badly designed tax systems; rather, the fault lies with the unwillingness of policymakers to take decisive action on banking and broader financial regulation, which leads to growing exposure of governments to any future financial crises.
The key threat to sovereign debt sustainability in the short term lies not in fiscal policy, but in government exposure to contingent liabilities created by multiple guarantees on banks’ liabilities as a result of the crisis and by financial institutions that are too big to fail. The on-going debate on the possibility of a ‘hair cut’ or debt restructuring for the most crisis-hit countries exemplifies that dilemma. Governments must put an end to this intertwining without delay. The OECD experts know that and have been calling, as at least implicitly, for splitting the large banks to shield commercial and retail activities – that serve the real economy – from the volatile investment banking activities.
On revenue side, the obvious “under-taxation” of the financial sector barely appears in the main recommendations by the OECD. The generalisation of Financial Stability Contribution (FSC) type insurance mechanisms together with the creation of a Financial Transaction Tax and the IMF suggested Financial Activity Tax would help redress the current under-taxation of the financial sector. Here the OECD is lagging behind. On that it is no small irony to compare the OECD’s insistence on broadening VAT with its total silence on the massive VAT exemptions which benefit the financial sector across OECD countries. Together with the current G20–Financial Stability Board “action plan” (Basel III, consolidation of the supervisory framework, regulation of the derivatives markets), these measures could help reduce governments exposure to the private banking sector. But the needed speed of reform simply is not there.
And it is dangerous because the fiscal consolidation packages currently being introduced threaten to have long-lasting consequences in terms of income and welfare distribution. Trade unions are well placed to know through their membership that social cohesion is breaking down across OECD societies; they are first-hand witnesses of rising populism within the working class. The political dimension of the crisis, the need to bring back some redistributive justice in the economy, is not factored in the OECD–IMF response. To the contrary, their response fuels the risk of weakening democratic institutions if key elements of fiscal policy are transferred away from democratically elected bodies through the constitutionalisation of fiscal rules and the empowerment of “independent” experts in the fiscal consolidation process.
TUAC Discussion paper The International Policy Response to the Post-Crisis Rise in Sovereign Debt – A trade union critique, April 2010
Hints of cautious optimism in the latest OECD assessment of the state of the global economy. The organisation expects economic activity in OECD countries to gradually pick up over the coming two years. However, the pace of recovery won’t be the same everywhere, and unemployment will remain high.
Overall, GDP in OECD countries is projected to rise by 2.3% next year and 2.8% in 2012. With an expansion of 2.2% in 2011, growth is forecast to be faster in the United States than in either the Euro area or Japan, which are both tipped for growth of 1.7%. Looking a little further ahead, the US expansion is forecast to rise to 3.1% in 2012, against 2% in the Euro area and 1.3% in Japan.
Despite the relatively upbeat message, the OECD is still strongly concerned about a number of factors that threaten the recovery. Among the most significant are a widening in global imbalances, which helped fuel the crisis in the first place. These could be exacerbated by uneven growth in the OECD area, as well as between the OECD and emerging economies, which are expected to perform even more strongly than the developed OECD countries.
Other potential problems include the possibility of further falls in house prices, especially in the US and the UK, high sovereign debt in some countries and possible abrupt reversals in government bond yields.
Click here for lots more coverage of the latest OECD Economic Outlook, including a webcast of the launch (starting 10am GMT, Thursday 18 November).
OK, wurfing (surfing the web at work) didn’t make it into the new edition of the Oxford Dictionary of English published today, but toxic debt and quantitative easing did.
Speaking of which, haircut was already there. Eh? Haircut, you know: “US informal: a reduction in the stated value of an asset”.
That’s one of the terms you need to understand to follow the argument in a new OECD Working Paper on the stress tests 84 European banks passed so brilliantly in July.
Adrian Blundell-Wignall, Special Adviser to the OECD Secretary-General on financial markets, and his colleague Patrick Slovik point out that the tests only considered “trading book” exposures to sovereign debt, while over 80% of exposure is on the “banking book”.
The trading book consists of the securities a bank buys and sells regularly, even daily, while the banking book contains the products the bank would normally hold on to until they matured, including the bonds used to finance sovereign debt.
For the trading book, the haircut is around €26 bn in the stress tests. No haircut was applied to the banking book, on the grounds a default would be virtually impossible over the two-year period considered. The tests also assumed there would be no bank failures.
Blundell-Wignall and Slovik argue that these two assumptions help to explain why despite the encouraging test results (only 7 banks failed) equity markets are still performing poorly, bond spreads remain high, and banks are still reluctant to lend.
If a bank fails, it cannot hold on to the longer-term assets on its banking book, which would have to be sold for whatever they are worth on the day, even at a loss, and in fact there would be no difference between the trading and banking books. In other words, shifts in the market value of sovereign debt do matter, unless you assume that the stress-tested banks never fail.
That’s a brave, or foolish, assumption in light of what we’ve seen since the crisis broke, but the assumption of no sovereign default over the next two years seems reasonable, given the €720 bn European Financial Stability Facility (EFSF) agreed earlier this year.
The EFSF could more than cover all the funding needs of the most exposed countries, even in the highly unlikely case that no securities could be sold on the open market.
So why are ratings agencies like Moody’s worried about the sovereign debt of even the US, Germany, France and the UK, countries they consider “well-positioned at AAA” in their latest figures?
They’re not worried about the next couple of years, but many analysts foresee problems in reforming labour and pension markets to ensure sustainable growth before the stimulus packages run out. In the medium-term, budget restraints will make these reforms more difficult.
In the longer term, Moody’s is afraid of a situation where states delay pension reform for political reasons, leading to a downward spiral as they try to borrow more to finance deficits, while at the same time, conflict between younger and older generations destroys the social cohesion needed to stabilise debt.
Countries in this situation would lose their triple-A rating.
This OECD paper warns that retirement income may become a “lottery” unless default strategies are carefully designed
The OECD Economic Outlook, released on Wednesday morning at the OECD Forum in Paris, projects economic growth for 2010 in the OECD zone of 2.7%. That’s in strong contrast to last year’s contraction of 0.6%.
But there’s substantial variation between regions in the pace of recovery. The United States is projected to see growth of 3.0% in 2010, or double the 1.5% expansion seen for Europe. Japan’s growth rate is projected at 2.7%.
Despite the recovery, unemployment remains high: Over the past two years, about 16 million people joined the ranks of the unemployed in OECD countries. However, the OECD suggests the unemployment rate may now have peaked at just over 8½%.
The OECD sees the economic outlook as “ moderately encouraging”, but, it warns, it could be jeopardized by “significant risks”. Among these are the danger of a sharp downturn in emerging economies like China and India, which are currently helping to drive the global rebound. The OECD is concerned about the potential for overheating in emerging economies, and warns that “a boom-bust scenario cannot be ruled out”.
The OECD is also concerned about the situation in Europe, notably the debt problems of a number of countries in the euro zone. Action taken by European governments and the European Central Bank have gone some way to calming market jitters, but, the OECD warns, “the region’s underlying weaknesses are far from settled”.
Find links to further coverage of the Economic Outlook