Reform not Regulation

I begin to like our stodgy central bank chief, Mervyn King:

reform of banking is essential

Not just regulation mind, Mr King wants banking to be reformed.
Battle lines are being drawn up between those who want to reform financial regulation and those who want to reform finance. Mervyn has chosen to be on the right side.

The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.

As the press is reporting he supports splitting the utility side of banking from their speculative activities. He is right; anyone who wants to take deposits from the public shouldn't be allowed in the casino. Or as he puts it:

Anyone who proposed giving government guarantees to retail depositors and other creditors, and then suggested that such funding could be used to finance highly risky and speculative activities, would be thought rather unworldly. But that is where we now are.

Splitting utility from casino banks is not his only idea. He wants new tools to:

(a) moderate the growth of the financial sector and
(b) lean against the macroeconomic effects of the credit cycle

This is more than I could have hoped for. The finance sector is too big and finance should lend less in the boom and more in the bad times. Mervyn drops hints that he could be even more radical:

It is hard to see how the existence of institutions that are “too important to fail” is consistent with their being in the private sector.

But he doesn't say what sector they should be in.

It is important that banks in receipt of public support are not encouraged to try to earn their way out of that support by resuming the very activities that got them into trouble in the first place.

Ouch! Who could be encouraging such recklessness?
King for chancellor?

BBC Churnalism

Churnalism (n) - the practice of turning a press release into published copy without ever going through the journalist's brain.

Here is another example from the BBC: Pound hit by falling UK inflation. The BBC tries to link the fall in inflation with the fall in sterling, as if the first has caused the second.

"This is bad news for the pound," Duncan Higgins, senior analyst at Caxton FX, is quoted as saying. "The CPI figures will weigh heavily on the UK currency and will continue to discourage investment."

Anyone who has ever opened an economics textbook knows that low inflation, relative to inflation elsewhere, tends to push up the currency.

It works like this. Imagine there are just two currencies, pounds used in Britain and FX used in RoW. If inflation is 1% in Britain and 3% in RoW then 100 pounds will be worth 99 pounds next year while 100FX will be worth 97FX (roughly). So 1 pound will be worth more FX next year than now. The pound should rise.

By the way, the falling pound is good news not bad in the current circumstances. It is adding to demand and will help to reduce the current account deficit.

Is the UK the Free Rider?

Britain was the first European country to move on fiscal stimulus. As other countries fell into line there was a fear that Germany might take the benefit of the boost to demand in other European countries while spending little of its own money on boosting demand in Germany. In time Ms Merkel came through and Germany has been pulling its weight.

Now Britain is going to be the first to withdraw the stimulus. From January the VAT rate will return to its old level and government spending will come under pressure. Of course the "automatic" stimulus of more benefit payments and lower tax take will still be there, and the government deficit will be as huge as anywhere in Europe. Which is the reason why the chancellor is reluctant to let the stimulus continue.

When Britain moved aggressively with monetary and fiscal stimulus the pound fell against the euro, potentially boosting demand from net exports. At the time I thought that this was fair as it gave the British economy some compensation for the demand which would leak to countries not making the same efforts to counteract the recession.

Now however, Britain is beginning to look like the free rider, and the low pound could be seen as a beggar-my-neighbour policy. (I remember Paul Krugmann using that expression when he visited Britain earlier this year.) I doubt that the pound will rise much. Monetary easing is continuing and interest rates are lower in the UK than Euroland.

Are we now going to gamble on other countries' fiscal expansion to get us out of recession?

Debt or Depression

The Tories seem to think that debt is worse than depression. Here is one more reason why they are wrong.

Government debt is manageable in a growing economy. Get the economy moving and a little bit of growth and a little bit of inflation will deal with the debt. Even with inflation kept to its 2% target, growth at the UK average of 2.5% is enough .

In thinking about government debt and deficits, I find this little equation helpful:
d=yD
where d is the government deficit (as % of GDP), D is government debt as (% of GDP) and y is the nominal growth rate.

This is the equilibrium debt-deficit equation. If the government consistently ran a deficit of d% then its debt would converge to D%, given a growth rate of y%.

What does this mean for the UK today? Let's take 4.5% as the nominal growth rate (ie growth rate before inflation is stripped out):
d=4.5%xD

This year the deficit is 13% of GDP. If it stayed at that level then debt would stabilise at 289% of GDP. If we felt comfortable with debt almost 3 times national income then a 13% deficit would be sustainable. We don't feel comfortable and the people lending the money wouldn't either.

If debt of 80% feels better then, government needs to bring the deficit to d= 4.5% x 80% = 3.6%.

The good news is that to stabilise debt, government doesn't need to run a surplus. It doesn't even need to balance the budget; it only has to hold the deficit to 3.6% for a (longish) period of time. (Compare that with the Maastricht Treaty rule that deficits should be below 3%).

If we want to get back to the old debt rule of 40% GDP, then the deficit needs to fall to 1.8% and the magic of a little bit of growth and a little bit of inflation will do the rest. (In practice the government would not keep the deficit constant; it should make the deficit smaller when growth is good and larger when growth is low.)

So far I have taken y= 4.5%. (You could work on 5% to make the calculations easier, but 4.5% is consistent with 2% inflation and 2.5% real growth.) What happens if nominal growth is say -1%? That could happen with low growth and deflation, the Japanese scenario.
d= -1%xD
Say the debt is at 70%:
d= -1% x 70% = -0.7%

So the government would need to run a surplus of 0.7% of GDP just to avoid adding to the debt ratio.

Even with slightly positive growth, say 0.5%, the figures are bad. To bring the debt level down from 70% , the Tories would need to cut the deficit below d= 0.5% x 70% = 0.35% of GDP, almost a balanced buget.

The conclusion is obvious: fix the economy first and then a little bit of growth and a little bit of inflation will make fixing the debt a whole lot easier.

No Time for Cuts Part 2

From the New Statesman via Mil.

David Blanchflower says:

The time for cutting public spending is not now, not next year and not the year after.

Two years ago the Bank of England was raising interest rates out of fear that rising oil and food prices would spark demands for higher wages leading to persistent inflation. I thought they were wrong, the US was already in recession and we were at risk. I discovered that there was a lone voice on the monetary policy committee arguing against rate rises, David Blanchflower. He was proved right.

I think he is right again.

Could it be that the fight against early cuts in spending is gaining momentum?