Wednesday, 29 September 2010

More quantitative easing for the UK?

Now here is an interesting news article in the Telegraph:

Bank of England's Adam Posen calls for more quantitative easing
The Bank of England should restart the printing presses and pump more money into the economy to prevent a "lost decade" of low growth and high unemployment, one of its senior policymakers Adam Posen has said.
So called "quantitative easing", or QE, accomplishes one thing and one thing only; it produces inflation. So how is that any use as a policy instrument to be used to "prevent a 'lost decade' of low growth and high unemployment"? Well, it does two major things:
  1. It deflates real wages, on the premise that real wages are flexible. A fair enough assumption at the moment given that unemployment is high generally there won't be too much resistance from or bargaining power with sellers of labour who might see the true value of their time fall.
  2. It deflates the stock of debt. Governments in particular borrow over long terms at fixed rates of interest. Inflation which is higher than expected at the time of issue will mean that the amount these governments will need to repay will be smaller in real terms (they will be paying back in the future using devalued money). In fact, if inflation is high enough they might end up paying back less than they borrowed.
Now think about that second point for a moment. Astute readers understand instantly that debt is a two sided coin. One person's debt is another person's asset. So, if higher than expected inflation means that borrowers might not have to pay back as much as they thought, or even as much as they borrowed, then the person who lent them the money is losing out by exactly the same amount. All we are witnessing is a transfer of wealth, not a creation of wealth or indeed a "destruction of debt" (which in fact is impossible for the reasons noted).

So what is the benefit? Is there any benefit? Well, I'm glad you asked, because the answer is yes/probably/sometimes.

Yes, in that for an economy facing the opposite case where inflation is unexpectedly negative and large (deflation) currently extended borrowers can easily find themselves in a debt death spiral. Instead of paying back less than they planned in case of higher than expected inflation, they might find themselves paying back much much more than they expected if prices fall over time. At the moment we certainly have over extended borrowers aplenty. An extremely widespread occurrence of such a debt death spiral (debt deflation) would indeed be a potential threat I for one would prefer to not test. Think of Greek, or Irish public finances for example. What if the debt stock which looks worryingly large and is increasing turned out to be a multiple of what we currently estimate it to be because every €100 that needs to be paid back in 20 or 30 years time turns out to be a massive €150 or €200 in today's money due to deflation? Can you imagine the crippling debt effect?

So inflation is probably a benefit in these circumstance, but not unequivocally so. Consider what happens if QE is successful. Debtors avoid the debt spiral and the €100 that, say, the Irish government needs to pay back lender in 20 years time turns out unexpectedly to be more like €50 or even €20 in today's money. Huzzah, the taxpayer is saved!!! Well, hold your horses there pilgrim. Who is on the receiving end of the now devalued €50 or €20. Look no further than yourself in retirement. Yep, pensions are funded predominantly by bond assets. The unexpected inflation has robbed you of the expected value of your savings in retirement. It isn't without reason that inflation is referred to as a tax on savers. In this case it is a tax, because the benefit mostly accrues via government accounts in reduced public debt repayment.

So that is the choice that we are looking at with Posen's policy suggestion. There is no outright economic gain here, but a potential aid to adjustment (reducing the price of labour), plus a potential redistribution of wealth, as noted from government bond holders to governments (and possibly from foreign holder of those bonds to your domestic government - which is a local benefit as a type of tax on foreign lenders) and from today's savers to today's debtors. If you fear the debt spiral scenario enough (and perhaps if many of your creditors are foreigners) it becomes a policy worth considering.

Tuesday, 28 September 2010

Implied default rates and compounding probabilities

I nice little primer on calculating implied default rates over at These are calculated under the assumption of no arbitrage, in that the expected value of the security with (implied or assumed) zero risk must be equal to or in excess of (under risk aversion) the expected value (probability weighted value) of the risky security.

The example there comes out for Ireland at about a 40% implied probability of default at some point over ten years. Sounds high, but think about this; a 40% probability of default in any of the next 10 years is equivalent to 5% probability of default in any single year.

Risk compounds just like interest rates.

Thursday, 23 September 2010

Irish politicians handy policy check list

I thought I would post a handy reference guide to some of the things I think will range from being simply useless to downright dangerous as the government and assorted politicians strive to save their skins and make people believe the fantasy that they "manage the economy" (of course "the economy" just is - they can only meddle with it for better or worse).

A starter list of things for politicians not to do (as the verbiage continues this might build):

  • boost consumer confidence
  • restore foreign confidence
  • just about anything to do with "confidence" basically
  • training schemes
  • job "creation" schemes
  • just about any hairbrained scheme where the objective is to "create" jobs
  • "knowledge economy" strategy
  • "innovation hub" strategy
  • "global education centre" strategy
  • just about any type of "strategy" - meaning in truth industrial policy

When does a recession become a depression?

About now in the case of Ireland I would reckon.

There is no formal description of what a "depression" is. Even the term "recession" is subjective and can vary in its definition.

I am using it to refer to a significant and persistant decline in real national income per capita. For Ireland, that means roughly looking at GNP (not GDP). And with the CSO release of national accounts data for the second quarter we find that Ireland has now moved into its third year of falling quarterly GNP:

It is also pretty meaningful, in that our real income (in aggregate) is 17% lower than immediately prior to the onset of this depression.

I would fully expect this to continue a bit longer yet. The economy is trying to deflate itself (i.e. Irish prices need to fall relative to other countries) and we have to repay a lot of debt owed to foreigners, which means no available capital to invest (it isn't the banks' fault) and a need to cut back on consumption to repay these foreigners.

These are pretty drawn out adjustments occurring. This is one drawn out depression we are in the midst of.

Friday, 17 September 2010

Thoughts on sovereign bonds #2

The yield to maturity on sovereign bonds has generally represented the "risk free rate" for financial markets. No other financial asset could provide for less risk that a fixed stream of cash flows emanating from the government of a sovereign country.

What is the risk free rate in the Eurozone now, say from an Irish perspective.

It can't be Irish government bonds. In the past the domestic sovereign bond issuer was seen as "risk free" because in the event of difficulty in making repayments the government could either levy higher taxes or print some more money. Not so any more on either count.

It can't be a market basket Eurozone bonds - generally weighted by amounts on issue. You could hold German government bonds alone at a lower yield, but presumably lower risk than a basket that includes Greek, Irish and Portuguese bonds for example.

Can it be German bonds? They are issued in the same currency. Within the Euro is Germany able to meet all potential fiscal demands on it via taxes or money supply? Probably not, as the German people clearly fear - Germans look obliged to help bail out the financial troubles of other and again, they no longer have their own currency to print. Outside the Euro, a different story might apply perhaps - a renewed German fiscal and monetary autonomy, which could allow it an increased capacity and backstops to repay any debt it occurs (and to accrue less debt int he first place). Unfortunately, new bond issues in Euro would be forsaken for NeuDeutschmark. The amount of German issued "risk free" Euro bonds would wain.

Is that it then? While the Euro remains in its status quo there is no traditional "risk free haven"? Is a German departure from the Euro the event that would bring a return of a proper risk free rate, but in doing so kill the Euro risk free rate off?

Sounds bizarre, but no different really to US, Australian or Canadian state or provincially issued debt. In those countries we see a Federal issuer with fiscal and monetary primacy fill the role of "risk free" lending. Should the Euro survive, do you doubt where the constitutional structure of the EU is headed?

Thoughts on sovereign bonds #1

Under pensions regulation derived from the European Commission, Irish pension schemes are restricted in the amount of financial interest they may hold in either the employing company or its wider group.

Is holding Irish government bonds now effectively a holding against the scheme sponsor for Irish banks? Let'e push that from the sublime to the ridiculous. Is holding German government bonds now the same as holding a financial interest in the parent of the sponsoring company of the pension scheme of an Irish Bank?

It's an interestnig philosophical question.