Quantitative easing in a monetary union - not as easy as it sounds

The Eurozone is heading gradually off on a path that might require the authorities to consider a large scale QE policy.

If government debt becomes too large to manage, then one way out of the pickle is to create lots of inflation that will erode the stock of debt over time. It is smoke an mirrors or course, as it does not create any wealth, but simply creates a transfer from bond holders to governments. The losers tend to be pensioners, since they are the bond holders in society in the main and receivers of fixed income directly or indirectly from long term government bonds. But that is a distributional issue tangential to the purpose of this post.

This post is to ask a more practical technical queston. How exactly would QE work in the Eurozone? Normally, say in the US or UK, the Central Bank would buy government debt for new money. This increases the amount of money in circulation, which if enough, will create more than enough liquidity which will then, in effect, be given away by banks who in the end won't be able to find any counterparties to deposit it with - because all the banks will have more liquidity than they want or need.

More money in the economy per unit of output produced will mean the ratio of Euros to output (GDP) will increase. The value of money will erode, which is inflation. In a previous post I have described how inflation then leads to a reduced burden on those in debt who have borrowed over a long term. Basically this means governments.

Now what is interesting here from a Eurozone perspective is that there are usually two distinct things going on here. There is the liquidity and eventual inflation that the QE produces. However, just as importantly, the act of buying government bonds for money retires some government debt. The Central Bank is owned by the government, so those bonds purchased can effectively be written off. In other words, what has happened is that the government, via the Central Bank, has called in its bonds and swapped them for an extremely cheap form of liability, or debt, that it will never have to repay - money; Dollars, Pounds etc. which are merely another form of government liability (although sitting on the balance sheet of the central bank).

Do you start to see the question here?

In the US the Fed would buy Federal bonds. These are debts owned by all Americans. They can be retired (swapped) for fresh dollars in the manner I described. The US government debt is both reduced and deflated.

However, what of the Eurozone? Whose government bonds will be purchased? And after that, can we employ the same logic and retire those debts, letting some countries off the hook?

The answer to the first question is that we can and probably would buy the debt of those countries that are prospectively insolvent , that have too much debt. Step forward Ireland. The answer to the second question is that we can, but with the full realisation that the rest of Europe would be bailing our Ireland, Portugal, Greece, etc. by swapping the debt incurred by those nations for liabilities (Euros) owned by all of Europe. The inflation that would ensue would adversely effect all the normal losers in this process (those pensioners in particular that I mentioned), but those losers in Ireland will have benefitted by the reduction in Irish debt that will allow.

Who will like this solution?

• The Irish, Greek, Portuguese, Spanish governments
• Irish, Greek, etc. state and civil service pensioners
• Irish, Greek, etc. taxpayers

Who will not like this solution?

• German pensioners
• German taxpayers

Those who might or might not like this solution?

• Irish, Greek etc. private pensioners (they will have their pensions eroded by inflation, but governments will be better able to afford to maintain higher level of public services - especially health)

It sure makes QE in Europe one hell of a political minefield, something I have not yet seen mentioned in the media.


Just as an aside. Where might a QE program start? Where better than a purchase of the €80bn plus in Irish government debt held by the ECB in Repo. agreements?

Fun with numbers - today's fun fact

Want a fun number fact?



64%






The current amount of "Repo" lending to Irish credit instutions as a percentage of our annual GNP. For those who don't understand jargon, that is probably a bit like going down to the pawn shop to borrow over half your annual income in order to buy this week's groceries down at Dunnes.



Stay tuned for another fun number fact tomorrow.

The Frankfurt dilemna - Ireland, hold on to your hat

So you think Ireland has some significant economic difficulties? Trying to manage our way off an explosive debt and deficit path for both the public sector specifically and the entire country generally is a painful adjustment.

Well, don't look now because things might get worse in the not too distant future. The reason is because short term interest rates might be on the way up before too long if recent trends continue, which if it comes to pass will make our adjustment even more painful and more difficult because the interest charge on the country's massive debt stock will rise too. Note that most of Ireland's total debt is subject to a variable, or short-term interest rate largely due to the concentration in variable rate mortgages of some description or another.

But why would interest rates increase? Surely it doesn't make sense. Well, tell that to those humourless suits at the Bundesbank who watch monetary aggregates like hawks. Those influential central bankers know that money supply figures have passed a clear turning point that means we should be ready to tighten monetary policy from its current sluice gates open mode.

Exhibit #1 - Monetary aggregates















M1 is narrow money, mostly notes and coins in circulation. M3 represents wider demand and interest bearing deposits in banks. Note what has happened to both in recent years. Before the full onset of the Global Financial Crisis (GFC) M3 was rising at a generous pace. People were borrowing from banks, that borrowing circulated back via economic transactions into deposits in banks. The Lehman Bros happened, at the point indicated in the chart. Initially it led to people putting wealth into cash (so M1 increased with an immediate spike) and then the ECB began cutting interest rates, promoting further growth in narrow money. M3 virtually stalled, as people didn't want to leave wealth on deposit with banks and the borrowing and deposit (known as money creation) cycle collapsed.

So this state of affairs continued. Until earlier this year. While M1 is still rising as monetary policy remains lax and interest rates remain low, M3 has started rising. The money creation process appears to have been rekindled. That is good news, because a continued downward money supply (M3) spiral would be a harbinger of deflation. However, it is also ominous in the sense that it indicates that the type of emergency low interest rates and lax monetary policy (including generous ECB repo lending and open market operations - e.g. Irish government bond purchase) may not be deemed appropriate any longer. That means higher ECB reference rates (the Refi. rate), which in turn will push up interbank rates and hence lead to higher retail rates, especially (say it softly) tracker and variable mortgage interest rates in Ireland.

Exhibit #2 - Euro monetary aggregates recent rates of growth
















This chart shows the most recent rates of growth, annualised rolling quarterly growth rates. M3 is now growing for the first time in over a year and not much below 5%, which would be within a range considered to be consistent with the long term inflation target of the ECB - 2%.

Exhibit #3 - Euro monetary aggregates annual growth rates















Even the annual (year on year) rate of change of M3 has turn positive, while M1 is growing at rates that would only be acceptable for short periods of time.

Ireland had better watch out, because nobody seems to be talking about this big smelly elephant at the moment.

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.

Where now central banks

Funny how we often see commonalities across disciplines. A famously clever man once said about the field of physics:

"There is nothing new to be discovered in physics now, All that remains is more and more precise measurement."

Lord Kelvin

Similar sentiment was probably held with regards to monetary economics until very recently. We just seemed to know it all, more or less, and the fruits of that understanding appeared to be ripening on the vine with low and stable inflation and interest rates.

Prior to the recent difficulties economists were probably guilty of complacency. Central banks seemed to have found their ideal role as independent guardians of price stability, with sole discretion over the use of monetary policy. That is entirely understandable. It was and still is believed that (1) "money is neutral", that is it has no long term influence on real incomes and that (2) inflation creates net costs and (3) inflation is purely a monetary phenomenon. Those three beliefs led to the 1990s craze for independent central banks tasked with meeting specific inflation targets.

An associated development was the division of roles, traditionally both held by a single central bank, where responsibility for regulation of the financial system went to a new and separate organisation.

And things appeared to be moving swimmingly. Monetary policy from Britain to Australia, via the US and Euroland was tweaked up and down by the various independent price guardians as demands appeared to dictate. Inflation was subdued and relatively stable everywhere that this was practiced. Sure, there was debate about rapidly rising asset prices (asset price inflation) and the need for monetary policy to consider this in an inflation targeting remit. But that argument didn't gain traction and was really at the periphery while goods and services inflation remained low and apparently under control.

The rest of course is history as the financial world neared complete implosion and we entered into a deleveraging process that might lead to anemic growth in a number of countries for a few years yet. So what will come out of this in the form of debate and possible reform of regulation and monetary structures and policy approaches? Here is a a few things that I think will come to the fore:

• Rethink on the separation of financial regulation and monetary policy roles. Many now better understand the potential for the two to be closely intertwined. A purist might say that things worked as they should; the world levered itself up on debt and tried to inflate itself via excess demand for goods and services (as well as assets), but central banks held tight on the money lever and inflation never took hold and eventually led to the end of the party before inflation could take hold. However, a more circumspect view might be that given the deflation that has now occurred in many countries policy wasn't optimal - was there a way to understand that non-monetary developments were a threat to price stability (i.e. a potential for a collapse and deflation) and that the regulatory environment might have had some role to play in mitigation? That is the debate to be had. Should financial regulation and monetary policy be closely considered in such a way that only a single organisation should be tasked with overseeing both in a coordinated fashion?
• Appropriateness of monetary targets. Up until today, despite some differing views, it is accepted in the mainstream that monetary policy should be used as an instrument to meet an inflation target defined as goods and services price inflation. Some have questioned in the past whether asset price inflation should have some weight in monetary policy decisions directly (as opposed to indirectly), but that argument has not held sway. Maybe that question needs to be opened afresh and rethought.
• International interdependence. With a floating exchange rate and an independent monetary authority (central bank) it is thought that an economy is insulated from monetary shocks from abroad. It doesn't matter if Ben Bernanke goes off on a bender and inflates the US economy because other countries can follow their own inflation targets and allow nominal exchange rates to adjust for changing relative prices. This adjustment occurs through money and foreign exchange markets. But have we seen, via highly integrated and increasingly large asset markets and importantly increasingly large balance sheets on financial intermediaries that straddle national regulatory boundaries, a potential short circuit to that independence? It is something that is worth understanding better.

It will be worth watching, but monetary economics should be one area of research that returns to focus over the immediate future, after suffering recently from being "pretty much solved".

NAMA. "It's about getting liquidity flowing"

I was in Cork yesterday attending the Chamber of Commerce conference there. One phrase that was oft repeated was that we needed to "get the liquidity flowing from banks again". That doesn't really make a lot of sense from an economics point of view. Liquidity in the strict sense of the banking system related to the workings of the money market; being that market for short-term lending (under 30 days by general convention). This is dominated by banks that use it balance their immediate needs for funds - say to fund withdrawals of deposits.

But I think what everyone meant was that they didn't think that banks were lending large enough sum to enough companies - my general impression was that this included any company that wanted/needed it.

A couple of observations on that line of thinking that seems to be too prevalent and, in my opinion, likely to meet a sudden stop against the cold hard facade of reality.

Firstly and briefly, should banks be lending? No. Banks should be managing risk. If a loan, line of credit or overdraft does not make commercial sense from a risk and expected return basis, it should not lend.

Secondly, what is likely to happen when the Irish banks wend their way to the ECB and exchange their NAMA bonds for some freshly minted Euros? As some commentators have already indicated, the likely outcome is that they will pay down some of their liabilities. They will shrink their balance sheets.

Why would they do this? Simple. Because their balance sheets are too large. Don't tell me you have forgotten already how we came to be in this mess? Let me remind you. We (the collective people of Ireland) borrowed until we had put into hock virtually all our future income earning potential. And then we borrowed some more. That, dear readers was the expansion of the balance sheets of Irish banks.

And flowing directly from that, we have our present economic obstacle. Too much debt - synonymously bank balance sheet are too large.

And flowing from that is the unavoidable economic correction that needs to take place. A contraction in the balance sheets of Irish banks.

The following things will cause this to happen:

• Writing off bad debt/defaulting on some liabilities starting from the top and moving down the capital structure (e.g. shareholders' equity, unsecured bond holders etc.).
• Use any excess liquid assets (thank you NAMA/ECB) to retire short-term laibilities

The following things would not allow this to happen:

• Increased growth in lending

And are you curious about how big the balance sheets of Irish financial institutions became of recent years? Here is a handy comparison. The UK is considered one of the more leveraged countries in the world. Total assets held against residents (i.e. outstanding lending to UK residents) reached 1.9 times annual GNP at the end of 2008. The equivalent for Ireland was around 2.5 times annual GNP. For the US the ratio is about 0.6.

People really need to be told. There is too much debt, which means banks will be taking every opportunity to shrink their balance sheets. That means no free money.

The "demise of the Dollar" - what it's really about

I posted yesterday about this buzz doing the rounds. I didn't know at the time, but it was Chinese whispers (pun intended) started by Robert Fisk. Enough said.

But that doesn't mean that some of the facts reported could be correct and most probably are. Various oil exporting countries like Iran, Venezuela and developing economies such as Russia and China have almost certainly been thinking about the Dollar for some time. However, not for the reason and economic ramifications that the widespread reports all declare.

I dealt with the issue of the ramification of changing commodity pricing to a different numeraire. Here I will discuss what is the more likely reason behind the supposed deliberations about the role of the Dollar in international markets.

The background to this is exchange rate regimes. Every geographical region - not necessarily defined by sovereign national boundaries but usually so - has over time developed a currency to aid in the exchange of goods and services, the accounting of prices and values and as a way to store value. Those are the three primary function of money:

• a unit of account
• a medium of exchange
• a store of value

These work fine within the regions in which they operate, but hit a road block when one currency region wants to exchange goods or services with another. Hence we need some exchange rate that will price one currency relative to another. This can be set by decree against some durable globally traded item (fixed to gold for example), or against the currency of another region or a basket of such currencies (fixed against the US Dollar for example), or left for the market to price it freely (a "floating" exchange rate). Note that there are all sorts of varieties of fixed rates with names likes "pegs", "crawling pegs", "currency boards" and others, but they are variations of a theme only.

Some floaters include the Australian Dollar, Sterling, Euro, the US Dollar. Some fixed rates include China, Iran, Venezuela, Russia, Saudi Arabia. Are you starting to see the pattern here? Well spotted. Those countries named as the ones colluding to bring the demise of the Dollar are those that fix their exchange rates to the Dollar. And this is what this story is really about.

This story is about the fact that these countries have tied their local currencies to the US Dollar, which means that they have effectively set the price of everything they produce (their income and output) to the price price of everything produced in the US, set in US Dollar prices. So if the US goes through an inflationary bubble and the price of things in US Dollars goes up, pressure will build in the country for prices to do the same thing, bringing in the first instance pressure on output (excess demand) and then inflation. That might seem confusing, but the simple point is that with a fixed exchange rate you will import inflation (or deflation) from the currency to which you are tied.

So it is with some of these countries. China in particular has been struggling with prices in Reminbi that have become out of kilter with the US. That means lots of demand for Chinese goods to be exported to the US. Current account surplus for China, deficit for the US. This brings pressure on Chinese productive potential, the economy is at full capacity and creates shortages and pressure for an increase in the price of these Chinese goods.

What is going on in the background is that this flow of demand for Chinese goods and services is creating a big demand for Chinese Reminbi in exchange for US Dollars at the fixed exchange rate. The Chinese government has agreed to give a fixed amount of Reminbi for each US Dollar and people are flocking to them in droves.

The Chinese authorities have two options.

1. They keep selling the Reminbi to all comers at the fixed exchange rate. As they do this they accumulate more and more US Dollars, which they need to keep in the form of currency, deposits, bonds etc. This will mean there are more and more Remminbi out in the world looking for a home. That leads to Chinese prices rising - inflation. They try to sell some of the Reminbi for other currencies, but the Dollars are coming in thick and fast and it is a difficult task. Witness the recent Chinese spending spree around the world buying up all manner of foreign assets and interest. This is them trying to unload all these US Dollars. And more are coming in every day.
2. The alternative is they "revalue" the exchange rate. Each Reminbi will now cost more Dollars in exchange. This chokes off the flow as it has increased the price of Chinese output relative to US output. It also relieves the Chinese economy of the inflationary pressures it was under. They might alternatively just let the currency float and allow the market to push the exchange rate where it will, most likely up in the first instance.

And this is what this story is all about. China in particular, but increasingly many oil producing nations since oil oil prices increased from the lows experienced over the entire 1990s, are following track #1. It is unsustainable as a policy, so they are being forced to consider #2. But there is a political problem with this. Having the exchange rate where it is, undervalued, is not healthy; the Chinese economy for instance is eroding under the inflationary pressures being put upon it the excessive growth that is occurring forcing much investment and expenditure that it might likely regret in years to come (the over-hyped expansion of a small number of urban areas for example). However, the Chinese government (and people to be honest) get a nationalistic pride out of a booming economy that is buying up foreign assets. That is not a criticism of the Chinese people, it is a common human trait. Anyone living in Ireland over the last 10 years will recognise instantly the swelling chests that come with an inflationary boom at home and the ability to stride foreign property markets like kings.

It is a familiar choice. Sensible economic policy, or populist sentiment and beliefs. The latter usually wins in the short term until the proverbial inevitably hits the fan. These countries have been dialling up the speed setting on their fans for a few years now and the projectiles are being stockpiled.

So Robert Fisk might have simply stumbled on the latest discussions about this problem, or this might be a straw in the wind indicating that the time of inevitable revaluation (or even currency float) for these countries is on the way.

That is a big story and an investment opportunity if you can find some cheap way to access it. Go long these mainly developing and OPEC currencies that are under pressure to revalue and short the US Dollar (the second part not necessary if you are US based already).

US Fed buying up government bond issuance - old news

I have seen via the propertypin.com that there seems to be a little consternation building in the bloggernet about the US Federal Reserve buying up Treasuries (bonds) issued by the US Federal government. See the Dailykos for some sudden realisation.


Well, this is pretty old news. In fact not much news at all. This is what is known as "quantitative easing". Look, the Washingtion post was writing about this in March. I know my broadband is the fastest in the world, but I tend to get my news downloaded the week it is published.

And it is exactly what some of the fearful or outraged bloggers think it is. It is a monetisation of government debt, or printing of money, or whatever equivalent terms you wish to use to describe it. And the potential ramifications are indeed as suggested; much higher inflation, depreciation of US Dollar etc.


It is just that it isn't news. Look here, it is already in the data. Here is a chart of the money base, sometimes known as narrow or high powered money. In simplified terms, currency on issue. This shows the amount of new money being injected into both the UK and US economies as both the Fed and the Bank of England practice "quantitative easing".





What happens next is that "broad money", which includes deposits at banks, rises. Well, it does if the financial system is working properly. Of course it hasn't been, so it isn't just yet (plus there is always some lag). But Fed (and BoE) need to watch for when it does - it will do so because banks will start lending again and households and companies will start borrowing again. At that point interest rates will need to go up - and pretty quickly.