8 April, 2010

This is a piece written for a conference on Islamic finance to be held on 29th April in Edinburgh.

Dear patient readers of this blog…please find below my latest Huff Post post.

Some may wonder why I cheered when White House Chief of Staff Rahm Emanuel announced that the president plans to cut the deficit, because he “does not want to keep on adding to the debt.”

It’s no secret that conservative economists believe that the way to cut the deficit is to cut government spending. In other words, government must manage the federal budget in the same way that you manage your household budget.

But in truth, the president must do the opposite.

To strengthen the levees against the rising tide of debt and the “hurricane of unemployment,” the president must both spend down the debt with a bigger fiscal stimulus, and also get a grip on monetary policy — regulating lending and keeping interest rates low for all of us, not just the banks.

Third, the administration must manage government debt effectively and not leave it to the self-serving and private financial markets.

I am surprised at how often I have to explain why the fiscal stimulus is so important. But because fiscal conservatives just don’t get it, they must be reminded of the well documented evidence again and again.

Government spending, unlike private spending, will pay down the debt by generating income, including tax revenues, and by reducing welfare payments. For unlike private households, governments generate revenues when they spend or invest, particularly on projects at home.

When a household spends its savings on say, a new wind turbine, solar panels for the roof, or insulation, money drains away from the household bank account. The engineers, builders and laborers that construct the turbine don’t pay money back into the householder’s bank account — regrettably.

By contrast, when the federal government invests in jobs that can’t be exported to China, the engineers, builders and laborers employed pay taxes back into the government’s account. They then spend the balance of their incomes in shops and businesses, and these pay taxes too. Indeed the spending might stimulate a small business to invest and hire, adding even more taxpayers paying back into the government’s account.

It’s called the multiplier effect because guess what? It multiplies government revenues. The evidence shows that the increase in revenues outweighs the spending and thus helps cut government debt.

However, it’s not enough to spend away government debt. More must be done, (and this is where Paul Krugman and I part company).

If the president is really determined to not “keep on adding to the debt,” then he must tackle monetary as well as fiscal policy. As John Maynard Keynes repeatedly emphasized, monetary policy must always precede and underpin fiscal policy. They go together like a horse and carriage — you can’t have one without the other.

It is not enough to use public funds to bail out the economy, while at the same time allowing the private banking sector to arbitrarily raise interest rates for government, commercial and household borrowing.

It’s particularly not fair — indeed it’s downright immoral — that the private banking sector is reaping such rich pickings from low rates set by the Federal Reserve; from the struggling body that is the US economy, and from government borrowing.

For proof of the bankers’ rich pickings, study the chart below from the International Monetary Fund. It shows (in pink) the low rates of interest paid by banks to the Fed and other central banks, in contrast to the rates of interest (in green) that the banks then charge to companies, households and individuals.

Note how the rates for those of us active in the real economy are always higher than they are for bankers borrowing direct from the Fed and/or central banks.

Then note how much they diverge after 2008. Bank borrowing costs fall to nothing, while private borrowing costs soar. No wonder bank profits are ballooning.

(The chart is from the IMF’s October 2009 Global Financial Stability Report. The composite real private borrowing rate [RPBR] is a GDP-weighted average of the U.S., Japan, euro area, and U.K. RPBRs.)

The Treasury must get a grip on high rates of interest — rates bankrupting businesses and homeowners, causing foreclosures and unemployment to rise — all “adding to the government debt” by increasing welfare spending.

The administration (through the Treasury, the Fed and the banking system) must adopt policies to force down rates across the spectrum, for government and the private sector; for the commercial and household sector as well as banks; all loans, short-term and long-term, safe and risky.

To stop “adding to the debt” it is vital to keep interest rates very low — while ensuring that lending is ‘tight’ — i.e. well regulated. Today, in the midst of the crisis, money is tight, and it is expensive.

Above all the Treasury must get a grip on its own debt management — and not leave that to the private, self-interested finance markets.

Because after all, bankers have one great way of making capital gains: by “adding to the debt.”

Motley Fool blogger TMF Sinchiruna spotlights the Times interview, describing me as “once ridiculed, later vindicated…” TMF Sinchiruna goes on to say: “Peter Schiff, Jim Rogers, Niall Fergusson, Ann Pettifor … these are the voices that I believe investors need to hear. Turn off the tv and look deep into the events of last year and consider for yourselves whether anything more than a hail-mary reflationary maelstrom has been heaped upon the fire that started it all.”

Read the Motley Fool article >

Also just did an interview for You and Yours on Radio 4 which was broadcast Wednesday. You can listen to it here.

Phil Thornton’s Times interview with me on the economy today.

“The economy is no longer in freefall and, as a result, there’s an enormous amount of complacency from politicians, in particular, about what will happen next. I believe politicians have given away the opportunity to restructure the banks and reconfigure the system.”

Read the interview >

by Ann Pettifor, 8 March, 2009. There is much confusion about the meaning and impact of QE. This is an attempt to summarise what it means, what it does not mean, and how it can be effective in preventing insolvencies by lowering interest rates.

I am indebted to Graham Turner of GFC Economics for sharing his knowledge and experience of Japan’s use of QE with me. Graham spent time in Japan during the years of that country’s Credit Crunch which began in 1990, and is also knowledgeable about the 1930s when QE was adopted by policy-makers.  Japan adopted QE eleven years too late – in 2001, but has since then kept interest rates below 2%.

Graham notes that Ben Bernanke’s book “Essays on the Great Depression” ‘contains no reference to Quantitative Easing…there is astonishingly little analysis of the monetary policy response that secured recovery (in the 1930s) in any of Mr. Bernanke’s essays.’

First lets remind ourselves that a bond is like a loan. The issuer is the borrower, the bond holder is the lender.  So when I buy a bond from the Federal Reserve or BoE, the governors of these banks are issuing a bond (‘I promise to repay on this date…at this rate…’) and I am trusting their word with my money. Bonds, like loans, usually have a fixed term, or maturity. The interest rate on the bond is known as the ‘coupon’, and is what the issuer pays to the bond holders.

Rates on company or corporate bonds are important because they determine whether companies can afford to borrow to invest, to pay wages or to manage cash flow. They determine whether entrepreneurs can take risks – and invest, e.g. in green technology.  If they can’t do any of these things they declare bankruptcy, and lay off their employees.

Above all interest rates determine whether companies can afford to repay the huge debts dumped on them by lenders, so-called ‘private equity’ companies and other financial institutions during the inflation of the credit bubble.

Interest rates on government and corporate bonds can be lowered by QE – purchases of government bonds by central banks and the shifting of these bonds out of the market, and on to the balance sheets of central banks.

The first myth to dispel is that interest rates are currently low. Base rates may be low, but the rates that companies pay, as Warren Buffett has argued is at ‘record levels’.  He tells shareholders that “highly-rated companies, such as Berkshire, are experiencing borrowing costs that, in relation to Treasury rates, are at record levels.  Though Berkshire’s credit is pristine – one of only seven AAA corporations in the country – (its) cost of borrowing is now far higher than competitors with shaky balance sheets but government backing.”

Graham Turner shows that ‘average yields on loans for non-investment grade companies in the UK rose to 31.66% on the 4th March, 2009.’ These are bankrupting rates.

The second myth to dispel is that QE is about ‘printing money’. QE is not about directly using liquidity  injections to boost the supply of money. As we have learned to our cost, plenty of liquidity has been injected into banks, but this has not slowed the pace of bankruptcies. As Turner notes: ‘money supply (M) is entirely endogenous, and depends on the structure of borrowing costs being secured through bond purchases. ‘  It will be vital for the Bank of England to set a long term interest rate target, and to use the purchase of government gilts to reach that long-term, and low target.

QE is about preventing debtors from defaulting. This is done by the Central Banks targeting lower rates of interest e.g. for 30-year bonds (or loans), and achieving this by purchasing government bonds and taking them on to their balance sheets, (It can be used to purchase corporate bonds, but is more effective in bringing down all rates, if used to purchase government bonds.)

These purchases are known as ‘open market purchases’.  By purchasing government bonds,  central banks increase the price of the bonds, but damp down the yields, or rates of interest, on these bonds. It is particularly important that rates on e.g. 20-year bonds should be driven down low.

Within a month of the Federal Reserve starting large scale open market purchases of government bonds in April, 1932,  corporate bond yields had started to fall decisively.

By buying up government bonds, the Federal Reserve or the Bank of England will increase the price of government bonds, and lower the yield – effectively the interest rate on these bonds. By lowering the rate on government bonds, central banks will help suppress rates across the board.

By lowering rates, they will begin to help companies, and stop the spread of insolvencies – the economic ‘virus’ at the heart of the crisis.

Two additional points: QE has to be applied early on in the crisis. If insolvencies are allowed to spread and engulf the whole economy, there comes a point when QE just cannot help. Second, in a highly synchronised, global economy, it is vital that central banks co-ordinate and co-operate to apply QE across the board. If applied in just one or two economies, the measure will not work. If it is not applied in the United States soon, then US insolvencies will cause unemployment to spiral higher, and will exacerbate global economic failure.

So the stakes are high, and the timing of QE measures vital.

7th December, 2008

On friday 5th December the Financial Times finally acknowledged that ‘real borrowing costs remain high‘. For those readers that may have missed it let me recap: UK interest rates are now at 2%. The three-month Libor rate (the London inter-bank offer rate – fixed by a committee of the British Bankers Association) has come down from 6% to just under 4%.  Mortgage rates for new borrowing are just under 6%. The cost of borrowing for companies (loans and overdrafts) is at 7%. The yield on UK corporate bonds (BBB) are just under 12%.  Lets hear no more about low rates of interest.

Real borrowing costs remain high

By Chris Giles, Economics Editor, Financial Times

(continued from previous page)

Cuts in interest rates are designed to boost demand in the economy in three ways. First, they should encourage people to save less and spend more; second, they should boost the incomes of borrowers, who tend to be shorter on cash than savers; and third, they should damp the exchange rate, boosting Britain’s trade performance.

But with demand in other countries as weak as in the UK, net exports are unlikely to increase quickly, in spite of sterling’s 20 per cent fall on a trade-weighted basis over the past year. Nevertheless, the Bank on Thursday stressed in its statement that it was pleased with the pound’s decline. “The further depreciation in sterling should moderate the impact of weaker global growth on the UK,” it said.

The main problem, however, is that the changes in official interest rates – both when they were rising in 2006 and 2007 and now that they are falling – have barely been passed on to most households and companies. An aversion to lending to anyone in the private sector has left short-term government paper as the only asset class that has tracked the official rate more or less closely. The yield on two-year government bonds was below 2 per cent on Thursday, with slightly higher rates for longer-dated paper.

Banks, which borrow at Libor (London interbank offered rate), have also seen a sharp reduction as official rates have fallen. But there are doubts on whether Libor is anything other than notional at the moment because banks are struggling to fund themselves at this rate. Mervyn King, the Bank governor, made a joke about this last week, saying Libor was “in many ways the rate at which banks do not lend to each other, and it is not clear that it either should or does have significant operational content”.

Mortgage rates for new borrowing have remained stubbornly high, reflecting this high cost of funding for banks. Only households with existing variable rate mortgages will see a big benefit from the rate cuts.

But it is companies that have gained the least from lower official rates. The cost of their borrowing from banks has been remarkably stable, at about 7 per cent, over the past two years. Fears of default have led to an explosion of the cost of borrowing in the corporate bond market for low-quality investment grade companies even as rates have fallen. Top-notch companies have also seen little benefit.

These limited movements in the interest rates people and companies pay and the lack of available credit are the direct result of the credit crunch. It is not surprising the monetary policy committee noted “it was unlikely that a normal volume of lending would be restored without further measures”.

Al Jazeera: 19th November 2008

On Wed. Riz Khan hosted a discussion on the financial crisis. I was surprised to disagree with economist and panelist James Galbraith over why it is that IOUs (or debt) issued by the Federal Reserve replaced gold as the world’s reserve asset. Watch the discussion on Al Jazeera’s site here.

Yesterday’s dramatic Bank of England 1.5% rate cut was an extraordinary admission of analytical failure. The Monetary Policy Committee of orthodox economists (with Danny Blanchflower the honourable exception) is well behind the curve. While it is tiresome to beat one’s own drum, I am obliged to point out that on the 12th July I wrote a short piece for the Guardian beseeching the Bank of England not to “sacrifice the economy on the cross of inflation targeting”. Today’s numbers from the Insolvency Service reveal that more than 4,000 companies have been sacrificed.  Company insolvencies have risen by 26.3% over a year ago, and by 10% over the last quarter. This represents the loss of a great deal of productive activity, and of thousands of jobs.

I do not have an army of economists undertaking research for me. Nor do I have the ample resources enjoyed by the Bank of England and the Treasury. And yet common sense, a cursory review of the direction of commodity prices, as well as a refusal to play the game of baiting workers demanding pay rises with threats of non-existent inflation – made the progress of prices perfectly clear.  Inflation rises in the Spring were not caused by wage demands, but instead by a spike in internationally-fixed commodity prices. The coming financial meltdown was soon going to dampen demand for oil and other commodities, and force those prices down again. In the meantime high oil and commodity prices were exacerbated by high real rates of interest. The combination was threatening the solvency of companies, households and individuals.That much was obvious to me. Why was it not obvious to the Bank of England and the Treasury?

But perhaps the most disturbing aspect of yesterday’s rate cut was the fact that it may not have any real impact on other rates within the economy. Private and nationalised banks are cocking a snoop at both the Bank of England and the Treasury, and both appear impotent. This is worrying. When governments appear to lose control over the economy, people look elsewhere for leaders that will exercise some control over the economic forces that impact so detrimentally on their lives and livelihoods.

The Bank of England and the Treasury’s ideological fixations and fetishes continue to worsen this crisis. Is yesterday’s dramatic rate cut a sign that Old Lady of Threadneedle St. might be catching up?  For the sake of us all, I sincerely hope so. But I fear it may be too late.

I wrote a piece on Keynes and monetary policy for the Standard, which appeared on Thursday, 23rd October, 2008. You can read it below. Today a group of monetarist economists , supported by a range of bankers, have written to the Telegraph objecting to a public works programme to help economic recovery. They are right that excessive liabilities on the government’s balance sheet could cause interest rates to rise, but government spending has a multiplier effect, and very quickly pays for itself. They seem unaware of this economic fact. There is some overlap between our views on monetary policy as an effective tool, but I disagree with their view that UK government spending has been excessive.

Nor do I share their complacent view that: “Occasional slowdowns are natural and necessary features of a market economy”. First, this is not a slowdown. This is a hugely destructive and likely to be prolonged global economic failure, unprecedented in history. Second, there is nothing at all “natural” or God-given about this failure. It is man-made and these letter-writers are largely to blame for the economic policies of financial de-regulation that have led to the biggest financial meltdown “since the First World War” to quote Mervyn King of the Bank of England.

From the Evening Standard, by Ann Pettifor

“JohnMaynard Keynes suddenly finds himself in favour with all those enamoured of fiscal policy. These range from governments and central banks trapped in economic orthodoxy to free marketeers in the private banking sector benefiting from taxpayers’ largesse. However, bail-outs will not prevent individuals, households, small and big businesses going bust because of onerous borrowing costs.Keynes’ advice would first and foremost be to cut interest rates to the bone; that is all rates, short and long, real, safe and risky.

Keynes laid far greater store by monetary policy than fiscal policy.He believed it is both sustainable and cost-effective to manage financial crises by sharply lowering borrowing costs.This remedy involves neither tax payers’ funds nor burdening the balance sheets of central banks or governments.Today the governors of the Bank of England and the European Central Bank stand firmly in defiance of this key pillar of Keynesianism. Contrary to his advice they prefer to keep interest rates high and periodically lose control over the Libor rate set by the private banking sector.

Keynes did not believe that the burden of economic renewal should be carried overwhelmingly by the public sector.Indeed he was against excessive public spending primarily because it caused long-term interest rates to rise.Instead he wanted to diversify the process of economic renewal by ensuring the private sector played a full part.For the private sector to be able to do that, requires extremely low rates of interest.Only by easing monetary policies will Alistair Darling and Mervyn King be said to be reflecting Keynes’ true priorities.”