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The IMF is in trouble – and not just due to its poor forecasts

The IMF is in trouble – and not just due to its poor forecasts

The International Monetary Fund (IMF) has played a prominent role in world financial affairs in the post-Second World War period. In the 1950s and 1960s, its main purpose was to support the system of fixed exchange rates. Since then its activities have evolved to embrace developing economies and both banking and sovereign debt crises.

The top ranked mainstream Journal of Economic Perspectives is hardly the place we would expect to read a strong criticism of the IMF.  But in the latest issue, this is exactly what Barry Eichengreen of Berkeley and Ngaire Woods of Oxford have done.

They argue that the effectiveness of the IMF has many similarities with that of a football referee. A great deal depends upon whether the players and spectators perceive it as being competent and impartial.  Eichengreen and Woods level charges against the IMF on several counts.

Perhaps the most serious is its track record on monitoring the world economy and warning of potential crises. Keynes, who was a great enthusiast for creating the IMF, envisaged that a key role would be as a ‘blunt truth teller’.  Elected politicians may try and fudge and obfuscate, but the IMF should tell things how they really are.  It would be unrealistic to expect anyone to have anticipated and warned of the US sub-prime crisis, the global financial crisis and the Greek sovereign debt crisis.  But, as Eichengreen and Woods put it “the IMF batted 0 for 3 on these three events, which suggests that its capacity to highlight risks to stability leaves something to be desired”. Using a different analogy, if a doctor fails to spot the symptoms of a disease, why should we trust his proposed cure?

The IMF’s track record on cures for sovereign debt crises is the second point of criticism. Judging whether a debt burden is sustainable is another tricky problem.  But the IMF has in general erred by lending for too long and postponing the inevitable restructuring.  This allows private investors to cut their losses, creating the infamous ‘moral hazard’ problem.  If you think the IMF will allow private lenders to escape, you will be more inclined to make a loan which is otherwise too risky.  The Fund’s decision not to insist on Greek debt restructuring in 2010, allowing French and German banks to bail out, is a case in point.  The overall effect is that when the restructuring does come, it is more expensive and disruptive for the economy which the IMF is trying to save.

Their criticism of the governance structure of the IMF is much less effective. For example, major decisions require an 85 per cent vote.  America has 16 per cent of the votes and so has a veto, which they argue reduces the legitimacy of the IMF.  The problem with widening the franchise is that standards of behaviour vary enormously across the world.  FIFA is the example of what is likely to happen when every country has one vote.  So on this charge, at least, things are better left as they are.

As published in City AM on Wednesday 9th March 2016

Image: World Money by Japanexperterna.se is licensed under CC BY 2.0

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China is drowning in private sector debt: there’s no telling how this one will end

China is drowning in private sector debt: there’s no telling how this one will end

The eyes of the financial and economics worlds are now fixed on China, with focus predominantly on Chinese stock markets and the country’s GDP figures.  A fascinating perspective was provided last week in the leafy borough of Kingston upon Thames.  The university has recruited the Australian Steve Keen as head of its economics department, and it was the occasion of his inaugural lecture. Keen was one of the few economists to highlight the importance of private sector debt before the financial crisis began in 2008.

The title itself was exciting: ‘Is capitalism doomed to have crises?’  Judging by the beards and dress style of the audience, many may have expected a Corbynesque rant.  Instead, we heard an elegant exposition based on a set of non-linear differential equations.

Private sector debt is the sum of the debts held by individuals and the debts of companies, excluding financial sector ones like banks.  He pointed out that in the decade prior to the massive crash of 1929, the size of private debt relative to the output of the economy as a whole (GDP) rose by well over 50 per cent.

The increase from the late 1990s onwards meant that debt once again reached dizzy heights.  In ten years, it rose from being around 1.2 times as big as the economy to being 1.7 times larger.  This may seem small.  But American GDP in 2007 was over $14 trillion.  If debt had risen in line with the economy, it would have been about $17 trillion.  Instead, it was $24 trillion, an extra $7 trillion of debt to worry about.

Japan experienced a huge financial crash at the end of the 1980s.  The Nikkei share index lost no less than 80 per cent of its peak value, and land values in Tokyo fell by 90 per cent.  During the 1980s, private sector debt rose from being some 1.4 times as big as the economy to 2.1 times the size.

In China, in 2005, the value of private debt was around 1.2 times GDP.  It is now around twice the size.  Drawing parallels with the previous experiences of America and Japan, a major financial crisis is not only overdue, it is actually happening.  And Keen suggests there is still some way to go.

So is it all doom and gloom?   Up to a point, Lord Copper.  High levels of private sector debt relative to the size of the economy do indeed seem to precede crises.  But there is no hard and fast rule on the subsequent fall in share prices.

Japanese shares fell 80 per cent and have not yet recovered their late 1980s levels.  In the 1930s, US equities fell 75 per cent, and took until 1952 to bounce back.  This time round, they fell by 50 per cent, but are even now above their 2007 high.  Equally, output responds to these falls in completely different ways.  In the 1930s, American GDP fell by 25 per cent, compared to just 3 per cent in the late 2000s.  Japan has struggled, but never experienced a major recession.    Still, Keen’s arguments leave much food for thought.

 

As Published in CITY AM on Wednesday 20th January 2016.

Image: Chinese Yuan Bills by Japanexperterna.se licensed under CC BY 2.0

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It is not just the Euro. Southern Europe faces a major structural crisis

It is not just the Euro.  Southern Europe faces a major structural crisis

Major shocks to social and economic systems ruthlessly expose weaknesses which can be contained in more normal times.  When the price of oil quadrupled in 1973/74, the different levels of resilience in the labour markets of Western Europe were quickly revealed.  Inflation initially rose sharply everywhere.  By 1976, it had fallen to 4 per cent in Germany, but was still 14 per cent in the UK.  German workers realised that the oil price rise was out of the control of their own government.  Demanding bigger money wage increases would be self defeating.  It took the deep recession of the early 1980s, when unemployment rose to 3 million, and the defeat of the miners to bring British inflation back under control.

In the same way, the financial crisis of 2007 to 2009 uncovered deep structural faults in most of the economies of Southern Europe.   The recovery in the UK took a long time to get hold, and it was only really in 2013 that we began to get over the shock.  But GDP here is now 6 per cent higher than it was at the start of 2008, when output began to contract.  In contrast, in Spain GDP is now 5 per cent lower than it was nearly eight years ago, and Portuguese output is 6 per cent lower. In Italy, the fall in GDP is as much as 9 per cent.  So between 2008 and 2015, a dramatic gap of 15 per cent has opened up between the levels of GDP in the UK and Italy.

Membership of the Euro does not help.  But there are much more fundamental issues.  A fascinating paper by Gianluigi Pelloni and Marco Savioli in the latest issue of the Economic Affairs journal focuses on why Italy is doing so badly.  A crucial reason is that Italy has a high level of corruption.  Transparency International ranks the countries of the world on this measure.  The least corrupt is Denmark.  Germany and the UK come into the charts at 12 and 14 respectively.  Italy is at number 69, along with Greece, Romania and Senegal.

Italy has suffered from a lack of restructuring of production.  The products in which Italy specialises are very similar to those of twenty years ago.  And the economy continues to be populated by vast numbers of tiny firms, specialising in commodities with low technological content in both the manufacturing and service sectors.

There are many barriers to both innovation and expansion.  For example, access to credit is difficult and complex, as a 2013 World Bank study highlights.  Start up costs are high.  The average number of years of tertiary education in the population aged over 25 is only half that of France, Germany and the UK, so the workforce is less capable of dealing with technological advances.

Pelloni and Savioli do detect some positive signs in sectors such as chemicals, food and pharmaceuticals.  But mere tinkering will not be enough.  Drastic reforms are needed to deal with the structural weaknesses exposed by the financial crisis.

As published in City Am on Wednesday 25th November

Images: Euro by Images Money licensed under CC BY 2.0

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CEO compensation and Jamaican demands for reparations: two sides of the same coin

CEO compensation and Jamaican demands for reparations: two sides of the same coin

David Cameron’s visit to Jamaica last week led to vociferous demands for the UK to pay the Caribbean island billions of pounds in reparations for slavery.  Most people here reacted with predictable eye-rolls and sighs.  Slavery was abolished throughout the British Empire in 1833, nearly two centuries ago.  Jamaica has been independent since 1962, over fifty years ago.  Surely they have had time to sort themselves out and get a decent economy?

There is much to be said for these arguments.  In the early 1960s, for example, South Korea was essentially a poor, agricultural society, only one step up the ladder from subsistence level incomes.  Now, it has a dynamic, modern economy with living standards similar to those of the West.  Countries such as Singapore have followed similar trajectories.

The demands for payment are a classic example of what economists call “rent seeking” activity.  The word “rent” here does not mean what you pay on your apartment to live in it.  The concept goes all the way back to Adam Smith himself, though the phrase was only coined in the late 20th century.  Rent seeking means trying to increase your share of existing wealth without creating any new wealth.

But we should not feel too much moral superiority over the Jamaicans.  Rent seeking has proliferated in Western society in the last couple of decades.  The US economy has performed well over this period.  Its success is reflected in the amounts paid to CEOs, with the average compensation in the top 350 firms being around $15 million a year.  This enormous sum is some 300 times higher than the amount the companies pay to the typical worker.  In the mid-1970s, the ratio was not 300:1 but only 30:1.  Even in the mid 1990s it was around 100:1.  This later figure would still hand the average CEO some $5 million today, not a bad sum to have.  It is hard to justify these payments in terms of the contribution the individuals are making to creating new wealth.  Some of it, yes, but essentially these pillars of our society have been rent seeking on a grand scale.

Rent seeking by the public sector characterised Gordon Brown’s long period as Chancellor.  Public spending rose dramatically.  But much of the increase did not go to provide better public services.  Instead, it paid for the private consumption of those employed in the public sector.  Some graduates in Hollande’s France flee abroad.  Most of the rest aspire to become a fonctionnaire.  Good pay, virtually unsackable, and with a gold plated pension at the end, it is a much sought after position.  Little wonder that France has essentially registered no economic growth since 2011.  Jeremy Corbyn eulogised the Italians for subsidising a steel plant rather than letting it go under like Redcar.  But rent seeking proliferates in Italy, and their living standards are now back to those of the late 1990s.

Economists disagree about many things, but they are united in their opposition to rent seeking, an unequivocally Bad Thing.

As published in City AM on Wednesday 7th October 2015

Image: “Street in Montigo Bay Jamaica Photo D Ramey Logan” by WPPilot – Own work. Licensed under CC BY-SA 3.0 via Wikimedia Commons.

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Keynesians are wrong: Cutting public spending can boost economic growth

Keynesians are wrong: Cutting public spending can boost economic growth

The key aim of George Osborne’s economic policy has been to eliminate the financial deficit of the public sector.  The main way of trying to achieve has been to squeeze public spending.  The orthodox economic textbooks maintain that this withdraws demand from the economy, and so leads to the growth rate being slower than it would otherwise be.

But can contractionary fiscal policy of this kind actually expand the economy?  At first sight, it seems something of a contradiction, the concept that spending less might cause higher growth.  An oxymoron, one might say – where I am using the word in its regular sense and not referring to those Greeks who voted ‘no’ in the referendum.   The very idea provokes howls of derision and outrage, from leading Keynesians such as Stiglitz and Krugman downwards.

Yet we have been here before.  In early 1981, the UK economy had moved into a deep recession, comparable in size to that which we experienced during the financial crisis.  In the budget of March of that year, the then Chancellor, Geoffrey Howe, cut the financial deficit by 1.5 per cent of GDP, or some £20 billion in today’s prices.  This prompted no fewer than 364 university economists to write to the Times in protest, explaining that the policy was completely misguided and would only serve to prolong the recession.  In fact, the economy began to recover during 1981, and posted a healthy growth rate of 2.2 per cent in 1982, followed by a boom rate of 3.9 per cent in 1983.

One swallow does not make a summer.  Is there any other evidence?  Tim Congdon, in a recent article in the journal Economic Affairs, claims that since the 1980s, ‘expansionary fiscal contractions’ have been the norm rather than the exception both in the UK and the US.  Keynesian support for fiscal activism is, he argues, unsupported by a large body of recent evidence.  To cite just one example, Congdon points to the substantial fiscal tightening under the Conservatives from 1994 and initially continued by Gordon Brown until 2000.  Over this period, the UK economy grew rapidly.

There are good theoretical reasons for thinking that cutting the government deficit could stimulate rather than contract the economy.  The classic paper was written by Robert Barro of Harvard as long ago as 1974.  Its rather mysterious title, ‘Are government bonds net wealth?’, has not prevented it from becoming one of the most cited papers in the whole of economics.  Barro, who was subsequently awarded the Nobel Prize for work such as this in macroeconomics, essentially argued that a nation cannot make itself better off by increasing its public debt. More recently, the work of the Italian economist Alberto Alesina, now also based at Harvard, has been influential in policy making circles in the European Commission and European Central Bank.

The simple view that more government spending boosts the economy appears to make common sense.   The opposing views are more subtle and complex.  But it is the latter which at present have the upper hand.

As published in City AM on Wednesday 12th August 2015

Image: “George Osborne 0482am” by alltogetherfool is licensed under CC BY 2.0

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Guaranteed bank deposits and the market for lemons

One aspect of the Greek crisis which will affect many readers is the reduction in the amount of cash in a bank deposit which is protected.  The Bank of England announced that the current guaranteed amount of £85,000 will be cut to £75,000 on 1 January.  This has led to predictable outrage, with Andrew Tyrie MP, who chairs the Treasury Select Committee with distinction, being one of the leaders of the attacks.

The provision of any sort of bailout involving banks raises tricky questions.  At the height of the financial crisis during 2008, the then Governor of the Bank of England, Mervyn King, agonised over the so-called moral hazard problem.  Once you rescue a bank with state funding, the incentives to banks to ensure their own liquidity and solvency in the future might be weakened.  King eventually decided that bailouts were essential.  A strong consensus of economists agrees with this view, although there are prominent names who dissent.

Without the deposit guarantee scheme, bank customers would certainly have much stronger incentives to discover for themselves the creditworthiness of any particular bank.  In general, the principle that the onus is on the consumer to find out about the risks of a purchase is widely accepted.  Sellers cannot misrepresent their offer, but otherwise it is up to the buyer.  This applies even to really big ticket items like houses.

The whole idea of protecting bank deposits, on this view of the world, is just another manifestation of the nanny state culture.  People are grown ups and should take responsibility for their own actions.  There is a lot to be said for this view in most cases.  But the bank guarantees are different.

Way back in 1969, George Akerlof of Berkley published a paper for which he eventually received the Nobel Prize.  It is called “The market for lemons”.  He didn’t mean the actual fruit, but ‘lemon’ in the sense of a dud purchase.  Akerlof illustrated his remarkably deep theoretical model with the example of the used car market.   If you see a classified ad for a second hand car and go to look at it, you can kid yourself that you know what you are doing by kicking the tyres like Del Boy.  But the plain fact is that the seller knows a lot more about the actual quality of the car than you do.  Economists love jargon, and this simple concept became known as ‘asymmetric information’.

Markets themselves are often used to try to correct such imbalance.  When you buy a house, you also buy the services of professionals like lawyers and solicitors. They supply you with the information needed to make you almost as knowledgeable as the buyer.  Even they can’t tell you the dog next door barks at night.  But with banks, dogs might bark all day and they are still very difficult for experts to hear.  Regulators, central banks, finance ministries all missed the fact that in 2008 many banks were essentially bust.  They all suffered from asymmetric information.  Deposit guarantees are a Good Thing and should not be reduced.

As published in City AM on Wednesday 1st July 2015

Image: Bank of England by Aleem Yousaf licensed under CC BY 2.0

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