Tuesday 20 march 2 20 /03 /Mar 11:17

A key feature of credit markets in the aftermath of the credit crunch has been extreme inequality in access to credit. Large corporations or relatively high net worth individuals perceived to have 'skin in the game' thanks to large amounts of loss absorbing capital have been able to fund themselves and often on favourable terms due to the effects of lax monetary policy, while those less able to put up collateral are denied credit or obtain it after paying a premium relative to other borrowers. Such differences in the cost of finance then amplify initial contrasts in financial performance as access to chaper funds ensures that the strong get stronger.


The National Loan Guarantee Scheme is most likely to reinforce this picture. Banks will pick the firms below the turnover threshold whom they are prepared to support and then price their loans at a discount (relative to the price absent any loan guarantee scheme) to reflect the subsidy on bank funding costs available when the government guarantees a portion of the banks' own funding in the markets. So the cost of debt will fall for a set of private sector firms, but there is no mechanism for ensuring an increase in net lending to the small business sector, and those firms unable to secure sufficient credit previously will find themselves in the same position going forward. Overall, whilst the credit easing scheme will lower the average cost of funds to the UK private sector, the inequality in private sector performance will continue and this is bad news given that small firms often offer the best prospects for rapid growth and job creation.


The National Loan Guarantee Scheme seeks to address the external finance premium that the money markets impose on the banks. A second and equally important external finance premium applies in the pricing of loans from the banks to the corporate sector. It is the second part of the chain that needs urgent attention. If the most crucial failure of the banking system at present, namely the very LOW QUANTITY of net lending is to be addressed, we need policies that induce banks to say yes to loan applications to which they would have previously said no. This means using government funds to partially guarantee not the loans from investors to banks, but from banks to firms, with the banks and firms in such relationships required to demonstrate the quality of the loan in order to qualify for the underwriying service.

By chris bowdler
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Thursday 6 october 4 06 /10 /Oct 17:38

The Bank of England's decision to resume quantitative easing through a further £75bn of asset purchases is a necessary step forward in an economy in which the outlook for private, government and foreign demand is bleak. In order for the move to have a meaningful impact on expenditure and growth prospects it is important that government plans to engage in credit easing (investing funds in instruments that directly support small business lending) are implemented rapidly and on a large scale. Given that the Bank of England, with a relatively thin capital base, is unwilling to take the risk of purchasing asset backed securities directly, the government has said it will engage in credit easing and so bear the default risk, but with the upfront resources effectively provided via the Bank's new and additional support for the gilt market.

The reason that the latest round of QE needs to be combined with credit easing is that portfolio rebalancing is central to almost all the mechanisms through which asset purchases may influence private sector demand, but its increasingly clear that there are frictions that limit such asset substitution. The first point is clear from thinking about the usual channels through which QE may operate

-- QE may flatten out policy rate expectations so that the costs for floating rate debt indexed according to the policy rate remain low for longer, so mortgage customers and small firms gain resources. But the reason we have indexed debt is that banks count on policy rate changes eventually showing up in similar movements in their funding costs, and for that to happen there has to be rebalancing of portfolios away from low yielding bonds to more risky assets. If there is no such rebalancing then banks will be forced to eventually increase the markup of floating rate debt relative to the policy rate, such that any stimulus to the private sector is short-lived.

-- QE may lower corporate financing costs in line with long-term gilt yields, but obviously this is critically dependent on cash injected into the markets being allocated to corporate bonds or equities in place of bonds.

-- QE may depreciate the real exchange rate, which requires that there is rebalancing in favour of foreign assets.

What factors stand in the way of portfolio rebalancing? One of them is that QE focussed on gilts with a long period to maturity means putting low yielding cash in the hands of the insurance companies and pension funds that have traditionally been important investors in long gilts. These institutions are subject to their own capital requirements based on risk-weighted assets. As the risk-weightings on private sector debt are higher than those on gilts, there are likely to be constraints on the extent to which QE funds can be used to improve private sector financing conditions rather than being re-invested in gilts and further decreasing the cost of government debt. The main effect of a stand alone QE would then be to simply widen the spread between interest rates paid by banks, firms and households and those paid by the government. To correct this problem, the government needs to take responsibility for channelling QE money to parts of the private sector that cannot spend and grow without additional credit. Needless to say, this must happen quickly and on a scale that approximates the addition to the QE programme. By offering to buy assets backed by small business loans, the government provides the banks with an incentive to expand that part of their loan books. There will of course be loan default risk to be shouldered by the government that may add to the national debt (even though the upfront purchases do not on the grounds that debt is being used to purchase an asset), but when markets fail due to excessive risk aversion, risk-taking on the part of a policy-maker is exactly what is required.

By chris bowdler
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Monday 26 september 1 26 /09 /Sep 17:14

As the search for a solution to the debt crisis affecting Greece and other European countries continues it's natural to ask exactly what part the constraints associated with monetary union have played in the origins and propagation of the crisis, and what options Greece would now be pursuing if it faced its current financing problems but exercised monetary independence. A first point to note is that Eurozone entry forced down borrowing costs for the Greek government (through raising expectations for Greek GDP growth and putting an implicit guarantee underneath its debts) and created an incentive for rapid debt accumulation. Now that such debt is proving unsustainable Greece needs strategies for relieving the debt burden and creating the economic growth needed to avoid a future debt explosion. A point frequently made in policy discussion is that a freely floating Greek currency would depreciate sharply to provide one ingredient for a growth recovery. The fact that this cannot happen whilst Greece is inside the Eurozone is one of the clearest examples of how current monetary arrangements in Europe have undermined macroeconomic performance.

A point that I think has received less attention is that, in this situation, an autonomous Greek central bank would relieve a large part of the debt/GDP burden through monetizing a component of the national debt, i.e. a permanent increase in the monetary base could be used to purchase and retire a portion of the debt in order to return the Greek state to solvency. In this way the central bank effects a transfer of resources from the private sector (whose nominal assets lose real value when monetary expansion raises inflation) to the public sector. Furthermore, the transfer is achieved without the need to pass austerity measures in the legislature that single out specific groups for the pain from budget tightening. In the Eurozone the ECB is technically able to do debt monetization but is unable to do so in practice. The resulting inflation tax would be distributed much more widely across Eurozone members and this is one reason for constitutional constraints preventing the ECB from conducting unsterilized purchases of sovereign debt. In the absence of central bank Greece is forced into a particularly inefficient approach to public finance -- there is insufficient use of inflation to effect resource transfers and over-dependence on conventional fiscal instruments to close the budget deficit. It seems increasingly likely that social and political pressures will block the use of conventional fiscal policy to return the state to solvency. The result is insolvency and the prospect of a default and fears over contagion that the Eurozone's fiscal and monetary authorities are ill-equipped to manage.

The point in this analysis that I want to relate to academic debate is the following: The formation of the Eurozone has imposed a costly constraint on European economies, in that they cannot pursue unilateral base money expansion for fiscal purposes, and therefore cannot exercise enough independence in the use of the inflation tax. This observation stands in contrast to the textbook analysis of the costs associated with monetary union. The standard example used in textbook analyses is that two members of a currency union may be subject to asymmetric IS curve shocks. In the simple Mundell-Flemming model the two could maintain full employment via a combination of different interest rates and exchange rate adjustment, but inside a currency union such adjustment is precluded and other adjustment mechanisms must be found (cf. Mundell's concept of an optimal currency area linked to labour market flexibility). Based on this logic, one of the criteria for assessing whether two countries should form a currency union is to ask how likely it is that they will experience asymmetric IS curve shocks. This is still an important test for the optimality of a currency union, but the recent crisis in Europe suggests that it needs to be extended. In addition to thinking about the feasibility of a common interest rate policy, it is important to consider the inefficiencies from common base money growth and limited use of the inflation tax. This in turn implies that vulnerability to different IS shocks is not the only threat to members of a monetary union. An equally important threat is differences in their fiscal trajectories (due to deficit bias, ageing populations, institutional failure etc.), which may necessitate differential use of the inflation tax that cannot be put into effect inside the single currency area.


By chris bowdler
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Thursday 22 september 4 22 /09 /Sep 17:20

The Federal Reserve has announced plans to implement Operation Twist over the next 10 months. During that time the Fed will use proceeds from sales of Treasury debt with less than three years to maturity to re-invest in longer maturity Treasury bonds. Additionally, to add a twist to its holdings of non-Treasury liabilities, the funds from maturing mortgage-backed securities will be invested in similar assets but of especially long duration.

The Fed's latest action can be interpreted as a logical extension of QE2. In the latter exercise there was explicit balance sheet expansion as additions to the monetary base were used to purchase Treasury debt. A widely recognized feature of QE interventions is that the financial and economic consequences depend not only on the quantity of reserves injected into the system, but also the kind of asset purchases that they are used to fund. In a world in which there was no segmentation of the yield curve and no commitment problems affected forward guidance for the policy interest rate, the kind of Treasury debt purchased would be of no consequence. However, theory and evidence suggest that both conditions fail.

Firstly, investors have preferred space on the yield curve, meaning that when the yield on an n-period asset is forced down through the central bank purchasing that asset at a reduced yield, there is only imperfect substitution to other assets along the curve so that the slope of the yield curve changes in addition to its height. By concentrating QE funds on long-dated debt the Fed can twist the yield curve. Accepting the view that declines in long rates relative to short rates are a form of stimulus given the importance of long rates for pricing US mortgages and corporate lending, Operation Twist gives extra bite to the stock of QE announced to date. This interpretation of Operation Twist is often described as reducing the term premium on long bonds. The Fed willingly accepts Treasuries with little compensation for the risk associated with future fluctuations in yields and, since the Fed is a big player  in the market, the market average valuation of risk declines so that the term/risk premium on long assets is forced down.

What is the role of QE and Operation Twist in relation to policy rate guidance and its impact on long rates? A conditional commitment to keep the Fed Funds rate at current levels for at least a couple of years can reduce long yields through either (i) reducing market expectations for short rates over the lifetime of long assets so that long yield fall via a simple Expectations Hypothesis of the Term Structure effect, or (ii) reducing the amount of uncertainty over market expectations of future short rates in a way that reduces the riskiness of long assets and shrinks the risk/term premium (matching the outcome from a reduced market valuation of risk arising from Fed actions and described above). However, both of these effects may be limited if guidance over future interest rates lacks credibility due to the interest rate path being at odds with central bank inflation targets -- markets attribute less than unit probability to future interest rates in line with the guidance because a future inflation problem (related or unrelated to monetary policy) will necessitate higher interest rates). How can QE and Operation Twist help to address this problem? Both may play a role as commitment technologies that help to increase the credibility of interest rate projections and ensure that they are reflected in current long rates. The logic here is as follows:

-- QE involves reserve injections beyond a critical level X necessary to drive the Fed Funds rate to a lower bound

-- so a pre-requisite for normalization of the Fed Funds rate is that reserve injections be reversed until reserves are forced below X

-- if the Fed then wishes to deviate from past Fed Funds guidance, it cannot do so immediately; it must wait for that length of time necessary to drain reserves below X

-- QE on a significant scale increases the time needed to eliminate excess reserves and therefore commits the Fed to a lower bound for the Fed Funds rate for a longer period, addressing the time inconsistency associated with interest rate projections

-- so long yields are determined based on a longer duration for short rates at the lower bound and less risk of a deviation from that level, i.e. long rates fall and monetary stimulus is imparted to the economy

-- what is the role for Operation Twist? QE is always subject to natural attrition if assets mature and the proceeds are not re-invested, and sufficient attrition could force reserves below the critical level such that the Fed Funds rate increases and deviates from previous interest rate guidance; but obviously the rate of attrition and the potential for a rising Fed Funds rate will be reduced if Operation Twist has been used to increase the maturity of the Fed's portfolio, so the above monetary stimulus is enhanced when QE is backed up by Operation Twist interventions.

An important assumption in this analysis is that the ability of the Fed to drain reserves and raise the Fed Funds rate at a rate in excess of that implied by natural attrition of the balance sheet is limited. Why might this be the case? An obvious option for draining reserves from the overnight market is reverse asset purchases. But dramatic reverse asset purchases may not be feasible in a short space of time, e.g. if the market price of Treasuries is low the Fed may wish to delay sales in order to allow a price recovery (if the Fed is averse to low bond prices then large and dramatic sales are to be avoided as they will force down the price).

Limits to the speed at which asset sales can be effected by the central bank have forced central banks to look at other options. One possibility now open to the Fed is that they use their new powers, conferred by the legislature, to pay interest on reserve deposits at the Fed. By offering a sufficiently high deposit rate, reserves in the market would be immobilized (the Fed converts a cash liability into a deposit liability). In theory, the draining of reserves from the market necessary to normalize the Fed Funds rate could occur via this mechanism, in which case QE and Operation Twist would not serve as effective commitment technologies. However, there are limits to how high the deposit rate on reserves can be set and therefore to the extent that it can be used to facilitate upward adjustment of the Fed Funds rate. Firstly, paying interest on reserves is a fiscal action (a point made by Goodfriend, JME 2011). As the Fed is not well placed to make a return on deposit liabilities (purchasing assets or making loans would push the reserves back to the market) it must rely on a fiscal transfer to cover the interest cost. Even if politicians are willing to provide this support, it may not be immediately forthcoming, or forthcoming on the scale needed to fund a deposit rate high enough to drain excess reserves from the market and allow the Fed Funds rate to rise. This is especially likely to be the case given that many politicians are opposed to paying interest on reserves -- the Congress already passed the TARP to bail-out financial institutions and is unlikely to want to pay those institutions a risk free return on the liquidity they have received in exchange for distressed assets.

If these constraints are sufficient to ensure that the Fed cannot effect rapid elimination of excess liquidity on any scale required, then QE and Operation Twist will help to address any time inconsistency associated with interest rate projections, and will in turn promote maximum monetary stimulus for economic recovery.


By chris bowdler
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Wednesday 21 september 3 21 /09 /Sep 18:55

During the last couple of weeks there have been conflicting assessments of the priorities for income tax cuts in the UK. A group of economists argued for scrapping the 50p top rate on the grounds that it is undermining national competitiveness and growth prospects. Others, including many Liberal Democrats, have argued for reducing the incidence of basic rate taxation through raising the income threshold at which the 20p tax rate kicks in. Here are three simple arguments in favour of prioritizing lower effective tax rates for low income groups:

1. The ongoing austerity measures intended to eliminate the structural budget deficit by 2015 are inevitably regressive given that low income groups are more dependent on state provided services. Prioritizing tax cuts towards the lower end of the income distribution would help offset this.

2. In response to the sluggish performance of the UK economy, partly linked to the conservativeness of fiscal policy, monetary policy has been extremely lax and has taken the form of bank rate at an effective lower bound for an extended period and asset purchases financed via quantitative easing. Although these measures have no doubt helped to achieve some rebalancing from public to private demand, they have not compensated for the increase in inequality due to fiscal policy. Instead, they have exacerbated such trends. The historic lows in interest rates have transferred billions from savers such as pensioners to wealthier homeowners that maintain a leveraged asset portfolio. The Bank of England's asset purchases have raised the profitability of large corporations and benefited those that have a stake in them via equity ownership or employment, but have not filtered through to those with lower down the wealth and income scales. Prioritizing tax cuts seems appropriate compensation.

3. The bleak outlook for GDP growth is partly due to a less positive outlook for equilibrium output following supply-side shocks, but also due to weaker than anticipated convergence on equilibrium due to deficient demand. Concentrating tax cuts on low income groups is an effective strategy for boosting effective demand given the much higher consumption propensity amongst this group. Through improving the GDP outlook, this kind of tax cut may well improve the budget position through a reverse paradox of thrift.

By chris bowdler
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