Saturday, 10 November 2012

The Chicago Plan: The Answer to All Our Problems?

In my last three articles for this blog, I have been arguing that following the financial crash of 2008, the UK’s road to recovery was always going to be long and slow whichever party happened to be in power. In an economy in which public spending is approaching 50% of GDP, overall taxation is more than 40%, and public borrowing makes up the difference – adding around £120 billion a year to our growing national indebtedness – there is so little room for manoeuvre that quick fixes simply aren’t available. Any increases in taxation to reduce the deficit, for instance, would almost certainly lead to reduced demand, lower economic activity and even lower tax receipts; while any attempts to boost demand, by cutting taxation or increasing spending would obviously necessitate even greater borrowing, which – as I hope I demonstrated in ‘QuantitativeEasing, Bank Lending & UK Government Borrowing’ – could only be sustained through even greater injections of cash from the Bank of England. Whichever party won the 2010 election, therefore, they would have had to have followed more or less the same programme, gradually reducing public expenditure as a percentage of GDP, while at the same time trying to foster growth using non-fiscal methods. Much as opposition politicians would like us to believe otherwise, there just isn’t a viable ‘Plan B’ – or not within the framework of conventional economic theory.

The problem is that, while the current strategy may be the only one any government could have adopted under the present circumstances, I don’t actually believe that it’s going to deliver us into the promised land any time soon, if ever. Oh yes, left to our own devices and given enough time, we could probably claw our way out of the hole we are in. The problem is, however, that being ‘left to our own devices’ is not something the world has planned for us. The UK may be a collection of islands geographically; but it is not so economically. And over the next eight to ten years – well before our own recovery is complete – I believe that further crises in the global economy, on a scale sufficient to render our own self-determined efforts somewhat otiose, are inevitable. 

The most serious of these external threats – as I pointed out in ‘The Limitations & Dangers of Quantitative Easing’ – comes from the USA, where the cumulative national debt, currently standing at $16.3 trillion, is forecast to rise to $25.9 trillion by the end of the decade. If this is allowed to happen, I believe that it will almost certainly precipitate a collapse in the US economy, with devastating effects for all of us.

In fact, the proximate cause of this collapse could start to become apparent as early as 2013, when, in addition to the $1.3 trillion dollars the US Treasury will have to issue in new bonds to cover that year’s projected deficit, it will also have to redeem maturing bonds with a face value of $378 billion issued in 2003. To do this, it will therefore have to issue another $378 billion in bonds, simply to recycle or churn the debt. 

An extra $378 billion, of course, doesn’t sound too bad. But over the next five years the problem gets progressively worse. By 2019, the churn rate reaches $1.42 trillion. That year, as a result, the total value of new bonds the Treasury would have to issue could well exceed $3 trillion – assuming, that is, that it is able to find enough investors willing to buy them. 

Even before then, however, worries over this exponentially accumulating chasm of debt, could well see US bond prices start to fall. Depending on the fiscal and monetary strategy of Obama’s second term administration, this, too, could start to happen as early next year. As a result, future bond issues, will have to be offered at progressively higher interest rates, further increasing the budget deficit in a way not envisaged in the current forecast. If, by 2019, US bond yields were to reach 5%, for instance – as well they might – I estimate that the US government could be spending as much as $1 trillion a year on interest payments alone. This would therefore necessitate even greater borrowing than the $3 trillion for that year already mooted. At this point, however, the bond markets will almost certainly pull the plug, leaving the USA in much the same position as Greece is today, unable to borrow any more money and therefore unable to repay the money it has already borrowed.

Unlike Greece, however, there is no organisation in the world big enough to bail out the US federal government. Not being able to redeem its bonds as they fall due, the US Treasury will therefore have to default. US banks holding US Treasury bonds will consequently have to write down the value of these bonds on their balance sheets. Many, as a result, will go bankrupt. With an impoverished federal government unable to underwrite deposits, most people with money in these banks will therefore lose it. As will many businesses, many of which, as a consequence, will also go bankrupt.

With the government having to match expenditure to tax receipts, pensioners and public sector workers will almost certainly have their salaries and pensions cut. Many public sector workers will also lose their jobs. With so many businesses also failing, the unemployment rate will soar. With far fewer people paying taxes, tax receipts will fall, requiring further cuts in expenditure. As the spiral downwards continues, those living on welfare may not get paid at all. As result, people could well go hungry; and there will almost certainly be social disorder and unrest.

Overseas, many banks holding US Treasury bonds, or loans to US banks, will also go bankrupt. The same domino effect will spread throughout the world. To make matter worse, probable disputes over resources may well lead to wars. In fact, there is ever possibility of a global famine. It could well be the worst disaster in human history. And the terrible truth is that unless someone does something fairly soon to prevent it, it is going to happen as surely as night follows day.

The problem, however, is not just that, to the outsider at least, the US political system seems totally incapable of generating either the will or the unity of purpose to confront this looming threat. It is also that, within the framework of conventional economic theory, it is not at all clear what should actually be done. The IMF, for instance, has recently warned the US government that it risks plunging the world into another economic recession if it fails to get agreement on a new budget, thus causing certain automatic tax rises and spending cuts – the so-called fiscal cliff – to be triggered at the end of this year. As these tax rises and spending cuts are precisely what the US needs in order to tackle its deficit, however, this sounds a bit like a doctor warning a drug addict not to come off the heroin for the sake of his suppliers. If it is a requirement of the global economy, therefore, that the US keeps on spending and borrowing itself into bankruptcy in order to keep the world turning for just a few more years before it finally tears itself apart, you have to ask whether the current economic and financial system is really doing its job.

For some months, as a consequence, I have been saying that if there is a solution to this problem, it will almost certainly emerge in the form of something radically new; something that we will probably look back on as a turning point in history; a Copernican revolution in economic theory. Then, a couple of weeks ago, I was sent a document which has led me to think that, just maybe, this revolutionary new theory already exists.

If so, it is called the Chicago Plan, so named because it was first proposed by a group of economists led by Professor Frank Knight at Chicago University during the late 1920s. In 1933, it was then further developed by Henry Simons and put forward in a memorandum to President Roosevelt as a possible solution to the Great Depression.

Partly because of the opposition of US bankers, and partly, one suspects, because it is so radical that, initially at least, it seems too much of a step into the unknown, Roosevelt declined to take it any further. Now, however, it is being floated once again, this time by the IMF, which, in August this year, published a working paper by Jaormir Benes and Michael Kumhof entitled ‘The Chicago PlanRevisited’

In it, the two authors re-examine the Plan’s core proposal: to require all banks to hold cash reserves equivalent to 100% of the deposits of their customers. This is what is known as ‘100% Reserve Banking’, and its first intended effect, as the name suggests, is to eliminate the kind of ‘runs’ on banks we saw in Britain, in 2007, in the case of Northern Rock. For if depositors know that, by law, all banks always have to hold enough money to cover 100% of possible withdrawals, in principle at least, they would no longer have reason to fear that, should their own bank come under pressure, it could run out of funds before they can get their own money out. This in turn, therefore, should make people less inclined to take the kind of action which, in the past, has so often made the prospect of a bank running out of money a self-fulfilling prophesy. 

What makes the Chicago Plan more than just a form of protection for depositors, however, is that, in order to achieve this first objective, it also requires that a currency’s monetary base – the money issued by a country’s central bank – should become 100% of the country’s money supply:  something which, as I pointed in ‘The Limitations & Dangers of Quantitative Easing’, is far from being the way things stand at present. Indeed, the amount of monetary base currently provided by most central banks – the amount of money that can actually be represented as cash – is usually only about 3% of the total money in circulation, the rest being created by the banking system itself. 

To understand how this happens, consider the set of very typical banking transactions outlined in Figure 1.

Figure 1: Buying A House

Here, Person A is buying a house from Person B. To do this, he borrows £100,000 in the form of a mortgage from Bank A. Ignoring the fact that, in reality, each of these transactions would take place within the banking system and that no actual money would change hands, Person A then pays this £100,000 to Person B in exchange for the deeds to the property. Person B then deposits the £100,000 in his account in Bank B, while, in order to cover the mortgage, Bank A simultaneously borrows £100,000 from Bank in B, thereby completing the circle.

Without any real money previously existing, the banking system itself thus creates £100,000. We can see this on the balance sheets of the two banks. On the balance sheet of Bank A, there is now a debtor account of £100,000 representing the mortgage and a creditor account of £100,000 representing the Inter-bank Loan. On the balance sheet of Bank B, there is a corresponding debtor account of £100,000 for the Inter-bank Loan and a creditor account of £100,000 in the form of a deposit. Moreover, both banks make a profit on this arrangement. Bank A charges Person A 5% on the mortgage while paying 3% on the Inter-Bank Loan, thus making a net profit of 2%. Bank B makes the same 3% on the Inter- Bank Loan while paying Person B just 1% on his deposit, thus also making a  net profit of 2%. And all this on money that didn’t exist prior to the transaction itself. 

100% Reserve Banking not only makes this illegal, it makes it impossible. For in order to hold cash reserves equal to 100% of its deposits, Bank B actually has to receive £100,000 in cash from Bank A at the point at which Person B pays the money into his account. This means that Bank A must first have this money before it can grant Person A a mortgage. In this way, the Chicago Plan thus effectively stops banks from creating money.

More importantly, it gives them no reason to encourage people to take out mortgages or loans they can’t afford, simply to go on generating and making profits from inflated and somewhat chimerical assets which then suddenly turn into dust once the bubble bursts and the debts have to be written off. Unlike Gordon Brown’s much vaunted and repeated claims of ‘fiscal prudence’, the Chicago Plan thus really does put an end to ‘boom and bust'. 

Not that it’s quite that simple, of course. For there is, as you’ve very probably noticed, one fairly obvious flaw to the Plan thus far. For given that, at present, the monetary base in most countries is only 3% of the money supply, were we to prevent banks from creating additional money through financial transactions without providing some alternative form of supply, it wouldn’t take too long before there wouldn’t be enough money in circulation to do all the things we need to do with it. 

This, however, is where the Chicago Plan gets really radical. For it proposes that central banks should, themselves, actually create more money. A lot more! The whole of the other 97%, in fact.

‘But what about inflation?’ you ask. After all, we all know that the phenomenon of central banks printing too much money is one of its primary causes. In ‘The Limitations & Dangers of QuantitativeEasing’, I myself warn that by increasing the monetary base through QE, governments run the risk of starting inflationary cycles once the economy picks up again.

This can only happen, however, if banks are allowed to multiply the monetary base through their transaction flows. Under the Chicago Plan, they are not.

‘But what about this massive new injection of cash itself? Won’t that cause inflation?’ After all, in issuing new cash equivalent to 97% of the current money supply, one is more or less doubling the amount money in circulation. 

But this is where the Chicago Plan gets even more radical. For it stipulates that this increase in the monetary base be used to buy up the country’s existing debt. And by this, I don’t just mean government bonds, but private debt as well. Nearly all of it, in fact – every mortgage; every private loan; every credit card balance – so that by the end of the process, the only debts still outstanding are certain categories of investment loan sufficient to keep the banks earning enough interest to make a profit. Instead of adding to the money supply, the new money issued by the central bank thus replaces the old money previously generated by bank lending. More to the point, the debt which currently balances customer deposits on bank balance sheets, is replaced by cash, thereby taking us close to the objective of a 100% cash reserve.

The resulting transformation of bank balance sheets is as shown in Figure 2, which is a slightly simplified version of the model presented by Benes and Kumhof in their IMF paper. The figures represent percentages of US GDP. 

Figure 2: Transformation of Bank Balance Sheets under the Chicago Plan

The first two things one will probably notice about the above table are:

a)      That the post-transition balance sheet is significantly larger than the pre-transition balance sheet, and

b)      That a new category of creditor account has been inserted in the form of Central Bank Credits (CBCs), which is to say loans from the central bank. 

This transitional structure is required because, under the new system, in which cash reserves must always be equivalent to customer deposits, banks will not be allowed to use these deposits to fund loans. Without some other form of finance, therefore, all loans would have to be funded out of the bank’s own equity, which, in most cases, would not be enough to generate sufficient interest to cover the bank’s operating costs, let alone make a profit. Under the Plan, it is therefore proposed that the central bank make interest free loans available to banks, both to ensure bank profitability, and to bring the banks’ cash reserves up to 100% of customer deposits. This is achieved because the CBCs are, of course, provided in the form of real cash. Thus while the credits, themselves, are shown as balancing investment loans, the cash that comes with them is added to the cash proceeds from the sale of other debt to provide the full 100% Cash Reserve.

The CBCs also form the basis for further growth. For after the transition, the Central Bank would then issue further cash loans to banks as required. Unlike under the current system, however, this would not be unfettered. The amount of additional money supplied to the banks each year would be strictly controlled, both to prevent inflation and to prevent the banks, themselves, from engineering another artificial boom. To customers seeking loans and mortgages, however, the system should appear no different from what it does today. While the banks would not be issued with enough money to extend mortgages to people who can’t afford them, there would still be enough flexibility in the money supply to meet legitimate demand.

The only question that remains, therefore, is what the central bank now does with all the loans and mortgages – not to mention Treasury Bonds – which it previously bought up and which it still has in its possession.
And here there are a number of options. The simplest, however, and the one originally proposed by the Chicago group, is what might now save us all from disaster. For it is that, in a one-off cleaning of the slate, all these old debts are simply written off. In one fell swoop, as a result, the entire mountain of debt which has been accumulating throughout most of the developed world for the last fifteen to twenty years, and which now threatens to bring the global economy crashing down around us, would simply disappear. Just like that!

So what’s the catch? Why haven’t we done it already?

The first, and I suppose greatest reason to be hesitant is that it is a massive leap of faith. Nobody has ever done this before. We therefore have no idea what all the implications are. 

Consider, for instance, the position of savers. In the past, their money has been used to fund at least part of most banks’ lending. As a result, they in their turn have received interest for effectively lending their money to the bank. As already pointed out, however, under the new system, it will no longer be possible for banks to use customer deposits in this way. If the banks are no longer able to earn anything from them, however, not only is it very unlikely that they will be willing or able to pay interest on them, from a banking point of view, it is very difficult to see what use they are. They are simply liabilities. So what’s to stop banks from declining to hold customer deposits at all and concentrating purely on their loan business, using their own profits and CBCs for finance? 

Indeed, I’ve been thinking about this problem for the last two weeks and the only measure I’ve come up with that would prevent banks from adopting just this policy is for the central bank to make its loans conditional on – and proportional to – the customer deposits of the receiving banks. 

Forcing banks to maintain customer deposits in this way, however, will also force them to try to find ways of exploiting them. Of course, they will be able to charge deposit customers for normal banking services, such as standing orders and issuing cheques; but in a competitive market, these charges are hardly likely bring in very much, and even if they covered the cost of administering current accounts, it still wouldn’t solve the problem of providing some level of interest for savers. One possibility, therefore, is for banks to offer some form of investment account, in which previously unproductive deposits could be used to purchase a range of dividend-paying equities and bonds, on which savers could then make a return and on which the banks could also charge a commission.

This would not contravene the rules of 100% Reserve Banking in that, as long as they did not, in themselves, become tradable entities or near-monies, investment accounts, in which the purchased equities and bonds balanced customer funds, would not be counted in the same way as savings accounts in which cash has to balance customer deposits. Despite being inherently more risky, such investment accounts might even be better for savers than the kind of savings accounts and fixed term bonds which is all most banks offer them at present. 

The problem, however, is that this is all just speculation. For we really don’t know how the new system will develop. Indeed, the only thing we can predict with any certainty is that it will throw up features which, today, no on could possibly predict.

That’s not to say, of course, that with respect to the Chicago Plan, itself, there aren’t at least two things of which we can be reasonably sure. The first is that this very uncertainty – regarding its implications – will be used by its opponents to ensure that it is never implemented. The second is that the number of these opponents will be legion, starting, of course, with the banks themselves. For in that the Chicago Plan effectively prevents banks from ‘creating’ money, should it ever be put into practice, it would clearly restrict the ways in which banks were able to ‘make’ money, thus rendering them far less profitable than they are at present. Bankers, far from being ‘masters of the universe’ would thus become mere service providers, a bit like the Post Office. And I can’t see many of them going for that.

Then there are the right wing political parties, such as the US Republican Party and the UK Conservative Party, which adherents of the left automatically assume are tied and beholden to moneyed interests. Whether or not this is true – and their response to the Chicago Plan may well be indicative in this respect – it is certainly the case that there will be those among their ranks who will view such state interference in the banking system as ideologically suspect. If it were ever proposed in the US, for instance, I would expect members of the Republican Party to claim that it was unconstitutional and to oppose it all the way to the Supreme Court.

Not that parties of the right are likely to be the only political opponents. Left wing parties, wedded to Keynesian solutions, which allow them to pump money into social programmes, not of course as bribes to the electorate but as ways of stimulating the economy, may well find that the rather limited annual increases in the money supply, imposed upon them by the central bank, enforce a fiscal discipline which they may well regard as politically unacceptable. It will certainly limit what they are able to promise voters at elections.

With the banks and both ends of the political spectrum thus likely to oppose it, the chances of any government implementing the Chicago Plan any time soon are therefore rather slim. My guess is that we’d have to get pretty close to the brink before any government even considered it, and even then they’d probably try to temper it in ways that would totally defeat its object. For that’s the nature of both politics and politicians. 

In my view, however, the ideas at the heart of Chicago Plan deserve real consideration. I am not saying that, as it stands, it is definitely the answer. Even less am I saying that it is the only answer. What is important, however, is that we don’t just blindly walk into the next crisis in the way we blindly walked into the crisis 2008. Nor should you assume that the politicians and their paid financial experts have got this covered. They didn’t see what was coming in 2008, and I don’t believe they see what’s coming now. Or, if they do, they’re floundering and are as much at a loss as to what to do next as everyone else. The important thing, therefore, is to bring this debate out into the open. And one way to do this is to look at proposals like the Chicago Plan, to examine and test them and see whether they really are possible solutions. 

At present, however – in the UK at least – the only mainstream publication which has even taken note of the IMF Working Paper is the Daily Telegraph (see ‘The IMF’s Epic Plan to Conjure Away Debt andDethrone Bankers’ by Ambrose Evans-Pritchard), and even here, as the title suggests, it is more sensationalised than explained. What we need, rather, is more informed debate, and for more people to get to know about it. If, after reading this, you therefore think that this is something we should be considering, and if, like me, you believe that the internet is possibly the one place left where ideas of this kind can gain currency and momentum, then perhaps you might pass the information on. And we’ll see where it takes us.

Saturday, 15 September 2012

The Limitations & Dangers of Quantitative Easing

a)      That following the financial crash of 2008, the UK’s four largest banks suffered a massive drop in their capacity to lend – some £1.8 trillion between December 2008 and December 2009;
b)      That in the two years since then – up to December 2011 – they only recovered £191 billion of this capacity; and
c)      That despite the Bank of England’s programme of quantitative easing or QE, all of this additional capacity has effectively been taken up by the UK government in order to finance its fiscal deficit.

I further argued:

d)      That the UK economy would not be able to return to its pre-2008 levels of growth until the banks recovered at least part of their former lending capacity;
e)      That this could not happen while the government continued to borrow at a rate faster than the banks could grow their assets; and that
f)       If an incoming Labour government actually wanted to implement its advocated strategy of increased fiscal stimulus, this could only be achieved through even greater levels of QE.

Since then, people have naturally come back to me asking why such a strategy of fiscally stimulating growth using QE would be such a bad thing; and despite my innate distrust of easy fixes I had to admit that I didn’t really know the answer. It occurred to me, therefore, that, despite its highly technical nature, it might be a good idea to devote a blog to exploring some of the pros and cons of QE with the aim not only of helping others to understand it better, but of getting a better handle on it myself.

So, to start with, what is Quantitative Easing?

Put simply, it is the creation of money ex nihilo by a central bank. One moment the money doesn’t exist; the next it does. Magic!

As a result, many presenters and pundits on mainstream news and current affairs programmes quite regularly describe it as the electronic equivalent of ‘printing money’, with all the connotations this brings with it. References are quite often made, for instance, to that period during the Weimar Republic when it is said that Germans had to go shopping with wheelbarrows, not to carry their groceries, but the bundles of bank notes that were required to pay for them. Whether this story is apocryphal or not, I leave you to decide; but for at least three generations of Germans it has come to represent the inescapable truth of what happens when a government tries to defy one of the most basic laws of economics: namely that the total amount of money in circulation within an economy is always equal, in value, to the total amount of goods and services available for this money to buy. If you increase the amount of money in circulation without increasing the amount of goods and services, therefore, these same goods and services simply end up costing more. Which is precisely what happened in the Weimar Republic when the government tried to finance its fiscal deficit simply by printing more bank notes. 

QE, however, differs from simply printing money in two respects. The first is that the new money which the central bank creates is used to purchase assets on secondary markets. This is very different from what happened during the Weimar Republic, when the newly printed bank notes went straight to the German treasury to pay public sector salaries and pensions. In the case of QE, the treasury first has to sell it bonds to commercial banks, from which the central bank then buys them. This means that, in principle at least, the central bank can always sell the bonds on again, or request the Treasury to redeem them when they fall due, thus taking the new money out of circulation again once it is no longer needed, something which is not quite so easy in the case of printed bank notes.

The second way in which it differs from simply printing money is that, when it was conceived, in Japan in the late 1990s, it had a very specific purpose: to increase the money supply during a period in which the bursting of a housing bubble had led to a financial crisis and period of economic contraction very similar to the one we are now experiencing in the UK. Economic activity had slowed appreciably, money for borrowing was in short supply, and the economy had not only fallen into recession but into a deflationary cycle, from which it is very difficult for any economy to escape.

This is because deflationary cycles – in which prices actually fall – have something of the effect of self-fulfilling prophesies. If people know that something they want or need is going to be cheaper the following week, they naturally put off buying it until retailers, desperate to obtain sales, do in fact reduce their prices. This then reinforces the popular perception of prices falling, which further accelerates the cycle. At the same time, with sales so low, more and more businesses, from manufacturing to retail, are forced to close or lay off staff. Unemployment rises, people have less money, and put off buying things even longer. The result is a vicious circle from which it is almost impossible to escape.

That is not say that the Japanese government didn’t try. They tried just about every form of fiscal stimulus imaginable. They tried tax cuts. Which didn’t work. They tried extensive building programmes: building bridges to nowhere and motorways no one used – or so it is said – though this too may be apocryphal. They then tried setting interest rates at zero, thinking that if people weren’t earning interest on their savings and credit was free, they’d avail themselves of the opportunity to borrow. But still nothing worked, not least because, with all these fiscal stimuli, and a contracting economy in which public expenditure, particularly on pensions and benefits, was consuming an ever increasing proportion of GDP, by the late 1990s Japan had the largest annual deficit of any country in the G20, with an accumulated national debt of 188% of annual output, the vast majority of it, of course, funded by Japanese banks. It was only when economists at the Bank of Japan realised that, even with interest rates set at zero, people and businesses couldn’t borrow money if the banks were lending it all to the government, that this new, revolutionary idea began to take shape. In 2001, the Bank of Japan thus embarked on the world’s first ever exercise in quantitative easing, buying up Japanese Treasury bonds from its own commercial banks in order to provide these banks with additional liquidity for lending to the private sector. 

And it worked. By 2006, when the programme was suspended, the Japanese economy was growing at 1.9% per annum, and the long deflationary cycle had finally flipped over into inflation.
The problem for us, however, is that we still don’t know what, under normal circumstances, would – or should – have happened next. For within eighteen months, the financial crisis hit the USA and Europe, quickly followed, in Japan, by the worst earthquake and Tsunami the country had ever experienced, which together forced its economy back into recession. By 2010, as a result, its QE programme had to be resumed. We can only therefore guess at what might have happened had the Japanese economy continued to recover. Yet it is in what happens during this recovery phase that the real dangers of QE lie.

To understand this better, we first need to look a little more closely at how the money supply within an economy works. The most important thing to understand is that it is the product of two variables: the monetary base – which is the total amount of money the central bank has made available for use within the economy – and the rate at which this monetary base effectively circulates. To illustrate: I deposit £1 in my bank account. My bank then lends this to a company which uses it to buy a piece of equipment. The manufacturer of this piece of equipment then uses it to buy raw materials and to pay my salary, which I deposit in my bank account. The same pound thus gets used over and over again even while it remains nominally mine. And it is this multiplying effect on the monetary base which produces the effective money supply.

In a balanced, well-managed economy, this multiple is usually somewhere around 1:35, and it is the job of the central bank to keep it more or less at this level. If it rises above 40, for instance, the economy is usually said to be overheating, with a risk of increased inflation, and the central bank therefore raises interest rates. This then slows down the rate of economic activity and the multiplier returns to normal. If it falls much below 30, threatening stagnation or recession, the central bank then lowers interest rates in order to stimulate economic activity. Up until its introduction by the Bank of Japan, the real problem for central banks, however, was what to do if economic activity still remained flat even after interest rates had been reduced as low as possible – or indeed to zero. Quantitative Easing solves this problem by temporarily increasing the monetary base, as shown in Table 1.

 Table 1: The Effects of  QE on Money Supply in a Recovering Economy

What Table 1 represents, in fact, is a fictional economy going through a number of stages: 

  1. In the first line, we have a smoothly running economy, with a monetary base of £40 billion, and an average multiplier of 35, giving us an effective money supply of £1.4 trillion.
  2. Next – as the result of a housing bubble, for instance – we see the economy overheating, with a multiplier of 45, producing an effective money supply of £1.8 trillion, which, in turn, would already be causing inflation to rise quite steeply.
  3. At this point the central bank would therefore intervene, raising interest rates, which, as a result of mortgage defaults, perhaps, could actually be the cause of the financial crash that we see next, with economic activity decreasing to a multiplier of just 25, and an effective money supply of just £1 trillion.
  4. Having reduced interest rates again – presumably without much success – the central bank then tries QE, adding an extra £16 billion to the monetary base, which, even with the reduced multiplier of 25, restores the effective money supply to the original £1.4 trillion.
  5. As a consequence, economic activity very quickly returns to normal and a multiplier of 35. On the new monetary base of £56 billion, however, this produces an effective money supply of £1.96 trillion; and although the goods and services this represents may now also be growing, possibly at 1% or 2% per annum, this nowhere near matches the increase of 40% in available money.
  6. The result, somewhat inevitably, is hyper-inflation, and it is this possible effect of sudden economic recovery upon an artificially inflated monetary base that is the inherent danger of QE.  
What this means, therefore, is that as soon as the central bank sees that a recovery is underway, it has to start a process of Quantitative Hardening or Firming: taking money out of the system again. The problem, however, is that although, as I stated earlier, this is perfectly possible in principle, in practice it could be a little more difficult.

The obvious way to go about it is for the central bank to simply put the bonds it purchased through QE back on the market. However, it has to be very careful how it does this, particularly if its government is still having to borrow money. A sudden glut of a country’s bonds may make it difficult for its treasury to get any new bond issues away, and will certainly reduce the price, thus putting up interest rates. If it doesn’t want to cut off the recovery before it has properly got going, therefore, it has to sell the bonds quite slowly. If it sells them too slowly, however, or waits too long, it is possible that the economy could start overheating and that inflation could already get a hold before the sell-off programme is complete, which would have an equally detrimental effect upon bond prices. 

This is because bonds are redeemed at a fixed face value. During  periods of inflation, as this fixed face value becomes worth progressively less, bond prices, therefore, quite naturally tend to fall. As inflation also tends to force up interest rates, bonds issued during periods of stagnation or recession, with low fixed dividends, also tend to lose value. What this means, therefore, is that, one way or another, the central bank is unlikely to get back all the money it injected into the economy when it first purchased the bonds. No matter how dexterous it is in managing the bond markets, some additional money will remain in the monetary base, and some level of inflation will result.

Another possible option, therefore, is for the treasury to redeem the bonds at face value, doing so, if necessary, even before they are due – assuming that there is provision for this. As few governments run surpluses – even when they are not running deficits – it unlikely, however, that many governments would be able to do this without additional borrowing. That is to say that they would have to issue new bonds in order to raise the money to buy back the old ones. The problem with this is that it would be very difficult for any government to do this if it were still having to borrow money to finance a deficit. In fact, it is for this reason, I believe, that, in making a form of QE available to Spain and Italy, the ECB has also made it a condition that these countries eliminate their deficits within an agreed timetable. During this period the ECB will buy an unlimited quantity of Spanish and Italian bonds from their commercial banks, thus providing these banks with greater liquidity to lend to the private sector and stimulate growth. Once this period is over, however, both countries have to be in a position where they no longer have structural imbalances in their economies – where they no longer have to borrow money simply for day to day expenditure – and are therefore in a position to borrow the money necessary to redeem their bonds from the ECB.

At this point, of course, you may ask whether this isn’t just as bad. Instead of borrowing money to pay pensions, these countries will now be borrowing money to pay back bankers in Frankfurt. I can certainly imagine friends in the Labour Party making some such comment. It is, however, to totally miss the point. For in borrowing money from their own rehabilitated commercial banks to redeem their bonds from the ECB, the countries involved would not now be adding to their national debts, merely repatriating part of these debts back into the normal banking system. More importantly, because they would not be borrowing to finance a structural deficit, once this repatriation was complete, they would end up with a balanced budget. Indeed, this proposal by the ECB contains the only QE exit strategy I have so far analysed, which, in the end, leaves the target country’s economy in tact and its finances sound: a fact which rather suggests that the Germans, with their collective memory of the Weimar Republic, are the only ones who have properly thought this through. 

This contrasts quite markedly with the USA, for instance, where there are no plans to cut the fiscal deficit, which currently stands at $1.3 trillion per annum and is budgeted to rise slowly but steadily until 2019, when the total cumulative debt, presently $16 trillion, is projected to reach $25.9 trillion, or $100,000 for every man, woman and child in the country. Given that since 2008, US banks have experienced a similar reduction in their lending capacity to those in the UK, you will not be surprised to learn, therefore, that over the last three years, in order to support this level of borrowing, the Federal Reserve has already provided somewhere in the region of $2 trillion in quantitative easing, and that yesterday it announced that, from now on, it would be providing an additional $40 billion a month on an indefinite basis until the economy picks up.
This, however, could take some time. For $40 billion a month is less than 40% of US Treasury borrowing. This means that US banks and other financial institutions will still have to lend around $60 billion of their own money to the government each month, thus depriving the private sector of this money, and providing a drag on growth. For although public borrowing to pay salaries and pensions does not stop money from circulating, by reducing the amount banks have to lend for house purchases and business investment, it channels the money along routes that have less of a multiplying effect. While quantitative easing may continue to expand the monetary base, as long as the US government fails to reduce its deficit, therefore, the monetary multiplier, representing economic activity, will remain depressed. 

How long the US economy, like the UK economy, is likely to stay in this state, I’m not sure. As I demonstrated in Table 1, the monetary base is only a very small percentage of the money supply. If the multiplier doesn’t change, one can go on increasing it for quite some time without it having much effect. As total US debt continues to increases, it is also likely that, regardless of the Fed’s intervention, its bond prices will come under pressure, and that US Treasury bond yields will rise, pushing up interest rates, which will also have a depressing effect on economic activity, keeping the multiplier low. Indeed, it is possible that the collapse of the US economy, when it finally occurs, will have nothing to do with the Fed’s QE programme, and that it will simply happen when bond markets start to feel, not only that the mountain of US debt will never be repaid, but that it can no longer be maintained. My guess, however, is that this will very probably be triggered when, even at low levels of economic activity, the expansion of the monetary base starts to have an effect on inflation. At this point, the Fed will have to discontinue its QE programme, thus leaving its banks to shoulder the burden of the deficit unsupported. As bond prices fall and yields rise, at some point the US Treasury will then not be able to sell all  the $100 billion to $150 billion in bonds it needs to sell each month in order to the keep the government afloat, and the USA will simply turn into Greece, only bigger and with two to three orders of magnitude greater impact. 

What this analysis indicates, therefore – unless anyone knows better – is that QE is only a sticking plaster. It is a short term measure that can be used, after a financial crash, to rebuild a country’s banking sector and refinance growth, while the government puts its economy in order. If the government fails to do this, however, not only is QE far less effective, it simply delays the day of reckoning and makes the eventual collapse even worse. The trouble is that while governments all around the developed world are now jumping on the QE bandwagon, seeing it as the solution to all their short term ills, very few are willing to impose the kind of hardship on their populations which correcting a structural imbalance requires.

In the USA, in fact, this has now become built into the political system. For while the constitutional division of power between the executive and legislature was meant to provide a series of checks and balances, it has now created a kind of impasse in which Republicans refuse to allow any tax increases while Democrats refuse to countenance any cuts in welfare. The result is an ever increasing deficit which no one can do anything about. Indeed, it is probable that the US economy is already beyond the point of no return, and that nothing anyone did now could prevent its inevitable collapse.

In the UK, however, there was a short period when the problem could have been met head on. For in 2010, when, following the financial crash, the current government was elected, there was a brief window in which the British public, shocked by what had happened, would have been willing to take the medicine. Had the new government announced real cuts in public expenditure at that point, they would therefore have been accepted. Knowing that before long, however, the architects of this new austerity would eventually come to be universally hated, and might never be elected again, the Conservative leadership simply bottled it. The budget they produced allowed for public expenditure to continue rising, while any trimmings they made to the previous government’s expenditure plans were back-ended to 2013-15, when they hoped renewed growth would make them virtually painless. As it is, continued government borrowing has stifled growth in the private sector and has put us in a very similar position to that of the US, in which quantitative easing is the only thing that keeps the wheels turning.

The real tragedy, however, is that very few people have any sense of this whatsoever. They believe the opposition when it tells them that the reason the government strategy is failing is that they tried to cut public expenditure too fast. As a result, the next government will almost certainly be a Labour government, which will try to stimulate growth by public expenditure, financed through borrowing, supported by QE. As this will continue to deprive our commercial banks of the money they need to finance the private sector, not only will this fail, it will simply make the problem worse when it finally becomes unsustainable.

The only good news is that this is probably all irrelevant. For when the US economy finally collapses – which I estimate will happen sometime around 2020 if not earlier – the entire global financial system will, of course, implode. It will make 1929 and 2008 look like minor hiccups. As a result it probably doesn’t matter what the UK government does. It’s Armageddon either way.

Me, I’m putting all my money – or what’s left of it – into gold!

Friday, 7 September 2012

Quantitative Easing, Bank Lending & UK Government Borrowing

In my last blog, ‘The State of UK Banks& The Long Haul to Recovery’, I tried to show that even if there were sufficient demand in the UK economy to drag the country out of its present state of stagnation, the UK’s four largest banks currently have far less money available to lend than they had at the start of the financial crash in 2008 – an aggregate total of £1,622 billion less, to be precise – and that due to forthcoming legislation, which will require UK banks to retain stockholder capital equivalent to at least 7% of their lending, this position is not going to be greatly improved any time soon. I argued, therefore, that with UK businesses and consumers no longer having access to this now lost pool of finance, there is very little any government can do to overcome the current inertia, and that to suggest that a change in fiscal strategy would magically make this happen is wishful thinking to say the least, if not mischievously disingenuous.

Since then, a number of people have come back to me citing the very widely held belief that, through the Bank of England’s programme of quantitative easing, the banks in this country have actually been provided with ample amounts of cash for new lending – contrary to my assertion –  and that for reasons best known to the banks themselves – or their unalloyed wickedness, as some would have it – they have simply failed to use this additional finance to help fuel growth in the way that was intended, preferring instead to line their own pockets.

Despite hearing something to this effect almost every week on countless news and current affairs programmes, this is so far from the truth, however, that one can only assume it to be politically motivated. For although the BoE’s programme of quantitative easing – or asset purchase, as Mervin King prefers to call it – has provided some additional liquidity for the banks, not one penny of this was ever intended to go to the private sector, a fact which very quickly becomes apparent once one realises that the assets the BoE predominantly purchases are UK Treasury bonds, and that it has reasons for making these purchases which are far more critical and pressing than the ever-present need for economic growth. Put simply, they are:

a)      To ensure that the UK government can raise all the money it needs to finance its deficit, and;
b)      To keep the demand for UK Treasury bonds – and therefore their price – as high as possible, thus keeping their effective yield – and therefore UK interest rates – as low as possible.

To those uninitiated in some of the more arcane financial practices of governments and banks, this view of what the BoE has been doing may come as a bit of a surprise. What you have to remember, however, is that although government bonds are traded on an international market, the vast majority of new bond issues are initially taken up by the banks of the country in which the issue is made. It is this, for instance, that has led to a certain circularity in the debt crisis in Spain, where, in order to finance the bailout its banks, the Spanish government has made a number of new bond issues. The only problem has been that the only banks to have taken up these issues have been Spanish, thereby undermining the credibility of the exercise somewhat.

What you also have to remember is that, over the last four years, from April 2008 to March 2012, the British government borrowed a net total of £520 billion, most of it, as in the case of Spain, from its own banks. Given that during this same period, the four largest banks in the UK saw the total amount of money they had to lend fall by £1,622 billion, without the support of the BoE, lending an additional £520 billion to the government would therefore have been rather difficult. Indeed, I doubt whether it would have been possible at all. Without the BoE’s intervention, therefore, it is highly likely that the Treasury would not have been able to get all of its bond issues away. UK bond prices would then have fallen, yields and UK interest rates would have soared, and we could easily have found ourselves in the same position as Spain or Italy, in our case requiring a bailout from the IMF. By continually buying up UK Treasury bonds from UK banks – thereby providing these banks with enough additional cash to buy new bonds as and when the Treasury needed to issue them – the BoE thus prevented this worst-cast scenario from becoming a reality.

Of course, it is also true to say that, by taking this action, the BoE incidentally provided UK banks with a constant stream of additional liquidity. And indeed, without this, they would now have even less to lend than is currently the case. To say that, as a result of this largesse, they should now be lending more, however, is still a little harsh, especially when one realises that while our banks have lent the British government £520 billion over the last four years, during this period they have only received £325 billion back from the BoE in asset purchases. That is to say that in addition to lending the government the BoE’s £325 billion, they have also had to lend them another £195 billion of their own, leaving them, in fact, with £195 billion less to lend to businesses and would-be home-owners.

This also explains why the BoE’s QE programme has had far less effect upon the overall economy than was generally expected to be the case. For given that all this new money has gone to the government, which has used most of it to pay public sector salaries, pensions and welfare benefits, that part of it which has come back to the banks in the form of additional deposits and paid down mortgages and credit cards, has simply been used to finance that part of the loan to government not covered by the QE programme.

In fact, one can see this in the figures for bank lending between 2009 and 2011, where the overall increase of £191 billion is almost identical to the banks’ own internally financed lending to government (see Table 1). This would suggest, therefore, that all the additional money which the banks have been able to make available for lending during this period has been entirely vacuumed  up by the Treasury.

 Table 1: Bank Lending 2008 - 2011

Of course, these figures are for just four banks, and do not therefore give us a complete picture. There would have been additional contributions to government borrowing both from other international banks and from smaller UK banks. In that the banks in this sample are the UK’s four largest, however, and in that two of them are partially owned by the UK taxpayer, it is almost certainly the case that, throughout these last four years, it would have been these four banks that would have been working most closely with the BoE and the Treasury to ensure that the government’s deficit was covered. Simply as a reflection of their size, it will also have been these banks that will have done most of the heavy lifting.

What the above table more significantly tells us, however, is just how pernicious public sector borrowing to fund current expenditure truly is. For not only does it store up debt for future generations – generations, which, as a result this debt, may not be able to afford anything like the same level of salaries and benefits – competing, as it does, with the private sector for funds, it also drains the life-blood out of an economy, something which Keynesian economists of the left consistently fail to appreciate.

Combined with the uncertainty in the global economy, this also explains the general failure of the current government’s economic strategy, based as it has been on a gradualist approach to reducing public expenditure as a percentage of GDP. For despite what opposition politicians are constantly telling us – that the government is cutting ‘too far, too fast’ –  as I pointed out in ‘The Straightjacket of Economics & the Wriggle-room Left for Politicians’, the government is not actually cutting public expenditure at all. As can be seen from the budgetary forecasts shown in Table 2, public expenditure is, in fact, scheduled to rise every year throughout the current parliament. All the government has actually cut are Labour’s planned increases and thus the projected rate of growth in public expenditure as it stood in 2010.

 Table 2: Planned Public Expenditure 2010 -2015

The thinking behind the government’s strategy, I believe, was that by restricting the rate at which public expenditure was growing to something below that of the growth in GDP, the public sector would automatically shrink as a percentage of the overall economy in a way that was almost painless, thus allowing the governing parties to maintain some level of political popularity. By the same token they also assumed that, as tax revenues grew with growing GDP, the annual deficit would also simply disappear. What the Treasury clearly failed to take into account was the fact that by maintaining an annual deficit greater than the rate of growth in available bank lending, it would be starving the economy of the finance it needed to make this strategy work. The result has been that public expenditure is still rising as a percentage of GDP, and the government’s deficit reduction plan has effectively stalled. 

It is for this reason that many back-bench Conservative MPs are now calling for a more aggressive approach to deficit reduction. The irony is, however, that if, as seems increasingly likely, this tension within the coalition causes it to fall apart, the beneficiaries will be a party which is absolutely wedded to the public sector and which believes that increasing public expenditure is the answer to each and every problem. 

The difficulty for Labour will come when they get into office and discover – if they don’t already know this to be the case – that there is absolutely nothing they can do. They won’t be able to borrow any additional money – or not without very significant tranches of additional quantitative easing – and total taxation is already at a level where any significant increases in tax rates are likely to be counter-productive – actually reducing tax revenues. For the truth is, as I also pointed out in ‘The Straightjacket of Economics & the Wriggle-room Left for Politicians’, the economy is in such a state that, unless one is willing to take the very unpopular step of radically cutting public expenditure, the way Margaret Thatcher would have done, there is very little any government can do but walk the kind of tightrope the present coalition has attempted.

It’s why so much of the current economic debate is so trivial. The only substantive fiscal stimulus the Labour Party has so far proposed, for instance, is a cut of 2.5% in VAT, a measure which would put an extra £12 billion a year into the pockets of consumers, and which they propose to fund through an additional levy on the banks – the perennial scapegoats – and some additional borrowing. Against a backdrop of an economy which has lost £1.6 trillion in available finance, however, £12 billion is a mere drop in the ocean.

And it is this that is the real tragedy. For while our politicians belittle each other from the despatch box, while arguing over whether or not VAT should charged on hot Cornish pasties, the real problems go unaddressed. There is only so much time, however, before the elephant in the room makes its presence felt. And when that happens, as eventually it will, we’ll all wish we’d paid attention earlier.

Monday, 27 August 2012

The State of UK Banks & The Long Haul to Recovery

Opposition politicians are very fond of telling us that the UK government’s economic strategy isn’t working and that it is time for Plan B. The tacit assumption behind this assertion is that there exists a set of policies which if correctly identified and implemented would lift us out of our current state of economic stagnation and return us to the halcyon days of robust growth we enjoyed just five years ago. What this fails to take into account, however, is that much of the finance upon which our former growth was based no longer exists: a fact which becomes very quickly apparent if one compares the balance sheets of the UK’s four leading banks in the year before and then in the three years following the financial crash of 2008.

 Table 1: UK Bank Financial Profiles 2007-11

In Table 1, I have picked out what I believe to be the four most salient balance sheet items for these banks during this very dramatic five year period: their overall profitability; their levels of assets and stockholder funds; and the ratios between these latter two measures. For simplicity, I have aggregated the figures for Lloyds TSB and HBOS for the years 2007 and 2008, even though the two banks didn’t actually merge until the beginning of 2009. I also have some concerns over the reliability of the figures for RBS, which, although taken from the bank’s own annual reports, don’t, on the surface, appear to make a lot of sense. I suspect that the apparent mismatch between the declared losses and their effect – or lack thereof – on stockholder funds during 2008 and 2009 has something to do with the timing of the various tranches of the UK government’s bailout package. What caused the massive drop in stockholder funds in 2010, however, a year in which the bank only recorded a loss of £0.67b, is far less easy to explain. If anyone can do so, I should therefore be very happy to hear from them.

Looking at the figures overall, however, the most surprising fact to emerge is almost certainly just how small the losses for 2008 actually were – at least, according to the banks’ own reports. Indeed, it appears that only RBS and the HBOS half of Lloyds Banking Group lost any money at all. Admittedly, HSBC’s profits were down and, at various points, both HSBC and Barclays were forced to raise more capital. But neither had to turn to the government for this and, in terms of profitability, Barclays seems to have sailed through the troubles more or less unscathed. The most significant effect on all the banks, in fact, had very little to do with actual losses. It was rather the effect it had on their assets: the mortgages and other loans extended to businesses and individuals on which a bank’s profits are made. For, as can be seen in Figure 1, over a period of just twelve months, these four banks were collectively forced to reduce the overall value of their assets – which is to say the volume of money they were lending – by £1,813 billion.

Figure 1: Bank Assets 2007-2011

One of the main reasons for this very rapid contraction is the way in which, over the last twenty-five years, most banking assets have been funded. For since lighter regulation was introduced in the 1980s, progressively less and less bank lending has been financed out the banks’ own ‘Stockholder Funds’: that part of their capital made up of equity and retained profits. The vast majority of the funding has come from customer deposits and loans from other banks.

Not that there is anything wrong with this in principle, of course. Lending other people’s money to third party borrowers is the main way in which banks make money for their shareholders. It is what allows them to multiply the earning power of their own capital. At present, for instance, the average net return on the assets held by the four banks listed above – the difference between the interest they earn on the money they lend and the interest they pay on the money they borrow, plus the cost of their own operations – is just 0.25%. By leveraging their own funds with those of their depositors and other lenders, however, they effectively multiply this to produce a return on investment for their shareholders commensurate with, and sometimes significantly better than other similarly priced equities.

In 2007, for instance, only 2% of the assets held by Lloyds TSB were financed out of stockholder funds: a gearing ratio of 50:1. This meant that their 0.25% return on assets was actually turned into a 12.50% return on stockholder capital, nearly all of which was distributed as dividends to these self-same stockholders, of whom, during that year, I happened to be one. Indeed, I remember staring in pleasurable disbelief at the dividend slips that came through my door at the time, wondering how the management at Lloyds were able to conjure such a trick. For it almost seemed too good to be true. Which, in a sense, of course, it was. For when, in 2008, it started to be recognised that a good many of the assets held by UK banks were worth considerably less than the value the banks, themselves, placed on them, those banks with highest gearing ratios were seen as particularly vulnerable. After all, it would only have required a 2% write-down in the book value of Lloyds’ asset register for the stockholder capital on its balance sheet to have been wiped out completely, at which point the bank would have been technically insolvent.

Fortunately for me, I sold all my banking stocks at the beginning of 2008. Not that I can claim any significant degree of prescience in this. I sold the shares to invest in a new business start-up which I thought was going to make an even bigger return. Unfortunately, with the financial crash, the market for this new company’s products and installation service effectively collapsed, and I lost more or less the same amount of money as I would have lost anyway. In the immortal words of Kurt Vonnegut: So it goes.

The real problem for the banking industry, however, was that, although those banks with the highest gearing ratios were clearly the most vulnerable, no one knew where the bad debts in the system actually were. They knew that they were mostly bundled up in mortgage based derivatives called Collateralised Debt Obligations or CDOs, but no one actually knew which CDOs were toxic, and which, if any, were perfectly sound. As a result, no bank could be entirely trusted. As a further result, therefore, inter-bank lending, on which the vast majority of banks relied to fund the vast majority of their assets, simply dried up. No one wanted to lend money to a bank which, like Lehman Brothers, could fail at any moment, virtually without warning. More to the point, starved of new borrowing, they were now hard pressed to meet existing obligations. When the loans they had made to existing customers were repaid, therefore, instead of re-lending this money to new customers, they had no choice but to use it to pay off their debts to other banks. Thus, in this merry-go-round of reduced lending, followed by reduced borrowing, followed by reduced lending, and so on ad infinitum, the combined balance sheets of the UK’s four largest banks were reduced by £1.8trillion.
Indeed, it was as much to put an end to this cycle of contraction as to prevent insolvencies that national governments throughout the world – though more particularly in the UK and the United States – intervened to support the banking system. This, thankfully, stopped the rot; but even today the asset registers of our four largest banks are still £1.6trillion smaller than they were in 2008. 

Not, of course, that all of this missing finance is money that, were it still available, could now be used to lend to UK businesses and would-be home-owners. All four of our largest banks are international in their operations. Thus some of this money would now be being lent in other countries. Particularly in the case of Lloyds and RBS, however, there is still a strong emphasis on the home market; and looking at all four banks’ divisional analyses I estimate that the pool of available finance for potential borrowers in the UK is still around £700-800billion lower than it was four years ago. 

Nor is it likely to grow back to its former size any time soon. 

Part of the reason for this is that in order to avoid another such banking collapse in future, under prospective new banking legislation, following the latest Basel Accord, all UK banks will soon be required to hold a minimum amount of stockholder capital as a percentage of their assets, and are already preparing for this, even though the question as to what the required percentage holding should be has yet to be decided. For while implementation of the Basel Accord is mandatory for all G20 members, its interpretation within the structures and codes of practice of a particular banking culture is the responsibility of national governments. Thus while some member states are arguing strongly for the minimum requirement of 7%, as recommended by the Basel Committee itself, others, including the UK, are proposing an even higher figure. In fact in May of this year, George Osborne astounded EU Finance Ministers – and effectively prevented Basel III from being enshrined in EU law – by insisting that the UK be allowed to impose an ‘own capital’ requirement of 10% on its banks, thus actually placing them at a disadvantage with respect to the banks of other countries, and potentially making a UK economic recovery even more difficult to achieve than is currently the case.

Why the UK government should be taking this strong line, in fact, has got many commentators rather baffled. One financial journalist has attributed it to the ghost of bailouts all too recently past. Others suggest that it is mere political posturing: George Osborne and David Cameron showing us how ‘tough’ they can be on fat-cat bankers. To appreciate the damage it could inflict on the British banking industry, however, one only has to go back to the reasons for bank gearing in the first place. For if UK banks are required to hold stockholder funds equivalent to 10% of their assets, the 0.25% return on assets they are currently enjoying would produce a mere 2.5% on investment for their shareholders. In contrast, the lower requirement of 7%, would produce a return on investment of 3.57%, which may not seem a lot, but in today’s market is a very significant differential, and would make investment in British banks inherently less attractive.

Of course, it is also intended that by denying banks the option of boosting their profits by increasing their gearing, they will be forced to become more efficient, increasing their return on assets by cutting costs, including the inflated salaries and bonuses they currently pay their senior staff. And in the long term, I do in fact believe that this will do more than any other measure to curtail the excessive bonus culture endemic within the banking industry. In the short term, however, most banks are currently cutting costs by simply closing branches and reducing staff altogether, while at the same time increasing their interests rates on loans and mortgages to customers to levels well beyond what a Bank of England’s base rate of 0.5% would seem to justify, all of which is having a negative effect on the UK’s economic performance.

Worse still is the effect these measures are likely to have on the rate at which banks are going to be able to increase their lending in the near future. For given that the requirement with respect to stockholder funds is defined in terms of a percentage of their assets, one obvious way for banks to meet this requirement is simply to shrink their asset registers still further. Indeed, in the case of three of our four biggest banks, this may be the only way.

 Table 2: Increases in Stockholder Funding Required Under Different Scenarios

One can see this in Table 2, which presents two sets of data. The first set includes the asset levels for each of the four banks at the end of both 2008 and 2011 and shows how much additional lending each bank would have to undertake in order to return to its 2008 level. The second presents the level of stockholder funds held by each bank at the end of 2011 and calculates how much additional capital they would need to retain or acquire in order to meet the required levels of stockholder funds, firstly at their 2011 levels of lending, and then at the 2008 levels. As you can see, even at the 2011 levels, Barclays, Lloyds and RBS would all need significant injections of capital even to meet the lower, 7% level of stockholder funding. 

The question arises, therefore, as to where this additional capital is going to come from.

Of course, all three banks could try to raise the money through new share issues. There are, however, a number of factors that would make this very difficult, particularly at present. As already pointed out, depending on the level of stockholding funding the UK government decides to impose on its banks, future returns on investment are likely to be considerably less than in the past. More importantly, the current level of uncertainty makes it very difficult for any potential investor to calculate what later returns are likely to be. There are also a number of skeletons still rattling around in some of our banks’ cupboards. In addition to the LIBOR scandal, of which we have not heard the last, according to the shareholder advisory group, PIRC, UK banks are still sitting on around £40billon of undeclared losses, £18billion of this total being hidden at RBS. Finally, to complicate matters further, both RBS and Lloyds Banking Group are still substantially owned by the UK taxpayer. Before putting any money into either of these banks, therefore, most potential investors would want to know what role, if any, the UK government intends to play in their management and direction, and what its medium term strategy is, particularly with respect to its own exit. New share issues, as a consequence, are a very unlikely prospect in anything like the near future.

The obvious alternative, of course, is for each of these banks to grow their balance sheets organically, using retained profits to swell their stockholder funds. As can be seen from Table 2, however, HSBC is probably the only one of these banks for which the organic solution is a realistic option. In fact, I calculate that if HSBC continues to grow its assets at no more than 2011 rates, and retains 75% of its after-tax profits for 2012 and 2013, it will already cross the 7% stockholder funding threshold by the end of 2013. In contrast, even if Barclays stopped growing its assets altogether and retained 100% of its after-tax profits, distributing no dividends at all for the rest of this decade, it still wouldn’t cross the 7% threshold until 2020. As for RBS and Lloyds, in 2011 they didn’t actually have any profits to retain.

That’s not to say, of course, that Barclays, Lloyds and RBS won’t find a way forward. In all three cases, however, I suspect that it will involve a significant amount of restructuring. One possible solution for RBS, for instance, would be to sell Nat West, a bank with a very strong brand, which, even in the current state of the market, would almost certainly attract a potential buyer, probably from one of the emerging economies. It would then become the responsibility of this new owner to meet the 7% own capital requirement, while RBS, having divested itself of Nat West’s asset register, and therefore reduced its own aggregated lending, would be able to add the proceeds of the sale to its stockholder funds, thereby very probably achieving its own 7% stockholder capital requirement in one fell swoop.

I’m not saying this is definitely going to happen, of course. The RBS board will be looking at all the options. The point is that some such restructuring is almost certainly going to be necessary before any of these banks can start growing their asset registers with any alacrity. Anyone who thinks that, with the exception of HSBC, any of our top four banks will be able to start lending money again at 2008 levels in anything like the near future is therefore simply deluding themselves. Politicians can go on television and admonish the banks to lend more all they like; but even if there were willing borrowers out there – enough to make a difference – the banks can’t lend what they don’t have and what they will soon be prevented by law from borrowing. Moreover, the fact is that even if the banks still had the additional £700-800billion of available finance they had in 2008, the world has changed since then, and there are now far fewer people willing to borrow money for speculative investments than there were four years ago, whether it be on property or on new business start-ups. If the supply of finance has dried up, the demand for it has also taken a bit of a hit. And when you put these two things together, it’s going to take more than an Olympic Games and a cut in VAT to overcome the inertia that has now firmly taken hold of the UK economy.

To understand just how difficult it is going to be break free of our present stagnation, however, one first needs to understand that what has happened since 2008 is not just a temporary local difficulty, and that just as the issues surrounding the banks are far more complicated and far-reaching than most people appreciate – as I hope I have now demonstrated – so too the change that has overtaken the demand side of the equation is far more profound and long-term than most politicians are willing to admit. To demonstrate this clearly, however, will require at least as much space as I have devoted the problems of our banking industry, and will therefore have to wait until my next blog.