A negative view of negative rates

My views on the disadvantages of low interest rates have been set out on this blog over recent years and increasingly there are indications that this view is moving into the mainstream. Indeed, across large parts of Europe the debate is not about low rates but rather negative rates. The theory of negative rates is simple enough: Banks are penalised for holding excess liquidity on deposit at the central bank and therefore have an incentive to lend it out. Whilst this policy may work for a limited period of time, it is now more than five years since the ECB lowered the deposit rate into negative territory. 

Today’s move to reduce it further to -0.5% may well be counterproductive although the ECB has finally recognised that forcing rates lower will simply impact on the bottom line of the banking sector and have introduced a system of tiering to provide some form of relief. Nonetheless, the negative interest rate policy is not having the desired effect and rather than continue with more of the same, it is time to reconsider our monetary options.

It is ironic that on the same day the ECB announced changes to monetary policy, the Swiss Bankers Association issued a strong statement decrying the SNB’s negative interest rate policy, arguing that “the societal, structural and long-term damages will become even greater the longer we find ourselves in this ‘lower forever’ environment.” SBA Chairman Herbert Scheidt argued that “negative interest rates are causing massive structural damage to the Swiss economy and disadvantages for the country’s citizens. They result in bubbles and damage the competitiveness of the Swiss economy long term because they keep unprofitable companies alive artificially. Negative interest rates also put the pensions of Swiss citizens at risk. A further lowering of interest rates would further exacerbate this issue. The longer negative interest rates remain in place and the greater the structural damage for Switzerland, the more urgent it becomes to ask from which point onwards countermeasures must be taken against negative interest rates.”

There are a lot of strong arguments there which deserve to be taken seriously. The idea that zombie companies are kept alive artificially is of short-term benefit to those who would otherwise be put out of work, but in the longer-term it hampers the efficient allocation of resources throughout the economy to areas where returns are higher. I have long argued that pension fund returns will be dampened by excessively low interest rates and a report this week highlighted that annuity rates in the UK have fallen to historic lows. Every £10,000 in the pot yields just £410 – down 12.3% from the start of the year – compared to between £900 and £1100 in the 1990s. In effect, buying an annuity to generate a guaranteed lifetime income will, in the words of pension expert Ros Altmann, “mean poorer pensioners for the rest of their lives.”

The impact of loose monetary policy on boosting financial markets to levels which look way out of line with fundamentals has been well documented. Although conventional P/E measures suggest that equities look extremely expensive in a historical context, the fact that the dividend yield on stocks is significantly higher than bond yields for the first time in almost 60 years means that investors are unlikely to dump equities any time soon (chart). By raising the net present value of housing services, low interest rates have also boosted house prices above fundamentally justified levels (a subject to which I will return). 

 

There is, of course, a risk that if markets have been inflated so much by low interest rates, any attempt to raise them will cause the bubble to deflate quickly. Central banks concerned with maintaining the stability of the financial system will be keen to avoid such an outcome. On this reading of events, the lower rates go and the longer they are maintained, the more difficult it becomes to raise them. The US may provide a counterfactual where markets continued to perform strongly despite the fact that the Fed was raising rates, but this was partially owed to the Trump Administration’s corporate tax cuts so the jury is still out.

We should not overlook the fact that central banks can only impact on the supply of credit and its price, but not demand, and we are increasingly at the point where reducing interest rates is akin to pushing on a string (to use the phrase attributed to Keynes). But I had an interesting discussion with a colleague who suggested there is nothing special about negative rates per se – the main problem is that positive rates have been baked into so much contract law that we struggle to deal with negative rates. He described a case of two identical derivative contracts where one receives a floating rate payment over the period of an EONIA contract whereas the other defines a fixed payment calculated on the reference (EONIA) rate. Both are essentially the same instrument in a world where interest rates are above zero but they are treated differently in a negative rate world because interest payments “cannot be negative” whereas the fixed payment can.

In a similar vein, the Finnish financial regulator is currently trying to assess whether it is legal for banks to pass on negative rates to retail depositors. Different countries have taken a different approach to this problem, with some refusing to levy the charge on retail customers. But this raises a question of whether depositors might simply withdraw their funds from one country and place them in another euro zone country where depositors are protected. To the extent that the period of negative rates has lasted longer than anyone initially anticipated, banks’ business models are going to have to change. Last month Jyske Bank in Denmark announced it would issue 10-year mortgages at a rate of -0.5%, although the bank will not lose money on the product since fees and other charges will be sufficiently high to ensure a profit. This may well be a template for the rest of Europe where fees and charges are likely to rise as banks struggle to make a profit in a world of negative rates.

It appears that ECB Council members were not unanimously in favour of the measures adopted today, with the central bank governors of France, Germany and the Netherlands reportedly opposed to a resumption of bond purchasing. Their views on negative rates are not known but this is an indication that northern European central bankers believe we are very near the limits of what an expansionary monetary policy can achieve. Mario Draghi may thus have delivered a poison pill to Christine Lagarde, who takes over as ECB President at the start of November. With Draghi having maxed out the credit card during his tenure, it will fall to Lagarde to deal with the consequences.

Education: Assessing the costs and benefits

The provision of education services, like health, is one of the things that the state does well. Never mind the fact that both are available in the private sector: The vast majority of us at some point or another rely on the state provision of both. But as is usually the case with such services they have also been used as footballs to satisfy various political ends. Since spending on the NHS is such a large part of government outlays, representing around 16% of total outlays, it is a subject I have covered on previous occasions (here, for example). Education also accounts for a not-insignificant proportion of spending – around 7.5% – and it is thus worth looking at some of the issues surrounding it.

My curiosity in this area was piqued by the announcement last December that the ONS is to apply a new treatment of student loans in the national accounts and public finance statistics which will have some profound effects on the data when the figures are rolled out later this month. The reason for the change is a sensible approach to tackle the fiscal illusions caused by their treatment in the accounts. But first, a bit of explanation is in order.  Student loans were first introduced in 1990 as a means of allowing students to cover their living costs. In 1998, they were extended to include loans to pay tuition fees, but in 2012 universities were permitted to increase the cap on tuition fees from £3,000 per year to £9,000 which raised the amount that students were permitted (required) to borrow. Many students can be expected to graduate with debts of around £50,000. They are expected to repay these loans over the first 30 years of their working lifetime, so long as their annual income exceeds £25,000, with interest charged at a rate of 5.4% (down from 6.3%).

As one who is old enough to have received a public grant to study at university, it strikes me as an egregious example of intergenerational unfairness and is a clear example of the law of unintended consequences. One of the reasons why the cap on tuition fees was bumped up in 2012 was to create a market amongst universities in which they could compete for students on price grounds. However, all universities decided to charge the maximum amount in order that their offerings were not perceived as inferior goods. It thus costs the same to study at Oxford or Cambridge as at Bucks New University.  The model has thus failed. It also does not make sense to me why today’s graduates, who still enjoy a wage premium over their non-university educated peers, should not simply pay higher tax generated by their well-paid jobs to repay the costs of their education as my generation did. I will accept that there may be fewer well-paid jobs about today, but the point still stands. Today’s students are being taxed twice: Once for the direct costs of tuition, where loans are charged at an interest rate 465 points above Bank Rate, and once for the higher wages which a university education (theoretically) generates.

Before coming back to the issue of student loans and public finances, an excellent article in The New Statesman questioned the impact of grade inflation on university education. This is, of course, not to denigrate the hard work that a lot of people put in to obtain their degree. But when 24% of students obtain the highest classification compared to around 7% in the mid-1990s, it is difficult not to be struck by the conclusion that there is some correlation between the need to give the customers what they want (good grades) and the increasingly extortionate amount that they pay (more on this another time). Education has thus become commoditised in a way that was previously unthinkable.

So what does all this have to do with public finances? As it currently stands, student loans are recorded as conventional loans in the national accounts – in other words, they are a public sector asset. But given the amount that students are forced to borrow and the almost usurious interest rate, coupled with the salary threshold, a large proportion of the loans will never be repaid within the 30-year timeframe. The Department of Education reckons that between 60% and 65% of the amount outstanding will have to be written off (other estimates suggest this figure could rise to 80%). Since it was never intended that the full amount of loans be repaid, it is therefore nonsensical to treat them in the public accounts as though they will be.

Accordingly, the statisticians will in future treat part of the amount outstanding as genuine loans whilst the rest will be classified as government expenditure. This will raise annual public borrowing by around £10.5 billion (~0.5% of GDP) and add almost £60 billion, or 4%, to national debt (2.7% of GDP) – see chart. It will therefore be interesting to watch out for comments around 24 September when the new data are released, arguing that the government has somehow been massaging the figures (it hasn't, but the accounting treatment has left something to be desired). However, at a time when the government has recently announced a big increase in public spending, it is clear that forecasts of UK government borrowing will be revised sharply higher in the months ahead. 

Nor is the student debt issue confined only to the UK. A VOX blog post looked at the situation in the US, where the market is far less forgiving, and concluded that high student debt burdens have a major impact on the behaviour of the debtors. Borrowers’ are constrained in their ability to take high-risk/high pay jobs “because they need to pay these loans and prefer more stable income” and find that their mobility is constrained as a result. The research also finds that “borrowers benefiting from debt relief … are also significantly less likely to default on their accounts, above and beyond their student loan accounts.”

The build-up of student debt has major implications for the wider economy and public finances. But to the extent that there are significant social externalities associated with education that have long been recognised but are difficult to measure (better heath, reduced tendency towards crime etc.), there is an argument that the government has an incentive to bear at least part of the costs of provision. In the current system where the cost burden is placed squarely on the consumer of education services, this in effect allows governments a free ride on the positive benefits it generates which is something else today's generation of students have a right to feel aggrieved about.

Brexit and the pound

Economics is the study of how people make choices under varying degrees of certainty. But it is the lack of certainty which concerns us at present as global geopolitical considerations impact on investors’ assessment of asset valuations. Here in the UK, the issue of Brexit further adds to the mix. We hear a lot about how this raises the risks to UK financial assets. However, we have to make a distinction between risk and uncertainty. As the economist Frank Knight put it almost a century ago in one of the earliest and most influential works on investment risk-taking, “there is a fundamental distinction between the reward for taking a known risk and that for assuming a risk whose value itself is not known.”

The valuation of risk underpins the insurance industry where actuaries have some idea of the possible range of outcomes. But there are some risks which we cannot hedge because we have no idea of the possible range of outcomes. Brexit falls into this category. Although there has been much concern about the fall in the pound in recent weeks, as anyone who has recently been on holiday abroad can testify, in truth it has traded in a relatively narrow range over the past three years after the initial post-referendum decline. The Bank of England’s trade weighted index, which is a broad measure of sterling’s value against a basket of currencies, has traded in the range 73 to 80 compared to a wider range of 79 to 94 in the three years prior to the referendum. Admittedly, it has traded at multi-year lows against both the EUR and USD of late but given the magnitude of the risks involved, it still surprises me that the pound has not traded even lower. Ten-year gilt yields have traded at all-time lows in recent weeks, in line with global trends, suggesting that the bond market has no real concerns about the UK government’s creditworthiness.

If we were to infer what was happening in the UK purely from watching market moves, we would not conclude that it was going through the most dramatic political crisis of modern times. One explanation for this apparently paradoxical reaction is that the markets cannot price what form Brexit is likely to take, let alone what happens in the event there is no deal, and are holding fire as a result. In other words, markets are trading an uncertain environment rather than a risky one. But we can gain some idea of currency market concerns by looking at trends in implied FX volatility, which is a measure of how much the market expects the pound to move. Three month implied GBP/USD vol has recently traded above 14% (chart above) – ahead of the 2016 referendum it was at 16% (and reached 18% in the wake of the referendum outcome). Aside from the period following the Lehman’s crash in 2008, when global assets were priced for the worst, we are close to the highest recorded levels of idiosyncratic sterling FX volatility.

Of course, the one thing that volatility measures cannot tell us is in which direction the currency is likely to move. But it is accepted that in the event of a no-deal Brexit, sterling will depreciate sharply. Since it is impossible to give any accurate assessment of how big the move is likely to be, we are reduced to taking the volatility measures as a guideline and applying a significant degree of judgement (or guesswork, if you prefer). Forecasting exchange rates is difficult enough at the best of times and these are not the best of times, so the indicative levels shown here should be treated as no more than that.

In the case of no-deal, my guess is that the GBP/USD rate will stabilise around 1.15 (a decline of around 5% from current levels) although it could initially go sharply lower to somewhere around 1.10 before recovering, if the experience of June 2016 is anything to go by. As has become evident in recent days, there is plenty of scope for upside in the event that a no-deal Brexit can be taken off the table. In the extreme case where the UK revokes the Article 50 notification the pound can be expected to rally strongly. Indeed, a simple model based on expected interest rate differentials suggests that fair value for the GBP/USD rate is around 1.50. The chart above shows that since 2016, the exchange trade has traded outside the model’s one standard error bounds which we can attribute as the risk premium baked into the currency since the referendum. Using this model as a benchmark, I reckon that this risk premium results in sterling being approximately 20% undervalued versus the dollar. 

To the extent that the currency acts as a barometer of the market’s assessment of a country’s economic health, the recent slide in sterling reflects the downbeat assessment of the UK’s prospects. But whatever happens in future, it is unlikely that current market levels reflect a stable equilibrium. Either the situation with regard to a no-deal Brexit gets worse, in which case the pound might be expected to fall further, or it improves in which case sterling’s fortunes will also recover. The events of the past few days, in which the prospect of a no-deal Brexit has at least been temporarily been put on the back-burner, suggests that there is some room for optimism. But a more sustainable recovery is unlikely until a permanent solution to the problem is found.

We all need to chill

UK parliamentary proceedings yesterday produced yet another night of high drama with MPs delivering a bloody nose to Boris Johnson who has learned a harsh lesson in the Realpolitik of Brexit. However, it only succeeded in raising as many questions as answers. Will there be a general election? If so, what would it resolve? Will the UK really leave the EU on 31 October, and if so, with or without a deal? What is the future of the Conservative Party following the expulsion of 21 MPs? All of these are interesting questions and will undoubtedly be looked at the weeks and months to come.

But what perhaps concerns me most of all is the increasingly short-term nature of the way the UK has handled the Brexit problem. Although we went through many nights of high drama under Theresa May’s premiership, her main objective was to buy the UK some time in order to minimise the economic risks. Johnson’s government has shown no interest in such a strategy. He is focused purely on the politics of delivering Brexit without a second thought for what will follow. Dragging the UK out of the EU at any price will have economic consequences which will be reflected at the ballot box. That said, I am not sure that Remain supporters have given much thought to the future either. Their objective is simply to prevent a no-deal Brexit, which is laudable, but what happens thereafter? They presumably cannot ignore the referendum result forever. And what happens if the 21 Tory MPs expelled from the party are replaced with fellow-travellers who ultimately allow Johnson’s government to pursue its goal of a clean Brexit?

One of the key lessons we have learned over the past three years is that the British political system is incapable of dealing with the Brexit question. As I have pointed out on numerous occasions, the fact that the Conservatives have “owned” Brexit means (a) failure to deliver reflects badly on them and (b) the divide between parties, which was already considerable, has widened further which makes cross-party cooperation difficult. Watching politicians from both sides of the political divide engaging in the adversarial process which passes for debate, it is evident that oratorical skills and points scoring are more highly valued than rational consideration. Only this afternoon, Chancellor Sajid Javid’s speech delivering the government’s spending review was twice brought to a halt by the Speaker who admonished the Chancellor for being overtly partisan in what was supposed to be a dry speech about public spending. I do not recall that happening during any parliamentary speech by any Chancellor.

The theatrical nature of parliament further encourages adversarial behaviour. As the blogger Chris Dillow highlighted in a post recently, presenting politics as theatre is dangerous because it allows journalists to focus on style rather than substance. As a number of other commentators have pointed out, this focus on style over substance has produced an environment in which the media seems less interested in the facts of the matter than whether it generates an engaging debate. In a fascinating article on pro-Brexit bias at the BBC, Chris Grey argues that the BBC has inadvertently stoked the partiality of the debate by giving equal air time to both sides. 

As Grey put it, “the overwhelming balance of opinion amongst economists, including those employed by the Government, is very clear: Brexit will be economically damaging and the main debate is the extent of the damage. Yet ‘balance’ suggests that the pro-Brexit minority of economists be given equal billing with the anti-Brexit majority.” The consequence of this is that people believed that the economic merits of leaving were as strong as those of remain. Worse still, “almost all of the factual arguments made by the Leave campaign were untrue (£350M a week for NHS, Turkey is joining the EU etc.), but ‘balance’ required the BBC to treat them as being as valid as the opposing arguments.”

Imagine a debate between pro- and anti-climate change supporters. The pro lobby is backed up by a scientific body of evidence compiled by highly qualified people who do not say that human activity is causing climate change but that it is highly probable. The antis do not have anything like the same degree of scientific credibility but shout louder. Should their arguments receive the same prominence? Most rational people would argue not since it is better to believe the experts and be proved wrong than listen to the deniers if they are wrong. But with Brexit it seems we are quite content to ignore the economics.

A number of factors have thus come together to create a climate in which it is no longer possible to have a rational debate about Brexit: Political miscalculation; an adversarial political system and misguided media attempts to ensure an unbiased debate are but three factors. So poisoned has the political climate become that amongst the 21 Tory MPs stripped of their party membership after their vote against the government’s Brexit policy are two former Chancellors of the Exchequer (Ken Clarke and Philip Hammond). But the greatest irony is that the grandson of Winston Churchill, Boris Johnson’s great political hero, is another of the victims. In his speech to parliament this afternoon, Sir Nicholas Soames sarcastically thanked the prime minister, whose “serial disloyalty has been such an inspiration to so many of us.” He ended by saying that “it is my most fervent hope that this House will rediscover the spirit of compromise, humility and understanding that will enable us to push ahead with vital work in the interests of the whole country.”

He speaks for many of us, lamenting the inability to engage in rational political discourse on matters of national importance. By continuing to reduce the space for evidence based policy, we run the risk of making bad political and economic decisions. As Soames’ grandfather said in 1938, “The stations of uncensored expression are closing down; the lights are going out; but there is still time for those to whom freedom and parliamentary government mean something, to consult together. Let me, then, speak in truth and earnestness while time remains.”

No good options (only bad ones)

Regular readers will know that I am no fan of Boris Johnson, having been critical of his actions over the past three years. Johnson has a long history of lying when it suits his interests (here for a list of issues which renders him sufficiently untrustworthy to take his public pronouncements at face value). Brexit has brought out the worst in him: Remember the weekly savings of £350 million splashed all over the side of that bus? Or what about the fact that he constantly undermined his prime minister whilst sitting in her cabinet?

Despite all of this – or perhaps because of it – I have been of the view that Johnson does not want a no-deal Brexit. Even last week’s execrable decision to prorogue parliament could be justified as an attempt to put pressure on MPs to sign up to the much derided Withdrawal Agreement. As I pointed out in my last post, one interpretation of the strategy was to ensure that it was impossible to reach a deal with the EU so as to put pressure on MPs to ratify the Withdrawal Agreement and dare Labour to block it, knowing that they could be blamed for a no-deal Brexit in any subsequent election. I still think that is a plausible strategy.

But over the weekend, it has become evident that the government is prepared to trample over democratic norms to an extent that was previously unthinkable. We had the unedifying spectacle of Michael Gove refusing to commit the government to complying with any laws passed by parliament. This was followed up by the threat to deselect any Conservative MP who votes against the government in order to block a no-deal Brexit. I do not want to describe what is happening as a coup – a word which has been bandied around a lot recently – but there is a new strain of authoritarianism in British politics, the likes of which we have not seen before (at least in peacetime). This is not the Conservative Party of Margaret Thatcher or Winston Churchill (Johnson’s political hero). 

The sheer hypocrisy of the deselection policy beggars belief. As Tory MP Alistair Burt pointed out in response to the government’s call for MPs to support its Brexit policy, “I did. I voted for the conclusions of the negotiations brought to Parliament in the WA [Withdrawal Agreement]. JRM [Jacob Rees-Mogg], his friends and current Cabinet members did not. Why am I, having loyally supported, now being threatened and not them?” It is hard to dispute the logic of this claim. On 15 January, 118 Conservative MPs voted against the government’s stated policy of ratifying the Withdrawal Agreement. On 12 March this number was reduced to 75 and by the time of the final vote on 29 March there were still 34 recidivists. The 196 Tory MPs who voted with the government on three occasions will not be inclined to be threatened by those who have consistently showed a lack of loyalty to the former prime minister. What comes around goes around, and Johnson’s lack of loyalty in the past means he cannot count on the support of those who he has previously let down. 

Nor does the deselection tactic make a lot of immediate sense. The government has a majority of one: withdrawing the whip from Conservative MPs means that they are effectively excommunicated from the party, increasing the likelihood that they will vote against the government on a range of other issues. But if the ultimate objective is to hold an election sooner rather than later, there may be some method to the madness – why else would a government want to operate without a working majority? As David Gauke MP said in a radio interview this morning, “I think their strategy, to be honest, is to lose [an attempt to rule out a no-deal Brexit] this week and seek a general election having removed those of us who are not against Brexit or leaving the EU but believe we should do so with a deal.” Indeed, newspapers this afternoon were full of headlines suggesting that Johnson would be prepared to trigger an election if he lost a vote ruling out a no-deal Brexit. However, an election can only occur if the government loses a vote of no confidence in parliament or if two-thirds of MPs vote for it. Either way, it will require the consent of Labour MPs.

Former PM Tony Blair has warned Labour leader Jeremy Corbyn against falling into the “elephant trap” of calling for an election. Blair’s words should be heeded. As much as people are opposed to Brexit and the way in which Johnson has ridden roughshod over the British constitution, there is no guarantee that voters will flock to Corbyn as an alternative. In fact, I am pretty sure they won’t. Obviously Corbyn does not see it that way but I would be prepared to bet that he will not improve on the relative success of the 2017 election result.

If Corbyn really wants to put pressure on Johnson, his strategy should be to get as many Tory rebels as possible to sign up to a motion which commits parliament to ruling out a no-deal Brexit, whilst refusing to rise to the bait of any vote which would trigger a general election. This has the disadvantage that if Brexit can be delivered without collapsing the economy it will hand Johnson an electoral boost. But a more likely outcome is that since the EU will not cave in on the Irish backstop, which the hardliners in the Conservative Party will not be able to accept, a disciplined Labour Party can hold the Tories’ feet to the flames for a much longer period and possibly even force the party to split which would be to Labour’s electoral advantage.

Unfortunately, this would mean a continuation of the political wrangling that has characterised the last twelve months – and that is definitely not in the electorate’s interest. But an election is not in the country’s interest either. The Fixed-term Parliaments Act of 2011 was designed to prevent governments controlling the timing of elections for their own purposes (which it spectacularly failed to do in 2017). If the terms of the Act had been adhered to, we would not have had an election since 2015 and would not have to face the prospect of another one until summer 2020. The 2017 election was a device to suit the government’s convenience – as will any plebiscite in 2019. If there is another election this year, it will further undermine the claim that a second EU referendum would be to disrespect the “will of the people.” 

Is there a way out of this political nightmare? It is hard to see one. We are paying the price for a litany of past mistakes – from the decision to hold a referendum at all; to drawing red lines around membership of the single market and customs union, to Johnson’s plan to resolve the issue by 31 October.  Whatever happens now, half the electorate will be left disaffected and angry. There are no good options – only bad ones.