How equal could UK property wealth be, given the current physical stock?

When trying to estimate inequality in Britain, it sort of depends what you’re looking at.

While UK income inequality rose significantly in the 1980s, it has stayed pretty steady since the early 1990s. Wealth inequality is greater by an order of magnitude, and wealth in the UK means private pension wealth (42% of household wealth) and property (35% wealth), with physical and financial wealth making up the other 24%. I have blogged before about wealth taxes, which I think are a good idea in principle. They may even feature as a key issue in the US Presidential election, depending on who gets the Democratic nomination. But it seems likely that the topic of wealth taxation will be off the agenda for some time in the UK.

The ONS calculates splits UK wealth inequality (with a Gini coefficient^ of 0.63) into net financial wealth (0.91), private pension wealth (0.72), and net property wealth (0.66). I’m guessing that with each of these having a higher Gini than the Gini for total wealth, some households have more pension but less property, some less property and more financial wealth etc.

Gini coefficients for UK wealth and income

gini1

The biggest driver of private pension wealth is whether you are in a pension scheme at all. Only 53% of individuals (aged 16-State Pension age) are in an active scheme, and this is after the +10% bump up that came from auto-enrollment .

If you are in a scheme, the biggest driver of your pension wealth is whether you are in a Defined Benefit scheme or a Defined Contribution scheme. I wrote a thread on the latest data here , and leave you with this cool ONS chart from the threads that shows pension wealth by age and scheme type. This is a big deal, and I would expect it to become an increasingly big deal.

db dc

But, as Arlo Guthrie said, that’s not what I’m here to tell you about. I’m here to talk about property inequality. Or rather, I want to know what level of wealth inequality is embedded in the physical stock of UK property wealth.

The seed of this question grew in the run-up to the General Election. Basically. if you’re going to apply wealth taxes to property (as an asset that can’t flee the country), then given my assumption that wealth inequality is way higher than income inequality (see first chart above), doesn’t this mean that people with top-quartile incomes aren’t going to be able to afford to live in their homes? (Yes, I know, tiny violin time.)

In order to make some headway I asked @resi_analyst for advice, and he kindly pointed me to annual transaction data files. With around 4-5% of residential properties changing hands each year it is maybe not a stretch to infer that they are a reasonable sample of the UK residential stock. I like this a lot more than looking at the (excellent) ONS Wealth & Assets Survey data because the WAS is a survey, while transactions represent a much bigger dataset.

And this is what I found, looking at easily-available from the last six years. The chart is log-scaled and shows the proportion of properties sold by price-point. So in the first 10 months of 2019 the median residential property transaction value was £235k. A quarter of properties changed hands for £355k or more, and 1% of properties changed hands for £1.26m or more. The stuff in the very top one percent is a bit whacky, and is driven by a very small number of super-high property transactions.

UK residential transactions by percentile price point, 2013-Oct 2019

dist1

This top-tail is interesting, but very small. I could imagine some of these being split up into flats (although a fair few are Belgravia flats already), and as such the structure of inequality in the property stock could be amended pretty easily. This would all require building work to do and my question is around the physical stock as it stands today.

If we remove the top-priced property from the distribution and examine only the bottom 99% on transaction values, things look a bit different (still requiring a log-scale, mind).

dist2

I applied a bit of VBA code kindly left hereto then calculate the Gini coefficients of the transaction values.

I was quite surprised by what I found.

Firstly, in contrast to the net property wealth data from the ONS, the level of inequality embedded in the value of physical private residential stock is actually not too far away from the level of income inequality in the UK. Taking out the top and bottom percentile of transactions (of course) makes this even more the case:

gini2

Secondly, if we were to take transaction values as a good proxy for the value of the stock, we have seen an increasing convergence between income inequality (dark blue line) and the embedded inequality attached to the physical stock of UK residential property (red line). Moreover, this isn’t a function of those whacky idiosyncrasies at the very top of the distribution of property transactions. We can see this to be true by looking at the Gini coefficient of the 1-99%ile of transaction values (light blue line).

gini3

The data exists to calculate this going back to 1995, but sadly the ONS data file is too monstrous for me to deal with in simple Excel.

Why is my estimate of the stock of private property stock value inequality so different from the net property wealth measure of inequality from the ONS?

  • Firstly, the whole point of my inquiry was to see how equal property wealth could be, given the current physical stock of property that is in place today. This is very different to measuring the current level of inequality that resides in property assets.
  • Secondly, the ONS net property wealth is calculated by netting mortgage debts off against the value of residential property owned. So If I buy a house for £235k with a mortgage of £200k, my net property wealth is £35k. That’s what net means. I care about the £235k while the ONS cares about the £35k.
  • Third, there are only 20m private sector residential dwellings (out of a total 24.2m dwellings), and I am looking at value-inequality within this dataset. The ONS reckons that there are 27.6m households. It’s not immediately clear to me how households are defined, as they appear to be defined in a way that is detached from homes. Regardless of this quirk, we know that there are a *lot* of households who don’t own.
  • Lastly, there are lots of wild assumptions in my data: that transactions are a decent proxy for the evolution of stock values; that things observed in England & Wales are true for the UK as a whole; that excluding BTL and offshore purchases doesn’t screw things up. Each of these could be wrong.

 

Maybe I shouldn’t have been so surprised. Somewhere between ‘a lot’ and ‘almost all of’ the value of a residential property is tied up in its locational value, and this locational value is significantly a function of the proximity to cash flows that flow from employment. If high paying employers set up in a given locality it’s going to boost the locational value of the area. Simples.

 

^ To quote George Banham of the Resolution Foundation, the Gini coefficient measures inequality on a scale from 0 to 1, where 0 is perfect equality and 1 is perfect inequality (a situation where one person has all the wealth).

Electoral maths for (parents of) 6yr olds

As I’ve tweeted, my six year old asks lots of questions about UK politics. And he has views.

But most recently he’s been asking how I will vote in the forthcoming General Election. I think he’s concerned that he’s getting different answers from different grown ups who he considers role models.

Beyond the whole ‘there are differing views, each legitimate’ chat, I decided to try to teach him about first past the post system as a way of explaining the concept that people don’t even always vote for the party with whom they most identify. Without an understanding of the electoral system, voting for your non-favourite party is kind of baffling (put brilliantly here by Douglas Adams).

First past the post is not tricky, but he is six. And I’m aware that I can sometimes complicate stuff. So rather than subject him to a verbal onslaught I told him that I had made a super-simple game for him that would explain. The point of this post is to share method with other parents who might be interested to convey the idea to their kids.

Imagine you are 18 and are getting ready to vote, I said. There are fourteen voters and six parties in your election. Who do you vote for? I passed him the pad of paper and told him to fill in the last box. He handed it back.

I asked him why he voted differently. He told me. That’s it.

Developed Market Privilege

With Boris Johnson proroguing parliament the chat has turned again to whether UK is becoming an Emerging Market (EM). Sure – suspending democracy to avoid losing power is a bold move for any British government/ monarch. But what does it actually mean to go full-EM?

The IMF definition of an Emerging Market studiously avoids words like dictatorship and democracy, focusing instead on income per capita and export diversification, but leaving plenty of wiggle room to change minds if an upstart somehow qualified as Developed. The World Bank scrapped the definition completely in 2016. MSCI and JP Morgan have their own convoluted definitions that control the entry into their widely followed equity and bond indices, respectively. Under any of these definitions the UK is miles away from going EM. But it’s a conversation with a very smart tweep about a year ago that really sticks in my mind.

If you live in a Developed Market it means that you are pretty likely to be well-off individually (when measured on a global scale). But it also means that you benefit from Developed Market Privilege: your government can run counter-cyclical monetary and fiscal policy.

Reducing (rather than raising) interest rates, and loosening (rather than tightening) government purse strings when an economic downturn comes might sound like common sense. And for Developed Market economies it is. But if you are an Emerging Market (EM) economy, things aren’t quite as simple. For EM economies, rate cuts and easier fiscal policy (that might help cushion the blow of a slowing or shrinking economy) might well be met by currency weakness, rising inflation, and a higher risk premium applied to the country’s debt and financial instruments by foreign (and domestic) investors, all of which might be somewhat counterproductive to the happiness of EM citizens. Bottom line, in the words of my interlocutor “at the risk of provoking the fixed-income goblins, the shibboleth is ‘in risk-off, am I buying or selling your debt?’”.

So being EM sounds not exactly brilliant, but also actually something that has a concrete definition relating to how credibility issues lead directly to currency weakness and financing issues. Given that pretty much everyone knows that a central bank can control the level of bond yields (if it is willing to pay a high enough price) this sounds like a story of Exchange Rate Pass Through (EPRT). A high EPRT should indicate EM-hood. A low ERPT might deliver DM-privilege. It’s actually a bit tricksy to calculate ERPT. Professor Kirsten Forbes is pretty awesome on this whole EPRT issue, and has the benefit (from my perspective) of having served on the MPC and looked at where the UK sits in all of this.

Taking both Forbes’ EPRT data, and looking also at what happens in risk-off situation, we get chart 1. The dark blue blobs are considered Developed Markets in bond indices, the blue diamonds are considered Emerging Markets. Higher ERPT are higher in the chart, and lower ERPT are lower in the chart. The average EPRT for his small sample of Developed Markets is lower than the average EPRT for this small sample of Emerging Markets, but there is not really much in it.

Chart 1: Exchange-Rate Pass-Through coefficient, vs Local bond-equity correlation coefficient 2004-15

erpt

One reason why ERPT differences might be so slight is precisely the different reaction functions of the central banks in EM and DM respectively. And this could be the thing that is informing the real distinction shown on the horizontal axis of the chart and observed by my clever friend: in risk-off I buy your sovereign debt if you’re DM and sell your debt if you’re EM. (Eg, perhaps Turkey’s ERPT was contained in 2004-15 precisely because every time there was a downturn that caused its local equity market to weaken, fiscal and monetary policy-makers may have collectively tightened sufficiently to push bond yields higher but protect the currency from moves that delivered higher inflation pass-through.)

So I think that the chart tells a story, and it’s one of control. Being rich, diversified, and having strong institutions has put a bunch of countries’ sovereign debt into that bracket labelled ‘safe assets’. These assets are bought by investors when things get hairy, bestowing upon respective governments the ability to deliver counter-cyclical policy (cutting rates and boosting government borrowing and spending when things get tough). This Developed Market Privilege is something that countries around the world have sought. Developed Market Privilege delivers enhanced control over your destiny – a form of economic sovereignty that is far from universal.

So is the UK going full-EM? It doesn’t seem that investors have yet given up on Gilts, although long Gilts look as though they have underperformed Bunds and Treasuries as the risk of a disorderly Brexit have increased. UK inflation isn’t soaring despite extended currency weakness. These things tend not to be linear, but I think it’s too early to declare the UK a banana republic quite yet. That said, the institutions on which the UK’s Developed Market Privilege depend appear to me to being eroded by the day.

 

 

Doing stuff for free

As I occasionally muse on Twitter, Diane Coyle’s stuff is fascinating and wonderful. If you’ve read her GDP book or any of her papers (and you ought to) I’ve nothing really to add.

But I have made a cut-out-and-keep picture of my understanding of some of the issues raised in trying to capture changes to GDP and productivity (with apologies to Diane). This is for me rather than you. It’s a bit messy, but here it is. And I like it enough to share, because prosthletise as I do, not everyone is familiar with the basic outline of these ideas.

If you’ve read this far, I expect you have one of 3 thoughts: 1) I already know this; 2) you’ve taken something simple and made it look complex, kthxbye; 3) can you explain? The rest of this blog helps people with thought number 3.

The big black line is the Production Boundary: a threshold between stuff that happens when you Do Stuff For Money (ie, captured in GDP), and when you Do Stuff For Free (ie, everything else).

Breaking the diagram into smaller pieces, let’s start with the up arrows:

When you find a new and better way to Do Stuff For Money (DSFM), this tends to be good for GDP growth and is good for the growth of GDP/ hour worked (generally thought of as productivity growth). On the diagram, this is #1 arrow on the left and captures all sorts of things from the invention of the harvester-reaper, to the roll-out of basic management training. Many if not most of the things we *all* agree about as boosting productivity do so through this arrow.

When you find a new and better way to Do Stuff For Free (DSFF), this doesn’t *directly* touch GDP growth or productivity growth. On the diagram, this is the #2 arrow on the right and captures things like the first order effects of the invention of Wikipedia or the computer language Python, learning how to cook better food, writing a blog etc. This saves us time and/ or is an improvement on what came before. It is good stuff that increases what economists would call the consumer surplus, but won’t deliver a first order boost to GDP.

There are a lot of other lines on this chart. All the other lines cross the black Production Boundary line.

When a red line crosses the production boundary from right to left it boosts GDP. When a red line goes from left to right it reduces GDP.

Famously, marrying your housekeeper reduces GDP as they pass from DSFM to DSFF (#3), even if the stuff they do doesn’t change (although in fairness it might). Divorcing your spouse and paying them to do stuff they would otherwise do for free (#4) strikes me as less conventional, but would deliver a GDP boost. What either means for aggregate GDP/ hour I guess depends upon how much you pay them per hour (as a monetary measure of their value) versus how the output per hour of the rest of the population is valued.

And now we come to some interesting bits.

Inventing and manufacturing something like a washing machine that saves us time and improves our non-market lives boosts GDP and consumer surplus (so arrow #5 is upward sloping). That is, if people generally do their own washing rather than pay someone else to so do. And so the activity of washing clothes shifts from the DSFF to the DSFM side of the Production Boundary.

And there have been some innovations like the self-scan checkout that move tasks from the DSFM side of the Production Boundary to the DSFF side (#6). Here, firms boost output/ profit per employee by substituting a combination of capital and customer labour for their own low skill labour. Unlike the washing machine, this is a slight hit to consumer surplus, getting shoppers to do the work that firms had previously paid staff to do (although maybe reduced queue-times make up for the hit; also, maybe some people enjoy scanning). So the end result is a slight decrease in consumer surplus and higher firm profit.

Online travel agents – like self-scan check outs – boost measured output per employee by shifting some of the work to the customer. But I reckon that the proposition is a cheaper outcome for the customer (#7). So GDP takes a first order hit as offline travel agencies shrink.

And lastly there is the case that Tim Harford wrote up about Microsoft Office. Tim’s mischievously makes the case that having office workers all writing their own PowerPoint presentations, doing their own expenses, etc, rather than what they are presumably experts in doing is an insult to the principle of division of labour, and a negative drag on productivity. I’ve popped this one in at #8 sloping down from DSFF to DSFM rather than just being an arrow of questionable direction sitting on the left hand of the production boundary. The logic is built on Tim’s blog: that having to do stuff in which you are not expert but which is not very taxing (ie, make bad PowerPoint presentations) may be a welcome relief from your actual work. It might even be thought of as a pretty rubbish, but fully-paid, work break. I don’t think I agree with Tim, but I 1) can’t think of another good example off the top of my head, 2) am keen to get symmetry in the diagram, 3) love Tim’s stuff.

Who cares?

Well, I think everyone actually cares about each of GDP, GDP/ hour and general welfare. But I also think that different people are incentivised to really care a lot about one angle more than another.

Government treasury departments care a lot about raising and spending money. For this, GDP is the most immediate concern. It is hard to tax stuff that is neither money flow or money stock, and GDP is money flow. Wikipedia may be awesome, but it is hard to get a cut of the welfare they deliver in order to pay nurses’ and teachers’ salaries. Things that boost GDP in some taxable way are good for governments that seek to resource spending decisions with tax.

Financial analysts and investors care about revenue, profitability, and spare capacity. For this, GDP is important, but output per employee is – I reckon – even more so. Changes in output per hour inform at the macro level the amount of spare capacity there is in an economy, and a boost in output/ hour can boost on a sustainable basis the ultimate level of GDP in a non-inflationary manner (keeping central banks away from the brake pedal). Output/ hour is also important for understanding how corporate profit margins will change. For example, if firms automate, they can produce more revenue per employee; if the cost of automation is not high this will boost profitability, helping boost firm values. And firms and investors will care a lot if some innovation (that they don’t own) shifts stuff across the production boundary. It could maybe wipe out an industry’s viability.

Citizens care about welfare improvement. We shouldn’t obsess over GDP growth if it is associated with reduced consumer surplus. That said, the correlation between measured GDP per capita and different measures of welfare is strong (maybe related to governments’ ability to intervene to raise outcomes being contingent on taxing GDP, don’t know). Have a follow of the brilliant @MaxCRoser https://twitter.com/MaxCRoser for a plethora of great charts, many of which show that places with plenty of GDP tend to get better health outcomes. Like this chart of maternal mortality and GDP/ capita, reproduced here from https://ourworldindata.org/

There is sooo much more to write on this, but frankly, I am poorly qualified to write it and Diane Coyle’s stuff reads much better. Also, check out the Bean Review.

Trump’s Libra/ Nature of Money Nightmare

So Trump has weighed into the nature of money chat on Twitter overnight. It had to happen sooner or later, so seems a good prompt to break my blogging holiday.

Facebook Libra looks fascinating, although to be honest I’m still trying to work out what the point of it actually is. To recap, Facebook has announced that it will launch a new cryptocurrency in 2020. Unlike Bitcoin et al it will be 100%-backed by an as yet undisclosed basket of fiat currencies. And Facebook + partners reckon they can get through the anti-money laundering regs that they’ll need to navigate so that we can all hold Libra in digital wallets and spend it on stuff on the internet. Money serves as a medium of exchange, a store of value and a unit of account. It kind of looks like Facebook could check all three boxes. Or maybe not?

The white paper makes a big play of Libra being stable, and thus filling a hole to serve underbanked folk around the world. As a portfolio manager I assumed that they equated stability to one of two things.

  1. Stable might mean non-volatile against my base currency. So the value of Libra shouldn’t jump around too much versus other stuff I call money like, for example, Japanese yen (if I’m Japanese) or South African rand (if I’m S African). But what if the yen and Rand jump around versus each other (spoiler: they do, and a lot!)? does Libra look more stable to the Japanese or to the South African Libra-holder? And, if somewhere in the middle of these two, what about to the American or Venezuelan holder? This is not clear.
  1. Or stable might mean non-volatile against the real value of a basket of domestic goods and services in my home country (this makes more sense to me). This maybe solves for my South African vs Japanese Libra-holder quandary if the Lira and yen have very high exchange-rate pass-through rates. But they don’t. In fact exchange-rate pass almost always through looks spooky-low.

So stable means something else I guess. Perhaps, as inferred in Trump’s tweet, the bar to stable is being less volatile against the USD than Bitcoin (a super low bar), or maybe it means as-stable-as-quants-can-get-it (perhaps setting the composition of reserve assets backing Libra from an optimisation that seeks minimum volatility against a user-weighted fiat currencies?). Who knows.

Why might I care? Because if a thing-trying-to-be-money is to be a store of value, its value should be well-correlated to movements in the price of the thing I want to buy. Which is one reason that central banks are so concerned with anchoring inflation expectations. Stability is required for the store of value box to be checked. And this needs to be checked to be money.

But let’s take Trump’s anxious third tweet in his thread – the one where he worries for the fate of the dollar.

In a scenario where Libra has supplanted the dollar as a medium of exchange it’s not a stretch to imagine that it really would become stable. Pastrami on rye sandwiches in New York delis could be priced the same in Libra from one day to the next. Their dollar price (if you wanted to calculate it) would fluctuate. How would the FOMC fulfil its inflation mandate? I guess that the dollar-Libra exchange rate would become one of the most important elements of monetary policy. The idea that the US might have to try to peg the dollar to a basket of currencies, the composition of which is decided by tech geeks who have decamped to Switzerland it the stuff of Trump’s nightmares.

How does Trump stop his nightmare unfolding? We get to tweet number 2:

From a finance-person perspective Libra looks like a multi currency money market ETF. But it also looks like an assault on the State’s ability to control our monetary lives.

Ill-regulated, Libra looks like a super-easy way to evade present or future capital controls (units recorded on the blockchain in Switzerland so I guess that if a country permissions its citizens to exchange their local currency for Libra, that’s it). And I can also see that it might be a way for e-commerce to once and for all rid themselves of individual countries’ fiscal reach (if transactions all take place on the Libra cyberledger, I can see that geographical fiscal jurisdiction might get tricksy). In an extreme scenario where Libra displaces a national currency as the medium of exchange I can see it leading governments to lose a major tool of macroeconomic policy as well as seigniorage.

But States really really don’t like firms playing fast and loose with people’s money. Despite what you might infer from the GFC and its aftermath, retail client money is super-highly regulated. And States would be loathe to throw away the ability to impose capital controls or tax domestic transactions at some point in the future. FinTech is a powerful thing, but so is FinReg.

What to do with our magic money tree

Governments are not households. Governments can – with the threat of their monopoly use of violence – invent taxes that people have to pay; households can’t. Governments can change bank regulations such that banks effectively have to buy their debts; households can’t. Monetary sovereigns like the United Kingdom can invent brand new money to pay their bills; households can’t.*

But if governments can invent brand new money to pay their bills, why do they bother inventing taxes or borrowing at all? Inventing money sounds a lot easier than taxing people so it’s worth asking why more governments don’t just do it. More specifically, what are the arguments against the United Kingdom engaging in monetary financing? Or, in the parlance of British politics, why not use the actual real life magic money tree that definitely does exist despite the protestations of our leaders?

One argument against tapping the magic money tree is the illegality of so doing under the Maastrict Treaty. But given the successful efforts of Brexiteers, this looks soon to be irrelevant as we exit the European Union and Take Back Control.

A second answer that lots of people yell is Zimbabwe.

To be fair, pretty much *everyone* agrees that monetary financing budget deficits is very problematic when *too big*. It’s just that no one can quite agree what *too big* means. In extremis, monetary finance will certainly threaten/ destroy monetary stability. But plenty of countries have deployed monetary financing without collapsing into hyperinflation. Hyperinflation is something that tends to be associated with the collapse of a state’s ability to project power within its borders (with an unclear direction of causality!) rather than simple monetary financing. Indeed, of the 152 countries for which the IMF researched the central bank legal framework in 2012, 101 permitted monetary financing. Hyperinflation has not been quite so widespread.

However, we run into trouble way before we get to Zimbabwe. And while I’m planning to return to this issue with a bit more nuance in the future, I think we can imagine the sort of trouble that might lie ahead with a very basic hand-wavy thought experiment.

When there is unused slack in the economy – people unemployed or underemployed, idle hospitals, schools, factories, offices etc – the government can run budget deficits, spend money and deploy these unused resources without generating cost-push inflation. This is not contentious. The counterpart to this budget deficit will be either new claims on government (assets in the form of bonds for folks with a low propensity to spend to switch their money into), or brand new money plucked from the magic money tree.** Both forms of fiscal stimulus create demand and use up economic slack. Yay! Adair Turner reckons that a pound imagined into existence by the government and spent would likely be more stimulative than a pound borrowed from folks who can afford to save, and I’m not going to quibble with him on this. But even advocates of monetary finance like Turner worry out loud that maybe it might become too tempting for politicians to restrain themselves from inventing more and more money as elections draw close.

However, rather than retread these worries let’s think about the political difficulties attached to *unwinding* these differently funded fiscal stimuli.

It’s pretty simple (when times are good) for politicians to make the case that we should prudently pay down debt (delivering a fiscal tightening). Blair and Brown did it. Clinton did it. Even though governments are *not* households, people generally think that they are near enough the same thing (they’re not) that such a line resonates.

The politics of unwinding monetary financing look harder. If governments invent new money when times are bad (delivering a fiscal stimulus), I think it would be tricky to sell the message when the economy improves that things are just so great that taxes need to rise to fund a big bonfire of money (delivering a fiscal tightening). I can’t prove it, but I think that ordinary (voting) people would get very cross about this idea, maybe cross enough to vote out the idiots trying to set light their money. Someone might even suggest that instead of a money bonfire, maybe taxes shouldn’t rise at all. Or maybe the tax proceeds could be used to build something that most folks might agree is needed at any given time – a new school, hospital, bridge, or something else that involves bidding real life people away from what they would otherwise be doing into some particular government-directed endeavour. But the whole point about raising taxes in this scenario would be to unwind the prospectively inflationary impact of an economy running at full tilt – precisely the sort of thing that comes from trying to build a new bridge when everyone is fully-employed already.

Some folks reckon that the whole point if monetary finance is defeated if you articulate its reversibility, and so concern about unwind is not only premature but completely misses the point. But it seems quite possible that absent a well-articulated exit strategy, folks in financial markets will infer that any future tightening will need to come through tighter monetary policy than the counterfactual pushing interest rates up.

And so while governments are *not* households, the household budget constraint *doesn’t* apply, there definitely absolutely really *is* a magic money tree, (and the problems of governance are not necessarily insoluble), it is not clear that this insight solves as many problems as one might hope.

PS: The brilliant people at Planet Money have done a podcast on this subject which is *much* better than this blog – do listen! Since I pulled a muscle and stopped running my podcast consumption has dropped so it’s only now (as finishing) the blog that I caught up on it. I thought about just tweeting the link to their show instead of hitting post on this blog but didn’t as they don’t quite get into the politics of unwinding monetary finance which I thought might be of interest.

* OK, crypto. Maybe even stock. I’ll deal with this another time.

** Many will argue that money is a claim on government, as a form of tradable deferred tax obligations. Ok, fine. But putting that in the middle of my otherwise semi-readable paragraph isn’t hugely helpful.

Second thoughts on miniBOTs

I generally operate on the principle that if people can show me how I’ve misunderstood something I will take that as a win. If they can do this without making me feel a complete fool, that’s an unnecessary but welcome bonus.

After blogging a couple of early (fairly negative) thoughts about miniBOTs yesterday, I had a bit of feedback. What followed was a brief epiphany during which I realised I was wrong and miniBOTs could actually be an awesome idea.

The epiphany was based on the notion that if there is slack in the Italian economy (which there surely is), and that this slack could be engaged without crowding out the private sector by the government doing generally helpful-to-long-term-human-goals-sort-of-stuff (again, likely true). This could be upgrading infrastructure, developing human capital, regional/ sectoral development financing, that sort of thing. And (importantly) the financing vehicle – miniBOTS – could be used by the government in a manner that was revenue-neutral or even revenue-accretive.

It would work like this:

  • Step 1: government puts out tender for xyz contract, payable in a certain value of miniBOTs;
  • Step 2: contractors bid for and win contract, then sell miniBOTs to folks owing large back-taxes at a discount.
  • Step 3: government collects back-taxes (and/ or taxes on the grey/ black economy that now steps into the sunlight with lower effective tax rates) that were otherwise lost. So debt doesn’t actually rise.

Reckoning that miniBOTs might trade sub-par (because, you know, some other government might turn up and think the whole idea was a bit whacko and stop accepting them as taxes in lieu of euros), contractors would probably want a few more miniBOTs than plain old euros for a given job, implying a financing yield (in terms the ratio of miniBOTs to Euros, or rather discount to par).* In other words, I believe that this new good-for-Italy-using-up-slack expenditure would cost more in miniBOTs than it would otherwise have done in plain euros.

But costing more miniBOTs than euros could be okay if a) it deploys slack productively; b) it is making investments that are possible that would have been impossible without miniBOTs, and; c) would ultimately be financed by gathering back-taxes/ black economy taxes. (The folks owing back-taxes buy the miniBOTs because – now there is a discount to par value of a potentially temporary nature – it costs them less, and they seize their chance.)

So rather than being an interesting money thing, it could actually be a bit of an elaborate tax amnesty/ tax cut in which government contractors also get a little richer than they otherwise might.

However, this epiphany lasted only 53 seconds.

My mind had sort of taken a temporary leave of absence, and I’d forgotten Gresham’s Law: the idea that bad money drives out good.

In other words the miniBOTs get bought by ordinary folk at the point at which they pay their taxes (and they then deliver them to government in lieu of euros), and there is no reason why back-taxes/ black economy taxes ever get touched.

The government still has to pay more miniBOTs than euros for stuff (because otherwise why would people take them) and legit taxpayers would buy them at a price below par (because otherwise why bother). And so the whole thing becomes self-defeating as miniBOTs collect in the Italian treasury rather than among the population as a whole, who prefer to amass monetary assets in euros unless tempted by discounts to par (and hence higher implied financing rates for the state) on miniBOTs. (And the scheme introduces scope for political favours to be awarded to connected contractors who might even repay this political debt through future party funding.)

Meanwhile, the Commission would likely look at miniBOTs as debt (because selling future receivables look very much like debt, as any credit card receivable securitization analyst will tell you), and given they look to be zero-coupon, would likely see them as tradable to next put date (see footnote), which is to say having very short term structure no matter how irredeemable they profess to be.

There is a second way that miniBOTs are interesting, and that is as an asset conjured our of nothing that has value to people in such a way as to create demand for a permanent stock (eg, a currency). In such a light, the scheme looks pretty identical to the creation of a new form of Outside Money, but as a Chartalist myself I think that for it to actually properly work the state would need to require the payment of taxes in miniBOTs rather than simply accept the payment of taxes in miniBOTs. In accepting rather than requiring, we get back into Gresham’s Law problems: the miniBOTs would need to have an implicit financing cost. And because of this the state would endure a weaker fiscal position than it would otherwise have (paying more miniBOTs than it would have needed to pay euros, but receiving back an equal number of miniBOTs to the number of euros it would otherwise have received in tax revenue). If the state chose to only accept taxes in the form of miniBOTs this changes things. But I think that this then touches on the legal tender issues discussed in the previous blog.

I’m still up for being persuaded of their merits. And if I wanted to shoe-horn Italians out of the Euro without actually bothering to make and win the case with them that this was what they would be doing (stirring up a fight with Brussels, maybe demonizing them along the way to the domestic population), miniBOTs seem a reasonable thing to introduce.

Absent this motivation, I still can’t see these merits right now. There could be a decent portion of folks who reckon a tax amnesty or tax cut would be self-funding. I know there is a decent minority of the population who think that Italy should leave the Euro. Advocates of these positions should make their case without engaging in bait and switch tactics.

Chances are you’ve thought about this more than me. If you can communicate simply and coherently why miniBOTs make senses in a way that doesn’t involve leaving the Euro please blog it (in English, sorry).

* It has been put to me that miniBOTs won’t have a term (ie a date at which they will necessarily turn into euros) and so my whole blog is somewhat off-base. But if I bought an irredeemable zero coupon euro-denominated security that was puttable at par, I would consider the term to be the first put date, and then measure its yield as a function of the discount to par and distance from par. (To get a bit more technical the first put date is the date at which it is advantageous for the holder to put the securities to the issuer, and this will actually depend on the price of all of the other securities on that issuer’s yield curve as well as the put date). I can’t think why anyone else (including the Commission) would not do the same.

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Update: the Bank of Italy has put out a PDF with their initial take on miniBOTs. It is the clearest thing I have read, and I was surprised and delighted that it did not contradict my understanding as conveyed in this blogpost and it’s predecessor.

Quick thoughts on mini-BOTs

So everyone in London has got excited about mini-BOTs – Italy’s prospective parallel currency after Munchau on Monday and then Dizard today have written about them in the FT.

A quick recap:

  • Italy has been a growth laggard (average GDP growth since 2004 has been 0%, although there has been steady slow growth since 2014), and has high levels of debt (c.130% of GDP).
  • March 4 saw the Italians go to the polls. Conventional wisdom saw the outcome as a likely stalemate unless the right-wing populist Lega Nord (the League) and the left-wing populist Five-Star Party could come together in coalition. As someone on Twitter put it, this would be like imagining the audience of BBC Question Time putting aside their differences and forming a government.
  • Five Star wants things like a Universal Income; The League wants things like flat taxes. In each party’s mind their own favoured policies probably pay for themselves with an exploding renaissance of growth. In everyone else’s minds (including each others) these policies probably lead to an exploding renaissance of debt issuance.

So there is this idea kicking around that they fund their wish-lists not by issuing currency (which they can’t do because the ECB is the monetary sovereign), and not by issuing bonds (which I guess they reckon the markets won’t like and the Commission will get prissy about as it will break all manner of rules). Instead they want to issue mini-BOTs – small-bill government debt that looks and feels very like Euro notes. And look and feel very much like money.

But would mini-BOTs be money?

They don’t look like they would be legal tender. But this might not be a big deal. Legal tender is a pretty narrow legal definition. My basic understanding is that it means something that law courts understand as being unlawful to refuse in payment of a debt. And in the Euro area, the Commission is pretty blunt about how only the euro is legal tender here. They also (helpfully) explain that although non-official (euro) currencies “have no legal tender status, parties can agree to use them as private money without prejudice to the official currency”.

In the UK we use lots of things as money that have no status as legal tender. Scottish and Northern Irish banknotes are not actually legal tender. Furthermore, 1p and 2p coins are legal tender for sums only below 20p, 50p coins are legal tender for sums not exceeding £10.

This isn’t the first time we have seen this sort of thing. Even in Italy there is some precedent for creatively using local currencies that are backed by state obligations as a currency, albeit at a local level. This nice story via Lorcan Roche Kelly tells of a local community that introduced a local currency that was backed by state debts. In fact, it looks in many ways to be a municipal version of mini-BOTS which provided credit to the local government and liquidity to the local economy.

But governments don’t usually do this sort of thing unless they are in trouble. So the signalling is pretty terrible.

  • Argentina issued one-year small-bill bonds (nicknamed Patacones) to its civil servants in a short-lived effort to keep its currency pegged to the US dollar. These were widely accepted (at a discount to US dollars) and McDonalds quickly launched their Patacombo meal. Patacones could be used to settle tax obligations with the state, just like mini-BOTs.
  • California issued state IOUs under Schwartzenegger in 2009 in a similar effort to cover its gaping budget holes, just as it had in 1992 and 1993. These IOUs were paid to vendors doing business with the state as federal law prohibit IOUs to state employees. I don’t know whether there is any European Directive that prohibits Eurozone countries from doing the same but somehow I doubt it. California didn’t turn out too bad? Well, banks only accepted these IOUs for five days before closing down this option according to wiki. The California Budget crisis rolled on until both spending was cut and taxes (and university tuition costs) were raised, as well as the rebound in the (national) economy that boosted tax takes.

Despite this, mini-BOTs might actually qualify as money by the rules of some monetary bean-counters (depending on their term). Whether they were used as a unit of account would determine where they sat in my Venn. Mini-BOTs would look and feel like money, but if they have a term to them (a date at which they can be redeemed for actual euros) I reckon that they just have just a lot of euro-moneyness.

In fact, they would likely turn out to be a strong reminder that the Italian state is not the monetary sovereign, and the subject of a big fight in Brussels as the Commission (rightfully IMHO) called them out as debt which would need to be included in Eurozone-specific debt numbers. And it is the prospect of this incipient fight that is roiling markets.

Moneyness of betting tips

In a gently mocking (but good-natured) tone, Lorcan Roche Kelly asked me yesterday (rhetorically) how much moneyness I thought a tip on the horses had. Answering rhetorical questions tends to win few friends, but I think it is an interesting one.

As background, money tends to be thought of as the stuff that functionally happens to satisfy three conditions: serving as store of value, unit of account, and medium of exchange. I still quite like this old Venn I made for a talk I gave on money:

In a conventional monetary aggregate sense, definitions of money vary from jurisdiction to jurisdiction, and within jurisdiction over time. The grey shaded sections in the two tables below show how UK M4 and Eurozone M3 monetary aggregates are defined and differ at a high level.

So, for example, UK households’ deposits with agencies of the UK central government don’t count as money to a UK monetary bean-counter, while Eurozone household deposits with agencies of Eurozone central governments do count as money to Eurozone monetary bean-counters. To someone less interested in counting monetary beans this seems a bit silly, but follows from having to draw the line somewhere – and the Bank give a nice primer on this here.

If you reflect that there are many many shades of grey, the appeal of an approach that recognises the extent of this gradation is significant. Hence the attraction of moneyness.

I think that maybe all Stuff apart from notes, coins and bank reserves administered by the central bank (ie, the stuff that sits in the part of the Venn that takes medium of exchange and store of value) has some money-like quality, however tiny, and that this portion of its value is its moneyness.

I like to think that the moneyness of a thing as being some function of its duration, creditworthiness and secondary market liquidity.

So I consider a small sight deposit in a highly creditable bank to have near full moneyness. A bond due to be repaid in thirteen months by a monetary sovereign (eg, UK government) would also (in my understanding, although not in a monetarist’s sense) have very high amounts of moneyness. The amount of moneyness would be lower for debts with more distant maturities, although longer-dated securities’ moneyness can be bolstered by the degree to which they are accepted and can be borrowed against as high quality collateral. Changing collateral haircut schedules in repo flowing from a change in view from a credit rating agency or central bank can quickly change the moneyness attached to long-duration instruments; changing secondary market liquidity conditions or changing regulations regarding rehypothecation could also be a big deal for aggregate moneyness. Shadow-banking folk have been banging on about this (perhaps using different terms) for years.

So, back to Lorcan’s dig. I actually think it is a genius of a question because it takes things to an extreme (the moneyness not even of a betting slip but of a betting tip!).

The tip in question was for Circus Couture, which was offered at 12/1 on the 4:20 at Ascot. According to our tipster these odds were far too good. Maybe 4/1 was fair. Is there moneyness attached to this tip? Sounds silly, but let’s take it apart.

We can think of a betting slip as a really really short-dated super-high yield ultra-junky bond. A 12/1 outsider is like a zero coupon bond offered at 7.70 and maturing the same day at par. If the bid-offer spread that is the raisin d’etre of bookmaking did not exist, there was perfect liquidity in this choice market and the odds were stable I can see that there is a case to be made that the slips value would be close to its moneyness at somewhere close to 7.7% of par. This recognizes for the market a role in altering the moneyness of contracts as information develops, and this strikes me as a not unreasonable characterization of real life.

But no-one bets on a horse based on the view that the odds are fair. A bookie’s whole business model is to get on the inverse of punter-facing odds to extract a steadyish return for services rendered, and this is hardly a secret. And I think punters walks into a betting shop seeking excess returns (as well as leisure services), and am not sure they are even risk-neutral. So I wonder to what degree the moneyness of the betting slip (and, actually, the moneyness of any credit security) should not be discounted using a rate higher than that used to value it to account not only for the perceived risk of pay-off, but also the uncertainty of pay-off. (There is probably a big literature on how financial markets proxy uncertainty as risk so that they can get it into models, but I haven’t sought it out.)

Moving on to the tip itself, if I put a bet on Circus Couture with the view that 4/1 was the fair price, this would be akin to buying a bond at 7.70 with a view that the fair price was 20. The value of the tip to me and anyone who believes the tipster is around 12.3 cents in the dollar. But the moneyness of the tip is zero, precisely because it accounts for my differences with the market.

I think this is just be a long way of saying that a tip is not ‘Stuff’, so it has no moneyness in the framework I set out. But given that money is a medium by which subjective views as to what value constitutes is triangulated (on a monetary wealth X conviction-weighted basis) *as well as a thing*, it feels weird to say that each and every of the individual subjective views that together coagulate into a market price are themselves without measurable worth (or measurable moneyness). Or rather that the worth of each view corresponds precisely to its market impact (the degree to which it moves the market price), and any account of moneyness that includes market price will be correspondingly impacted.

This leads me to the view that a good betting tip* (that is ultimately right) has no moneyness even if a bad betting slip (attached to an ultimately losing horse) does (prior to the race!). But if there was a way to securitize betting tips…

* In the end the tip was bad – the horse came in fifth – so maybe zero worth

Why Debt is both Interesting and Important

Yesterday the Resolution Foundations launched a report on Household Debt in the UK. It is, as one would expect of them, excellent. I was on the panel at its launch and had a chance to say a few words. I had prepared bullet points to guide me, and at the suggestion of Tony Yates have typed these into actual sentences, adding also a couple of footnotes and a chart to give a bit more substance to comments that might in retrospect have lacked context. I spoke for nine minutes, and you can actually watch the whole event (including very good presentations by Matt Whittaker, Jan Vlieghe and Sian Williams) here.

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Debt is a web of contracts that binds our social and economic lives together. As such, household debt is not only interesting, but important. Its importance can be seen at a very human level, and bodies like Toynbee Hall do great work in ensuring that the profile of this very human aspect to debt is rightly prominent. But it is important also to our understanding of the macroeconomy, the stability of the financial system, and our understanding of the nature of monetary policy.

Discussing household debt is a strange thing to do at an aggregate level. By this I mean that it makes absolutely no sense to think about it as if it was attached to a representative household. Evenly distributed in a closed economy, no level of debt is unsustainable or unserviceable. But, evenly distributed, debt is also functionless.*

Another complication in thinking about household debt from a representative household perspective is that – unlike a household – changes in savings rates and gross debt, while individually important for activity, are entirely unrelated at an aggregate level.** Instead, Household debt appears to be largely a distributional issue for the household sector – intermediated by the financial sector.

However, changes to household debt have a variety of important macroeconomic and policy, as well as human, implications.

Starting first with the economy, it is pretty straightforward that changes in household debt are important to demand. Given the relatively self-contained nature of household debt, rising debt looks – from an empirical perspective – like a transfer from households with a low marginal propensity to consume (MPC) to households with a high MPC. The chart below the level of monetary assets and monetary liabilities residing in the household sector over the last twenty years. When the blue dots are above the orange line, the UK household sector has net monetary liabilities that exceed net monetary assets. To be clear, this does not include non-monetary assets like housing, equity, land, and other stuff. It’s just monetary or pseudo-monetary assets.*** An observation one might make is that monetary assets and liabilities are around the same level as one another, and so while the reality will be messier, we might think of household debt as being on a net basis an intra-sector distributional issue.

Household monetary assets vs household monetary liabilities, 1997-2016

When a rise in aggregate consumer demand has been accompanied by a rise in household debt we can and should ask to what extent such a move upward in debt load might be sustainable. Having a sense as to how this debt growth has been distributed amongst different debtors, what form this debt takes, and how vulnerable the debt service is to changing short term interest rates is helpful – and the report helps us understand better these things.

Secondly, changes and levels in household debt have important implications for financial system integrity. One person’s debt is another person’s asset, and as such, a precarious debt load is not an issue only for the indebted, but for the owners of capital. The relatively self-contained nature of household debt, intermediated by the financial system, means that higher debt loads lead to more counterparty risk. And this counterparty risk is likely to concentrate in financial institutions.

Indeed, many of the recent financial crises and recessions have been characterised by a series of debt contracts that we have ‘known’ as having low-credit risk characteristics suddenly being revealed as having high credit-risk characteristics (the Eurozone sovereign debt crisis, structured credit during the Global Financial Crisis, the dotcom/ Anderson credit bust, and the Savings and Loan Crisis to name but a few). As Mark Twain put it with somewhat greater panache: ‘What gets us into trouble is not what we don’t know. It’s what we know for sure that just ain’t so’. The Resolution Foundation report and much of the work that the Bank has done on UK household debt points to there being no great threat today, and from what I see I would agree. Whether this take is wrong will be a matter of record.

Thirdly, changes to household debt can tell us something about the appropriate stance for monetary policymakers (in ways only tangentially related to point one). Claudio Borio of the BIS outlined the issue nicely in a 2013 paper when he asked whether, in seeking to understand whether an economy is operating beyond trend, monetary policymakers should consider both inflation and the growth in private sector credit as signs that the economy was operating above potential growth. Jan Vlieghe in his speech to the SBE conference in 2017 argued that information about the location of the equilibrium rate of interest might be embedded in directional changes in household debt load. But changes in financial depth and the arrival of things like PCP finance that might just be a step change in the way we purchase things – that the report highlights as accounting for much of the UK consumer credit growth in the past couple of years – might be important to consider as part of these frameworks.

So in summary, this report’s analysis is really welcome. It helps us to better understand the changes in household debt and lifts the bonnet on important distributional issues. I agree with its findings that household debt does not look – today – to represent a threat to financial market stability and it makes a strong case that the credit surge does not appear to be associated with a dangerous over-extension among families least able to bear higher debt loads sustainably. And it highlights the pinch points for the future, which as one might have guessed sit with the more financially fragile households.

However, I wonder to what extent the transmission mechanism of monetary is to effect transfers from those households with high MPCs to those with low MPCs, crushing demand from indebted households – as suggested by James Cloyne et al in their 2016 Working Paper (although admittedly they said that this aspect was swamped by general equilibrium impacts of rate changes). Will an enhanced understanding as to the real human cost of rising rates change policymaker reaction functions?

 

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Pesky footnotes: probably the most interesting bit of the blog.
* If you and I each create an IOU due in two years time for £1 trillion and hand them to one another, both assets and debts are created. The magnitude of this act of asset and debt creation us such that UK household debt would – in aggregate – more than double. But because we each held the means to service our enormous individual debts (in the form of our enormous individual assets, which consist of claims on each other), the debt is utterly serviceable and sustainable. It is also functionless.

Really interestingly, Chakraborty et al put out an amazing paper algo-guessing a complete loan-level data set in December last year. I really recommend people read it here

** I didn’t understand this for the first twenty years of my career. I tend to think of savings as claims on others (eg, monetary assets). But, using the logic of the ONS Blue Book:

The household savings ratio is equal to the net change in claims on other sectors [i.e. change in household net lending/ borrowing number (NSSZ)] plus the cost of building new homes [ok, it’s actually the total gross capital formation number (NSSX), but that’s basically the same thing], plus a tiny number that hardly registers [aka, the acquisition less disposals of non-produced non-financial assets (NSSY)], all divided by total household resources (NSSF). To be more specific, it is these codes but particular to the household sector rather than the household + NPISH sector, but I don’t have them to hand, and they are pretty much the same numbers.

Household debt is the sum of all of the debt liabilities of households.

So – and quite logically – if Bank X creates a deposit through lending £20 to Household X, so that Household X can buy a service (let’s say a haircut) from Household Y (who then saves it), total debt rises by £20, but there is no change in the household savings ratio. There has been an expansion of the total household balance sheet, and an intra-household-sector change in the distribution of monetary assets and liabilities.

*** Household monetary assets are defined here households’ holdings of money, debt securities, and other accounts payable, plus non-life insurance technical reserves; household monetary liabilities consist of loans and accounts payable.