A quick blog on Pix

Banco Central do Brasil launched an instant state-backed retail payment system back in November 2020 called Pix. You might know all about it already. If not you should.

Why? Pix is a powerful case of the state innovating to benefit its population, disrupting the rents collected by financial institutions & big tech.

What problem was Pix trying to solve?

Firstly, payment systems are expensive. McKinsey reckon that in 2019 payments revenues doubled over the last decade to around $2 trillion in 2019 – 2.6% of the GDP of countries covered by their work (and rising)! Running a payment system is super-profitable. To take Visa and Mastercard as examples, profit margins are comfortably north of 40%.

But that’s how capitalism is supposed to work right? Smart people get together to form banks, or firms like Paypal, Visa, Square etc, innovate better products that make our lives easier/ nicer/ more productive and get super-profits in return. Yes!

These super-profits are supposed to be competed away as they attract new competitors. The market is supposed to solve these problems, not the state! However, there has been little sign that these super-high margins are getting squashed. Network effects attached to payment systems can represent huge competitive moats!

As a non-profit state-backed retail payment system, Pix is much much much cheaper. Take a look at the chart below from the Bank of International Settlements’ recent report:


Second, payments systems can be slow. And this can be a problem for small firms. Nowadays, when I buy a sandwich with my debit card my phone buzzes to tell me the money has left my account. But it may not reach the vendor for days. So small firms will see themselves as essentially financing banks and others in the payment system. Pix delivers final settlement in seconds.

How successful has it been? Hugely. Pix has become the number one payment means by transaction volume, used by 114m people – 67% of the adult population – having been launched only in November 2020.

Okay, but why should you care?

The state is generally seen as good at funding a lot of the basic science, and even some quite advanced bits and pieces (like, er, the internet) that private sector firms then commercialise. But we tend to rely on market forces to eat away rents. Rents can prove very sticky. Pix offers an example of the state innovating, bringing to market what appears to be a superior product to its population, and in so doing leaning hard against these sticky rents.

But that’s just Brazil, right?

There’s an awful lot of work going on to bring the possibility of Central Bank Digital Currencies (CBDCs) into existence across the world. The BIS survey of central banks in 2021 found that around 85% of central banks were engaged in work on CBDCs. Pix is not a CBDC. But it does offer a glimpse into the way in which a retail CBDC might be successfully introduced, and the sort of impact low-cost digital state money could have on the payments market.

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Crypto, Art, Stocks and Power in 2021

My day job is to lead a team of people who analyse and invest in financial market assets on behalf of clients. It’s mostly stocks and bonds.

Portfolio managers tend to seek to identify assets that will command higher prices some time in the future and/or deliver a predictable set of future cash flows. We talk about ‘valuation’ in the strictly financial sense quite a lot. Keynes, writing about financial valuation, likened it to a contest in which to win, contestants needed to guess which photo most other contestants would identify as the most beautiful (rather than applying their own individual tastes). I think this is right, but sort of brushes over the epistemological nature of the contest as lived.

Portfolio managers focus of earnings, inflation, non-farm payrolls, Fibonacci retracements, or whatever else that rocks their boat when assessing financial value. In so doing, they are asserting some internal model as to how the world should think about valuing assets.

Every time the internal model works (eg, stock jumps when earnings surge/ beat) another little positive reinforcement loop is completed. Confidence rises that the internal model as to how portfolio managers think things should be is a close approximation to how things are.

But every now and then a thing comes along to remind us how all financial valuations actually work. This year three things came along: NFTs, cryptocurrencies, and meme stocks.

I have zero professional experience of the art market. Beeple’s mega-Christies sale got the world’s attention. It brought attention not only to digital art but also NFT’s more generally and got folks asking how such valuations might be possible. For me this question carries an easy (if perhaps banal) answer.

The price paid, like that of any artwork, indicated not its extraordinary artistic worth but rather that (usually) at least two people of substantial financial means reckoned that the art in question is worth more to them individually than some chunk of their financial wealth. Art’s financial value is plutocratically determined. One person thinks a painting is worth $1m? Nada. Two people with plenty of financial muscle think it’s worth $1m? It’s worth $1m.

Is the easy answer to NFT/ fine art valuation an easy answer to cryptocurrency valuation? I think so.

Bitcoin/ Dogecoin/ etc have been around for a while. But 2021 saw their collective financial value boom to around c$2.4tn. I don’t encounter people getting mad that a Duchamp Readymade might be inappropriately valued in the context of it’s likely future cash flows: we all know its future cash flows don’t exist.1 But plenty are enraged by substantial financial valuation being attached to either crypto in general or a particular piece of contemporary art.2 And I think people get cross for largely similar reasons.3

While folks scratch around to try to consider valuation frameworks for cryptocurrencies along the lines used to value currencies or commodities, I am more persuaded that the appropriate valuation framework to apply to them is – like NFTs – that of contemporary art.

What about Meme stock valuations? Just like art and crypto their valuations too are also plutocratically determined. The performance of stocks like GameStop and AMC generated the same challenges to the financial world’s established epistemology of financial value as those posed by crypto. The reason why it felt different was that it was done on home turf.

In asset management the idea of active management in a state of market inefficiency is based on the notion that by scraping together good insights, information and analysis it is possible to generate super-normal risk-adjusted returns. I buy into this in a big way. But it is predicated on the notion that others are employing broadly the same mental model around what should command financial value. After all, if you’re looking for super-normal risk-adjusted returns, there’s no point (as a small investor in public markets) identifying awesome firms that will deliver strong and above consensus results if they are going to be subject to a multi-year or multi-decade valuation death spiral (because no-one else reckons that strong and above consensus earnings should translate into higher financial value). Firms that satisfy the model tend to be ascribed a higher financial valuation, while those that don’t may find themselves less able to attract financing upon which their business may depend.

For all the hate out there amongst conventional folk for Chamath Palihapitiya – sometimes characterised as a mega-rich tech bro with political ambitions, punting what is for him spare change into the GME trade in a bid to buy a constituency – I thought that this interview with him by CNBC’s Scott Wapner addressed the issue more clearly than I have seen elsewhere (emphasis mine):

Palihapitiya: …the fact that they shouldn’t be allowed to exist because all of a sudden like because we decide that they should be obliterated into the ground

Wapner: No, they should be allowed to exist. They should be allowed to exist at whatever price their stock should be value at based on what their earnings are and this stock was like seventeen eighteen dollars not that long ago.

Palihapitiya: Who says that? Who says that? Do you want to make the same argument about Tesla? It’s gone 10x in a few months. You don’t know what it’s worth – let’s be honest okay?

Wapner: You don’t think that Tesla’s growth prospects…?

Palihapitiya: Scott – I have my own model for the company. I’m allowed to underwrite however I want to own it. Everybody who bought that stock is also underwriting how they want to own it. And the point is – just because you’re wrong, doesn’t mean you get to change the rules. Especially when when you were wrong you got bailed out the last time. That’s not fair.

The conventional philosophy of security valuation informs a lot of real world decisions as to how resources are allocated. In demonstrating that the financial valuations of firms (just like cryptocurrencies and contemporary art) are plutocratically determined, the Redditters reminded us that those with financial power get to determine financial value.

The strong relationship between financial valuations and fundamentals exist only to the extent that fundamentalists are the ones holding financial power.


1 I mean, sure you could put together a business plan to acquire a top notch art collection, build a private museum, employ staff, charge entry, and make oodles of money. But I’m unconvinced that such plans underpin the art market.

2 It’s not just the financial valuation that gets people cross of course. People also get cross about the facilitation of criminality that is perceived to be engendered, scope for mis-selling they pose to the unsuspecting given an almost total absence of regulation, and jaw-dropping environmental damage attached to proof of work. Labelling these as differences will likely be contested.

3. I think that the reasons that people get cross about the financial value attached to contemporary art falls into five broad categories:

  • Resource allocation: when people who have the resources to drop millions on art do so rather than something else (eg, solving world hunger);
  • FOMO: when people pay large for someone else’s art, and completely overlook their own artwork (category reserved for artists, although also maybe also dealers and collectors who don’t own the stuff commanding the sky high prices);
  • My money! When public money is spent on something that someone doesn’t like (Carl Andre’s Equivalent VIII – ‘those bricks in the Tate’ – is still probably the most famous example);
  • Culture Wars: owing to the exclusionary and condescending culture that grows up in the industry that springs from these high prices.
  • Money & Value ontology: when monetary value – which so often is deployed as a proxy for actual value – has been assigned to something that someone sees as valueless (and this proxying is, to be fair, the conceit which underpins the allocation of scarce resources in a market economy).

It appears to me that these are analogous to the reasons people get cross about crypto asset financial valuations.

Bitcoin’s energy debate (and the Nature of Money)

Joe Weisenthal‘s morning notes are always worth a read. This morning he touched on a topic that I’ve been thinking on for a few days – the arguments around Bitcoin’s electricity usage.

The electricity consumed by the Bitcoin network is a bit more than Pakistan’s – a country of >200m people. Is this worth it? I went down this rabbit hole after tweeting this out a few weeks back:

You can browse the replies at your leisure but you can see that there was not a lot of love from the Crypto Bros. I tend to use Twitter as a learning resource, and in between the abuse I got some nice links to counter-arguments. They took me back to my old favourite subject: the nature of money.

Money is the medium that makes otherwise incongruent things comparable from a market perspective.

We all attach our own and different subjective values to different marketable things, but a marketable thing’s monetary value represents the crystalized triangulation of all of our subjective values (weighted by our individual monetary means). Simmel wrote a lot about this, basically outlining money’s role as reifying societal value.

So while the subjective value/ utility that I ascribe personally to a Bitcoin might be lower than that to which I ascribe a glass of clean drinking water, the money-weighted triangulation of subjective values/ utility ascribed to a Bitcoin is much much higher at around $46k.

Mark Carney outlined in his recent Reith Lectures that this money-centred value theory is actually somewhat new. In the late nineteenth century and early twentieth century, a group of economists known as neo-classicists launched an upheaval in value theory – comparable to the Copernican revolution in science. For older theoreticians like Smith, Ricardo and Marx, markets determine the distribution of value which was derived from labour. According to the neo-classicists, labour doesn’t give a good its value; instead, labour is valued because it is an input to a good onto which people project value. We can see how much value they project onto a good or service in its price (which serves as a money-weighted triangulation of subjective value). As such, price became the best description of value. Or, too take this to the extreme, Price = Value.

Going down this line of argument, the resources are consumed in delivering Bitcoin Proof of Work have been bid away from other projects because PoW has a higher value attached to it than any other activity. And as such it is idiocy to focus on electricity used by that which the market has determined to be the highest value activity.

Another line of defence in the energy use of Bitcoiners is that electricity isn’t fungible, and so Bitcoin mininng effectively utilises stranded or unreliable generation assets and turns them into something considered useful by many rich people (ie, Bitcoin). Some advocates sometimes go on to say that Bitcoin mining arbitrages electricity costs, although I think that this pushes the argument too far because energy that is ‘stored’ in Bitcoin form cannot later be released. A rehearsal of such arguments can be found in this popular blogpost.

I do see an integrity in these lines of argument. If we take the [price = value] route in judging the value of a thing to society, singling out Bitcoin’s environmental costs over the environmental costs of other things is nonsense.

Crypto Bros use a lot of electricity mining/ transacting in Bitcoin and ascribe positive subjective value to this activity even though I see this as pointless pollution with a large environmental cost.

I use electricity in connecting to the internet; I ascribe positive subjective value to this activity, but some readers of this blog might see it as pointless pollution. To one another we each say:

But I am unconvinced by the argument. I am unconvinced because I can see that such arguments would work to justify the generation of any form or level of pollution if activity of polluting delivers a monetary value. And I don’t feel comfortable signing off on that.

Maybe it’s a question about capturing the cost of the negative externalities attached to pollution properly – that would be the economist’s take, and one that I imagine Crypto folk might be happy with (although would maybe require inter-governmental alignment and enforcement that is antithetical to the Crypto crowd).

Maybe it’s just a recognition on my part that while markets and money are and have been – in my view – kind of amazing, they will always be incomplete and a poor clearing house for questions of axiological ethics. Which is a bit of a problem if they are used as such.

Money, Tax and The Left

Jo Michell has written a good piece in Tribune countering arguments from some on the Left around the necessity of taxation.

It’s a short piece that you should read, but I understood it as going a bit like this:

  • Case 1: If there is lots of economic slack in an economy (think loads of folks unemployed sitting at home wasting their skills and producing nothing), government can spend newly printed cash to boost the economy and there are frankly few immediate downside consequences.
  • Case 2: If there is not much economic slack (eg everyone has a job), printing loads of cash to spend on new projects will mean bidding folks away from their private sector jobs (which were presumably economically productive and need to be filled) and also puts more cash into the system than is wanted, so those with cash balances play a game of hot potato (trying to rid themselves of cash balances and transferring them to one another in exchange for goods, services, financial assets like shares, real assets like houses, or indeed foreign currencies – resulting in higher prices for some or all of these).
  • The problems in Case 2 can be addressed with taxation. This reduces aggregate cash balances and “the wasteful consumption of the wealthy” to make resources available for “socially-useful spending”. And actually, taxation can be deployed in Case 1 too.

Jo’s beef looks to be with the MMT crowd, who I think he reckons have dragged elements within The Left away from understanding taxes as useful (given that the magic money tree really does exist). Jo was pretty careful not to go all inflationista in his piece, but it’s plenty obvious that monetary stability – or what Keynes referred to as confidence in the currency – is at the heart of his argument.

But I do wonder whether some folks on the Left may have taken to MMT either because:

  1. they have different views around the strength of institutions in the political economy (eg, print now and we’ll have no trouble whacking taxes and/ or interest rates up at a later date if we need to). I have my doubts. Or;
  2. they see lower confidence in the currency as a *desirable outcome*.

There are lots (and lots) of problems with capitalism as an organising system, but I would not describe myself as anti-capitalist and as such see a reduction in confidence in money as an undesirable outcome.* If I were an anti-capitalist Leftist then Keynes’ famous argument (citing Lenin) that the best way to destroy the Capitalist System is to debauch the currency makes debauching the currency sound pretty interesting!

I’d always understood this Keynes/ Lenin argument to be that you need money to make capitalism function, and so destroying money as a store of value, unit of account, and ultimately as a medium of exchange through hyperinflation collapses the economic system. Pretty straightforward. If this is what attracts some on the Left to MMT I don’t think Jo’s arguments for creative use of the taxation system will shift them.

But it was interesting today to read chapter 6 of The Economic Consequences of The Peace from which Keynes/ Lenin’s phrase is taken. I’m now less sure that my straightforward understanding of Keynes/ Lenin’s argument was right.

Keynes elaborates that inflation destroysI Capitalism by:

I find this fascinating. These are four points that I would recognise as being pretty zeitgeisty, although not points I would have immediately associated with inflation. I don’t know whether they really are the Four Horsemen for the Capitalist system, but they seem to be gaining ground despite the absence of inflation.

With regard to the use of the tax system, I’m with Jo here, and have been for some time. Monetary financing needn’t spell disaster and may indeed be required to prevent deflationary spirals. But tax serves a purpose – in fact many. What sort of taxes should the Left focus on? Wealth taxes!

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* I reckon that many/ most of the problems associated with capitalism can be offset or corrected by a liberal democratic State designing and revising a rules-based framework, with discretion to compensate for inequitable outcomes and the power to offset market failures of many descriptions. This makes me, I think, a social democrat. This may be naive, but I would prefer to channel energy into improving the rules/ governance rather than dismantling the construct.

A Better Fiscal Rule

Neville Hill and I originally wrote this piece in early summer 2019, but never quite finished it. As all the excitement over fiscal rules ahead of the 2019 UK General Election kicked-off, we wrote up a précis which was published by FT Alphaville.

We then submitted a longer version to the Society of Business Economists’ annual Rybzynski Prize and were delighted to be shortlisted. Since then we have received a number of requests for the longer version. Here it is:

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Fiscal rules have never been so prevalent among nations, but most fiscal rules fall victim to charges of ineffectiveness, over-complexity, asymmetry and harmful pro-cyclicality. The succession of fiscal rules – national and supranational – to which the United Kingdom has made itself subject since 1992 are no exception. We argue for a new fiscal rule that might help secure fiscal credibility that is intuitive, counter-cyclical and potentially symmetrical.

Today the United Kingdom targets a falling debt stock as a percentage of GDP and a cyclically-adjusted budgetary balance over the medium-term. Eurozone member states are subject to a plethora of deficit constraints and an obligation to reduce the debt stock to 60% of GDP.

Most of these rules are being met. But these rules are no longer fit for purpose in a world where policy rates are low and central banks have little room to ease.

Why a fiscal rule?

The economic, political and social consequences of each of debt default and high inflation are severe.[1] And there appears to be a limit to the proportion of total economic output that can be directed by a government towards public debt service, bounded by political, social and financial market parameters.[2] Furthermore, while monetary sovereigns can always summon into existence more money to service debt, there are good reasons why they might not always want to.[3] As such there is a powerful imperative towards limiting or reducing debt on the part of governments seeking to maximise long-term fiscal flexibility.

But while long term fiscal sustainability is a goal upon which every government can agree, the short-term incentives to increase spending can prove politically irresistible.[4]

Fiscal rules are means by which governments can seek to bind themselves (and demonstrate to others that they are bound) to the masts of fiscal rectitude. And while mixed, the evidence suggests that episodes of significant debt reduction have been associated with the introduction and use of fiscal rules across a number of countries over many decades.[5]

Fiscal rules fall into one of four categories – budget balance rules (maximum deficit), debt rules (creating upper limits on government debt), expenditure rules (limiting growth of expenditure) and revenue rules (generally targeting revenue as a percentage of GDP). [6] Each of these approaches have sought to secure debt and, consequently, monetary sustainability. Debt rules go directly to target an upper bound for government debt stock, while the others provide intermediate targets that will restrain or reduce the level of government debt. The rules are all asymmetric – they instruct governments to cut deficits or debts, but do not set a lower bound, or instruct more expansionary policy. That may reflect the fact that they were largely designed in the wake of the fiscal and monetary policy failures of the 1960s-1980s, when there was a compelling need to demonstrate fiscal and monetary credibility.[7]

What’s the problem?

Existing fiscal frameworks recognise the prospective dangers attached to a high and spiralling stock of debt, but are not designed to see the dangers of inappropriate deleveraging. Pro-cyclical fiscal tightening (raising taxes and cutting government spending in the midst of a slowdown or recession) can be especially damaging to the economy,[8] and the rules described above, targeting maximum debt stocks or government deficits, are prone to signal the necessity of fiscal tightening at precisely the moment of maximum pain.[9] Critically, they assume that monetary policy will be free to administer short-term demand management and so may be mis-specified when rates are at or near the lower bound.[10]

And they willfully ignore information embedded in financial market prices, seeing markets only as prospective constraints to fiscal flexibility: a capricious and constant source of risk. This, as we discuss below, presents another source of asymmetry: governments cannot ignore the message of very high borrowing rates, no matter what their fiscal rules are.

Simply put, while any fiscal rule will be clunky, the existing rule set poses meaningful problems and dangers when policy rates are at or close to the lower bound, as they have been for the past decade.

A better fiscal rule

A key aim of fiscal rules is “sustainability”: to ensure public finances are managed to avoid the risk of default or inflation. And although the size of a government’s debt obviously has implications for sustainability, it is not the only metric that matters. Nor is it the most important.

Sustainability is the economic and political capacity of the state to meet its financial obligations. We think debt interest service as a percentage of GDP is a better metric than debt stock when it comes to capturing the concept of sustainability. When debt service is very high, governments find it challenging to dedicate tax revenues to paying coupons on bonds. But conversely, when it is low it would suggest there is room for fiscal expansion.

Debt service is a product not of stock alone, but of the size, tenure and type of existing debt stock, the growth in economic output, primary fiscal balance, choice of new issuance, and the level of market interest rates. These factors, furthermore, are interdependent.[11] In summary, debt service is a function of the past fiscal legacy that must be managed, the present economic environment that is ever-changing, and external expectations as to future economic and monetary conditions. Furthermore, it responds to changes in its determinants fairly slowly, especially if the debt and issuance tenure is long (see Appendix). That means fiscal rules based on debt service targets will generally only necessitate gradual changes in fiscal policy, not abrupt dislocative shifts.

Debt stock and debt service then are related, but distinct. They can move in opposite directions for decades as a glance at recent United Kingdom budgetary history can show. In 1980 the United Kingdom spent 5.2% of GDP towards servicing government debt; debt to GDP stood at 46.2%. Fast forward almost forty years and we can see debt service as a percentage of GDP having fallen to 2.7% of GDP (2.0% of GDP after the fiscal impact of QE is taken into account), while debt to GDP had almost doubled at 89% of GDP. This startling fall in debt stocks and interest costs moreover is not unique to the United Kingdom (see Figures 1 and 2).

Figures 1 & 2: Debt stocks as % of GDP since 1978; Interest costs as % of GDP since 1978

Fig 1-2

Instances where interest costs have reached 5% of GDP have tended to be met by alarm in Finance Ministries, and fiscal adjustment programmes have tended to follow (Canada’s 1985 and 1995 Plans, Italy 1988 and 1995 Plans, the UK’s 1976 IMF programme and 1980 Medium-Term Financial Strategy).[12]

There have been multiple other instances where fiscal adjustments have been delivered by G7 governments – most recently the UK’s 2012-2020 programme of austerity that seeks to target debt stock. But as Blanchard and Tashiro (2019) argue in relation to Japan – where debt-to-GDP is more than 2.5X higher that seen in the UK and debt service is 30% lower than the UK as a percentage of respective GDP – the appropriate fiscal policy for the Ministry of Finance may well be an increase rather than a reduction in primary deficits over coming years, given the macroeconomic challenges of re-anchoring inflation expectations in firmly positive territory and delivering higher levels of economic growth while the Bank of Japan remains at the effective lower bound. A higher debt stock is not a desirable end in itself, but nor is it necessarily a greater danger than an inappropriately tight fiscal policy when debt service is low.

The reason for this fall in debt costs despite the surge in debt was the collapse of market interest rates. In 1980 long term Gilt yields stood at 13.9%, and by 2017 they had fallen to 1.0% This decline in market interest rates reflects changing market expectations of economic growth and inflation. But the fall in market interest rates from a fiscal policy perspective appears to have been taken as an event rather than as a signal. A government’s decision to ignore the information embedded in asset market prices short-circuits the ability of easy monetary conditions to prompt economically stimulative fiscal policy; refocusing fiscal rules towards debt service would remove this short-circuit. Fiscal rules focused on debt service also remove an asymmetry. As we have seen time and again in the past, markets pricing extremely high rates provoke or necessitate a restrictive policy from governments. But extraordinarily low borrowing costs do not provoke the opposite – a stimulative policy – as governments are often constrained by nominal targets for the stock of their debt or the size of their deficits.

A symmetrical fiscal rule?

While a new fiscal rule that targeted a maximum debt service ratio would be a vast improvement on the current fiscal rules, it is worth exploring whether there are further benefits to be had by also setting a minimum debt service ratio. We believe that so doing would deliver three principle benefits.

Firstly, it would introduce more powerful counter-cyclical fiscal impulse. The government would be prompted to take the initiative to invest when the cost of so doing was lowest, the need was at its highest, and the potential knock-on inflationary consequences of which would be helpful rather than counterproductive.

Second, it would introduce a mechanism by which fiscal and monetary policy coordination might be enhanced. Lower interest rates – signalling expectations that economic output was far below potential – would prompt a looser fiscal policy to boost output, while higher rates would prompt fiscal retrenchment.[13] Furthermore, when the central bank undertakes large scale purchases of government debt (QE) it not only reduces interest rates in government bond markets, but government debt interest is reduced further by the central bank returning the difference between its policy rate and the yield to maturity of the government bonds it holds back to the government. At present, that reduces UK government debt service by 0.7% of GDP.

Thirdly, introducing a policy that forcefully and automatically addresses the Keynesian ‘liquidity trap’ removes downside uncertainty over the course of long-term economic growth and inflation. As such its adoption could keep interest rates and long-term bond yields at higher levels than they would otherwise be, and other UK financial assets might attract a reduced risk premium (associated with the prospect of obviating stagnation). But the symmetrical nature of the rule would also provide assurance that fiscal contraction would come onto the agenda if inflationary expectations became unanchored.

Again, we believe more research is required before a target for the lower bound of debt service is selected but would envisage that it would reasonably be around 2% of GDP. In 2018 the United Kingdom’s debt service costs amounted to 2.7% of GDP before the fiscal dividends of QE are counted and 2.0% after.

Most fiscal rules fall victim to either the charge of ineffectiveness, over-complexity or harmful pro-cyclicality. The succession of fiscal rules – national and supranational – to which the United Kingdom has made itself subject since 1992 are no exception. We believe that this proposal is worthy of examination as a potential exception to this charge sheet.

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Appendix: Term of debt matters

When looking at a government’s debt dynamics we can see that term structure matters. Among developed bond markets included in the Bloomberg Barclays Global Treasury index, the UK has the longest average maturity (figure 2.1) – standing at more than twice the weighted average maturity of US government debt. Looking more closely at the UK’s refinancing requirements, we can see that they fall unevenly across time as principal and interest payments are, by their nature, somewhat lumpy (figure 2.2).

Figures 2.1 and 2.2: Weighted average maturity of developed government bond markets; Term structure of UK government debt, June 2019 – assuming RPI yoy at 3%

Fig 3-4

Bond market yields – determined by the price at which investors are willing to buy existing bonds in the secondary market, and rates of interest at which borrowers are willing to originate new borrowings – can vary meaningfully from decade to decade. The term of existing and new borrowings impacts how quickly these market-driven yields will inform fiscal sensitivities.

The relatively high term length of UK debt reduces the fiscal sensitivity to changing market expectations around the future course of the Bank of England’s Bank Rate, economic growth, and inflation (where a drop in each of these has historically corresponded to a fall in market yields).

To illustrate this let’s consider a (relatively bleak) scenario for the UK (table 2.1) over the next fifty years. In the first decade we model bond yields at levels not too distant to where they are today, sluggish nominal GDP growth, and a primary deficit (government budget balance before interest costs) of 1.5% of GDP. This scenario is consistent with a stable debt stock as a percentage of GDP, and gradually falling debt service costs.

From 2029-2039 we model a shock to bond yields, rising dramatically to 6%, nominal growth slowing to an even more derisory 3% per annum, and a larger primary deficit of 2% of GDP per annum. From 2039 onwards, we model a combination of continued derisory nominal GDP growth, a fiscal tightening such that the government runs a small primary surplus, and a fall in bond yields to 3%. The Retail Price Index (to which current inflation linked Gilts are indexed) is modeled to stay steady at a growth rate of 3% per annum.

Table 2.1: scenario to illustrate the implications of financing term

table 2

Figures 2.3 and 2.4 show how the modeled scenario can have quite differing implications for both the fiscal cost of debt service and for the contemporary stock of debt as a percentage of GDP. The purple line assumes that primary deficits and refinancing needs are met exclusively through the issuance of new five-year bonds at the modeled marginal bond yield (which is assumed to be stable across all maturities). This choice of tenor sees interest costs rise rapidly to 7% of GDP between 2029 and 2039 before receding even more rapidly to 4% over the subsequent five years. Debt to GDP rises from 2029 until 2044 when it reaches 135% before beginning a glacial decent, reaching 127% by 2071. The grey line illustrates the impact using the same assumptions but this time assuming that financing needs are met through the exclusive issuance of ten-year bonds. The light blue line shows the impact of issuing exclusively twenty-year bonds and the dark blue the impact of issuing exclusively thirty-year bonds.

Figures 2.3 and 2.4: Interest as a % of GDP; debt as % of GDP

Fig 5-6

Concerns that a fiscal rule associated with the fiscal costs of debt service rather than debt stock might put the government at the mercy of markets capture a truth that governments’ fiscal costs of debt are determined in part by market yields.

But every government seeking to finance its expenditures through the bond market will already be sensitive to market yields; the degree to which governments have heightened or dampened sensitivity to market movements is very much in their control of their debt management functions. Shifting to a fiscal rule that focused on debt service would put the question as to how much sensitivity the government wanted to have to market rates firmly in the hands of the hands of the government.

References:

Blanchard, O. 2019. ‘Public Debt and Low Interest Rates’. American Economic Review 109, no. 4: 1197–1229 https://www.aeaweb.org/aea/2019conference/program/pdf/14020_paper_etZgfbDr.pdf

Blanchard, O & Leigh, D. 2013. ‘Growth Forecast Errors and Fiscal Multipliers’, IMF Working Paper No 13/1 https://www.imf.org/~/media/Websites/IMF/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp1301.ashx

Blanchard, O. & Tashiro, T. 2019. ‘Fiscal Policy Options for Japan’, PIIE Policy Brief 19-7, May 2019. https://piie.com/system/files/documents/pb19-7.pdf

Borensztein, E. & Panizza, U. 2008. ‘The Costs of Sovereign Default’, IMF Working Paper 08/238, 2008. https://www.imf.org/~/media/Websites/IMF/imported-full-text-pdf/external/pubs/ft/wp/2008/_wp08238.ashx

Broadbent, B. 2014. ‘Monetary policy, asset prices and distribution’, speech given a the Society of Business Economists Annual Conference, October 23. https://www.bankofengland.co.uk/-/media/boe/files/speech/2014/monetary-policy-asset-prices-and-distribution

Debrun, X. & Kumar, M. S. 2007. ‘Fiscal Rules, Fiscal Councils and All That: Commitment Devices, Signalling Tools or Smokescreens?’ in: Banca d’Italia (eds.) Fiscal Policy: Current Issues and Challenges, Papers presented at the Banca d’Italia workshop held in Perugia, 29–31 March 2007, pp. 479–512. https://www.bancaditalia.it/pubblicazioni/altri-atti-convegni/2007-fiscal-policy/Debrun_Kumar.pdf?language_id=1

Fischer, S. 1996. ‘Why are Central Banks Pursuing Long-Run Price Stability?’ Jackson Hole Symposium, August. https://www.kansascityfed.org/publicat/sympos/1996/pdf/s96fisch.pdf

HM Treasury, 2017. Charter for Budget Responsibility: autumn 2016 update. January. https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/583547/charter_for_budget_responsibility_autumn_2016_update_final_for_laying_web.pdf

Hughes, R., Leslie, J. & Pacitti, C., 2019. ‘Britannia waives the rules?’, Resolution Foundation, October. https://www.resolutionfoundation.org/app/uploads/2019/10/Britannia-waives-the-rules.pdf

IMF, 2002. Assessing Sustainability, May. https://www.imf.org/external/np/pdr/sus/2002/eng/052802.pdf

IMF, 2009. ‘Fiscal Rules – Anchoring Expectations for Sustainable Public Finances’, Fiscal Affairs Department, December http://www.imf.org/~/media/Websites/IMF/Imported/external/np/pp/eng/2009/_121609pdf.ashx

IMF Fiscal Rules Dataset, 1985-2015. http://www.imf.org/external/datamapper/fiscalrules/map/map.htm

Lledó, V., Sungwook, Y., Fang, X., Mbaye, S, Kim, Y. 2017. ‘Fiscal rules at a glance’, International Monetary Fund, Washington DC, March. https://www.imf.org/external/datamapper/fiscalrules/Fiscal%20Rules%20at%20a%20Glance%20-%20Background%20Paper.pdf

Mauro, P. (ed). 2011. Chipping Away at Public Debt: Sources of failure and Keys to Success in Fiscal Adjustment, John Wiley & Sons.

Mauro, P., Romeu, R., Binder, A., & Zaman, A. 2013. ‘A Modern History of Fiscal Prudence and Profligacy’, IMF Working Paper No. 13/5, International Monetary Fund, Washington, DC https://www.imf.org/external/pubs/ft/wp/2013/wp1305.pdf

Portes, J. & Wren-Lewis, S., 2014. ‘Issues in the Design of Fiscal Policy Rules’, Department of Economics Discussion Paper Series No.704. May. https://www.economics.ox.ac.uk/materials/papers/13342/paper704.pdf

Rogoff, K. 1987. ‘Equilibrium Political Budget Cycles’, NBER Working Paper 2428. http://www.nber.org/papers/w2428.pdf

Romer, C. D., & Romer, D.H. 2019. ‘Fiscal space and the aftermath of financial crises: how it matters and why’, Brookings Papers on Economic Activity, BPEA Conference Draft’, March 7-8. https://www.brookings.edu/wp-content/uploads/2019/03/Fiscal-Space-and-the-Aftermath-of-Financial-Crises.pdf

Summers, L.H. 2014. ‘US economic prospects: secular stagnation, hysteresis and the zero lower bound’, Business Economics Vol 49, No2. National Association for Business Economics. http://larrysummers.com/wp-content/uploads/2014/06/NABE-speech-Lawrence-H.-Summers1.pdf

[1] See for example Borensztein. & Panizza. (2008), Fischer (1996).

[2] See IMF (2002) on the degree to which fiscal sustainability can be understood as a political concept.

[3] While the limiting factor on private sector or foreign-currency-denominated sovereign indebtedness is creditworthiness, the degradation of which can be observed in financial instability, the limiting factor on monetary sovereign debt and deficits is the acceptability of the currency, the degradation of which is manifest in monetary instability – via currency weakness, inflation, and/ or a fracturing of the financial system.

[4] These are the so-called ‘shortsightedness’ and ‘common pool’ problems. For shortsightedness see Rogoff (1990); for ‘common pool problem’ see Debrun and Kumar (2007).

[5] Debrun and Kumar (2007), IMF (2009).

[6] See IMF Fiscal Rules Dataset (2016) for a catalogue of past and present fiscal rules at the national and supranational level, and Lledó, et al (2017) for a history of fiscal rules by country.

[7] Sovereign debt markets exist not only to finance government deficits (or rather sterilise the monetary impact of fiscal payments in excess of tax receipts), but also to provide funding benchmarks for private bond issuers, and to serve as high quality collateral for the domestic financial system. Sovereigns not requiring external financing have issued full yield curves of benchmark securities for these reasons.

[8] Blanchard & Leigh (2013).

[9] Romer & Romer (2019) examine the motivations attached to large and small-scale episodes of austerity across the OECD since 1990 and find instances where the communicated rationale for pro-cyclical austerity was misplaced fear of loss of market access.

[10] This criticism is certainly not universal, with Wren-Lewis and Portes (2017) and Hughes, Leslie & Pacitti (2019) notable attempts to incorporate monetary constraints to a fiscal rule. Towards the end of 2019 the Conservative Party announced that the UK’s fiscal framework (requiring a cyclically-adjusted deficit below 2% by 2020-21 and the delivery of a reduction in the net debt to GDP ratio each year unless the Treasury judges that there has been a ‘significant negative economic shock to the UK economy’ (HM Treasury 2017)) would be replaced by a requirement to run a balanced current budget excluding capital expenditure from 2022, a 3% of GDP limit to net investment and a 6% of tax revenues maximum for debt interest costs, beyond which government must reassess its borrowing plans with the goal of stabilizing debt stock. While a step in the right direction, this approach retains the asymmetry of previous fiscal rules.

[11] A simple shorthand for estimating the change in debt as a percentage of GDP is the equation: , where r and g represent the interest rate and growth rate respectively (in either real or nominal terms), while d and p represent the stock of debt and primary surplus (each as a proportion of GDP). Setting Δd to zero delivers a framework for achieving a stable debt to GDP ratio. Simply put, a higher rate of economic growth, a lower interest rate, and a higher primary budget surplus are all things that help to reduce debt stock.

[12] See Mauro (2012).

[13] There is a further question as to whether a symmetric fiscal rule should be set to target interest costs net of the Bank of England’s Asset Purchase Facility (APF) payments. Doing so would turbo-charge monetary-fiscal coordination by delivering to the Bank of England a mechanism to provide direct and immediate fiscal space that must be deployed by the Treasury if the lower bound of interest costs as a percentage of GDP was not to be breached. This is because coupons paid on the gilts held in the APF by the Treasury are returns to the Treasury (minus financing costs) , and as such quantitative easing: a) delivers real fiscal dividends in the form of a lower net interest cost; b) could require the Treasury to ramp up debt issuance such that the minimum debt interest payment rule was met. The degree to which such levels of coordination would threaten the Bank’s independence and institutional credibility need though to be considered in weighing this option, as would the costs of unwind.

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.

 

 

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.

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.

——

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.