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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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.

Household Debt in the UK

Yesterday I argued that if you want to discuss what changes to household debt might mean, you need a decent framework for assessing the fluidity of the microstructure of debt. To illustrate I set out two hypothetical countries with identically modest aggregate household debt loads – but with different sensitivities to changes in interest rates, and differing levels of financial stability. I called them Debtzania (where debt is concentrated and debt-to-income ratios for debtor was high) and Feudaland (where debt is thinly spread and a few households are creditors).

Which of these economies does the UK most resemble?

Using the NMG/ Bank of England survey data we can examine where it is in the income distribution that UK household debt falls.

Table 2 shows that most debt is owed by those in the top three deciles of the income distribution, and on sums below £175k. The mortgage-dominated nature of this debt and the untroubling LTVs with which it is associated may explain it to some as both rational and desired.

Table 2: Where household debt sits, by pre-tax income decile and total debt cohort

We can perform the same analysis for deposit balances held among our sample (knowing that at the macro level, total monetary assets and total monetary liabilities in the household sector are roughly the same), the output of which is shown in Table 3. It is perhaps not surprising that most of the money is owned by members of the upper half of the income distribution.

Table 3: Where household deposits sit, by pre-tax income decile and total deposit cohort

We could treat each income decile as a separate sector and look at the transfer of net monetary claims between them (in the form of savings and borrowings). This is shown in Table 4, and the data suggests that the flow of savings is on a net basis from lower income cohorts to upper income cohorts, typically to deliver mid-sized mortgages (we could, of course, reverse the causality in this description). This concentration of debtors might sound a bit more Debtzanian than Feudalish.

Table 4: UK households by pre-tax income decile and total debt cohort, estimated net saving/ borrowing flow

But debt sustainability is only really an issue for those in debt, and will correspond to their ability to service debt. And so in Table 5 we examine how debt-to-income ratios vary across the our matrix of UK household debt and income distribution. After all, small cohorts of high debt-to-income ratios was the thing identified as problematic when looking at otherwise untroubling Debtzanian aggregate debt statistics. Here we can see that debt-to-income ratios look pretty high for almost all debtors, but least troubling for highest income households where most nominal debt resides.

Table 5: UK household debt-to-income ratios, by pre-tax income decile and total debt cohort

And so the problems for policymakers seeking some rules of thumb to estimate sustainable or unsustainable levels of household debt appear twofold.

First, there is a data issue. Our sample size of around 6,000 households is small (as evidenced by @jmackin2’s outrage yesterday), even before we start to exclude households that refuse to give data in which we have interest. For the purpose of this blog I have used a snapshot, but I think that we need to compare datasets on a longitudinal basis. When the numbers on the matrix change, we need to understand whether this the result of movement on the income dimension or debt dimension.

Second, we have a question over the appropriate unit of analysis. In discussing Feudaland and Debtzania we argue against this being the overall economy, but as suggested by a comparison between the matrices of debt and income distribution on the one hand, and deposits and income distribution on the other, splitting the population into income deciles takes us not much closer to the issue at hand. There are meaningful flows between debtors and creditors within members of any given income decile. The appropriate unit of analysis is perhaps the household. But that statement seems a bit nuts.

The chart below looks at individual households in the NMG survey, rather than treating them as aggregated cohorts. It’s messy, but maybe messy is what works.

Putting aside human concerns for families struggling with the very real problems attached to sever indebtedness, why should policymakers care?

FPC members care because widespread unsustainable household debt can lead to problems for financial stability. But, through this lens, problems in debt service among low income households with small but unsustainable debt balances are just not worthy of deep interest: they are insufficiently likely to cause systemic financial problems.

MPC members care because changes in appetite for debt might tell them something about the location of the neutral real interest rate. Through this lens it might seem that it doesn’t matter what individual households are doing, but does matter what they collectively do. And I guess that if this is true, changes in the optimal level of debt which can only be inferred from an examination of its microstructure will be an important in any decision as to the wisdom of ‘leaning against the wind’. And they will care because cashflow impacts for indebted households following changes in interest rates are part of the transmission mechanism.

What to do?

Despite data shortcomings, there are some suggestions that we can draw out. First, in considering changes to household debt, policymakers should do well to treat aggregate debt statistics with caution. Having an idea as to whether they are dealing with Feudaland or Debtzania, and the degree to which there is stability in the microstructure of the debt distribution seems important. Second, examining the entire distribution of nominal debt-weighted debt-to-income ratios (and changes thereof) appears to be a step towards more capturing more meaningful household debt characteristics, changes in household behaviour and systemic debt problems.

Reverse ferret on household debt

A couple of blogs ago I posed the question as to how the sustainable level of household debt might be identified for an economy. I then reckoned that there might be a decent 30k ft way of addressing this question. This post serves as a bit of a reverse ferret. I’m not saying that the previous approach was wrong, but after some back-to-basics thinking I understand that its rightness is overly-dependent upon the stability of something that it may or may not be wise to assume. In my defence, I reckon *every* macro approach relies on this stability (comments section please to correct me). But I take little comfort in expressing a popular view based solely on its popularity.

Debt is an entirely distributional issue. Evenly distributed in a closed economy, no level of household debt is unserviceable or unsustainable. But evenly distributed, debt is also functionless. Every sustainability question rests upon the microstructure of debt loads across different households. And so, from a macro perspective, debt is tricksy to say the least.

This all becomes clear in an example. Let’s imagine two super-simple closed economies with no sectoral flows: the Kingdom of Feudaland and the Republic of Debtzania.

The Kingdom of Feudaland consists of 10m households, each of them with perfect equality of employment income (at £20k per annum), making its GDP worth £200bn per annum. Household debt sums to £20bn, and interest rates are 15%. Debt is owed by 9.625m households to the other 375,000 remaining households (evenly). Interest costs are eminently serviceable (£312 per annum per household in transfers from the debtors to the creditor households, each of whom receives a handsome £8,000 per annum in interest).

The Republic of Debtzania also consists of 10m households, each of them with perfect equality of employment income (at £20k per annum), making the GDP worth £200bn per annum. Household debt also sums to £20bn, and interest rates are also 15%. Debt is owed by 375,000 households to the other 9.625m households (evenly). Servicing this debt costs the debtor households £8,000 per annum. The creditor households each receive a modest £312 in interest income on their savings.

Table 1: Feudaland and Debtzanian debtmetrics

The aggregate debtmetrics for Feudaland and Debtzania are exactly the same (Table 1). At 10%, the aggregate household debt to income ratio looks pretty low, as do aggregate interest payments as a proportion of GDP at 1.5%. But the microstructure of the debt distribution is what matters in assessing the sustainability or otherwise of these two economy’s debt loads.

Feudaland, despite its wealth inequality, looks to be a beacon of financial stability. The debt-to-income ratios for debtors are pretty low at 10.4% of income, and servicing ongoing interest costs is universally manageable, absorbing 1.6% of income. Feudaland’s wealth inequality might eventually prove politically unsustainable, but it would be hard to call it financially unsustainable, even in an environment where interest rates doubled.

Despite exactly the same aggregate debt-metrics, Debtzania looks much more financially fragile than Feudaland. The majority of its citizens are savers, but they have amassed claims on the small minority of financially-fragile debtors who must pay out 40% of their incomes in interest payments to keep out of default. Debtzania debtors’ debt-to-income ratios are individually high at 267%, and it is probably fair to say that a doubling of interest rates might bring meaningful problems to Debtzania’s financial system (with associated morality stories).

Now imagine being a monetary policy maker in each of the two countries. At what point should you worry about changes to aggregate household debt, and at what point could you infer that household debt in your country is too high? If a policymaker looked to their countries’ respective histories for clues they would, in so doing, be making the assumption that the microstructure of debtor-creditor relationships would be relatively static (or at least semi-stable) over time.

With a static microstructure of debt in Feudaland we might expect to see household default rates relatively unresponsive to wild changes in aggregate debt loads or interest rates. Policy makers might draw the lesson that household debt – at only 10% of GDP – is far too low to worry about, and that rising debt could be a sign that households were moving towards their optimal debt load (and so should not be met by any ‘leaning against the wind’). One could even imagine the cultural trope of creditworthiness being assigned to Feudalanders (backed by the empirical evidence of minuscule historical credit losses).

With a static microstructure of debt in Debtzania, we might by contrast expect to see household defaults rise and fall with both real (and nominal) interest rates and debt-loads. Those 375k households who do the borrowing may – if cross-country evidence holds in our mythical land – do a disproportionate amount of the spending in the economy. And so monetary policy might prove a particularly speedy macro tool for demand management: introducing higher and lower pain thresholds to debtor households and transferring higher or lower amounts of debtor household incomes to creditor households with lower marginal propensities to spend. It would be unsurprising if Debtzanians acquired a reputation of being quick to default; concerned politicians might encourage them all to save more.

In short, if the structure of the distribution of debt was utterly unchanging in both countries, policymakers might reasonably rely on each country’s individual history of debtmetrics to determine policy pinch-points.

But the usefulness of any historical comparisons (in terms of aggregate debt-to-income ratios or debt-service ratios) rests on this microstructure of debt being pretty concrete. The more changeable the microstructure, the less useful any historical comparisons.

Imagine again that the microstructure of debt distribution in Feudaland shifted to match the distribution in Debtzania, perhaps as its demography shifted through population ageing and associated changes in savings habits. A policymaker following only aggregate debtmetrics might infer that the change in default patterns was associated with some cultural shift in the population. When in fact, aggregate debtmetrics had instead done a good job at masking this demographic sea change.

It is not clear that I, or anyone else who makes macro comments on matters of household debt, has a decent framework for assessing the fluidity of this microstructure.

In the next post I look at the data that I can see readily available for the UK.

In search of a better World Interest Rate

Financial market practitioners are, if nothing else, pragmatic in their approach to analysis. Finding something that works is great. And when something stops working it tends to be discarded. After a twitter convo last night with some smart folks I’m going to outline something that I have tried and discarded in the realm of seeking an answer to the question as to how the long dated real yields across the world might be determined by macroeconomic variables.

Some years ago when I was a full-time bond geek I asked my then CIO (the wonderful Michael Hughes of BZW Equity-Gilt Study fame) how he thought about assigning relative value in the inflation-linked bond market. (Please bear in mind that this preceded the ‘popular’ preoccupation with discerning the true r-star by some years.) 

Simple, he told me. Think of the real yield as the bid for international capital: there should be an inverse relationship with current account balances. I regressed 10yr real yields with current account deficits as a percentage of GDP, and there was an okay fit. Markets are forward-looking so I took consensus c/a balances (proxied by IMF forecasts). A better fit.

Here’s the chart* with and without the UK using today’s IMF forecasts:
It’s not the worst chart in the world at first glance (although @Barnejek might disagree). It gave me a speck of hope that there might be some useful stuff here that could improve on King & Low 2014.

King & Low sought to provide a ‘world interest rate’ series that can be used by all sorts of people. And it has since been heavily cited. They basically take an unweighted average of available ten year inflation-linked bond yields, and also a GDP-weighted average of the same instruments (finding them pretty indistinguishable). As far as papers by former G7 central bank governors go it is unextraordinary. But I like the idea of a global real yield and for play for having a stab at it.

As a practitioner, developments within one market appear to drive others, although the ‘aggressor’ market appears to change. (So, for example, it could be US Treasuries setting the tone for the world’s bond markets until the ECB decides to institute QQE and starts driving the car. And then the BoJ rocks up and declares Yield Curve Control. That sort of thing.) In financegeek language, developed market bond yields appear to be cointegrated. This is uncontroversial.

Finding a world interest rate that recognises adjustments for the international balance of payments (which looks from these charts like they might be a *thing*) could be interesting. Rather than looking at the simple average of the historically small number of issued bond yields and calling that the world interest rate, you could instead plot the course of the intercept of the regression line on the chart over time: a line not distorted by a country’s idiosyncratic balance of payment positions (or at least aggregating and controlling these idiosyncratic distortions).

When I tried this approach I came up with an answer that was not radically different from King & Low. The green line in the chart below is not far from King & Low’s blue line (which I extended by updating their dataset) and is modestly below (taking account of the degree to which King & Low’s issuers typically run current account deficits, and that they hadn’t made any credit spread adjustments to their data). Not that different. But better?

However, we now reach the disappointing part of the story. How stable is the relationship shown above in the nice scatter/bubble charts? Not very. As the next two charts show, the r-square of the relationship goes to pot 2008-2014 (although here I am using actual c/a balances rather than forecast ones). And the slope of the line actually flips from negative to positive in 2008 (admittedly, some really reallly crazy stuff was going on in international inflation-linked markets then – stuff that I still talk to people about today, so maybe that’s forgivable).

I haven’t GDP-, M3-, or duration-equivalent-bond-market-size-weighted the dots to find this r-square, so maybe things improve with a bit more work.

Bottom line: The cutting room floor is littered with ideas that don’t quite make the cut. I really like this way of thinking about international real yields, but am disturbed by the episodic nature of the relationship actually ‘working’. Pragmatism leads me to look in other directions if I want to link international real yields to international macroeconomic variables.

If anyone has had more success in this approach please do drop a comment in below.

————– 

* I take the average IMF c/a balance for 2017-2021 as a percentage of GDP and compare here to 10yr real yields on inflation linked bonds as at 28th November 2017. I have adjusted the UK for the RPI-CPI ‘wedge’, and the Eurozone real yields by the difference in their 5yr CDS and Germany’s 5yr CDS so that it doesn’t become a credit quality chart. The bubble sizes are common currency GDP; I was wondering whether they should be common currency M3 or bond market size in 10yr duration equivalents. Not sure.

Finding the *right* level of household debt

My last post reflected on the Borio/ Vlieghe idea that the Equilibrium Real Rates (ERR) should perhaps be defined not just by inflation, but also by changing debt levels. Since then I have been thinking about that list of tricksy questions I listed at the end of the post. I want to have a stab at one – specifically, whether it is possible to define the ‘optimal nonfinancial debt’ for an economy. Short answer: maybe, but I don’t have the skills to know*; in the meantime I’ve got a way to think about it from 30k feet. 

Thinking about optimal debt loads from 30k feet by cleverer people than me has had a frankly shocking record.** That said, my MPhil thesis on the geopolitics of emerging market finance, has given me familiarity with debt sustainability models that I think could maybe be helpful. The bottom line of debt sustainability frameworks tends to be that there is rarely an impossible level of debt, but debt does get meaningfully tougher to service as debt rises, rates rise, and growth slows. Big surprise.

Let’s look at the UK household sector as a whole through the lens of a super-simplified sovereign debt dynamics framework.*** We know what disposable household income growth and effective interest rates have recently been. And we know where the household debt stock has got to. As the chart below shows, it has risen to 138% of disposable income.


So what is the ‘primary surplus’ (or in the households’ case the net acquisition of financial liabilities minus interest payments as a percentage of household disposable income) required to stabilise household debt-to-disposable-income at 138%? The answer is around about 2% right now. And what is the actual ‘primary surplus’? Around -2%. So debt is growing, and is growing quickly. And the Bank of England appears to be worried about this worrying rise in household debt. (Again, read the last blog on this here.)

We can compare the primary surplus required to stabilise debt levels over time (blue line in the chart below) to the actual primary surplus recorded by households (grey line). You may notice that when the grey line is below the blue line, debt rises. When the grey line is above the blue line, debt falls. It’s a super-simplified little framework. The chart on the right compares the gap between the two lines to the change in debt-to-income: we can see that it doesn’t capture everything, but it sort of works(ish).


While extremely simple, this framework highlights the degree to which the issue of changes in debt sustainability (a somewhat different and easier question to the optimal debt load question) is a function of income growth, interest rates and debt loads. And in seeking to answer the question as to why households have re-levered recently, we can quickly hypothesise an answer that doesn’t involve a spending splurge. (The incredibly smart Neville Hill at Credit Suisse, who kindly shared his data with me that I used to calculate the blue line, argues exactly that here.)

What pushes the blue line up and down so erratically? Well, the most volatile input to the little debt dynamics ‘model’ is household income growth. The spike up in the blue line in recent quarters appears to have been driven by a collapse in nominal household income growth through 2016. In other words, it sort of looks like households are expecting the sharp recent slowdown in income growth to be temporary.

If the slowdown in household income growth isn’t temporary and the Bank of England raise rates to try to control household debt growth, the blue line gets a double-whammy. The following projection shows the path of the breakeven primary surplus in an environment where household disposable income growth continues at the sluggish pace of the last year and three rate rises over the next three quarters:


Actual household consumption would have to drop consumption pretty darn quickly to stabilise debt levels. And I can see households interpreting this as monetary policymakers arguing that the beatings will continue until morale improves.

Where does this leave the idea that an understanding of the ERR should take into account debt growth? I’m still scratching my head on this, but it seems to introduce some qualifications at the least.
—————

* Given the importance of this question for all sorts of things, it is frankly weird that there hasn’t been more research on it. I feel pretty confident that it might be advanced by some awesome econometricians who have experience in mining large panels of ONS household data, but is there anything to say on the matter before then?

** In the wake of the GFC, Ken Rogoff and Carmen Reinhart’s empirical work on debt at a sovereign level attracted sufficient policymaker attention to get them cited as the intellectual handmaidens of austerity. Indeed, ex-UK Chancellor George Osborne cited their work directly ahead of the fact as the rationale supporting austerity. But since the aspects of the R&R work looking for debt optimality has been shown to be uncharacteristically error-strewn.

*** Simply d[(r-g)/(1+g)]=pb, where d = debt/ disposable income; r = effective household interest rate; g = annual growth in household disposable income, and; pb = household net acquisition of financial liabilities minus interest payments as a percentage of household disposable income.

Tl;dr for the TSC

A few months back the UK Parliament’s Treasury Select Committee (TSC) invited anyone and everyone to submit in 3,000 words their views about post-crisis monetary policy. I can imagine that TSC members’ junior researchers must have been thrilled by the prospect of reading all the submissions for their political masters on the 16 open-ended essay questions set in the terms of reference.

I read all thirty four of the written submissions and post the tl;dr for each below so you wouldn’t have to. Thirty four. I hope that the authors who see each of their 3,000+ word missives so ruthlessly and flippantly précised (with potential misreading) take this in the good spirit in which it is done.

Why did I do this? Erm… It seemed like a better idea at the start than it did by the end?

Actually, three reasons. First, political support for Bank operational independence has been sagging. The Prime Minister has been drawing attention to distributional inequitiesassociated with QE. The Chancellor had to make a statement to Parliament in support of QE after City rumours of private briefings in which he inferred that backing for further rounds of QE would no longer be forthcoming. Senior Conservative politicians have publicly attacked the Bank (for example, here or here). And the Labour front bench have been airing prospective reforms that would remove operational independence. It was in this political context that the TSC, which holds the Bank to account, launched its inquiry into post-2008 monetary policy. I wanted to get a sense as to what the submissions said.

Second, I read a lot of policymakers, academics and investment bank stuff about QE. Much of it is very good. But this is a genuine free for all from bloggers, academics, finance professionals, think tanks, former policymakers and private unaffiliated individuals who could be bothered to express a view. I found in the submissions some perspectives that were genuinely new and interesting to me. Reading them has sparked a bunch of thoughts.

Third, I submitted myself, and so was interested as to where my views sat within the body of submissions.

I also learned during the course of reading these about the Cobden Centre, which appears to have done a decent job of making its presence felt rather firmly. The Centre which appears to campaign for an end to fiat money was founded by Steve Baker MP, a member of the TSC, who used to work in IT at Lehman Brothers before turning to politics. Affiliates of the Centre submitted five of the thirty four written testimonies and gave one of the three oral testimonies. I have no sense as to whether these submissions were coordinated or not, but thought it striking that only one of the five written submissions mentioned their affiliation in their self-description.  Four of these written submissions can probably be summed up with the words ‘buy gold’; the fifth was fascinating. I have put these together at the end.

The summaries are in the order shown on the Parliamentary website, but grouped into policymakers, academics, finance folk, think tank, unaffiliated, and Cobden; I include Twitter handle where I could find it. They start long and get shorter…

 

Current and former MPC members

Ben Broadbent, Deputy Governor Monetary Policy, Bank of England

Monetary policy can affect nominal quantities, but not real ones over the long term. Real bond yields are set globally, diverging due to local risk premia or the market’s currency expectations. As a small open economy, our real rates are imported and low policy rates are a symptom, not a cause. Target saving can’t be a thing if savings rate falling. QE works. DB pension deficit not our fault, but probably haven’t hit growth much. Precautionary hiking to lean against the wind of financial imbalances appropriate only if macropru unavailable; BoE has FPC. Distributional impact analysis shouldn’t leave out impact of looser policy on overall income of both savers and borrowers (Cloyne 2016). Low productivity leads to low rates, not vice-versa. When QE is unwound BoE balance sheet will, nevertheless, need to be pretty big given regulations and banks’ demands for reserves.

Professor David Miles, ex-MPC member

Like @moyeenislam, reckons post-QE will still see huge reserve balances for banks, but QE need for duration will be absent. So BoE should own UKTBs to limit capital risk.*

*But he knows there aren’t enough T-Bills and so is flagging that the UK government needs to change its debt profile and shift it much shorter as QE unwinds. It could also be interpreted as an area for monetary-fiscal collaboration that saw the BoE signal that it will be a steady holder of short-term financing instruments for HMT and so HMT can benefit from lower debt service costs (if term premia proves to be positive).

Andrew Sentance, PWC and former member of the MPC (October 2006 – May 2011) @asentance

Rate cuts and QE were appropriate responses to crisis but ushered in generally above-target inflation but not stronger growth. Much of the time the BoE was ‘looking through’ ‘one-offs’, but this looks a little silly over a decade. Adverse consequences from post-08 monetary policy felt in housing (boosting prices), pensions (elevating deficits), savings (incentivising people to spend or buy risky assets) and productivity (zombies and service sector getting trade boost from GBP weakness that made it unnecessary to invest). Hike rates.

There is also an oral testimony that you can watch here from Charlie Bean and David Miles,as well as Detlev Schlichter – a guy from (you guessed it) the Cobden Centre.

 

Academics

Professor Huw Dixon, Cardiff Business School @Econdixon

Policy of financial repression is being pursued and is mistaken given economic output and employment are around ‘natural’ levels, hurting savers and retail banks and helps hedge funds and investment banks. Inequality a problem but not one for monetary policymakers. Hiking rates to 3-4% will boost confidence. Doesn’t seem to understand basic monetary economics double-entry book-keeping.

Professor Emeritus Sheila Dow, University of Stirling, and former special advisor on monetary policy to the Treasury Select Committee (2001-10) @sheilacdow

Distributional effects of monetary policy changes should be analysed ex ante as they impact effectiveness of policy transmission. Also, in concerning itself with aggregates rather than distribution, a value judgement is made that market processes ensure a just distributional outcome (wages and salaries reflect worth, etc). Distributional impact of monetary policy can create social problems that require fiscal spend to fix. Bank-HMT cmte should form to discuss interdependencies.

Professor Richard A. Werner, D.Phil. (Oxon), Chair in International Banking, University of Southampton who invented the term Quantitative Easing as a recommended policy for Japan in 1995 @ProfessorWerner

Interest rates are not a useful tool of monetary policy but should rise. BoE should desist QE, try to steepen the curve, and pressure UK banks to lend to non-financial SMEs. Bank credit creation determines nominal GDP growth. HMT should stop issuing bonds and borrow from banks.

Isaac T. Tabner, PhD, CFA, DipPFs, Senior Lecturer in Finance, University of Stirling Management School @IsaacTabner

Lower interest rates make house prices rise, absent generalised deflation.

Roger E. A. Farmer, Research Director for Macroeconomics, NIESR @farmerrf

There is no NAIRU or natural rate of interest. If inflation doesn’t rise, BoE should hike rates while either HMT does coordinated fiscal easing or BoE buys lots of equities. FPC can and should maintain a price for the average value of publicly traded equities that is consistent with full employment.

Lord Skidelsky, cross-bencher and Keynes biographer @RSkidelsky

Near-ZIRP & QE have probably helped at the margin but the distributional impact has been counterproductive and adverse, threatening independence. Fiscal is better. British Investment Bank. People’s QE.

Tony Yates, Professor of Economics, University of Birmingham @T0nyyates

QE was necessary (although not flawlessly executed); Forward Guidance was pants; inflation target should be raised to 4%; MPC should declare expected rate path; and an institutional architecture should be prepared for large-scale private asset market intervention, technocratic fiscal coordination, and introduction of helicopter money.

Professor Philip Haynes, University of Brighton @profpdh

QE boosted asset prices, including house prices. Rents too. And wealth inequality. Monetary policy should target credit at productive investment, working with the Chancellor.

Professor Mariana Mazzucato @MazzucatoM and research fellow Matteo Deleidi, University of London

Lower rates boost household demand for housing and goods, pushing debt higher; corporates investment intentions don’t respond to changing price of debt. Fiscal expansion would’ve been better than QE.

Eric J. Levin, Reader in Economics (Retired), University of Stirling and Robert E. Wright, Professor of Economics, University of Strathclyde

Viscous loop in play: demographics forcing up savings rates, pushing down demand and interest rates, wrecking pensions funding and boosting demand for bonds.

Professor Francis Breedon, Queen Mary’s University of London

QE could have been £2bn cheaper if executed via HMT issuing directly to BEAPFF (although this would have been illegal under Art 123 of Lisbon Treaty).

 

Finance folk

Association of British Insurers (although written by NIESR) @BritishInsurers

QE has increased DB pension deficits and lowered annuity rates. Under Solvency II, lower interest rates increase both the value of liabilities and the quantity of capital that insurers need to hold to insure their non-market risk, creating a trade-off between the fund’s valuation and its solvency. The highly sensitive nature of these movements to interest rates can generate volatility, which is a challenge to manage, dis-incentivises the insuring of longevity risk, and acts pro-cyclically. 50bp rate change moves Risk Margin by 20%.

Robin Churchouse (Finance Director) and Andrew McPhillips (Chief Economist), Yorkshire Building Society @Yorkshire_BS

Savers hit by QE, and markets have grown dependent on central bank support. Target saving not really observed, but nor have low rates reduced saving. Distribution is a matter for HMT.

Professor Mark Blyth, Brown University, @MkBlyth and Eric Lonergan, fund manager at M&G @ericlonners

QE1 was good, less so later versions. Success of policy 1980-2008 maybe dependent on coming from starting position of anachronistically high real rates. Monetary policy largely out of road; heli-money to households is the way the BoE should best respond to a downturn, should it come before rates are high enough to be cut in response.

Toby Nangle, Global Co-Head of Multi Asset, Columbia Threadneedle Investments @toby_n

Target saving a thing, but jury out on how big. QE sorta worked by boosting asset prices but houses are assets too. Death of DB pension system accelerated by QE, but regs and global environment too; low rates an opportunity for HMT. Nangle-Goodhart. Awesome charts.

Building Societies Association @BSABuildingSocs

QE was necessary, but further rate cuts, and in particular negative rates, could be counterproductive. Target savers abound, their number boosted by rising house prices and falling rates. Brexit will hit investment and economic growth.

Peter Dixon, senior economist at Commerzbank AG @commerzbank

Monetary policy is overburdened in the UK but the BoE has done a decent job. Target saving is a thing.

Neil Smith, Altus Investments & Plymouth University @NelsonSmythe

QE is bad unless it’s People’s QE. Abba Lerner was right and the UK should embrace Functional Finance.

 

Think tanks

Tomorrow’s Company, think tank @Tomorrows_co

QE sort of worked by boosting asset prices and household wealth (unsustainably), but a shame it was needed. Sectoral flows approach taken and monetary toolbox empty, absent overt monetary financing. Companies never reduced their hurdle rates so diminished monetary transmission. BoE chat kept GBP firm, undermining international rebalancing.

Positive Money, think tank @PositiveMoneyUK

Banks don’t really lend to businesses any more so low rates & QE just boosts asset prices (incl housing) and heighten inequality, especially between generations. People’s QE.

New Economics Foundation, think tank @NEF

Loans make deposits. QE1 stopped a liquidity crunch but made the rich richer. Bank lending overwhelmingly secured on property so property cycle key. BoE should target inflation, finl stability, inequality, house price inflation and employment at a regional level, public and trade deficits and ecological considerations. And a pony.

Jubilee Centre, a Christian think tank @JubileeCentre

The system is broken. Move to 100% reserve-based banking, complete household deleveraging, and abolish LOLR as well as tax breaks associated with incurring debt.

pH report

The UK population is ageing. We can prove it. Also, monetary policy isn’t set up to deal with this.

 

Unaffiliated

Michael R Garrard, a straight-talking autodidact

This man has been successively ripped off, is rightly pissed off, and is articulate. Reckons MPC is not in control: private companies are.

Richard Simmons studied as an economist and has worked in businesses

QE should fund big venture capital funds that can equity-finance early, mid, late-stage projects or infrastructure, with spin-out privatisations profiting the state.

Ralph Musgrave, economics blogger and unsuccessful British National Party PPC in the 2010 General Election @RalphMus

Today’s regime is a dog’s dinner! People’s QE.

 

Cobden Centre @CobdenCentre

I thought it best to group all the affiliates of the Cobden Centre together (where affiliates are defined as people described by the Cobden Centre on their website as their authors, founding fellows, directors etc). The Cobden Centre campaigns for an end to fiat money and was co-founded by Steve Baker MP who sits on the TSC.

Toby Baxendale, former vendor of wet fish and co-founder of The Cobden Centre @TobyBaxendale; Max Rangeley, founder of ReboundTAG @NotesfromMax

QE is immoral; shift to 100% reserve banking and a low tax regime should happen. The global liberal elite should be worried. Things will end badly.

Alasdair Macleod, Head of Research at Goldmoney @MacleodFinance

Buy gold. We need a policy of sound money to build solid foundations for economic growth, and a gold standard works deliver sound money. Buy gold.

Vishal Wilde, student who ‘devote[s] his life to fighting for Freedom and Justice because he believes God’s Will is a Free and Just Will’ and has written for the Adam Smith Institute

Multiple monies in circulation and free banking would be great.

Keith Weiner, founder of the Gold Standard Institute USA @kweiner01

Whatever the question, gold is the answer.

Anthony J. Evans, ESCP Europe Business School and IEA @anthonyjevans

BoE should target nominal income rather than inflation. Policy is too loose and has generated malinvestment. Markets provide better answers than policymakers. Some nice framing of epistemological questions.

 

–Fin–

Pocket money rate cuts

Talk in the Nangle household has turned to interest rates cuts. Specifically, the prospect of rate cuts from the ‘Bank’ I run for my kids on which I pay 10% per week that I have previously described here.

As I’ve explained, I founded the Bank as a way to combat the weekly pocket money flush where money *had* to be spent on *something, ANYTHING!*. This behaviour was then followed by complaints that they could never afford things that they might actually want. Giving them APRs on balances that are enjoyed by only the more dubious loan sharks did the trick.

Those of you older than 10 will have spotted immediately the flaw in the initial design – that the Bank is a redistribution mechanism from me to them that rewards saving to such an extreme extent that it could quickly cause it (and me with it) to go bankrupt. By being the Bank, I am borrowing wonga from my kids at outrageous rates.

For this reason I was particularly careful to spend a good deal of time at the inception of the Bank talking to the kids about how the rate would be set weekly and could be changed at my discretion. I even raised the possibility of negative rates at some point in the future, which drew cries of disbelief and outrage from my 8 year old.

Fast forward a year and it’s rate cut time. Why? Because, basically, my 6 year old gets it. From his 60 pence a week pocket money he has, with the help of compound interest, amassed a fortune of £50, giving him an unearned income of £5 per week and rising that he sinks back into the Bank. My 8 year old meanwhile has maintained both a balance of between £2-15, and a healthy scepticism of the value of saving for its own sake – preferring to save for something specific, buying it, then starting again.

My 6 year old looks at my 8 year old and wonders why she doesn’t save more. My 8 year old looks at my 6 year old and wonders why he values the abstraction of a ledger entry over all the stuff she has actually bought. Differing perspectives, both valid. I am very proud of them both.

My sky high APR has crushed the kids’ aggregate demand and on my son’s current trajectory, he will soon own the house. Yes, the Bank has embedded a useful lesson about how it *might* be useful to defer consumption. But, the house. Something must be done, and it’s name is financial repression.

The motivation to cut rates comes from a desire on my part to deleverage, or at least ease the pace of leverage growth to which my children are willing counterparties. But with such different marginal propensities to consume, should I cut the Bank rate or introduce a tiered set of rates that preserves high rates of interest on small balances, is less generous to larger balances, and penalises hoarding?

I worried that a tiered rate regime might be too complicated and could incentivise odd behaviour so I asked my 8 year old what she would do if marginal rates sloped downwards and went negative from £40 out. I had expected her to say that she would keep excesses in piggy bank cash. But her answer was intriguing and, if the ING survey is to be believed, specifically Anglo-Saxon:

‘I would get mummy to start a second bank with a positive interest rate and put the extra money in that instead’.

And so it seems that, in the Nangle household at least, negative rates would be greeted principally by a portfolio balance effect and a reach for yield rather than a dash for cash.

At the end of the original pocket money blog I reflected that what I had created was less a Bank and more a defined contribution pension system. Perhaps the logical next step is to take a leaf out of Osborne’s book and introduce a Lifetime ISA to compete with the current system. But for now, we have opted for a tiered rate regime which is far from perfect. It does serve to reduce my risks, and remains more generous than anything else around.

Amount of contributions required to save a balance of £100

LISA

 

LDI and the Efficient Market Hypothesis – my fictional pub chat with John Ralfe

A couple of weeks back I wrote a work piece about asset allocation. John Ralfe (@JohnRalfe1) sent a mini-Tweetstorm response and invited me to have public discussion about it on Twitter. I think that this would be better done over a pint in a pub, but since John doesn’t actually live in London and I wasn’t proposing to get on the train to Nottingham I’ve written this blog.

Given that my initial piece was a work thing (as opposed to a personal blog thing) I’m not going to go into it here, although you can easily read it on my employer’s website. It is basically an outline of how strategic asset allocation processes tend to operate, and active asset allocation can prospectively operate under forthcoming Local Government Pension Authority reform. Real Friday night stuff.

But John’s critique of it is not actually dependent upon the piece’s contents, so don’t worry about reading it to make sense of this blog. I understand John as instead wanting to critique the very notion that defined benefit pension funds should make ever asset allocation decisions.

For folks of you not familiar with John, he has quite a reputation in the world of institutional pension management. As former head of corporate finance for Boots (the biggest pharmacy chain in the UK) in the early noughties he was credited for shifting Boots’ pension assets out of equities and into bonds in an effort to match estimated liabilities with cashflows from fixed income securities (I am hazy on the detail, and you should ask him). This made headlines in not only trade press but mainstream press. As a 26 year old fixed income fund manager I followed the whole thing with great interest. Everyone in the industry did. Importantly, I understood his call to shift assets not as a call on the likely returns from the equity or the bond market, but rather a decision that Boots as a sponsor of a large pension fund should not be making calls on the likely returns from the equity and bond markets – even over very long investment horizons. Instead, they should be taking risks in its area of expertise (pharmacy retailing, and associated businesses).  The development of pensions regulation, invention of the Pensions Regulator and the Pension Protection Fund, the development of accountancy rules (think FRS17, IAS19 etc), and the frankly unreliable and volatile risk markets has led to the mass popularisation of this approach in the UK. I have met many a company finance director expressing the desire to want to get pensions out of the boardroom, and some of my day job involves helping them do so. So while it may not be technically true, I think of John as the founding father of LDI – Liability Driven Investment – in the UK.

LDI is a mammoth thing in the UK – so mammoth that anyone with a remote interest in finance or financial markets without a passing understanding of it should probably read up to familiarise yourselves with it. I draw a horribly crude thumbnail sketch in paragraphs below, but this is a very readable, short non-technical overview. In fact, as I’ve argued here the conditions that have led to its success are sufficiently mammoth a thing that they need to be considered when contemplating non-traditional monetary policy in the UK.

Around about the time that John invented LDI (or at least brought into the mainstream), markets were experiencing what we now refer to as the dotcom crash. This was accompanied by accountancy scandals at Enron, Worldcom, et al that ultimately brought about the dissolution of Arthur Andersen – one of what were the big five global accounting firms. Equity markets were all over the place and the vast bulk of UK defined benefit pension schemes were thrown into massive deficits. Why were they thrown into deficit? To answer this we need to step back and ask of what a defined benefit pension actually consists. The answer to this question has (I believe) changed from a legal perspective over the decades, and has ultimately landed as a form of deferred pay that ranks pari passu with senior unsecured creditors (this off-the-top-of-my-head legal definition is complicated by the creation of the PPF a few years back, and I’m happy to insert a snappy more correct definition of the legal status of someone’s defined benefit pension assets not yet in payment).

Firms that have promised to pay their retired ex-staff monthly payments until death don’t know the exact size of the final bill for which they have put themselves on the hook. They employ actuaries to estimate the size and timing of likely future payments that they have promised to make. Changes in the actuaries’ estimates of likely mortality developments will impact their assessment of payment sizes and timings; financial market volatility will not. Reasonable actuarial estimates of these likely payments can be huge for individual companies. Mega-humongous-huge for the UK in aggregate.

And so it would be weird if accountants didn’t want to represent within the financial statements of a firm some clues pertaining to these often very sizeable liabilities. But rather than reflecting the terminal (estimated) value of liabilities (eg, I owe Deborah £100 fifty years from now if she doesn’t first die), accountants decided that a more sensible approach would be to reflect the estimate of terminal liabilities discounted using market interest rates, so arriving at the present value of liabilities. So instead of showing that I owed Deborah £100, the accounts would show that I owed Deborah around [£100/(1+50yr bond yield)^50] which, when using a yield of 5% equates to me owing Deborah £8.71. This may sound barmy, but if I were to put £8.71 into a fifty year zero coupon bond at a yield of 5% I would get back £100 in fifty year’s time – just in time to pay off my debt to Deborah. So the accountants thought this a sensible approach, and put this way it does sound pretty reasonable.

What has happened in recent years is that bond yields have fallen (with my understanding of structural drivers of bond yields outlined here). Furthermore, bond yield declines have been most substantial during equity market falls (think flight to quality, anticipation of lower interest rates and lower inflation in forthcoming years due to the disruption associated with financial market crisis, etc). So using the example of my debt to Deborah, let’s say that 50yr bond yields fall from 5% to 3%, the present value of the debt I owe Deborah will have risen from £8.71 to £22.81. It is important to note that the amount I owe Deborah hasn’t changed (it is still £100), but the liability reflected in financial statements will have grown almost three-fold due to changes in market rates used to turn terminal values into present values. By discounting terminal values (estimated by actuaries) back to present values, accountants could present stakeholders with a fair picture of firms’ financial health in a manner consistent with the efficient market hypothesis which won Eugene Fama his Nobel prize.

Getting back to pension schemes being thrown into massive deficit by the dotcom crash, we can see that while the terminal value of pension liabilities did not change (ok, they did go up a bit as actuaries have for many years increased their life-expectancy expectations) the present value of liabilities shot up as bond yields fell, and – for funds that chose to invest in equities rather than cashflow-matching bonds – asset values fell. Falling assets and rising liabilities made for a toxic mix, the result of which has been wholesale closure of defined benefit pension schemes, the diversion of large amounts of corporate income into financial assets in order to begin to plug the deficit (especially in an environment which saw the birth of the Pensions Regulator and Pensions Protection Fund in the UK). Here’s a picture of the ongoing death of DB pensions from the Pension Regulator’s excellent annual Purple Book :

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Meanwhile Boots pension funding levels would have been largely unaffected by falls in yields and falls in equity markets from the point at which it did the asset switch. It had largely closed down the mismatch between accountants’ estimates of the present value of actuaries’ estimates of ultimate cashflows payable to defined benefit pensioners by buying long-dated cashflows (in the form of fixed cashflows associated with bond coupons and principal payments). So while the accountants’ estimates of the present value of liabilities soared, so the value of assets also soared as bond prices rose (both being a function of long-dated yield collapse).

This has been a long preamble, and could have been skipped if John and I had met in the pub. Despite it being long I have skipped any discussion of real rates versus nominal rates (more than a little important), and a whole host of other real life (but complicating from a blog perspective) issues/ factors. But we have to move on to John’s Twitterstorm that he has since asked me to answer (a few times).

Here it is in text, with links to the original tweets embedded:

1 “Strategic Asset Allocation”, as correctly applied to an individuals fund, is a category mistake when applied to a DB pension fund @toby_n

2 A DB pension fund is not a self contained economic entity, but simply part of the capital structure of the sponsor @toby_n

3 Asset/liability mis-match in DB pension fund changes capital structure & increases financial risk for sponsor just like gearing @toby_n

4 If a sponsor wants to increase gearing, then directly borrow – transparent & tax efficient – not indirectly thro DB fund @toby_n

5 If a sponsor believes in “SAA” in DB fund, then borrow long term debt & buy financial assets & explain why to shareholders @toby_n

As you can see, it’s an entirely reasonable position from the founding father of LDI in the UK. And John makes very strong points that it would be silly to refute if one accepts his premises (which I have tried to relate in paragraphs above but may have got wrong, and with no John in pub, hard to know). Furthermore, his premises (if these indeed are his premises) are tricky to theoretically refute, rooted as they are in Nobel prize-winning stuff. The issues I have with John’s position (and the whole LDI edifice) can probably be summed up in a rambling question and a couple of observations.

My question:

Given that LDI is a hedge against changes in an accountant’s present value calculation of an actuary’s estimate of terminal cash flows, what is the best way to judge the correct price of this hedge; or rather, is it ever possible to overpay for this hedge, and if so, what tools would I need to employ to understand whether I was overpaying?

I have written about this before in relation to whether house prices (as an effective hedge) can ever be too expensive. I don’t have a definitive answer, but I suspect that hedges can be too expensive and asset prices can be wrong (and have bet my career on this suspicion). But I don’t observe anything in the LDI approach to help frame this judgement. Instead I understand it placing what looks to be an intolerable burden on the efficient market hypothesis to determine that a hedge must always be appropriately priced. In other words, this approach lends itself to the conclusion that it is impossible to overpay if you are paying the market price, no matter what the market price.

This leads on to my two observations:

  1. The size of UK defined benefit liabilities is larger than the market of physical hedging instruments on a duration-weighted basis.* Simply put, while it might be theoretically possible for  DB funds to collectively go down the LDI route, (an practically possible for some of them to go down the LDI route), it is not practically possible for them to collectively so do. This will be of surprise to no one working in UK fixed income markets, but surely throws doubt on the idea that pension funds seeking to hedge liabilities can do so without distorting the price of that hedge (seeming to undermine a central tenet behind the use of the efficient market hypothesis by accountants and actuaries).
  1. While fixed rate assets can be used to match accountants’ estimates of actuaries’ estimated liabilities, this is true because of the tautological construct. And as such while I accept that the LDI approach will be the very best possible hedge against my accountants’ estimate of my actuaries’ estimates of my liabilities, I am not convinced that the reality of the tautology should define the investment structure of pension fund assets in the UK (especially given observation 1 above, and my unwillingness to believe that it is impossible to overpay for a hedge). Fixed rate corporate bonds, equities, and commercial property are all just claims on corporate profits. Despite all being but claims on future profitability/ future economic activity, only one of these claims has any place in a full LDI construct. That just seems odd to me.

If I was having my pint with John rather than answering his Tweetstorm in this overly-long blog, I would expect he would parry by repeating point 2-4 (which are super-strong points). And I would probably repeat my question and observations. And I genuinely don’t know what would happen after that. I’m fairly sure that neither of us would change the other’s mind. But I also hope that we would emerge the wiser about the other’s position (and perhaps even with enhanced respect for each other’s position). Hence the interest in the pint.

 

 

* I should share my extremely back-of-envelope workings so that they can be properly challenged.

The Pension Regulator’s annual Purple Book indicates that UK private sector DB pensions have combined liabilities on a buy-out basis of £2.1 trillion. They also say that a 10bps fall in Gilt yields increases these liabilities by 2%, inferring a duration of around 20yrs.

Let’s look at how much UK fixed income duration exists that might be used to match these liabilities. (Yes, I know that most LDI is done synthetically, but can’t get away form the idea that the duration has to reside somewhere. This may be my fatal gap in understanding.)

First, let’s take the entire stock of UK fixed income securities (as represented in the BAML Broad Sterling Market UK00 index). This has a face value of £1.47 trillion, but a market value of £1.78tn and a duration of 10.2yrs. Leaving aside curves in our hunger for UK duration *of any description* let’s call this £908 billion of 20yr equivalent duration paper.

And let’s add on to this the entire stock of inflation-linked Gilts with a market value of £540bn and a duration of 12.4yrs and call this another £335bn of 20yr equivalent duration paper. Summing these together we get to £1.24 trillion of 20yr duration equivalent paper.

What about the missing £857bn of 20yr duration securities that needs to be bought so that DB pension funds can cashflow match? It doesn’t look like it exists.

John Ralfe has written a reply here that you should have a read of.