My daughter’s political career is already over

Unwittingly, I may have killed my 8yo’s prospects of a political career even before she could even say Hard Working Families. How? Well when she was born Gordon Brown was giving out money to babies in the form of Child Trust Funds. I did the paperwork and put the money into the most unimaginative thing possible – a cheap FTSE100 tracker fund, with the idea that I would think more about where it should be invested at a later time.

What’s the problem? Well, in short, this:

  
(Just to be clear, the asset line is for the whole fund, not my daughter’s holding.)

She will never be able to say that she didn’t have a trust fund.

She will never be able to say that she never benefitted from offshore investments. 

When the press has a go at her evil financier father who must’ve known what he was doing, she should best not defend me so as not to put me ‘in play’. 

It would be a real mistake for her to tell the press that commingled investment funds are domiciled offshore typically so that the owners of units don’t get taxed twice for owning underlying shares and that she would be as liable for tax through her offshore holding as she would have been by holding the underlying shares direct. 

She should by no means tell people that actively choosing to buy a product (like, let’s say, a book over the Internet, or a fancy branded coffee) is probably more ethically dubious than investing in commingled investment funds offshore that are registered with the tax authorities and push all income and capital through the tax system in *exactly the same manner as investing directly onshore* would, but at a fraction of the cost given economies of scale.

Because that would just be digging herself a deeper hole.

That’s all too complicated, and she would then undoubtedly have to apologise for a massive and self-inflicted communications failure.

On the other hand, there is the chance that if she went into politics she possibly might embark upon a programme of government that is premised on economic illiteracy, be overly political in the way she chose to distribute resources, and call periodic imbecilic referenda.

So perhaps I’ve done the rest of us a favour.

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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 :

Screen Shot 2016-03-10 at 22.29.00

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. 

A Tonic for Millennials’ Pensions Gloom

It seems that Millenials have been getting rather flustered on Twitter in response to the FT’s suggestion that they should save £800 per month if they want to get a decent pension. With the median gross wage for 22-29 year olds at around £21k pa (translating into a take-home pay of £17,500 pa) you can see why telling them they’re stuffed if they don’t save £9,600 pa might get them annoyed. So I thought I’d try to cheer them up.

About 12 years ago – when I was 28 – I went to an event in Cambridge hosted by John Eatwell at which a young Ed Balls answered questions about his career etc. Balls was excellent – engaging, articulate, and erudite. I was extremely impressed by this Number 11 SPAD and did what many young folk do in such situations: I sought to show off. So I assembled and delivered a long and pointed question about the forthcoming pensions crisis. I’d read a bunch of papers and books on the subject and so thought I knew my stuff. As such the speech I reeled out was more like a verbally-delivered data-laden op-ed than a question really – you know the type. I was *that* ridiculous idiot.* Anyway, before Balls could respond Eatwell jumped down my throat, basically telling me that I didn’t know what I was talking about and referring me to a paper he’d written. I’m glad that he did because the paper was very good.

Eatwell’s very short pensions paper contains some very very basic ideas that are so simple that they are frequently lost in plain sight. I would summarise them as follows (although do read as it has a bit more than just this):

  1. A pension pot is an asset;
  2. An asset is a claim on someone else;
  3. That ‘someone else’ – for the cohort as a whole – can only be non-pensioners;
  4. From a macroeconomic perspective that does not incorporate either distributional outcomes across income groups or differing efficiencies of state versus private investment, and implicitly assumes medium -term current account balance, unfunded pay-as-you-go state pensions and pre-funded private defined contribution pensions are identical: they are both just claims on non-pensioners.

Or to put it another way, pensioners will collectively consume output produced by the young. Money, as always, mediates – and so in place of ‘consume output produced by’, read  ‘receive income from’. Pensioners will receive an income that can come only from non-pensioners. This income could be in the form of rent, dividends, and interest only from the young, or the proceeds of asset sales made only to the young. This income could be in the form of tax transfers only from the young. Or some mixture. It was ever thus and it will ever be thus.

And so society has a choice as to what level of income pensioners should collectively receive, and how this should be distributed.** Society today includes an ever-swelling portion of pensioners. The two really big variables here that determine aggregate pensioner consumption are: 1) the collective output of the young (of which pensioners consume some slice); 2) the size of said slice. There is the (sizeable) issue of inequality among pensioners of course, but let’s park that for now.

When we move on to the pensions that millennials might prospectively receive, the two key variables determining their collective pensions will be: 1) the collective output of folks not yet born (that they will have to breed or import); 2) the size of the slice that they can persuade their unborn spawn to part with. Saving £800 per month might be one strategy to build a claim on the millennials’ unborn spawn. It doesn’t seem  bad one if they are to be raised on the inviolability of property rights and the societal necessity of monetary stability, but I’m not sure that millennials have their parenting strategies planned out that far yet.

For my part, I am doing my best to busily follow the FT’s pointers and accruing claims on millennials’ future economic output so that I can claim a decent slice of it when the time comes to hang up my boots. But I’m hedging my property rights bet by being nice to millennials.

persons-0008

UPDATE: Ben Southwood (@bswud) from the Adam Smith Institute has written this reply. Do read it.

* I groan every time I hear someone do this now, in the shame-filled knowledge that I was once (perhaps a lot more than once) *that* guy.

** The choice can manifest in level of state pension, tax treatment of unearned income, capital gains etc.

Policy making in an Elysium scenario

On Wednesday evening I was fortunate enough to attend the Annual dinner of the Society of Business Economists. The keynote speaker was the Ignazio Visco, Governor of the Bank of Italy,  who gave a thoughtful and wide-ranging speech covering the whole waterfront of economic challenges. The key points for me of the speech were as follows:

  • Inequality is high and rising (especially when considering the top 0.1%). And this is true in both income terms and wealth terms.
  • Technology is developing that threatens to automate a staggeringly large proportion of jobs (Visco reckons that forecasting 45-50% of total employment will be replaced outlined here would not be outlandish), delivering a rolling disinflationary shock to the economy. The poster image of this view is the chart below that comes from Frey & Orborne‘s work.

Frey and Osborne 1frey and osborne 2

  • Macroprudential policy can be expected to be increasingly relied on to stop monetary policy stimulus feeding through into reckless misallocation of capital/ poor lending to risky projects that might undermine the stability of the financial system.

The governor had plenty of other interesting things to say (competing theories of secular stagnation, and a host of other questions), and I would encourage people to read a version of his speech here. But I don’t think I’ve misrepresented the three bullets above as three of the main points.

Now, I’ve already put my stake in the ground about where I stand on some of this stuff, and it stands in stark contrast to the bullets presented above. (I’m more of the view that there have been waves of concern stretching back pretty much forever about the degree to which technology will deliver mass unemployment and crippling real wage cuts, but these have all so far come to nothing. Meanwhile, there is a massive demographic transition coming through in front of our eyes, the upshot of which appears to me likely to deliver labour some bargaining power.) But what if he’s right and I’m just plain wrong?

Let’s run the idea ad absurdum (yes, I know, real life has a habit of getting in the way of running ideas to the extreme conclusions). But if we did:

  1. The folks who own the robots will own the means of production (as well as the means of accountancy, the means of lawyering etc etc), and there will be no room for pontificating about labour power: labour power will be kaput. Income from the sales of robot overlord kit and robot overlord output will accrue to these members of the capitalist elite, and they shall have a fine life. But given their microscopic marginal propensities to consume (and the fact that they will have become autarkic with the help of their robots) there would be a big demand problem in the economy, and disinflation (if not deflation) is the norm.
  2. If central banks continue to shy from helicopter money, focussing instead on setting the appropriate rate of interest at the short (and perhaps through QE, the long end), the days of positive nominal, let alone real, interest rates becomes but a halcyon memory. But permanently negative real rates (as set by the economy, and implemented by the central bank) inflate further the net present value of cash flows attached to the firms that own our robot overlords (in turn owned by the ultra-rich), heightening inequality outlined in #1.
  3. Given what might be decent returns to robot overlordship you might think that the sector attracts lots of fresh capital. It does, but in the form of equity finance, given the high risks associated with technology even in the robotic sector, and the macroprudential framework that has been thoughtfully put in place to guard against financial accidents that might result from speculatively financing start-ups that challenge the big players means, on the ground, that entrepreneurs are credit-rationed for the sake of financial stability. The folks that provide this equity finance are typically drawn from #1, although periodically someone does something truly clever and special, is lionised and held up as an example of how the whole system is actually very meritocratic (further buttressed by the fact that all the professional careerists go and work in the big robot overlord firms proving that the return to education is high).

Okay, I might have stretched the whole thing a little far, but let’s continue for a moment. What, exactly, is the problem that I’ve outlined? After all:

  • The economy is larger (in volume terms) and more efficient than it would have otherwise have been (or the robots wouldn’t have been able to take over). Tick?
  • There is a dynamic form of capital allocation in play (albeit in equity finance only, but that has less financial system risks anyway) to challenge the robot overlord firms, preventing complete monopolist behaviour. Tick again?

Would policymakers sit back and let this scenario play out? What happens when this sort of plutocracy collides with democracy? Put another way, what is the likely policy response to an Elysium scenario (good Blomkamp sci-fi film, underrated in my view), in which what really matters is ‘who owns the robots?’

There are some readers who might say “open your eyes, this dystopian future has been developing for decades and the answer is obvious: plutocrats win, democratic institutions are captured, and the cultural zeitgeist is also captured into knowing that the system of the day is both economically optical and morally sound“. I would counter that while it is hard to ever step out of one’s cultural context, a whole host of measures of well-being (life expectancy, health, literacy, etc) suggest that the fruits of economic growth have to a certain extent been widely-shared, and we are nowhere near the Elysium point at a national level (although this is certainly less true at a global level).

Through the instruments of the state, we collectively have in place a structure that facilitates/ optimises capitalism (contract law, property rights, state monopoly of violence etc) so that the economy can – in aggregate – grow to its potential, and we can then deal ex post with questions of distribution. This is what I understand Lord Mandelson meant when he said he was “intensely relaxed with people getting filthy rich as long as they pay their taxes“. Sort of Rawls, if perhaps not exactly. 

It seems clear to me that addressing the dim and distant Elysium scenario with a traditional monetary policy response would be problematic (see #2 above). And given that it is a question of ‘who owns the robots’ in this dim and distant scenario, I wonder whether either (a) a wealth tax, (b) a heli-money financed acquisition of robot overlord property rights, or maybe (c) a Guardian campaign to nationalise the robots would gain popularity. Disregarding option (c), I think that option (a) would be fair, but it seems that few others agree. But option (b) rhymes with my understanding as to how assignats came into existence in France in 1789: as a way to finance the acquisition of venal offices off their pre-Revolutionary holders.* (Assignats have ultimately been associated with monetary instability and hyperinflation, although it is not clear to me that this experience serves to support the quantity theory of money as much as a view that money is a microtechnology of daily trust that is ultimately somewhat fragile.) It would be strange if we found ourselves revisiting techniques used in the late eighteenth century to deal with a twenty first or twenty second century problem.

After I wrote a draft of this blog I saw on Twitter that Andy Haldane spoke this evening on all of these issues in a reasonable amount of depth. Reading the speech I think his views are very interesting, and are of course laid out in a fuller, more eloquent, and well-contextualised manner. (To be fair, he probably spent more than two tube journeys typing them up on an iPhone.) He indicates that he, like Visco, are taking the potential implications of automation seriously as a prospective intermediate disinflationary force. He ends with the idea that there are three public policy solutions that might be put into motion (relax, retrain and redistribute), and this sounds pretty reasonable (actually, Visco did make a big play for retraining now I think about it). I would have loved to have asked Haldane a question on the prospective use of helicopter money for the Elysium scenario. I hope Duncan asked it.

*Rebecca Sprang outlines in her brilliant book that ‘no one (not even Marat or Robespierre) took the truly revolutionary position of suggesting venal offices might be illegitimate privileges that could be cancelled without payment’ (p87). It seems even in Revolutionary France that radical ideas of wealth tax were considered beyond the Pale.

Inside and Outside money at the end of the yield curve: a footnote

Back in April I gave a presentation at a conference in Oxford in which I discussed some brilliant work by Branko Milanovic, Charles Goodhart and Ben Broadbent , and posited that if squinted your eyes just so, lots of things made sense in a way that might be a little against the consensus. Specifically, the asset boom story of the past thirty five years, decline of labour power and increase in inequality in the West, general disinflation and a lower trend nominal GDP in developed markets might all just be an expression of the radical globalisation and rise of China that has transformed our day to day lives. If so, then Summers’ Secular Stagnation thesis might prove to be a needlessly elegant paradox for central bankers to muddle over. Furthermore, with China approaching a Lewis point, this historical trend could be challenged and potentially thrown into reverse (higher labour power, rates, headwinds for asset prices, and some portfolio construction stuff too).

It went down sufficiently well that I wrote it up, and VoxEU kindly published it on their site giving it a wider audience than it would otherwise have had.
It has been brought to my attention that the terminology I used in the piece is perhaps either a bit confusing or confused (maybe both?). Specifically, I might be too liberal with my use of the term ‘Wicksellian rate’ for economists’ liking. This is carelessness or ignorance on my part rather than an attempt to execute an intellectual sleight of hand. So please take this blog as an extended footnote to the voxeu piece that seeks to explain:

a) what I mean by Wicksellian rate, and;

b) how changes in market expectations of this rate impact asset prices. 

It’s a bit long-winded, but I am trying to be relatively precise, which hopefully will reveal most accurately my confusion in language or content. Feedback welcome!

  1. I understand the Wicksellian rate to be the real rate of interest that keeps an economy that is running at full capacity in balance (eg, the policy rate is neither stimulative nor constrictive). This is another term for the ‘neutral rate’, as outlined by Greenspan here, Broadbent here, and Bernanke here. (I am aware that there is a big literature on whether the neutral real rate is even a legitimate notion to entertain, but have so far through my meagre readings been insufficiently persuaded to drop the notion, and enjoyed Brad DeLong’s recent post on the matter.)
  2. We live in a monetary economy that features outside money (central bank/ state money), and inside money (private money invented by banks in the form of deposits every time a loan is made, and to a meaningful extent invented by anyone who considers an asset to have moneyness and can persuade others of this feature). The Wicksellian rate will be a rate that consists of some mixture of the expected or inferred rate of return on some mixture of outside and inside monies. It would be nice if central banks told us the mix they thought important as this would help market folk like me understand their reaction functions better. And from time to time we do get hints (like footnote 24 in Carney’s Jackson Hole speech, the prominence or otherwise of mortgage spread charts in Bank of England QIRs, etc). And maybe that is fair enough given that central bankers are just doing their best to guesstimate through the fog.
  3. But the Wicksellian rate is set by the economy and not by the central bank. Central Banks seek to guesstimate where it might roughly be (including things like credit premia, liquidity premia etc), and they then manage their nominal (outside money) policy rate and expectations thereof around this guesstimated real rate to either stimulate or restrict demand and return the economy to it’s long run potential.
  4. Monetary sovereign bond markets (eg, the Gilt market in the UK, the US Treasury bond market in the US) can be thought of from a bunch of angles, one of which is that they consist of market participants’ best guesses as to where this overnight rate might be over time (ok, plus a guesstimated term premia, guesstimated liquidity premia, guesstimated premia associated with a raft of regulatory provisions on banks etc). And so by looking at the yields on Gilts or US Treasuries with different maturities you can back-out market participants’ expected term-structure of rate expectations set by the Bank if England or the Federal Reserve respectively.
  5. These monetary sovereign bond yield curves can furthermore be decomposed into a guesstimated path of real rates and a guesstimated path of inflation. And the real part of the curve (eg, inflation linked real rate curve) can be thought of as the market’s best guess at the term structure of the (outside money) Wicksellian rate, +/- near term cycle stuff.
  6. So actually, the long(ish) forward real rate is going to be the market’s best guess as to the (outside money) Wicksellian rate for the economy.
  7. Inside money yield curves are priced off outside money curves. The starting point when pricing term credit (let’s say, the interest rate that a company might have to pay to borrow on a fixed rate basis when borrowing for ten years) is to observe the monetary sovereign yield for that term, and add additional yield premia to compensate for estimated higher liquidity costs, estimated credit costs, some premium to reimburse the costs associated with performing credit analysis etc. (Fellow bond geeks may take issue with this point as being too massive a simplification, but I don’t think much is lost leaving this description in place.)
  8. So you get lots and lots and lots of private (inside money) yield curves describing the market yields associated with different term borrowings of different private borrowers. Many if not most will feature only one point.
  9. These curves consist of yields (aka discount rates) that are used to discount expected cash flows and calculate the asset price in a discounted cash flow (DCF) analysis. If the cash flows are unchanging, a falling yield equates to a rising price and vice-versa.
  10. We can also use DCF when looking at non-bond asset pricing. It’s just that we have to imagine what the cash flows might be and also imagine what risk premia to apply.
  11. So after you have finished building a model of company earnings, you still need to imagine into existence an appropriate discount rate to apply to your model’s resultant cash flows to calculate your assessment of its ‘fair value’. Given that equity is the most junior liability in a company’s capital structure, the discount factor that you would apply to these equity cash flows might still be higher than the one applied to the same company’s most junior debt obligation, which in turn would be higher than its more senior obligations of equivalent term. The observable (inside money) discount factor/ yield curve would in turn be priced as higher than the monetary sovereign’s yield of equivalent term (eg, point 7 above).
  12. I take a bunch of approaches when I look at equity discount rates. A super-simple one is to look at the trading relationship between corporate debt and consensus forward earnings yields. One is a nominal yield, the other one is generally believed to be a real one. But the nominal one contains an estimate of real rates and an estimate of inflation.
  13. With only marginally more complexity, I solve the equity internal rate of return from current equity prices, consensus earnings projections for as far as they are available, and estimates for residual nominal earnings growth rates taken from historical relationships between nominal earnings and GDP, assumptions about profit share of GDP and payout ratios. CAPM is another approach, and I think this one is interesting too.
  14. To cut a long (enough) story a little short, underlying all private discount rates sits the outside money (government bond) yield curve with its pricing of anticipated inflation, near term policy developments, and long-term guesstimates of the (outside money) Wicksellian rate. Changes to that last bit change asset prices all over the shop.

So while it is clear to Woodford et al that the Wicksellian rate is a real variable relating to the marginal return on capital rather than a real (eg, inflation-linked) market rate, in my analysis it is also the market’s best guess of the likely medium to long-run unobserveable equilibrium (Wicksellian) real interest rate. And crucially, as the market expectation of this real rate falls, so asset prices (the present value of cash flows that use this falling market rate in some way, eg, #7-10 above) rise correspondingly.

This raises what now feels like a perennial market-circularity question: to what extent have rising asset prices been a function of diminishing rather than improving prospects in the West? (Eg, when weaker cash flows are accompanied by a lower discount rate for those cash flows, the asset price implication is ambiguous rather than negative.) Or, in the phraseology of my voxeu blog, to what extent might demographically-driven resurgence in labour power raise the Wicksellian rate in the West, and with it deliver a headwind for asset prices and challenges for portfolio construction?

In my day job I have plenty to say on this, but it would be inappropriate to say anything on my private blog. Instead, here’s a link of me and Joe Weisenthal chatting about it a couple of weeks back.

The Government Budget vs Household Budget Analogy Competition!

Apologies to those expecting insight from me. Trying something a bit different.

There has been a tendency for politicians to speak about government finances as being analogous to household finances. 

And there has been an equally persistent tendency for economists and marke-folk to giggle at them for so doing. 

That this state of affairs has persisted for such a long time speaks to the profound failure of economists and market folk to effectively communicate in plain English why the analogy (at least in the case of monetary sovereigns) is a bad one.

I was hoping to use the comments section of this blog to elicit attempts at explaining why it is a bad analogy, with minimal use of technical jargon, abstract terms, etc.

Anyone up for giving this a shot? I reckon 50 words max, but the shorter the better.

Why aren’t all taxes wealth taxes?

Tax – like government debt issuance – is really just a means by which a government sterilises the monetary expansion that would otherwise occur when it spends.* But the interesting thing about tax is, of course, the way it can target this sterilisation at different groups and activities. Looking at a tax system gives clues as to what societies consider fairness to be, and what they consider the State to be for. It’s surprising to me that wealth taxes don’t feature more meaningfully.

Advocates of wealth taxes argue that the asset-rich can afford to be more heavily taxed (they are, after all, rich). And pragmatically, wealth can be taxed (in the form of a property taxes at least) because it’s, like, right there.

Opponents see them as pretty much the most unfair form of tax imaginable. Because unless your wealth is inherited (separate blog on this…) you’ve already paid a bunch of taxes on your income en route to it becoming wealth. So wealth taxes would tax already taxed income.

Both sides have good points. They seem to be founded on different ideas about what the State is for. This is a complex subject, but I think all would agree that the State is unique in wielding the monopoly use of violence in society and that it does so (at least in pluralist democracies) to enforce laws that have been collectively arrived at, and to enforce property rights.

For example, when I buy a house, in pops my name on a government ledger next to an address. And the State acknowledging my claim is really very valuable to me because it buys me the State’s protection in support of my claim to exclusive and perpetual use of said house. If anyone bigger and stronger comes to turf me out of my house or take possession of my stuff, that good old State violence comes to my defence. So when I buy a house what am I buying? The house? Or the credible threat (and perhaps reality) of violence on the part of the State to protect my exclusive occupation that I buy in perpetuity? I think this is the same thing.

This outline of the State’s function is pretty crude: it envisages the State as a protection racket, and the social contract as being one in which rich folks buy-off poor folks with hospitals, schools, pensions etc in exchange for them to accept the status quo (eg, not challenge the claims that rich folk have over most of the land, buildings, businesses, debts, and general stuff, and in so doing, allow them to remain rich).

How is this threat of State violence (as well as schools, hospitals etc) paid for? The State as a monetary sovereign can just imagine the money into existence. But if taxes are to be raised (and they probably should be raised) to sterilise this new money, from whom should they be drawn? It doesn’t seem unreasonable to suggest that they should be drawn from those interests that benefit the most from the State’s existence. By supplying hospitals etc as well as police, courts, and prisons you could argue that We’re All in it Together. But I can also see that someone with zero taxable income but billions of property should be paying lots of tax as part of the protection racket. And insofar as wealth correlates with income maybe this is true: the top 1% in the UK do indeed pay something like 30% of the income tax.

So far, so consensus. Our tax system might not usually be explained as above, but I don’t think it is wildly controversial.

However, it is strange that the State pays for the means to enact violence (as well as all those schools, hospitals, etc) by taxing the flow rather than the stock of wealth. If you buy arguments of marginal utility to justify high incomes (which I’m pretty sure I don’t, but most seem to), taxing incomes instead of wealth leans against meritocracy and social mobility, and towards preserving interests many of which have wildly anti-democratic roots. And that to me sounds like a bad thing. So it seems to me that taxes on wealth are more in keeping with the social contract than taxes on income. And I’m not sure I properly understand the argument against.

* Monetary sterilisation is the process of removing one unit of money from circulation for each unit of money added to circulation. Money can be added into circulation through central bank asset purchases (like QE), by the central bank lending to the private sector (like Long Term Repo Operations), or by the central bank lending to its parent (the government). Money can be removed from circulation by swapping it for stuff which is not quite money (like term debt) or by imposing an obligation to surrender it to the monetary sovereign – swapping it for security. The price of security is something nebulous.

Pocket Money meets Piketty

So following a general EconFinance Twitter exchange over the weekend about rules of thumb for kids pocket money, @drlangtry_girl sent me this Slate column on the subject. The column advocates giving kids somewhat more ($1 per year of age from pre-school inflating meaningfully) than I miserly offer my kids. The interesting bit to me is its advice to force an equal three-way split between spending, saving and giving as this would encourage kids to think about and engaging with money in a mature way. Getting people to think about money is a laudable aim.

For what it’s worth, I thought I would set out the Nangle household arrangement.

Judging by my peers’ arrangements, I don’t give my kids much (10p per year of age starting at age 5 – so a five yr old gets 50p per week, a six yr old gets 60p etc). What do I hope to achieve by giving my children any pocket money at all? Probably some familiarity with extremely basic budgeting decisions, some of which involve judging instant gratification against deferred gratification (spend 50p to buy sweets today vs save for 12 weeks to buy a watch in a museum gift shop, to take a recent example).

Why might I want to encourage an ability to save in my children? I just think this a useful thing for someone to learn to do. There might be some echo of the Stamford Marshmallow experiment, or more likely a older understanding of its conclusions, that is ricocheting across popular culture framing my approach.

Furthermore, some academics suggest that giving pocket money and encouraging saving can have a discernible impact on later lifetime savings rates. And while John Eatwell is right that from a macroeconomic perspective it doesn’t matter how pensions are financed (either state transfers from workers to pensioners, or the accrual of monetary claims by pensioners on current workers), I still have a lingering suspicion that a system in which claims are intermediated via financial markets would dominate an entirely state-intermediated system when it comes to associated trend growth rates. So I’m comfortable encouraging them into higher savings patterns (and trust the state to generate large fiscal deficits if required to balance the economy).

However, the problem is that children in general, and my children specifically, tend to have pretty high internal rate of return (IRR) hurdles: a chocolate today is certainly worth a lot more than a chocolate in a year’s time to them. It’s as though the whole Swiss National Bank move to negative rates just passed them by. In fact, a ‘game’ that you might play with your kids is uncovering their IRRs by asking them how they would prefer a chocolate today or two/ three chocolates tomorrow/ next week etc. I have found that IRRs reduce exponentially with age, but are still mighty high.

So going back to the real life saving-up trade-off: a £6 gift shop watch has got to be worth a LOT more to them than twelve 50p packs of sweets if my children are going to delay gratification for twelve whole weeks. And so my providing such miserly levels of pocket money could be counterproductive, discouraging saving.

A few months ago, in order to address this issue, I invented a bank (or rather, a ledger). I currently offer my kids 10% interest per week on pocket money deposits (rate fully adjustable). This is far below my estimate of their IRRs, but it has big novelty value and the compound interest thing is pretty amazing for them to witness. The catch is that any money that goes ‘into’ the bank cannot be spent on sweet stuff. So the ledger looks a bit more like an unregulated Defined Contribution pension scheme with a lot of concentrated counterparty risk than a bank. That is to say it is a fiscally-subsidised monetary claim that can be accessed only to purchase assets approved by the fiscal authority (me). I thought about whether I should remove the requirement not to purchase sweets come April 6 but think I’ll let the government beta-test that approach before rolling it out in my household.

I’m not sure I’ve got the right system in place yet, but it does facilitate good conversations about money (and the nature of money). I do worry that the real lesson I am giving my kids is that r>g, which was not what I set out to do at all.

But in its defence I would say three things:
1. My kids have used the bank a fair amount to build up sums of c.£5-6, which entails a good deal of delayed gratification. This is far better than the pre-bank days.
2. While the notion of giving interest on deposits might seem pretty dated, I am hoping that it prepares my kids well when they consider taking on debt in later life (eg an understanding that compound interest works both ways).
3. When I put it to my 7yo this evening whether she would prefer the Slate system that would give her an immediate income boost but require the abolition of the bank, she is really in two minds about it.

The London property ladder: are you kidding me?

Londoners earn more than citizens in other parts of the United Kingdom. And they spend a lot of time either moaning about how expensive property is in the capital (if they don’t own) or patting themselves on the back for being such fabulous investors (if they do own).

I earn more than the average Londoner and have done for some time. It still took some years of being super-frugal until I had a deposit large enough to lever myself to the hilt and buy a studio flat near Kings Cross when it was still all junkies, gangs and prostitutes. Given that property is more expensive than ever I wondered how different the savings calculus is for younger well-paid people today. (You know where this is going, but I’ve got some cool charts.)

The young well-paid people I have in mind just about sneak into the higher rate tax band. As such, they earn notably more than the median Londoner. And as a measure as to how low property aspirations are, I’m not going to pitch this young well-paid Londoner against the median London property. We all know that this wouldn’t be a fair fight and they’d never stand a chance. Instead I’m going to be pitching them against the property priced cheaper than 75% of all other London property (priced, incidentally, in line with my first flat).

I’ve got data only going back to 1997, which is fine for my purposes as that was the year I started earning.

The result is this graphic below:

London Savings

This shows, for a given year from which a higher rate taxpayer salary was drawn, when a lower quartile London property could be purchased for a given post-income tax savings rate (assuming that a 4X gross salary mortgage is also obtainable and obtained). So someone who started work in 1997 on a higher rate income (no, I didn’t get a higher rate salary in my first job), and who put aside 20% of their post-tax income could have bought a lower quartile priced London property after 12 years of saving. If they had put aside 25% of their post-tax income they could have had the keys after only four years. If they had saved 40% they could have moved in after only one year on the job.

I hope that by colour-coding it you will see quickly how things have changed over time. It basically backs up what any idiot knows: London is increasingly unaffordable not only for ordinary people, but also for higher earners.

Another way of showing a subset of the same data is to chart the number of years for which a higher rate taxpayer needs to save 30% of their post-tax income before the first opportunity arose to leverage themselves 4X into a lower quartile priced London property. I’ve slightly cheated on that last data point: the 2004 entrant still can’t quite afford to buy, but for the sake of the chart I’ve given them the deeds.

number of years London

So if you are lucky enough to own and you hear younger people complain about London property prices, it might be worth reflecting that they might genuinely have a harder time than you. And that you own your London home either because you are actually quite rich, quite old, or most likely both. The London property ladder now misses several rungs.