Institute for Research in Economic and Fiscal issues

IREF Europe - Institute for Research in Economic and Fiscal issues

Fiscal competition
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January’14: Confidence Rises and Inflation Stays Low. Is Everything Under Control?

The statistics tell us that recession is over. Yet, while this has triggered tapering in the USA, it has also prompted a new of ECB promises to keep interest rates low. In the meantime, EU authorities do not seem how to deal with the world of banking, which is far weaker than meets the eye.

Policymakers’ Confidence Rises. Is This Justified?

Despite the flimsiness of turnaround evidence, stock and other market movements both in Europe and the US were claimed by policymakers as proof that economies are back on track. Are they?

Over the festive season European policy makers continued to express confidence that policies are working: in their view, the recession has bottomed out, the recovery is underway, the euro has been saved.

What is the evidence for such optimism? Firstly, let’s look at the markets. Gold,
traditionally a haven for bearish investors, fell in price by 28% in 2013. Stock markets rose strongly. The ECB’s pledge to “do whatever it takes” eased the perception that investors were worried about fresh sovereign defaults, and resulted in most countries’ borrowing costs ending 2013 at the lowest levels since crisis eruption. Italy’s 2013 short-term debt issuance costs averaged only a tad above 2%, resulting in a €6bn reduction to 2014 budgeted debt service costs.

Eurostat released some supportive economic data. Retail trade rose in the EuroArea (EA17) by 1.3% in November (it had decreased by 0.4% in October). Unemployment in EA17 for November was at 12.1%, described as stable since April. Eurostat also released a consumer price inflation forecast of 0.8% for December, down from 0.9% in November. However, also released were industrial producer price data showing a decline in November (but by only 0.1%).

There was no GDP data release since the last Newsletter. However, the evidence supposedly behind the optimism of policy makers boils down to tiny improvements in statistical data, small reductions in the speed at which national debt levels are increasing, and very modest levels of GDP improvements in a number of European countries.

We are therefore less inclined to accept the likelihood of the turnaround story hardening much in 2014. The outlook rather portends a relentless increase in national debt to GDP levels. Unemployment is entrenched at the 12% level for some years to come, which bodes negatively for growth prospects. And price stability will ensure that the real levels of national debts and costs of debt servicing will stay constant, offsetting the benefits of low interest rates.

If policy maker confidence is unjustified, unemployment and possible debt defaults raise concerns of social disorder. Price deflation may offset that, but recent data detail is worrisome. Even when consumer spending falls, people have to eat. Behind the headline inflation forecast the data reveal a steady relative increase in the level of food price inflation compared with the other three index components (energy, services, and non-energy industrial goods).

For these reasons we expect the public’s confidence in policymakers and institutions to continue to fall. This will at some point in 2014 re-raise the spectre of the unaffordability of national debts and, in circular fashion, lead back to another less stable phase of the post-crisis era.

Central Banking: Tapering Takes Off, But Only Across The Ocean

Tapering was welcomed by markets only because loose money pledges were affirmed.

The reaction of investors to the US Federal Reserve’s December 18th announcement of the start of tapering was positive. The Dow Jones Industrial Average reached a 14 year inflation adjusted high, and the S&P 500 ended the year up 27%.

Many moderately sceptical analysts were caught out; they had expected markets to fall upon such an announcement, based on summer market wobbles when the announcement of tapering’s inception was first expected in September.

The absence of market panic was interpreted by mainstream media as proof that the Fed’s monetary policies were leading the US ever more strongly out of recession. However, the 2013 tapering story is that stock market movements have become a reverse indicator of recovery based on traditional macroeconomics. On one day in August when UK retail sales data showed an unexpected jump, US unemployment data also came out showing the lowest jobless numbers for six years. These two news items would normally be viewed as positive, but the result was a sharp fall in US and many European stock markets. The explanation for this seemingly perverse reaction is that investors have become dependent on loose monetary policy and were frightened that the start of tapering would herald its end.

But, behind the December announcement lay confirmation that investors have little to fear. Although the headline news was that QE is to be trimmed from $85 billion per month by $10 billion, the subtext confirmed that benchmark rates will stay low “well past the time that the unemployment rate declines below 6.5 percent, especially if projected inflation continues to run below” the target of 2 percent.

This brings to mind a particularly prescient quote from 2013, by the Bank of England’s Andrew Haldane. “Let’s be clear”, he stated to a Parliamentary scrutiny committee in July, “we have intentionally blown the biggest government bond bubble in history. That is where we are, so we need to be vigilant to the consequences of that bubble deflating more quickly than we might otherwise have wanted.”

Banking and the Volcker Rule

Despite confidence that regulation is improving, public trust in banks is at an all time low. Will the Volcker Rule in the US or banking union in Europe bring about significant improvements in banking trustworthiness?

The past year saw the hardening of two contradictory themes in banking. New evidence of ever more distasteful malpractice appeared on a weekly basis, yet policy makers are confident that new regulations will work.

On the malpractice side, last December JP Morgan reached a criminal settlement deal with prosecutors to avert charges of aiding Madoff. In the UK, a report charged RBS with systematically triggering customer insolvencies to enable it to buy their assets on the cheap in liquidator fire sales.

Yet officials from both the US and Europe claim to have taken giant steps to protect taxpayers from future bailout costs.

In the US the new era of bank regulation was the Volcker rule restricting bank proprietary trading; in Europe we have banking union, which is consistently reported as virtually settled. Even the mainstream press, however, appears to have appreciated that the detailed Volcker rule does not match the rhetoric. The opportunity to set out a simple rule was not taken up, since the December emission amounted to 953 pages.

In Europe, the negotiations have been attritional, and with elections looming, it is likely that something will be announced that simply skirts the tricky issues. These will be presented as details that can be worked out later. Two stand out. Disagreement as to whether national or central authorities will be responsible for invoking the resolution procedure has already led to the production of a very convoluted wind-up procedure. It is unlikely that the resolution fund’s assets will be deployed in practice in time to prevent the contagion and disruption which the existence of the resolution procedure was meant to prevent. Secondly the size of the planned Europe-wide fund is very small. €55 billion euros is less than the amount which the Bank of England has already asked the UK’s big banks to raise just to achieve regulatory minima. There is a risk that the single resolution mechanism will materialise merely as a symbolic gesture.

Perhaps the reason for Europe’s difficulties in agreeing resolution details is that Germany’s negotiators suspect that deep problems in banking remain untouched or even encouraged by new regulation.

One example of this is the practice of ‘rehypothecation’. In very simple terms, rehypothecation is the practice of banks (or prime brokers in the securities and derivatives markets) of using for their own purposes assets that have been lodged with them as collateral by customers. Lehman’s collapse led to problems for hedge funds who had agreed to rehypothecation and the practice had appeared to be in decline. In 2012, the practice had been believed to have been ruled out, especially as the 2011 collapse of MF Global revealed astonishing levels of unlawful rehypothecation. Yet, this practice has been surprisingly legitimised under new Basel Committee rules enacted in September.

The move has not gone unnoticed and has been heavily criticised and there are concerns about the inability to monitor the rule’s limitation of permitted rehypothecation to a single ‘re-use’ of each piece of customer collateral. Further, the notion that the original customer can be protected by requiring collateral takers to change the rules affecting the deposit that the takers pays in cash to the lender, is simply wistful.

To conclude, it seems that the historical record of regulators failing to understand hidden leverage in the banking system is confirmed. In particular, regulators are likely being blindsided yet again as banks continue to seek and find method after method of increasing the leverage of the financial system.

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