Monday, 21 April 2014

The Myth of Barter

Admitting that a story which has been around for long is wrong is not an easy task. Yet, it is one of those stories for which the counter argument actually makes much more sense than the original. The first time I saw the argument about barter never taking place in primitive societies was when going through the Chicago Plan (a nice refutation of which can be found here). Although this made some sense, I could not really claim full understanding of the whole issue until I read David Graeber's "Debt: The First 5,000 Years" (and a book review of which I hope to write soon).

The book's argument on barter can be summarized in the following: In small, prehistoric societies, barter never existed; there are no anthropological evidence to support this theory. In fact, credit (even though not in the way we understand it now) was the only way through which activities were taking place in such societies. A simple way to understand how this makes sense is by imagining that the only people in the world are you, 3 of your best friends and your spouses, a total of 8. Now, let's say that one of your friends is good in setting traps, the other is a great gatherer, you are a great hunter and the last is an amazing farmer. At the end of the day, each of you will have collected some amount of food, be it large or small. If your gatherer friend had just a small amount of food would you let him starve to death because on a single day he could not have come up with enough food?

The answer here is no. First of all, you are friends and friends don't let each other die of hunger. Second, you need a gatherer in the group just in case everyone else has trouble finding food; even though your friend might not die tonight, starved people are more prone to diseases and other ills. Then, you need the extra person just in case some beasts attack you, or in case someone else is sick. Therefore, it is against both your personal as well as societal interest to let your friend starve. If you are going to offer your food to the other members of your group, and reciprocity is innuendo here, then there is no point in employing any source of measurement for what you offer. In two day's time, you will not wonder whether the meat you offered your friend was more than the grapes and apples offered in return. Just having them at the time is much more important.

What should be the juice of the above paragraph is that money has no place in a small society, where everyone knows everyone. Money only arises when we have to deal with strangers, whose ability to reciprocate we cannot know of. Still, it might have been easy to propose a rather complicated system of goods with equal value, for example, a chicken worth 3 kilograms of sugar or 4 kilograms of flour, just like Mesopotamians used to do. 

Yet, the use credit was much easier than the use of any kind of money. I owe you 2 chicken, you some other person 3 kilograms of rice and so on. In ancient times, debts was the currency in circulation not money. The reason might have been just that money has to be something that everyone can use and accept or that money by John (i.e. credit) might not be accepted by Jill if she believes he is not creditworthy (obviously, some collateral was to be placed in case the person offered the loan could not repay: even people were at times traded in exchange for debt write-offs).

Enter the state. Imagine a sovereign ruler, so powerful that some consider him to be a deity. Nothing is now easier than the use of this power as a means of generating profit to fund a war or any other construction within his empire. Creating money was simply taking an amount of gold, stamping the face of the ruler and then giving it for payment to soldiers or anyone else who deserves payment for a price much higher than the what it cost to manufacture it. Why gold or silver and not anything else one might ask. The answer lies in (albeit denounced by Graeber) Paul Samuelson: it is simply because they are useless in any other form than creating pretty (and expensive) objects. Having copper as a metal during those times would have been an incentive for someone to use them to build arms or anything else if he could get them cheap enough. Gold would not offer the same incentives.

The reason for creating money is, as the book states, the facilitation of both trade and state transactions. Offering the state's guarantee on something has a much greater bearing than that offered by John or Jill and creating a market is easier when money is employed than when it is not. In essence, you need states (or at least some sort of regulator) for markets to exist. (For an argument against fully free markets Graeber points out to the situation after the fall of the USSR in the 1990's and the chaos which followed.)

In brief, the story is this: barter did not exist in the way usually portrayed by economics textbooks and money did not evolve as a consequence of bartering (i.e. people exchanging goods with others and having trouble keeping up with accounts). Barter was non-existent in prehistoric times and credit arose much before money did. Markets are in fact heavily reliant on money and money is non-existent without the state. Recent experience with Bitcoin also shows the same; without any backing from a state or any regulations behind it, it is evolving into a commodity rather than a means of transaction.

Saturday, 5 April 2014

The Irony behind NPLs and Lending

This post could actually be summarized in one sentence: If you want Non-Performing Loans (NPLs) to fall, then you have to increase lending. Still, I don't really hope that I will be able to convince many just by stating this. Thus, what follows is an exposition of why the amount of loans (and more so of new lending) matters when it comes to NPLs and, in addition, when bank regulatory capital requirements are concerned.

NPLs are loans for which "payments of interest and principal are past due by 90 days or more". There is nothing more rational than to think of the rise in NPLs as an outcome of the crisis. This, nevertheless, is where most stop their arguments; the problem is that asking "why?" matters the most when it comes to policy. The answer is again so simple everybody has thought about it: it's because people lose their jobs and cannot repay their mortgages or other consumer loans, because there's no investment and no consumption forcing businesses to default and putting more people on the dole. 

The correlation is obvious as can be seen in the case of Greece:
Source: CEIC Network
NPLs as a percentage of total gross loans. Source: Index Mundi
The additional problem here is that crises usually come around when banks are already contracting their balance sheets, so the hit in consumption and investment is even harder: less consumption, less demand and less money to go around as well. As a consequence, firms face serious trouble meeting up with their obligations. If they cannot make ends meet, then their loans enter the NPL category. When more NPLs are created, then the bank is more constrained by its regulatory capital needs as bad loans are assigned a higher risk weight than before. Thus, the higher the NPLs the lower the banks' ability to lend out more money.

The problem resembles the one of austerity: we need a government budget surplus but we cannot do it since by cutting expenses and transfers (e.g. pensions) we are reducing consumption and thus government income. Similarly, we want smaller banks, but we cannot do it without retracting money from the economy. As money is reduced, consumption and investment become more scarce and business struggle for survival; many go bankrupt. Driven by this lack of funds, unemployment rises resulting in even more NPLs.
How can we get out of this mess? The solution (ironically) is not that banks have to decrease their exposure. It's that they have to increase their lending in order to get the economy going again. If the economy does not have enough funds to pull itself out then countries experiencing these issues will face Greece-like situations: prolonged measures to make things better, but only making them worse (here's looking  at you austerity!). When lending is increased then more investment is created; subsequently, more jobs and more consumption, leading to an increase in income and a decrease in the loans which cannot be repaid. When people have more money, loan payments which could not be paid before are met now. Nobody wants to lose their house, and no bank want to be stuck with one. In addition, less NPL's actually mean less capital needs, thus more funds to lend, thus more profit for the firm. Still, instead of lending and preventing this from happening, banks are forced by regulators (and themselves as well) not to lend out funds.

As said before, there is a time and place for everything. Just like it wouldn't make sense to continue expanding fiscal policy in a boom (see the UK experience), or performing QE operations when times are good, it does not make sense to use austerity measures when times are bad (Greece, Spain, Italy, Portugal, Ireland). Similarly, banks should not be pressured to reduce their credit exposures during downturns. Yet, unfortunately, policymaker decisions do not appear to be counter-cyclical.

Tuesday, 1 April 2014

Does QE mean money printing?

Although the debate on the effects of QE on the economy and whether QE is deflationary or inflationary has (at least in my mind) been settled, there seems to exist a rather going "concern" on whether the buying of government bonds from the Central Bank equals money printing. Whether it does or it does not have separated people into two camps: those who believe that too much QE can lead to hyperinflation and those who believe that it will cause nothing of this kind.

But first things first: QE, although usually defined as the purchase (by the Central Bank) of government bonds in the possession of commercial banks. Yet, there is also an additional point: the one where the Fed purchases new bond issues. To see why this points holds see the following breakdown:

As it is obvious from the above, the only major change in the categories is the increase in foreign demand for US debt and the increase in the Fed's share of debt. Essentially, as many have argued before, when QE is initiated, collateral in the form of government bonds becomes more scarce in the economy. This is supposed to make the banks focus their funds elsewhere, meaning an increase in lending. These operations are usually conducted by the Fed either at the expiration and the re-introduction of a bond or by direct "investment" in the markets.

The point to be made here is that if the bonds are purchased from the pile of existing bonds then QE is nothing but an asset swap: cash is exchanged with bonds (both at zero risk for the bank). This does not mean an increase of the money supply whatsoever. Yet, if the government decides to issue additional bonds (remember the whole "raising the debt ceiling" debate?) then the Fed is essentially creating new money by purchasing some of them.

Remember that in order for newly printed money to enter the market it has to either be channeled through government spending or by throwing these amount off a helicopter. (If we choose the former then Monetarism and Keynesianism are essentially saying the same thing.) Thus, if the Fed purchases bonds from new issues, then it is essentially creating new money to enter the market via the government spending channel. Here, we are talking about money which did not exist before. Again, if it was a bond rollover then we would be talking about an accounting increase in cash and a decrease in government bonds (both on the asset side of the balance sheet) which have no effect on the money supply. If the money is lent, then we have an indirect increase in the outstanding amount of money in the economy, via the money multiplier, yet, this is not money printing. It is printing only if the Fed purchases new bond issues.

Now suppose that the Fed buys some new bond issues. Should we experience hyperinflation? The answer is no and not because increasing the money supply does not mean an increase in inflation. It is simply because of timing. Since the money base (M0) is just about 1/3 of the broad money in the economy (MZM) the effects of a rise in M0 just offset the decrease in MZM due to deleveraging. This is the major reason why the money supply in the US has been increasing over the last year despite the decrease in loans. It is just now, that the increase in bank lending has returned to its "normal" growth rate, that QE has began tapering.
Is QE a panacea? Obviously not. As already said, it may cause short-term asset bubbles and disinflation as a result of increased investment in the stock market. Still, those are just short-term effects and compared to the contrary (in the case of the US, a huge depression). In addition, just like fiscal stimulus, it can only be implemented when times are bad. In booms, QE and fiscal stimuli can cause private investment "crowding out" thus forestalling growth and creating additional inflation. In booms, the latter two tend to cause more damage than good. The two camps referred to at the beginning of this article can both be right but at different times: when times are good, QE can cause high inflations. When times are bad, it does not.

Overall, QE remains a good idea, despite its short-term side effects. The big question of whether the ECB will be able to apply something like it in the Eurozone remains to be answered.

Saturday, 29 March 2014

Understanding ECB Comments: How Central Bankers (Should) Think

Central Banking should come with a warning: Anything you do, will be the cause of major criticism. When I usually see reactions on comments by ECB officials, it usually of the "they know nothing/understand nothing kind". The job is not easier for the US Federal Reserve either; it has a long been a while since I've heard no reactions to policy changes. When the Fed initiated QE, Cassandras said it would drive inflation rates sky high; it didn't. When tapering started, Cassandras (different ones I hope!) complained that it would have a severe effect on the economy; still nothing. Yet, while the usual aphorisms on Central Bank statements and actions have been going around for a while, what is usually the problem is that do not see things from their point of view: that of a person/institution who have a great effect on the economy.

Whether we like to admit it or not, Central Banks do have a lot on their minds. When times are good they have to be careful to prevent bubbles from forming and when times are bad they have to act in order to make them better and be careful not to make them worse. A clear example of the Central Banker's power and the strong grip he or she has on the economy, are reactions to verbal statements. When Alan Greenspan spoke of irrational exuberance for the first time in 1996, markets tumbled; when Mario Draghi gave the "anything it takes to support the euro" speech in August 2012, this is how the Forex Market reacted:
It is really not a question whether the Central Bank has an effect on the economy, it's about how big it is and the answer is that it's huge. Even if policies do not drastically change market conditions in the short-run  (they usually change them in the medium-run), comments and speeches do have a stronger effect since they affect investor confidence. This is why Central Bankers are very careful of what they say and this is why they should (and do) never speak of bad news.

As we know, the ECB, through its Board, has denied that deflation is a problem. Jens Weidmann has stated that the drop in inflation is nothing but temporal. Whether he actually believes that or not, is something we will never find out. Now, dear reader, imagine what would happen if the ECB or it's board began to talk of deflation being a problem in the Eurozone. As a first reaction, markets would drop and the euro would rise making exports harder. Investment would gradually be reduced and the whole economy would enter a vicious cycle of decreased consumption, drops in wages and less investment. More so, the whole procedure could actually be initiated just by the Central Banker admitting that deflation exists, as most people "know" that deflation is a problem.

Then, with regards to ECB reactions and comments, what would the reader, an ordinary citizen of the Eurozone prefer: a Central Banker denying the existence of deflation thus allowing the markets to continue without paying attention to what he says, or a Central Banker admitting or warning about the dangers of the current deflation and forcing a deflationary cycle on the economy? If you ask me, the former is much better than the latter, if only for employment reasons.

Who knows: maybe the ECB does know something more than we do when it comes to deflation. If not, then measures to counter deflation can be expected at the next meeting. Still, too much truth can actually harm the economy at times. In fact, I would even go as far as claiming that a Central Banker should act like Titanic's orchestra: even when the ship is shipping (s)he should calm everyone down and tell them that it's all going to be all right.