Wednesday, 27 August 2014

Scottish Independence Myths - How to buy imports?

I've been amazed at how poor the understanding is on how cross border trade actually work in a modern financialised world. It's almost like they've never spent any time at the sharp end of a firm's invoicing and payment operation, and exposed to the constant stream of marketing from banks.

The introduction of an independent free-floating Scottish currency is no barrier at all to cross border trade - because the banks are already setup to support it and make money doing so. It's very straightforward.

Let's run through a scenario. As we have already learned Scotland runs balanced trade with the rest of the world and the trade deficit is therefore with the United Kingdom. So we'll take the case of a Shropshire based company exporting goods/services into Dumfries and Galloway.

The exporter could throw up their hands, refuse to accept Scottish money under any circumstances and demand payment in good old British pounds.  The result of that would be the loss of the customer (probably to a Scottish based competitor or one that read and understood bank marketing leaflets), reduced turnover and profit and perhaps even layoffs amongst the staff. Only economists would think that is a rational response to the situation or at all likely.

In a real business, sales is everything and you do whatever you can to keep the customer. Exporters need to export. The first call would be to the firm's bank to see what they can do.

Here is the overview of the situation:

For simplicity I'm assuming that the customers and supplier both bank with RBS. That isn't at all necessary. This setup just cuts out the noise of clearing and makes the point very clear. 

The Kirkcudbright branch operates primarily in Scottish Pounds and does its reserve operations with the Scottish Reserve Bank. The Telford branch operates primarily in British Pounds and does its reserve operations with the Bank of England. The customer's bank account is in Scottish pounds and the Exporters in British Pounds. 

RBS plc owns both the bank branches and produces its own balance sheet in British pounds - because that's its functional currency. That means Scottish assets are translated into the functional currency equivalent at the reporting date according to the usual IFRS rules. In other words Scottish assets are reported in British pounds even though they are actually denominated in Scottish pounds. 

So we take a sale of goods and services from the Exporter to the Importer. The exporter prices the invoice in Scottish Pounds because that's all the importer has. In this case 'no deal' unless the exporter does that. (Again that isn't necessary, the process works just as well in reverse). 

Of course Scottish Pounds are no good in Telford. So they have a word with their bank in Telford, who is quite happy to purchase the invoice at the current exchange rate. So the exporter is credited with British pounds (which as we know the Telford branch just created ex nihilo) and the Bank takes the invoice.

This expands the balance sheet of the Telford bank branch - it has an invoice asset and a cash liability to the exporter, plus a bit of profit for itself. 

Now because RBS has Scottish businesses it is quite happy to receive Scottish pounds. So it instructs the Importer to settle the invoice to the bank's own account at the Kirkcudbright branch - in the usual manner of any factored invoice. An intra group loan (which in banking circles is known as a 'deposit account') links that back to Telford and clears the invoice. 

What has happened here is that the bank has executed a swap because it has a foot in both camps anyway. Therefore it can provide the swap service quite happily to those entities that don't have that structure available to them - for a fee of course. 

The actual structure will be more complicated than this simple overview (the factoring operation is likely to be a separate subsidiary with multi-currency accounts for example), but the essence is the same.

From the point of view of RBS plc, it had liabilities in Kirkcudbright to the Importer and now it has slightly smaller liabilities in Telford to the exporter - plus an amount of profit for itself. The exporter produced and sold their goods and stays in business, the importer got their goods and can use them.

Win-Win all round. Another good day for dynamic currency systems.

Monday, 11 August 2014

Scottish Independence Myths: the currency board

The Scottish independence debate is winding up, and Alex Salmond is insisting on going down with his ship clinging tightly to his 'currency board' idea.

A currency board is how you peg your currency to another. It is, essentially, an implementation of the 'Gold Standard' that locks the monetary policy of one country to another and restricts the activities of the central bank to maintaining that peg.

And yes you can do that unilaterally. Scotland can indeed 'keep the pound' if that is what they want to do.

But of course that means that money can simply drain from the country under any period of stress, and the government is powerless to maintain the necessary excess savings ratio in those circumstances. So you quickly go down the tubes like Greece, or Argentina.

At least with Greece they had a formal arrangement with their 'pegged' central bank that eventually forced the ECB to act to stabilise the situation and bring the interest rate on government debt down. The UK has rejected that option, correctly, as not in the UK's interest.

Argentina had no such formal arrangement with the US central bank, and they are still paying for the mistake decades later. This is the route that Salmond proposes.

I'm with Warren Mosler on this idea:

a currency board is an instrument of colonial exploitation, designed to force net exports in exchange for net financial assets via downward adjustment of real wages via 'deflation.'

It's not wrong to call it a crime against humanity.
Scotland is currently a partner in the United Kingdom. Alex Salmond wishes to change that relationship to one of a subjugate colony. A very strange idea of independence.

Thursday, 31 July 2014

Don't bind your hands Argentina

It really is long past time that Argentina dealt with the hangover of the ridiculous peg they under took in the last millennium.

In other areas the law has evolved to realise that debt that cannot be paid will not be paid, and a formal wind up procedure is available in every civilised state that ensures that both creditor and debtor take the necessary cold baths as soon as possible and as quickly as possible so that economic progress is not stalled.

And in other areas of international law it is recognised that a prior parliament cannot bind a future one if the will of the people is behind the change. So treaties can be torn up, and alliances changed.

But apparently not so in the area of state debt owed in a foreign currency. There both the sensible nature of bankruptcy and the right of self-determination by the people doesn't seem to apply.

While that is the case, no sovereign state should ever borrow money in a foreign currency. Not ever. It should immediately repudiate or redenominate any that exist and constitutionally bar itself from undertaking such a practice at any time in the future.

And that is what Argentina should do now. Clear the deck permanently so that it can move on.

There is never any need for the state to get involved in issuing foreign currency debt instruments in the free floating era.

A clever state understand that private entities that can go bankrupt can undertake those sort of actions - so the private banks and the private companies can do the foreign borrowing if they see that as appropriate for their purposes.

For very early stage developing countries, the services of the IMF may be useful in getting very basic infrastructure and a functioning modern banking system in place. But Argentina is way beyond that.

A clever state understands that exporters need to export. They need to sell their goods and services to fulfil their own profit making objectives. Unless those exporters find a way to take the importer's currency and swap it for their own currency then the deal will simply not happen and no goods will be made or shipped.

For states that are export led, they necessarily have to undertake 'liquidity swaps', or the world quickly runs out of the right sort of money to allow deals to happen. They understand that the 'liquidity' enables new deals to happen that wouldn't otherwise happen, growing the real economy at the same time as the monetary one.

The result over time is that export states tend to accumulate foreign currency assets. Some then call these 'sovereign wealth funds'. That saving is forced as a consequence of the export-led policy. The export-led policy has to go first before those savings can ever be used.

Now of course an exporter is going to try and tie an importer's hands, but a clever import nation will realise that and refuse to deal on those terms. There are plenty of exporters and they are desperate for new markets. So you hand out trade permits to those who can offer the best liquidity deal. That then avoids an eternity in purgatory being whipped by the United States, which has either lost the plot internationally or is trying to force an end to this ongoing farce depending upon your point of view.

Argentina has had a series of very bad governments making very bad mistakes. Hopefully it has learned some lessons and can move forward. We shall see.

Be strong Argentina. You have nothing to lose but your chains.

Friday, 25 July 2014

Does QE 'finance' Government Spending? Of course it does. Get over it.

The Law School at the University of Sheffield as come up with an interesting paper about the legalities of QE - primarily in the context of the Eurozone.

Clearly QE is the central bank buying Treasury bonds by proxy. You can wave hands and make arguments as much as you like, but ultimately that is what is happening. The central bank's new money helps replenish Treasury's buffers and reduces the relative amount of interest that Treasury is paying into the wider economy.

That is just the central bank doing Open Market Operations by proxy - lowering the time preference reward on the longer dated paper. Once you consolidate the government accounts you get the true picture.
Consolidating Quantitative Easing does not significantly reduce the overall liabilities of government but it does reduce the number reported as government borrowing. Once intra-government transactions are eliminated, the scheme represents an exchange of gilts (liabilities of the National Loans Fund) for central bank reserves (liabilities of the Bank of England).
As MMT says, it's just an asset swap which results in relatively less interest coming out of the consolidated government sector into the rest of the economy. That then triggers a portfolio reconfiguration in the rest of the economy.

It is probably instructive to look at the mechanism of government bond buying relative to the banking system.

Government bonds need to be issued because there is insufficient taxation coming in and there is a silly rule in place saying that Treasury can't run an overdraft in central bank liabilities. What that means, on the other side of the fence, is that the non-government sector has stopped spending. Because if they spend, that generates tax which eliminates the need to issue some of the bonds in the first place.

So the starting assumption is that people have stopped spending and they haven't spent enough to offset government spending with taxation. That is what 'net saving' means.

At that point non-bank private entities only have two choices overall. Leave it in a private bank or buy government paper. If they buy the government paper, then some bank reserves disappear from banks and top up the Treasury's buffer.

If they decide to leave it in a private bank, then the private bank retains the extra reserves and they can decide whether to keep the reserves (in an account at the Central Bank), or buy Treasury paper. If they buy Treasury paper then some bank reserves disappear from the banks and top up the Treasury buffer.

So once all the private sector, including the banks, have finished doing their thing then either the Treasury buffer has been topped back up, or the Treasury buffer is short and the Central bank holds the difference as central bank reserve liabilities.

Now the Central Bank, if it is operating truly in the autocratic dictatorial mode that neo-classical economists aspire to, is caught in a quandary. Because its job is to maintain aggregate demand by persuading more people to borrow. If you're in a slump that doesn't happen. No matter how much you complain about banks they won't lend unless there are creditworthy borrowers at the front door.

If the central bank follows the silly restriction rules to the letter, then Treasury will be short on its buffer and won't be able to spend as much (assuming Treasury sensibly refuses to chase the market and calls the Central Bank's bluff. Remember we're assuming a hypothetical standoff situation here where the Central Bank will bounce the Treasury's cheques. The National Monetary Authority really, really believes in divine-right theory).

So aggregate demand will fall and people will lose their jobs. The Central Bank has nowhere to go. It can't push lending because that is pushing on string and Treasury can't spend to get the Central Bank out of a hole because of the dogmatic rule of the Central Bank. So the result would be a depression, which would then eliminate the private sector's savings because they would be forced to spend them. But the destruction would eliminate a lot of perfectly good capital as well.

All the Central Bank could do is start buying things itself, taking over the fiscal authority's job and enriching those it chooses without recourse to the democratic process.  And the days of Kings and Barons are thus restored.

As any first year law student will tell you, there is no law without enforcement. That way bad law can wither on the vine and fade away.

Monday, 7 July 2014

On the Nature of Banks - Payment Clearing

A couple of comments over the last week have suggested that the nature of the payment clearing system isn't perhaps obvious to all. I hope this post will help you see how it works, and show you why banks don't really lend reserves.

If you think about the bank payment system as a process during the day you'll realise that payments and deposits move around in a variety of different ways completely un-coordinated with each other and turning up at completely different times. Additionally it can take time before a payment requested in one system is recorded as a receipt in another.

Therefore the payment system is actually a specific implementation of a system pattern known as the Producer-Consumer problem The reason the problem is a problem is because of what is known as the 'boundary conditions' - what happens when there is nothing in the buffer or the buffer gets full. That is where it gets its other name - the 'bounded buffer problem'. I've probably spent most of my career trying to implement near optimal solutions to this problem.

Reams of papers have been written about it and many PhDs awarded, but there isn't a solution that operates all the time, handles the boundaries effectively and is optimally efficient. It is always a trade off. 

Here it is applied to central banking:

Lots of payers and payees all transacting with the clearing system asynchronously - the buffer here being the clearing accounts at the central bank. 

If you operate this system with bounded buffers then in certain circumstances - under strain or when there are mistakes - you will get cascade failures in the payment system. This is exactly the same as what happens when you take your mobile phone into a weak WiFi area. The network buffers exhaust or fill and you start to get applications generating errors or just exploding. Similarly if your disk fills up on your computer. Lots of errors, lots of information loss, lots of clearing up to do afterwards. 

The central bank gets around this problem in relatively simple way. It simply redefines the problem and makes the buffer essentially unlimited. Do that and the impact of boundary conditions vanishes. The system is guaranteed to work at its most efficient.

So, intraday, any central bank user gets an effective unlimited overdraft (technically an intraday liquidity repo) to ensure that the payment system always clears. Then at the end of the day everybody squares their positions with each other and the system resets to zero ready for the next day. 

Bank A and Bank B both start the day with zero on their account at the central bank, and the payments move around. Towards the end of the day there has been a net transfer of 100 from Bank A to Bank B

Position 1: Just before end of day
Bank A now has a debt to the central bank it needs to clear at the end of the day, so it makes an offer to borrow 100 in the overnight market which Bank B gladly takes up. This allows Bank A to clear its position at the central bank.

Position 2: Just after end of day
The extra intraday reserves vanish in a puff of accounting logic and the overnight position is in place.

You'll note that the overnight position is precisely the same as the one you get if Bank A did a direct transfer to Bank B. To allow the transfer to happen, Bank B has to take the place of the depositors that wish to move out of Bank A to Bank B. Bank B has to become the creditor of Bank A to balance the extra depositors it now has. 

So the extra reserves required to support additional loans made by the banks simply pop into being during the daily clearance process and disappear again just as quickly during the end of day clear up as the interbank lending market does its job. All dynamically, as required, to support the efficient operation of the payment system. 

Of course if the banks stop trusting each other and refuse to bid in the overnight market then the central bank has to take action. It then becomes the 'lender of last resort' and position 1 persists overnight with Bank A paying a fee to the central bank, and the central bank likely paying nothing to Bank B.

Another alternative to that facility would be to insure interbank lending, or simply do away with the interbank market completely and leave position 1 in place all the time. 

Tuesday, 1 July 2014

On the Nature of Banks - 'Insured' vs. 'In Specie'

I've never been entirely sure why banks confuse people so much. They really are very simple creatures. They make loans and back those up with deposits and other borrowings, charge a margin for one over the other in return for making an underwriting decision, and undertake to swap their liabilities around in various manners to maintain their liquidity.

And that's about it really. In fact all the problems start happening when you let lending banks do anything much more than this.

In a monetary system there are two main ways of setting up a banking structure. You can either have an 'in specie' system where the central bank issues actual liabilities and assets in the denomination currency to back the banking system (also known, inaccurately, as 'full reserve'), or you can have an 'insured' system where the central bank promises to issue actual liabilities and assets when certain events happen. For the rest of the time they remain 'contingent'.

This is what a commercial bank's balance sheet looks like in an 'insured' scheme:


Insured Deposits are those covered by the country's deposit insurance scheme (here in the UK it is 100% of the first £85,000 per person). All other deposits are uninsured or 'bailed in'.

Bank Bonds are corporate bonds issued by banks, issued on the money markets usually as traded securities. Examples include Permanent Interest Bearing Shares (PIBS), or Bank Subordinated Bonds.  These differ from the 'fixed rate bonds' that you hear banks selling, which are really just a form of term deposit.

Preference Shares are very similar to bank bonds but have a lower claim on the banks assets and therefore should pay a high interest rate to offset the risk. They are also classed as equity instruments rather than debt instruments.

Ordinary shares are the normal shares/common stock in the bank and which receive the bank's variable dividend payment.

If a bank's lending turns out to be bad and the loan section therefore shrinks, then the losses accrue to the right hand side of the balance sheet from the bottom upward. Ordinary shareholders lose out first, then preferred shareholders, all the way up to insured depositors.


The Bank is then insolvent and the central bank (or other authorised government body) steps in to administer the failed bank under the insurance arrangements. Where necessary it issues Central Bank Reserves to pay the insured depositors, and writes the loss out to its own balance sheet. The assets of the failed bank are sold to other market participants, the central bank recovers its loss form those assets and if there is anything left the other creditors get a fraction of their investment back. 

So in reality the insured depositors don't really hold their money with the commercial bank. They hold it with the central bank because the risk has been transferred via the insurance policy. Which is what insurance was invented for. 

Change the accounting policy of a bank to require that it shows the insured element explicitly and you get this:


Change it again to require that the balance sheet is split into responsibility areas and you get this:


Remove the word 'contingent' and that is what an 'in specie' system will look like under the current policy settings.

Any other magical powers ascribed to 'in specie' systems are either due to hidden policy changes, (which can be just as easily be applied to an 'insured' system), a misunderstanding of how banks or money things actually work on the part of those making the claims, or (mostly) just plain political propaganda.

'In specie' and 'insured' systems are operationally identical. You can transform the balance sheet of one into the other. Nothing substantive changes. That's why MMT has always been agnostic on the subject.

Friday, 27 June 2014

UK Sectoral Balances and Private Debt Levels - Q1 2014

Fairly stable structure here now that has been about the same for a couple of years - similar in shape to the 2002 to 2008 period.
The household sector is borrowing more and the non-financial sector continues to save. But so far the household sector really hasn't got into party mood and gone bonkers.

And the private debt levels:
The big news here is the continuing relative deleveraging of the non-financial sector. Businesses are paying back debt faster than they are taking it out and this is reflected in the sector lending by the reduction in net-lending to other sectors. Credit acceleration is now deeply negative and unless that changes it points to a pull back at some point.

Q2 preliminary data is mixed and confusing. Once again we'll only know when all the results are in. And we have to wait until September for that.

Source: Office of National Statistics, tables RPZD, RPYN, RQAW, RPZT, RQCH, DJDS (Seasonally adjusted Net Lending/Borrowing per sector plus residual error) and YBHA (Gross domestic product at market prices, seasonally adjusted). Private sector debt based on tables J8XI, NLBC, NKZA, NNQC, NNRE, NNXI, NNXM, NNWK, J8XK, NLSY, NLUA, J8XM, NJCS, and NJBQ (Lending, securites and derivatives per sector, not seasonally adjusted) scaled by BKTL (Gross domestic product at market prices, not seasonally adjusted).