Tag Archives: Mervyn King

Peak Uncertainty

As we face the peak weeks of the COVID19 virus in the major developed economies, one thing the current COVID19 outbreak should teach us is humility. As humans, we have become far too arrogant about our ability to shape the future. A new book by the economists John Kay and Mervyn King (a former Bank of England governor during the financial crisis) called “ Radical Uncertainty” argues that economists have forgotten the distinction between risk and uncertainty with an over-reliance on using numerical probabilities attached to possible outcomes as a substitute for admitting there are uncertainties we cannot know. How many one in a century events seem to be happening on a regular basis now? Their solution is to build more resilient systems and strategies to confront unpredictable events. Such an approach would have a profound impact on how we organise our societies and economies.

Currently, planning for events with a large impact multiplied by a small probability allows us to effectively continue as we have been after assigning the minimal amount of contingency. Imagine if sectors and industries were run based on been prepared for tail events. That would be a radical change. Very different from our just in time supply chains which minimise capital allocation and maximise return on investment. Our approach to climate change is an obvious case in point and how we have heretofore ignored the environmental externalities of our societies and economies. Given the financial costs this crisis is going to place on future generations, I would suspect that the needs of this cohort of our society will become ever more urgent in the aftermath of the COVID19 pandemic.

As many people grapple with the current uncertainties presented by this pandemic, we are currently at peak uncertainty in Europe and the US. We are only now getting a sense of how the outbreak is peaking in Europe given the lock down measures in place. How the virus reactions to the relaxation of current measures, how the outbreak will peak across the US and other continents, the economic impact of the outbreak, or the societal impact amongst many other issues are as yet unknown. We do know however that with time over the coming weeks some of these answers will become clearer. For example, as the graph below from the FT shows, we known the approximate path of the outbreak given the policies being pursued today.

A positive narrative could be that existing medications pass rushed COVID19 trials and prove they can blunt the impact of the virus thereby altering the shape of the curve. We can also speculate that once the first wave is contained, we will develop strategies on a combination of mitigation measures (e.g. reduced isolation methods, antibody and other testing to return sections of the population to work, immunity passports, etc) to slowly transition to the new normal. The logistics of such a phased return to normal will be complex and a nightmare to enforce, particularly if self-isolation measures are in force for lengthy periods and people believe any second wave can be well contained by battle hardened health systems. We can be confident that a vaccine will be developed, hopefully by early 2021, but it will take time to get the vaccine distributed and administered in bulk. Mid 2021 is likely the best we can realistically hope for.

At this stage, my rough guess at a base case scenario on the timing for European and US lockdown is 3 to 5 weeks with another 6 to 10 weeks to transition to a semi-new normal. That’s somewhere between mid-June and early August with Europe leading the way followed by the US. A more pessimistic case could be that discipline amongst the population gets more lax as the weeks drag on and a second wave gathers momentum with a second lockdown required over the summer followed by a more timid and gradual transition afterwards lasting until the end of the year. Obviously, these timings are pure guesses at this time and may, and hopefully will, prove way off base.

The economic impacts are highly uncertain but will become clearer as the weeks pass. For example, with just the first fiscal stimulus package passed in the US, the politicians are already listing their priorities for the second (and likely not to be the last either), Morgan Stanley expect the cyclically adjusted primary fiscal deficit to rise to 14% of GDP and the headline fiscal deficit at 18% of GDP in 2020, as per their graphic below. Given the unknown impact of the crisis on GDP numbers, these percentages could approach 15% to 20% with total debt of 110% to 120%. It’s depressing to note that prior to this crisis the IMF said the U.S. debt-to-GDP was already on an unsustainable path.

Although the euro zone comes into the crisis with less debt, last year it was 86% of GDP, Jefferies said in a ‘worse case’ outcome where nominal GDP falls 15% this year, the bloc’s budget gap would balloon to 17% of GDP from just 0.8% last year. They estimate in this scenario that the euro zone debt-GDP ratio could rise above 100% in 2021. As a percentage of GDP, Morgan Stanley estimated the G4+China cyclically adjusted primary deficit could rise to 8.5% of GDP in 2020, significantly higher than the 6.5% in 2009 immediately after the global financial crisis. Unemployment rates in the short term are projected to be mind boggling horrible at 20%+ in some countries. It seems to me that the austerity policies pursued after the financial crisis will not be as obvious an answer to repayment of this debt, not if we want western societies to survive. Addressing generational and structural income inequalities will have to be part of the solution. Hopefully, an acceleration of nationalism wouldn’t.

On the monetary side, the Fed’s balance sheet is now estimated to be an unprecedented $6 trillion, an increase of $1.6 trillion since the start of the Fed’s unprecedented bailout on the 13th of March. Bank of America estimates it could reach $9 trillion or 40% of GDP, as per the graphs below.

As to corporates and the stock market, dividends will undoubtably be under pressure as corporate delevering takes hold and without the crack cocaine of the bull market, share buybacks as the graph below shows, I fear there will be more pressure on valuations. The Q1 results season and forward guidance (or lack thereof), although it may have some surprises from certain firms in the communication, technology and consumer staples space, will likely only compound the negativity and uncertainty.

Using unscientific guesses on my part, I have estimated base and pessimistic operating EPS figures for the S&P500 as below. Based upon a forward PE (on a GAAP EPS) of 15 (approx. 12.75 on operating EPS basis), which is the level reached after the dot com bubble and the financial crisis, the resulting level for the S&P500 is 2,000 and 1,600 in the base and pessimistic scenarios respectively. That’s a further 20% and 35% drop from today’s levels respectively.

The coming weeks will likely be horrible in terms of human suffering and death across the developed world (one cannot even comprehend the potential suffering in the developing world if this insidious virus takes hold there). There is always hope and uncertainty will reduce over time. Major decisions will need to be made in the months and years ahead on the future of our societies. Learning from this pandemic to build more resilient societies and economies will be a task that lasts many years, possibility even generations. Major changes are coming after this health crisis subsides, hopefully they will be for the better.

Stay safe.

10 x Hopelessly Lax = ?

The economist Sir John Vickers, himself an ex Bank of England Chief Economist, recently had a pop at the current Bank of England’s governor and chair of the Financial Stability Board, Mark Carney.  He countered Carney’s assertion that “the largest banks are required to have as much as ten times more of the highest quality capital than before the crisis” with the quip that “ten times better than hopelessly lax is not a useful measure”. I particularly liked Vickers observation that equity capital is “a residual, the difference between two typically big numbers, of which the asset side is hard to measure given the nature of banking, and dependent on accounting rules”.

In a recent article in the FT, Martin Wolf joined in the Carney bashing by saying the ten times metric “is true only if one relies on the alchemy of risk-weighting” and that banking regulatory requirements have merely “gone from the insane to the merely ridiculous” since the crisis. Wolf acknowledges that “banks are in better shape, on many fronts, than they were a decade ago” but concludes that “their balance sheets are still not built to survive a big storm”.

I looked through a few of the bigger banks’ reports (randomly selected) across Europe and the US to see what their current risk weighted assets (RWA) as a percentage of total assets and their tier 1 common equity (CET1) ratios looked like, as below. The wide range of RWAs to total assets, indicative of the differing business focus for each bank, contrasts against the relatively similar level of core “equity” buffers.

click to enlarge

Wolf and Vickers both argue that higher capital levels, such as those cited by Anat Admati and Martin Hellwig in The Bankers’ New Clothes, or more radical structural reform, such as that proposed by Mervyn King (see this post), should remain a goal for current policymakers like Carney.

The latest IMF Stability Report, published yesterday, has an interesting exhibit showing an adjusted capital ratio (which includes reserves against expected losses) for the global systemically important banks (GSIBs), as below.

click to enlarge

This exhibit confirms an increased capital resilience for the big banks. Hardly the multiple increases in safety that Mr Carney’s statements imply however.

Stuff Happens

Mervyn King is not remembered (by this blogger at least) as a particularly radical or reforming governor of the Bank of England. It is therefore surprising that he has written an acclaimed book, called “The End of Alchemy”, with perhaps some of the most thoughtful ideas on possible reforms we could make to get the global economy out of its current hiatus. One of the central themes in the book is the inability of existing Western economic orthodoxy to adequately consider the impact of radical uncertainty. He quips that “current policies based upon the model of the economics of stuff rather than the economics of stuff happens”.

King defines radical uncertainty as “uncertainty so profound that it is impossible to represent the future in terms of probabilistic outcomes”. A current example could be the Brexit vote this coming Thursday, with commentators struggling to articulate the medium term knock-on impacts of this tightly forecasted vote. This post is not about Brexit as this blogger for one is struggling to understand the reasons and the impacts of the closeness of the vote. I do think the comments from Germany’s finance minister, Frank-Walter Steinmeier, this week that a leave vote would mean “the EU will find itself in a deep crisis” are pertinent and amongst the many issues we will likely face in the medium term if the UK actually disengages from the EU. The current mood of voters in Western economies, such as the UK and the US, does underline the urgent need for radical thinking to be adopted into the way we are addressing global economic and social issues in my view.

King’s book is not only full of interesting ideas but he also has a cutting turn of phrase. Amongst my favourites are:  “economists mistrust trust”, “liquidity is an illusion”, and “any central bank that allows itself to be described as the only game in town would be well advised to get out of town”. Before I go over some of King’s ideas, I think it would be useful to recap on the conclusions from other recent books from UK authors on policy measures needed to address the current stagnation, in particular “The Shifts and the Shocks” by the highly regarded Financial Times commentator Martin Wolf and (to a lesser extent) “Between Debt and the Devil” by the former UK financial regulator Adair Turner. Wolf’s book was previously reviewed in this post and Turner’s book was referenced in this post.

Wolf articulated the causes of the financial crisis as “a savings glut and associated global imbalances, an expansionary monetary policy that ignored asset prices and credit, an unstable financial system, and naive if not captured regulation”.  Wolf argues for practical policy measures such as much higher and more resilient capital requirements in banking (he rejects the 100% reserve banking envisaged by proponents of the so-called Chicago Plan as too radical), resolution plans for global systemic financial institutions, more bail-inable debt in banking capital structures and similar alignment changes to the terms of other financial contracts, proper funding of regulatory bodies and investigators of criminal misbehaviour, tax reform with a bias towards equity and away from leverage, tax on generational transfers of land, measures to address income inequality (due to the resulting dilution of demand stimulus measures as a result of the rich’s higher propensity to save) and measures to encourage business and infrastructure investment, education and R&D.

Wolf also highlights the need for new thinking at global institutions, such as IMF and those (unelected) bodies governing the Eurozone, particularly the urgent need (although he is pessimistic on the possibility) for global co-operation and radical action to address the imbalances in the global economy. The need for deeper co-ordination, irrespective of narrow short term nationalistic interests, is nowhere more obvious than in the Eurozone with the alternative being financial disintegration. The Brexit vote is an illustration of the UK electorate’s preference for disintegration (as is the popularity of Trump in the US), presented by shady politicians as a return to the good ole days (!??!), and is perhaps a precursor to a more general disintegration preference by voters across the globe. Wolf observes that “financial integration has proved highly destabilizing” and that “the world maybe no more than one to at most two crises away from such a radical deconstruction of globalized finance”.

Turner’s book is more focused on the failure of free markets to “ensure a socially optimal quantity of private credit creation or its efficient allocation” and the need for policy makers to constrain private credit growth, particularly excessive debt backed by real estate, and the creation of less credit intensive economies. Turner argues that “the pre-crisis orthodoxy that we could set one objective (low and stable inflation) and deploy one policy tool (interest rate) produced an economic disaster”. In common with Wolf, Turner also advocates structural changes to tax and financial contracts to incentivize credit away from land and towards productive investment and policies to address income inequality. Turner also rejects 100% reserve banking as too radical in today’s world and favours much higher capital requirements and restrictions on the shadow banking sector. On the need for China and Germany to take responsibility for the impact of their policies on global imbalances, he repeats the pious lecturing of current elites (without the negativity of Wolf on the reality of such policies actually happening). Similarly he repeats the (now) consensus view on the need for the Eurozone to either federalise or dissolve.

As to real solutions, Turner states that “our challenge is to find a policy mix that gets us out of the debt overhang created by past excessive credit creation without relying on new credit growth” and favours the uses of further monetary measures such as Bernanke’s helicopter money, once-off debt write off and radical bank recapitalisation. Although he highlights the danger of opening the genie of money finance, his arguments on containing such dangers in the guise of once-off special measures are not convincing.

King highlights many of the same issues as Wolf and Turner as to how we got to where we are. The difference is in his reasoning of the causes. He points to significant deficiencies in the academic thinking behind the policies that govern Western economies. As such, his suggestions for solutions are more fundamental and require a change in consensus thinking as well as changes in policy responses. As King puts it – “I came to believe that fundamental changes are needed in the way we think about macroeconomics as well as in the way central banks manage their economics”.  According to King, theories upon which policies are based need to accommodate the reality of radical uncertainty, a model based upon the economics of stuff happens rather than the current purest (and unrealistic) models of the economics of stuff. King states that “we need an alternative to both optimising behaviour and behavioural economics”.

One of King’s most interesting and radical ideas is for a compromise between the current fractional banking model and the 100% reserve narrow bank model proposed under the so-called Chicago Plan. As King observes “to leave the production of money solely to the private sector is to create a hostage to fortune” and “for a society to base its financial system on alchemy is a poor advertisement for its rationality”. The alchemy King refers to here (and in the title of his book) is the trust required in the current “borrow short-lend long” model we employ in our fractional banking system. Such trust is inherently variable due to radical uncertainty and the changes in the level of trust as events unfold are at the heart of the reason for financial crises in King’s view.

Perhaps surprising for an ex-governor of the Bank of England, King highlights the dangers of overtly complex regulations (the UK PRA rule-book runs to 10,000 pages for banks) with the statement that “by encouraging a culture in which compliance with detailed regulations is a defence against a charge of wrong-doing, bankers and regulators have colluded in a self-defeating spiral of complexity”.  He warns that “such complexity feeds on itself and brings the system into disrepute” and that “arbitrary regulatory judgements impose what is effectively a high tax on all investments and savings”. This is a sentiment that I strongly agree with based upon recent experiences. All of the authors mentioned in this post are disparaging on the current attempts to fix banking capital requirements, particularly the discredited practise of applying capital ratios to risk weighted assets (RWA). A recent report from the Bank of International Settlements (BIS) illustrates the dark art behind bank’s RWA calculations, as per the graph below.

click to enlargeAverage Risk Weighted Assets

King’s idea is to replace the lender of last resort (LOLR) role of Central Banks in the current system to that of a pawnbroker for all seasons (PFAS). In non-stress times, Central Banks would assess haircuts against bank assets, equivalent to an insurance premium for access to liquidity, which reflect the ability of the Central Bank to hold collateral through a crisis and dispose of the assets in normal times (much as they currently do under QE). These assets would serve as pre-positioned collateral which could be submitted to the Central Bank in exchange for liquidity, net of the haircut, in times of stress who would act as a pawnbroker does. The current regulatory rules would then (over a transition period of 10-20 years) be replaced by two simply rules. The first would be a simple limit on leverage ratio (equity to total nominal assets). The second rule would be that effective liquid assets or ELA (pre-positioned collateral plus existing Central Bank reserves) would be at least equal to effective liquid liabilities or ELL (total deposits plus short term unsecured debt). The graphic below represents King’s proposal compared to the existing structure.

click to enlargeFractional Banking Pawnbroker Seasons Banking

King states that “the idea of the PFAS is a coping strategy in the face of radical uncertainty” and that it is “akin to a requirement on private institutions to take out compulsory insurance”. He highlights its simplicity as a workable solution to the current moral hazard of the LOLR which recognises that in a crisis the only real source of liquidity is the Central Bank and it structurally provides for such liquidity on a pre-determined basis. Although it is not a full narrow bank proposal, it does go some way towards one. As such, and as the graphic illustrates, it will require a significant increase in equity for private banks (similar to that espoused by Wolf and Turner, amongst others) which will have an impact upon overall levels of credit. Turner in particular argues strongly that it is the type of credit, and its social usefulness, that is important for long term sustainable economic growth rather than the overall level of credit growth. Notwithstanding these arguments, the PFAS is an elegant if indeed radical proposal from King.

Another gap in modern economic theory and thinking, according to King, is the failure to follow policies which address the problem of the prisoner’s dilemma, defined as the difficulty of achieving the best outcome when there are obstacles to co-operation. King gives the pre-crisis failure to recognise that each private bank faced a prisoner’s dilemma in running down its holdings of liquid assets, and financing itself as cheaply as possible by short-term debt, as the only means of competing with its peers on the profit expectations of the free market. The global economy currently faces a prisoner’s dilemma as the current (tired) orthodoxy of trying to stimulate demand is failing across developed economies as people are reluctant to consume due to fears about the future. In his own acerbic way, King quips that we cannot expect the US “to continue as the consumer of last resort”.

Current policy measures of providing short-term stimulus through low interest rates are diametrically opposite to those needed in the long run in King’s view. People, in effect, do not believe the con that Central Bank’s artificial reduction in risk premia is trying to sell, resulting in a paradox of policy. King believes that “further monetary stimulus is likely to achieve little more than taking us further down the dead-end road of the paradox of policy“. This means that Central Banks are currently in a prisoner’s dilemma – if any of them were to unilaterally raise interest rates, they would risk a slowing of growth and possibly another downturn in their jurisdiction. A co-ordinated move to a new equilibrium is what is needed and institutions like the IMF, who’s role is to “speak truth to power”, can hypnotise all they like about what is needed but the prisoner’s dilemma restricts real action. Unfortunately, King does not have any real solution to this issue besides those hopeful courses of action offered by others such as Wolf and Turner.

The unfortunate reality is that we seem to be on a road towards more disintegration rather than greater co-operation in the world economy. King does highlight the similarities of such a multi-polar world with the unstable position prior to the First World War, which is a cheery thought. Any future move towards disintegration across developed economies doesn’t bode well for the future, particularly when the scary issue of climate change is viewed in such a context. I hope we wouldn’t get more illustrations of the impact of radical uncertainty on our existing systems in the near future, nor indeed of our policymaker’s inability to address such uncertainty in a coherent and timely way.

I do however strongly recommend King’s book as a thought provoking read, for those who are so inclined.