Steve Williamson, the recession, and New Keynesian economics

This recent post by Steve Williamson explains, far better than I did, why no more conventional stimulus is needed in the US.  It’s an argument that carries over fairly neatly to the UK.  And the sort of analysis that confronts head on calls for the authorities to pump up demand by the likes of Paul Krugman and Simon Wren Lewis.

He argues that monetary policy is not the tool to help solve the recession, because all monetary policy is good for is sorting out the distortions created by temporarily sticky prices.  And those distortions must have come and gone, because on average prices are fixed for somewhere between 4 months and a year.  4 months if you take the median frequency of all price changes in the US; a year if you exclude price changes associated with sales, which tend to be followed by a return to the old price.  Output may be far below its pre-crisis trend, and unemployment far higher than pre-crisis levels, but this cannot be laid at the door of monetary policy.

Though I agree with the basic point, and the perspective taken, Steve’s post I think is not the end of the story.

First, one can make the same point about conventional tax and spend fiscal policy.  Many of these instruments, if loosened, would work like monetary policy, stoking up demand.  The coexistence of stable inflation and very weak output would suggest that stoking up demand would just create more inflation.  That might bring temporary benefits, and we can argue about whether the costs of temporarily higher would be worth it, but such policy would not solve the underlying problem.  So, when Steve says that the solution is ‘fiscal’, one has to rule out demand management, since that is essentially like monetary policy.

The second point I’d make is that Steve rather unfairly associates New Keynesian explanations of the crisis and associated policy prescriptions with the simplest possible sticky price model.   This model has a smoothly growing trend potential output, and no other distortions apart from those imparted by sticky prices.  Steve is knocking over a straw man here.  Many researchers using modern sticky price models incorporate financial frictions that impart time-varying distortions to the economy.  For example, if you take a look at Larry Christiano’s web page, you will find several of them.  These papers basically combine sticky price models with Bernanke and Gertler’s model of the financial accelerator.  Models with sticky prices and the financial accelerator show that the two distortions interact.  Monetary policy has effects on the real economy because of sticky prices.  These are amplified by the financial accelerator.  So Steve is right to say that sticky prices and wages can’t explain the great contraction, or rather all of it, but he’s wrong to imply that one should therefore discard these models.    The sticky prices only model is an inadequate tool to describe the recession and proscribe what to do about it.  But, suitably enriched, it is potentially enlightening.   Of course, not everyone would be happy with building in these extra frictions.  Some probably think of it as building a second story to a house of cards.

Third, and relatedly, in these models it’s not the case, as Steve suggests, that monetary policy should simply focus on stabilising inflation.  It’s almost true in the models, because they imply that inflation is more costly by an order of magnitude than anything else.  (Whether this is true of the real world is open to question.)  But not quite.  In sticky price models with financial frictions, a worsening of the financial friction pushes down on output and up on inflation.  Monetary policy can alleviate the financial distortion, but at the cost of higher inflation.

Fourth, he responds to the possibility that the cost of finance may be inefficiently distorted by recommending that the Government (via its agencies) get out of the housing market.  Interpreting the sticky price model plus financial frictions models broadly, one might argue the opposite.  One reason why output may be inefficiently low (say these models) is that the cost of finance is inefficiently high, made so by the fact that the agency problems are worse than normal.  (Perhaps the value of collateral is unusually low, and lending to borrowers unusually risky, therefore).  In such a situation it might be efficient for the deep-pocketed government to intervene in mortgage financing.  (Might).

 

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Comments on retrospective guidance on forward guidance from the BoE

The Bank of England has been trying to clarify what it was doing when it launched its policy of forward guidance, committing not to think about tightening monetary policy until unemployment fell to 7% (provided….).  The fog is lifting somewhat, but lots of questions and puzzles remain.

Charles Bean spoke at Jackson Hole, saying pointedly that forward guidance in the UK was NOT about injecting more stimulus by holding rates lower for longer and causing an inflation overshoot.  He gave two reasons.  One referred to past, above target inflation, and translated as implying that more stimulus was not needed.  I agree with that.  But I find it hard to square that language with Carney’s at the Inflation Report press conference when the policy was first launched.

Also, one could nit-pick here.  Forward guidance was aimed at making sure that interest rates were forecast to be lower for longer than markets would have counterfactually forecast them to.  And one might presume that markets would forecast how and when MPC would raise rates based on how they have responded to movements in inflation and unemployment in the past.  That sounds pretty Woodfordian to me.  For Bean’s comment to be consistent, the MPC judgement must have been this:  once rates were freed from the zero bound, MPC would respond as they normally had.  For some reason markets were either i) forecasting that they would become more inflation-nutter-like than they had previously been (for no apparent reason) or ii) taking a more optimistic view of the conjuncture than they were.  ii) seems more plausible than i) to me.  Particularly if one recalls that the MPC were judging the pick up in the inference about demand to be reflected perfectly in an equal, and therefore inflation-neutral, pick up in supply.  Though Bean and his colleagues seem to feel the need to stress i) instead.  (There has not been an equivalent campaign to clarify that the MPC’s view of the conjuncture is less benign than the markets’).

A second reason Charles Bean gave as to why forward guidance was not of the Woodfordian type referred to the fact that the MPC could not bind its future members.  (So there was no point in trying).  I found this puzzling.  The commitment just made requires committing its future members.  John Cunliffe will take over from Paul Tucker.  Mr Bean himself will probably sign off in June 2014 when his current term expires, before MPC are forecasting that unemployment will hit 7%.  Ben Broadbent’s term is up in May 2014, and is Paul Fisher’s.  Potentially, there might be four new MPC members who didn’t vote for forward guidance who one would have to take as pre-committed.  (And of course there is nothing stopping an MPC member going back on the agreement, nothing except words).   So in fact MPC’s ‘inject no more stimulus’ forward guidance policy IS like Woodford’s in respect of requiring commitment from individuals who might not be able to offer it.

Spencer Dale and James Talbot [Head of the Bank’s Monetary Assessment and Strategy Division, instrumental in preparing the analysis of forward guidance for the MPC] write on behalf of the Bank in a VOXEU column.  In this piece, and in that by Charles Bean, mention is made that ‘more effective’ refers in part to reducing uncertainty.  This risks confusing the ‘no more stimulus’ message.  Indeed Mark Carney seems to have persuaded the entire media that forward guidance was about trying to kick start the recovery, a central plank of which was the extra spending that would come with being confident that interest rates were not going to rise.  To be consistent with the ‘no more stimulus’ message, MPC would have had to tighten somewhat to offset the stimulatory effects of reducing unemployment.  No mention is made of this.  Is the uncertainty effect calculated to be too small to warrant any compensating tightening? [More on this in another post.]

Also potentially confusing is the phrase in the Dale-Talbot piece that refers to forward guidance as enabling MPC to ‘explore the scope for economic expansion without putting price or financial stability at risk’.  This phrase is totally mysterious.  What does it mean to ‘explore the scope for economic expansion’?  Elsewhere in this text and Bean’s we are getting the new message that no more stimulus was intended.  But ‘explore the scope for economic expansion’ is easily read as ‘have a bit more of a go at further economic expansion, more confident now than before that we can do this without overdoing it, in particular that that’s   how others will see it since we have these knockout clauses’.  Whatever it means, why does forward guidance help them do it?  Suppose it simply means ‘continue with the already very stimulative monetary policy so that we stimulate demand as much as we can without generating too much inflation’.  Why does explaining what will happen to future rates, and the knockout, help?  Since policy is not meant to be any more expansionary, the help guidance gives must simply be in the knockout clauses.  Before, we can infer, there was a risk that the (similarly) stimulative policy plan would put price or financial stability at risk.  Now guidance enables the MPC to ‘explore the scope for economic expansion’ (translate do what it was doing before) more confident than before that the punch-bowl will be removed if things get out of hand.  This all seems to hang together too, but it doesn’t match the rest of the stories about forward guidance.

For me ‘explore the scope for economic expansion’ is confusing jargon.  It sounds like a text thrown in the direction of the doves (by a hawk), in particular at Mark Carney, that sounds a little stimulatory, but nevertheless stays within the ‘no more stimulus’ rubric set out by Charles Bean.

The common message from both the Bean and Dale texts is that no more stimulus was intended.  If that was the case, then presumably Bean and Dale must view the Carney press conference launch a total failure.  Carney was careful to use the ‘more effective’ language. But almost everything else he said subsequently was calculated to direct observers to the ‘more stimulus’ conclusion.

The Bank of England won’t and shouldn’t try to cap house price increases

A UK, housing-industry lobby group, the Royal Institution for Chartered Surveyors, recently called for the Bank of England to try to ‘cap’ annual house price increases at 5%.  This is in the context of evidence that house prices are accelerating again in the UK, despite measures of turnover remaining relatively subdued, and comments by Mark Carney, Bank of England Governor, that the Bank might contemplate interest rate rises if a housing boom got going.

‘Capping’ annual house price inflation would not be a good idea.  Houses perform several functions, and the demand and supply for these functions will likely vary from time to time, in ways that could mean that increases or decreases far greater than 5% in annual terms may be necessary and desirable from the point of view of society as a whole.

One obvious thing houses do is offer what economists would call ‘housing services’, what the average punter in the ‘Dog and Duck’ would call shelter.:  all that is nice about living under a roof.  (It’s dry, harder for people to steal your stuff, and you have more privacy than on the street).  Supposing the supply of shelter roughly fixed, the price of shelter services will rise and fall with demand.  Some factors determining the rise and fall in demand for shelter should play out slowly – like changes in the average size of households, or changes in net migration.  (In the UK the former has shrunk with single parentage and divorce, putting pressure on houses, and net migration has been strong for ten years or so).  But some such factors might move quite quickly, in line with changes in disposable income, or expected disposable income.  These dived at the start of the recession, for example.   If we could establish that even these fast-moving influences on the fundamental price of housing services would not change prices by more than 5% in a year, then perhaps there would be some sense in the cap the RICS were calling for.  But we can’t possibly claim this.

Houses don’t only offer shelter.  They are also an asset.  Since they usually last, if built well, and can be re-sold, they provide a way to store wealth.  One key factor determining asset prices is the price of consumption today relative tomorrow, or the real interest rate.   Once again, some of the factors determining the real rate move only slowly over time, but some of them moving very quickly.  Demographics affect the real rate, and, social catastrophes like wars or plagues aside, move slowly.  Young people are trying to bring forward consumption, spending out of income they don’t have.  The middle-aged are saving for when they can no longer work.  The old are running down their savings, unable to work or tired of it.  More young people puts upward pressure on real rates to encourage those that can to save and lend it to them. (Etc).   Another key factor determining real rates though is beliefs about the trajectory of income over the future.  If we all discovered that we were going to get some huge windfall in the future, we’d try to spend some of that now by borrowing, pushing up real rates.  When real rates go up the value of an assets falls.  News about the future, or changes in beliefs about the future, can materialise quickly and have very large effects on the ideal price for houses.   In the face of such changes, caps don’t make sense, no more so than capping the price of oranges relative to apples.  Of course, if the authorities had better insight into the trajectory of national incomes than those investing in houses, then there might be justification to try to limit house price movements accordingly, to bring about the price people would strike if they knew as much about their own futures as the Government, but even then the ideal price could move a lot more in a given year than 5%.  And after 20 years in the Bank of England, watching the last housing boom and bust play out alongside our forecasts, I see no reason why we should think that the authorities have this special insight.

Houses do other things too.  They hedge people against fluctuations in rents.  (If rents double shortly after I retire, but I own a house, what I can buy out of my pension is protected.  If I don’t own a house, I can afford much less food after paying for my housing).  And houses protect people against inflation risk. (For example,

 I doubt the component of house prices that is related to hedging fluctuations in rents varies that much.  But inflation (and deflation) risk could.

There is plenty of research showing that volatility in house prices may be bad.  One line of reasoning in particular is that house prices amplify booms and busts.  Housing serves as collateral for loans.  In a boom, the demand for borrowing may rise anyhow, but rise even more because a rise in house prices increases the amount of collateral households have, and this reduces the cost of borrowing because lenders are more confident of selling the security and recovering the loan if the household defaults.  But these models don’t give us enough to argue for a quantitative cap on house price changes from one year to the next.  I expect and hope that the Government and the Bank ignore the RICS’ suggestion.

Imagine a counterfactual world in which George Osborne understood the deep irony in his speech…

Notice two arguments in George Osborne’s ‘mission accomplished’ speech.

1.  After several years of declining or stagnant output, we at last have evidence of  moderate growth in official data and other positive, survey indicators.  This demonstrates that those that argued that the government’s ‘Plan A’ austerity deficit-reduction policies were wrong.

2.  We shouldn’t judge the Bank of England’s forward guidance policies a failure, because yields may have been even higher in a counterfactual world in which forward guidance hadn’t taken place.

Oh, the irony!  Surely he and his speechwriters must be aware of it!   Argument 2, of course, is watertight.  We might be sceptical of it, because yields did not really fall on the announcement of forward guidance, during which short period one might think that there was little else affecting them.  But it is still logically correct.  Argument 1, of course, as forcefully argued by Simon Wren-Lewis and Paul Krugman, is completely fallacious.  The argument that looser fiscal policy would have meant a shallower and shorter recession is not undermined by output eventually starting to grow.

Can we rescue the Chancellor from this absurd boast?  Some were arguing that the austerity implemented will tip us into a vicious circle of ever larger deficits and ever-declining output.  The turnaround in the data makes that less likely to happen now.  Can we consider that particular argument won?  Not really, no.  First, since Plan A was embarked on, we have had two measurable relaxations in the deficit reduction targets.  Who knows, if Plan A had been stuck to (as the Government promised at the time) we might have experienced this vicious circle.  Second, even the reduced probability that something will happen does not make it wrong to have forecast that this would happen back in 2010 when Plan A was first embarked on.  Just as the fact that I roll a double six does not make my initial forecast that this was not very likely wrong.

Krugman pointed out that although this is bad economics, it is probably good politics.  I think he is sadly right.  But it is a shame that politicians get away with it.  Speeches like this debase economic discourse, and political discourse about economics.   Osborne would probably like to be remembered for his good work in setting up the Office for Budget Responsibility, and introducing apolitical oversight and restraint on fiscal policy.  But if this is the case, it is strange that he succumbed to the temptation to run these cynical, false arguments about his austerity plans, cynical because they count on the economic illiteracy of the listener, a cloak behind which you can do with fiscal tools what you feel like to make sure that you get elected.

(And I say this as someone who was arguing that looser fiscal policy was not necessary (eg on account of high and stable inflation) nor prudent (need to save for another rainy day in the financial system)).

Why hasn’t anyone called the ECB’s bluff over OMTs?

Last Summer, the ECB stemmed the panic in peripheral sovereign debt markets with a promise.  The promise was to undertake ‘Outright Market Transactions’;  purchases of short-term debt issued by troubled sovereigns, from secondary markets, in quantities not limited at the outset, provided the country in question submit itself to the discipline of seeking conditional assistance from the European Stability Fund.  It seems amazing to me that this has worked so well and that no-one has tried to call the ECB’s bluff.

Why do I think OMTs are a bluff?  If markets did not believe the promise, and continued to require such high premia from peripheral sovereigns that the sustainability of their finances, and their continued membership of the euro was in doubt, the ECB would be pouring good money after bad.  It would stand to lose a great deal on the bonds it bought, whose value would be very uncertain, clouded by a possible redenomination and/or default.  The protection of buying short-term bond would not be much protection, as their value could evaporate in minutes.  It is at least possible that there would not be the political support from the core, creditor countries, already on the hook to the tune of around 700 billion euros if there were a quick euro area break-up, to back unlimited ECB operations as this dynamic played out.  Even if it could be argued that such operations were in the core’s long-term interests, it is surely possible, if not highly likely, that voters in Germany (for example) would themselves panic as purchases began,  or that the German leadership would worry that they would.

If the view that this was how things would turn out were to take hold in markets at any point this would cause the premia that the OMTs had eliminated to re-emerge and force the ECB’s hand.  The ECB’s promise is bluff because they could not carry it out, nor would they wish to, in all possible circumstances.   The ECB’s discussion of multiple equilibria in speeches like this one by Coeure on the ECB board is highly pertinent. But its account of the phenomenon is misleading.  Since the ECB would clearly could not, nor would not want to carry out unlimited OMTs in all circumstances, it clearly is a valid candidate forecast that they would not, and that the events associated with them not doing it (sovereign default, euro exit) might take place.  Since it is a valid forecast that this would happen, it’s also valid to forecast that others will forecast that this will happen, and so on.  In order to stop a self-fulfilling prophecy, you have to make it irrational to forecast doom in the first place.

The OMT bluff is also not particularly well executed bluff, and there are several curious aspects to it.

One is the talk about redenomination risk.  The ECB wishes that we believe it can distinguish between redenomination risk and other premia priced into troubled sovereign bonds.  It’s important for the motivation for the policy that it argues it can, because addressing other premia (like those connected with troubled sovereign solvency) is the preserve of fiscal policy, which is the preserve of other bodies.  If the opposite view of OMTs were to prevail, that might risk the German constitutional court standing in the way of OMTs, or risk people believing that it might, which would trigger all the events described above.  Even if were possible, conceptually, to separate out this particular premia, it would be a stretch to believe that the ECB could measure it.  But in this case, it is surely not possible to distinguish ‘redenomination risk’ from risks connected with the solvency of a government and an exit from the euro.  The two are bound up with each other, because it is precisely that prospect of running out of money which would mean that governments would be forced to pay their bills by printing their own.

Another curious aspect of the bluff is the talk of the conditionality of the OMTs.  This is needed to make OMTs as un-fiscal as possible.  If it can be argued that the fiscal problems are being addressed by an explicitly fiscal body or fund (the IMF, the EFSF or ESM), then there is no further fiscal problem to deal with, and the OMTs can be argued to be a measure aimed at monetary policy purposes.  But this is just talk.  One can almost argue the opposite.  That without the fast-moving, potentially unlimited capacity of the monetary authority to create money to plug the financing gap of troubled sovereigns, the slower-moving, clearly limited capacity of the ESF and its sponsors would not work.  And it is also stretching it to argue that this fiscal conditionality is watertight.  The ‘reforms’ spoken about as being required as part of an ESF loan are not specified.   As we have seen with Greece and Portugal, it is a subjective matter as to whether they have been carried out.  Once the loan in exchange for reform is agreed to, it is often, after the event, not in the interests of the lender to carry out the threat not to hand over the money when reforms don’t happen.

Yet another curious thing about the bluff is the behaviour of the political custodians of the ECB and the currency union.  One might guess from the fact that Draghi announced OMTs that Merkel and co supported them.    But that it is not an adequate rebuttal of the charge that OMTs are a bluff.  It simply says that the ECB got Merkel’s agreement to have a go at bluffing.  (After all, if you have run out of options, why not try it?)  What evidence have we got that the Germans would be willing to follow through?  Has there been any decisive change in the opinion polls indicating public support for extending much larger credit to troubled sovereigns in the euro area?  I’m not aware of any such shift.  More plausibly, the German political elite extend credit reluctantly because they know that this is the view of their voters;  that explains their tardiness before OMTs, and it must surely colour how they view OMTs themselves.

One can almost see these concerns and delicacies in the central texts outlining the bluff, the text that describes the limits or lack of them on OMTs.  ‘No ex ante quantitative limits are set on the size of Outright Monetary Transactions‘ is the phrased used.  The phrase is clearly aimed at making it clear that they don’t want to disclose a cap yet, because that would allow people to look at the cap and figure out whether they think it is large enough to do the job.  But then, the text does not have, yet could have, had a prhase that said ‘whatever quantities are deemed necessary to convince market participants that pricing in a risk of exit is not rational’.   So in the absence of such a text, should we interpret what has been written as ‘not yet limited, but if things start going badly, it soon will be, don’t worry, and we will pull out’?  It’s as if the ECB knows it can’t actually write ‘unlimited’, because they know that it would not be believed, nor judged consistent with their mandate.  There are no fiscal funds earmarked to recapitalise ECB losses associated with ‘ex post limited’ OMTs, and allowing these losses to be absorbed by money creation is not consistent with the mandate for price stability, nor would be judged so by the German constitutional court.  The phrase ‘no exante quantitative limits’ seems designed to impress a busy markets trader, but reassure a concerned German constitutional lawyer.  It might well reassure the lawyers, but I don’t understand why it should have impressed markets.

If you are persuaded that OMTs are just bluff, and a bluff not very well executed at that, it’s then a puzzle why the policy was so successful, and no-one has tried, seriously, to call the ECB (and the Germans) on it.

Scottish? Don’t let the SNP hoodwink you into thinking you can have a currency union without tight fiscal oversight

Back in April, the Treasury published a report explaining, in short, that an independent Scotland could not be a member of a currency union, managed by the Bank of England, without considerable fiscal oversight.  The Scottish National Party (SNP) dismissed this report as ‘scaremongering’.

In this post, I want to reiterate why the Treasury was right, and if anything understated the problem, (probably scared itself of being accused of scare-mongering).  The SNP’s failure to address this important issue of institutional design reveals either incompetence on their part, or, worse, indifference to the future macroeconomic stability of Scotland and a determination to make sure that the Scottish electorate don’t grasp the issue.  10 years ago, this debate would have been much less clear cut because we did not have the example of the euro area on our doorsteps.  Now, however, we can see clearly what happens when countries combine to form a currency union, but have independent fiscal and financial stability policies.

The short answer to this question is:   without intrusive fiscal oversight, the currency union of the Rest of the UK [or RUK] with Scotland would look like the currency union in the Euro Area.  Not good!  In fact, even worse, because the size of the balance sheet of the banking sector in Scotland relative to GDP is much higher than say, the typical basket case Mediterranean country.  And worse too because the exposures to Scottish banks of the UK probably exceed those of the European core to the periphery.  So, it seems pretty clear to me that the RUK would not want to sign up to a currency union on these terms, contrary to the SNP’s assertions.

To spell things out a little more:  the RUK would want to ensure two things. First, Scotland supervised its banks to the same standard as the RUK supervised its system.  Second, that Scottish fiscal policy was sufficiently conservative as to be able to cope with a failure of its banks.  Otherwise, in the event of a crisis, there would be irresistable pressure (just as for the European core now) to offer a bail-out to Scotland, so that it in turn could protect Scottish banks, and thereby protect RUK banks from a run as a result of worries about exposure to the affected Scottish institutions.  Without these two guarantees in place,  there would be every incentive for the Scots to free-ride on UK financial guarantees.  The Scots might be tempted to offer lax capital or oversight, in the hope of retaining or attracting further domiciled banks, and obtaining the tax revenues that come with it, while relying on the incentive of the RUK fiscal authority to bail it and its banks out in the event of a crisis.  [This is one way of reading Salmond’s response to the proposed acquisition by RBS of ABN Amro.  He welcomed it because it beefed up the profits that would be billed to Scotland, and the tax revenues that he could argue should be hypothecated for Scottish spending].

This problem would be less severe if Scotland were forced to manage its own currency and exchange rate against the RUK, because Scotland would have the option of plugging the gap in its finances by printing that currency, and the fall in the currency that would be associated with a financial-sovereign crisis would stimulate export-led growth (just what the European periphery are lacking now).  The knowledge that such an option exists would put an (inflation risk) premium on Scottish government bonds, but it would also lessen the likelihood of a run on those bonds and the banks that held them.

This is why the RUK government would not be content to maintain a currency union with Scotland without tight fiscal and financial stability oversight, which, in effect, amounted to a fiscal union.  And the reasons, to repeat, are almost identical to those governing the struggle over how to work through the European crisis.  Scots voting for political independence in order to achieve fiscal independence should not count on remaining part of the Sterling currency union.

Even with a floating currency, there would still be some incentive for a RUK government to offer aid to a Scottish sovereign having difficulty financing a bail out, or guaranteeing Scottish deposits to prevent a run on Scottish banks, and an associated plunge in demand for RUK exports to Scotland.  (The funding for Ireland during the euro area crisis that the UK offered was not for altruistic purposes).  And knowing this, there may well be some incentive to free ride in advance (with lax regulation and higher tax revenues accruing).  So from this perspective only, namely, to ensure a watertight financial stability union, while Scottish and RUK banks are so intertwined, RUK voters should hope that the Scots vote no.

The analogy with Europe isn’t perfect.  One of the reasons why Germany has not yet pushed to cut Greece loose is because of the precedent that might be set for Portugal, Spain, even Italy, and the worry that default and exit by these countries might become a self-fulfilling prophecy.  There would not be the same problem for a RUK contemplating kicking out Scotland from a currency union in the event of a financial crisis.  There would be no further entity within the currency union that might have to break away.  For that reason it would be less traumatic for the RUK to force a Scottish exit in a crisis.

Another reason why the analogy isn’t perfect is that a currency union with an independent Scotland would happen with the experience of a Euro Area crisis fresh in everyone’s minds.  One would presume that the real possibility of a break-up of the Scotland/RUK union would make a break-up itself less traumatic.  For one thing, RUK banks would think carefully about the price they wanted to pay for Scottish bonds, and would not treat them as substitutes for RUK ones, as it appears that markets in general did when pricing euro area core and periphery bonds in the run up to the crisis.

Political economy of subsidies to bank borrowing

Not the modest interventions to try to stimulate lending, but the huge subsidies to bank borrowing implied by the state guarantee to prevent banks failing (discussed in various writings by Andrew Haldane), which allows them to borrow from private markets at low cost.  Simon Wren Lewis writes about how these came to pass in his blog ‘Mainly Macro’, speculating that it was about bankers lobbying politicians.

But why do politicians give in? Another speculation to add to Simon’s:  these subsidies translate into fat profits for banks, which translate into tax revenues now.  These revenues can be handed out to constituents now to buy votes now.  The liabilities taken on (the costs of a future bail-out) are not realised now.  They come as and when a financial crisis is realised.  Most likely, the taxes, and the constriction on pork-barrel spending plans, that come with a crisis, will hit some future government, a long way beyond the planning horizon of politicians focused on the next election.  That’s why governments are content with the subsidy, because they aren’t paying for it.  On the contrary, they share in the spoils.

Something aggravating the problem is the international competition between tax jurisdictions for banks’ profit (and tax revenue) cyphoning machines.  The Basel Accords were attempts to solve both problems:  regulating banks to make the realisation of crisis-related liabilities less likely, with the cost being lower profits (and tax revenues), and by agreement eliminating international competition.  However, some might see these Accords as highlighting that the problem is still there.  The fierceness of the competition between governments, and the difficulty for each of them in forgoing the goodies, makes it hard to strike an agreement that does any more than make a dent in the problem.