Tag Archive for 'Bank of England'

Terrible news from Apple (AAPL)

Published on 25 January 2012 at 3:58 pm in Academia, Economics, Europe, Finance, UK and USA. Tags: Apple, Bank of England, Credit crunch, Europe, Excess Reserves, Federal Reserve, Tim Cook, UK, USA.

Apple just reported their profits for 2011Q4. It turns out that they made rather a lot of money. So much, in fact, that they blew past/crushed/smashed expectations as their profit more than doubled on the back of tremendous growth in sales of iPhones and iPads. [snark] I’ll bet nobody’s talking about Tim Cook being gay now. [/snark]

It’s an incredible result; stunning, really. I just wish it didn’t make me so depressed.

I salute the innovation and cheer on the profits. That is capitalism at its finest and we need more of it.

It’s that f***king mountain of cash (now up to $100 billion) that concerns me, because it’s symptomatic of what is holding America (and Britain) in the economic doldrums.

The return Apple will be getting on that cash will be miniscule, if it’s positive at all, and conceivably negative. Standing next to that, their return on assets excluding cash is phenomenal.

Why aren’t they doing something with the cash? Are they not able to expand profits still further by expanding quantities sold, even in new markets? Are there no new internal projects to fund? No competitors to buy out? Why not return it to shareholders via dividends or share buybacks?

Logically, a company holds cash for some combination of three reasons: (a) they use it to manage cash flow; (b) they can imagine buying an outside asset (a competitor or some other company that might complement them) in the near future and they want to be able to move quickly (and there’s no M&A deal that’s agreed upon faster than an all cash deal); or (c) they want to demonstrate a degree of security to offset any market perceived risk with their debt.

Apple long ago surpassed all of these benefits. The net marginal value of Apple holding an extra dollar of cash is negative because it returns nothing and incurs a lost opportunity cost. So why aren’t their shareholders screaming at them for wasting the opportunity?

The answer, so far as I can see, is because a significant majority of AAPL’s shareholders are idiots with a short-term focus. They have no goddamn clue where else the money should be and they’re just happy to see such a bright spot in their portfolio. Alternatively, maybe the shareholders aren’t complete idiots — Apple’s P/E ratio has been falling for a while now – but the fundamental point is that they have a mountain of cash that they’re not using.

In 2005 that wouldn’t have been as much of a problem because the shadow banking system was in full swing, doing the risk/liquidity/maturity transformation thing that the financial industry is meant to do and so getting that money out to the rest of the economy.[*] Now, the transformation channel is broken, or at least greatly impaired, and so nobody makes any use of Apple’s billions. They just sit there, useless as f***, while profitable SMEs can’t raise funds to expand and 15% of all Americans are on food stamps.

Don’t believe me? Here’s a graph from the Bank of England showing year-over-year changes in lending to small- and medium-sized enterprises in the UK. I can’t be bothered looking for the equivalent data for the USA, but you can rest assured it looks similar. The report it’s from can be found here (it was published only a few days ago). The Economist’s Free Exchange has some commentary on it here (summary: we’re still in trouble).

So what is happening to all that money? Well, Apple can’t exactly stick it in a bank account, so they repo it, which is a fancy way of saying that they lend it to a bank (or somebody else in the financial industry) and temporarily take some high quality asset like a US government bond to hold as collateral. They repo it because that’s all they can do now — there are no AAA-rated, actually safe, CDO tranches being created by the shadow banking system any more, they’re too big to make use the FDIC’s guarantee (that’s an excellent paper, btw … highly recommended) and so repo is all they have left.

But the financial industry is stuck in a disgusting mess like some kid’s hair with chewing gum rubbed through it. They’re all just as scared as the next guy (especially of the Euro problems) and so they’re parking it in their own accounts at the Fed and the BoE. As a result, “excess” reserves remain at astronomical levels and the real economy makes no use of Apple’s billions.

That’s a tragedy.

[*] Yes, the shadow banking industry screwed up. They got caught up in real estate fever and sent (relatively) too much money towards property and too little towards more sustainable investments. They structured things in too opaque a manner, failed to have public price discovery and operated under distorted incentives. But they operated. Otherwise useless cash was transformed into real investment and real jobs. Unless that comes back, America and the UK will stay in their slow, painful household deleveraging cycle for another frickin’ decade.

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Improving the Euro

Published on 31 August 2010 at 1:23 pm in Economics, Europe, Finance, Politics and Welfare. Tags: Bank of England, BBC, BBC Radio 4, Charles, Euro, Europe, European Central Bank, Germany, Greece, Maastricht, Spain, UK.

On BBC Radio 4, Jonathan Charles — the BBC’s European correspondent in the 1990s — has done a special on the Euro and the trouble it’s experiencing. It’s well worth a listen if you have 40 minutes to spare.

It reminded me that I’d meant to write a post on two things I think ought to be done in improving the long-term outlook for the single currency. None of this is particularly innovative, but I needed to put it down somewhere, so here it is.

First, a European Fiscal Institution (EFI)

At the start of February, when Greece and her public debt was dominating the news, I wrote:

Ultimately, what the EU needs is individual states to be long-term fiscally stable and to have pan-Europe automatic stabilisers so that areas with low unemployment essentially subsidise those with high unemployment. Ideally it would avoid straight inter-government transfers and instead take the form of either encouraging businesses to locate themselves in the areas with high unemployment, or encouraging individuals to move to areas of low unemployment. The latter is difficult in Europe with it’s multitude of languages, but not impossible.

Let me hang some meat on those not-even-bones. I like the idea of a partially shared, European Fiscal Institution (EFI) that can conduct counter-cyclical spending, subject to strict limits on its mandate. I am deliberately avoiding calling it an “authority” because that implies a certain freedom of action, which I oppose. Instead, I think that an EFI should:

be limited to implementing commonly-agreed automatic stabilisers (in particular, a universally-agreed-upon minimum level of unemployment benefits);
be able to issue its own “Euro bonds”;
have a mandate to retain the very highest regard for the safety of its borrowing; and
be funded (and its bonds be guaranteed) by member countries in a manner part way between proportionate to population and proportionate to GDP.

I do not think that membership of such an institution should be required of any European country. If a non-Euro country wants to be in it, fine. If a Euro country wants to not be in it, fine.

The unemployment benefits provided would be the absolute minimum that everyone could agree on. I want to emphasise that this should be extremely conservative. If it ends up being just €100/week for the first month of unemployment, so be it; so long as it is something. Member countries would provide additional support above the minimum as they see fit.

This will have several benefits:

It will help provide pan-European automatic stabilisation in fiscal policy.
It will provide crucial intra-European stabilisation.
It will increase the supply of long-dated AAA-rated securities at a time when demand for them is incredibly high.
It will decrease the ability of Euro member countries to argue that they should be able to violate the terms of the Maastricht Treaty at times of economic hardship as at least some of the heavy lifting in counter-cyclical policy will be done for them.

Second, country-specific lending standards

A crucial problem with a single currency is that it imposes a one-size-fits-all monetary policy on all member states, even when those states’ economies are not perfectly synchronised. Synchronisation was, and is, one of the requirements for accession to the Euro, but perfect synchronisation is impossible. In particular, inflation rates have varied significantly across the Euro-area, meaning that the common-to-all interest rates set by the ECB have been, by necessity, too low for those economies with the highest rates of inflation (e.g. Spain) and too high for those with the lowest rates of inflation (e.g. Germany).

But the (causal) link from interest rates to inflation travels via the extension of credit to the private sector, and the level of credit is determined not just from the demand side (with agents responding to changes in interest rates), but also from the supply side (with banks deciding to whom and under what conditions they will grant credit). Monetary authorities in individual member countries therefore retain the ability to influence the level of credit through regulatory influence on the supply of the same.

Altering reserve requirements for banks operating in one’s country would be the crudest version of this mechanism. A more modern equivalent would be changes to the minimum level for banks’ capital adequacy ratios. Imagine if the Spanish banking regulators had imposed a requirement of 10% deposits on all mortgages from 2005.

I suspect that the new “macro-prudential” role of the Bank of England, in addition to its role of more conventional — and, with Q.E., unconventional — monetary policy will grant them the ability to engage this sort of control. I think it will become more important over time, too, as the British economy continues its (to my mind inevitable) decline relative to the Euro-area, the UK moves closer to the textbook definition of a “small, open economy” and the BoE thus finds itself more constricted in their choice of interest rates.

Update 13 September 2010:

The new Basel III capital adequacy requirements are out and they appear to enable exactly this second idea. Good!

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Money multipliers and financial globalisation

Published on 8 January 2009 at 1:44 am in Economics, Finance, UK and USA. Tags: Bank of England, Federal Reserve, Greg Mankiw, Interest rates, Monetary base, Money, Money multiplier, UK, USA.

Important: Much of this post is mistaken (i.e. wrong). It’s perfectly possible for America to have an M1 money multiplier of less than one even if they were an entirely closed economy. My apologies. I guess that’s what I get for clicking on “Publish” at one in the morning. A more sensible post should be forthcoming soon. I’m leaving this here, with all its mistakes, for the sake of completeness and so that people can compare it to my proper post whenever I get around to it.

Update: You can (finally) see the improved post here. You’ll probably still want to refer back to this one for the graphs.

Via Greg Mankiw, I see that in the USA the M1 money multiplier has just fallen below one:

M1 Money Multiplier (USA, Accessed: 7 Jan 2009)

At the time of writing, the latest figure (for 17 December 2008) was 0.954. That’s fascinating, because it should be impossible. As far as I can tell, it has been made possible by the wonders of financial globalisation and was triggered by a decision the US Federal Reserve made at the start of October 2008. More importantly, it means that America is paying to recapitalise some banks in other countries and while that will help them in the long run, it might be exacerbating the recessions in those countries in the short run.

Money is a strange thing. One might think it would be easy to define (and hence, to count), but there is substantial disagreement of what qualifies as money and every central bank has their own set of definitions. In America the definitions are (loosely):

M0 (the monetary base) = Physical currency in circulation + reserves held at the Federal Reserve
M1 = Physical currency in circulation + deposit (e.g. checking) accounts at regular banks
M2 = M1 + savings accounts

They aren’t entirely correct (e.g. M1 also includes travelers cheques, M2 also includes time/term deposits, etc.), but they’ll do for the moment [you can see a variety of countries' definitions on Wikipedia].

The M1 Money Multiplier is the ratio of M1 to M0. That is, M1 / M0.

In the normal course of events, regular banks’ reserves at the central bank are only a small fraction of the deposits they hold. The reason is simple: The central bank doesn’t pay interest on reserves, so they’d much rather invest (i.e. lend) the money elsewhere. As a result, they only keep in reserve the minimum that they’re required to by law.

We therefore often think of M1 as being defined as: M1 = M0 + deposits not held in reserve.

You can hopefully see why it should seem impossible for the M1 money multiplier to fall below 1. M1 / M0 = (M0 + non-reserve deposits) / M0 = 1 + (non-reserve deposits / M0). Since the non-reserve deposits are always positive, the ratio should always be greater than one. So why isn’t it?

Step 1 in understanding why is this press release from the Federal Reserve dated 6 October 2008. Effective from 1 October 2008, the Fed started paying interest on both required and excess reserves that regular banks (what the Fed calls “depository institutions”) held with it. The interest payments for required reserves do not matter here, since banks had to keep that money with the Fed anyway. But by also paying interest on excess reserves, the Fed put a floor under the rate of return that banks demanded from their regular investments (i.e. loans).

The interest rate paid on excess returns has been altered a number of times (see the press releases on 22 Oct, 5 Nov and 16 Dec), but the key point is this: Suppose that the Fed will pay x% on excess reserves. That is a risk-free x% available to banks if they want it, while normal investments all involve some degree of risk. US depository institutions suddenly had a direct incentive to back out of any investment that had a risk-adjusted rate of return less than x% and to put the money into reserve instead, and boy did they jump at the chance. Excess reserves have leapt tremendously:

Excess Reserves of Depository Institutions (USA, Accessed: 7 January 2009)

Excess Reserves of Depository Institutions (USA, Accessed: 7 Jan 2009)

Corresponding, the monetary base (M0) has soared:

Adjusted Monetary Base (USA, Accessed: 7 Jan 2009)

If we think of M1 as being M1 = M0 + non-reserve deposits, then we would have expected M1 to increase by similar amounts (a little under US$800 billion). In reality, it’s only risen by US$200 billion or so:

M1 Money Supply (USA, Accessed: 7 Jan 2009)

M1 Money Stock (USA, Accessed: 7 Jan 2009)

So where have the other US$600 billion come from? Other countries.

Remember that the real definition of M1 is M1 = Physical currency in circulation + deposit accounts. The Federal Reserve, when calculating M1, only looks at deposits in America.

By contrast, the definition of the monetary base is M0 = Physical currency in circulation + reserves held at Federal Reserve. The Fed knows that those reserves came from American depository institutions, but it has no idea where they got it from.

Consider Citibank. It collects deposits from all over the world, but for simplicity, imagine that it only collects them in America and Britain. Citibank-UK will naturally keep a fraction of British deposits in reserve with the Bank of England (the British central bank), but it is free to invest the remainder wherever it likes, including overseas. Since it also has an arm in America that is registered as a depository institution, putting that money in reserve at the Federal Reserve is an option.

That means that, once again, if Citibank-UK can’t get a risk-adjusted rate of return in Britain that is greater than the interest rate the Fed is paying on excess reserves, it will exchange the British pounds for US dollars and put the money in reserve at the Fed. The only difference is that the risk will now involve the possibility of exchange-rate fluctuations.

It’s not just US-based banks with a presence in other countries, though. Any non-American bank that has a branch registered as a depository institution in America (e.g. the British banking giant, HSBC) has the option of changing their money into US dollars and putting them in reserve at the Fed.

So what does all of that mean? I see two implications:

Large non-American banks that have American subsidiaries are enjoying the free money that the Federal Reserve is handing out. By contrast, smaller non-American banks that do not have American subsidiaries are not able to access the Federal Reserve system and so are forced to find other investments.
The US$600+ billion of foreign money currently parked in reserve at the Fed had to come out of the countries of origin, meaning that it is no longer there to stimulate their economies. By starting to pay interest on excess reserves, the US Federal Reserve effectively imposed an interest rate increase on other countries.

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