Jeremy Corbyn’s plan to rewrite the rules of the UK economy


Jim Pickard and Robert Shrimsley





































Chart showing UK parties poll










The repo markets mystery reminds us that we are flying blind

Quantitative easing means there is a greater chance of the global financial machine misfiring

Gillian Tett

NEW YORK, NEW YORK - SEPTEMBER 18: Traders work on the floor of the New York Stock Exchange (NYSE) on September 18, 2019 in New York City. As concerns about a global economic slowdown mount, the Federal Reserve on Wednesday cut interest rates by a quarter percentage point for the second time since July. (Photo by Spencer Platt/Getty Images)
The dramatic gyrations of repo rates this week triggered by a 'temporary' cash squeeze suggests neither the Fed or investors completely understand how the modern financial machine operates © Spencer Platt/Getty Images

What the heck happened? That is a question many market participants are asking about events this week at the US Federal Reserve.

But the confusion is not due to the issue that was supposed to grab headlines — namely Wednesday’s announcement on interest rates. That storyline is clear (ish): although the Fed cut its core policy rate by 25 basis points, officials also signalled their reluctance to cut rates again too soon while growth is strong. That is sensible, predictable and readily understandable.

Instead the development that is sowing shock and confusion is related to the normally arcane matter of financial plumbing. At the start of the week, overnight borrowing rates in the repurchase or repo market, where traders do short-term deals to swap treasuries for cash, suddenly spiked to 10 per cent, up from their normal levels of 2-2.5 per cent.

Repo rates declined after the New York branch of the Fed pumped $75bn into the markets for three days running. But conditions remain jittery. After all, the last time we experienced this scale of gyrations in repo rates was the 2008 financial crisis.

So should investors worry? Yes — and no. One piece of good news about this week’s events is that the movements were not sparked by the same issues in the 2008 panic, namely a fear of financial collapse. Instead, the trigger appears to be due to “temporary mismatches in the demand for funding and availability of cash”, as JPMorgan explained to its clients in a note.

More specifically, American companies typically need around $100bn of cash to pay tax bills on September 15, which prompts big withdrawals from the money market funds that are an increasingly crucial pillar of the repo markets. This year, this outflow coincided with Monday’s $54bn settlement of treasury coupons, creating more demand for cash. The resulting squeeze may have been exacerbated by an additional dash for funding among players hit by the unexpected surge in oil prices due to the drone strike in Saudi Arabia.

The other bit of good news is that Fed officials seem ready to offset these temporary problems by employing “flexibility when needed”, as Simon Potter, then a senior official at the New York Fed, noted last year. This nimble and creative approach is another contrast to 2008 — and very welcome.

But here is the bad news: the fact that a “temporary” cash squeeze created so much drama shows that neither the Fed nor investors completely understand how the cogs of the modern financial machine mesh. That is partly because “money markets have been and are now changing quickly in response to regulatory, technology and business model incentives”, as Mr Potter put it.

A decade of extraordinary monetary policy experiments has left the system badly distorted. Thus the Fed is now like a pilot flying a plane with an engine that has been stealthily remodelled. Neither the passengers nor the pilot knows how the engine’s shifting cogs might affect the controls during a wave of turbulence, because there is little historical precedent.

Take the matter of bank reserves. Quantitative easing earlier this decade caused an explosion in the level of reserves that private banks place on deposit with the Fed, hitting a peak of $2.9tn in 2014. Since the Fed started rolling back QE a couple of years ago, those reserves have shrunk to $1.3tn as of this summer. Until recently, Fed officials thought that was enough cash to keep the system running smoothly. Although $1tn in reserves are tied up by regulatory and liquidity requirements, the remaining $300bn “buffer” was presumed to be sufficient to absorb unexpected market shocks.

This calculation was always a guess, not scientific projection, since the Fed has never before unleashed QE — or tried to unwind it. And, as Lorie Logan of the New York Fed said in 2017, you only truly know that a reserve buffer has run out when rates spike.

The best guess now is that $300bn is not big enough. “The Fed is learning as it goes,” explains BMO Capital Markets. Although Fed officials will probably introduce new tools to create additional safety buffers, JPMorgan fears that “this sort of volatility will only persist” given all the structural changes under way.

This is unnerving. But the bigger point that investors need to understand is this: the more that QE (and its partial reversal) reshapes global finance, the greater the risk that the cogs in the machine unexpectedly misfire. That is no reason to panic. But central bank pilots — like investors — are learning on the job. Better hope they stay completely alert.

Hitting the ceiling

Why the Fed was forced to intervene in short-term money markets

The repo rate spiked in an alarming echo of the financial crisis

THE FEDERAL RESERVE had plenty to fret about as it prepared to discuss policy interest rates on September 17th and 18th. Trade tensions and wilting global growth have led businesses to cut back investment in the second quarter of the year. In manufacturing, production and capacity utilisation have been falling since the end of 2018. Though the Fed has described jobs growth as “solid”, some analysts worry that the labour market is wobbling. As expected, these concerns prompted the central bank to lower rates for the second time this year, by 0.25 percentage points, to a target of 1.75-2%. But the meeting was overshadowed by turmoil in money markets.

On September 17th, for the first time in a decade, the Fed injected cash into the short-term money market. The intervention was needed after the federal funds rate, at which banks can borrow from each other, climbed above the level targeted by the Fed. It rose as the “repo” rate—the price at which high-quality securities such as American government bonds can be temporarily swapped for cash—hit an intra-day peak of over 10%.

On September 17th the Fed offered $75bn-worth of overnight funding, of which banks took up $53bn. The following day it again offered $75bn-worth. The amount demanded by banks rose to $80bn.

That sent shivers down spines. A spiking repo rate was an early warning sign before the financial crisis. In 2007, as market participants began to doubt the quality of collateral backed by mortgage lending, repo rates jumped as lenders hoarded cash.
 The latest jump was unlikely to have been caused by such doubts. Most collateral is now high-quality American Treasury bonds or bills. Even so, there are reasons to worry. America’s banks and companies seem to be short of cash. And during the turmoil the repo rate stopped tracking the federal funds rate. This link is the main way monetary policy influences the economy. A gap opening between the two deprives the Fed of its most important policy tool.

Fortunately, the Fed’s interventions seemed to work. The repo rate has returned to its usual level, close to the federal funds rate, which in turn is within the range targeted by the Fed.

Even so, the turmoil raised questions about how the Fed plans to handle future cash shortages. The mere prospect marks an important shift for America’s financial system. Before the financial crisis the Fed controlled the federal funds rate using a “corridor”, with a ceiling and a floor. Banks with too little cash could borrow at the ceiling rate.

But there was no compensation for extra cash held at the Fed (the floor interest rate was zero).

To keep interest rates precisely on target the Fed used “open market operations”, swapping Treasuries and cash to control liquidity in the banking system.

Six years of quantitative easing changed this paradigm.

To push down long-term interest rates, the Fed bought vast quantities of long-dated Treasury bonds. Its balance-sheet ballooned to $4.5trn. The holders—mainly banks—ended up with mountains of cash. To keep market interest rates at or above the policy rate, the Fed was authorised by Congress to raise the floor from zero, compensating banks for their cash that it held. The ceiling became redundant, as did open market operations. Only the floor mattered.

But banks’ cash piles have dwindled of late. Since late 2017 the Fed has been reducing its balance-sheet by not reinvesting all the proceeds when its assets mature. The balance-sheet shrank from $4.5trn in 2017 to $3.8trn in June this year. Moreover, a wider budget deficit means the Treasury has had to issue more bills and bonds.

So far this year it has issued an average of $63.9bn-worth of bills and bonds per month, net of repayments.

During the same period in 2017 the monthly figure was just $19.6bn.

As banks buy Treasuries, their cash piles fall.

The surplus reserves banks hold in their deposit accounts at the Fed fell from $2.2trn in 2017 to $1.4trn now.

No one knows how much surplus cash banks need to feel comfortable. That depends partly on regulations, which have increased the amount of cash banks must hold as a buffer, but also on business sentiment. Banks’ near-death experience in 2008-09 has left them with a strong desire to hold plenty of extra cash. Economists have attempted to estimate the level at which banks would start to squirm, most coming up with estimates of $1.2trn-1.5trn.

Usually banks have at least this much on hand. But they may not have had on September 16th, for relatively benign reasons. That was the deadline for quarterly corporate-tax payments, meaning companies asked banks for more cash than usual. The Treasury had issued $77bn-worth of bills in the previous week. The buyers, mostly banks, also had to pay on September 16th.

The Fed anticipated these events, said Jerome Powell, its chairman, but did not expect such an extreme reaction. As banks’ cash piles shrank, they grew reluctant to lend to companies and other counterparties. The repo rate spiked. Some banks stepped in, lending to companies at elevated rates. But then those banks tried to borrow from other banks in the federal funds market, pushing up the rate. This prompted the Fed to intervene.

Cash would have become scarce sooner or later, says Bill English of Yale University. In a growing economy—especially one with a rising government deficit—the demand for bank cash increases over time.

The Fed now faces a choice. It could return to conducting frequent open market operations to pin down interest rates, as before the crisis. Or it could keep the current system and avert future cash shortages by expanding its balance-sheet enough to keep the banking system permanently saturated with liquidity, even as demand for cash grows over time.

On September 18th Mr Powell suggested that the Fed would opt for the latter, saying it wanted reserves to be ample enough to avoid operations of the sort carried out in recent days. He also announced technical tweaks that will mean banks are compensated a little less handsomely for cash deposited at the Fed, which might encourage them to lend a little more in the repo market instead.

It is unclear how quickly balance-sheet expansion might be resumed.

This week’s events suggest it may be soon. As Mr Powell said after the Fed’s meeting, “I think we’ll learn quite a lot in the next six weeks.”

US Military Options in Iran

By George Friedman

The United States has openly accused Iran of being behind the drone and cruise missile attacks on Saudi Arabia’s largest oil refinery. Now the question is what the United States will do in response.

The U.S. is in a difficult position. The attacks did not directly affect the U.S., save for the spike in oil prices, which actually helps the American oil industry. There is a temptation to let the attacks slip into history.

But the United States has formed an anti-Iran alliance in which Saudi Arabia is a key (though weak) player. Saudi Arabia is under internal pressure from members of the royal family who oppose Crown Prince Mohammed bin Salman, and low oil prices have undermined the kingdom’s political cohesion. Doing nothing would call the U.S.-sponsored coalition into question.

Saudi Arabia is an important player in the Sunni Arab world – and that world is the main threat to Iranian expansion. Failing to respond to an Iranian attack on a vital Saudi facility could help Iran increase its power throughout the region. During Donald Trump’s presidency, the United States’ inclination has been to avoid initiating direct military action in favor of applying economic pressure instead. He has maneuvered to minimize and halt active military engagement. Military action against Iran, therefore, would both endanger the alliance structure and cut against U.S. strategy.

An alternative option would be to introduce new sanctions, but there are two problems with this move. First, sanctions do not have the psychological impact military action does. The psychological impact would be on both Iran and the Sunni world, and the logic of the situation requires it. Second, the U.S. has already imposed painful sanctions on Iran’s economy. Any further sanctions would have limited effect and insufficient heft.

There is one military option that would have a severe economic shock but would also limit U.S. exposure: imposing a blockade on Iranian ports, with a selective closure of the Strait of Hormuz. This strategy has three weaknesses. First, a large naval force of multiple carrier battle groups would have to be deployed for a potentially unlimited time.

Second, the fleet could come under attack from Iranian missiles, and while we would assume that U.S. naval vessels have effective anti-missile capabilities, any mistake could cost the U.S. a major vessel. To counter this, anti-missile air attacks as well as defensive measures would be needed, creating a second potentially costly dimension to this operation. Finally, such a blockade is by definition without a terminal point. If Iran does not fold under the pressure, the blockade could continue indefinitely, since ending it without a successful outcome would be seen as a defeat.

Another possible response would be to launch strikes against Iranian targets. The most appropriate target would be the factories producing drones and cruise missiles, along with storage facilities and so on. Here, the problem is getting accurate intelligence. The U.S. has undoubtedly been cataloging such things, but acting on poor information could result in an Iranian strike on U.S. forces or another sensitive site under informal American protection. This would only compound the problem of the Iranian attacks on the Saudi refinery.

The difficult question the U.S. faces is whether it should take an action so painful that it will block any further actions from Iran. If a blockade doesn’t shatter Iran’s economy, then escalation to eliminate its offensive air capability is needed. As for an air campaign, history has shown that they tend to take much longer than expected and sometimes fail altogether, providing the adversary an opportunity to take offensive action on its own. A U.S. attempt to eliminate Iran’s strike capability can be costly, and hidden Iranian missiles can attack regional targets. As with a blockade, an air campaign can go on indefinitely. Small-scale retaliatory strikes open the door to Iranian countermoves and could escalate into an extended operation.

As for sending in ground troops, not only does that not quickly solve the problem of Iranian air power, but it also returns the U.S. to a posture it has been in since 2001: occupation warfare.

The U.S. military fully deployed can defeat the Iranian military and take terrain, but to hold it against a hostile militia would create interminable conflict with casualties that cannot be sustained. Iran is a big and rugged country, with a population of 82 million people, more than twice as large as Iraq or Afghanistan. And the idea that U.S. troops would be greeted as liberators is mere fantasy.

Apart from an air attack on Iran designed not to achieve a significant goal but rather to give the Saudis confidence in the U.S., the options for a direct attack are not promising. But there is another way to think about this problem. The United States has been concerned about Iran’s expanding political influence. But this creates potential targets that are of high value to Iran – and hitting these targets would be less daunting than an attack on Iran itself. Iran has its own or proxy forces in Iraq, Syria, Lebanon and Yemen. It has invested a great deal of time, resources and risk in creating these forces that are now holding territory in these countries.

Consider Lebanon, a place where Iran has been highly active since the 1980s through its proxy Hezbollah. If Hezbollah could be crippled, the political structure of Lebanon would shift out of Iran’s control, and Iran’s anchor on the Mediterranean would be gone. Such an operation could not be left to the Israelis partly because their force is much smaller than what the U.S. could bring to bear, and also because collaboration between U.S. and Israeli forces would put the U.S.’ Sunni allies in a difficult position. Such a response would directly hurt Iran’s interests but could be carried out at lower risk and at higher cost than other options.

Indeed, the very threat of an attack on Hezbollah might cause the Iranians to change their strategy. Of course, an attack there might also unleash a torrent of missile strikes from Iran, and that is the downside of this and all the other strategies. But the advantage is that where other strategies would likely fail to achieve their goals, an attack on Hezbollah might well succeed. It would be something Iran would not want to see and would be carried out by secure U.S. forces. Alternatively, the U.S. could attack Iranian forces in Syria, but that would have a lower impact.

This is a theoretical exercise; answering Iran’s attacks with an air campaign on a proxy power is unlikely. The Saudis would have trouble portraying it as U.S. commitment to Saudi security.

Attacks in Syria, Iraq and Yemen would all suffer from a lack of clarity and from the fact that Iran itself would not be hit. There is the possibility that the Saudi air force could retaliate, but its ability to sustain losses and conduct an extended air campaign is doubtful. The Saudis could fire missiles at Iran, but that would begin an open-ended exchange, and the U.S. strategy has to be to hurt Iran in a mission with closure.

The Iranians know the dilemma they have posed the United States. They have bet that the risks are too high for the United States to respond. But the problem in Iran’s thinking is it can’t be sure the degree to which the U.S. sees Iranian expansion as a threat to U.S. long-term interests in the region. So the Iranians are asking the U.S.: Are you feeling lucky?

There would appear to be no good military options. Doing nothing could well destroy the anti-Iran bloc the U.S. has worked hard to create. The likely but not certain answer to this problem will be a symbolic retaliation. The problem with retaliations, however, is that they get out of hand.

A Better Way to Solve China’s Debt Problem

By Nathaniel Taplin

China tweaked its dysfunctional interest-rate system in late August, but held off on the deeper reforms needed to solve its bad-debt problem. Investors hoping for more radical change could be in for a long wait.

One reason is that fundamental reforms risk seriously damaging already-shaky bank balance sheets—and at a point when Beijing’s drive to replenish bank capital in the markets is under threat.

August’s rate “reform” was mostly an acknowledgment of changes that have already taken place. China’s central bank is phasing out its old benchmark lending rate, which banks were supposed to use as a basis price for loans, and replacing it with a “loan prime rate” derived from bank quotes. But the old benchmark had in effect been abandoned already. The People’s Bank of China hasn’t adjusted it since 2015, and banks are free to lend far above it. Weighted average lending rates midyear were 5.66%, compared with a benchmark of 4.35%.

To conduct monetary policy since 2015, the central bank has instead relied primarily on tweaks to banks’ reserve-requirement ratios and on special lending facilities. Loan prime rate quotes are now supposed to be based on the most important of these: the PBOC’s medium-term lending facility, which sported an outstanding balance of 3.4 trillion yuan ($476 billion) in August, up from zero in mid-2014. That huge balance means banks’ funding costs, and the rates at which they lend, already depend significantly on MLF rates. The new prime rate simply formalizes this.

The real problem for China isn’t bank lending rates, which have been more or less liberalized for years, but deposit rates. Banks can’t freely raise these to compete for deposits without running afoul of central bank guidance. That means regional banks that dominate small business lending struggle to attract funds, because retail depositors perceive them as less safe than bigger peers.

Banks are free to lend at interest rates far above the PBOC’s old benchmark. Photo: jason lee/Reuters

Cheap deposit funding instead flows to bigger banks, giving them little incentive to lend to private-sector borrowers. They can earn nearly risk-free money by funneling funds to inefficient state-owned companies. These can’t afford higher rates but are also highly unlikely to go bust.

Fully freeing up deposit rates would help solve both problems. Private enterprise would get a boost, and so would small banks that otherwise have to rely for funding on risky high-interest wealth-management products, “structured deposits” or other dubious workarounds.

Unfortunately, this reform would also mean that a lot of infrastructure and other state-owned loans made at too-low rates couldn’t be refinanced and would have to be written down, damaging bank capital. And banks might struggle to recapitalize themselves by selling equity-like perpetual and convertible bonds, as Beijing would like, because of problems at small lenders like Bank of Jinzhouand Baoshang Bank.

Uncertainty regarding creditor payouts after Baoshang Bank’s takeover by regulators this summer caused a brief panic in China’s money markets in June. On Sunday, Bank of Jinzhou announced it was withholding a year’s worth of interest payments on “contingent convertible” dollar bonds. Future buyers of such bonds may require significantly higher rates, if they are interested at all.

China needs deeper interest-rate reforms to win its continuing battle against bad debt and wasteful investment, but it also needs a lot more bank capital. Until the state steps in more forcefully to deal with the problem, aggressive—and much-needed—reforms to the way banks lend will probably remain on hold.

Brexit Purgatory and the German Economy


By Ryan Bridges


The Question of Trade





Why Germany Is Holding Fast





The Political Calculus





The Benefits of a Progressive Consumption Tax

Many economists already favor a consumption-based tax system for raising revenue on grounds of efficiency and simplicity. In an environment where wealth inequality is rising inexorably, the case for doing so has become increasingly compelling.

Kenneth Rogoff

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CAMBRIDGE – Is it time for the United States to consider switching from income tax to a progressive consumption tax as a way of addressing growing wealth inequality? Many economists have long favored a consumption-based tax system for raising revenue on the grounds of efficiency and simplicity. However, despite occasional vocal adherents, it has never gained political traction. Is it time to think again?

One of the main objections is that switching systems would require a potentially complex transition to avoid penalizing existing wealth holders, who would be taxed when they try to spend accumulated savings on which they had already paid income taxes. Yet, in an environment where wealth inequality is rising inexorably, that drawback may be a virtue. Moreover, a great strength of a consumption tax system is that it does not tax saving, and also gives firms more incentive to invest.

Certainly, there are other, more straightforward ideas for tackling wealth inequality. US Senator Elizabeth Warren has proposed an ultra-millionaire tax on the 75,000 wealthiest American households, which would amount to a 2% annual wealth tax for those with more than $50 million, rising to 3% for billionaires. Warren’s bold proposal has set off an intense debate among economists on just how much revenue it would bring in. Emmanuel Saez and Gabriel Zucman of the University of California, Berkeley – heavy hitters in the inequality literature – have endorsed Warren’s plan, estimating that it would raise nearly $3 trillion over ten years. A number of prominent ultra-rich are also on board.

But Harvard’s Lawrence Summers – a former US Treasury Secretary and a towering figure in public finance – has argued that such estimates are wildly optimistic. Summers and his co-author, University of Pennsylvania law professor Natasha Sarin, have suggested that a better path to the same end would be to implement a broad range of more conventional fixes, including an increase in the corporate-tax rate and eliminating ultra-wealthy families’ ability to avoid capital-gains taxes through bequests.

The debate is ongoing. However compelling the moral case for a wealth tax may be, it has historically proven difficult to garner large revenues from it. But Saez and Zucman have held their ground, arguing that much depends on the resources the US Internal Revenue Service is given to implement the tax. Regardless, both sides agree on the objective, and the general direction of the debate foreshadows what to expect if a progressive like Warren wins the US presidency.

I am not unsympathetic to Warren’s plan, nor to the Summers-Sarin approach, but both are complex to implement. Why not target the same aims with a better system that enjoys broader support and will therefore prove more enduring?

Back in the mid-1980s, Stanford University’s Robert Hall and Alvin Rabushka advocated what was essentially a twist on a value-added tax (VAT) that segregated wage income and allowed for greater progressivity (even more so in a refinement proposed by Princeton University’s David Bradford in his “X-tax”). A consumption tax (which is not a sales tax, but rather uses similar information to that required by the existing tax system) is simple and elegant, and could save a couple hundred billion dollars a year in deadweight accounting costs. Importantly, these plans contain a large exclusion so that lower-income families pay no tax at all.

But instead of using an exclusion for low-income households, the system can achieve progressivity by providing a large lump-sum transfer (as in a universal basic income), as suggested by leading Portuguese macroeconomist Isabel Correia, who estimates that her plan would result in both higher growth and greater income equality than under the current tax system. Correia’s analysis focuses on the long run, but with a transition suitably designed to protect small family businesses, it should be possible to ensure short-run gains as well.

Of course, in terms of fairness, much depends on how large the transfers and exemptions are, and how low the tax rate is set. Until now, it has mostly been a smattering of Republicans who have favored switching to progressive consumption taxes (though a variant was championed by the liberal icon Bill Bradley, a former US senator from New Jersey). Ironically, one reason the idea has not received broader Republican support is conservatives’ recognition that a consumption tax would be so efficient that the government could too easily raise funds to expand social programs.

Many on the left, meanwhile, respond to the idea in knee-jerk fashion, believing that a consumption tax must somehow be regressive because sales taxes are regressive. They fail to understand that a progressive sales tax can be implemented entirely differently.

Of course, any large change in federal taxation has complex effects, including from its interaction with state and local tax systems. And the US Congress probably has an innate bias in favor of a complex tax system with lots of loopholes and exemptions, giving members leverage over potential donors. But that is all the more reason to jump at the opportunity to clean up the system and help mitigate wealth inequality at the same time.
