Are Central Banks Storing Up a Future Fiscal Problem?

In the past week, I’ve come across two different pieces (one by the BIS and one by the UK’s Office for Budget Responsibility) warning that the maturity of public debt in advanced economies has been shortening and this could have fiscal implications during a recovery.

This warning might seem surprising since the Covid crisis and the low long-term interest rates of recent years have seen governments issue lots of long-term debt. Indeed, conventional measures of average public debt maturity are increasing. In the euro area, the average maturity of public debt has increased from about six years a decade ago to about 8 years now.  In the UK, the average debt maturity is a whopping 15 years.

DebtMaturity

So what are the BIS and OBR talking about? They come up with different numbers by calculating an average maturity that includes reserve balances held by commercial banks at central banks. These reserve balances are generally compensated by central banks using their short-term policy rate and BIS and OBR are treating them as overnight debt when doing their average maturity calculations.

The BIS say about central bank asset purchases

Considering the consolidated public sector balance sheet, these operations retire long-term government debt from the market and replace it with overnight debt – interest bearing central bank reserves. Indeed, despite the general tendency for governments to issue at longer maturities, central bank purchases have shortened the effective maturity of public debt. Where central banks have used such purchases more extensively, some 15–45% of public debt in the large AE jurisdictions is in effect overnight.

Similarly, the OBR’s calculations show the median maturity of UK debt falls from 11 years to 4 years if you include reserve balances as an overnight liability. As an aside, I’m not sure median maturity is particularly interesting. If half my debt is due in 2 years, then that’s the median maturity. But it does matter whether the other half is due in 3 years or 100 years. I suspect median maturity has been chosen here for dramatic effect.

There are two reasons to worry about a shortening maturity for government debt. First, short maturities raise the probability of some kind of funding crisis. If the debt is all due relatively soon and investors decide not to roll over their funding, then there could be a debt crisis requiring a sovereign default and\or a large fiscal adjustment.

Second, and less dramatically, if the economy recovers and central banks raise interest rates, then the short-term debt will re-price at these higher interest rates and raise interest costs for the government.

Should we be worried? I don’t think so.

Rollover Concerns

I’ve always been uncomfortable with the labelling of central bank reserves as liabilities. Yes, in recent years, central banks have chosen to pay interest on them but they get to choose that interest rate and it can be zero if they want it to be. These are not debts that look like a normal person’s debts. But whatever about the labelling, I don’t think you can legitimately include central bank reserves in an average maturity calculation designed to measure potential debt rollover pressures.

These reserves are created by central banks to pay for asset purchases and there is nothing the banking system can do to get rid of them. An individual bank might be unhappy with having so much on reserve with the central bank but if they try to get rid of them by buying a security or extending a loan, their reserves just end up with another bank. As Ben Bernanke said, they’re like a hot potato.

Given this, there is no direct comparison between a sovereign bond maturing and an overnight reserve balance “maturing”.  The owner of the maturing sovereign bond has to be paid and the money must be found from somewhere to pay it off – either the government’s existing cash balances or via new borrowing. In contrast, the banking system cannot demand that its reserves be “paid up.”  In any case, the reserves already essentially are money and they can be turned into cash on demand.

So the risk of funding crises for most advanced economies is minimal and the real story of recent years is that governments around the world, but particularly in the UK, have locked in lots of very long-term low-interest debt.

Rising Interest Costs

This is, on the face of it, a more legitimate concern. Central banks used to raise interest rates by generating an artificial shortage of reserve balances, thus increasing the market interest rate paid to borrow these balances. In an age where reserves are in huge excess supply, this method doesn’t work anymore. Instead, central banks raise market interest rates by increasing the interest rate they pay on reserve balances to commercial banks and this rate then acts as a floor on market rates.

If central banks end up paying high interest rates on their reserve balances while holding a portfolio of long-term fixed rate bonds, then in theory, the central bank could start to make losses as interest paid exceeds interest earned. This could reduce their remittances back to central government and thus have fiscal effects. Taken to an extreme, there could be a scenario where there needs to be payments in the other direction because the central bank has so little money left it can’t fulfil its interest on reserves policy.

Thankfully, there is no need to worry about this stuff. Crucially, we know now that central banks can affect market interest rates without compensating all reserve balances. The Bank of Japan and the ECB operate a tiering system in which the interest rate on reserve balances is zero up until a bank’s reserves reach a certain level and then an interest rate is applied on those remaining balances. This keeps the marginal cost of funds in the economy at the policy rate while detaching the policy rate from the average cost of remunerating reserves.  Currently, these central banks have a negative policy rate but tiering could be operated in future to raise interest rates without having much impact on the central bank’s profits.

Even if central banks decided to continue paying the policy rate on all reserve balances, there are reasons not to be too concerned. While reduced central bank profits during a monetary tightening are possible, outright losses are less likely. A 2015 Federal Reserve study simulated a sharp monetary tightening and concluded there may need to be a few years when the Fed reduced remittances to the Treasury to zero but the overall impact was relatively small. There are also other assets held by central banks that will provide an increased return as interest rates rise. For example, the interest payments on reserves created by the Eurosystem to make loans to banks are always more than offset by the higher interest payments charged on these loans.

So you could argue that technically neither the BIS or OBR are outright wrong about the maturity of “consolidated public liabilities” but there are good reasons to not be concerned about the points they raise. And claims about “ticking debt bombs” from the usual austerity cheerleaders should be taken with a massive dollop of salt.

Thoughts on Online Education

I see that many UK universities are announcing they are staying mainly online for 2021-22, with only small group teaching happening in person. I am not going to judge whether this is the right policy for the upcoming year because public health is not my area of expertise. However, Manchester University have announced that this is a permanent change and I suspect many others are considering this option.

Personally, I think making decisions now to permanently get rid of in-person lectures would be a mistake, both on the substance of the issue and on the timing and processes for making a decision of this sort. A few thoughts below.

Educational Substance

I have been teaching online since March 2020 and have worked hard at it. After a period recording lectures without anyone listening live, I settled on an approach of teaching online at the time of my scheduled timetabled slots and also recording the lecture. Despite my initial fears, I think this has worked reasonably well and feedback I received from students has generally been positive and kind.

The positive feedback for this format reflects both the live element and the recorded element. For some students, it is very important to be able to participate in their lectures in a structured timetabled way and also to be able to interact with a lecturer during a live session. My undergraduate classes have large class sizes and I will admit that I get more questions online – via the chat box – then I ever did when I taught live. Asking questions in front of many class mates is intimidating for most people but typing a question into a chat box is not – the question can also be sent just to the lecturer, giving the student complete privacy.

For other students, the access to recordings of the lectures is hugely positive. Students have told me it’s great that they can pause and rewind the lectures, particularly when they are covering something technical and how they can listen to lectures while they are on a walk, if it is less technical.

But there are important downsides to not having in-person lectures. In online lectures, students do not turn their cameras on and it is difficult to insist that they do. This means lecturers cannot see whether they are being understood. Manchester University have “pledged to continue in-person teaching for lectures with an “interactive” element, such as question and answer sessions.”  But all live teaching is interactive. When my students are in front of me, I can see how they are responding to what I am saying. I can see how many look a bit puzzled, I can tell if they are smiling at my bad jokes or if they are paying attention to a bit that I signal is very important. Chat box questions are fine but they are not a substitute for a lecturer’s ability to “read the room”.

Another important interaction that is lost is the ability to come up in person after class to talk to a lecturer. I run online office hours and have been pleased with the number of students that have used them. Indeed, I plan to retain this option when in-person classes return. But students are more likely to use the online hours to go over a number of issues on the course rather than the traditional quick exchange after class to clarify what we have just discussed or to perhaps ask about something related to their degree or something that is tangentially related to the course material.

Finally, it is important for students to be learning around other students and to have the time and space to talk about what they are learning after lectures. Universities can try to encourage online study groups but there is no good substitute for meeting the other people on your course and talking with them about how they are getting on.

For these reasons, I strongly hope that my university returns to in-person lectures as soon as it is safe to do so. Based on communications from our President, I fully expect this to happen.

Are there things that we have learned from teaching online? Yes. When I return to live teaching, I plan to record the lectures.  Currently, I’m thinking of teaching live both in-person and on Zoom using a laptop brought to lectures.  This would allow students to either attend in person or listen live at home or listen to a recording. Students that attend live could still use a chat box via phone or laptop to ask questions. This retains the advantages of online teaching while bringing back the benefits of live teaching.

Some lecturers will be uncomfortable with this approach because of the technology demands it places on them (I’m pretty good with tech but I don’t know if I can actually pull it off). Others will argue that learning in person is the “gold standard” and making lectures available online will reduce class attendance and damage educational standards.

I’m not so sure. My courses are popular but attendance at lectures has always been pretty spotty. Whether lecturers like it or not, students are not always in a position to attend every lecture, whether it be because they get sick, or have to work a part-time job to support themselves or perhaps have a long commute because housing costs in their university’s location are prohibitively expensive. Making recordings available would benefit these students but it can also benefit the students who actually attended class. When students are revising for exams or writing an assignment and think “what did the lecturer say about that in class again?” with recordings they can go back and listen.

I have also switched to having weekly online MCQ quizzes to replace an MCQ midterm exam and I have decided to keep this since it seemed to work better at keeping students engaged and the feedback I received from students was also positive.

So we have much to benefit from by using technology but that doesn’t mean we should scrap in-person lectures.

A Difficult Sell

You can see from the above that I am not wholly negative about online teaching and my experience is that for some students, the positive have actually outweighed the negatives. But universities need to understand that the majority of students want to at least have the option to attend lectures in person and that going into college to learn and meet other students is a crucial part of the university experience.

And as can seen from the initial response to Manchester’s announcement, students and their parents will respond to the removal of in-person lecturers with the demand to reduce fees: If you provide us with an inferior service, then we’re not willing to pay you as much.  This puts universities in a difficult situation because it is not cheaper to deliver online education than in-person teaching. You still need to pay the lecturers and they actually spend more time on things like recording lectures or designing new assessments that work online than they did in the past when you could just show up to teach in person and set an exam to be taken in an exam hall.  Expenditures on tech support and cloud storage also likely go up.

Longer term, there may be savings from having fewer staff and students on campus but for now those cost savings are likely to be small. Moreover, any move to downgrade the importance of in-person teaching in UK universities would be ironic since the additional income that came with the £9,000 annual fees and the race for high fees from international students had lead to a boom in capital spending on campuses as universities competed with each other on the basis of the quality of on-campus life as well as educational quality. De-emphasising the campus experience will be a very difficult sell.

Timing and Process

The issues around how to combine technologies and in-person teaching are complex and there are many lessons to take from our recent experiences. I have listed some above but I’m sure there are lots of aspects that I haven’t considered or that affect subjects that I don’t teach.

To my mind, now is not the time for universities to be taking decisions to permanently change their approach to teaching. Universities should instead instigate processes of consulting with staff and students about what they like and dislike about the online approach and then focus on how much of the good new stuff we can keep while retaining as much of the good old stuff as we can. Where trade-offs emerge, they should be carefully weighed up. If this process takes a few years, then so be it.

There is also a deeper issue. Students that have signed up for a degree based on in-person lectures should not be told in the middle of this degree that those lectures are being discontinued.  How many would have chosen to attend the university if they had known the experience was going to be radically different from what was advertised? Purely on the grounds of fairness and avoidance of reputational damage, I would recommend that any university considering this move should wait until the graduation of the final student cohort that was advertised a degree with in-person lectures.

Presentation on “Do Central Banks Control the Price Level?”

A few weeks ago, I was invited to speak on “Do Central Banks Control the Price Level?” by the Forum for Macroeconomics and Macroeconomic Policies (FMM) at their annual conference. The panel also included Frances Coppola and Scott Fullwiler.

My presentation is here and you can find video of the session here. I went last, starting at 56 minutes.

 

Presentation on ECB: Monetary Financing, Helicopter Money etc.

PublicPolicy.ie held its second online conference today on “Ireland’s COVID19 Crisis Response: Perspectives from Social Science.”   I gave a talk on a panel titled “EU Dimensions of a Policy Response”.  I mainly discussed the role of the ECB, covering some of more extreme potential measures it could take. I discuss monetary financing, helicopter money and the idea of the Eurosystem selling all its gold and returning the money to governments.

Here are the slides. The video is here.

Brexit: One Clarification and One Concession the EU Could Offer the UK

After a chaotic two months in British politics and with little time remaining before the UK is set to leave the EU, its parliament has now requested the EU replace the crucial backstop protocol in the Brexit withdrawal agreement with some other set of unspecified “alternative arrangements.”  The Prime Minister reversing course on the deal she agreed after two years of intensive negotiations was never likely to go down well with the EU27 and the immediate negative response from Donald Tusk suggests there will be no re-opening of negotiations.

Simply ignoring this latest request may work out for the EU. After a few more weeks without progress, enough MPs may finally decide that the impending chaos of no deal is worse than the deal Theresa May agreed to in November and which is still on the table. The UK could end up signing up to the November agreement, though this would be seen as a humiliating outcome for many of the politicians who enthusiastically voted for last night’s “Brady amendment”.

There are a number of reasons, however, why the EU, and particularly Ireland, should be wary of pursuing this strategy and I suggest they should consider an alternative route involving a clarification and a concession on the backstop.

The reasons to be wary?

First, without further negotiations or concessions, it is possible that the UK parliament may end up delivering a no-deal outcome that very few profess to want. In the absence of a deal that can pass the House of Commons, even after a potential delay of the Article 50 process, the no-deal crash out becomes the default option and odds on it continue to rise. The Brady vote has probably entrenched some Conservative MPs into a position they will find difficult to give up without some movement from the EU. It may make no economic sense whatsoever for the UK to exit without a deal but Brexit has never made economic sense and its most intense advocates are growing ever more determined to leave at almost any cost. The EU member state that would be most damaged by this outcome would be Ireland.

Second, the strategy of providing no response at all to the Brady vote could poison EU\UK relations and their North\South equivalent in Ireland for many years even if the November agreement is eventually passed. Many in the UK will feel, rightly or wrongly, that they were bullied into the agreement by the EU without appropriate considerations for the perceived problems associated with the backstop. In Northern Ireland, the DUP will claim the backstop was imposed by the EU against the preferences of a majority of the House of Commons. Unionist objections about a lack of democratic legitimacy of the backstop, in which Northern Ireland remains subject to EU regulations and customs rules but has no say in deciding those rules, will continue to be a cause of discontent for many years.

So what could the EU do to respond to last night’s vote?

A Clarification

Firstly, the EU could clarify that it has no objections to the UK leaving the joint customs union with the EU after the transition period, provided Northern Ireland remains within the EU’s customs union and aligned on goods regulations.

Brexit wonks could argue that this clarification shouldn’t really be necessary since this is the original version of the backstop that the EU offered, so it should be clear they are willing to still offer this. The all-UK backstop was a hard-won concession to the UK.  It reduced the amount of trade disruption to be experienced over the medium-term by the UK while it was still negotiating trade deals with the EU and the rest of the world, and it prevented the need for customs checks on goods going from Great Britain to Northern Ireland.

Still, the nature of the all-UK version of the backstop does not seem to have been well understood in Westminster, partly because Theresa May never spent any time explaining its benefits. Instead, among Brexiters, it has become widely held that this all-UK backstop is an attempt to “trap” the UK permanently within EU structures and hamper it from successfully negotiating its own trade deals.

A simple clarification from the EU on this issue, to be added to the political declaration, could help to resolve this unnecessary confusion about the all-UK backstop.

A Concession

That still leaves the question of the Northern Ireland element of the backstop. Theresa May probably did not devote much political capital to selling the fact that Great Britain could move out of the backstop without difficulty provided Northern Ireland remained in it because she was determined to keep the DUP on board and they would not have been pleased with this being sold as a positive feature. As it is, in addition to losing many Tory colleagues who disliked the all-UK backstop, May also failed to get the DUP to support her November agreement and has now acceded to their request that she ask the EU to modify the backstop.

So what can be done? The motivations of the EU and Irish government for the backstop proposal are well known and there are severe limits on how much they can move. Moreover, the nebulous mooted “alternative arrangements” to the backstop mentioned in the Brady amendment don’t present a useful basis for current discussions.

However, the EU could do the following: Use the political declaration to offer the citizens of Northern Ireland a referendum on whether to remain within the EU’s customs union and single market five years after the beginning of the operation of a Northern-Ireland-only backstop.  This referendum could be repeated at perhaps ten-year intervals thereafter.  Should a referendum show the people of Northern Ireland wanted to exit the backstop, the EU would agree jointly with the UK to end this arrangement.

I have proposed the idea of a referendum within Northern Ireland before, back in November 2017.  I still think an approach of that sort should have been considered and polling suggests the backstop would have received majority support. It is too late now to consider a referendum of this sort prior to the UK exiting the EU. However, a promise to hold a referendum five years after the end of the transition period would provide a clear concession to those who believe the backstop arrangements would be harmful to Northern Ireland by offering them a chance to convince their fellow citizens to end the arrangements after a period.

This proposal would also give the citizens of Northern Ireland a number of years to experience “life in the backstop” and to consider the benefits and costs associated with it before making their own decision about whether to continue with this arrangement.  I have detailed previously how the backstop would probably provide some important benefits for the Northern Ireland economy and that the perceived intra-UK frictions associated with it are likely to cause only minor difficulties compared with the far larger problems associated with a hard intra-Irish border. The costs and benefits of being excluded from future UK trade deals may also become more apparent. I suspect it may turn out that Northern Ireland consumers and farmers won’t actually be too concerned about missing out on the chlorinated chicken and hormone-injected beef brought about by trade deals with the United States or South American countries.

The Irish government and EU could also offer to work to address concerns about the “democratic deficit” associated with the backstop. It may be possible for Northern Ireland to have non-voting members of the European Parliament or for the Irish delegation of MEPs to include a couple of delegates elected via votes from those in Northern Ireland. The EU could regularly hold workshops and listening tours in relation to upcoming regulatory changes that could affect Northern Ireland as long as it remains in the backstop.

Another benefit of this proposal is that it would allow at least seven years for the UK and Irish governments to explore more fully the options for “smart border” technologies which have been widely promoted by some and heavily doubted by others. A well-funded joint project by the EU and UK on the possibilities available could be prepared to provide concrete information to Northern Ireland’s voters on the way the border would operate should they ever choose to leave the backstop. My guess is that no matter how smart the technologies, a hard border of some sort would be required if the backstop is removed but this proposal would give Ireland and the EU at least seven years to prepare for this potential outcome.

The danger of this approach from the perspective of the Irish government is that it may only kick the can of a hard border down the road by seven years or more. But it may also help to avert a no-deal Brexit and provide invaluable time to prepare Irish firms for potential future arrangements. One could also argue that if the backstop arrangements cannot receive majority support in Northern Ireland over time, then they are probably not politically sustainable anyway.

Would This Be Enough to Get the Deal Through the UK Parliament?

Would these clarifications and concessions be enough to avert a hard Brexit? It’s hard to know but a final attempt at outreach could at least convince some MPs that the EU and Ireland have listened and addressed their concerns about the UK’s ability to conduct future trade deals and the democratic legitimacy of the backstop for Northern Ireland.

I suspect the DUP will not accept a proposal of the sort outlined here but these ideas may be enough to convince sufficient numbers of Tory waverers and Labour leavers that the deal on the table represents a better outcome than no deal. In addition to helping pass the withdrawal agreement, a final effort of this sort from Ireland and the EU could hopefully also set a tone for a more co-operative future relationship with the UK.

The UK’s £39 Billion Brexit Bill

A few points on the £39 billion payment which the UK government has agreed to pay the EU as part of the withdrawal agreement.

This payment is regularly raised by Brexiters as a key negotiating issue. It is often claimed the £39 billion saved by refusing to make this payment will allow the UK to spent lots of money on important priorities e.g. Priti Patel sayswe would also not need to hand £39 billion over to the EU, giving the Government resources to support economic growth, job creation and new trade opportunities.” It is also claimed the EU are very scared the payment won’t be made and will thus make last concessions to secure the money e.g. Daniel Moylan at BrexitCentral reckonsIt is possible that the EU could give in, agreeing the wholesale removal of the Irish backstop from the text in exchange for the money on which they have so desperately counted.”

The reality, however, is that both sides of this argument – the benefit to the UK and the costs to the EU – tend to be wildly over-stated by Brexiteers. Here is a useful table from a House of Commons Library explainer on the topic, breaking down the different elements of the £39 billion.

BrexitBill

The table shows that the £38.7 billion bill includes £16.3 billion in contributions to the EU’s multi-annual budget during the transition period. During this period, the UK will continue to receive funding from EU programmes.The House of Commons Library report estimates the UK will receive about £8 billion of this funding back during 2019-20 in the form of payments to farmers, structural funds and funding for research (see page 8). These payments would not occur if there is no deal. This means the financial “benefit” to walking away from the withdrawal agreement would really be £31 billion, albeit at a cost of the UK being seen to have reneged on financial commitments it made to its EU partners.

Second, this net payment of £31 billion would be spread over time.  Scrapping the additional net contributions to the EU budget would amount to saving of £4 billion per year this year and next.  The rest of the payment is spread over time, with the bulk of it, £19.8 billion, being paid over 2021-28 and a smaller amount of £2.6 billion being paid over 2021-64. That works out to be a benefit of £2.5 billion per year over 2021-28 and £56 million per year thereafter until 2064.

How much will the UK government be able to do with this money? UK GDP was £2 trillion pounds in 2017. A trillion is one thousand billion, meaning the £4 billion savings this year and next would be one fifth of one percent of UK GDP and the £2.5 billion per year savings over 2021-28 would be about one eighth of one percent of UK GDP.

So while £39 billion may seem like a huge figure when quoted without context, the reality is that this will do very little to boost the spending power of the UK government. In fact, these numbers are well below the kinds of figure by which UK budgets often overshoot or undershoot doing to various random events without anyone paying much attention e.g. the OBR’s March 2017 forecast of the budget deficit over 2017/18 was £17 billion too high (see page 35). The dividend from not paying the Brexit bill will effectively be rounding error in the public finances.

And what about the EU27? The £2.5 billion net payment per year the EU would be losing over 2021-28 equates to €2.8 billion euro per year. EU27 GDP is estimated to be €14.538 trillion last year. That’s €14,538 billion. So this loss would equate to 0.02 percent of EU27 GDP per year for eight years. That’s one fiftieth of one percent of GDP. The idea that this tiny amount is being “desperately counted on” by the EU is laughable and anyone relying on the EU to fold because the UK won’t pay its “Brexit bill” will be sorely disappointed.

The bottom line on this issue is that, viewed from a macroeconomic perspective, the Brexit bill figures are tiny and people really should not believe that this bill represents an important part of the costs or benefits of Brexit for either the UK or the EU.

There is a wider issue here in relation to explaining macroeconomic issues to the public. Any figure larger than a few million seems to ordinary people to be “a lot of money”. So “£350 million pounds per week for the NHS” or “£39 billion to spend on whatever we want” seem like huge windfalls to a large fraction of the public who, let’s be fair, can’t be expected to know the actual totals for GDP or public expenditure. It’s thus important for those contributing to public debate to put raw macroeconomic numbers in an appropriate context.

Briefing Paper and Presentation on Growth in Europe

I spent November 2018 in Sydney visiting the University of Sydney.  While there, I competed my latest briefing paper for the European Parliament’s ECON committee “Monetary Policy in an Era of Low Average Growth Rates“.  I also gave a seminar on the related topic of The Euro Area’s Long-Term Growth Prospects: With and Without Structural Reforms.

Briefing Paper: Should central banks be concerned about virtual currencies?

My latest briefing paper for the European Parliament’s Economic and Monetary Affairs committee is titled “Should central banks be concerned about virtual currencies?”

This is part of a collection of papers delivered to the committee prior to their meeting on July 9 with ECB President Draghi. The papers can be found by clicking here and expanding on where it says “Monetary Dialogue – 9 July 2018″.