Lessons from the Past: 1953 and all that….


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Young Loan

Imagine a country that finds itself so heavily indebted that it cannot adequately repay its creditors. The debts were incurred by a previous government, and arguably in largely as a result of non-productive, profligate spending.  The country’s best efforts in trying to repay its debts first lead to a deep recession and great social unrest. This debt is renegotiated on more than two occasions and very significant haircuts applied, with the remaining debt to be paid over a longer period than before. A later government defaults entirely on the debt, but still manages to lead the country into deeper and deeper problems, eventually followed by dire catastrophe.

A mere eight years after the fall of the catastrophic government, the country has amassed even more debt, more than doubling the total abrogated. A syndicate of some thirty-one creditors is formed to find a solution in good faith. A conference of all these creditors is called to decide how much is owed and how to handle the problem. Negotiations with a troika of lenders representing all creditors ensue and finally a satisfactory compromise is found. Altogether the process takes almost two years.

That compromise involves reducing the amount of the debt by about 50%, making it payable over up to 30 years with reduced interest rates and a grace period of five years over which no principal will be repaid. Last but not least the indebted country, which has been treated as an equal partner throughout the negotiations, need not pay if it cannot pay: it will only pay up to 3% of its export revenues in any year.  If the country feels that it cannot repay even that, it can have recourse to arbitration.

If this sounds like a description of how Greece got into a mess of debt, and a prescription of how that mess could be cleaned up, so be it. In fact it is a description of how one of the worst serial defaulters of sovereign nations in the 20th century was treated, a nation that had one of the worst inflation records of that century, that changed its currency on a number of occasions, and a nation whose record of international cooperation was quite simply cataclysmic. With the help of the agreement with the troika, it went on to put its house in order, becoming one of the most successful countries on earth.  This is the story of Germany, its debt, and how the troika that it negotiated with wiped the slate; or at least a large part of the slate.

It is easy with hindsight to think that the negotiators in 1953 would safely assume that all would go well and that the problem had been solved. But this is far from obvious: in the words of a contemporaneous commentary, from H.J. Dernburg of the Federal Reserve Bank of New York, “It would require almost prophetic vision to answer the question whether or not the debt settlement plan will be successfully consummated over its lifetime of some forty years. ….. only time will tell whether the present debt settlement is of more than passing interest….. Essentially, its fate will depend on the ability and willingness of the present and future German governments to give the plan continued support”[1]

By the time negotiations started in London in 1953 we had reached the stage where, in the measured and laconic terms used in the preamble to the eventual agreement, “for about twenty years, payments on German external debts have not, in general, conformed to the contractual terms; that from 1939 to 1945 the existence of a state of war prevented any payments from being made with respect to many of such debts; that since 1945 such payments have been generally suspended; and that the Federal Republic of Germany desires to put an end to this situation.”  Those 67 words summarised a far more complicated situation. On more than two previous occasions between the wars conferences had been called to discuss or eventually restructure the German debt; initially Reparation debt.

The first restructuring took place under the Dawes plan in 1924, and essentially lengthened the repayment period significantly as well as providing an international 7% loan of $230 million (≈$3.1 billion 2015) to Germany. $110 million of that loan was syndicated in the US by Morgan Guaranty and was quickly oversubscribed[2],[3]. Germany could not keep up the payments and a second restructuring was secured under the Young plan of 1929-1930.  That plan reduced the amount outstanding by a haircut of 20% to US$ 100 billion (2015 dollars) and extended the repayment period to 59 years until 1988. A loan of $351 million (≈$4.9 billion 2015), bearing interest at 5½ percent, was issued to the public at 90[4]. $98,250,000 of bonds was issued in the US under the plan, also syndicated by Morgan Guaranty.[5] The Bank for International Settlements was created in Basel to handle the payments.

It is important to note that by 1929, Germany was eager and willing to come to some arrangement. In sharp contrast to the post-hyperinflation Dawes negotiations, “Germany was no longer in a state of collapse… She was eager for a new arrangement…. she wanted to face her obligations of every description as once more a wholly free and independent member of the family of nations.”[6]

The Young Committee’s restructuration plan had hardly been put in place when it once again became apparent that Germany could not or would not pay its debts: the global crash began in May 1931with the failure of the Creditanstalt, the largest Austrian bank. The global depression had set in and world trade had collapsed by the time US President Herbert Hoover secured the accord of 15 nations for a one-year moratorium in July 1931[7]. One year later, Belgium, France, Germany, Italy, Japan and the United Kingdom attempted one more time to restructure (or indeed forgive) Germany’s Reparation Debts[8]. Subject to concessions from the US, the countries agreed not to seek immediate payments from Germany and to reduce the remaining debt by a haircut of close to 90% to $713 million, but specifically preserved the rights of private bondholders under the Dawes and Young Loans. Overall German nominal reparation debts had been reduced by over 97%, though it is estimated that by 1933 Germany had repaid some 12% of its reparation debts (including interest)[9].

This left Germany with the Dawes and Young loans as the only remnants of its reparation debts left to repay, over a number of years.

However this only covers a part of the pre-WW2 German debts dealt with in the 1953 London Agreements, for between the wars, German public and private borrowers embarked on a massive borrowing spree, such that by 1932, the German share of total world debt was about 14%[10]. Almost 12 percent of all foreign loans issued in the United States between 1924 and 1929 went to German cities[11].

As the table below shows[12], the borrowers in US Dollars were heterogeneous in nature:

German Bonds

By the time that preparations were taking place for the London Conference of 1953, pre-war German debt (including Dawes and Young loans) were estimated to total $2.5 billion (1953 ≈ $22 billion 2015).

On 30th January 1933 Adolf Hitler was appointed Chancellor of Germany by Hindenburg, and the new regime wasted no time in abrogating payments on its debt. Rather than openly declare default, it “pursued a complicated policy motivated less by respect for the sanctity of debt than their need to maintain trade ties with their creditors.”[13] In March, in a speech to the American Chamber of Commerce in Berlin, the Reichsbank president Hjalmar Schacht had clearly and somewhat cynically telegraphed his ultimate intentions, saying “I believe one could name several South and Central American republics which defaulted three or four times, but have always been given credit again.”[14] On June 14th, 1933, he announced that from July 1, half of the debt service on any foreign denominated bonds would now be paid in special inconvertible scrip issued by the Reichsbank. In today’s  world of Credit Default Swaps, in which defaults are very precisely defined, this would undoubtedly be an event of default.

By 1934, Germany defaulted entirely on the Young and Dawes loans, though after pressure from London it once again started servicing the UK tranche only. By the time the war started, German debt service had largely ceased (though both private and public authorities had been repurchasing their bonds quietly on the open market (see Klug)).

We have already stated that the majority of the German extant debt under negotiations was incurred after 1945. Whereas pre-war debts totalled some $2.5 billion (1953 ≈ $22 billion 2015), debts incurred after 1945 were about $3.5 billion (1953 ≈ $30.5 billion 2015). The total under negotiation therefore amounts to about $52.5 billion 2015.

The German negotiating delegation was led by Hermann-Joseph Abs, and the 1953 troika consisted of France, the United Kingdom and the United States. Negotiations ran from 27th February to 8th August 1953, though the Agreement is dated 27th February[15]. It entered into force generally on the 16th September 1953.

Some of the details of the agreement follow:

The 7% Dawes Loan 1924

Interest was reduced to 5 ½ % on the US tranche and to 5% on all others. After March 1958, a sinking fund of the principal of 3% for the US tranche and of 2% for all others would be applied. Final maturity would be in 1969. Accumulated unpaid accrued interest to be recalculated at 5% and paid for with a 20-year German Government 3% bond with a 2% sinking fund after 5 years. Bonds for the accrued owed before 1944 to be issued in payment in 1953; that for monies owed and accumulating between 1944 and 1953 to be issued upon the reunification of Germany[16].

The 5 ½ % Young Loan 1930

A similar scheme as for the Dawes loan, but with 5% interest on the US tranche, 4 ½ % on others, a 1% sinking fund from after March 1958 on all tranches, and a final maturity of 1980. A 20-year 3% German Government bond with a 1% sinking fund after 5 years to cover accrued interest recalculated at 4 ½ %, with similar terms on accruals between 1944 and 1953[17].

Young loan bonds were to be repaid in the currency of origin, converted to US$ at the rate prevailing at the time of issue and then back into the currency of origin at the rate prevailing on 1st August 1952. A table[18] summarising the effects is below:

Toung Loan Reval-Deval 1929-1952

It goes without saying that the gold clause did not apply, although this was hotly argued during the negotiations. But there would be a further devil in the details popping up later as a result of clause (e)[19].

The 6 percent External (Match or Kreuger) Loan 1930

Interest reduced to 4%, sinking fund from March 1958 at 1 ¼ %, final maturity 1994, accrued recalculated at 4%, and otherwise treated the same as the Young loan.

New terms and conditions are applied to every class of every type of borrower, public and private, with the only anecdotally worthy item occurring with bonds of the State of Prussia (which had simply been abolished): the 16 years of accrued interest (from the end 1936 to March 1953) were deferred “until such time as the territories belonging to the State of Prussia and now outside the territory of the Federal Republic shall be joined to the Federal Republic, at which time payment shall be subject to negotiation”[20]. And the negotiators could not reach agreement on Austrian government debt, which was held over for further, separate negotiations[21].

We have already mentioned in the third paragraph of this note what were the overall terms of the Agreement. However interesting may be their details, of more importance then and now were the structure, principles and atmosphere surrounding both the preparations and the negotiations themselves.

The Conference on German External Debt which drew up the guidelines and principles upon which the Agreement negotiations were based stated in its final report that “The Conference recognised the principle that the trans­fer of payments under the Settlement Plan implies the development and maintenance of a balance of payments situation in which those payments, like other payments for current transactions, can be financed by foreign ex­change receipts from visible and invisible transactions so that more than a temporary drawing on monetary re­serves is avoided. …. It recommends that due account should be taken by all concerned of the principles referred to in this paragraph. Transfers of interest and amortisation payments due under the Settlement Plan should be treated as payments for current transactions and, where appropriate, included in any arrangements relating to trade and / or payments between the Federal Republic and any of the creditor countries, regardless of whether such agreements are of a bilateral or multilateral nature”[22] In its Memorandum on the Agreement on Ger­man Foreign Debt presented to the Bundestag with the necessary legislation to pass the London Agreement, the German government stated that the principle whereby “the payment of transfer commitments must only be made from a current surplus in the balance of trade and current accounts” had been “unanimously agreed by creditors and debtors, and by the representatives of all 31 countries”.

Consultation in the event that Germany had a difficulty in making payments was included, in Article 34 (b), which states in part “if the consultations are concerned with a situation in which the Federal Republic of Germany finds that it is faced with difficulties in carrying out its external obligations, attention shall be given to all relevant economic, financial and monetary considerations which relate to the ability to transfer of the Federal Republic of Germany, as influenced by both internal and external factors… Due regard will be paid to the principles by which the Conference on German External Debts was guided, to the objectives at which it aimed and to the undertaking of the Government of the Federal Republic of Germany to do everything in its power to ensure the fulfilment of these obligations. Advice shall, if the principal consulting Parties to the present Agreement so decide, be sought from appropriate international organisations or other independent experts.”[23]

Eight years after the war, Germany was treated as an equal. As Guinnane puts it “The agreement embodied three general principles: the amount Germany owed was reduced considerably; she was given a long period in which to repay; and the amounts owed in any given year were tied to her ability to make transfers.”[24] Jürgen Kaiser states “Ger­many was explicitly spared from any “structural ad­justment” policy – i.e., budget cuts, tax increases, and so-called structural reforms in the interest of ongoing debt service payments to the outside world.”[25] No IMF conditionality here then. Indeed, Abs himself states in his autobiographical account of the negotiations that they included “an explicit rejection of Anglo-Saxon austerity”[26].

One cannot suggest that a template be created from the details of the Agreement: a cookie-cutter approach is not appropriate when renegotiating international sovereign debt. Too many variables are involved. The US, which received the largest haircut, both absolutely and relatively, might not be so sanguine today, both for financial reasons and geopolitical ones: “West” Germany is no more and nor is the Soviet Union.

In addition, to get out of debt you have to come into it first: many will say that paralleling contemporary debt problems to Germany’s in the 20th Century is comparing apples to oranges. But notwithstanding the cliché, there are many similarities between apples and oranges: fruit, vitamin C, shape, size; and in why we grow them and how we handle them. It is precisely by comparing them that we can highlight both similarities and differences. And in this instance we should be able to learn from both.

So several general lessons should nevertheless be retained: treat the debtor nation as a partner, and with respect, and with generosity, avoid the collective punishment of its people, do not try to be paid what cannot be afforded. In other words be sensible. These lessons are not new: words to that effect abound in earlier literature about debt and debtors. We just seem to have lost sight of them.


Annex I, D, 11 of the Agreement states in its entirety:

“Græco-German Arbitral Tribunal claims

A preliminary exchange of views has taken place between the Greek and German Delegations in regard to claims held by private persons arising out of decisions of the Mixed Græco-German Arbitral Tribunal established after the First World War. This will be followed by further discussions, the result of which, if approved, should be covered in the Intergovernmental Agreement.”

In 1972, almost 20 years after the Agreement (to which Greece was a party), in “Claims arising out of decisions of the Mixed Graeco-German Arbitral Tribunal set up under Article 304 in Part X of the Treaty of Versailles (between Greece and the Federal Republic of Germany)” the same Arbitral Tribunal referred to in Footnote 18 above ruled in part as follows:

“The negotiations to be conducted … (note: between Greece and Germany) must be guided by the following principles:

(a) They shall be meaningful and not merely consist of a formal process of negotiations. Meaningful negotiations cannot be conducted if either party insists upon its own position without contemplating any modification of it.

(b) Both parties are under an obligation to act in such a way that the principles of the Agreement are applied in order to achieve a satisfactory and equitable result.”[27]

In the arguments to the Tribunal, the Counsel for the Kingdom of Greece complained that in the light of previous failures to reach an agreement “there was danger of the Kingdom of Greece receiving ‘a stone instead of bread’.”[28]

This dispute just happened to be between Greece and Germany, but the italicised and bold text above applies to all negotiations at all times.

We do not know what happened next in this dispute. We do know what is happening now.


Abs, Hermann-Josef (1991): Entscheidungen 1949 –1953. Die Entstehung des Londoner Schuldenabkommens. Mainz-München

Agreement on German External Debts, 27th February 1953

Dernburg, H. J.  – Some Basic Aspects of the German Debt Settlement – The Journal of Finance Vol. 8, No. 3 (Sep., 1953)

Final Report of the Conference on German External Debt 1952

Foreign Affairs – October 1934 -The Dawes and Young Loans: Then and Now –

Gelpern, Anna  – Feb 2015 – Pari Passu’s Golden Fossils (Very Preliminary Draft)

Guinnane, TW – January 2004 – Financial Vergangenheitsbewältigung- The 1953 London Debt Agreement – Economic Growth Centre Yale Discussion Paper 75

James, Harold – 1986 – The German Slump: Politics and Economics 1924-1936. Oxford: Clarendon

Kaiser,J – 2013 – One Made it Out of the Debt Trap – Lessons from the 1953 London Agreement – Freidrich Ebert Stiftung – International Policy Analysis

Klug,A – November 1993 – The German Buybacks 1932-39- A cure for overhang? – Princeton Studies in International Finance No75

Schacht, Hjalmar – March 16, 1934 -“The Problem of Germany’s Foreign Indebtedness.” Address by the President of the Reichsbank before the American Chamber of Commerce in Germany, Berlin; printed by the Reichsbank

UN Reports of Arbitral Awards – 26th January 1972 – Volume XIX pp27-64 : Claims arising out of decisions of the Mixed Graeco-German Arbitral Tribunal set up under Article 304 in Part X of the Treaty of Versailles (between Greece and the Federal Republic of Germany)

UN Reports of Arbitral Awards – 16th May 1980 – Volume XIX pp 67-145 : “The Question whether the re-evaluation of the German Mark in 1961 and 1969 constitutes a case for application of the clause in article 2 (e) of Annex I A of the 1953 Agreement on German External Debts”


[1] H. J. Dernburg – Some Basic Aspects of the German Debt Settlement – The Journal of Finance Vol. 8, No. 3 (Sep., 1953), p. 299

[2] The Dawes and Young Loans: Then and Now – Foreign Affairs October 1934 part III §1

[3] “Under the 1924 Dawes Plan, Germany borrowed approximately $200 million from foreign bondholders in U.S. dollars, British pounds, Italian lire, Swedish kronor, and Swiss francs. The Dawes Plan Loan (as the bond issue was called) was part of a deal to resume reparations payments and help stimulate the German economy. The Dawes Loan bonds had priority claim on Germany’s foreign exchange, and were secured by certain tax revenues. The U.S. dollar tranche alone was indexed to gold to protect the creditors from currency depreciation.” Anna Gelpern  – Feb 2015 – Pari Passu’s Golden Fossils (Very Preliminary Draft)

[4] The difference of 10% corresponded to fees and costs!

[5] “The Young Plan Loan raised approximately $300 million, with bonds denominated in French francs, U.S dollars, British pounds, Swedish kronor, Dutch florins, Swiss francs, German reichsmarks, Italian lire, and Belgian belgas, listed in order of the respective tranche sizes. Two thirds of the proceeds went to pay reparations; the rest to the German government for investment in railways and the postal service. In contrast to the Dawes Loan, all the Young Loan tranches were indexed to gold at their value on the date of issue.” Ibid. See also The Dawes and Young Loans: Then and Now – Foreign Affairs October 1934 part III §6

[6] Foreign Affairs 1934 Part IV

[7] The London Protocol of 1931

[8] The Lausanne Conference of 16th June – 9th July 1932

[9] The US concessions required were never granted and the whole process was quickly overtaken by world events.

[10] Klug,A – November 1993 – The German Buybacks 1932-39- A cure for overhang? – Princeton Studies in International Finance No75, pp 5 & 8

[11] Guinnane, TW – January 2004 – Financial Vergangenheitsbewältigung- The 1953 London Debt Agreement – Economic Growth Centre Yale Discussion Paper 75 p 16, citing James, Harold, 1986. The German Slump: Politics and Economics 1924-1936. Oxford: Clarendon Press p 95

[12] Klug,A, p.8

[13] Guinnane, p. 18

[14] “The Problem of Germany’s Foreign Indebtedness.” Address by the President of the Reichsbank before the American Chamber of Commerce in Germany; Berlin March 16, 1934; printed by the Reichsbank. Cited in Foreign Affairs 1934

[15] Agreement on German External Debts, 27th February 1953 (“Agreement”)

[16] Agreement Annex I,A,1 (a) to (d)(p20)

[17] Ibid Annex I,A,2 (a) to (d)

[18] Dernburg p.305

[19] Clause (e) states “Should the rates of exchange ruling any of the currencies of issue on 1 August 1952 alter thereafter by 5 percent or more, the instalments due after that date, while still being made in the currency of the country of issue, shall be calculated on the basis of the least depreciated currency (in relation to the rate of exchange current on 1 August 1952) reconverted into the currency of issue at the rate of exchange current when the payment in question becomes due.” Later arguments occurred when the Deutschemark revalued significantly on two occasions: is the least depreciated currency the most appreciated one? See “The Question whether the re-evaluation of the German Mark in 1961 and 1969 constitutes a case for application of the clause in article 2 (e) of Annex I A of the 1953 Agreement on German External Debts” ruled upon on 16th May 1980 by the Arbitral Tribunal created by the Agreement. The 82 page decision (including a dissenting opinion of some 30 pages) is a cornucopia of interesting precedents, including “The Case of the Northern Cameroons”. Exegetical scholars will enjoy the fact that the Agreement was written in three languages (English, French and German), none of which took precedence.

[20] Agreement Annex I,B,2,iii

[21] Agreement Annex I,E,15

[22] Final Report of the Conference on German External Debt 1952: paragraphs 21 etc

[23] Quoted by Kaiser,J – 2013 – One Made it Out of the Debt Trap – Lessons from the 1953 London Agreement – Freidrich Ebert Stiftung – International Policy Analysis

[24] Guinnane p.27

[25] Kaiser,J – 2013

[26] Abs, Hermann-Josef – 1991 – Entscheidungen 1949 –1953. Die Entstehung des Londoner Schuldenabkommens. Mainz-München p.195

[27] UN Reports of Arbitral Awards – 26th January 1972 – Volume XIX pp27-64, P. 64

[28] Ibid P. 63


“Printing Money” and Inflation


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Printing Money Shaped2

Although sometimes nicknamed “dead presidents” different denomination US Dollar bills do not all carry the portrait of a president: the $100 bill pictured above sports Benjamin Franklin, who was many things in life, but never President of the United States. Nor was Alexander Hamilton, portrayed on the $10 bill.  Of the seven denominations in current circulation ($1, $2, $5, $10, $20, $50 and $100), the other five have presidents on them, three of whom were also generals (Washington, Jackson and Grant).  There are five other denominations which are no longer circulated (if they ever were): they are for $500, $1,000, $5,000, $10,000, and $100,000. Of those, only the $10,000 is not adorned with a presidential face: instead it is Salmon P. Chase who is immortalised there.

Milton Friedman was a famous economist.  Although there is no question that as economists go, he was undoubtedly a good one, as most economists go he also held some pretty dismal views.  And I call them dismal not for the classical reasons (which are downright obnoxious[1]), but because some were just wrong, some misleading, and some have led to all sorts of social and political problems.  For the moment we will focus on just one (egregious) error.

Take one of his most famous sayings, usually partially quoted as “Inflation is always and everywhere a monetary phenomenon”. He actually went on to make his meaning more precise by adding “in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”.  That precision helps us to be certain that he was plainly wrong.  And the very special way in which he was very very wrong indeed highlights a particular arrogance that is all too common among (at least how we use the words of) dead economists: for he totally disregarded one of the key variables in the monetary equation that he helped to make famous (and discussed below).

Unfortunately one of the residual memes from the otherwise widely discredited vogue of monetarism that reigned over the policies of too many central banks in the last quarter of the last century is that if we let the money supply grow faster than the growth in GDP, we are inevitably heading for an increase in inflation. Indeed the recent few years have seen and heard any number of scaremongering predictions, often from “reputable” economists that the US (among others) is heading for hyperinflation. Plenty of politicians have jumped on this bandwagon because it suits their ideology however witless the driver of the wagon.

It is true that various measures of money supply in various countries have expanded at historically high rates: so how can I be so sure that the predictions of hyper (or even simply high) inflation are so wrong?

The first point to make is that so far there have indeed been rapid increases in money supply…. But nowhere have they resulted in equally (or even vaguely) rapid surges in inflation. In fact various measures of inflation are at historical lows in the US. We are still waiting.

The second point to make is that “so far so good” is not a panacea: it is after all what the apocryphal jumper from the top of the tall building is heard to say as s/he passes the 5th floor on the way down, and the point of the joke is precisely that in the end the jumper comes to no good!

The key to understanding what is going on is to look at why anyone might think the way Milton Friedman does above.

The idea that prices and the amount of money around are closely linked is even enshrined in our thinking at the level of “common sense”: we talk about “too much money chasing too few goods”, and it seems obvious that if such a thing is allowed to happen, then that excess of money will force the price of the goods up.

I have always found it a good way to understand an idea simply to take that idea to what I call its pathological extremes.

In this instance I would ask: how does the chasing affect the price? i.e. what happens if the money doing the chasing is doing it very slowly?  What happens if the money is chasing sooooo slowly that it is hardly moving at all? In fact, what happens if the money stops moving: i.e. what happens to the prices of goods if no-one spends any money at all (for whatever reason: we may all be saving all our money for a rainy day during a particularly dry spell)?

Well if no one spends any money, then no goods get sold, which results in a backlog of goods, reducing most people’s desire to produce any more goods since the ones already around are not selling.  So if no one spends any money, prices certainly do not go up, HOWEVER much money there is not doing the chasing!  If anything prices will go down (in an attempt to tempt people into spending, and in an attempt to reduce the overhead costs of having the goods in the shop, or in a warehouse), and fairly obviously economic activity will slow down too! And note that this will happen however much money is pumped into the system or “printed”. You cannot force people to spend if they do not want to, and if they do not spend then prices will not go up.

So obviously, in this extreme “pathological” case, where money does not get spent, there is NO relationship between increasing the amount of money and increasing the price of goods.

And actually, that is in fact how this theory of the relationship between money and prices SHOULD be.  The classical way of expressing the relationship is thus :


I haven’t used a formal equation before in this blog, and I will not often do it… but sometimes we have to put into formal pictures what we experience.

The formula above translates into English really quite easily, and its truth is really quite intuitive: it states that the amount of money in the system (M) TIMES the rate at which it gets turned over/spent (i.e. its “velocity” V) is EQUAL to the price of goods (P) TIMES the quantity of goods (Q). We can go a little further without unduly oversimplifying the idea by pointing out that over any period the change in PQ is the practical equivalent of GDP (i.e. over any given period the value of the goods produced in a country IS its GDP).  Equally we should note that if we are interested in inflation (which measures the change in prices or P) then we must be looking at the changes: the change in the amount of money over a period, times the rate at which it gets spent is equal to the change in prices times the number of goods produced in that same period.

The first point to note is that just increasing M certainly does not necessarily mean that we are increasing P, for we could be increasing Q, or decreasing V or witnessing any number of different combinations.

The second point to note is that, in fact, in a healthy economy (i.e. one growing at its naturally sustainable rate with minimal inflation), you would naturally expect M (the money supply) to increase.

It should be reasonably obvious that if velocity is dropping (i.e. people are not spending as fast as before), then prices are most unlikely to be going up, even if we pump money into the system.  In other words, Friedman’s famous dictum manages to completely miss the importance of the velocity of money, as though that were completely irrelevant. And the problem that Milton had was precisely that he thought that velocity was indeed irrelevant on the grounds that it seemed to have remained remarkably stable for a very long time in the US.

M2 V before CrisisNot as stable as Milton thought [2]

 Even if that were the case (and it kinda depends on how you measure velocity), a basic thought experiment such as the one described above should have been enough for  a genuine seeker after truth to realise that observed long-term stability does not imply that instability is impossible (ask anyone living on the San Andreas fault).

The fact is that during this crisis the velocity of money has significantly diminished. Worse: the trend of velocity seems to be heading lower, indicating that the propensity to spend is still diminishing.M2 V in Crisis

And that means that the likelihood of new money leading to increased inflation has also diminished, even without new production.  And the whole point of injecting new money into the system is to channel it NOT into higher prices, but into higher PRODUCTION…. which as I have pointed out already is usually the reason why we want money supply to increase in a healthy economy. 

Far from condemning us all to hyperinflation, the “quantitative easing” of a number of central banks (such as the Fed, the Bank of England, the Bank of Japan, and to a lesser extent the European Central Bank) is designed to prime the pump of increased production, in the hope of dragging the various economies out of their lackadaisical recoveries into ones where unemployment drops back to significantly lower levels. And the drop in the velocity of money is only one reason why this policy is exceedingly unlikely to lead to inflation: I will mention a number of others in coming posts.


©Copyright Chris Golden July 2013

[1] First used by Thomas Carlyle when arguing for a reintroduction of slavery…..

[2] Source: FRED (Series ID: M2V)

Bonuses : What is to be Done?


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Remuneration can take many forms, but in the end it’s a question of “Show me the money!” as Rod Tidwell so succinctly puts it in “Jerry Maguire”.  Both CEO pay packages and financial traders bonuses have grown so large in the last 20 years that they threaten the stability of the social contract.

In the context of inequality I have recently posted about the level of remuneration of the highest paid people in the US, where it is estimated that in 2011 the top 15,837 families had incomes of AT LEAST $8.0 million (including realized capital gains) but actually AVERAGING $23.7 million[1].

The US now mandates that companies reveal just how great that level of inequality is, by publishing the difference between the pay of CEOs and that of workers[2]. But because the Securities and Exchange Commission (SEC), which is meant to say how the requirement would be implemented has not yet bothered to write the rules, almost three years later we still have no CEO-to-worker pay ratios published.  Furthermore a number of the largest companies in the US are actively lobbying against the requirement in an attempt at least to water it down.

Both Bloomberg[3] and the AFL/CIO[4] have done their own calculations[5].  In both calculations the numbers are quite massive, and the gap has increased more than 10-fold since 1950.  The graph below shows how that ratio has progressed (exponentially) since 1950, though it hides the fact that the ratio is significantly lower today than at its peak just before the start of the crisis. A more detailed measure (and commentary) can be found here.

Progression of the CEO to Worker Pay Ratio since 1950

CEO Worker Pay Ratios

(The circle areas reflect the ratio, and the dot in the middle is about 4 times the representative worker’s base)

Just to add insult to injury, there seems to be no relationship between high pay and high performance.  Indeed recent research has shown that, in the words of the Harvard Business Review blog :

“If shareholders think a CEO has done something good to boost profits, they reward the boss with a pay increase amounting to 48.9% (on average) of the perceived contribution to higher profits. But when the CEO is seen as causing a profit decline, there’s a zero effect on his or her pay, Lucian A. Taylor of The Wharton School reports from his study of more than 4,500 chief executives.”[6]

We should also note that it is not only CEOs who earn extremely large sums: part of the underlying (and social) debate on the background to the financial crisis that still blights large parts of the globe was the level of bonuses in financial companies, especially to dealers.

In particular, it was notable how often extremely large pay-offs were based on present profits which seemed to have been booked without taking into account any hidden (or often quite visible!) future risky liabilities incurred in creating that profit.  To translate that last sentence into plain English, let us illustrate with an example: suppose an insurance underwriter takes in a much greater amount of premium than last year by selling many more insurance policies, and, in doing so, also gains market share from competing companies…. It would look at first sight as though s/he deserves some special recompense for doing such a great job, no?  But what if the only reason that business increased so much was because the policies were sold too cheaply?  And what if on top of that a number of the policies go catastrophically wrong, resulting in pay-outs many many times the size of the TOTAL premiums gathered? The underwriter would have been paid a bonus based on present performance, with no account taken of possible future disaster resulting from that very “performance”. And THAT is exactly what happened at AIG[7] as well as in a number of other places! So all too often the hope of receiving inordinately large bonuses provided perverse and asymmetrical incentives to take risk with other people’s money, where you win big if you get it right (often as much by luck as by skill); but you lose little (and often not even your job) if you get it wrong. That kind of incentive is a form of moral hazard.

So what is to be done? The first step is to realise that change will not occur swiftly, nor should it be mandated or enshrined in law in any way. The move towards the perverse idea that the sole purpose of a quoted company is to maximise shareholder value (in the restricted sense that value here only gets measured in terms of dollar profitability, or worse, in the share price) is a relatively recent one and took many years to take root. And it will take many years to uproot it.  What is most important in this context is the triumph of ideas, not the enforcement of laws: no law mandates that maximising shareholder value should be the purpose, let alone the sole purpose, of a quoted company.

What is needed is a deeper understanding of the purpose of a company, and how that purpose fits into the structure of a civilised society. That understanding has to be nurtured and promoted, repeated to all and sundry and consciously propagated, until it takes root in society in general, and in the financial and political world in particular, just as that incredibly destructive meme about shareholder value has managed to parasite itself on the rest of us.

What form might this understanding take?

I have discussed this over many years with many colleagues, friends and acquaintances, including many who still hold to the old meme, and the following is the distillation of the conclusions we have usually ended up with.

There are four other constituencies that have a claim on a company’s earnings/profits.  They are :

The shareholders: shareholders do, after all, “own” the company, and may legitimately feel that they have a right to at least some of the company’s profits.

The employees: any given employee may well be replaceable (even the ridiculously overpaid CEO or massively overbonused trader).  But the employees as a whole are essential. They should therefore expect to get paid, and to be paid fairly relative to other employees of the same company.

The taxman: all companies require the basic infrastructure provided by the society within which they work, whether that infrastructure comes in the form of a framework within which the law of contracts is upheld and enforced; or in more practical ways such as the maintenance of the roads used to transport the company’s products.  There are a myriad ways in which taxes support the business of all and any company, and they are often ignored. We may wish to argue about whether we get value for money for our taxes, but we undoubtedly could not continue for long without any of what is provided (whatever the more rabid believers in free-markets or in libertarianism may believe in their wetter dreams).

The company itself! : Yes, the company itself has a right to expect that some of the earnings it has created should be ploughed back into it, whether in the form of R&D, to expand the range of future products, or in the form of the amortisation (and therefore eventual replacement) of equipment et al, or in the form of physical or geographical expansion of the company’s operations. A company should legitimately expect a significant portion of earnings to be retained as an investment in the company’s future.

How do we translate the existence of these four worthy constituent parts of a company’s ability to create wealth and profit, into a structure of how that wealth and profit should be distributed? And how does that structure itself get translated into action by companies?

My suggestion is that any discretionary remuneration (i.e. bonus over and above basic salary) should be considered unacceptable if it ever totals more in any year than the total that the company in the same year pays 1] in dividends to its shareholders, 2] in total ordinary payroll to its employees 3] in total taxes to local and other government, and 4] what the company retains in earnings (i.e. invests in itself).

Any translation we agree upon needs to become a social meme, an accepted truth, and the goal is two-fold: to banish forever the concept that maximising shareholder value is the sole purpose of a company; and to make it completely unacceptable for bonuses of any kind to breach the basic four limits described above, in letter or spirit.

[1] Of course it’s not all wages/salaries (or even S Corporations)… but it is remuneration

[2] Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act

[5] The difference between their two averages probably derives from the fact that the union’s calculation is based on only 327 of the Fortune 500 companies, whereas Bloomberg seems to have used all 500

[7] Some may wish to argue that there is a difference between CDS and insurance…. And there is, but not enough to obviate the point that I am making.



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In Which Some Specialised Terms Used In Posts Within This Blog May Be More Or Less Defined

Bond : In the financial sense a bond is a promise to repay a debt, usually contractual (though as far as the City of London is concerned it is simply a solemn promise with no specific context and which is as good as your word). Bonds generally take the form of a security (which in the past generally meant that there was a physical manifestation of the contract), with terms and conditions more or less clearly stated.  The normal minimum variables of a bond are: the name of the borrower (i.e. who is making the promise to repay), when it will be repaid (i.e. the maturity date) and in what form.  In addition most bonds bear a coupon, which is to say that they pay a regular amount of interest between the moment of receiving what was borrowed and eventually repaying it.  Beyond that there can be any number of additional features.  We may examine these elsewhere at other times, either in the glossary or in a blog post or two; but this is neither the time nor the place to do so.

CDO : CDO is the acronym of Collateralised Debt Obligation, which makes everything so much clearer.  It is perhaps self-referentially ironic that CDOs are actually notorious for their opacity.  CDOs are a form of securitization in which a pool or portfolio of existing bonds is used as the collateral for a brand new set of bonds, which is divided into seniority tranches.  The bonds in the portfolio provide the cash with which the CDO will pay interest and eventual the principal at redemption.  The clever additional feature is that the order in which we disburse the cash received from the portfolio bonds depends on the seniority of the CDO bond.  Thus the most senior tranche must be paid all the interest it is due before the second most senior tranche is paid; and the second most must be paid before the third etc. This clever prioritisation of payments is what allows for the alchemy of the transmutation of credits.  Indeed, suppose you own a number of different bonds, all of which are rated BBB (which is about as bad as you can get and still be eligible for most “serious” investment).  What is clear is that barring some very very unlikely catastrophe (so large that whether your bonds pay your interest will be the least of your worries, coming some way after “where will I find food to eat today?”), the great majority of your bonds will pay what they owe on time and in full.  This means that although before the fact there is a risk that some may not pay correctly (which is why they are rated BBB), after the fact you will observe that most (and quite possibly all) will have in fact paid as promised.  The problem is that before the fact you cannot know with certainty which ones will turn out to be OK.  This is the little conundrum that is solved by the CDOs scheme of prioritised payments.  And the alchemy is simply to note that if you own the most senior tranche of a CDO, you will get paid first, which means that you will get paid correctly with a degree of certainty close to total … which happens to be a close approximation of what is meant when we say that a bond is rated AAA.  In other words, by prioritising the order in which funds received from a pool of BBB bonds are paid out to the owners of different tranches of the CDO, you can ensure that the most senior tranche will, in fact, have the credit characteristics of a AAA bond. Et voila!

Coupon : A coupon is what you cut away from a piece of paper (newspaper, magazine or financial security such as a bond) to exchange against some advantage within a specified time period.  It may be exchangeable against three tins of baked beans at a cheaper price than prevailing; or against a sum of money (usually in a specified currency… or choice of currencies… or sometimes a commodity… or a choice of commodities), particularly if you have just cut it away from a bond.

Debt/GDP : This ratio is commonly applied to countries in order to get an idea of their solvency (in other words how likely they will be able to pay their debts).  GDP is a rough measure of a country’s income: it measures the value of all the goods (and services) produced in a country over a given period (which is usually one year). The debt measured is usually the consolidated gross central government debt (so, for example it would not include provincial debt in Canada). Although it is based on an intuitively attractive analogy with how we look at personal creditworthiness (i.e. against personal income) it is deeply flawed and is in fact an extremely poor indicator of potential default.  Just for a start, a government’s debt is not paid for by a country’s income, but by the government’s revenues.  The argument used to justify the GDP proxy is that it is an indication of the maximum potential income of the government, in the sense that the government’s revenues cannot exceed 100% of the country’s GDP.  A little though about what is likely to happen if a government’s tax rates even begins to approach 100% is enough to make one realise just how absurd is the construction of this ratio.  In passing we may wish to note that the highest debt/GDP ratio measured in an OECD country since 1900 is 767%, in Canada in 1946. Canada did not default. Unfortunately, although this ratio would never be taken seriously by a professional long-term investor in a country’s debt, it is taken seriously by enough unprofessional investors to be able to have short-term effects on a country’s ability to borrow. Far more serious than the ratio’s possibility of engendering short-term effects on government bond yields is the unfortunate fact that politicians all too often believe this nonsense measure, or at least claim to when it seems to justify their ideological dogmas. As such the debt/GDP ratio has a good claim to be one of the most destructive memes in contemporary finance.

Deflation : We all know about inflation, because most of us have lived through periods of “high” inflation.  These periods are when prices in the shops and elsewhere seem to rise quite quickly.  Less common are periods of deflation, which is when prices tend to drop.  Of course we know of individual products or types of product which seem to drop in price: computers or mobile phones are the obvious example.  But a generalised drop in prices across a wide cross-section of goods is considerably rarer; and is considered quite dangerous by policy makers.  In order to understand why, we need to engage in a little bit of thought experiment: if prices were dropping across the board in a meaningful way, you would undoubtedly continue buying your everyday products, such as food and toothpaste, but would you replace your car right away if you did not absolutely need too… if you had good reason to believe that it would cost you 20% less this time next year? So protracted deflation can be self-feeding: you put off your purchases, so the sellers of the goods you are not buying drop their prices further in an attempt to entice you to buy.  If this reflexive behaviour turns into a vicious cycle it is one that is difficult to break: we have a good idea how to break the vicious cycle of inflation, and central banks seem to do it very well when necessary.  If you put interest rates high enough you will slow growth and with it inflation.  It is like pulling on a string to drag a weight in one direction.  Unfortunately the inverse is not as effective: you cannot drop interest rates below a certain level (usually assumed to be zero, 0%): that weight that you could drag along by pulling on the string doesn’t seem to want to move when you push on it. Deflation is a big problem if it is accompanied by reduced activity: if enough people put off their purchases for long enough, economic activity will slow, unemployment increases, which itself leads to a drop in consumer spending. This engenders fears about the future, further dampening the likelihood of spending.  It is easy to see how this phenomenon could spiral out of control.  (Note that the scenario we are describing is accompanied by a drop in the velocity of money). But deflation is not necessarily an economic problem: it only becomes so if depressed economic activity and depressed prices are associated together.  If falling prices simply encourage consumption (which could easily be the case: do I put off getting a mobile phone because it may be cheaper next year?), then deflation can have a positive impact.  As noted in a post elsewhere, the UK went through a period of 100 years when prices were dropping one year in two, and overall prices dropped by almost 25%.  That period was one of protracted growth and optimism for the UK.  On the other hand, Japan has been experiencing protracted deflation for a good few decades now, and that period has been one of extremely low growth and general pessimism for Japan. As with so many concepts in finance and economics: it all depends… one the one hand things could go this way, but on the other hand…..

Eurobond (classical): Until recently there was only one clear connotation to the word “Eurobond”, and that was the one which Julius Strauss of Strauss Turnbull meant to give it when he coined the term.  He came up with the designation at the time of the first Eurobond issue in 1963 “to replace the outdated foreign dollar bond description and to portray the Europeanisation of the market”.  Although there has always been some argument about the details, over time the word has come to refer to a bond issue initially widely internationally distributed outside the country of the borrower, by a syndicate of international banks from different countries and free of any withholding tax on principal or interest. Although some used to hold that the issue had to be in a currency other than the borrower’s own, and that it had to be listed in Europe, and that the bonds had to be uniquely in bearer form, times have changed, the market has evolved and the definition has evolved with it.  Essentially this form of Eurobond refers to an issue that is internationally distributed by a syndicated of banks and/or securities houses largely (but not exclusively) based in Europe. These Eurobonds do actually exist in reality, though perhaps no longer physically!

Eurobond (recent): More recently the term Eurobond has come to be applied to any number of schemes involving some form of joint borrowing by the sovereign members of the Eurozone (i.e. countries using the Euro as a currency). Although there are examples of predecessors to the EU (and in particular the EEC) borrowing with the joint and several guarantees of its member states over 30 years ago, apparently any modern version of such a structure seems to be beyond the pale; at least for the moment.  I believe that a form of such borrowing is well-nigh inevitable, but doubtless the powers that be will continue fiddling for awhile yet. These Eurobonds do not currently exist in reality, other, perhaps, than metaphysically; and there are arguments about even that!

Eurozone : The Eurozone is the name commonly given to the group of countries that have adopted the Euro (€), or more ridiculously “the single currency”.  ON the 1st January 1999 eleven members of the EU adopted the Euro: they were Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. Since then Cyprus, Estonia, Greece, Malta, Slovakia, and Slovenia have joined the original members .To date the Eurozone has only ever expanded in membership, and now (as of 1st July 2013) consists of 17 of the 27 EU members.  IN agreement with the EU Andorra, Monaco, San Marino and the Vatican have also adopted the Euro as their official currency and may issue their own coins. Kosovo and Montenegro have adopted it unilaterally, in somewhat the same way as has Panama the US Dollar (though Panama also uses the Balboa).

GDP : GDP is the acronym for Gross Domestic Product.  It is a rough measure of the value of a country’s production of goods and services in any given period. As a statistic it is a relatively recent construct, and few countries were actually compiling the relevant data before the end of the Second World War.  For purely practical reasons of data gathering and measurement, GDP estimates are likely to be revised once or twice in the relatively short-term (i.e. in the first six months after the period being measured).  But for methodological reasons entire time-series of GDP may be changed many years after the initial release. There may be any number of reasons for these changes, including the recategorisation of certain types of effort form non-productive to productive or otherwise.  For example is an unpaid carer (taking care for example of their aged parents) engaged in productive labour? In addition there is a very important distinction to be drawn between real and nominal GDP (particularly if we are looking at long periods).  Nominal GDP is what the current production would be worth right now.  Real GDP is measured after inflation: if the value of your production has increased over the past year by 10%, but prices rose by 5%, nominal GDP growth would be 10%, but real GDP growth would only be 5%.  What measure of inflation is used to convert from nominal GDP to real GDP is another matter for discussion…. But there is the concept of the GDP deflator, of which more later.

Paying agent : a paying agent is an organisation (usually a bank) that acts as the agent of a borrower to make payments on that borrower’s behalf.  For example if you lend to the United States by buying a US Treasury bond, you may be lending to the Treasury, but you will collect any interest and principal from the US Treasury’s paying agent, in the form of one of the 12 US Federal Reserve Banks.

Happy Anniversary


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Autostrade top

The basic terms and conditions of what is considered by most to be the first Eurobond issue, or at least of the first of the modern era. Originally designed in part to exploit a tax loophole allowing transactions between foreign counterparties in the UK to escape tax, the $15 million issue was the first in a market that saw over $4.5 Trillion of issuance in 2009, and is on track to match 2012’s issuance total of $4.0 Trillion this year.  The cash raised never got to Autostrade: instead IRI lent the proceeds to FINSIDER, the Italian steel company. It took over six months to iron out all the details of the first issue.

The week before last, on Monday 24th, I was lucky enough to be a guest at a celebration gala dinner held at The Savoy in London. What was being celebrated was the 50th anniversary of the Eurobond market.
To be sure sometime on the 1st July 1963 at the offices of S. G. Warburg & Co in London a subscription agreement was signed for a new issue, and around the 17th July 1963, $15,000,000 face value of bearer bonds issued by Autostrade were made available at the Banque Internationale à Luxembourg. The issuer, Autostrade, was a company owned by the Italian state which built and ran the Italian motorways; and the issue was guaranteed by IRI, described on the advert publicising the issue as “the principal Industrial and Financial Holding Corporation owned by the Italian State”. They paid a coupon of 5 ½% and had a final maturity of 1978 (or 15 years).
The fact that they were bearer bonds and available in Luxembourg became a regular feature of Eurobonds, and speaks volumes. Bearer bonds are anonymous: as their name implies they can be carried about on one’s person. In these days of electronic finance it is difficult to understand that there was a time when investors would actually own physical securities such as stocks and bonds, which they might well keep in their safe at home. On coupon or dividend day, they would dutifully go to the paying agent to collect their income. In the picture published with an earlier post, we see a wide cross-section of the British middle and upper-middle class queuing at the Bank of England to collect the dividend on their Bank of England shares.  In the case of the Autostrade bonds, the same thing would have happened at the Banque Internationale à Luxembourg… but very few in the queue would have actually been local Luxembourgeois: holders would have come from France, Germany and Belgium, and perhaps even further afield. Among them may have been an apocryphal “Belgian dentist” the avatar of the typical retail investor who bought such bonds. Having arrived at the paying agent in Luxembourg, the coupon on the bond would have literally been clipped off (the word “coupon” comes from the French “couper” which means “to cut”)… and exchanged for cash. Bearer bonds therefore were a perfect vehicle for avoiding taxes, which is one of the reasons why the Eurobond market met with such initial success and grew so fast. It is also why almost all securities today are “dematerialised”, i.e. exist only in registered format, which format is almost certainly electronic, and which cannot be hidden anonymously in a safe or under mattress.
The Eurobond market grew fast, and fifty years after the Autostrade issue the Eurobond market may rightly be said to be one of the most important sources of capital anywhere on the globe. The first issue was in US Dollars, but there have since been Eurobond issues denominated in almost every convertible currency on earth. The great and the good gathered in the Savoy had much to be proud about, and were humble enough to say out loud that whilst much good may have stemmed from the development of international capital markets, particularly in the more efficient global deployment of resources, the key motivation for growth and innovation in these markets was hardly altruism. Greed and the profit motive have led us to make mistakes, and occasionally to lose our way, perhaps especially so in the last decade.
One way we have strayed is by giving less and less information to potential investors about the bond we may be asking them to buy. The Autostrade issue’s newspaper announcement (reproduced in full below) gives us more informationAutostrade

about the borrower in one page than many of today’s prospectuses do in 50.  But information may not be enough: Andrew Haldane tells us that a rough calculation indicates that to be fully informed about the underlying assets of a CDO-squared[1], we would have to plough through some 10 MILLION pages of information. And in a market noted for its numerous and sometimes complex innovations, we have certainly shown ourselves too easily capable of abusing intrinsically positive ideas which, used correctly, enhance rather than deteriorate the commonwealth.

But this is probably true about the development of any significant market, be it for capital or otherwise. And I was certainly lucky to stumble upon this particular market at the start of my career, straight after leaving Balliol with a degree in Philosophy and Theology and a literally metaphysical feel for, and training in, speculation.  Little did I know then that I would participate in developing the wild frontier of international finance, and how much I would learn in doing so.  But let us not forget the roots of the market: a mere ten years after that first issue, the first serious study of the Eurobond market[2] speculated on what attracted investors to it.  Of the five reasons why investors were attracted to it, Dr H. C. Donnerstag gave as the top reason “a desire for tax minimisation and even tax evasion”.  Last in the list of five reasons came “genuine investment purposes”.  Greed is never very far away when money is concerned.

But I have to admit that I was happy to be invited to the party.

[1] A CDO-squared is a CDO whose assets are other CDOs. A CDO is a collateralised debt obligation, and is defined in greater detail in the glossary.

[2] Dr H. C. Donnerstag, 1975, The Eurobond Market

Sharing the Pie


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Queueing for Soup in 1931 - courtesy of Al Capone

At the end of 1930, Al Capone opened a soup kitchen serving three free meals a day for people who were made unemployed by the Depression. According to one of Capone’s biographers, Laurence Bergreen, “The soup kitchen was carefully calculated to rehabilitate his image and to ingratiate himself with the workingman, who, he realized, had come to regard him as another unimaginably wealthy and powerful tycoon”

We all know that inequality has been increasing… pretty much everywhere in the world: that even if the poor are not all getting poorer, well the very rich are getting significantly richer faster than anyone else.  What surprises most people is by just how much the gap has widened… and just how much the very very very rich have, whether in wealth or income. For example according to Picketty and Saetz, the sages on the matter, the 0.01% with the highest income in the US had an average income of close to $24 million in 2011. That group’s share of total income rose from 0.5% in 1973 to 3.2% in 2011, and the lowest paid of the 15,837 families concerned received just under $8 million.  Probably the best known graphic is the one immediately below, illustrating how the US plutocracy is back to the commanding heights which it dominated towards the beginning of the last century and until the start of that great depression:

130618 - Top 10% Pre-tax Income Share in the US, 1917-2011

But we would be mistaken if we think that this resurgence is uniquely an US phenomenon.  Or that inequality is at its worst in the US, as the CIA map below indicates:

130618 - CIA GINI Map 2009

The US may be in the same range as China or Argentina, but it is not as bad a Brazil.  Noticeable however is just HOW much greater equality[1] is in the other Anglo-Saxon countries (Canada, Australia, the UK), and throughout Western Europe.

But the ILO[2] Global Wage Report 2012-3 out recently highlights that the share of national income (or GDP) that is going to labour (i.e. to workers) has been steadily dropping, pretty much everywhere.  For example the OECD has found that in the 20 years between from 1990 to it declined in 26 out of 30 devel­oped economies for which data were available, dropping from 66.1 per cent to 61.7 per cent.  The decrease in developing and emerging economies was even steeper (as illustrated below).  And all of this was taking place as labour productivity was increasing.  In fact according to the ILO, “between 1999 and 2011 average labour productivity in developed economies increased more than twice as much as average wages”[3]. Productivity in the US has increased by 85% since 1980: in the same time real hourly wages have increased by merely 35%.

Adjusted labour income shares in developing and emerging economies, 1970–2007

130618 - Adjusted labour income shares in developing and emerging economies, 1970–2007

There are a number of key points to be noted here. First the trend is across all industries, so this is not the result of a move to industries that are more capital-intensive. And that this trend is not specially localised: it seems pretty global. So it probably isn’t the result of specific local policies. Nor is it limited to developed countries: emerging/developing ones are just as bad.

The ILO thinks that “the drop in the labour share is due to technological progress, trade globalization, the expansion of financial markets, and decreasing union density, which have eroded the bargaining power of labour. Financial globalization.. .. may have played a bigger role than previously thought.” In particular, the globalisation of trade has increased the pressure on the competitiveness of a country’s exports, which itself puts a downward pressure on the wages of those producing the exports.

But the most interesting aspect of the ILO’s tentative explanations for the trend is that it mentions both trade and financial globalisation, but it does not mention the missing elephant in the room: which is the lack of labour globalisation.  We have known that free trade is a win/win since the days of Ricardo… but we seem to have forgotten that it has been shown to be a win/win only if we constrain both capital flows and labour flows[4], and these days we have liberalised capital flows, but not labour flows: immigration is pretty controlled everywhere on earth.

There is of course also the question of distributing the gains in labour productivity more fairly, which would go a long way to rectifying the situation.  But what is clear is that if we let this trend continue, then we are simply impoverishing ourselves: in a forthcoming paper Onaran and Galanis of the ILO show that over a range of 15 countries and the Eurozone, a 1% drop in the share of national income going to labour consistently reduces the rate of private consumption as a % of GDP, and by close to 0.5% in both the US and the Eurozone[5]. The effect of exports is in the opposite direction: they increase, but only for a few countries do they do so by a rate (as a % of GDP) that is greater than the decrease in the local private consumption caused by the same relative decline in wages in the share of the pie.

In other words, it is not by entering into additional export competitiveness that most countries are ever going to grow their way out of this depression.

[1] Note that not everyone thinks that equality is desirable: according to some notorious recent research, “Can’t We All Be More like Scandinavians? Asymmetric Growth and Institutions in an Interdependent World”, the authors argue “that the more harmonious and egalitarian Scandinavian societies are made possible because they are able to benefit from and free-ride on the knowledge externalities created by the cutthroat American equilibrium.” In other words, the Swedes can only afford their egalitarian welfare state because they piggy-back off the innovatory entrepreneurship that stems (uniquely?) from the inequality of US capitalism.

[2] ILO: the International Labour Organization, a UN agency based in Geneva

[5] See Figure A1 on p 91 of the ILO report.

17th June 1982


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130617 - Blackfriars Bridge

The picture shows Blackfriars Bridge in the late 19th century. The bridge is a peculiar one inasmuch as it is the only place where the City of London stretches to the south bank of the Thames.  The City’s boundary guardian dragons are perched on the “other” side of the bridge, which gives the entire southern half of Blackfriars Bridge the rather unique postal address of “City of London, SE1”.

June 17th 1982

Just over thirty years ago, in May of 1982, when I was working for Goldman Sachs, I was sent off to Rome for the first time.  One of the most important partners at the time was George Doty Sr: he was in charge of administration and was effectively the Treasurer/CFO in the days when Goldman was still a partnership… and the partners took very good care of their money.  George Doty (who died only last year) was a prominent Roman Catholic.  I say that because he made no pretence about it, wore his faith on his sleeve, and actively supported all sorts of Catholic charitable works.  Goldman was only just beginning to become seriously internationalised: for years John Whitehead had made predictions about how soon 30% or 50% of Goldman’s revenues would come from international business (i.e. outside the United States).  But at that time they had one solitary non-American partner in the 90 or so partnership (and I believe that even he held dual-nationality), and the London office had maybe about a dozen people working on the fixed-income trading desk.  That was up from four years previously when I had joined as the third member of the desk.

In any case, the international business was only in the early stages of development and one of George Doty’s fond desires was that we start doing business with the Catholic Church. So I was dispatched to the Vatican to introduce the partnership’s services to the Istituto per le Opere di Religione, the so-called Vatican Bank, which was apparently active in bond markets.

I had a nice time in Rome, and went to my appointment in the Vatican.  I tagged on to a group of tourists and at the salient moment peeled off and approached a Swiss Guard, who leaned forwards as I whispered the details of my mission in his ear.  He promptly stood to attention, stamped the pole of his halberd on the ground and opened one of the high imposing oak doors for me, then saluted and ushered me in to the inner sanctum: the looks on the faces of the tourist group, who until then had simply assumed that I was one of them, was something I will never forget.

What I will also never forget was that the interlocutors I met with were quite happy to do business with the firm, but let it be known in no uncertain fashion that we would have to come to some discreet arrangement to make matters flow more smoothly.  I had heard some comments from the street about the fact that doing business with the IOR could involve some interesting transactions, but had never been propositioned in quite such an obvious way (however discreet it was). Goldman Sachs was an unbelievably ethical institution in those days, whatever people might think about it now, and it was simply unthinkable that any such desired arrangements could be entered into.

I was now faced with a diplomatic dilemma: I had to let it be known that the IOR were not a suitable client for the firm, even though the third most powerful partner there specifically wanted Goldman to do business with them.  I had little choice but to say that under the know-your-customer rule I could not agree to let the firm do business with the IOR, but that obviously others might wish to have a go themselves if they felt that it was OK once they had met the customer.

This did not go down well, and there was some discreet pressure to rethink my position.  In those days the Goldman London Office was in the old (London) Times building, which no longer exists, but which was located on Queen Victoria Street, just opposite Blackfriars Station, next to Blackfriars Bridge.


And it was there, at Blackfriars Bridge that on the 17th June 1982, some few weeks after my abortive trip to Rome, the hanging body of Roberto Calvi was recovered, his pockets filled with bricks.  Few questions were ever asked again about my judgment on the matter of the suitability of our potential counterparty in the Vatican.

©Copyright Chris Golden June 2013

Stocks and Flows


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130613 BLOG  - Nile and Med3The picture shows the Nile and its delta in the bottom right hand corner, flowing into the Mediterranean, with the discoloration from alluvial mud extending into the sea. Measuring 6,650 km from the source of the Kagera in Rwanda or Burundi, the Nile is the longest river on earth, and its drainage basin covers about 10% of the land mass of Africa. Its FLOW depends on numerous variables and is far from constant, as its periodic flooding would indicate. The STOCK (or volume) of the Mediterranean is estimated to be 3,750,000 km3, or 900,000 cu mi.

Unfortunately there are some very basic concepts which all too often have to be kept in mind in the frequently confused way that we all talk about events, and especially economic or financial events.

For example we often say things like “The currency market is HUGE!”, and indeed, in one sense it is.  The sense in which we mean, correctly, that the currency market is HUGE is that the turnover in the foreign exchange or FX market, the amount of currencies exchanged into other currencies every day, is undeniably enormous: it may have peaked at $5 TRILLION per day sometime in September 2011[1], but it is still probably more than $4 TRILLION a day right now. We will have greater detail on the precise number sometime in September, when The Bank for International Settlements (BIS) in Basel publishes its Triennial Report (officially known as the “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in 2013”).  Fairly obviously, in this instance we are talking about the turnover of the FX market, which is otherwise known as a FLOW.

But when we ask, “What is the biggest government bond market in the world, and how big is it?” (answer: the US), we are not usually referring to size as measured by turnover. What we really mean is “What country has the greatest amount of government bonds outstanding right now, and what is that amount?”  And the answer to that question[2] (Still the US, with $11.3 TRILLION outstanding at the end of the first quarter of 2013) is not a FLOW, but a STOCK.

So when we talk about the size of a market, or when we try to measure various “things” in the financial world we do need to be clear whether we are measuring a STOCK or a FLOW. In general, the FLOW we measure is always the difference between the STOCK of an item at two different points in time: in mathematical terms the FLOW is the first derivative of the STOCK, or in other words, the FLOW is how much the STOCK has changed. So, in passing, FLOW can easily be a negative number, but STOCK seldom is (though obviously it CAN be). And the FLOW is measured over a period of time, whereas the STOCK is a snapshot taken at a particular moment.  And of course it only really makes sense to compare a FLOW to its corresponding STOCK: it might be fun to measure the size of the US Treasury Bond market in terms of the daily turnover of foreign exchange  market (2.14 days in September 2012), but it probably doesn’t mean a whole lot.

You would have thought that such a distinction is an easy one not to forget, a difficult one to overlook when doing real economists’ work in the real economists’ world! But strangely enough, that is not by any means always the case.

Let’s look at an example which is currently considered a VERY IMPORTANT MEASURE not only by too many economists (who SHOULD know better), but, much more importantly by FAR too many policy makers and politicians (who generally cannot be expected to know better, poor darlings!).  We have mentioned the measure in an earlier post (actually in the earliest post this blogger has written): it is the ratio of debt to GDP.

Now debt/GDP is the shorthand measure most often used to determine (in a shorthand kind of way) how sustainable a country’s indebtedness may be: in other words if the debt to GDP ratio is too high, then the country won’t be able to borrow, and will go bankrupt as a result (or at least that’s the theory, in a shorthand kind of way). And actually, though it is a pretty poor predictor of anything, it is not an entirely useless measure. But it may be a misleading one.

To get an idea about how useful it may be, imagine that you are trying to get a mortgage.  What is the mortgage lender (probably a bank) going to consider? Among its considerations will undoubtedly be what income you have with which to pay off the mortgage, and that is a little bit like considering a country’s debt/GDP to determine whether it can pay its debts, but only a very little bit like it. And that is because, not only is it not a very accurate analogy but even then,  it is by no means the only aspect that the bank will look at. The bank will obviously also look at the value of the property you want to buy, and how much money you will put into it yourself, and actually these two factors will tend to be much more important in the bank’s decision to lend.  An intelligent mortgage lender would take a number of other factors into account, but as the recent crisis has highlighted only too well, most mortgage lenders are not that intelligent.

That it is an analogy at all is the result of our minds wanting to spot similar patterns in order to draw similar conclusions about what we are seeing.  Without getting too scientific about it all, this is probably a result of evolving in a space where we were prey as well as predator: we can’t afford the time to examine the subtle differences between signals that may tell us whether we are about to become another creature’s meal or not, so we are quick to draw similar conclusions from similar signals.  So if the bank looks at our income before lending us money to buy a house, which is something we have experienced and know about, then the temptation is to say that things probably work the same way at the level of a country….. and a country’s income is generally measured by what we call GDP!   But notice first that this is a FLOW.  And it is not a very accurate analogy because GDP is not the income flow that will pay the government’s debt.  The government will pay its debt from its revenues, which are essentially various forms of taxes, and whilst there IS a relationship between the changes in both government revenues and GDP, it is not a particularly strong one (61% correlation in the UK from 1901 to date).  And government can change its tax policy (and thus its income) considerably more easily than you or I can change either our jobs or our salaries. And we certainly cannot print money, which is, after all in the final analysis, a solution which is always open to governments[3].

So GDP is a FLOW…. And the government debt is a STOCK…. and the GDP FLOW is not actually related to the government debt STOCK… (other than talking about the same country)

As we saw above, FLOWS are dimensioned in time, which simply means that we measure flows over time. Accordingly the turnover of the currency markets we mentioned earlier was daily, and GDP is usually measured on an annual basis.  And therefore debt/GDP merely measures the size of the debt in number of years of TODAY’S GDP, and since GDP is not constant, ironically, the greater the debt/GDP ratio is, the more inaccurate is the inappropriate measure.

Furthermore, the STOCK of government debt is not constant: debt matures, treasuries issue other debt.  The average life of the stock of debt will differ from country to country, and from time to time. So assessing a country’s solvability (or even just the sustainability of its debt) by using the debt/GDP measure without introducing any other parameters is like trying to determine the volume of the Mediterranean from the length of the Nile.  Or measuring the size of the US Treasury debt in the number of FX turnover days……

©Copyright Chris Golden June 2013

[1] According to Morten Bech of the BIS in “FX volume during the financial crisis and now”

[2] Or at least what most people mean by that question: i.e. “What is the outstanding interest bearing marketable public debt issued by the US Treasury?.  There are many variations on exactly what we may mean by the general question “How much debt does the US have?”… and there will be many posts about that!

[3] Actually, bank notes are just another form of government borrowing: they are technically perpetual zero-coupon government bonds. They have a greater degree of liquidity than “interest bearing marketable public debt” (which is why they pay no interest, since liquidity has a cost), so redeeming government debt with new bank notes is not as dramatic as it sounds: it is merely changing the liquidity of the government debt… but that is fodder for another post.

Sometimes Common Sense is Not Enough


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130612 BLOG - dividend-day-at-the-bank-of-england

This is a detail of “Dividend Day at the Bank of England” by George Elgar Hicks, a painting that can be found at the Bank of England. It should remind us that at the time this post talks about, although it was the central bank of the UK, the Bank of England was privately owned, with shares that paid a dividend.  It was only nationalised in 1946, after the 2nd World War.  

Often what seems obvious common sense at first sight turns out not to be so simple.

Over the last few years it has become commonplace to accept that pretty much all western countries are radically over-indebted, to the degree that our very futures are at risk… not to mention that of our children and grandchildren. Furthermore, we are told, these levels of debt actually seriously slow down growth: the destructive meme is doing the rounds that debt/GDP in excess of 90% leads to significant slower expansion of the economy.  There are all sorts of aspects of this sadly mistaken dogma that are simply wrong, and I will be examining a number of them in future posts over the coming weeks.  But one of the problems with this naïve view is that it flies in the face of history.

For example, take a closer look at what happened in one of the countries whose current government is most rabid about reducing debt from “unsustainable” levels.  The Victorian era began with the United Kingdom heavily indebted: the Napoleonic wars had cost the country hugely, and by Waterloo in 1815, the debt/GDP of the UK was almost 225%.  But it didn’t stop there: for another six years of peacetime the debt/GDP ratio continued to grow, peaking at over 260% in 1821. By today’s standards the country’s debt was positively monstrous: put in context, when the UK’s present government was elected in 2010 with its clarion calls of debt reduction, the debt/GDP stood around 65% of GDP, or almost exactly ¼ of its peak some two-hundred years previously, and WAY below the average over the whole period since 1800 (which is over 110%).UK Debt - Now and Then

In the one hundred years between Waterloo and the beginning of the next big war in 1914, the UK’s debt/GDP was cut by about 90% from over 260% to less than 30%.

During that time, real GDP growth averaged 2.1%, which was about double the average GDP growth for the previous 100 years. And which is higher than the average real growth rate during the almost 100 years SINCE 1914 of 1.95%.

But given today’s fashionable though totally erroneous views on government debt and growth, the most interesting feature of that period is that for the first 50 years, when the debt/GDP ratio was more than 90%, real GDP growth averaged 2.5%, and at a significantly lower average of 2% for the next 50 years, when the ratio was below 90%!  Furthermore the Victorian era is generally considered to be the height of the British Empire and of Britain’s influence and power across the globe.  Halcyon days indeed; and not blighted by misguided ideological views about debt!

So how did this happen?  Those who know about what can happen in high-debt countries might be tempted to assume that the British simply inflated the debt away.  After all, the UK has a (somewhat undeserved) reputation for inflation.  But in fact, over the one hundred years between 1815 and 1914 the price level DROPPED by almost 25%.  Sure, there were some years when inflation was positive (in fact 51 of the 100 years had positive inflation), but overall the average annual rate of inflation was just over -0.2%.  So that’s not how they did it…..

There are a number of factors involved in how they did it. But suffice it to highlight three for the moment in this post:

1] In real terms (after deflation) the debt actually increased by 16%. But the nominal amount of debt outstanding (which is what concerns us) did not change a whole lot, dropping a mere 10% between 1815 and 1913: GDP growth did the rest.

2] The long-term government bond yield for the 100 years averaged 3.18%, which means that average interest paid by the UK on its national debt during that period was somewhere between 3% and 4% (one calculation would put it at 3.6%); and the interest burden peaked at 9.3% of GDP before gently collapsing to 0.8% by 1913 (the last time that it has been below 1%).

3] The major source of government revenues shifted from duties and tariffs (on goods) to income and consumption taxes.

But the purpose of this post is NOT to explain just HOW the Victorians managed their huge debt burden down to such a low level while maintaining good growth and low (to negative) inflation, but simply to point out THAT they did do it.  Which itself simply highlights the fact that a high debt/GDP rate is not necessarily the most urgent priority when facing a long-term growth trough… as is the case in so many western countries at the moment.

I have noted that the period we have been looking at was one of protracted deflation, yet we are told these days (and I tend to agree) that deflation is to be avoided at all costs: so how come it worked out for the Victorians? Well that’s a whole other story… and a whole other post.

So the next time that someone tells you that a high debt level is an impediment to growth, ask them to explain what happened during the reign of good Queen Victoria….

©Copyright Chris Golden June 2013