How QE works

Various commentators are saying that Europe’s QE won’t work, or QE in general doesn’t work because it just boosts the value of assets. Increasing the reserves of banks, critics say, doesn’t cause banks to lend money to the real economy.

That’s irrelevant. QE is not supposed to make banks lend more money. Banks don’t need reserves to lend money, or rather it works the other way. Banks lend money if there’s demand for loans, and then ask for reserves which are always given.

What QE does is indeed to boost asset prices. Central banks buy bonds, people who sold the bonds buy stocks, stocks go up in value. Or people who sold the bonds spend money, money ends up in company profits, stocks go up in value.

And this how QE works. What happens when stocks go up in value? Companies expand and hire more people. What happens when stocks fall in value? They cut costs and lay off people. When stocks rise in value pension funds are wealthy. When they fall, poor.

In our imperfect system QE is a blunt instrument that makes rich people richer while boosting the economy. The problem, though, is with concentration of financial wealth, not with QE.

How to understand Greece’s negotiations with its creditors, part 1

Greece: We can’t pay the interest on our debt because the principal is high, the rate of interest is high, and our income is much too low thanks to the income-reducing austerity measures imposed by our creditors.

Creditors line so far: Prioritize paying creditors above anything else. We don’t care about the cumulative damage it does to your economy.

Greece with Syriza: We refuse to do that any more. Besides, can’t you see it’s pointless? We have less and less income to possibly pay you with.

Creditors after election: Well we can’t remove the debt principal from the books because debt is money and European nations’ money would have to disappear.

OK, these are good opening positions for negotiation. Greece is asserting you can’t collect from a business you’re running into the ground. Central bankers are asserting that “Europe’s money is our balance sheet” and you can’t remove debt from the assets side of the balance sheet without something bad happening to the liabilities (money) side.

What next? Compromise I expect. Either central bankers accept that balance sheets with liabilities exceeding assets are OK for central banks, or they’ll figure out a way to make old debt a token asset that generates little or no current account obligations. The first would be easiest, but the economic Zeitgeist is against it so I expect the latter. Some sort of indefinite near-zero real interest rollover as is the case with US or Japanese debt.

To clarify for the concerns of northern European folk:
No-one really expects a nation to pay back its debt. It’s not a project to build a highway, or little of national debt is like that. Nations borrow more or less indefinitely and the amount of debt may rise and fall but that’s an investment concern like the stock market rising and falling in valuation. Generally debt is supposed to rise slowly, and to pay it all back is a bad thing because it removes bonds from the investment market. Neither is Greece expected to pay back northern Europe nor are northern European taxpayers on the hook to pay Greece’s bill to someone. Sovereign debts are not like auto loans.

Rather, sovereign debts are like stocks or mortgages. They’re assets in the banking system. Greece essentially borrowed into a bubble and in 2010 was revealed to be a bad asset. Greece’s economy is worth less than it’s mortgage, so to speak. Bad call, maybe reckless, but it’s the truth. Since then the bad asset that’s Greece’s debt has been passed around until it ended up in Europe’s central banks, the way bad assets in the US ended un in the Fed. That’s OK, it’s partly what central banks are for. No one is going to liquidate a central bank because its liabilities exceed its assets. Except the ECB, if they decide to. But that would be dumb.

So what the negotiation is about is seeking one of two outcomes: Either agree in banking circles that having big holes in the balance sheets of central banks is OK, in which case they can write off a big chunk of debt and put the remaining amount back on the investment market on a sound footing, or figure out a clever way to keep the debt on the books so the books look neat but the debt generates no real interest or pressure on the real economy. The first is emotionally cleaner and revives the economy, and it’s what Syriza wants. The latter buries the problem until it dies of old age and is the Japanese approach. I like Japan…

Why is there an oil price?

Why is the oil price well-behaved? I mean why is it settling in a range around $50 a barrel instead of being stuck at a few dollars per barrel, the marginal cost of the cheapest producers? Or for that matter why isn’t it much higher, at several hundred or thousands of dollars? These questions are not as trivial as they appear.

I know that different producers face different costs of extraction and shipment, with Saudi Arabia bing the cheapest and US fracking the most costly. If producers also face scaling limits on production, that would create a sloping supply curve. But do they? What’s stopping Saudi Arabia from pumping the oil out of the ground much faster and meeting the entire world demand until its oil fields run out? It could then charge a price just below the amortised extraction cost of the next cheapest producer.

Is there a technical or geological limit on how fast you can drain an oil field? Faster extraction of course requires more rigs, but the capital requirement is moot. If one rig is profitable at a given oil price so are 100 rigs, assuming the oil field and the market last longer than the capital amortization period.

A fully competitive market with zero foresight, in other words concerned only with present returns and assuming oil reserves and world demand lasting indefinitely, would suggest an oil price close to the lower bound. That we’re not seeing that suggests producers are factoring some aspect of future or total expected returns into their supply decisions. In other words they set the NPV of future returns above zero. Hold that thought.

What’s at the other extreme? What if some really far-sighted people, say Norwegians, value future returns on par with the present? Then they should say “Hang on, this oil belongs not just to us but to our children and our children’s children. All future generations need to be compensated for losing their finite resource, so we’re keeping it in the ground until it’s the last oil in the World and prices are many times higher than thy are now”.

If a producer can wait, assuming oil stock is finite but world demand persists indefinitely, you’d expect them to sit on the oil until production collapses, there are acute shortages, and they can extract punitive prices. That’s the way to maximize total returns if you set the NPV multiplier of future income at 1, that is you value the future as much as the present. Nobody does that, not even the Norwegians.

So what determines the price of oil? Is it the intersection of a textbook competitive supply and demand curve, where supply means marginal production cost and capital amortization? Is Saudi Arabia simply trying to drive US shale (fracking) out of the business? That’s the theory that prevails in the business press. Or is there something more subtle going on?

If producers are basing their supply decisions not just on spot supply and demand but on some sort of future returns calculation, they have three factors to balance:

An NPV curve (Net Present Value) or how they value money today vs. money in the future. This is subjective. War or fear of losing power may make the current leadership of an oil producer unusually short-termist. Oh look, ISIL, Yemen, the Saudi king just died…

Finite stock considerations, in other words recognizing that the stock of oil that each producer has is not infinite. Neither is the world total. Peak oil looked like an overriding concern a few years ago, but with the exploitation of shale and other expensive reservoirs the concern has abated. Oil is still not infinite though, and it’s finite within one or two human lifetimes meaning that producers should care.

The uncertainly of future demand. Sure, demand fluctuates but it’s rising indefinitely or at last not falling, is it? Well that assumption may be dramatically wrong. Oil demand may well drop abruptly because of climate limitations, or because of a technology shift to a superior form of energy such as solar. If you’re an oil producer with foresight you might want to get your money now before that happens.

I find these price-influencing factors at least as plausible as the naive assumption that there’s a price war going on against shale. If they apply, low prices may persist much longer than analysts are expecting, or may revert quickly. Prices may also move much lower or much higher than the cutoff point for shale which appears to be near current levels. We’ll see. But if a lot of volatility happens, and price turns out not to be driven by shale costs, don’t be surprised.

Here’s why I’m voting SYRIZA

I’m in Greece, partly so I can vote in the upcoming Greek elections where the leftist euro-reform party SYRIZA is expected to win. SYRIZA would probably win without me, but I felt it was important to come and vote for this important event. From the tone of the media inside or outside Greece you get the impression that a SYRIZA victory represents some kind of Euro disaster. On the contrary, I feel a SYRIZA government in Greece (or another one like it in Spain or Italy, this is about policy not people) is a bold step towards the solution. I regard it with optimism, even jubilation. Let me tell you why.

Disclaimer: I’m close to some SYRIZA candidates, policy thinkers, or MPs so I may be biased.

First why am I voting in Greece? I don’t live there. It would make more sense for me to vote in the UK where I live and pay taxes, but I don’t get the privilege. I guess native Britons are afraid I might vote for someone worse than David Cameron. Our concept of EU citizenship is still half-baked compared to America so we vote for national elections in our country of origin. We’ll fix it, but until then we have EasyJet democracy. In any case, I don’t feel strongly about voting on Greek affairs. I feel it’s important to vote, via Greece since that’s where I have a vote, for changes in Europe.

At a basic level I feel a duty to avert a bad outcome and push for a good one. If you recall, two elections ago the extreme right scored well in parliamentary elections in Greece. A surprising result that showed rising intolerance, fear, and naive insularity in Greek society. I find it abhorrent. At the same time you saw the Front National in France and Britain’s UKIP, which I see as equally negative but better at hiding behind a veil of respectability, gaining ground. SYRIZA is the polar opposite of these parties. In a climate of extreme right-wing euroskepticism, I feel it’s imperative to vote for leftist euro reform in Greece, Spain, or elsewhere. So that’s a defensive reason to turn up and vote.

The other reason, and the main one, is I don’t want an EU president and finance minister elected only by Germans, running the EU in a way that only suits Germany. Ms Merkel is our de-facto EU president. It’s clearly not Mr Hollande or Mr Juncker. Mr Schäuble is Europe’s finance minister. Whether German citizens like it or not, these officers set policy for the Eurozone, not just for Germany. They run the Eurozone in a way that serves the interests of narrow or short-sighted mostly German capital while driving real economies especially in the south into depression. This is wrong, and we need to use the democratic process to change it. Because of institutional inertia we non-Germans can’t vote for the Eurozone’s de-facto president and finance minister. Eventually these will be elected EU-wide but now, urgently, we must force our German-elected EU leaders to change their policies.

The way to do this is for the governments of peripheral countries to confront Ms Merkel and Mr Schäuble with the failure of their policies. This is what SYRIZA intends to do. It’s not an anti-Europe or anti-Euro party but it has to say, realistically, that current EU policy towards the periphery is not working. Greece’s economy is in depression and it’s debt is unsustainable, as it has been since 2010. Debt restructuring and expansionary monetary policy are needed to end the crisis. A growing consensus of economists agree, so we witness establishment papers like the FT urging the same policies that SYRIZA favors, for pragmatic economic reasons.

What will happen if SYRIZA is elected and starts renegotiating debt and austerity measures with Berlin? I think mainly compromise. EU institutions will have to accept balance sheet losses, which can easily be covered by monetary expansion. Greece will have to live within its means day to day, which given the big drop in incomes since 2010 is now possible. SYRIZA is new so it can enact better tax policy, touching previously untouchable classes, and in return can reasonably ask the EU for welfare assistance towards the poorest citizens. On election night the markets will jitter and possibly overreact, but forcing a Grexit is in nobody’s interest. In the long run markets agree with SYRIZA’s program and EU-wide policies such as quantitative easing that it aligns with.

A win for SYRIZA will be an important event for Europe, not because Greece is important but because some peripheral country needs to stand up for a change in EU policy. It could be Spain or Ireland, but looks like it’ll be Greece. Far from that being a disaster or some new chapter in the Euro crisis, I think it’ll be a triumph of the democratic process and post-crisis Europe’s finest hour.

Insulting the prophet

Presumed Muslim militants (remember, they could very well be provocateurs) have attacked a satirical paper in Paris killing 12 people, including legendary cartoonist Wolinski. How is the West supposed to react? Tolerating these rare events is an option. But if we think there’s a problem to solve, what is the right thing to do?

There are only two ways. One is to convince the overwhelming majority of Muslims that insulting Muhammad is OK. Convince them that no harm is done, or that whatever non-Muslims say in their societies is not worth taking a life over. If the overwhelming majority of spiritual leaders accept that, then you treat a fatwa as an act of war from the few who don’t. It’s a small act of war so you don’t snd the bombs in, but an act of war nonetheless. That was the stance taken by Margaret Thatcher on the Salman Rushdie fatwa, without so much emphasis on the soft convincing part. Typically the West tells Muslims: These are our principles, press freedom first, respect to you on your terms a very distant second or not something we entertain.

The alternative is for the West to censor depicting and insulting Muhammad and treating deviations as hate speech. It’s a revolutionary idea, but perhaps we could agree that antagonising 1.6 billion people is counterproductive. The West does not have sacrosanct freedom of speech. There’s plenty of precedent for censorship, some to protect minorities, most to support government and corporate agendas including copyright. A specific ban on depicting and insulting the prophet is not a slippery slope and certainly falls at the benign end of the spectrum, unless we dislike Muslims or think they’re crazy to take offence. Neither do we have to really eradicate the offending satire. The West just has to say we respect Islam, we make this illegal and will prosecute offenders.

I’m a humanist, mostly utilitarian atheist. To me respect and censorship looks like the option that reduces harm.

It depends if you think Muslim anger is genuine and widespread or the work or oppressors and agitators. Also whether you consider the question open or closed. Free speech exists to resolve open questions. When society reaches a consensus the question is closed, until the consensus is no longer current and it is reopened. The West wants to open a question that Muslims may want closed.