Many economists and commentators are instinctively pro private sector and anti public sector when considering the solutions to our prolonged recession. With our government debt situation as it is, a cautionary approach is understandable. But here I want to suggest two examples within the larger debates, where what can sometimes come across as intellectual prejudice needs to be backed up more carefully, and where perhaps a more unbiased basis for differentiation would be preferable.
Alternative differentiation: Productive verses unproductive debt, rather than public verses private debt.
art of the initial idea for this short essay came from something in Adair Turner's Cass Business School lecture - "Debt, Money and Mephistopheles: How do we Get Out of This Mess?" on 6 February 2013.
Much debate on macro-policy is bedevilled by a failure to be explicit about those two steps of the logic. As a result the same commentators will sometimes:
In other words, Turner is reflecting on the tendency for prejudice to be shown between the means (or “different levers”) of generating greater aggregate demand, even when the mechanism between the means and the benefit of the end result is, to all intense purposes, the same. This observation of Turner's rings true for me, in that I have noticed automatic assumptions being made that government solutions are inflationary and saddle our children with debt, while private solutions are merely “getting the economy going” and a return to healthy levels of investment. These prejudices are often presented as implicitly obvious, but are in fact only partly or not at all backed up by good economic reasoning.
I noticed recently during the Budget coverage on Sky News, that on the banner at the bottom of the screen they had a counter which was clocking up the government's ever-growing debt. This device I thought provided quite a loaded background to the budget debates, and one could imagine Fox News in the US doing the same. It struck me that, given the Chancellors recent 'Help to Buy' proposals, would there be a case for now, and would there have been a case for eight or so years ago, having a similar counter noting the country's total mortgage borrowings.
One rationale for the discriminating mindset of the free marketeers is that private debt usually represents profit making investment, in that firms have seen an opportunity and aim to exploit it for future gain. In contrast, government spending tends to be just a sucking black hole, satisfying present wants, but not contributing anything concrete to future repayment capability. The repayment of the extra business debt can be borne by new profits generated from the investment, but the repayment of the government debt has to come from the freshly squeezed income of future tax payers and businesses. This suggests that the correct prejudice would be to distinguish between debt which contributed to greater output potential in the future, and debt which did not.
But are mortgages productive investments in this respect? A mortgage can be viewed as a productive and rewarding investment on a personal level, in that it saves paying rent and eventually gains a property asset. But on a national scale, a large increase in mortgage borrowing on a slowly growing housing stock, just represents a distribution of money from up-sizers to down-sizers, or between the generations. This obviously is the debate that the policy has sparked. In Britain, one of the biggest silent revolutions over the past decades, has been that a quiet section of middle aged and elderly society are now sitting on small unearned fortunes in house equity, while new buyers struggle to afford a house. For those who ask; where has all the money gone? this is a large part of the answer, … house equity! In terms of being an economically productive investment, one could argue that the section of any extra mortgage borrowing which motivates new house building is real investment, while the rest is just wasted on unproductive and socially divisive asset price inflation. The higher mortgages caused by the later section will not make future tax payers more taxable.
I have left out the potential of government borrowing and spending in general to contribute to a Keynesian multiplier effect on the broader economy, which is a whole other debate. In terms of using government debt finance to spend in non infrastructure areas merely to reflate the economy, perhaps there is an argument for saying this is a viable policy in general during a recession, and the world as a whole does need it. But perhaps Britain's higher than average exposure to the financial services downturn, and subsequent government debt caused by the British bank bailouts on top of the recession, means that Britain should be given a free pass not to join in with any more of this international aggregate demand boosting efforts, and instead should be allowed to free ride on the government stimulus of other countries. Perhaps this underlying recognition that we need stimulus on a global level is what makes the IMF's present attitude towards Britain seem inconsistent with their past country level advice.
In other words, if your finances are as bad as ours are, but you really need to increase economic activity to compensate for a deleveraging and hoarding private sector, you had better make sure your government borrowing is spent on something that will ease repayment in the future. A return to house building in the South-east directly financed by the government is an option I have sympathy for, as that debt would have a very good prospect of paying for itself.
Alternative differentiation: Controlled and appropriate base money expansion, rather than public verses private means.
The central topic of Adair Turner's excellent Cass Business School lecture mentioned above, is the subject of Overt Monetary Finance (OMF), or 'Helicopter Money' to give it its flippant nickname. Turner is all too aware of the prejudiced against public sector interference in general in this area, and against this kind of policy in particular, when he writes:
To print money to finance deficits indeed has the status of a moral sin – a work of the devil – as much as a technical error. … The ability of governments to create money is a potential poison and we rightly seek to limit it within tight disciplines, with independent central banks, self-denying ordinances and clear inflation rate targets.(p.3)
Even when it is effectively proposed, overt money finance is the policy that dare not speak its name. OMF therefore maintains its taboo status – and there are good political economy reasons for why that is so. … The challenge is therefore to take the possibility of OMF out of the taboo box, to consider whether and under what circumstances it can play an appropriate role, but to ensure that we have in place the rules and institutional authorities which would constrain its misuse. … It must also be subject to clearly defined disciplines to guard against political economy risks.(p.31)
Much of the austerity narrative used by the Coalition government relies on the concept of it being constrained by our high government debt level. Introduce the idea that the government could print money, and the being responsible narrative falls apart somewhat. There are probably many people who do indeed believe that it would be helpful for money supply to expand presently, and would have supported lowering interest rates if they had had any further room to drop. So you could ask: if base money supply is growing, does it matter if the cat is black or the cat is white? But many of these same people are wary of crossing the printing money Rubicon, due to a lack of faith in political discipline. Recently, again on a TV news program, when this subject was being discussed, one guest interjected vehemently by saying something like “Oh God, so we should end up printing money like Zimbabwe!” But this I think represents an unreasonable prejudice that is not justified by any evidence of rampant corruption or profligacy to be found, and certainly not within the Bank of England itself.
As Turner recognises, by creating money the government would only be doing in a formal and planned way, what in boom times the banks did in a way which was limited only by the extent of the leveraged boom in finance:
But fractional reserve banks, simultaneously creating private credit and private money, can greatly swell the scale of debt contracts in an economy and introduce maturity transformation. And there is no naturally arising mechanism to ensure that the scale of such majority transformation is optimal. As a result banks can greatly increase the scale of financial and economic stability risks. They can also play an important autonomous role in the creation and destruction of spending power, i.e. of nominal demand, and as a result can generate booms and busts in overall economic activity. (p.11)
In other words, bank creation of money, which can be thought of as their own version of 'debt funded stimulus', systematically over shoots in good times and under shoots in recessions, as Keynes' animal spirits wax and wane. The Bank of England changing interest rates is normally enough to even out this cyclical swing a bit, but at present, when lowering interest rates has run out of steam as a policy, eyes are turning to these other strange and forgotten levers. But right-wingers fear that give the short-termist politicians access to this new lever as a proposed last resort, and they may instead print money for bread and circuses today, and to hell with future price stability. Where as in contrast, at least private sector money creation is more objective, mechanical and derivative of economic activity. But, just because it is derivative of private economic activity, that does not mean that private debt is inherently harmless or without consequence. As Turner states in one of his main conclusions:
If we got into this mess through excess private leverage we should be wary of escape strategies which depend on creating more private debt. (p.40)
Turner's discussion of nominal GDP targets are a clever suggestion to possibly get around the political temptation to misuse an OMF policy, and a clever solution to the all important expectation implications, which are always key to inflation issues. In this approach, nominal GDP targets are set for the future, and if real growth does not materialise, the authorities aim to meet the target with inflation by printing money. When real growth is weak, spare capacities in the economy mean inflationary spirals are unlikely. When real growth returns, the authorities are obliged, in a black and white fashion not susceptible to political fudging or double speak, to take their foot off the gas and park up their helicopters. The degree to which a nominal GDP target is met at a specific time, then becomes a usefully clear measure of a government's, or the Bank of England's competence, ability and integrity.
Turner argues effectively that Japan would have benefited from targeting nominal GDP during the last 15 years. He also introduces comparisons in the way the US and Britain handled post war debt. The 1930s are the period usually evoked in making historical comparisons with today. But as Western countries have kind of learnt that lesson, and as a result in general ALREADY HAVE sunk in the large amounts of government money to try to revive / save their economies (like the WWII spending), perhaps, as Turner hints, it is now the period around the 1950s which are most instructive for today. The 1950's are often considered a golden age for the US despite its WWII debt, so learning from Turner that its debts were “post facto … money financed” (p.27) is significant, and fits in with Turner's inflation rather than deflation biased themes:
Countries such as the UK and the US, which achieved public sector deleveraging after the Second World War, were only able to do so with growth rates of nominal GDP far above current rates (EXHIBIT 23-25). Both rapid real growth rates and inflation rates in excess of interest rates (achieved via effective “financial repression”) were essential to the deleveraging process.(p.16)
Keynes himself was nothing if not agile and unprejudiced in his economic thinking when it came to questions of private verses public solutions. He was also famous for his 'Essays in Persuasion', which sought to stop his contemporary economic generals from fighting the last war, (like inflation today?) or being “the slaves of some defunct economist”. In his discussion to the Macmillan Committee in 1930, in response to the sharp deflation of the period, he had something to say regarding the contemporary recieved wisdom on the subject of money supply, and against the idea of continuing an austerity policy (far more extreme than today's) to reduce domestic real wage costs:
My reading of history is that for centuries their has existed an intense social resistance to any matters of reduction in the level of money incomes. … Throughout history I can only recall two occasions at all comparable to the present one. One was the highly analogous deflation which followed the Napoleonic Wars, … very much like the one we are going through now, was one which brought this country to the verge of revolution, … The other analogous case was the price fall in the middle ages prior to the discovery of America and the influx of precious metals to Europe. The fall of prices was, then, an appalling problem, and it was only mitigated by monetary readjustments. Many of our monarchs rest under unjust imputations of depreciating the currency for their own personal advantage. I am sure they only did it to avoid what they regarded as intolerable wage adjustments. There is no question as to the impoverishment of the world that occurred; and subsequently the High Renaissance and the general process of recovery were based on the accumulation of profit which took place during the period of the rise in prices, lasting about 100 years, which followed on the influx of gold from America. But apart from these two periods I do not think there is anything to prove that it was ever easy to bring about material fall in the level of money incomes. (Keynes, 1981:64)
Finally, interestingly in the lecture Turner reveals that Milton Friedman in his early career proposed the concept of governments never having spending deficits or surpluses, but instead printing and destroying currency in either instance to suit. In parallel, the assumption that needed to go along with this approach was that the ability of private banks to create money would be taken away. What a disconcerting and radical set of ideas this sounds to our 2013 ears. And from Milton Friedman who would later become the darling of Thatcherism and Monetarism!
But Friedman argued in an article in 1948 not only that government deficits should sometimes be financed with fiat money but that they should always be financed in that fashion, with he argued, no useful role for debt finance. (p.3)
Second, however, what both my illustration and Friedman’s proposal assume is that all money is base money, i.e. that there is no private money creation (no “inside money” in Gurley and Shaw’s terms) (Gurley and Shaw 1960). This in turn is because in Friedman’s proposal there are no fractional reserve banks (EXHIBIT 9). [Banks would be made to hold 100% reserves against what they lent out!] In Friedman’s proposal indeed, the absence of fractional reserve banks is not simply an assumption, but an essential element, with Friedman arguing for “a reform of the monetary and banking system to eliminate both the private creation and destruction of money and discretionary control of the growth of money by the central bank ”.(p.7)
When economists of the calibre of Simons, Fisher, Friedman, Keynes and Bernanke have all explicitly argued for a potential role for overt money financed deficits, and done so while believing that the effective control of inflation is central to a well run market economy – we would be unwise to dismiss this policy option out of hand.(p.4)
Note: Interested in economics and economic history, Rob Julian recently wrote an article titled "Keynes on the Slump: A Guide to Keynes' Thoughts During the 1929-32 Crisis, with a Focus on International Relationships and Protection"
The word compete has two meanings, to strive to win and to take part in a competition. In popular discourse it is interesting how the first definition dominates over the second. To be competitive means to be good enough to take part as much as it means to win at all cost.
When my Dad talked about the Olympics he talked of the ethos of “The joy is to compete, not just win”.
When we talk about “Open Competitive markets” what is the balance we have in mind between these two definitions, and is it right?
Edward de Bono had an interesting example of reductio ad absurdum. Democracy is a good thing; therefore more democracy must be better than less. Carry that on and you end up with a national referendum on what to have for breakfast. Try the same exercise substituting efficiency for democracy and you end up buying each piece of paper individually by competitive tender.
Now try this: “competition is good, therefore more competition must be better than less”.
We have lived in an era of 40 years with the dominance of free market thinking and with it competition.
Regulators are given a duty to promote competition.
Yet over 40 years there is an increasing body of evidence that competition, as currently understood, doesn’t always deliver.
Let’s look at some of the arguments.
Competition is supposed to lower costs, promote innovation, improve service, and improve value for money for the public purse. I can remember that in the early 80s I was told at a think tank meeting that monopolies were immoral and free markets kept the participants honest.
When the utilities were deregulated, the promise was made that in time the need for regulation would diminish as the market took hold. Energy prices would fall and attracting private sector investment would secure continuity of supply.
Competitive markets are the engine of growth and stability. That’s certainly challengeable since 2008.
I don’t want to go through here some of the benefits that have been realised, so this may seem like a bleak analysis, but bear with me.
I’m just about to get my first defined contribution pension. The annuity valuation indicates that I have to live 21 years to get the sum back at 0% interest. The fees eat up much of what I have saved. Indeed costs of the competitive UK pension market are up to 3 times some of our “less competitive” European counterparts. So much for cutting costs!
I spent 75 minutes yesterday on a call centre for a privatised utility trying to report a fault. I don’t believe in naming and shaming so I won’t. It was frankly appalling. In comparison my last contact with HMRC was a delight. Service, what service?
Government IT projects are often described as a disaster waiting to happen, often in my experience unfairly. Yet all of these are procured by open competitive tender. Value for money? Furthermore the contractual mind set in competitive tender has been known to squeeze out, not stimulate innovation, as it’s proven difficult to procure innovation.
As for honesty, can I just say PPI and Horsemeat?
The recent reports on LIBOR have described dysfunctional corporate cultures driven by individually hyper-competitive individuals.
Energy prices have risen and the private sector is demanding large public subsidies to invest in new energy infrastructure. We will be perilously close to the capacity of the national grid around 2015-16 and energy security cannot be guaranteed.
The standard response to all of these is to be blame procurement or regulation. Yet regulation was supposed to diminish over time. The promise was that it was temporary to allow for competition to grow against the privatised giants.
I find it interesting that Michael Gove, a Conservative Education Secretary last year wanted to establish a monopoly for exam boards on the grounds that competition had led to dumbing down and a race to the bottom.
Put like this a mark of gamma and “Could do better” looks generous. In a more balanced piece I would be comfortable with a beta, but not an alpha under any circumstances.
In contrast Europe’s strength in 2G mobile phones that spawned Vodafone was born out of international co-operation. WWW was invented at CERN in an international collaboration.
There is that horrid word “co-opetition”, competing through collaboration that is occasionally used for this phenomenon. This is the difference in Game theory between zero-sum games and win-win.
I’m not arguing to go back to some sunny uplands of the past which never existed. On the contrary, we only progress by tackling difficult and intractable problems.
If we are to secure the benefits of open markets for the long term, then I argue that we need a nuanced debate about the value of competition, not a blind acceptance of it.
I am reminded of a poster in a work place “Flogging will continue till morale improves”.
Is this a case of competition isn’t delivering, what we need is more competition?
Houston, we have a problem. Not quite what Swigert or Lovell said, but it is certainly true of scheme valuations. While examining 22 schemes in preparation for the EFFAS response to the DWP Call for Evidence on smoothing, I calculated the average signal to noise ratio of these schemes. It was staggeringly low at just 27%; for one scheme, it was less than 10%.
The concept of the minimum discernible signal is immediately relevant; the signal cannot be separated reliably from the noise until it exceeds the level of the noise, but here it is half the noise level. The inference: these schemes have been managing their affairs on a wing and a prayer - and so have both the Pensions Regulator and the PPF.
These may not be a representative sample of schemes overall, but they ranged from the very large to the small; they had followed a range of investment strategies and degrees of “prudence”; some had closed to new members and some to future accrual. This was a rather diverse sample. In fact, these management operations had amplified the average annual increase in total liabilities over the past five years to 4.2% p.a. from 2.3%; in other words, the signal in the period under analysis was large.
Simple averaging lowers reported volatility and increases the signal to noise ratio. With five year smoothing, it only increases to 29%, but with 25-year smoothing to 46%. This hardly seems worth the effort in the five-year case, but the story does not end there. At an annual frequency, the correlation between equity and debt returns is 0.48 and increases to 0.82 under five-year smoothing. This correlation is actually higher than some schemes are achieving with their complex liability driven investment strategies. It is also notable that the correlation between equity returns and the return on capital of the UK private sector decreases from -0.29 to -0.44. In other words, equity is seen to have better diversification characteristics, and is better at enhancing member security than previously thought. Finally, when bond yields are smoothed, they relate more closely to the profitability of the UK corporate sector; liability values become more closely aligned with the corporate sector’s ability to pay. Figure 1 shows the time series of returns from equity, bonds and the UK private non-financial sector, together with five-year smoothed equities and bonds. This also makes evident that, for more than a decade, the returns from financial markets have been lower than the profits of the UK corporate sector – funding has been inefficient over this period.
There is an important caveat this; the use of smoothing does not contain any new information as to the value of assets or liabilities – but it does make proportional trends in funding status more evident. As a risk management tool, it is superior to the status quo. However, the real merit of smoothing lies in its value as signal of the intention of government to resolve the issue of valuation correctly.
The Regulator has asserted that there is sufficient flexibility in current regulation and that it already considers affordability to the employer sponsor.
The claim to adequate existing flexibility rests, in very large part, on the use of the expected return on assets as a discount rate. This fails to recognise that the use of a common discount rate for assets and liabilities is a necessary but not sufficient condition for accurate scheme evaluation. One problem is that this will not result in accurate sponsor liability exposure values, no matter whether the scheme is in deficit or surplus. Under this approach, the volatility of the asset portfolio becomes all-important and for our illustrative schemes, this averages 14.1% of scheme value. Any consistent derivation of the expected return on assets will retain the volatility of those assets. The signal to noise ratio would be just 23%, while under current regulation it is 27.0%. In other words, using the expected return on assets in a consistent manner actually results in outcomes that are less informative than under current approaches. This could represent a serious risk for the PPF as it admits the possibility of significant misstatements of liabilities in times of sponsor distress and manipulation of reported scheme funding status in evasion of levy obligations.
The Pensions Regulator’s claim of flexibility in agreement of deficit repair schedules conflicts with numerous reports by actuaries, other advisors and trustees of considerable difficulty in agreeing these. Here, flexibility conflicts with its responsibilities to the PPF. If the Regulator is already using this flexibility, it is clear that this must be inadequate from the perspective of sponsors for the Call for Evidence to have come into existence. Moreover, if the Regulator is using this flexibility, they really should be accountable for its consequences, which they would be if it were an explicit objective.
The fact that this Call came about gives the lie to the often-repeated assertion that sponsor employers no longer wish to provide DB pensions. It is evident that their concern is with provision under current practices and regulations.
We should be concerned that both the Regulator and the PPF believe that “funding trumps covenant”. In the past, we have likened this to believing that seatbelts trump brakes. This view is in direct conflict with the Regulator’s sponsor assertions. This funding view gives rise to the belief that two schemes with identical assets and liabilities have an equal funding ratio, which is incorrect. The liabilities that should be recognised by a sponsor depend upon the terms under which they were originated. This subject is explored in depth in a recent paper titled "Keep Your Lid On: A Financial Analyst’s View of the Cost and Valuation of DB Pension Provision", which shows how schemes may be accurately valued without recourse to market rates or prices.
This point is illustrated (as figure 2) using zero coupon bonds issued by two companies. One was originally a fifteen-year issue which offered a 10% rate of return to maturity – the valuation date is five years prior to maturity. The other was a ten-year issue that originally offered 5% as a yield to maturity.
The 5% bond has a liability value of 78.35% at the valuation date, five years prior to maturity, while the 105 bond has a value of 62.09%. A creditor may claim these amounts if insolvency were to arise at valuation date. This is the acceleration position for a coupon-bearing bond; at insolvency, the creditor’s claim is for repayment of principal plus accrued interest under the original terms. This is sound mitigation of the inherent moral hazard problem.
Suppose that these bonds have assets of 69.66 as security, with an expected return of 7.5% to the five-year maturity, then rather than being both identically (and fully) funded, we see that the 5% issue is underfunded and the 10% issue overfunded. Back-projection of this level of funding shows that the funding view is not time consistent as it implies that the 5% was over-funded at inception and that the 10% issue was underfunded.
This is a form of market price valuation issue. The market price may be the value to the marginal investor, but that value is not the company’s obligation, nor is it the value that a creditor may claim in insolvency. Market consistency is neither fair value consistent nor time consistent.
To our knowledge, neither the PPF nor the Regulator considers this aspect of the sponsor obligation, which in turn means that they are basing their judgements on incorrect estimates of scheme liabilities. This funding trumps covenant view is all pervasive; the Regulator supports it, and the PPF actively promotes it through levy amount determinations. This goes well beyond concern with the quantum of funding and extends to the composition of the fund.
It is also notable that the Regulator’s actions in pursuing insolvency recoveries in the courts have also contributed to the unwillingness of banks and others to lend to companies. Numerous public statements were made that the judgements obtained would result in higher lending margins and lower availability of bank credit. A cost-benefit analysis of this legal pursuit, and its consistency with consideration of the interests of sponsor employers would be most interesting.
The special contributions, required by the Regulator over its lifetime, could have reduced the dependence of the UK private sector on their banks by more than 50%, lowering their likelihood of insolvency. Funding is, at best, an incomplete solution to the problem of sponsor insolvency, and in recent times ineffectual; lowering the likelihood of insolvency is superior in many regards.
In pursuing these claims and contribution demands, it was correctly pursuing its objective of protecting the PPF, but at potential costs to sponsors that are substantial, and probably went without formal analysis or consideration. These are powerful arguments for an additional objective for the Pensions Regulator, and for smoothing as a first step towards correct valuation practices.
Note: the two EFFAS responses to the DWP Call for Evidence and the paper, “Keep your lid on!” are freely available from www.longfinance.net and www.futureofpensions.org. These issues will also be discussed at a Financial Services Knowledge Transfer Network/University of Warwick conference taking place at the Royal Statistical Society in London on March 21/22.
The moral ambiguity of Debt
debt • noun 1. a sum of money owed. 2. the state of owing money. 3. a feeling of gratitude for a favour or service.
Oxford English Dictionary
This quotation sits the start of David Groeber’s excellent new book on the history and anthropology of debt . The definition illustrates really neatly that we do not have a coherent well thought through morality around the concept of debt, leading to confusion and blame shifting. Here is a small sample:
There is little doubt that our moral position on debt is confusing and ambiguous. Our attitude to it seems to border on cognitive dissonance, causing us to try desperately to believe several mutually contradictory things. This problem and the associated moral ambivalence have been around for millennia. The book was interesting, but ultimately frustrating as it illustrated the problem without positing a solution. So it is with a mixture of trepidation and brashness that I will try to bring some order to this confusion.
I will do this by building a table of the different combinations of choices that the borrower and lender could take, and then using it to bring out four principles that can be used to judge if a decision to lend money at interest can be considered “moral” or not.
An options table is built by boiling things down to a series of Yes/No decisions. If a potential borrower is looking for a loan, rather than a gift, then there are three actions that may (or may not) happen.
From the three decisions above there are 23 = 8 possible combinations of outcome. But of those only four are plausible, as shown in the table below. Whatever is planned, eventually one of these four scenarios below will transpire, either by accident or by design.
Figure 1: The four scenarios
I posit that if the following four principles are met, then the loan is “moral”, and that any “immoral” loan will fail on one or more of the principles. As with all such principles, it is the exception that tests the rule. I do not believe in moral absolutes, but I do believe in moral principles. As with all moral principles, it is always possible to think of exceptions to the rules, but the more bizarre and implausible the exceptions to the principles have to be to engender a debate, the better the principles are in the first place.
This almost goes without saying, but the lender should not deceive the borrower as to the terms of the agreement, hide costs or later demand more than agreed. Both the borrower and the lender should also agree what would happen if the loan is not repaid. The actions in the table should be unambiguous and understood in the same way by both parties.
Figure 2: The terms of the agreement must be well defined and known to both parties.
This principle is possibly the easiest to enforce, as it is about what people are saying, rather than what they are doing or thinking. Rules can be made. Indeed there are laws that enforce clarity (for example by forcing lenders to calculate their interest rates in the same way).
To meet this principle, both sides should not only be saying that the loan will be repaid, but also hoping and believing that the borrower is able and willing to pay back the money (see below).
Figure 3: A morally acceptable agreement
It would be immoral (as deceit would be involved) for a borrower to take out a loan, hoping or expecting not to repay. Perhaps he does not believe that the lender will be willing to enforce the debt, (as with loans from family members) or he may think that the lender will be unable to enforce it (if the borrower intends to abscond with the money), and does not intend to repay at the time of the loan. This is shown below:
Figure 4: An immoral loan (fraud)
Intent not to repay in this way is generally illegal (fraud), and society has structures and rules in place to prevent or stop this happening.
But there is another immoral loan when the boot is on the other foot. This is where the lender hopes and expects that the borrower will default on the loan because he wants to cash in on the collateral (e.g. acquiring a house of greater value than the loan). The borrower may well think that he will pay back, but the lender doubts he will be able to, and relishes picking up the collateral. The “Liar loans” that led to the crash of 2008 were in this category. By making loans to less and less creditworthy people, the American mortgage companies were hoping to cash in on the sale of repossessed houses. It would have been a great idea if the house prices had not collapsed, leaving both the borrower and the lender with nothing. Shylock from the Merchant of Venice was also in this category by insisting on a “pound of flesh” that was offered as collateral rather than a cash repayment that was offered.
Figure 5: Lender does not expect borrower to repay
Setting morality aside, this policy is not without its risks for the lender; in particular many new laws favour the borrower over the lender, meaning that people trying this out may end up with the “Take money and run” scenario instead. The lender may also incur costs for enforcing the payment.
A way to ensure that ‘thoughts are pure’ is to ensure that the borrower defaulting is a lose/lose situation for both parties, and so that the lender hopes to profit from charging interest, rather than from picking up the collateral.
If the lender believed that he should lend even if the borrower would get away without punishment, and the borrower believes he should borrow even if punished, then the deal meets the principle.
Figure 6: A morally acceptable agreement: contradictory beliefs about default.
It is at this place that an argument can be made for the morality of charging interest in the first place. A lender may be approached by several borrowers each of whom intends to repay but each of whom has a chance to default (even though nobody intends to). To get his money back the lender would be required to charge interest to cover the risk.
It is also at this point that things get a bit sticky as there is a requirement for the borrower and the lender to believe mutually contradictory things. It is argued that a moral lender should be somewhat magnanimous towards a borrower who cannot repay through any fault of his own (perhaps the borrower bought seeds for his farm with the loan and the crops failed), and the lender should not insist on all the punishments previously agreed. But on the other hand, the lender is aware that if he becomes known as a “soft touch” then the borrowers will be tempted not to try too hard to repay their debts.
There is another moral obligation on the lender that seems to be increasingly used as an accusation of immorality against lenders. It is said that a lender should have a moral obligation not to make loans unless he believes the “Loan repaid” scenario is preferable to the “No deal” scenario for the borrower.
Figure 7: Principle 3 - Lender thinks “Loan repaid” scenario will be best.
That is, the lender has to think that at the end of the repayment period the borrower will thank the lender and be glad that he took out the loan, rather than wishing that he hadn’t.
The arguments supporting this are that transactions should be a win/win situation, with both sides gaining from the loan, and the borrower should not be conned into thinking it’s a win/win when it’s actually a win/lose.
Paying back a loan, even if it all goes according to plan, can be a very painful process, and it is very easy for a borrower to be optimistic and assume things will miraculously turn out all right when he takes out the loan, underestimating the amount of efforts that will be needed to pay it back. In general, the lender will be more familiar than the borrower with the lending process and the consequences of receiving loans. He will be best able to evaluate the true cost of the loan.
To make this judgment the lender will have to know what the borrower wants the money for (e.g. investment or expenditure), and what sacrifices he will have to make so he can repay the loan.
A lender should sometimes say to a borrower “It is irresponsible for me to lend you the money, as I think that you will be in a worse state than if I didn’t”.
Not to do this is the equivalent of selling defective goods. The buyer agrees to what he thinks is a good deal, but in fact it isn’t. Lenders are rewarded for making loans that get repaid, not for making the customers’ lives happier in the long run.
Payday loan lenders can be criticized under this principle. Many of these take pride in being crystal clear about the terms of the loans they offer. It expects the borrowers to pay back. It passes Principle 1 and Principle 2 with flying colors. However it is still criticized for Principle 3. The feeling is that the borrowers shouldn’t be taking out the loans in the first place, as to do so would imply getting into worse financial difficulties than before.
It is here where excessively high interest rates can be criticized. High interest rates will increase the ‘pain’ involved in paying back the loan, perhaps nudging the borrower towards the “it would have been better if I hadn’t taken out the loan” scenario.
On the other hand...
Despite true intentions people who take out loans may have difficulty paying them back. There is then a very human tendency to blame somebody else for your misfortunes, and to build a story in your head absolving yourself from all blame. The moneylender is the ideal scapegoat. The lender is demonized in the minds of the borrowers who genuinely misremember details of conversations that happened, convincing themselves they were miss-sold. Self-deception is worse than outright lying here. Sometimes the lenders are genuinely surprised at what happens as well. They expect to lose 10% of the loans through “hard luck” stories, but because the economy takes a nose dive 50% of the loans are lost.
What perhaps they should be doing is to get some feedback on the wisdom of taking out the loan with the benefit of hindsight at the end of it all. Perhaps we need to organize a feedback site where customers can answer a simple question, at yearly intervals after the loan was taken out.
“I am glad I took out the loan True/False”.
Even if the results are less than what the lenders would like, the relative positions would serve to deter genuine miss selling and the number of happy customers would show to the self-deceived borrower that not all the loans turned out as bad as his did.
An extension to the above is what is often called “ethical lending” which is mainly interpreted as not lending to borrowers who will themselves use the money further down the line for immoral purposes (even if they are perfectly moral and honest with the lender). An “ethical lender” will usually not loan to companies that use child labour, or produce tobacco or weapons. Instead of ensuring a win/win just between the two parties agreeing to a loan, the win/win concept is beyond the lender and the borrower to the well being of the world as a whole.
Unfortunately, this involves adding an extra action to the three laid out at the beginning, that is the decision of the borrower to use the money unethically. So our table is extended from three to four rows. This results in the following as our final principle for “moral” lending.
Figure 8: Lender refuses unethical use
Looking at our four principles, we can begin to see why bankers and moneylenders have acquired such a reputation for being unethical. It is firstly because they are the ones with both the greater number of temptations to behave unethically, and fewer penalties in law if they do. But it is also because the lender is the perfect scapegoat if something goes wrong with the loan. The borrower can then retrospectively paint himself as a victim of being "miss-sold" the loan by the lender.
Progress is being made on three of the four principles, but principle 3 remains the difficult one to achieve. It is a genuine temptation for the lender, and also a perfect retrospective way for irresponsible lenders to shift the blame back onto the borrower. The simple solution proposed (feedback by borrowers at the end of the loan on how glad they were to take out the loan), may serve to reduce both problems.
This article also illustrates the power that thinking in terms of options tables has in bringing clarity and focus to confusing situations. This approach (formalised as Confrontation Analysis) can equally be helpful in the context of legal, business and political negotiations.
Market prices reflect fear and greed, telling us about the last disagreement over value, but little or nothing about an asset’s usefulness in meeting future pension payment cash-flows. It was this growing realisation and disquiet, on the part of, among many, the NAPF, CBI and Association of Member Nominated Trustees, that led to the DWP call for evidence on smoothing. The evidence that current accounting and valuation standards produce results that are volatile and biased is now overwhelming. Management of a scheme under these standards is a thankless and expensive task of Sysiphean dimension and Augean substance; disclosures and transparency serve to mislead rather than inform trustees and members.
Some have argued against any form of smoothing on abstract principle. This fails to admit that pension schemes are themselves smoothing mechanisms – they share and average savings, investment and pensions over multiple and extremely long time-periods. It also fails to recognise that the current “mixed attribute” standard of discounted present values for liabilities and market prices for assets itself contains a smoothing mechanism – that is exactly what any discounting process does when reducing future payments to a single present value.
Of course, the accounting and valuation debate is nothing new – it has simmered in the background since its introduction a decade ago. It is the sheer volume of evidence, of its pernicious effects, which is new.
Perhaps the greatest obstacle to conclusive resolution of this debate has been the absence of a technique that fully resolves the issues that have been identified. In a recent paper titled "Keep Your Lid On: A Financial Analyst’s View of the Cost and Valuation of DB Pension Provision", prepared for Long Finance and the European Federation of Financial Analysts Societies, this lacuna has been filled.
In this paper, the Internal Growth Rate (IGR) of a pension system is introduced, along with methods that fully meet reporting objectives and management needs. The proposed method is:
Liability projection is standard actuarial routine in scheme valuation; no change is proposed. In order to achieve consistency in comparison, the projected cash-flows from assets, rather than current asset values derived from market prices , are compared with the pension liability projections. The projection of asset cash-flows is well-established in the econometric literature. Comparison of cash-flow projections is the comparison of apples with apples , a basic requirement of any measurement process; not apples with trees as the standards require. We should remember that the largest trees do not necessarily deliver either the most or the best apples.
Comparison of cash-flows also eliminates any prospect of pension schemes being operated as Ponzi schemes; the heart of a Ponzi scheme is that prices will enable continuation until collapse, which cash-flow projection will expose with the absence of the next dividend or coupon, a matter of weeks or months rather than decades. The projection of income and expense also offers us a prime risk management tool – we can observe directly the timing and amounts of shortfalls and surpluses of income relative to expenses.
The key insight of the paper concerns the discount rate at which these income and expense cash-flows are compared. It turns out that there is a natural rate, known as the internal growth rate (IGR), which applies to any scheme, and which is fully determined by the terms of the pension awards. This amounts to no more than requiring that the present value of contributions must equal the present value of the promised pensions . In this, the approach considers an element of scheme design overlooked in current practice, contributions.
The IGR is the implicit or unstated rate of return promised to members on the contributions, given a set of pension expectations. In a book-reserve scheme, it is the cost of the contribution capital to the sponsor. For a funded scheme in deficit, this is the cost of the deficit capital to the employer. This is important; this method informs us directly as to the amount and cost of a deficit to the sponsor, which can only be extracted with great difficulty from current standards and practices. Formally, this is simply a fair value condition.
The fact that this proposed method is fair value consistent demonstrates, through the differences which arise with “market-consistent” approaches, that the current “market-consistent” techniques are not “fair value” consistent – which should trouble the accountants greatly. By considering contributions, the IGR avoids any need for exogenous variables, such as the use of arbitrary rates and prices. This also shows that the Pension Regulator’s claim, that flexibility in the choice of the expected return of assets is sufficient to remedy the problems, is false. That approach will result in liabilities that are misstated and volatility of valuations due to the continued use of market prices for assets. The use of variables (e.g. market prices, gilt yields, choices of asset returns) that are exogenous to the system and do not reflect scheme arrangements and dynamics will always produce erroneous results. The IGR enables accurate and consistent evaluation of the state of the pension system when applied to the income and expense projections. This will go far in restoring trust and confidence in our pensions system.
The IGR is a slowly moving rate, because the real activity in any year is marginal – pensions paid and awards made are typically less than 3% of the scheme’s overall size. It is only with major revisions to contributions or pension expectations that the IGR moves by more than a few basis points. This stability of reporting is complemented by the elimination of spurious external effects in valuations – and quantitative easing surely qualifies as the spurious effect, par excellence, over the lifespan of pension schemes. Changes to the IGR are real and the information in the valuation meaningful. Using this method, it will be possible to avoid unnecessary and costly interventions in scheme management, that are purely aimed at improving reporting under current (misleading) standards rather than on improving fund dynamics.
The estimate of fund IGR may incorporate the entire fund design, including funding arrangements with sponsors and the use of insurance and guarantees; this is not possible under current methods, for example, the market value based approach. The IGR can be used to assess and measure the impact of management interventions, such as liability driven investment and closure of schemes to new participants, and sheds new light on the question of the affordability of DB schemes.
The IGR can be estimated in a number of ways, but the simplest of these is illustrated as Figure 1, which shows the contributions and projected pensions payable and their present values under the IGR.
This can then be used as the discount rate at which income and expense cash-flows are compared. The results of this comparison for an illustrative scheme are shown as Figure 2. This figure shows the cash flows arising from the asset portfolio held and the pension expense cash flows. It also shows the current market value of assets at the evaluation date, together with the present values of the income and expense flows.
This figure shows that the present value of projected income flows exceeds the present value of pension expense flows, when both are evaluated at the IGR. In other words, the scheme is solvent having a small surplus. It is notable that the present value of income is far lower than the market price valuation of those assets. This arises because the income yield on assets is currently far lower than the IGR. The corollary to this would be that if the income yield on market assets exceeded the IGR, the value of that income stream would exceed the market value of the assets. This is rarely the case.
The relatively high value of the IGR, which for this illustrative scheme is 7.68%, arises because this is the average rate implicit in awards, many of which were made long ago – they stretch back through time to the 1940s and include periods when inflation and returns were high, notably the 1970s and 1980s. The scheme has a long memory – a product of its intrinsic smoothness.
Some have noted that it might be possible to manipulate the income cash-flow projections. It indeed might be, but such manipulation should show itself in failures to receive income as projected in a matter of months and revisions then be required . The audit process is a simple and immediate one.
Perhaps, the most important thing to realize is that the modeling of asset prices is a hard task, in large part because they are very volatile, but by contrast, the modeling of income flows is relatively simple, since these are an order of magnitude less volatile than prices. Indeed, when an appropriate time serial model is used for income projections, the curse of forward error propagation that bedevils so many asset price models can be entirely eliminated. Such cash flow projection techniques also provide incentives for schemes to invest for the long-term, rather than speculating on short term management success measured by transient prices.
The interpretation of these valuations is simple; they are fair value estimations. The present value equality of contributions to pensions is just that, a fair value condition; in fact, it is the most primitive of all fair value conditions, a precursor to such more complex constructs as arbitrage-free pricing. With market prices so different, we can see that market consistency does not ensure fair value.
However, if we wish to produce figures that are market consistent we need do no more than rescale the surplus (or deficit) by the ratio of asset value at market prices to the value derived under the IGR. Why we should wish to do this is a mystery. The 5/95 confidence intervals for the market consistent evaluation is +/- £74 million for this illustrative scheme, while the equivalent confidence intervals under the IGR is +/- £7 million. It is clear that most of the volatility we currently observe in scheme valuations is an artifact of the manner in which we account for and value them – a self-inflicted wound. This market consistency adjustment ratio is a measure of the value of the income generated by assets at current market prices – it is a fundamental metric of value to a scheme. The current high value indicates that market prices are high and value poor. This is a direct aid to the intuitively correct practice of buying assets when their prices are low and value high.
The proposed method also opens vistas of new risk management techniques that are more effective and efficient that current buffers and “prudent” evaluation.
EIOPA has been proposing that pension schemes should produce holistic balance sheets and we have seen some amazingly complex models developed to address this question. These are unnecessary with this approach. Any deficit produced under the IGR method may be directly inserted into the sponsor balance sheet, where it would displace retained earnings and equity. Moreover, we know the cost of this liability to the sponsor employer – it is the IGR. The comparison of the sponsor’s return on capital with the IGR tells us about the sustainability of a pension situation. In fact, we can immediately do all of the standard asset and debt service coverage evaluations of basic credit analysis. Covenant assessment becomes a trivial process.
This approach also reveals that much of the concern over rising costs in defined benefit pensions is misplaced; the product of poor accounting and vested interests. The illustrative scheme shown here would report a deficit of 17% under IAS 19, when the reality is a surplus of 12% under the proposed method.
Arbitrary periods over which we might smooth asset and liability values may lack any intellectual merit, but would have powerful value as signals of the intention of government to make changes that support the provision of DB pensions. Regulatory self-interest is sufficient to motivate this. Introduction of the approach proposed will decrease the amounts and variability of special contributions and see either an increase in corporate tax receipts or an upsurge in corporate investment. The IGR method proposed is smooth – exactly as smooth as the scheme itself – and that is smoothing over the entire life of the scheme.