It has, in short, become an article of received wisdom, rarely questioned other than at sites like The Cobden Centre.

Andrew Haldane^[1] of the Bank of England did so in a recent speech. Although I’m not convinced he always followed the logic of his analysis to its natural conclusion, he clearly outlined the structural developments that led to the current debacle and offered several sensible policy suggestions.

It was a long speech: the transcript runs to eighteen closely typed pages with a further eleven of references, charts and tables. It would make no sense for me to try to cover the whole thing in any detail: for those sufficiently interested in the topic, do read the original.

What I want to do is bring forward enough of the material to enable a closer focus on some of the more critical issues, and to highlight a few areas where I think Mr. Haldane may be in error.

♦  ♦  ♦

He began with a review of changing incentive and control structures within banking stretching  back to the early 19th century.

At that time, most banks operated as unlimited liability partnerships. Tightly hobbled in this fashion, “banking was a low concentration, low leverage, high liquidity business.”

“Equity capital often accounted for as much as half of all liabilities, and liquid securities frequently accounted for as much as 30% of banks assets.”

Whatever its other merits, at least under this arrangement “governance and balance sheet structure [were] mutually compatible.”

With bank investors so utterly exposed, credit growth was severely hampered. The structure also relied on the substance of bank shareholders. For both reasons, the pressure for change was intense, led, amongst others, by Walter Bagehot.

In time, therefore, unlimited liability changed to extended liability, usually composed of some mixture of reserve liability and uncalled capital:

“Under reserve liability, existing shareholders were liable for additional capital in the event of bankruptcy. By 1884, British banks had reserve liability of around three times their paid-up capital. This placed them on a similar footing to US banks, which had adopted a system of double liability in 1863.”

Although less strict, this new regime also kept risk appetites under control for a time. Two developments led to its eventual abandonment. First, as the banks grew in size and progressively consolidated, vetting shareholders to ensure their capacity to meet reserve liabilities became increasingly impractical. Second, and arguably more critically, actually calling up reserve liabilities came to be seen as self-defeating. Doing so might well exacerbate a crisis. Boards simply couldn’t bring themselves to pull the trigger when in theory it might have done the most good.

And so this second regime also gave way to something more closely resembling our own:

“[B]y the 1930s the governance and balance sheet structure of banks was unrecognisable from a century earlier. Ownership and control were amicably divorced. Ownership was vested in a widely dispersed set of shareholders, unvetted and anonymous. Their upside payoffs remained unlimited, but the downside risks were now capped by unlimited liability. The pool of reserve capital had largely evaporated.”

♦  ♦  ♦

At this point, Haldane brought in Robert Merton’s contingent claims model. Although new to me, it rang true at once. In simple terms, it tells us “that the equity of a limited liability company can be valued as a call option on its assets, with a strike price equal to the value of its liabilities.”

It’s an elegant little concept. And, while it applies to any limited liability company, clearly the greater the leverage the more it skews the incentives of equity holders. Ergo, it’s tailor-made for messing with bank behaviour.

Still, I’m not entirely comfortable with some of the conclusions Haldane drew from it.

He takes the fact that the value of an option is enhanced by an increase in the volatility of whatever underlies it and applies that directly to the much broader canvas of bank behaviour. “Because volatility increases the upside return without affecting the downside risk”, banks will naturally “seek bigger and riskier bets” to “maximise shareholder value”. There’s much truth in this, but I think there’s also a fundamental error. After all, the option represented by bank equity vanishes if a bank fails. Equally, although he’s right that the “downside risk” is not absolutely affected by increased volatility (the equity holder can lose no more than he’s invested), the probability of that risk materialising changes if “bigger and riskier bets” are taken.

His conclusion that “joint stock banking with limited liability puts ownership in the hands of a volatility junkie” therefore seems overstated, perhaps grievously so.

What’s more relevant, I think, is the incentive effect on management. With the spread of equity participation through option grants in recent decades, senior bank management in effect acquired an option on an option (appropriate, perhaps, in an era that also gave us CDOs both squared and cubed).

It isn’t that Haldane ignores management incentives. Indeed, late in the speech he discusses the effect of introducing return on equity (ROE) as the principle performance metric at some length, and there’s no doubt in doing so he’s highlighting something important. Had return on assets (ROA) been chosen instead, things would have turned out very differently. As he says, it has the great virtue of “cover[ing] the whole balance sheet and, because it is not flattered by leverage, do[ing] a better job of adjusting for risk.”

Not least, it would have drastically cut the absurd remuneration. Had ROA rather than ROE been the metric from 1989 onwards:

“By 2007, their (bank CEOs) compensation would not have grown tenfold. Instead it would have risen from $2.8 million to $3.4 million. Rather than rising to 500 times median US household income, it would have fallen to around 68 times.”

♦  ♦  ♦

At this point, he briefly recaps and then highlights what he sees as a puzzle:

“The story so far. Ownership and control rights for banks are vested in agents comprising less than 5% of the balance sheet. To boost equity returns, there are strong incentives for owners to increase volatility. Those risk-taking flames have been fanned by tax [policies favouring debt over equity] and state aid [all the direct and indirect state underwriting of bank related risks]. As stories go, this one sounds grim.

But this story also contains a puzzle. Long-term shareholders in banks have not obviously reaped the benefits of these distortions. The purchaser of a portfolio of global banking stocks in the early 1990s is today sitting on a real loss. So who exactly is it extracting value from these incentive distortions? The answer is twofold: shorter-term investors and bank management.”

Reading that second paragraph for the first time, I thought “Aha. Finally.” I was sure the answer to the “who” would be bondholders and bank management.

Here’s his explanation for putting in shorter-term investors instead:

“Institutional investors in equities are typically structurally long. They gain and lose symmetrically as returns rise and fall. Many shorter-term investors face no such restrictions. If their timing is right, they can win on both the upswings (when long) and the downswings (when short). For them, the road to riches is a bumpy one -and the bigger the bumps the better. As in Merton’s model, all volatility is good volatility.”

Although he’s perhaps a bit blasé about the ease with which market swings can be timed, it’s certainly true there are winners from the shorter-term trading game. And market-makers do thrive on volatility (albeit within reason, even for them). However, these opportunities aren’t confined to bank stocks; they apply to all stocks, indeed to all markets.

The sharp fall in average bank stock holding periods he thinks might bolster his thesis is equally universal. Average holding periods for all equities have been in secular decline for at least 50 years, and the patterns look much the same.

I can’t see, therefore, that short-term investors deserve their spot on this podium of winners. Bank debtors, my first pick, still seem a far better choice.

When he turns to bank management (the other big winner), his focus is on the effect of tying incentive arrangements to ROE. It’s a most interesting and useful discussion, but I’m not sure it properly zeros in on the deeper principal-agent problem.

Unlike bank shareholders, management really doesn’t have much downside. Because they’re effectively holding an option on an option, their incentive skew was, and often still is, near absolute. Setting aside reputation for a moment (which seems to have been a tolerably safe thing to do in the last decade), it truly was all upside.

I’m not suggesting this explains the crisis: far from it. But it did provide a powerful incentive to light the afterburners on a system that was already skewed and overextended.

Before moving on, one last quote from his discussion of the ownership versus control dilemma:

“When the downswing came, the volatility of equity returns sent many banks to the wall.”

Obviously true, but I’m not sure it sits all that well with his earlier comments about the incentive structure for equity holders, much less with Merton’s “all volatility is good volatility”.

♦  ♦  ♦

Let’s turn to the missing component in this discussion of asymmetrical incentives: the role and influence of bank debt.

Haldane does a great job tracing the historical experience and analysing where things went so badly wrong. Put simply, lenders to banks should in theory provide a countervailing influence to the somewhat one-sided incentives of shareholders. After all, their risk/reward curves are near mirror images:

“This quasi-disciplining role of debt persisted up to the Great Depression. Calomiris and Mason (1997) find that debt and equity prices did a reasonable job of distinguishing good and bad banks during the Chicago banking panic of 1932. Indeed, they signalled distress fully six months prior to banks’ failure.

As the 20th century progressed, however, evidence of debt disciplining became patchier. Studies in the 1980s typically failed to find balance sheet risk having a significant impact on banks’ subordinated debt spreads (Gorton and Santomero (1990)). Evidence from the 1990s was more encouraging (Flannery and Sorescu (1996), Morgan and Stiroh (1999)). But even then the link was weaker among larger banks, with little evidence of market prices influencing banks’ risk decisions (Bliss and Flannery (2002)).”

During the lead up to the crisis, this break was complete. In fact, for a while the correlation looked negative with CDS premiums for banks falling “dramatically between 2002 and 2007″ at “precisely the time risk in the system was building.”

How could this be?

“As much as bank management and the authorities may pre-commit to debtors bearing risk ex-ante, they may be tempted to capitulate ex-post.

“Economists call this a time-consistency problem. Agents cannot credibly commit to stick to their guns in the midst of war. Private contracts for bank debt and public policies towards bank debt suffer from a severe case of this time-inconsistency problem. Having debtors assume pain is fine on paper. But crisis wars are not waged on paper. And if debtors recognise that risks in contracts will not be enforced, they will no longer have incentives to price risk and exercise discipline themselves. So it has been for well over a century.”

In 2008, for example, just when it would have been most useful, banks chose not to convert hybrid debt to equity. Why? “Because they too feared scaring creditors and making a bad liquidity situation worse.” In the public sphere, the incentives are even more heavily skewed towards capitulation.

As if all this weren’t enough, the astounding growth of banking assets in relation to GDP^[2] made matters even worse:

“Big, connected firms increase the chances of a bad situation turning not just worse but catastrophic. Knowing the authorities will shoulder that tail risk, debt-holders will not price it for themselves. That is doubly unfortunate, as it means debtor discipline will be weakest among institutions for whom society would wish it to be strongest. Worse than that, bigger banks will then benefit from an implicit state subsidy, for cheaper debt means fatter profits. That might itself encourage further risk-taking.”

It’s a vicious cycle and despite all the sound and fury of recent years, I don’t know that things are any better in this regard than they were in 2007. Arguably, they’re worse.

Haldane provides estimates on the value of this implicit subsidy. For the four largest UK banks, they range from tens of billions of pounds per year up to hundreds of billions. For the 22 largest global banks, the range is “hundreds of billions of dollars per year, on occasions four  figures.”

Even more remarkable, perhaps, is the doleful fact that these numbers represent “a large chunk [of], and sometimes exceed, the measured value added of the financial sector to annual GDP.”

♦  ♦  ♦

At the end of the speech, Haldane looks at what might best be done. Given his focus on the way in which ever more distorted incentives lie at the root of most of these problems, he sees “these interventions [as] best directed at incentives themselves. Otherwise risk-taking is likely to be simply displaced, rather than curbed, by reform efforts.” Amen.

He put forward four suggestions:

1. Higher equity capital: As he says, it’s the most obvious solution. It would “act on at least three of the underlying incentive frictions. It would  put more skin in the game for equity-holders, thereby reducing their incentives to extract option value. It would reduce leverage directly, thereby reducing banks’ capacity to risk-up. And it would increase banks’ capacity to absorb loss, thereby reducing the probability of official intervention.”

He views Basel III is a useful starting point, but no more. He thinks the eventual capital ratio should be considerably higher, perhaps as much as 20%. He anticipates the inevitable counterargument that “equity is expensive” and acknowledges the distortions stemming from current tax policies and state subsidies. However:

“Using [these arguments] to support lower capital ratios is to argue that three wrongs make a right.”

Amen again.

He favours leveling the playing field between debt and equity, perhaps even by doing both. That is, not only reducing the tax deductibility of interest but also “allowing firms to deduct from profits an allowance for corporate equity . . . .” Radical, certainly, but he believes it may be justified because of the large negative externalities (the “deadweight costs of default and the growth sapping effects of debt overhang”).

2. Equity-like liabilities: Additional equity doesn’t entirely remove the “asymmetry of payoffs”. Nor does it “guarantee discipline by debt-holders.”

So, in addition to higher capital ratios, he favours contingent convertibles (CoCos). They’re not new, and they are controversial, but he suggests two conditions to enhance their effectiveness.

“First, no discretion on the part of bank management or the authorities about when and how conversion takes place. Such discretion undermined the effectiveness of uncalled capital in the 20th century and hybrids in the 21st.”

“Second, conversion needs to take place well ahead of bankruptcy. Doing so avoids the deadweight costs of default which, for too-big-to-fail institutions, are likely to be too large to be tolerable by the authorities. That is what undermined reserve liability in the 20th century. It is also what risks jeopardising the effectiveness of so-called bail-in debt in the 21st.”

Basing the trigger for their conversion on “market-based measures of capital adequacy” (in other words, on market capitalisation) would satisfy both conditions.

3. Control rights: Here he considers extending voting rights beyond equity holders, such that “governance and control would then be distributed across the whole balance sheet.”

4. Performance and Remuneration: We covered this earlier. His suggestion, if you recall, is to shift the performance metric from ROE to ROA.

♦  ♦  ♦

Back at the start, I said I wasn’t convinced Haldane had followed the logic of his analysis to its natural end. Let me try to explain why.

Early on, he said:

“Under the assumptions of Modigliani and Miller (1963) (MM), the pricing of risk by debt-holders ought to neutralise fully any effect of increased leverage on the value of the firm. Provided shareholders maximise firm value, and the world behaves according to MM, debtor discipline ought to defuse completely incentives to gear-up.”

If that’s right, and absent distorting interventions I think it is, then most of the problems we’ve experienced (together with the seemingly endless complexity of the proposed solutions) stem from just one thing: an unwillingness to allow bank debtors to suffer loss. Or, put another way, to allow markets to function and contractual arrangements to be honoured.

The question is why.

Haldane puts it down to the time-consistency problem. “Having debtors assume pain is fine on paper. But crisis wars are not waged on paper.” I see the argument of course. I even see the force of the argument. Still, it strikes me as an assertion rather than something truly axiomatic.

Much of the unwillingness, I’m sure, is grounded in fear. The size, complexity and interwoven nature of modern universal banking is a powerful deterrent to serious meddling. What if it goes wrong? Mightn’t the whole damn thing just collapse if bank investors get scared? Then where will the funding come from? Banks of course play on this uncertainty and ignorance, sometimes subtly and sometimes with the crassest of threats.

Then too, much of the non-deposit, non-secured bank lending comes from pension funds and other institutional investors who are for the most part investing on behalf of households. No prizes for causing them pain either.

The incentives, as Haldane suggests, are indeed all skewed one way.

Still, if banks weren’t so highly leveraged, many of these concerns would melt away. Convert a sizeable chunk of bank debt to equity and the nailbiting would be done by bank management and shareholders (and, from that point on, by bank debtors) rather than regulators, politicians and the rest of us. Given that non-deposit, non-secured bank debt often represents a quarter or more of total bank liabilities, it’s not as if there’s a shortage of available capacity.

It wouldn’t be easy. I understand that. But then again, nor are any of the alternatives. The day when pleasant solutions were on offer is long past.

At any rate, I would have liked to see Haldane worry at this issue a good deal more. He’s one of the few who grasps how vital it is to get at causes rather than simply suppressing symptoms. In the hierarchy of causes, gutting the risk management contribution of the greater part of bank balance sheets must surely rank reasonably high.

_________________________________________________________

1 Executive Director, Financial Stability and Member of the Financial Policy Committee.

2 In the UK, bank assets to GDP increased from 50% to over 500% at its recent peak. This, as Haldane sees it, is the “bigger bet” strategy at work in pursuit of higher equity returns. So too with the increased variation in returns on bank assets (“two and a half times more volatile at the end of the 20th century than at the beginning”), which he takes as evidence of the “riskier bet” strategy, once again encouraged by equity’s asymmetric incentives.

All true, but there were also larger influences at work. Without government backstopping and constant central bank additions to base money, the rapid relative expansion of the banking sector would have halted long ago and at much lower levels. As for the heightened volatility, isn’t that mostly an offshoot of this extraordinary growth, not only due to the increased leverage itself but also the spread of speculative trading that’s followed in its wake?

“The time has come to employ this nuclear option [the printing press] on a grand scale.”

Not doing so, he says, would ensure a renewed recession with increased unemployment, falling house prices, reduced real business investment and so on. I think he’s right that these unhappy events are on the way. Question is, would employing his nuclear option make things any better?

To answer that we need to understand why we’re beset by all these difficulties. Wolf sees the root problem as feeble demand. Again, I think he’s right, but only in the sense that it’s the most visible, proximate cause. There’s a deeper question he doesn’t address; why is demand so weak? If the reasons are structural, throwing money at the problem is unlikely to help. Indeed, it could just as easily make matters worse by impeding the necessary adjustments.

The key question, then, is whether pre-GFC growth was sustainable. If instead it was a hothouse flower, then trying to revive it outside of the conditions that allowed it to flourish is not only impossible but foolish.

♦  ♦  ♦

Looking back, the outstanding feature of this period was the growth in debt, particularly by households. Much of it, indeed most of it, flowed into property, fuelling the most extravagant and widespread boom ever seen. In some countries, such as the US, the aftermath is already well advanced, with housing prices down over 30% from the peak; in others, such as Australia, it’s hardly begun. The UK is somewhere in the middle.

If the only consequence had been a widespread real estate bubble, things would have been troublesome, but not disastrous. Unfortunately, there were others. The sense of growing wealth occasioned by the remarkable asset appreciation profoundly affected economic behaviour. Saving from current income seemed less and less necessary as the boom went on, and so consumption took more of the economic pie. If investment also remained strong, then growing external deficits necessarily followed. In addition to this indirect effect on savings, some borrowing also fed directly into consumption; at the peak of the boom in the US, for example, households were borrowing 5-6% of GDP through mortgage equity withdrawal against their appreciating houses. No other country quite matched this lunacy, but many shared the general trend.

Clearly, some of the resulting demand was unsustainable. When consumption is funded by borrowing (whether directly or via reduced savings because of the wealth effect from credit induced asset appreciation), it’s effectively stolen from the future. This essentially artificial demand disappears once the credit boom ends. On top of that, the need to restore weakened balance sheets means higher future savings will further depress demand in rough proportion to the earlier excess.

♦  ♦  ♦

None of this is hard to grasp. Still, this core structural impediment is usually ignored when responses to our current woes are considered. In part no doubt because it’s a particularly unpleasant thorn to grasp, but also because conventional economics has long paid too little attention to the effects of credit on the real economy. What we’re in (and are likely to remain in for a long time) is a balance sheet crisis, against which the usual nostrums are helpless. Even measures that until recently were regarded as extraordinary are losing their mojo.

Quantitative easing, for example, no longer makes sense. Since 2007, when the first open rumblings of the coming crisis sounded, base money in the UK rose from £70 billion to £200 billion; in the US, from $800 billion to $2.6 trillion.^[1] As a result, excess bank reserves at the BoE and Fed are at unprecedented levels, in both cases roughly equal to 10% of GDP. The sort of illiquidity which QE can remedy is no longer a weak spot in the system (indeed, it hasn’t been for a long time).^[2]

As for the alleged benefits of lower long term real rates brought about by QE, the picture’s far from clear. Ashwin Parameswaran at Macroeconomic Resilience argues that suppressed real rates can have “perverse and counterproductive effects”. It’s usual to focus on the plight of debtors, who clearly benefit from lower rates. That’s only one side of the equation, however. The world is full of savers and investors too, who (particularly in ageing demographics) may respond by “increased savings and reduced consumption in an attempt to reach fixed real savings goals in the future”.

Whether or not Wolf has considered such potentially perverse effects, he certainly recognises that illiquidity isn’t the problem. He has something quite different in mind in his call for gloves off QE: namely, the full-blown monetisation of government spending.

♦  ♦  ♦

I guess it was always going to come to this. The accumulated imbalances are simply too large to ultimately respond to lesser measures. Indeed, it’s the continued employment of those fiscal and monetary measures over recent decades (albeit on a lesser scale) that brought us to this impasse. At no stage were the necessary adjustments and corrections allowed to unfold. The political incentives all pointed the wrong way.

Now it’s true that for as long as belief in the efficacy of central banks and governments persists, such lesser measures may give the appearance of working, as they’ve done in the last three years. Once that faith begins to seriously erode, however, the game is up. I imagine Wolf sees that moment as nigh, and again, I think he’s probably right. The unfolding train wreck in the Eurozone is displaying all too clearly the limits of officialdom. They may cobble together another solution that the market is willing to buy, at least for a while, but it does look more and more as though the tide is inexorably going out. Recent events in the US are hardly more comforting.

Here’s what Wolf favours:

“Personally, I would favour the “helicopter money”, recommended by that radical economist, Milton Friedman. This would be a quasi-fiscal operation. Central bank money could pass via the government to the public at large. Alternatively, the government could fund itself from the central bank, directly. Better still, the government could increase its deficits, perhaps by slashing taxes, and taking needed funds from the central bank. Under any of these alternatives, the central bank would be behaving like any other bank, creating money in the act of lending.”

The distinction between these alternatives is presumably clear to him. To me, they appear to be different ways of expressing much the same thing; that is, monetisation of deficit spending. At any rate, he goes on to say:

“In current circumstances, a policy of direct financing of government by the central bank should recommend itself to monetarists and Keynesians. The former have to be worried by the fact that UK broad money (M4) shrank by 1.1 per cent in the year to July 2011. The latter would have to be pleased that governments could run still bigger deficits without increasing their debt to the public.”

That M4 is shrinking despite all the BoE’s efforts illustrates the strength of the prevailing headwinds. Once a credit boom ends, the deflationary undertow that accumulates over the course of any major debt buildup soon reveals itself, its strength proportionate to the extent of the preceding boom. The private sector belatedly sets about repairing its balance sheets, reducing consumption, cutting investment and focusing on saving. This time around, governments have been offsetting the debt households and businesses are trying to shed by furiously taking on their own.

In the US, for example, household indebtedness peaked in the second quarter of 2008 at $13.929 trillion; at the end of June this year, it was $13.298 trillion. Business borrowing didn’t peak until the fourth quarter of 2008 at $11.151 trillion; although it’s ticked up again in recent quarters at the end of June was still “only” $11.019 trillion. The financial sector is the standout: at the end of 2008 it was $17.119 trillion; the latest figure was $13.830 trillion. Across the three sectors, a reduction of $4.052 trillion, or 9.6%. Set against this, the federal government owed $5.243 trillion in March 2008; today, it’s $9.778 trillion, an increase of $4.535 trillion. Plus there’s another $186.5 billion in fresh state and local government borrowing.

Given UK deficits exceeded those in the US and Wolf says he’s looking to substantially up the ante, it seems he’s not kidding about the “grand scale”.

♦  ♦  ♦

It’s hard not to be sympathetic. Absent fiscal and monetary support, our credit pyramid would simply collapse; quite possibly, given its scale and scope, more dramatically than in the early 1930s. Equally, even with a continuation of fairly aggressive fiscal and monetary support, private sector deleveraging is likely to continue for many years to come, weighing on consumption, dragging down investment and keeping unemployment frustratingly high.

What to do, what to do.

Keeping demand up at all costs, as Wolf so fervently desires, has its problems, not least that demand isn’t homogeneous. It’s not an abstract aggregate, it’s the result of an almost infinite multitude of individual, highly idiosyncratic demands. So too with the supply that tries to meet it; it’s also bewilderingly complex, with much productive capacity suitable only for very specific ends. Helping these two mesh as sweetly as possible is what the market’s meant to do. One doesn’t have to be an Austrian to wonder if central bankers and politicians pulling at levers they (and we) only dimly understand is likely to help this process.

One thing’s certain. When demand is hyped, whether by a credit boom or unfunded deficit spending, malinvestments proliferate. The less organic and sustainable the demand, the greater the errors that will be made as business tries to meet it. Someone has to pay for those real world errors, whether it’s lenders, shareholders, or all of us when the losses are in one form or another assumed by government. That they can apparently be paid for with dollops of freshly created money doesn’t change the underlying reality. It just disguises it, and further confuses us all.

The current complexity of economic and monetary matters, and the often disconcerting speed of change, aren’t just the fruit of globalisation and rapidly evolving technologies. Much of it’s rooted in the Alice in Wonderland quality that now pervades money and credit. It can feel like a world full of wormholes and time travel, where quite a number of impossible things do indeed happen before breakfast.

Few of them, unfortunately, are good.

In any case, I can’t help thinking deliberately goosing aggregate demand is more likely to perpetuate our problems than solve them. Highly individual, sustainable demand can’t successfully interweave with complex, specialised supply when the information needed to do so is being constantly and violently distorted. Cutting with the grain by smoothing the adjustment process seems a better bet than impeding it, particularly if we devote some of the saved resources to protecting the more exposed and vulnerable amongst us.

Does thinking that way that make me a liquidationist, one of the unaccountable sadists Wolf sees peopling the other side of his argument? I obviously don’t think so. What to me seems called for is a sort of compassionate realism; trying to understand the deeper nature of our economic problems, accepting those things (as the old prayer has it) we can’t change, and then carefully seeking to unravel the knots rather than binding them ever tighter.

Wolf’s approach risks everything. Quite apart from the fact that I don’t think it would work in the long term, if the full resources of the state are thrown into the battle, along with the very nature of money and credit, where’s the fallback position?

♦  ♦  ♦

That said, there is a powerful case for cushioning the deleveraging that’s underway, since left to its own devices the deflationary collapse would be shattering. More as a cautious retreat under fire, though, rather than a frontal counterattack.

Back in the early days of the crisis, we badly erred in holding bondholders immune. Not only was it inefficient, it was unjust. When financial institutions faltered, their bondholders (like any others in a failing commercial enterprise) should have been forced to take a serious haircut or, better yet, had their holdings converted to equity. The financial system would have been left in a far stronger position to weather the storm. The approach still has merit, but given how far things have deteriorated governments would almost certainly have to chip in with additional recapitalisations as the great unwinding slowly progresses.

As for the central long term goal, surely it’s the restoration of a natural balance between sustainable supply and demand. Without that, no recovery can last. I think we must accept that much pain and toil lie between here and there, even if all goes comparatively well. The multitude of errors made in recent decades can’t be wished away, however much we’d like to do so.

Excess credit, togther with the general profligacy and distortions it encourages are what brought us to this pretty pass. Is more of the same really likely to get us out?

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1  Fiscal policy has been no less aggressive. From 2007-2010, the UK averaged deficits of 8.9%. Much the same holds true in the US, although their deficits post crisis rose a little more slowly. Taking a much longer view, the UK managed a surplus in only five years since 1973, curiously enough exactly the same tally as the US, although the years didn’t exactly coincide. In any event, anyone wanting to claim deficit spending hasn’t really been tried has a hard row to hoe.

2  I do wonder at times if these huge excess reserves might one day wreak unexpected havoc. Contrary to conventional wisdom, their overall level is entirely in the hands of the central bank. Individual banks may succeed in getting rid of some (through making loans or purchasing investments), but they inevitably come back into the system somewhere as soon as the recipients spend or deposit the proceeds.

If the markets become more confident, or more inclined to speculate, it’s not hard to imagine an accelerating rush by individual banks to deploy reserves. All of it, at the system level, entirely fruitless. Not an easy beast to rein in, I’d have thought, if first it bolts.

I see two options for central banks were that to happen. Either vaporise sufficient reserves (through sales from their portfolio) to neuter this impulse; or, raise the rate they pay on reserves to a high enough level to discourage the process. Neither seems attractive. Brave indeed would be the central banker who embarked on the former in these tricky times. As for the latter, with the reserves outstanding it would surely not be cheap.

Truth is, each of these qualities fluctuates with the prevailing social mood: they’re inherently pro-cyclical. When it would be ideal from society’s point of view for them to zig, they tend to zag. Nor is there much reason to think this is going to change anytime soon. We’re human, all too human, and so would be well advised to insulate critical social systems from our long-term shifts in sentiment.

Easier said than done, though. Not only because designing foolproof (or, more accurately, resilient) systems isn’t easy, but also because even assuming we do there’s every chance our progeny will find a way to undo them during the next great wave of optimism.

Still, we can but try.

Adair Turner (chairman of the UK Financial Services Authority) and Mervyn King (Governor of the Bank of England) are both acutely aware of this dilemma. Far more than any other senior financial markets officials, they try to get at the deeper underlying causes.

On Monday, October 25th, King gave a talk in New York entitled “Banking: From Bagehot to Basel, and Back Again”.

“The real failure was a lapse into hubris – we came to believe that crises created by massive maturity transformation were problems that no longer applied to modern banking, that they belonged to an era in which people wore whiskers and top hats. There was an inability to see through the veil of modern finance to the fact that the balance sheets of too many banks were an accident waiting to happen, with levels of leverage on a scale that could not resist even the slightest tremor to confidence about the uncertain value of bank assets. For all the clever innovation in the financial system, its Achilles heel was, and remains, simply the extraordinary – indeed absurd – levels of leverage represented by a heavy reliance on short-term debt.”

And: “Of all the many ways of organising banking, the worst is the one we have today.”^[1]

♦  ♦  ♦

Both see financial markets as inherently unstable. Unlike other markets, they appear incapable of managing their own affairs. Thus, from Turner:

“If instead we believe that liquid financial markets are subject for inherent reasons to herd and momentum effects, that credit and asset price cycles are centrally important phenomena, that maturity transforming banks perform economically valuable but inherently risky functions, and that the widespread trading of credit securities can increase the procyclicality of credit risk assessment and pricing, then we have challenges which cannot be overcome by any one structural solution.”

King is even more explicit:

“A market economy has proved to be the most reliable means for a society to expand its standard of living. But ever since the Industrial Revolution we have not cracked the problem of how to ensure a more stable banking system. We know that there will always be sharp and unpredictable movements in expectations, sentiment and hence valuations of financial assets. They represent our best guess as to what the future holds, and views about the future can change radically and unpredictably. It is a phenomenon that we must learn to live with. But changes in expectations can create havoc with the banking system because it relies so heavily on transforming short-term debt into long-term risky assets. For a society to base its financial system on alchemy is a poor advertisement for its rationality.”

Both settle on similar, and equally blunt, solutions.

After reviewing and to varying degrees approving of measures such as levies and taxes, the Basel III framework, programs to deal with “too big to fail” institutions, and enhanced resolution procedures, they each conclude only one reform has a chance of being truly effective. Namely much, much higher capital requirements. Neither nominates a specific figure but both clearly favour a multiple of anything currently proposed.^[2]

King: “The broad answer to the problem is likely to be remarkably simple. Banks should be financed much more heavily by equity rather than short-term debt. Much, much more equity; much, much less short-term debt. Risky investments cannot [sensibly] be financed in any other way.”

While similar in principle, Turner suggests an additional component:

“Instead two elements should form the core of the regulatory response to the crisis: much higher bank capital and liquidity requirements and the development of new macro prudential through-the-cycle tools. Together these can help address the fundamental issues of volatile credit extension and asset price cycles.”^[3]

♦  ♦  ♦

Both recognise only too well that the maturity transforming, risk-taking functions that were recently taken to such extremes can’t easily be done away with.

King put it simply: “”[It's] difficult because it is the nature of the services – not the institutions – that is the concern.” If suppressed in one area (through, for example, instituting narrow banking), these functions will inevitably pop up somewhere else. Some new “shadow banking” system, perhaps, there to grow and mutate until somewhere in the distant future it produces a fresh crisis, and cries for yet another bailout.

I’m more and more inclined to agree, not only with this diagnosis (which I’ve never doubted), but with their proposed solution.

This is a change from my thoughts in January. Then, I favoured reining in and insulating the banking system itself in various ways while allowing the wider financial system to operate largely on the basis of caveat emptor. In other words, within standard civil and commercial laws they could do as they liked, but only in the full knowledge the cavalry wouldn’t arrive if they messed up.

Now, I’m increasingly persuaded this latter condition is unrealistic; if a new shadow banking system did go berserk, there’s every chance the government of the day would feel it had to step in. That being so, it may be best to forget about trying to force different functions into different silos, and instead settle on this simpler approach of far less regulation and much higher capital requirements that would apply across the whole financial system. At least then there’s a chance this constraint could be sustained, even in the face of a new period of extreme optimism.

In order to ensure an even more robust system (as well as introducing another layer of market discipline), both King and Turner are adamant that creditors to the financial system should take the hit before taxpayers, and should know that they’ll have to do so. No argument; this is a pet bugbear. From “Money, Credit and Financial Systems”:

“One of the more grievous errors made during the depths of the crisis was to load the burden of bailing out the financial system onto taxpayers while giving creditors a free pass. It’s easy to see why depositors should for the most part be exempted (to do otherwise would have been to induce panic and unilaterally change the understood rules of the game), but creditors of failing banks should either have been forced to take a haircut, or had some portion of their holdings converted to equity. Not only would this have had the salutary effect of boosting capital at no public cost, but the banks’ indebtedness would have been reduced at the same time.”

“As well as playing hell with the public finances, this decision ensured that public faith in the fundamental fairness of the official response to the crisis was profoundly undermined, and understandably so. Whether it was done out of fear and panic, or because of the uncomfortably close relationships between government and the major players in the financial system, I don’t know, but the “fat tail” costs of this decision are likely to be very high indeed.”

♦  ♦  ♦

There is a more elegant, market-based solution than this forced high capitalisation approach, one that would generate natural constraints on credit growth, that has the potential to be genuinely resilient. At least in theory. I touched on it in the title essay of this site:

“In the absence of a lender of last resort, and given the rate of credit creation would tend to be set by the most conservative banks (since, through the process of daily clearing, banks expanding credit more rapidly would equally quickly lose reserves to their less adventurous fellows), a specie based, 100% reserve free banking system would probably be both surprisingly conservative and require only the most light-handed regulation.”

I still think that’s true, although having looked more deeply into the theory and history of free banking, I’m no longer convinced 100% reserves are necessary. Largely unregulated, gold-based, fractional reserve free banking systems worked well for lengthy periods in Scotland, Canada and Hong Kong, amongst others.^[4]

With the best will in the world, though, I can’t imagine governments giving up control over money and credit by acceding to the reintroduction of gold^[5]in any form, much less to a full, denationalised version of the gold standard. Besides, how could any proposal to radically free up markets possibly succeed when almost everyone is convinced they failed precisely because they were deregulated?

No, the die was cast once the notion progressively took hold from the early part of last century that it was the government’s job to protect depositors, manage interest rates and underwrite economic growth. It doesn’t matter that the long-term consequences of this shift (despite the best of intentions) have been almost uniformly harmful. A deep conceptual shift took place over the last 60 to 80 years and I don’t see how it can be reversed. Perhaps the breakdown of the existing financial order (should the authorities be desperate enough to push the current trend of QE and fiscal deficits to extremes) could create the circumstances where such a radical shift in attitudes is conceivable. Perhaps, although even then it’s impossible to know what form it might take. In any event, one couldn’t possibly wish for it; the path there would be littered with casualties and catastrophe.

We must hope a safer way out of the current mess is eventually found. A slow return to sanity, perhaps born of a growing recognition that a far less malleable reality underlies all these monetary arabesques. A focus on production, on savings and investment, on prudence, on assisting the necessary transitions and restructurings rather than impeding them, and last, but by no means least, on helping and protecting all those amongst us who are vulnerable.

To better the odds, it would help to have a reasonably clear goal to aim for in the restructuring of our battered financial systems^[6], one that’s not too arcane, that can be widely grasped. Of the alternatives on offer, King’s and Turner’s broad approach^[7] seems not only politically possible, but also most likely to be effective.

I’d add only one rider; that the longstanding role of central banks in so freely supplying reserves^[8] to the system (and/or making reserves almost entirely irrelevant) should also come under the microscope. Without being constantly underwritten in this fashion, financial systems could not have grown as they did over the last century. Under the older system of widespread reserve requirements, a given level of base money could only give rise to so much credit creation. This could be bad enough, to be sure, as we saw in the repeated cycles of boom and bust in the 19th century, but without the certainty of reserve availability (whether through growth in base money or reduced reserve requirements), the excesses of recent decades would have been impossible.

If this need for long-term restraint in the provision of reserves were broadly accepted amongst professionals, it’s possible to imagine that message being effectively conveyed to the public, much as one can with Turner and King’s approach. They both share a kind of commonsense acceptability. First though, the reality of what happened over the last 80-100 years has to be seen for what it is.

It’s no coincidence that in the hundred years to 1900, consumer prices in the US halved while in the next hundred they multiplied by over twenty times. Or that along the way, and certainly not only in the US, credit metastasised like a cancer. Today, debt outstanding almost everywhere is so unthinkably large that it paralyses policymakers. Its rapid unwinding would tear through economies like a cyclone, leaving chaos and devastation in its wake. Trying to prop it up, on the other hand, solves little or nothing and risks an even worse crisis in the future.

And this is progress?

We’ve managed to dig an exceptionally deep hole. Getting out of it will require clear sightedness, not only about what we need to do, but also about how we got here. Regardless of how we approach it, tough times lie ahead.

The tragedy is we seem determined to take the illusory, apparently easier roads first.

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1 That’s also my view. As I wrote in July 2007 on Ultimi Barbarorum: “Put simply, if the financial system is to be deregulated (which I certainly favour) then participants must not be saved from their own foolishness. If the political decision is made that protection is to be provided, then fairly stringent regulation ought to continue. What we have is the worst of both worlds.”

2 For example, King notes “Bagehot would have been used to banks with leverage ratios (total assets to capital) of around six to one.” That is, non-risk weighted capital of 15%+.

3 I think he’s probably right. As he says “Higher continual capital and liquidity requirements will still however leave the economy vulnerable to destabilising up-swings in credit supply and asset prices, deriving from the interaction between maturity transforming banks, credit securities markets, and self reinforcing credit and asset price cycles.” Amongst his suggestions are: varying capital and/or liquidity requirements across the cycle; imposing constraints, like LTV limits; and being willing to tailor these by broad category of credit so as to better target those sectors that are going off the reservation.

4 In theory, of course, a free banking system could operate with a strictly limited amount of fiat base money substituting for gold. Given the ease of producing it, however, and all the normal political temptations, it’s hard to imagine the necessary discipline lasting all that long.

5 Martin Wolf wrote a piece at the FT a week ago entitled “Could the world go back to the gold standard?” It’s a useful tour of the alternative ways in which gold might be reintroduced into the financial system. He concludes that none of them would work, and that many would do direct harm. Despite my preferences in an ideal world, I’m inclined to agree with him. Only a pure gold standard, entirely free of variously linked national currencies, and operating within an equally free international banking system would have any chance of working properly.

6 Some financial systems don’t fit this description at all. Australia, for example, which sailed through the crisis with minimal damage, or even disturbance (albeit with the early need for some comprehensive government guarantees).

There were good reasons: the excesses of subprime lending were largely avoided, both in terms of domestic origination and the purchase of exotic overseas securities; banking leverage was not extreme; regulation was tighter and more effective; the economy benefited from its strong commodity export orientation; government indebtedness was (and still is) extremely low, and early and aggressive steps were taken to stimulate the economy.

Whether this (partly deserved) good fortune holds in years to come is another matter. The level of household indebtedness in Australia is as high, or higher, than anywhere else in the world, as are housing prices in relative terms. A large external imbalance, and the heavy reliance of the banking system on wholesale offshore funding, adds to the vulnerability. It’s a dangerous combination.

7 Labelling the combination of high capital requirements and creditor liability in the event of a crisis as “King’s and Turner’s approach” is of course merely a form of shorthand. While it does seem to fairly reflect the essence of their respective views, they have differences (as noted above), are still engaged in a long and complex process, and also view many of the more conventional reform measures as potentially useful.

8 Reserves are base (or “high-powered”) money held by the banking system. Under our current structure, that means vault cash and cash reserves held with the central bank. The latter provides the means for each bank to meet its daily obligations to the clearing system as cheques, transfers and other payments from all banks are processed and netted out. When reserve requirements were still central to the system, a bank without reserves in hand (or at the very least the absolute certainty of being able to borrow them from other banks or, at worst, the central bank) not only couldn’t extend credit, it wasn’t even in a position to meet its existing obligations. As reserve requirements were progressively reduced, however (or dispensed with entirely), their effectiveness as a constraint largely vanished. It mattered then only that the central bank made sure sufficient reserves were in place to ensure comfortable daily clearing, which of course they’ve done for decades.

When it comes to nature, we’re both part of it and a profound external influence. We shape the world around us for ill and sometimes for good, not only through deliberate actions but also, of course, merely by being here. Some of our activities and their consequences in the natural world, were we only willing to listen, could teach us much about how to better manage man-made systems such as the markets and the economy.

Forestry management provides a striking example. Our natural inclination is to put fires out wherever we can, not only to safeguard valuable property but also to protect the forests themselves and their many wild occupants.

In pursuing this practice, however, subtle changes take place over time. Dead trees and fallen branches accumulate and the undergrowth becomes thicker and much more widespread. Finally a fire occurs that we’re unable to stop, one that feeds on all the detritus to produce firestorms so powerful they can at times fundamentally change a whole ecosystem.^[1]

The analogy to our economic management in recent decades is obvious, particularly when it comes to the financial system. There too, fires were continuously put out, all with the laudable goal of sidestepping the pain and distress of downturns.

As with the forests, for a long time it seemed to work wonderfully well, ushering in an exceptionally long period of largely uninterrupted growth fondly termed by some  as “the great moderation”. Many even believed the business cycle had finally been consigned to the rubbish bin, a relic defeated by modern understanding and newly contrived management tools.

It was, of course, an illusion, a period of apparent grace during which imbalances of all kinds were allowed (indeed encouraged) to flourish and accumulate. As with the forests, this long period of suppression finally so distorted matters that the next blaze to break out was very nearly unmanageable.

Almost all system resilience had been lost.

How and why we let this unhappy illusion proceed isn’t such a great mystery. Where politicians have the power to alleviate apparent ills, the incentives to do so are overwhelmingly powerful. To expect them to not act, to deliberately allow events to take an apparently unnecessary and painful course, is almost certainly to expect too much. The incentives are all wrong.

In any event, the result of all this well-meaning (and, it must be said, self-interested) activity was a progressive deterioration in the many feedback mechanisms that actually enable markets to work. Positive ones were given every assistance, indeed new ones were regularly invented, but negative feedback? Thank you but no, we don’t need any of that here.

♦  ♦  ♦

The catalyst for these thoughts is an intriguing website called Macroeconomic Resilience. The concept of resilience is used there to gain a better understanding of social systems such as markets. The author (who prefers to remain anonymous) provides the following definition for resilience: “[T]he capacity of a system to absorb disturbance and reorganize while undergoing change so as to still retain essentially the same function, structure, identity, and feedbacks.”

In order to be resilient, any system must have an effective complex of countervailing feedback mechanisms. Without these, it wouldn’t have the capacity to absorb shocks, whether positive or negative, while retaining its essential character. Take our individual immune systems: if they’re too weak, external organisms will invade and wreak havoc; if, on the other hand, they themselves aren’t properly kept under control they can turn on us in the kind of self-immolation that characterises auto-immune diseases. And so on and so on. All systems, even the most apparently simple, generally have a multitude of intricately interlocked influences that feed off, oppose, or sustain each other.

Our anonymous author (let’s call him MR) applies this concept very nicely to markets:

“However, in a dynamic conception of markets, a resilient market is characterised not by the absence of positive feedback processes but by the presence of a balanced and diverse mix of positive and negative feedback processes.

Policy measures that aim to stabilise the system by countering the impact of positive feedback processes select against and weed out negative feedback processes – Stabilisation reduces system resilience.”

Exactly right, I think, and nicely put. This principle (that the desire to avoid destabilisation and short-term pain merely ensures more of both is likely in the long-term) lies at the heart of almost everything that’s wrong with our economic and financial systems.

MR takes as an example the minor meltdown on May 6th this year, rightly questioning one of the more common explanations, namely that it was the result of a kind of perfect storm: “When the WSJ provides us with the least plausible explanation of the “Crash of 2:45 p.m.”, it is only fitting that Jon Stewart provides us with the most succinct and accurate diagnosis of the crash.” Here’s Stewart’s take:

“Why is it that whenever something happens to the people that should’ve seen it coming [but] didn’t see [it] coming, it’s blamed on one of these rare, once in a century, perfect storms that for some reason take place every f–king two weeks. I’m beginning to think these are not perfect storms. I’m beginning to think these are regular storms and we have a sh–ty boat.”

Indeed. MR again: “So what is the true underlying cause of the crash? In my opinion, the crash was the inevitable consequence of a progressive loss of system resilience. Why and how has the system become fragile? A static view of markets frequently attributes loss of resilience to the presence of positive feedback processes such as margin calls on levered bets, stop-loss orders, dynamic hedging of short-gamma positions and even just plain vanilla momentum trading strategies . . . . “

The real problem, though, as noted earlier, is that through a desire to protect against positive feedback processes, negative feedback is progressively weeded out. Back to MR.

“The decision to cancel errant trades is an example of such a measure. It is critical that all market participants who implement positive feedback strategies (such as stop-loss market orders) suffer losses and those who step in to buy in times of chaos i.e. the negative-feedback providers are not denied of the profits that would accrue to them if markets recover. This is the real damage done by policy paradigms such as the “Greenspan/Bernanke Put” that implicitly protect asset markets. They leave us with a fragile market prone to collapse even with a “normal storm”, unless there is further intervention as we saw from the EU/ECB. Of course, every subsequent intervention that aims to stabilise the system only further reduces its resilience.”

The end result is a system subject to catastrophic phase shifts, where even normal storms can bring on an almost complete collapse as one-sided feedback processes snowball. In other words pretty much exactly what happened with the whole global financial crisis.

There’s plenty more meat at the site, including consideration of how poorly conceived regulation can undermine resilience and system diversity, the degree to which individual behaviour is shaped by institutional structures, and how Minsky’s notion that stability breeds instability has parallels in the field of ecology.

I’ll almost certainly come back to some of these in future posts but in the meantime recommend you go and have a look for yourself.

___________________________________________________________

1 Like most things, forestry management seems to become more complex the more one delves into it (until, perhaps, some blessed day when knowledge and experience fuse to reveal deeper truths). That day obviously hasn’t, and never will, arrive for me but from what little I do know views such as these about the dangers of fire suppression are now widely held.

First though, some points of agreement.

Krugman was vocally unhappy about much of what took place during the boom years. He railed against the excesses of the financial system, and the deregulatory zeal that allowed it to run so completely out of control. He expected it all to end badly, although perhaps not quite to the degree it has. He’s also consistently argued that deflation, not inflation, is the greatest danger for the foreseeable future.

No argument, from me at least, on any of this. Nor do I really want to argue with his critique of the simplistic view put forward by those he terms “the apostles of austerity”; namely, that cutting spending and/or raising taxes won’t bring on further short-term pain. It will. To pretend otherwise is disingenuous at best.

The real question is whether there’s any way to avoid this pain that doesn’t bring even more disastrous consequences in its wake. After all, it isn’t hard to make the case that our current impasse is the direct cumulative result of decades of repeated refusals to wear short-term pain. This, in my view, is where the true policy failures occurred (although there’s been no shortage of errors in the various responses to the crisis as well). For anyone with a similarly obsessive interest in these matters, they’re explored in greater depth in “Money, Credit and Financial Systems: Are Crises Built into Their DNA?”.

I don’t share Krugman’s passionate belief in the benefits of more spending but governments do have a critical role to play in the face of this kind of crisis: first, to spread the pain as fairly as possible; second, to care for those who are most vulnerable; and, finally, to facilitate the necessary adjustments rather than standing in their way. Given that so many resources (with labour foremost amongst them) tend to be both plentiful and cheap during crises, it probably also makes sense to embark on carefully chosen investment projects with a realistic chance of being profitable .

Trying to return economic activity to pre-crisis levels, however, is definitely not amongst those useful roles. Much of the output gap that many, including Krugman, are so eager to fill is illusory. Boomtime patterns of demand (and the supply capacity that arose to meet it) were heavily shaped by the ceaseless flow of credit, not only in their extent but also in their nature. Today’s patterns are different and, in the absence of rapid credit growth, much smaller. Tomorrow’s are likely to be even more so. Adjusting our productive capacity to these shifts is one reason why the aftermath of credit booms tend to be so painful and drawnout.

♦  ♦  ♦

Yesterday, in “A Terrible Ugliness Is Born”, Krugman took Liz Alderman’s portrait of Ireland for the NY Times as the departure point for a fresh assault on the “apostles”.

It’s been a constant theme of his that much of the rationale for austerity rests on the presumption that markets must be appeased, that a failure to do so will bring things tumbling down. Two things, in his view, argue strongly against this idea. First, the continuing ability of high deficit countries like the US and the UK to borrow at historically low rates suggests the bond vigilantes aren’t exactly saddled up and ready to go. Second, he maintains that those countries who have signed up for the bread and water regime, like Ireland and more recently Greece, have been treated no more kindly by the markets than those who, like Spain, have been more reluctant.

The first, I think, is a bit of a furphy. CDO’s could also be funded at relative rock bottom rates prior to the crunch, and it’s only a couple of years since CDS spreads for Greece and its unhappy compañeros were cruising along at not much over 50 basis points. This despite (to take Greece as an example) a long, largely uninterrupted period of current account deficits averaging over 10% of GDP, government deficits averaging about 5% of GDP and negative net national savings (that’s before net investment is taken into account). Definitely not good in other words. So a serious crisis in Greece was already baked in for many years but ignored by the market. Truth is, when it comes to the markets facts don’t matter until suddenly they do. Who’s to say something similar isn’t happening with the US and the UK?

As for the second, that austerity isn’t bringing any benefits to its practitioners, here Krugman is either being worryingly simplistic or letting a desire for rhetorical effect push the inconvenient bits (aka reality) aside.

He has, for example, made much of the fact (most recently here a couple of days ago) that Spain’s risk spreads are less than Ireland’s. As it happens, that difference is narrowing with Spain now only one basis point below Ireland. More importantly, however, comparing CDS spreads on two countries without considering their fundamentals makes no more sense than doing the same thing for two companies.

♦  ♦  ♦

Ireland is certainly no specialty of mine but I did run across an intriguing piece from Professor Morgan Kelly of University College, Dublin. He divides the 15 year period of growth from 1991 to 2006 into two distinct periods: the 1990s with increased competitiveness, rising employment and an extraordinary growth in exports; and the first half of the last decade when things morphed into a frenzied boom in construction and (of course) an equally astonishing growth in credit. A couple of charts from his article illustrate the extent and some of the consequences of the latter.

In 10 years, bank lending to households and non-financial corporations more than tripled, from about 60% of GNP to over 200%. Most of it went to finance mortgages and development activity. The results weren’t pretty.

Amongst the many figures and comparisons provided by Kelly, one stood out: “By 2007, Ireland was building half as many houses as Britain, which has 14 times its population.”

When the bubble finally burst, Ireland was left with an extraordinarily overextended financial system (even by the rich standards of the last decade) and a very tough decision. Should the government back the banks all the way or let bank creditors (other than depositors) suffer the consequences of their folly? Unfortunately, it chose the former.

With total bank assets in Ireland equal to almost ten times GDP (about 40% of them international in scope)^[1] this was a momentous, and possibly fatal, choice. I’d wager that most of the concerns swirling around Ireland, the sort that keep its risk spread as high as it is, stem from this sword now hanging over its head. Kelly sums it up in his closing paragraphs:

“Ireland is like a patient bleeding from two gunshot wounds. The Irish government has moved quickly to stanch the smaller, fiscal hole, while insisting that the litres of blood pouring unchecked through the banking hole are “manageable”. Capital markets may not continue to agree for long, triggering a borrowing crisis which will start, most probably, with a run on Irish banks in inter-bank markets.

Ireland may therefore present an early test of the EU bailout fund. However, in contrast to Greece, Ireland’s woes stem almost entirely from its banking system, and could be swiftly and permanently cured by a resolution which shares the losses of Irish banks with the holders of their €115 billion of bonds through a partial debt for equity swap.”^[2]

♦  ♦  ♦

Spain also had a boom, both in real estate and in credit, but in relative terms, at least compared to Ireland, it was a piker. At the end of 2008 its banking system had liabilities equal to about three times GDP, high enough to be sure, but well within the current exaggerated range (here in Australia, by way of comparison, the ratio is just a touch over two).

At any rate, I’m sure you get my point. Ireland is in the doghouse for some highly idiosyncratic reasons, ones that as Kelly suggested above, it could change. Until and if it does, comparisons such as those made by Krugman are of little or no value. Even less, if that’s possible, than would normally be the case.

Nor are his comments about Greece’s failure to be rewarded for its new-found parsimony much more relevant or useful. Until I looked at its national accounts, I had no idea just how badly Greece had run off the rails. As suggested by the few numbers quoted earlier, it truly is an economic basket case. Its austerity measures, however well meant, are almost certainly both too late and too little. Mostly too late.

Truth is, it’s probably not politically feasible for Greece to work its way out of this mess and so, barring some miracle, I don’t see how a restructuring of its debt can be avoided. The market seems to be coming to a similar conclusion; the 5 year risk premium closed last night at 10% over equivalent duration US Treasuries. Higher, for the first time, than the panicky levels hit prior to the EU/IMF bailout package in early May.

These are slow motion tragedies, albeit in part self-inflicted ones, and we’re likely to see many more in coming years. How best to respond  is no straightforward matter and all of us, I think, if we’re honest, know that we’re only feeling our way forward. Although my framework is very different to Krugman’s, I often get real value from his writings as well as thoroughly enjoying them. Providing, that is, they don’t slip across into propaganda.

Of late, it’s felt at times as if he’s been flirting with that boundary.

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1 Countries with disproportionately large banking systems face very real dangers, most vividly illustrated by Iceland’s implosion. When they have their own currency (like Switzerland, the UK and of course Iceland) those dangers are heightened. William Buiter has written some interesting articles on this topic, for example here and here.

2 If only. The failure by authorities around the world to force bank creditors to absorb their rightful share of losses, whether through haircuts or the conversion of some of the debt to equity, was in my view the single most critical error made during the crisis. It was a classic case of privatised profits and socialised losses and quite apart from the ongoing burden to taxpayers, the decision gravely undermined public confidence in the fairness of government decisions. The long-term cost may well, in some cases, prove critical.

]]> http://moneycreditandfinancialsystems.com/2010/07/01/the-perils-of-partisan-commentary/feed/ 0 moneycreditandfinancialsystems kelly_fig1 kelly_fig2 http://moneycreditandfinancialsystems.com/2010/06/19/australia%e2%80%99s-mixed%c2%a0diagnosis/ http://moneycreditandfinancialsystems.com/2010/06/19/australia%e2%80%99s-mixed%c2%a0diagnosis/#comments Fri, 18 Jun 2010 14:48:57 +0000 Ingolf http://moneycreditandfinancialsystems.com/?p=346 Continue reading →]]> Credit booms generate economic and financial imbalances. The longer a boom lasts, and the more extreme the expansion, the greater these will be.

The results show up in balance sheets and income statements. Whether it’s an individual household, economic sector or the external position of a country, that entity’s financial statements tell the tale.

In Australia’s case, sectoral debt figures show remarkably divergent trends in credit growth.^[1]

At 73.1%, non-financial business debt as a percentage of GDP is only 7% higher than in 1988. The high point in the intervening years was 85.6% in Sept 2007. General government debt (federal and state combined) actually declined, from 42.1% in 1988 to 22.7% now. Prior to the crisis, it hit a low of 13.4%.

The real action was in the household sector, where debt to GDP started at 42% in 1988 and is now 109.7%.

In international terms, Australia’s non-financial business debt is middle-of-the-pack, our government debt perhaps the lowest in the developed world but our households rank near the top. There are countries with higher levels (Switzerland, for example, at 118% in 2007), but there aren’t many of them.

The growth in household liabilities far outpaced income. Debt to disposable income started at 62.8% and ended last year at 169.7%. And, despite historically low interest rates, 10.6% of disposable income still went to paying interest. In September 2008, that figure was 15.3%.

Concerns about household debt are generally countered by pointing to the other side of the ledger. After all, at 19.1% of total assets and 29.4% of housing assets, household debt doesn’t seem so bad.

It looks even more reassuring compared to the US where housing debt before the downturn was just over 40% of housing assets.^[2] It’s a disparity that seems odd given household debt in the US is in relative terms lower than ours. The answer is in the value of dwellings relative to GDP.

Over there, even at the peak of their boom this ratio never exceeded 165%; here, it was 308% in December 2007 (up from 178% in 1988). So, homes here are almost twice as expensive in relation to the total economy as they were in the US at its market peak. Surprising as that may seem, it does at least fit with one recent survey in which six Australian cities figured amongst the top 10 most expensive residential real estate markets in the world.

♦  ♦  ♦

After Australia’s banking system was deregulated in the mid-1980s, a change in lending patterns was immediately obvious, although it took time for the train to gather speed.

Real estate prices closely paralleled the resulting growth in mortgage debt. It’s been (indeed still is) a classic asset based lending boom where rising prices (powered by expanding mortgage credit) in turn seem to justify ever more lending. These are sweet and seductive cycles that can seemingly spin their way to heaven, and in the years leading up to the crisis they played out in much of the developed world. Unlike everywhere else, though (except for Canada), after a brief hiccup when the crisis was at its most intense the cycle here resumed. So much so that residential real estate prices hit all-time highs in the last year.

Justifications are offered, of course, and there’s truth in at least some of them. For one thing, Australia never overbuilt like the US. Indeed, quite the contrary according to all those who lay the blame (or the credit, depending on your point of view) for persistently high prices at the door of a chronic supply deficit.^[3]

Perhaps. Certainly, the rental market here is for the most part tight. Still, even those parts of the US that were similarly constrained by geography and other restrictions (like San Francisco^[4]) were hit hard once the cycle turned. Prices are always made at the margin, and demand can undergo dramatic shifts when unemployment takes hold and broader economic conditions deteriorate.

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A recent study provides strong evidence that the degree of household leverage is tightly correlated with subsequent economic performance. Mian and Sufi (University of Chicago and NBER) analysed the debt growth of US households, not only in aggregate but also in detail across 450 US counties.

“[T]he recession both began earlier and became more severe in high leverage growth counties relative to low leverage growth counties. The top 10% leverage growth counties experienced an increase in the household default rate of 12 percentage points and a decline in house prices of 40% from the second quarter of 2006 through the second quarter of 2009. In contrast, the bottom 10% leverage growth counties experienced a modest increase of 3 percentage points in the default rate and a 10% increase in house prices.”

Ditto for durables consumption, residential investment, and rates of unemployment. For all these measures of economic activity, they found “the correlation between leverage growth and the severity of the recession is robust to county-level control variables for demographics, cyclicality, and industrial composition.”

The study is a useful reminder that credit is in no sense neutral; leverage always has real-world consequences, some of them quite severe.

Only time will tell if things eventually play out in a similar fashion here. One thing, though, is certain. Household balance sheets are incomparably more stretched than they’ve ever been before and we’re therefore singularly ill-prepared for tough times. Or for higher interest rates. At these levels of leverage, the impact of a serious rise in rates hardly bears thinking about.

♦  ♦  ♦

Ploughing through this local data threw up some interesting trends. The one that most surprised me was the long-term shift in household disposable income in relation to GDP.

Over the last 50 years, it’s fallen from just under 80% to its current level of 62.9%. As can be seen from the following chart, the slide accelerated post-1983 and in the early years of the last decade.

Throughout, consumption stayed relatively constant with the most recent level of 55.8% of GDP only slightly below the starting figure of 58.1%. Clearly, household savings had to suffer. Until 1983, they were usually over 10% of GDP but from then on it was all downhill with negative prints for quite a few quarters between 2002-5. The crisis (such as it was in Australia) briefly lifted household savings to 4.6% but by the March quarter this year they were back down to 1.6%.

We don’t fare all that well by international savings standards although the UK has in recent years done distinctly worse. Only Germany (in common with most other European nations) managed to sustain household savings at historical levels. It’s curious that Anglo-Saxon countries have been so uniformly prone to debt accumulation in the last few decades. Perhaps it flows at least in part from their approach to financial deregulation.

As we saw from the earlier chart, while household disposable income and savings rates steadily fell in relation to GDP, the gross operating surplus of private and financial corporations rose from about 15% to 22.3%.

In simple structural terms, therefore, households have been the big losers in relative income and in absolute savings over the last 50 years. The corporate sector picked up some of what they lost but net national savings still fell substantially. In the early 1960s, they ranged from 13-16% of GDP whereas for most of the last decade they’ve been only 6-10%. Post crisis, burdened by government deficit spending (and more recently by the renewed drop in household savings) national net savings hit a new all time low of 4.65% in the December 2009 quarter.

No mystery, then, about why our current account deficit is so tiresomely chronic. With these savings rates and a continuing high rate of investment^[5], no other outcome was possible. Net external liabilities of $757 billion (or 59.5% of GDP) as of the end of March this year are the cumulative result.

Hardly in the Greece or Portugal class but still up by almost 20% of GDP in the last 20 years. The need to refinance these obligations as they fall due (while also funding the ongoing current account deficit) does make us much more vulnerable. Particularly in a world where ongoing capital flows can no longer be taken for granted.

♦  ♦  ♦

In “Diagnosing the Disease” I suggested the failure to accept that much of recent economic growth was inherently unsustainable badly distorted policy responses to the crisis.

The ready availability of credit (both internal and external) over recent decades enabled investment in Australia to grow while spending on consumption held at historical levels. It also helped push asset prices far higher in real terms. So much so that some, like residential real estate, are now radically out of line with the underlying economy.

This process feels good while it lasts, of course, and for us it hasn’t quite ended. Unlike much of the rest of the world, our bill has yet to be presented; we’re still lingering over coffee and cognac.

Whether the investments we’re making bear fruit remains to be seen; so much is directly or indirectly dependent on the China story. However that may turn out (and I do think the resources boom is probably due for a rude, albeit temporary, interruption), at least this spending stands a decent chance of producing adequate returns.

Not so for all the consumption done with borrowed money, where the households who succumbed have a long and painful road ahead of them. Nor for much of the more extravagant real estate investment; it no doubt brings great pleasure to its owners but it adds nothing of note to our productivity. In essence, it too is consumption. While we may indeed have a housing shortfall, much of what we do have far exceeds its primary role as accommodation. Given much of this extravagance has also been put on the tab, it’ll weigh us down for many years to come.

♦  ♦  ♦

A few basic conclusions seem inescapable.

Households can’t continue on their current path for much longer. No one knows exactly how much debt is too much, but it would be foolhardy to argue that we aren’t already pushing the boundaries. In any case, to the extent the borrowing didn’t go into productive investments, those households who took it on will have no choice but to consume (and invest) less in the future.

Our government should accept that household debt needs to be wound back. It can then facilitate the necessary adjustments rather than trying to impede them by encouraging more consumption and borrowing. It can also work towards bringing housing prices back into a more sustainable relationship with the underlying economy rather than pumping them up with grants and subsidies. And, if indeed we do have a real housing shortage, focus on sensibly boosting supply.

Given the sheer extent of the excesses and imbalances both here and more particularly internationally, the real crisis almost certainly still lies ahead. Squandering resources on makework schemes and grand infrastructure projects of questionable value therefore seems shortsighted at best. Yes, we’d all like to avoid pain entirely, but the history of our actions makes this impossible. To pretend the problems are minor, and to as often as not ignore the most pressing ones, merely guarantees greater difficulties down the track.

Far more useful, surely, for the government to work out how best to respond if (or in my view when) the next storm hits. To prepare plans and administrative capacity so that when it does the most vulnerable can be adequately protected and the way smoothed for the rest of us to make the necessary structural adjustments. Education and retraining capacity, support networks, potential investment projects that could generate real returns while also boosting employment, carefully targeted supplementary welfare schemes; these are the sorts of things they could usefully plan for. And, while we wait to see how many of them may be needed, fiscal capacity should be tended carefully rather than splashed about.

Despite all the challenges that lie ahead, we needn’t be unduly gloomy. With a bit of good sense and decent preparation, they’re  entirely manageable. Indeed, by world standards we’re in an enviable position. Whatever we end up suffering is likely to be a fraction of what others must endure.

For that we must be grateful to accident, geography and abundant natural resources. And, at least in part, our own efforts.

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1 Unless otherwise noted, all data is from the ABS or the RBA.

2 The sharply declining real estate prices since then lifted this ratio to almost 60%, a timely reminder that debt (until it’s either paid back, re-negotiated or defaulted on) is a fixed amount while the asset prices it funds are anything but.

3This argument is so ubiquitous it’s hard to believe there isn’t a good deal of truth in it. From a macro point of view, though, it is slightly puzzling. Dwelling investment over the last 50 years ranged between 3.8-6.8% of GDP. During the peak baby boomer household formation period it averaged around 5.5% as against 6.1% over the last decade and yet we still apparently suffer from chronic underinvestment in residential real estate. Perhaps I’m missing something obvious. For some perspective the Federal Reserve Flow of Funds figures show residential investment in the US during the boom years of 2004/5 was 5.75% of GDP.

4 Having roughly tripled in the decade leading up to the peak in mid-2006, prices in San Francisco very nearly halved in the next three years.

5 I was a bit surprised at how high Australia sits in the international rankings of gross fixed capital formation as a percentage of GDP. In 2008 (the most recent data from the OECD Factbook 2010), only two countries ranked higher, China at 41.1% and India 34.5%. Our 29.4% for that year is up by 4-6% from the levels of the 1990s and the first few years of the noughties. As an aside, the fact that investment here didn’t falter at all during the crisis was a critical factor in keeping our downturn so shallow and so brief. In the US, by contrast, gross investment fell by about 3.5% of GDP between 2008 and 2009.

a

Where government stimulus spending ends up, and how, are quite as vital as the spending itself. In the end, it’s no more immune to the logic of productivity than private investment, even though the primary goal will often be something quite different.

Unfortunately, discussions about the merits of stimulus spending often skate around this issue.

There’s another complication that also too rarely sees the light of day. Each credit induced boom generates its own combination of imbalances and unless government policy takes these into account, efforts to cope with the ensuing crisis will be kneecapped.

♦  ♦  ♦

Credit ain’t just credit, either.

By their very nature, booms generated by a fractional reserve banking system don’t result from the lending of genuine savings. Much of the credit produced is in effect ex-nihilo, literally “out of nothing”. Loans are made, recycled back into the banking system when spent and then for the most part lent out again in an endless cycle.^[1] Out of it comes a rapidly expanding and intricately interlocked set of IOUs. The only constraints are the reserve requirements (if any) imposed on the system together with a need for continued loan demand.

In a non-fractional reserve system, money lent is no longer available to the lender until it’s paid back. The act of lending is literally the transfer of the use of those funds for the duration of the loan. Not so under our system. As depositors, we all retain access to most of our funds while they are at the same time lent out in the continuous process described above.

As a result, for as long as the credit expansion lasts we’re collectively misled into acting as if there were more resources available than in fact exist. Certain structural consequences must follow and these are common to every credit induced boom.

First, credit funded economic activity is, in large part, effectively stolen from the future. Unless the borrowed funds are fruitfully invested, future consumption must be reduced. No ifs, no buts, just a cool, unpalatable fact.

If we bought on hire purchase, ran up our credit cards or withdrew equity by increasing our mortgage, we have no choice but to consume less in the future than we could have otherwise. Until the debt is renegotiated, paid off or defaulted on, part of our current and future income is already spoken for.

(None of this, by the way, is a comment on whether borrowing for consumption is good or bad in some moral sense; we must each of us make that decision for ourselves. If the costs are properly understood and can be weighed up against the benefits, then caveat emptor. My intent here is purely to consider the broader economic consequences).

Second, businesses respond to this credit induced demand with new capacity and hiring, higher wages and, quite often, additional borrowing. All of which in turn make their own contribution to economic activity in an apparently virtuous cycle.

♦  ♦  ♦

And the end result when at last the growing imbalances become too heavy to bear?

What had been seen as sustainable growth turns out to be anything but. It had instead been temporarily supercharged by non-savings based credit. Households who joined in the game are left to face the unpleasant side of the cost/benefit equation while businesses have to grapple with excess or, even worse, entirely misconceived capacity, much of it debt financed.

None of this is exactly rocket science.

Unfortunately, though, generations of immersion in a world of fiat currency, fractional reserve financial systems has undermined our grasp of the relationship between money, credit and reality. Both of the former are for the most part still treated as if they had the same meaning as under the far simpler and less leveraged systems of days past.

This confusion, together with a continued failure to accept that much of recent economic growth was inherently unsustainable, has badly distorted our policy responses to the crisis.

It’s not easy to correctly treat a disease if the diagnosis is flawed.

I will of course be returning to these issues from time to time. This was merely intended as a brief introduction and overview. The specific pathology of our malaise, and the sort of treatments we might choose if it were better understood, are both immensely challenging topics.

With some countries already knocking up against sovereign limits while next to nothing has been achieved in the way of structural change, there aren’t many topics that rate as more critical.

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1 This picture has been somewhat complicated in recent years (particularly in the US) by the growth of the shadow banking system. The broad principle being laid out here, however, remains essentially unchanged. For more on all of this, see the essay “Money, Credit and Financial Systems” .

Yes yes, I know. That very thought has long kept me from making such a foolish move.

So what tipped me over the edge? Well, two things.

First, early this year I finished a piece aimed at bringing the whole business of money and credit within the grasp of an intelligent lay reader. Not only how they’re created and why things have gone so terribly wrong, but also what a more sane and stable financial system might look like.

Even allowing for my bias, I was happy with it. Unfortunately, it fell into an awkward hole; much too short to be a book but too long to be sensibly published anywhere else. So, it went into the too hard basket.

What brought it out again was the second, and persistent, thing.

Despite the superabundance of commentary out there (much of it very good indeed), while reading it I sometimes found myself wanting to express a slightly different take. One focusing on the longer view, seeking to find and explain patterns of behaviour and structure that might allow these chaotic times to be seen in a clearer perspective.

Given my long-standing fascination with these matters, and the vital importance of the ongoing broader conversation, the wish to take part in it in the end outweighed good sense.

So, here we are.

I won’t be prolific; indeed, at times lengthy periods may pass with no commentary at all. At other times, I might worry some particular aspect to death. Only time will tell.

In the meantime, that lengthy essay, “Money, Credit and Financial Systems (Are Crises Built into Their DNA?)”, can be found to the right.

Bon appetit.