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Those Mystery Debt Issues

OK. Let me take another stab at this one.

There is no debt problem.

Now enjoy the summer.

We are beset with folks arguing that nations running big budget deficits ‘need’ to cut spending in order to assuage the credit markets. I have tried to argue this is fallacious reasoning, yet the fear continues. Indeed, every time it dies down, it pops right back up in a slightly modified form.

So let’s be logical.

First: there is absolutely no evidence in the credit markets of even mild concern, let alone panic. If there is one market where we should have confidence that current prices reflect a consensus view of the economy’s future, it is the market for government debt. History tells us that price movements in that market are a pretty good indicator of what the investors in government debt are thinking. And, by and large, these investors are amongst the most sophisticated there are anywhere. So the price of government debt is something we should pay attention to as an indicator of the sentiment – mood, outlook, or forecast – of these sophisticated investors.

What do current prices tell us?

That those investors are far more concerned about the likelihood of depression and deflation than they are about excessive debt and inflation. Interest rates in the market have dropped from the slightly higher levels they were back two years ago. Bond auctions are over, not under, subscribed. People are actively searching for government debt as a ‘safe’ investment. Let me repeat: rates are down, not up. Investors are scooping up, not divesting government bonds.

I happen to agree with the credit market’s conclusion.

The risks inherent in our current position are mostly downward. We are far more likely to fall into a repeat recession, and possibly a bout of deflation, than we are to boom ahead and run into unmanageable debt burdens and inflation. All of our most recent indicators show the economy slowing down from what was a very short and uneven burst of growth last fall and early this year. Austerity measures are simply adding to the downward pressure and ensuring that the slight chance of a boom is firmly eliminated. The credit markets are telling us that they recognize this and evaluate the future through a pessimistic lens.

That pessimism is driven, not by excessive debt, but by deficient demand.

OK. So maybe they’re wrong, and the ‘gut’ feel of the austerity advocates is right. What can we say to defuse that?

Second: take a look at worldwide cash flows.

The aggregate shortfall of demand worldwide is creating a staggering amount of cash. This is simple arithmetic. If people are earning, but not spending, they have an excess of cash. They become creditors. The global private sector is generating about $3 trillion in spare cash each year at the moment. Don’t forget that it is the private sector in retreat when we have a recession. So private sector savings have shot up. This includes businesses who are sitting on ‘war chests’ of cash, consumers who are paying down credit cards, and everyone else who is simply not spending. With consumption and investment this slack, the world is awash with cash. And cash is useless as an investment in itself.

So what happens?

People look for places to invest. One such place is government debt. In other words governments create debt to offset the step drop in private sector demand, and the private sector buys that debt rather than take the risk of making direct investment or consuming. So the sytem comes back into balance.

It is only when the private sector starts to see better investment opportunities within its own domain – i.e. within the private sector itself – that problems could occur. In this case investors would want to withdraw their cash from government debt and invest it in higher return, but also higher risk, projects and activities. This point of change in the attitudes and flows of cash is what could cause a run up in interest rates. Only then does the larger money supply implied by the bulge in government debt become a potential inflation problem.

It is at this moment that government funding strategies need to change course and the private sector be allowed to forge ahead.

We are nowhere near that inflection point. This is the constant and firm message from the credit markets.

In fact, if anything, those markets are crying out for more debt and thus more stimulus.

Ah … but what about all this debt? Is it not a burden on the future?

No.

It is an investment in creating that future.

The cost of living through a period of very low growth, and potentially through deflation, is vastly greater than the cost of the debt necessary to reflate growth and get GDP back to its historic levels. The higher rate of growth will allow the debt burden to be reduced as a percentage of the economy. The cost of the debt as a percentage of total government spending will increase, but as a percentage of the total economy it will be a minimal increase, if any.

People who wring their hands about passing on debt burdens to future generations would be better advised to focus on the economy itself. Given the choice between an anemic economy with low debt and a vibrant economy with higher debt, future generations would be stupid to choose the former over the latter. Vibrant growth begets opportunity, and ways in which to pay down debt, that are not on offer in a sluggish economy. And it is opportunity we should be handing down to the future, not our own fearful withdrawal from growth. In other words we should not enforce our own view of austerity on the future, but seek to create the opportunity for future generations to make their own choices. The best way to do that is to get the economy back to healthy growth.

Does this mean we have no fiscal issues?

No.

I have repeated timer and again: we have major budget funding issues to deal with.

But they do not relate to the recession, or the debt needed to fend off depression.

They relate to our fundamental choices: how to pay for retirement and health care, how to pay for defense, and how to offset the imbalances that our economic freedom produces within society. For the past thirty years or so we have followed a relentlessly self-regarding path with respect to those choices. We have focused on the self and not the community. Individualism trumped society at every turn. That created great wealth for some, and a massive redistribution of the economy’s earning power away from the middle class to a much smaller percentage of the population. It exposed the fragility of the middle class, which was a post war phenomenon based upon a very different social arrangement. It returned much of that middle class to the edge of poverty – month to month living – and away from the ‘American Dream’ of comfortable retirement ‘earned’ by a life of virtuous hard work.

The hard economic reality is that virtue and hard work do not guarantee anything. We are now learning that. The institutions put in place after the Great Depression to mitigate this hard truth, and to allow the middle class to enjoy a modest version of the life the wealthy have always enjoyed, were swept away once we started to view them as encumbrances or barriers to our continued advancement. We were beguiled into thinking we could all be rich, if only those institutions were abolished. Instead, we simply watched society revert to the older distribution of wealth, with more and more of us ‘doing the right thing’ but still being left behind.

A particularly hard lesson is that the focus on the individual withdraws funding from the community. Our bedraggled infrastructure speaks volumes about our choices. We assumed the roads, rails, and schools would repair themselves while we bought retirement homes, played golf, and had our faces and various other body parts uplifted.

Which brings me to one last comment about debt:

As always there are two sides to the story. Debt and deficits can be productive or they can be destructive. A debt created in order to invest in a productive asset is never a bad thing as long as that asset pays more than it cost to put in place. Government spending on infrastructure, and even on consumer protection, falls into that category. But debt that is incurred without a productive use is both frivolous and, ultimately, damaging.

This is where the debt fearing amongst us have a point.

Most of our current debt problems relate to the Bush tax cuts that produced no lasting wealth creation. They were simply a shift of wealth from one segment of the population to another. GDP did not rise in response to the massive debt we incurred to pay for those tax cuts. Nor did investment. We have no enduring infrastructure. We have no new roads, rail systems, no new schools, no great research initiatives, and no burst of private sector invention. All we have is appalling job creation and an enlarged number of marginally poor people. Oh … and two wars. There is no asset being passed on to the future, simply a problem.

The problem being that we refused to face our limitations. Or that we were limited at all. It became ‘unAmerican’ to talk about the limits to growth. It was ‘unpatriotic’ to mention that we needed to make choices explicitly. Instead we were led into a period of avoidance and implicit choice. The cynicism of which is breathtaking. How else we we justify the Reagan deficits? How else do we explain the plunging into debt that the 1980’s brought us? How else do we explain our apparent comfort with the 2011 expiry date put on those Bush tax cuts? It seemed like a long way off at the time. And we didn’t care about the dire budget consequences we would face when the expiry came up. Instead we basked in the few extra dollars we all received at the time. As an example of extreme fiscal folly, those tax cuts, and our complicity, are hard to top. It is extraordinary that the generation culpable for that series of decisions is now suddenly concerned about fiscal rectitude, just as the baby boomers ‘threaten’ the stability of the budget that they denuded of funding.

Perhaps it is this that so disturbs many folks that they are now fearful of all debt.

If so I hope I have reduced that fear and helped focus us on the real issues.

So allow me to end this by repeating, and modifying, my opening line:

There is not debt problem.

But there is a choice problem.

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Jobs, Trade, and Debt: What’s New?

There was a modest flurry of reporting this morning that enables us to take the temperature of the economy. Unfortunately, once again, we are left with a ho-hum feel. This really is a long slow slog.

Jobs:

The weekly release of new claims for unemployment assistance showed a very modest – 6,000 – improvement and came in at 462,000. This was very slightly above expectations and so is something of a disappointment. Worse: the four week moving average rose 5,000 to 475,500 which tells us that any positive momentum in the job market we saw late last year has dissipated. This conclusion is backed up by the fact that claims are now running about 7% higher than they were in November. While some of this loss in momentum can be attributed to the oddities of the weather and spotty data collection, every week that goes buy without improvement undermines those factors as sufficient explanation for what’s going on.

A better explanation is simply that the economy is close to a stall, and needs another kick start. Frankly the jobs bill that just passed through Congress is an affront: it is way too small to have enough immediate impact, and relies far too much on tax incentives rather than direct job creation.

Lurking in the underbrush of the data is an ugly fact: long term unemployment is growing steadily and has now reached 4.56 million receiving regular assistance and a grand total of 11.36 million people receiving some form of unemployment aid. With Federal programs already stretched to 99 weeks it is hard to see what more can be done in terms of assistance. I think the obvious next step would be work programs in the manner seen during the Depression. So far, though, such ideas have not received much attention in Washington.

When we discuss unemployment aid it is very important to recall its stimulative value for the economy. Since unemployed workers are generally very hard up, they tend to spend any aid they receive. So channelling stimulus cash through the unemployment assistance route is an extremely effective way of getting aggregate demand to rise. It is demand we are attempting to reflate with the stimulus and we get a great ‘bang for the buck’ with unemployment aid.

I won’t comment again on the inhuman folly of the Republican position that aid acts to undermine a worker’s determination to seek work. I am sure there are examples of such idleness. I am equally sure that those instances are not representative of the general unemployment market. If they were we would not be witnessing the long lines ate job fairs, job workshops, and employment bureaus that we are. The Republican view is reminiscent of Victorian England before the emergence of the labor movement. The paternalistic moralizing that underlies such an attitude towards those unfortunate enough to have lost their job is staggeringly demeaning and massively insulting. Yet it still crops up. Personally I find it disgusting. From the point of view of economic policy it makes no sense either. Unfortunately, as I have said here many times, orthodox economic theory lends its support to the ‘unemployed as indolent’ perspective: according to the Chicago school of economics – Milton Friedman’s legacy – anyone who is unemployed has specifically chosen to be such. That theory assumes an unemployed worker values leisure so highly that they prefer to remain unemployed rather than find work at a lower wage. Hence there can be no ‘involuntary’ unemployment. The persistence of this specious thinking is one reason it is hard to purge right wing politics of its frequent bouts of paternalism, which is unfortunate when, as now, we need a united front with which to confront the terrible social effects of a crisis.

Trade:

File this in the category of ‘not good news’. Our trade balance shrank 6.6% in January to $37.29 billion. This is not good news for the simple reason that it probably indicates that worldwide economic activity slowed somewhat. The last thing we need is a global retrenchment. It is also unfortunate since the previous two months had seen large increases in the deficit which had all the feel of a strong economy: not only were we exporting more, but we were importing more as well which is usually a sign of increasing demand and industrial activity. A sudden stall such as that in January is something we need to watch carefully. A repeat in February would be unwelcome.

While I am on the subject of trade I should mention the administration’s export initiative. Politicians always love export stimulating programs because they draw a straight line between a surge in exports and a healthy outlook for jobs. Allow me to pour cold water on that notion.

It takes a little thought to see why a surge in exports and thus a surge in jobs is not a healthy thing. There are two essential reasons.

First: any increase in our exports implies an increase in someone else’s imports. All we do in this case is to create jobs here at the cost of jobs there. The lost income abroad will eventually feed its way through as lost demand and eventually a loss in demand for our goods. To maintain our trade advantage in the face of this lost demand we would have to cut prices and engage in a trade war. The end result would be an erosion of activity and the potential loss of those jobs we created at the start.

Second: a surge in export related jobs would put pressure on our labor market. Right now that seems like a good idea – we have tons of slack to be taken up. But as that slack is removed and as the domestic economy improves the added export related jobs will exert inflationary pressure on wages and will cause the Fed to have to raise interest rates. This would cut off domestic growth at a lower point than normal, meaning that fewer domestic jobs were created during the business cycle. In other words the extra jobs in export industries come at the expense of fewer jobs in domestic industries. Over the course of the entire business cycle the number of jobs created will be the same, they will simply be allocated somewhat differently.

This is basic economics.

The only way to create extra employment over a business cycle is to increase total – ‘aggregate’ – demand. That way more stuff will be bought from all industries whether they are export, import or domestic only.

So stimulating exports, while it appeals to voters, politicians, and to business leaders in exporting companies, has no long term value. There are no extra jobs created and the effort simply masks losses elsewhere.

This is why stimulus should focus on reflating demand rather than on targeting specific industries.

Beyond stimulus, an industrial policy that helps expand the economy in a general sense has value, but that is not what the administration’s export initiative appears to be about. Obama should get back to finding ways to develop new industries and leave exports alone.

Debt:

One of the great features of this crisis, especially in the recovery stage is the massive de-leveraging going on. Households and businesses are shedding debt at unprecedented rates. Debt still continued to climb in the fourth quarter – at a 1.6% annual rate – but that represents a significant withdrawal from credit. Don’t forget the economy grew at over 5.5% during the same period.

According to the government businesses cut debt at rates never before seen, and the fourth quarter increase was the smallest on record – going back to 1952. The outstanding debts of non-financial companies fell at an annual rate of 3.2% in the fourth quarter, bringing the drop for the year as a whole to 1.8%.

Meanwhile households cut their debt levels by an annualized 1.2% in the fourth quarter, bringing the annual decline in that sector to 1.7%, the first annual drop ever.

At first sight these figures seem welcome: one of the chief concerns of the past few years has been the indebtedness within the economy. So de-leveraging appears to be a sign of a more healthy balance being established within the economy.

Not so fast. Think about this a little: every dollar spent on debt elimination is one less dollar spent on investment or consumption. All this debt reduction is putting a massive constraint on demand. No wonder the economic recovery is so slow. As in all things there needs to be a better balance between debt reduction and spending. Right now the economy has veered far to heavily towards thrift and too far away from expenditure.

But there is an offset. One that has been much debated recently: government debt.

One reason why the surge in the Federal deficit has been of little concern is that it is filling the debt void opened up by the huge private sector retrenchment. That’s why total debt is still rising even in the face of the private sector cutback. Without that surge in public debt aggregate demand would have imploded completely and we would most likely be in a deep depression.

Conversely, those who argue that the surge in public debt is somehow ‘crowding out’ private debt – making it difficult for businesses to raise debt and thus invest for the future – is clearly wrong. There is no private demand for debt to be crowded out. All the data suggests otherwise: the private sector has gone into a deep freeze and is trying to shrink itself at an unprecedented rate. The crowding out argument might have some validity during a normal business cycle, but this is far from such a cycle. We are witnessing an historically large retrenchment, which requires an equally historically large response.

One reason why the economic recovery is so meager is that policy makers completely misread the unique character and size of the crisis. Especially the impact that the banking implosion would have on the real economy.

It is vital that we all grasp the true nature of our current problems and understand that we are dealing with crisis whose size and scope is beyond any other than the Great Depression itself.

So, yes, debt retrenchment is great in the medium and long run. But short term it is acting as a massive brake on GDP growth. Only continued government debt creation can fill the gap and keep us afloat. Hopefully there will come a time soon that we can switch back to private sector borrowing and reduce the Federal debt. Right now any discussion on the subject is being rendered moot by the private sector’s actions.

So what do we make of today’s data on jobs, trade, and debt?

The economy is still a mess. The issues are still complicated and not easily tractable to simple policy shifts like the export initiative. Nor is debt reduction necessarily a good thing

This year continues to look very difficult. Even though we have made progress, it is both tenuous and far to reliant on government support. We are still waiting for private business and households to stop reducing. Only then will we see an easier path emerge. And until then risks abound.

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Californiastan?

I haven’t poked fun at California lately, but how can I pass this up?

Bloomberg and Reuters now reports that the cost of credit insurance on California debt is now higher than that of such rock solid, fiscally sure places as … Kazakhstan, Lebanon, and Uruguay.

Ouch!

All the media attention being focused on the mess the Greeks have made of their economy, and it is an enormous mess, misses the point. The Greek economy is small compared with California’s. Very small. A Greek debt default would not shatter the world economy, but a California implosion could. Remember: California is the world’s eighth largest economy, and its $20 billion a year deficit is destroying its ability to raise cash to meet its obligations. Actually that’s not quite accurate: what is hurting most is the fact that the state seemingly has no intention of fixing its problems, or ability to to get its political gridlock settled so responsibility can be placed squarely on anyone. Calofornia has become the poster child for the way in which hard and fast constitutional limits can scupper sensible or responsive politics. The people voted for the series of disasters that have led to California’s slide, so they have to shoulder the blame.

As for Greece: I learned today that Greek bureaucrats get not twelve monthly paychecks, but fourteen. They get an extra monthly check twice a year. Plus the Greek retirement age is 61 – way below the EU average. No wonder the place has a budget crisis. It’s laughable.

But for California credit risk to be more expensive than Kazakhstan … that’s just insane.

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Our Policy Conundrum

I have spent much of my time recently lashing away at the notion that either monetary policy [i.e. interest rates] or fiscal policy [i.e. the Federal budget deficit] should be tightened any time soon. Nowhere in the data is there a sign that now is close to appropriate for such a move.

“It is not the absence of good economics and policies, it is the absence of sensible conversation that threatens our economy most.”

But the debate rages on. Quite why I have no idea. Perhaps it is because, as Paul Krugman says, central bankers hate being ‘accommodating’. They much prefer being old curmudgeons. He goes on to add that as far as he can tell the ‘debate’ seems to be one in search of a problem to solve, rather than targeting something we have to deal with now. I tend to agree. The whole discussion has a decidedly artificial air to it.

So, for the sake of clarity let me repeat: we do not need to tighten. Not now, and most likely not next year either.

In fact there is ample reason to believe we interest rates should stay where they are for three whole years.

I realize that I am repeating myself here, so in the interests of balance allow me to pull together a couple of plausible reasons that tightening should occur sooner – in line with what the hawks are arguing.

The most obvious is our national fiscal balance that is now completely out of whack. How you respond to this depends upon your point of view regarding its origins and likely size post-crisis. The hawks see the deficit as a proxy for the debt load it implies. In turn this suggests we need to be aware of the limited appetite there might be for US bonds. Two numbers are bandied about with abandon: the debt/GDP ratio which has surged from the low 40% range up to about 70% and could keep on going higher for a while; and the absolute deficit which stretches away in negative numbers for as far as the eye can see. It is the combination of the two that worries people. It worries me too. The reason being that while short term surges in debt are fine – they are the results of crises – once the crisis abates the debt load should ease. If the Federal deficit remains unchecked that easing will be insufficient and our reliance on the bond markets may stay too high.

Here comes the interpretive part:

People who are hawks look at the ‘history’ of the US and do not see any ability to balance the books. They are therefore concerned that the debt/GDP ratio will stay at some lofty and unsupportable level. Others, me included, look at the same numbers and think that the debt/GDP ratio will come down in due course and that it is an entirely manageable problem.

Let’s do a quick run through the thought process that suggests the problem is manageable.

One aspect the hawks focus on is the cost of carrying the debt. We have to pay interest on the debt so we need to generate wealth to cover it. Assuming that interest rates adjusted for inflation stay within historic ranges – let’s say 2.5% – the implication is that it will cost between 2% and 2.5% of GDP to pay the debt load. That’s a lot of money, but in the context of the economy as a whole it is not a big deal. It is certainly something we could cope with. So debt load is not a problem.

The bigger issue, in the eyes of the hawks, is the deficit. As long as we run a deficit we are adding to the pile of debt we owe and not reducing it. Here the hawks have a big point. In fact I agree with their sentiment in this regard. All countries have experienced debt surges: mostly these are associated with crises of one sort or another. Wars rank high on the list. Depressions likewise. What sets the US apart is that has also had debt surges without a crisis to cause such a surge. Twice in fact. And both in the past thirty years. These are the two events haunting us at the moment and which make the hawks queasy. The two events? The debt spikes caused by the Reagan and Bush supply side budgets. One in the 1980’s and one in the 2000’s. These are the only two examples in American history of a debt binge being unaccompanied by a crisis. They were self inflicted wounds. They also prove, to the hawks, that the US cannot be trusted to be fiscally conservative.

Read that through again. It is very edifying.

The two events that are undermining the US’s reputation for fiscal conservatism were the result of policies and budgets enacted by Republican presidents.

Ironic huh?

Moreover the hawks all seem to be people who cheered on those two events as being stimulative supply side policies guaranteed to kick the economy into high gear.

Both failed. The last one spectacularly.

So the hawkish crowd all appear to be a tad cynical – to my eye – when they cry foul over the debt surge we now have but not those other two. Especially when they use the debt build up consequent to those supply side budgets as evidence the Federal deficit is running away unchecked.

Setting that cynicism aside: they have a good point. Structural, long term or permanent deficits are not a good thing. They undermine the trustworthiness of the US government when it says that it can mange its affairs responsibly. Somewhere out there in our projected budgets there must be a balanced set of books. Credibly balanced. With the emphasis on credible.

This is the nub of the hawks argument. We lack credibility. The fiscal mess that Reagan and Bush made has muddied the waters. The US lost its reputation for conservatism. Add in Obama’s social agenda that could add to the cost of running the government and it is easy to see why the hawks coalesce around the debt ratio as a harbinger of doom.

From my point of view I agree with the notion that we need to eliminate our structural budget gap. This means we have to have a debate about our priorities. An open an honest debate. I had hoped that the health care ‘debate’ would be the first step along that road, but I was disappointed. It devolved into a smear campaign so quickly that the big issues and choices disappeared beneath a welter of lies, innuendo, and name calling.

The end result of this debate will have to embody compromise that no one really likes – it is always hard to be enthusiastic about compromise – and will include cuts in favorite programs as well as tax increases. We will have to allocate our wealth more carefully and we will have to encourage thrift. Up to a point. It will mean that we have to get much better at wringing wealth from our resources: higher productivity and less waste. The US extracts less GDP per person from the energy it consumes than any other country. We are wasteful. That shows up in our imports. It detracts from our ability to be productive. This is simple stuff, but if opponents rally against such statements as being somehow ‘un-American’ we will never get to the root of our problems.

Liberals like myself need to understand that our social programs need to be put on a sustainable footing. Most were designed for a population with very different life expectancies and so on. They all need to be updated. That requires a pragmatic flexibility and honesty on the left so far lacking.

Conservatives have to get used to the idea that Americans like these social programs and want to keep them. The free market alternatives just don’t work for most people because of all the reasons that free market economics teaches us: the theories only work because of the utopian assumptions needed to make them tick. Put those ideas into the real world and you get the kind of unfettered capitalism that just ran us onto the rocks. Abandoning people to the whims of free markets exposes them to a turbulence only the wealthy can withstand. It predestines them to failure and undermines their sense of community. So government is necessary. It may be an ‘evil’, but it is a necessary evil. So conservatives need to embrace that fact and cooperate in making government responsive and efficient, rather than gutting it and hoping it fails.[see Katrina].

The deep divide in today’s politics – the incessant culture wars – are preventing this necessary debate from occurring. The focus of those wars on social issues eliminates a central ground existing for economic issues: life is rarely binary, but our politics have become so. The biggest loss appears to be fiscal conservatism. Neither side really embraces it. And as I mentioned above, the biggest irony is that the right wing totally abandoned conservatism in an effort to avoid having to confront the essential left of center tilt of the population with respect to social programs. I think both Reagan and Bush thought they could undermine the credibility of government as an economic force by plunging it towards bankruptcy – this is Grover Norquist’s famous mantra about ‘starving the beast’. What they forgot is that this implies bankrupting the nation along the way. It’s an easy mistake if your perspective is tainted by the view that somehow the government is not part of America. That may be difficult to square with ‘we the people’, but it is the dominant view amongst the hawks now girding for a fight against the Federal deficit. Since to Reagan and Bush the government was the enemy of America, plunging it into a permanent sea of red ink was an act of liberation. Reality is different of course. The government is us. And we are now awash with that Reagan and Bush induced debt.

Along the way both left and right have avoided a conversation. Both have drifted into the illusory world of free markets where magic things happen without any effort by any particular person or group. Reagan, Bush senior, Clinton, and then Bush junior all relied on this illusion in order to avoid having to discuss priorities and deeper problems. The magic would deal with it. We could just sit back, relax, and enjoy the grandeur of the American Dream. We stopped talking about the gritty issues of long term economic growth, competition, or infrastructure, and started living for today alone. That’s why I call it the era of illusion. Maybe self-delusion is more apt. All I know is we forgot to talk about difficult issues. The conversation ended.

The debt hawks are doing us a favor by re-starting the discussion. The problem seems to be that the conversation is all one sided. That, and the facts don’t seem to be important in shaping their views. I fear the great divide has seeped into our economic policy conversation.

So this is our conundrum:

It is not the absence of good economics and policies, it is the absence of sensible conversation that threatens our economy most.

Maybe the bond markets should be worried!

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Too Big To Fail

Of all the issues facing the economy one stands out as having potential to throw the economy back into crisis. Yes, the lack of consumption may make us fall into a second recession, but that is not a crisis – we know how to deal with it. No, the lack of long term safety and soundness in our banking system remains as that potential trigger. Specifically the damage that could be done by banks that are deemed ‘too big to fail’ [TBTF]

I have sounded off on this plenty of times so I will not repeat myself: I think we need a mixture of breaking up the big banks and much more rigorous regulation on their activities, especially on their trading accounts.

The debate on how to manage these behemoths is no getting up a head of steam. Today Barney Frank weighed in with his proposal to institute a tougher regulatory regime. I don’t agree with his proposal since it leaves the big banks whole, but at least we now have something to shoot at or argue over.

The central component of the Frank idea is to establish a central authority comprised of representatives of various regulatory agencies with the power to wind up the mega banks in a relatively painless way.

One of the bug stumbling blocks we have at present is that, while shareholders stand to lose everything in bankruptcy, bondholders and, crucially, counter-party creditors are protected by the taxpayer safety net. This extension of safety to sophisticated creditors, rather than just to ordinary depositors, has vastly complicated the winding up process of banks and made the cost to taxpayers extremely high. This ongoing, and implicit rather than explicit, guarantee by the taxpayer sits behind the willingness of creditors to continue to lend to big banks even when the bank’s leverage has reached dangerous levels. As I have said before: this implicit guarantee needs to be made explicit. The banks should either pay for it or give it up. Since they cannot operate any longer without the taxpayer safety net they’d have to pay. That would hammer their profits and strip away their delusions of grandeur.

But Frank doesn’t go there. Instead he simply seems to advocate a more efficient bankruptcy process that would foist losses on the bondholders as well as the equity holders. This means that in an extreme event the guarantee would disappear for the bondholders at least. But for an ongoing bank taxpayers would still be on the hook and creditors would be willing to lend at lower rates than would be otherwise prudent.

Lest this sounds arcane I want to point out that the implicit guarantee does not extend to smaller banks: those we have let fail. The implication of this is that smaller banks are at a constant competitive disadvantage: their cost of borrowing will be higher, this means their margins and profits will be lower. The big banks will be able to gobble up even more of the business. they will get even more TBTF.

I have no problem with having aggressive bankruptcy plans available to the regulators – the whole Lehman and AIG mess suggests such plans are long overdue. But tightening control must go beyond that.

As George Shulz has said: too big to fail means too big to exist.

Break up the banks.

Addendum:

I have a good friend who works at one of the regulators. His view from the inside is much more nuanced than mine and, in some ways, more pessimistic. The point being that there seems to be a total lack of political will to attack the issues presented by mega banks. Amongst these issues are:

  • International conformity of regulation – right now the big banks simply move business around the globe to countries with less strict regulations. When they go bust this leaves a trail of legal recrimination, confusion, and indecision. This ‘regulatory arbitrage’ needs to be stopped.
  • The entire mess of derivatives needs to be curtailed. The big banks have conjured up ways to package and sell things that boggle the mind. Just the names of some of the corners of Wall Street tell it all: ‘dark pools’ where trades take place away from public scrutiny; synthetic derivatives, which are derivatives based upon other derivatives; and, of course my favorite, sovereign credit default swaps – which only have value if the US defaults on its debt, at which point I would wager the banks trying to collect will have deeper problems than US treasury default.
  • Capital rules that need to be adjusted to rein in off balance sheet assets and take away the lower capital requirement for securities.
  • Risk management techniques that are self evidently fatally flawed: the collapse of the banks last year was less a capital adequacy problem than a liquidity problem. The entire fabric of risk management failed: from the fancy math right through to the inability to sell assets to raise cash. We all need to understand that markets fail. Without accepting that central premise everything else doesn’t matter. When markets fail no one can sell assets – there are no active buyers, that sends asset values crashing well below any reasonable floor, panic ensues, and banks suddenly lurch from being safe and sound to bankrupt because what they thought was a source of cash is no longer available.
  • Compensation reform. This is less easy than it sounds since it requires re-wiring the way we all think about finance. A few years ago no one paid anywhere near the attention to daily stock market gyrations as we do now. The emphasis on quarterly earnings reports needs to go away. This relentless short term focus forces managers to take risks beyond that acceptable long term. Since bonuses tend to be tied to the short term the entire focus of business needs to shift to the long term view. Only then will pay structures be easy to reform.
  • Lastly the rating agencies, whose complete lack of objectivity drove them to insanely poor analysis, need to be forced into a totally reconstructed and neutralized way of business. Those who rated what became toxic assets as triple A need to be removed from the industry permanently: they obviously were both clueless and probably corrupt.

One last thing on liquidity.

Another good friend of mine with military background used to tell the tale, suitably sanitized of course, of US military planners constantly failing to recognize the logistical bottlenecks represented by limited troop availability. Each sector commander assumed that the ‘cavalry’ was available to him to deal with a crisis is his designated area. What they all missed is the effects of a systemic crisis: clearly the same cavalry cannot be in two places at once fighting two separate crises. This is analogous to bank liquidity: banks who make liquidity plans built upon the assumption that they alone will be looking for cash miss the point. A systemic crisis means everyone will be trying to raise cash. That will flood the markets and destroy asset values. Risk management has to be systemic. How we do that and preserve bank independence is another matter.

Big bank war games perhaps?

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