Reinhart

Yes the two are intertwined.

There is no doubt that in order to achieve solid sustained growth over the next few years we need to reform our banking system. So while bank reform may appear to be arcane and, frankly, marginal, it is so central to all our prospects that everyone should be as active as possible in its formulation.

By now we are all fed up with the jargon so beloved of bankers and the banking ecosystem of regulators, accountants, rating agencies, lawyers, and politicians. We have all had to digest the enormity of the folly that led to the system’s collapse two years ago. And we have had to watch, some of us aghast, as the same people who destroyed the economy reap huge personal profit from its slow resurrection. Nothing, it seems, can prevent bankers from looting the economy.

And I mean looting.

It is no coincidence that banker incomes are directly correlated with bank deregulation. The relationship is incredibly close: the more banks are allowed to be ‘free’ the more bankers earn personally. In times of loose regulation bank profits soar, debt accumulates at prodigious rates, and periodic asset bubbles plague the growth of the non-bank economy. During such times economic growth is volatile and exhibits both high peaks and very low troughs. It is as if the bankers have the rest of us on a string and bounce us about in order to shake loose any cash we might have.

This is what I mean by looting.

The extra profits made by the banks during periods of loose regulation are not associated with any discernible improvement in capital allocation. Don’t forget that it is capital allocation that is the central purpose of banking. Banks take short term money and translate it into long term loans. This is inherently risky. So banks go to great ends to measure, manage, control, and monitor that risk. Except in those periods of deregulation. That’s when making money comes easily to the banking system. Absent strong regulation banks can play riskier games: they can indulge in imaginative ways to funnel cash into their own profit streams rather than in supporting the economy at large. They can grow in size, scope, and complexity unhampered by nasty bureaucratic limitations. They can add more assets without adding more capital to support them. And they can invent all sorts of fees, charges, and contractual wrinkles to syphon off money from their customers.

Worse still deregulated banks can become single-mindedly focused on short term profits at the expense of long term profits. A short term view is not just easier to manage, but requires less overhead – cost – in monitoring risk. Once the burdens of having to be careful are removed, banking becomes fun, and extremely lucrative.

That’s when the instability escalates. Along with a short term focus comes a memory loss. Banks are notorious for forgetting the causes of the last crisis. They always assume that, somehow, this time is different. It never is. That is the theme of the brilliant book by Reinhart and Rogoff – by far the best book to emerge from the crisis. They go back 800 years, study 66 countries, and countless crises. Their book examines all these events and summarizes it all neatly: financial crises are common, inevitable, predictable, and deeply dangerous.

Some countries are particularly prone to crisis: Greece was in almost perpetual default for a century after about 1800. It is by far the most default prone country the authors studied. Other perennial defaulters – France and Spain – go through bouts, but all seem to settle down as their economies mature. Others seem never to have a problem: Canada and Denmark stand out in that category.

The point is that crises are regular phenomena. Additionally: anyone using a short term view to develop risk strategies is doomed. As the authors aptly point out: anyone searching for a ‘once in a hundred year flood’ in twenty five years worth of data has only a 1 in 4 chance of finding it. The extreme folly of the silly people who built all those failed CDO’s and other derivatives fell into this short term trap. They looked at data going back a decade or so to build their risk models. Why? because that data is easily and cheaply available. Getting a better data set would have been both time consuming and costly. With risk management based upon such a limited view of history it was inevitable – absolutely certain – that a crisis would erupt. It was as if the idiots on Wall Street were intent on rebuilding the Titanic without taking into account the fact that icebergs exist. Yet we are supposed to suffer their hubris and laud their innovative capabilities.

Reinhart and Rogoff also pass on some sobering news: recovery from a bank created crisis is always long, slow, and difficult. This is because the economy’s credit allocation system – the essence of banking – is crippled for a long time as the banks rebuild profits and capital. It is also because bank crises are associated with asset bubbles and debt binges, both of which need to be ‘unwound’ in order for the economy to return to health.

This is why bank reform is so critical.

We are destined to suffer for a few years as we get back to health. By suffer I mean that the economy will not grow at its historically normal pace on a sustained basis for some time. The enormous re-balancing that needs to take place as regular people re-organize their expenses and savings, as businesses reduce debt, and as the government struggles to cope with its deficit, inevitably slows activity down. It also makes growth more prone to bouts of volatility due to the heightened uncertainty that always accompanies a re-adjustment.

During this re-balancing we need a quiescent banking system. One that has returned to basic banking principles and has lost its appetite for quick deals making and short term profit. We need careful banking. Prudent banking. Tight lending standards. Solid risk management. Boring and dull banking.

We all have an interest in the banking system. It is a utility. We all need it. We all have an interest in its safety. That’s why we all should be willing to pay to fix it when it breaks. It belongs to us, not the banks. It is the common property of anyone who trades, buys or sells things, saves, makes payments by check , wants to exchange currencies, or wants to borrow. In order to use such a utility we need it to have custodians. We need those custodians to provide the system’s services efficiently and at low cost: the economy does not make it wealth from banking but from the non-banking activities that banking allocates capital to. A high cost banking system – one where profits pile up for the banks – is imposing a cost on the rest of the economy. It is no longer acting as a lubricant for economic activity, it is acting as a source of friction. We all have an interest in eliminating that friction.

That means regulating the banks so that they do not capture capital but distribute it.

Wisely.

Since the banking system is a common property that we periodically need to fix, we all need to reduce the likely cost of that fixing. This also means regulation in order to reduce the damage done when the banks next forget.

And if there’s one thing we should all now know: the banks are stupid, they will forget.

Reinhart and Rogoff attribute the title of their book to an anonymous trader at the time of the Long Term Capital bail out. The trader mentioned that all the money stolen or lost due to robbery, fraud, and other such catastrophes was trivial compared with the amount lost due to four words: “this time is different”.

It never is.

Let’s all absorb that message and get to work on bank reform.

The recovery depends upon it.