Ah! Gold.

Gold’s swoon has triggered a good deal of schadenfreude, some subtle, some less so.

It’s hardly a surprise after eleven years of gains and often tiresome crowing from its more partisan supporters. Question is, apart from the emotional satisfaction of putting the boot in, are these critics justified?

Their complaints seem to revolve around four principal themes:

• Gold isn’t an investment. It produces no income and should therefore, at best, be regarded as a trade.

•  It can’t be valued properly. With no income, and no shortage of existing stocks, the bull case is entirely reliant on an unending supply of greater fools.

•  Gold’s supporters are true believers, more akin to members of a cult than rational economic actors.

•  In any case, it’s way too volatile to ever be a proper currency, even if that were theoretically possible or desirable. All the fools who bought the “gold is money” pitch are going to get buried.

Well, maybe.

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In any case, let’s consider them one by one.

• No argument: gold isn’t an investment. If it’s anything (monetarily speaking), it’s base money, or currency. To believe otherwise is a category error. Most serious gold bulls understand that even if the word “investment” is sometimes bandied about carelessly.

Whether “trade” is the right descriptive term is a bit trickier. For some, it certainly is. For others, however, those who categorise gold as money, it’s a precautionary holding, likely to do tolerably well if most other things financial are going down the tubes.

•  Can gold be valued properly? Seems more like a zen koan than a question with a clear answer, doesn’t it? At one level, the critics are undoubtedly right: with no income stream and superabundant existing stocks, gold is entirely at the mercy of perceptions. Still, it’s also true that greater fools have shown up with reassuring regularity for the last few thousand years. Is that likely to change any time soon? We’re probably each obliged to answer that question individually. And to accept the consequences.

By the way, while gold doesn’t yield anything, nor does physical currency. To earn anything on either, you have to lend them out.

•  It’s certainly true that there’s a sizeable subspecies of goldbugs who are cultlike in the intensity of their beliefs. They have their demons, their gods, their sacred texts, and see this crisis as the final scene in a battle between good and evil. Gold for them is a symbolic lightning rod, not to be subjected to dispassionate analysis, much less ridicule.

Thing is, stripped of this emotional baggage (which is in any case rooted in politics and often religion), their monetary beliefs aren’t without foundation.

There is, after all, a long history of gold as money. Not as the reflection of some quasi-religious belief, but as a matter of cool, pragmatic, bottom-up agreement. It’s what the markets chose and for all its intermittent problems, the (real) gold standard worked well for a long time. Even today central banks all have gold on their radar screens (unaccountably or otherwise) and quite a few are busy acquiring more. Indeed, much of the non-Western world continues to view gold as real money. Foolish? Perhaps, although I don’t think so. In any case, ignoring that possibly uncomfortable fact is even more foolish. After all, right now these are the guys and gals with the savings.

•  And yes, it does fluctuate, sometimes a lot. It’s hardly alone though, is it? US stocks fell 23% in one day in 1987 and some 30% in a few weeks in 2008; the yen tumbled 18% in under a week in 1998. And so on.

Did this lead to their dismissal as an asset class? Of course not. These things sometimes happen in markets where speculation has run rife. When the stars then align and players from every time frame suddenly find themselves on the same side of the market, weird stuff happens. Sensible people understand that and form their views accordingly. Certainly, drawing far reaching conclusions from such structural aberrations is plain foolishness.

Time alone will provide the answers to most of these vexing issues. We’d probably be wisest to pay no more attention to the (often amusing) fulminations of the more extreme critics than to those of their targets.

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So, has gold bottomed?

Well, nobody knows of course. Short-term, it depends on whether the weak hands are finally out. FWIW, I think most of them probably are. Longer term, what matters are the policies governments and central banks run in years to come. If fiscal and monetary prudence took centre stage, gold would almost certainly go into a long-term nominal bear market. If, as seems to me more likely, the current activist extravagance persists, or intensifies, then the nominal (and probably real) upside still beckons, perhaps with even greater volatility. And, quite possibly, for years to come. We may as yet have only seen Act I.

In any case, caveat emptor.


P.S. The title comes courtesy the traditions of a popular Urdu newspaper. According to a friend who once read it regularly, whenever a local notable died it invariably printed a minor editorial with the heading (for example): “Ah! Qasim Rizavi.”


Pity the central banker

If central banking were a stock, you’d go short.

Blue-chip mystique still clings to it but you can feel the reputational parabola slowly gathering momentum on the downside. Its projects are too large and diffuse, the resources to achieve them too crude and there are mounting signs of unhappiness and confusion at the top.

Given their long-standing rock star status, pity the central banker; the fall from grace may be vertiginous.

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The Governor of the Old Lady seems more attuned to this unfolding trend than most. On my reading, he metaphorically ran up the white flag in a recent speech. It was the oddest mixture of explanations, implicit apologies and rationalisations imaginable from such an august perch. Do have a look; it’s not long.

King finished with an amusing touch: “As for the MPC [Monetary Policy Committee], you can be sure we shall be looking for as much guidance as we can find, divine or otherwise. What better inspiration than the memory of those children on Rhossili beach singing Cwm Rhondda.”

Perhaps the South Wales Chamber of Commerce seemed a forgiving place to lay out some of central banking’s many puzzles.

Put simply, his message was: I know what we’re doing seems a bit crazy, and I know all the fundamental problems are still out there waiting to be solved, but what else can we do?

What’s even scarier is that I understand what he means. After all, most of the really important stuff, like correcting the monstrous accumulated imbalances of recent decades and setting a more sensible course for the future, isn’t within the Bank of England’s remit. And yet, because the magic wand is in their hands, everyone looks to them to do something. Anything.

Which, as we know, they did. Cumulative QE (so far) of £375 billion, or 25% of GDP, enough for top spot amongst its Western institutional colleagues. As King suggested, the market is well and truly sated:

During the crisis central banks have provided liquidity to banks on a truly extraordinary scale, so much so that there were no takers for additional liquidity in our latest auction. It is still useful to keep their auction facility as an insurance policy. But banks are now overflowing with liquid assets.

Insurance policy indeed. Any more QE would seem in danger of plunging the whole business into farce.

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King, as he often does, got to the nub of the matter early on in his speech:

In the long run, we will need to rebalance our economy away from domestic spending and towards exports, to reduce the trade deficit, to repay our debts, and to raise the rate of national saving and investment. So you are probably puzzled by the fact that we seem to be doing exactly the opposite of that today. Almost 4 years ago now, I called this the “paradox of policy” – policy measures that are desirable in the short term appear diametrically opposite to those needed in the long term. Although we cannot avoid long-term adjustment to our economy, we can try to slow the pace of the adjustment in order to limit the immediate damage to output and employment.

He’d be only too aware, I’m sure, that our current intolerable mess is the result of giving in to a long succession of apparently desirable short-term policy measures. In each of the would-be and actual recessions of recent decades, politicians and central bankers strove to “limit the immediate damage to output and employment.” And, for the most part, succeeded. Trouble is, of course, in doing so earlier excesses were never allowed to sort themselves out; instead, they were carried forward with compound interest and then added to afresh.

How does one ever decide that now, finally, is the moment to pay the piper?

Thing is, even if King thought the time was now (or, quite possibly, a few years ago), it’s out of his hands. He can advise, plead, cajole, threaten to resign, but he can’t decide. So too with his compatriots elsewhere, many of whom have also been delicately (and sometimes not so delicately) pointing out the limits of of monetary policy and pleading for deeper structural reform.

As King said immediately after his comment about banks now overflowing with liquid assets:

Their problem remains insufficient capital. Just as in 2008, there is a deep reluctance to admit the extent of the undercapitalisation of the banking system in many parts of the industrialised world. The verdict of the market is clear – without central banks support banks still find it expensive to borrow.

What’s true of the banking system is no less true for the economy more generally. There’s way too much debt and not enough equity. Until that imbalance is dealt with (together with all the real world distortions it fostered) there’s no chance of organic growth, just the hyped up, artificial variant produced by great bouts of fiscal and monetary stimulus.

Central bankers are burdened with a kind of original sin. After all, without their unfailing support and encouragement (together with the very nature of the fiat fractional reserve banking systems over which they preside), the credit excesses of recent decades would have been quite impossible. Can any of them coolly and dispassionately disentangle and measure the system in which they’re so deeply embedded?

I don’t know, but it’s not hard to imagine King lying awake in the early hours of the morning.

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So what’s the endgame?

With overall debt levels rising (still), rates pinned to the floor and vast amounts of excess liquidity sloshing about (thank you Mervyn, Ben, Mario et al), a private sector busily trying to repair its collective balance sheet and economies everywhere in the doldrums because of massive imbalances, anyone who says they know the answer is dreaming.

What we can say is that policy is distinctly, perhaps even irretrievably, assymmetrical. Central bankers are conditioned to leap into action at the merest hint of renewed weakness, much less deflation. As with both fiscal and monetary stimulus in recent decades, the political incentives all run one way. In the absence of sustained, reassuring economic growth, it’s hard to see what might change this bias.

Right now, all the resulting excess liquidity is mostly languishing in reserves at various central banks, collecting a paltry return and seemingly doing no harm. There’s a bit of fresh lending going on here and there, but demand is low and the banks, generally, remain relatively cautious. Fact is, central bankers are tearing their hair out because of the financial system’s lack of responsiveness.

Careful what you wish for, perhaps? According to Ashwin Parameswaran, the market’s current willingness to hold unusually large quantities of money because of the crisis induced desire for safety and liquidity may not hold if “real rates turn significantly negative”:

Once real rates become sufficiently negative, credit growth explodes and the positive feedback loop of ever higher inflation fuelled not just by currency repudiation but by active exploitation of the banking and central bank discount window to access essentially free loans is set in motion. In other words, hyperinflation in modern capitalist economies is characterised not just by a collapse in the demand for deposits but an explosion in demand for loans at the free lunch level of nominal interest rates enforced by the central bank.

Whether these huge reserves might one day wreak unexpected havoc is something I’ve long wondered about too. What I hadn’t realised until I read Ashwin’s links was how critically important explosive private credit growth has often been in earlier hyperinflations.

It makes perfect sense, of course. Once the incentives are strong enough (and what could be stronger than seriously negative real rates?) the whole machinery of credit and money creation is unleashed. One shudders to think how silly things could get.

Could it really happen today, in the US, the UK, or Japan? Could central bankers miscalculate or lose control so badly as to set this particular doomsday machine in motion?

Cassandra though I often am in these matters, I struggle to see it. After all, there’s no shortage of historical horror stories at hand. Still, like armies, central bankers are inclined to fight the last war, and after the 1930s they’re understandably paranoid about letting debt deflation get the upper hand. As Bernanke said at a conference honouring Milton Friedman on his 90th birthday: “Regarding the great depression. You’re right, we [the Fed] did it. We’re very sorry. But thanks to you, we won’t do it again.”

So it’s not inconceivable. It just needs inflation to get away enough to generate juicy negative real rates. With so much dry tinder already around and central banks all leaning one way, that’s not inconceivable either. Remember too that while individual banks can get rid of reserves through making loans or purchasing investments, overall, banks can’t. What one loses, another gains. One can therefore imagine an accelerating rush by individual banks to deploy reserves, all of it, at a systemic level, entirely fruitless and on the other side newly hungry demand intent on exploiting negative real rates. While the notion of hyperinflation still seems . . . well, a bit hyper, it doesn’t strike me as an easy beast to rein in if it bolts.

To bring it under control, central banks would either have to vaporise sufficient reserves through sales from their portfolio to give banks pause, or, raise the rate they pay on reserves high enough to discourage the process. Neither seems attractive. Brave indeed would be the central banker who embarked on the former in these bone china delicate times. As for the latter, with reserves so high (and still growing) it sure wouldn’t be cheap.

Tricky business, central banking.


Haldane’s “control rights (and wrongs)”

In the wake of the crisis, the question of whether financial markets are capable of effective self-regulation took centre stage. The near unanimous verdict was that they are not. The crisis itself, following on as it did from a period of extended deregulation, seemed to provide a definitive QED. So much so that surprisingly little attention has been devoted to working out why this might be so.

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 (PDF). 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.

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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.”

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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.”

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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”.

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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?


What to do, what to do

Martin Wolf has usually managed to moderate his inner interventionist. No longer, it seems. In a recent column, he casts caution aside:

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.

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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.

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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 £185 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.

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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”.

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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?

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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 may well 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, together 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?

[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.

This article was previously published at Money, Credit & Financial Systems.