The Safety vs. Easy Money Policy Dilemma Comes Into Focus

I’m surprised the little conundrum has not dawned on the officialdom sooner.

Any return to safer practices means less leverage and less freely available credit. Less freely available credit, short term and maybe even intermediate term, means less rapid growth (with a binge as big as we had, the drying-out will take time), although it will presumably mean a more sustainable rate of growth. But policy makers think the economy has a God-given right to growth, and more is better.

Now I actually think that intellectually, a lot of people do recognize the first set of conflicts intellectually, but emotionally, they do not want to make the choice. It’s the modern version of St. Augustine’s plea, “Lord, give me chastity, but not just yet.” And as a piece by Gillian Tett in the Financial Times illustrates, some of the interconnections may not be obvious to those trying to rewrite the rules:

But as the political jostling – and lobbying gathers place – the more important sector to watch might yet be the securitisation world. To most non-bankers, the word “proprietary trading” conjures up images of sharp-fanged bankers or hedge funds darting between assets, eager to make a quick buck.

However, in practice the big concerns of global regulators may lie elsewhere. After all, what blew the really big holes in the balance sheet of banks such as Citi, Merrill Lynch and UBS back in 2007 and 2008 was the fact that these banks had all taken huge quantities of so-called “super senior collateralised debt obligations” (or supposedly safe mortgage assets) onto their trading books.

While those trading books were supposed to be used for short-term deals (including “proprietary activity”), in practice those CDO assets were held for a long time, using the bank’s own capital.

This move was driven partly by necessity (the banks could not flog the super-senior assets anywhere else). However, another crucial issue was that Basel capital rules allowed banks to hold these items in their “trading book” with virtually no reserves, whereas provisions would have been demanded had these instruments been placed in the normal banking book.

So, in light of that, international regulators linked to the Basel committees are eager to dramatically tighten trading book rules, to force banks to hold more capital. And this might yet give a new twist to Volcker’s plans. Most notably, if the Obama threat to clamp-down on “proprietary trading” can be redefined as an attack on the abuse of the “trading book”, then groups such as the Basel committee will almost certainly lend their support. And if the debate does then move into that redefinition of “proprietary trading” then the banks will find it hard to fight back.

That will undoubtedly please some US politicians. However, there is one catch. One key reason why credit was so cheap in the early years of this decade was that banks were pumping out CDOs. And a central factor behind that was that it was cheap – and easy – to produce CDOs when banks kept burying the super-senior debt on their own books, or with entities such as AIG.

Yves here. The short form of what Tett said is CDOs are bad news (that may seem like an overly broad conclusion, but my book takes you through their destructive uses). The FDIC’s proposed rules on securitization would ban “resecuritizations” which would include CDOs whose elements were tranches from other bonds. But that was one of the major raisons d’etre of CDOs was to bundle up the bits of securitizations that investors did not want, structure the cash flows again, and sell the various pieces. So not having an outlet for the unwanted tranches would constrain the securitization process and make less credit available

A second set of conundrums may be operative as well. Our economic and financial model of the last 30 years, that of a high degree of international trade and robust cross border capital flows, may be inherently unstable. There are three factors that suggest why.

The first is empirical: large cross border capital flows are associated with bigger and more frequent financial crises. Correlation is admittedly not causation, but that conclusion emerges resoundingly from Carmen Reinhart and Kenneth Rogoff’s work on financial crises. Similarly, the post war period through the mid-1970s, which was notably free of major incidents, was one of capital controls and less trade than now.

The second is that we have a defect in our current currency arrangements, similar to one that plagued the gold standard. Countries that run sustained trade deficits are punished via deflationary adjustments. But there are no mechanisms from discouraging countries from running sustained surpluses, particularly by pegging their currencies too cheaply. France accumulated large gold reserves in the runup to the Great Depression in just this fashion, as China and the Asian tigers have accumulated large foreign exchange reserves in our day. While it is easy to blame the profligate borrower, it takes two to tango.

The third is that it may prove impossible to have an effective international regulation for capital markets firms. As a second Financial Times piece, on Obama’s plans to increase capital ratios, indicates, some of the measures the US would like to implement do not sit well with European banks:

If the much-debated “Volcker rule” that would ban deposit-taking banks from proprietary trading is not approved, the Federal Reserve and other bank regulators could be asked to fine-tune capital requirements to make risky activity more expensive.

However, at the Group of Seven meeting in Canada earlier this month finance ministers complained to Tim Geithner, the US Treasury secretary, about the rule, unveiled a month ago by Paul Volcker, the veteran former Fed chairman.

“We can’t just transpose or copy ideas proposed by Obama to the European continent,” Michel Barnier, the European commissioner, told a press conference this week.

Dominique Strauss-Kahn, writing in the Financial Times yesterday, complained of “locally reasonable but globally myopic initiatives” and argued that global regulators needed to work more closely to form a co-ordinated approach.

Another impediment to effective international regulation is Dani Rodrik’s policy trilemma: that nation-states would have to cede too much authority to an international regulator. Now there could be some half-way houses on some issues, although it isn’t at all clear how to make transitions even on narrow issues.

So that means if the authorities do not find a way to reduce the high degree of interconnectedness in our financial system, another big blowup in the not-too-distant future is likely. And as the Depression did, that may force a reversion to institutions that are national in scope. Again from the FT, quoting Dominique Strauss-Kahn:

“If banks have to lock up pools of liquidity in every national jurisdiction, their capacity for intermediating capital across borders could fall, and their charges for doing so rise, to the detriment of the world economy,” he said.

Yves here. It would be better if I were wrong, but it may be that intermediating capital across borders with insufficient checks is indeed part of the problem. If so, then policy makers are faced with the sort of choice they hate, namely, among unattractive options, where the best is the least bad. There may be no way to have large, fairly unfettered cross border capital flows and financial stability. While greater growth looks enticing in the short term, the political and social costs of the periodic blow-ups now look too high relative to the apparent gains.

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  1. Uncle Billy Cunctator

    “If banks have to lock up pools of liquidity in every national jurisdiction, their capacity for intermediating capital across borders could fall, and their charges for doing so rise, to the detriment of the world economy,” he said.”

    Are they including Dark Pools in all this philosophizing, or is their purpose to quietly facilitate the flows despite appearances?

    Has anyone recently done a comprehensive study of what they are, how much is flowing through them, and is it possible currently to know from whom and to whom it’s flowing?

    Outside of a few “oh my, Dark Pools sound scary and mysterious” articles last year, I have yet to see anything close to a complete picture of what they are and the potential for abuse (as if use isn’t abuse enough).

    1. Uncle Billy Cunctator

      Here they are saying that there is in fact transparency, because all the darkness occurs pre-trade:

      “The executions done in dark pools are only hidden from the public and other brokers before and during trading. “I think it is important to remember that dark only refers to a pre-trade state. Once a trade occurs, regardless of the venue, it is reported to the consolidated tape,” said Tim Mahoney, chief executive of BIDS Trading and co-developer of the New York Block Exchange, a joint venture between BIDS and the New York Stock Exchange.”

      Would every transaction from every participant be required to be reported on the “consolidated tape”?

      The article also, while minimizing it, discusses the ease with which traders can game trades. Surveillance, they say, is the reason it won’t get out of hand. Please. Who’s watching the watchers here?

  2. jake chase

    You are exactly right. Instability and crisis are the price of unfettered capital flows. Bretton Woods was the last sensible attempt to deal with this reality. It lasted 25 years. I give Basel three, at the outside. We are all now in the business of anticipating the next crash. Much anxiety for those stuck with money, but at least the ranks of the anxious continue shrinking, every month.

  3. RueTheDay

    MBS, CDOs, and other forms of securitization are not the core problem. The problem is the concept of “credit insurance”, that seems to be required to make securitization work. It takes three primary forms – monolines, CDS, and the implicit (now explicit) government guarantees from the GSEs.

    Think about it. In any fixed income security, the interest rate is supposed to reflect (among other things) credit risk. In theory, the cost of a credit insurance vehicle should be exactly equal to the risk premium attached to the interest rate in its absence. The fact that credit insurance exists means it’s cheaper than the interest rate risk premium. Unless there is some sort of information asymmetry or economy of scale that a monoline or a CDS protection writer has over THE ENTIRE BOND MARKET, there is no reason for this to be the case. The existence of credit insurance is predicated on the underpricing of risk, furthermore it ENCOURAGES the underpricing of risk.

  4. DoctoRx

    This is another example of Taleb’s emphasis on redundancy at the expense of efficiency. Teleologically, we have two kidneys so that if one is damaged, we go on living. Obviously we continue to have too much emphasis on fast money/leverage vs. safety.

    1. carol

      “A reduction is (in) credit has the effect of reducing the money supply which is deflationary.”

      Sure. But what is the alternative?

      The world ran into peak debt. Not because paying back the debt became impossible, as no one needs to pay back debt. After death, one’s children settle the debt with the proceeds from one’s assets (or refuse to accept the estate). And a country does not need to pay back debt as our children and grandchildren not only inherit the debt, but also the physical and societal infrastructure.

      The world ran into peak debt, because of a limit to the debt servicing ability. How can there be over-leverage and/or off balance sheet securitization again, when people and businesses do not earn enough to service the ever-increasing debt (both private and public)?

      Either we get interest-free debt (not likely if you’re not a “bank holding”), or we get a reduction in debt servicing costs by reducing debt.

      1. jdmckay

        The world ran into peak debt, because of a limit to the debt servicing ability.

        I’m not so sure about that. The world (and US especially) was well into peak debt before our various accounting mechanisms publicly disclosed so. Entire BushCo econ team, most of Wall Street, and Countrywide all were declaring health of economy here well after point of no return was crosssed.

        I would say we ran into peak debt because pwr brokers controlling levers of US finance and econ lied… they plain and simple lied. And we have such a dumbed down populace that, smelling shiite for so long but told the aroma was roses, has somehow become a hypnotic state.

        How can there be over-leverage and/or off balance sheet securitization again, when people and businesses do not earn enough to service the ever-increasing debt (both private and public)?

        Well, I’d start by penalizing fraud in huge, massive ways. The scope of what’s happened here, w/not only no adverse consequences to the crooks but a federal bailout for ’em… I dun’o, that’s not a moral hazard: it’s guarantee for a repeat performance.

        I’d throw those *uc*ers in jail forever, dress ’em in suits, and parade ’em down main street at regular intervals as a reminder similar to Germany’s conscious effort @ remembrance of Third Reich atrocities, the idea being to not let it happen again.

        I’d submit Singapore as a model example: their contract law, requirements for performance of said contract, and swift retribution for even minimal fraud in transactions has kept things straight there while they’ve prospered. It was Singapore money, you may recall, that bought up Merrill and few others on the cheap as they were sliding to oblivion.

        How is it that Jack Abramhoff… CEO of the most far reaching and corrupting politicical fraud (on so many levels: money, bribed officials, and huge portion of GOP acting on his wishes via a phone call… to name a few) is about to be released from prison (less than 6 yrs.), but Rep William Jefferson gets more than twice that for a couple instances of what Abramhoff did every day.

        How does the purveyors of the Ca. Energy crisis, engineered and executed by Enron and a few Texas energy companies, which brought Ca. to it’s knees and cost +/- $33b, and fully enabled and assisted by the Bush Fed gov… nobody went to jail ( a couple low hanging fruits is all ).

        I don’t know. In America this last decade, AFAIC the message is: CRIME PAYS.

        If it were up to me, that’s exactly where I’d start: make it clear, w/no exceptions… you run a fraud scheme you’re going to do hard time and a lot of it.

  5. alex

    Yves: “there are no mechanisms from discouraging countries from running sustained surpluses, particularly by pegging their currencies too cheaply”

    Part of the great wisdom of Keynes’ Bancor proposal was that excess current account surpluses would be taxed.

  6. john c. halasz

    I’d question the premise that less leverage, hence higher capital ratios, hence more capital tied up in finance and lower ROI on finance industry capital, translates necessarily macro-economically into lower rates of growth. Down-sizing the financial sector and lowering its rate of profit means increasing the relative attractiveness of longer-run, if more uncertain and less liquid, investment in capital stocks in the real productive economy, and the flows of revenue and income derived therefrom. Which is, er, where all real economic growth actually comes from and what ultimately pays off incurred debt and interest. A highly profitable financial sector with low capital ratios is actually just extracting rents on the real productive economy and distorting the distribution of income that otherwise would flow from it. It amounts to an inefficient tax on the entire economy and its sustainable demand generation, aside from the instability and short-termism it induces.

    1. ray l love

      john c.,

      Your point is a good one although with so much dependence on service-based activities I doubt if ratios could come down very much. The expansion of the financial services sector was in part meant to be a global solution to the high relative cost of US labor back in the 60s and the 70s and there may be a runaway train effect by now. This train is in part fueled by an employment bubble in the financial services sector. Naturally, incomes could adjust downward and still be exorbitant. So in that respect the problem has some similarities to our health-care mess, but that does not provide much optimism.

      It makes me wonder if this employment bubble can be traced back to the deferment policies of the Viet Nam era. I am old enough to remember a time when college grads were pumping gas and flipping burgers, and, wages for the working-class have been going down ever since. It seems a little suspicious too that the immigration laws became increasingly ignored starting not too many years later? And it seems ‘very’ suspicious that so little has been said about the potential for a real estate bubble being in part the result of too many bankers, brokers, and real estate agents.

  7. ray l love

    This may be overly simplified for some, but, when citizens earn, save, and invest those savings — asset values remain tied to incomes. If the pace of securitization were also tied to this bottom-up growth there would be synchronization, if incomes kept pace with growth.

    The efforts to solve the current imbalances ignore that global aggregate demand is failing to keep pace with global lending requirements. For example, The Asian economies, especially Japan’s, became dependent on US household debt which has, of course, proven to be unsustainable. The problem therefore seems to have its roots in the global pace of upward mobility and the creation of borrowers/consumers. The fact that China now produces more autos than the US gives a hint of how the intended roles of nations, as part of the Globalization plan, are not developing as intended. One could argue I suppose that the emerging nations are not ‘sharing’ their upwardly mobile consumers/borrowers with the developed nations, but considering that the benefits of Globalization have created a rapid expansion of an investment/leisure-class in the developed nations, and considering that Globalization was largely orchestrated by institutions such as the IMF, WTO, and the World Bank, with each of these clearly favoring the interests of the advanced economies, it is difficult to blame the lesser developed nations for meeting the needs of their citizens as the result of efficiency.

    So it seems to me, that with so much focus on banking failure issues, this is much like what transpired after the Great Depression. There seems to be a “run on the banks” explanation in the making. There was of course a 71% poverty rate before the crash, and now, if the US economy is put in its comparative global context, the bottom end of the workforce earns about 16 cents per hour (based on the World Bank poverty standard of $1.25 per day, with a 40 hour work week). But of course the US only relies on ‘those’ workers to consume beverages that are sweetened with corn syrup. And one US banker can earn as much as about 50,000 of these workers so perhaps the scrutiny on banking is in the right place, but just not focused on the ‘people’ part of the problem.

  8. scraping_by

    I found in the book Stock Market Logic by Norman Fosback that the Fed announcing a higher reserve requirement was an absolute sign of a declining stock market. His numbers were flat for a year and then a fifteen point drop.

    This higher reserve requirement can’t be directed primarily at stocks, however. If the Fed wanted the Dow fall it could sell off some of the monstrous portfolio it’s acquired since last March. This is good old fashioned macroeconomics. Shift a bit of that M1 to M2 and higher to keep inflation at bay. It would be ironic if they stole all that money, just to have it turn worthless through inflation.

    Of course, with all the cash the banks have been given, especially the cash for trash, they don’t need no stinkin’ M1. Indeed, the gifts they’ve been given might suffice to cover the new, higher requirement. If they haven’t bonussed themselves too much.

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