The accepted wisdom on Greece

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Detlev Schlichter had a great piece on his Paper Money Collapse blog yesterday, in which he argued that Greece should return to the gold standard. But let’s leave that conclusion aside for the moment – what I really liked about the article is the way it systematically debunks a lot of the dodgy ‘accepted wisdom’ circulating about the Greek crisis.

In particular, Schlichter takes aim at the idea that Greece would be better off outside the euro because that would allow it to devalue its currency, and in the process monetize (or inflate away) its debt while boosting exports. According to the accepted wisdom, such a policy would allow Greece to get over its debt problem and give its economy a shot in the arm.

But as with much accepted wisdom, this is really just another example of the good old broken windows fallacy in action. Yes, inflation might erode your debts. But it also undermines savings – preventing the accumulation of real capital – and distorts economic decision-making. Before long, inflation inevitably turns out to be the road to economic ruin.

And yes, devaluation might boost exports. But that doesn’t do much to further overall prosperity: the boost to exporters only comes at a cost to importers, while in terms of access to internationally traded goods and services, everyone immediately becomes poorer.

Crucially, moreover, Schlichter points out that this ‘soft money solution’ isn’t even likely to succeed in its stated objective – avoiding a default:

Once the markets sense that the government or its central bank tries to “inflate the debt away”, the currency and the domestic debt get sold and real interest rates shoot up. This quickly worsens the debt dynamics for domestic borrowers, most importantly the government itself. In the end you get both, hyperinflation and sovereign default, as has happened numerous times before.

Ultimately, you can’t get away from the fact that governments just can’t keep spending more money then they raise in taxes. And they can’t just print away their problems with money created out of thin air. A successful, sustainable economy needs sound public finances and sound money. The have-your-cake-and-eat-it-too approach is a dead end.

Clegg wrong on bank privatization

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Eamonn has a post on the Guardian's Comment is Free site today, criticising Nick Clegg's suggestion that shares in the nationalized banks be handed free out to every elector. You can read the whole thing here, but this extract should give you the flavour:

Colleagues and I contemplated such ideas in the late 1970s, as a solution to Britain's huge nationalized industry sector, but we quickly abandoned it…

We went through 20 years of privatizations and we gradually worked out the best ways to do it. The shares need to be offered to those who actually want to own part of a bank. They need to be offered cheap, and in installments, so that a wide number of the general public participates. There needs to be national advertising to generate interest. Shares must be easy to buy. There need to be incentives to discourage people from flogging them at the first opportunity. The share offer needs to be underwritten by financial institutions. Some part of the shareholding needs to be reserved for financial institutions – but that proportion scaled back if the public demand exceeds expectations. The shares should be sold a bit at a time, so the taxpayer gets the full value possible from a (hopefully) rising share price over two or three years. Which they wouldn't under the proposed scheme.

We have learnt all these techniques before, in previous privatizations. It would be a mistake to ignore all those lessons, even from the best of motives.

Ringfencing won't work

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George Osborne is set to announce his intention to require banks to ‘ringfence’ their retail operations. Essentially, the retail part of universal banks (the bit that deals with your savings, and makes loans to individuals and small businesses) will become a separate subsidiary within a wider ‘group’. That subsidiary will be separately capitalized and subject to its own capital adequacy requirements (the suggestion is 10% equity capital to risk-weighted assets).

The idea is that this ring-fencing will make it easier for the government to let failed investment banks go bust, since they’d be able to fail without ordinary depositors being wiped out in the process. And if ringfencing does make it clear to investment banks that they will not be bailed out, that would remove the implicit risk subsidy they currently receive, and make them behave more cautiously.

I’m not so sure. It seems to me that both Osborne and the Independent Commission on Banking have missed the point somewhat. The issue is not just that universal banks are using the implicit government guarantee that comes with their retail operations to take more risks on the investment side – as the ring-fencing proposals would suggest. In fact, banks are generally taking more risks – across their whole businesses – because of the government guarantee. It simply isn’t the case, as most people assume, that retail banking is safe whereas investment banking is risky. Remember Northern Rock? Or US sub-prime lending? The ‘utility’ has caused us as much trouble as the ‘casino’.

And the big, big problem with what Osborne and the Commission are proposing is that they are effectively making the government guarantee of retail banks explicit. And that, as Andrew Lilico convincingly points out over at the Telegraph, means retail banks “will have incentives to engage in the riskiest practices the nature of their businesses allow.” Ringfencing might reduce the risk subsidy that we’re giving to investment banking, but it increases the risk subsidy to retail banks, and will inevitably make them less stable and more problematic in the long run. Slightly higher capital adequacy ratios will do next to nothing to offset this.

I’ve said before that no amount of regulatory oversight is ever going to be able adequately replace proper market discipline in banking. If we want our financial system to be safe and stable, we need to get depositors, bondholders and shareholders to realize that their money is only safe as the bank that’s holding it. We need to get banks competing on their risk profiles, rather than just ticking the regulatory boxes and declaring to the world that they are safe as houses. And we need bank executives to know that their livelihoods depend on their investment decisions.

Whatever ringfencing would achieve, it would not achieve any of that.

Neither one thing nor the other

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The FT reports that Sir John Vickers, the chairman of the Independent Commission on Banking, has admitted to the Treasury select committee that the commission’s proposed reforms “might not prevent more failures or free the taxpayer from providing support to the sector.” He is absolutely right, and that’s why the commission’s proposals are somewhat deficient.

As I’ve written before, by far the most pressing task facing financial reformers is to reintroduce proper market discipline into the banking. Bank executives need to know, beyond any doubt, that they won’t be bailed out if they make bad business decisions. Bondholders – that is, people or institutions who lend money to banks – need to know that their investment isn’t risk free. Even savers and depositors need to realise that their money is only as safe as the bank holding it is sensible.

Such market discipline would do far more for financial stability than any amount of regulation and enlightened ‘supervision’ – with all the information and incentive problems that brings with it – ever could.

But some people say this is just pie-in-the-sky stuff. They argue that while – yes – a real free market in banking might work, that’s just not something we’re ever going to have. Democracy, they say, means that banks are always inevitably going to be bailed out. At the very least depositors (and probably bondholders too) are going to receive full or partial government protection. In other words, they say that you just can’t possibly eliminate the risk subsidy that government gives the banks, and which inclines the financial system towards instability.

I hope this isn’t the case, but if it is, it probably suggests a far more radical regulatory approach than the Independent Commission on Banking has considered. It might even point in the direction of ‘narrow’ or ‘limited purpose’ banking, which would involve imposing strict structural divisions in the finance industry, and require banks to hold dramatically higher levels of liquid reserves. Bank of England governor Mervyn King has nodded in this direction.

Of course, I’d much prefer the free market option, but the trouble with the Independent Commission on Banking’s proposals is – arguably – that they do neither one thing nor the other. They don’t eliminate moral hazard and risk subsidies or restore real market discipline to the financial sector. But they don’t offer a particularly strong regulatory response either. As such, the banking sector is liable to cause more problems in future.

If you think speculation is bad, wait until you see the effects of no speculation

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It's been a commonplace for months now, that rises in food prices, the bouncing around of oil, the general manner in which commodity markets are volatile, is all being driven by speculation.

You know, this idea that if people are playing with money to make a profit then they must be doing something wrong?

The current bugbear is that such speculation makes prices more volatile. As volatile food prices are certainly not a good thing for the poor, who spend so much of their incomes on food, thus speculation in such things, which causes volatility, is wrong and must be banned.

The only real problem with this line of thought is that there's no evidence at all that the speculation leads to the volatility. Indeed, in theory, speculation should lead to reduced volatility, as Adam Smith points out (start at para 40). Theory's all very well of course, but how does this work out in practice?

Yes, that's right, onions, where speculation through futures and options has been banned this past 50 years, are vastly more volatile in price than oil is, where everyone and their grandmother can speculate to their hearts' content.

If you think speculation causes price volatility, just have a look at what happens to price volatility when speculation is banned.

Proof of the Efficient Markets Hypothesis

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The Efficient Markets Hypothesis is something that drives a certain sort of lefty into a slavering fury. For they take it to mean that we are saying that all markets all the time markets is the most efficient method of organising our socio-economic system. Thus when something like the Great Financial Crisis shows that markets aren't perfect they are able to crow that obviously markets aren't efficient and thus they get to tell us all what to do instead.

However, that's not actually what the efficient markets thing is all about. Rather, it comes in several flavours, the "weak" form of which is an obvious truism. When deciding what prices should be in a market markets are efficient at processing the information about what prices should be in a market. The semi-strong form goes on to say that markets will process all information openly available, the strong form that markets will process all information, publicly available or not.

There is, as you will note, absolutely nothing in this at all that says that organising defence as a market will be efficient, or that there should or should not be a welfare safety net. All that is under discussion is how well markets process information. And we seem to have some really rather strong evidence in favour of the strong form:

We estimate the impact of coups and top-secret coup authorizations on asset prices of partially nationalized multinational companies that stood to bene fit from US-backed coups. Stock returns of highly exposed firms reacted to coup authorizations classi fied as top-secret. The average cumulative abnormal return to a coup authorization was 9% over 4 days for a fully nationalized company, rising to more than 13% over sixteen days. Pre-coup authorizations accounted for a larger share of stock price increases than the actual coup events themselves. There is no effect in the case of the widely publicized, poorly executed Cuban operations, consistent with abnormal returns to coup authorizations reflecting credible private information.

As you can see, market prices reflect what the spies are going to do: something which we would regard as being pretty secret information really. Yet markets do process it efficiently, to the extent that what is still secret about what is going to happen moves markets more than what actually happens when it happens.

Yes, of course, the likely explanation of this is spies and their friends loading up on stocks that will benefit from what they're about to do: insider trading in fact. But that's still strong proof of the strong version of the efficient markets hypothesis: for we don't say that the processing of information by markets must necessarily be moral, just that it's efficient. As insider trading is, even if it's not moral/legal.

As an aside, one joy is that I found this research at Henry Farrell's place, who is a co-blogger at Crooked Timber with John Quiggin. Who has just published a book which uses the Great Financial Crisis to prove that the strong version of the efficient markets hypothesis is obviously and clearly wrong. Should be an interesting conversation between the two of them really.

How to reduce moral hazard

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What the system needs is bank failures. You know, Charles Darwin was a great economist.

Anonymous

Collective Delusion

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Four years ago this month, New Century Financial, one of America’s largest sub-prime lenders, filed for bankruptcy, signalling the start of the global financial crisis. Arguments are still flying as to who or what caused the crisis with banks largely cast as the biggest villains, closely followed by inept regulators.

The most obvious explanation is that too many were borrowing too much that they couldn’t repay, whether they were governments, companies, home buyers or shopaholics. In this frenzy, the banks merrily kept the punch bowl topped up while the regulators saw no reason to spoil a good party.

Earlier this week, our own Tom Clougherty reiterated how the implicit government guarantee that no bank would be allowed to fail distorted the normal risk-assessment process and misallocated investment flows.

Now comes another fascinating insight into how insidious the effects of such market interference can be. In an article by Mark Brickell, a former chairman of the International Swaps and Derivatives Association, those distortions are seen as corrupting the fundamental market data that the banks and regulators need to assess risks.

According to Mr Brickell:

Government policy inadvertently distorted the data used to measure risk, so that mortgage loans appeared to be less risky than they really were…Risk managers compile a record of historical price changes and plot the probability of large future shifts. Lenders, securities underwriters, rating agencies, and regulators all rely on some variation of this technique to help measure risk…Pre-crisis default rates were low, making mortgages look like low-risk investments to portfolio managers, their regulators and many others.

That historical data, though, was becoming increasingly skewed by federal policies. US regulators, like those overseas, allowed financial groups to make mortgage loans using less capital and more borrowed money than they required for other loans.. As demand for housing rose, so did home prices. And as policy pumped up home prices, the rate of mortgage defaults was artificially suppressed because distressed borrowers had no need to default. As the bubble grew, they could sell the home at a profit and pay off the mortgage, or simply refinance.

Every mortgage decision…relied to some extent on the skewed database. So did rating agencies. Oversight by regulators suffered from the same flaw…This should make it easier to understand why so many got it so wrong.

In other words, not only did government policies distort the market, they distorted the underlying data used to assess the market.

This is no surprise to friends of the Adam Smith Institute and is a salutary warning for other markets where government policies, however well intentioned, seek to skew behaviour.

Vickers: a partial solution at best

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I’ve not yet had the chance to read all 214 pages of the Independent Commission on Banking’s interim review, which was published yesterday. But going by initial impressions, I’m not convinced that their main proposal – requiring banks to ring-fence and separately capitalize their ‘retail’ (as opposed to ‘investment’) operations – deals with the fundamental problems in the banking sector.

Basically, the big problem is that the government effectively subsidizes bank risk-taking by guaranteeing (implicitly or explicitly) that banks cannot go bust. That gives shareholders (whose liability is already limited) an increased appetite for risk, and means they are unlikely to impose any restraints on bank activity. It also means banks can borrow far more cheaply than other corporations, and that its bondholders are unlikely to pay much attention to what is being done with their money. Finally, it means that depositors pay no attention to the stability of the institution they are entrusting with all their hard-earned cash. In short, government guarantees mean there is no market discipline to keep bank risk-taking in check.

Governments then inadvertently compound this problem by setting 'risk-weighted' capital and liquidity requirements. This is intended to offset the problem created by government guarantees by created minimum ‘safety standards’. In fact, these requirements tend to have two unintended, harmful effects. Firstly, they basically involve regulators setting a single cost for various risks. This drives market concentration – in order to comply with the regulations, everyone goes for the same investments at the same time, ensuring that the risks, should they materialize, are systemic. Secondly, these regulations create a strong incentive towards regulatory arbitrage – banks investing in order to ‘game’ the regulations. As well as perverting the allocation of capital, this creates opacity in the market, which also increases the potential for systemic risk.

In short, despite best intentions, government intervention first encourages banks to take more risk, and then ensures that those risks are likely to be both systemic and opaque. It is a recipe for disaster.

On that basis, I’d argue that banking reform should have two key aims. Firstly, it should ensure that banks can fail without triggering a wider financial and economic crisis. In doing this, the reform should make clear to market actors that banks will be allowed to fail if they get themselves into trouble. Secondly, reform should ensure that regulation does not distort capital allocation or drive market concentration.

The Commission’s proposals deserve a more in-depth assessment against these principles than a blog post will allow, but it does seem clear to me that the interim report released yesterday provides – at best – no more than a partial solution to the banking system’s problems.

Where are those bond vigilantes?

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The standard retort to those who say that governments cannot borrow more, forever, has been that if this were so in the short term, then we'd see the bond vigilantes. The interest rates demanded would rise, pushing bond prices down and raising the costs of government borrowing. You know, like has happened in Greece, Ireland, Spain and Portugal....

More accurately, we would see the effect of such bondsters: they would influence prices simply by not buying any bonds, meaning their actions would not be directly visible.

Which leads us to something that, while not an immediate sign of the coming apocalypse, should at least make people give pause for thought.

Based on still to be publicly reported data by Pimco's flagship Total Return Fund, the world's largest bond fund, in the month of January, has taken its bond holdings to zero (and -14% on a Duration Weighted Exposure basis). The offset, not surprisingly, is cash. After sporting $28.6 billion in "government related" securities, TRF dropped to $0.0, while its cash holdings surged from $11.9 billion to a whopping $54.5 billion (based on total TRF holdings of $236.9 billion as of February 28).

To unravel this for you. The world's largest private sector bond fund now has no holdings at all in the world's largest bond market, that for US Government debt.

Yes, this is only one bond vigilante but where Bill Gross and Pimco go others tend to follow.

And do note that whether people should not buy, or dump their holdings of, Treasuries based on sound analysis of the full faith and credit of the United States is entirely irrelevant. It matters only whether they will or not. If they do, then interest rates will rise, nipping in the bud a recovery and condemning future generations to paying even more interest on the national debt, soaring as it is as a result of the massive deficit.

It's not that I want to scare anyone or anything, but we do have one extremely large bond buyer now on strike and it won't take all that many to do so to make it obvious where those bond vigilantes are and what they're not doing.