December 10, 2014

Martin Wolf, silly risk aversion is not part of our western values.

In a recent OECD paper titled “Trends in income inequality and its impact on economic growth”, authored by Federico Cingano, we read the following note:

(5) With perfect financial markets, all individuals would invest in the same (optimal) amount of capital, equalizing the marginal returns of investment to the interest rate. This occurs as complete markets allow poor individuals, whose initial wealth would not allow reaching the optimal amount of investment, to borrow from the rich (infra-marginal gains from trade). If, on the contrary, financial markets are not available, and the returns to individual investment projects are decreasing, under-investment by the poor implies that aggregate output would be lower, a loss which would in general increase in the degree of wealth heterogeneity (see e.g. Benabou, 1996; Aghion et al, 1999).

Substitute “risky” for the “poor” and you should be able to understand that current credit-risk-weighted-capital (equity) requirements for banks creates an under-bank-lending to those perceived as risky that leads to a lower aggregate output, most specially that of the future, which is dependent on the risky risk-takers having fair access to bank credit.

Martin Wolf, in “Europe’s lonely and reluctant hegemon” December 10, with relation to Germany's responsibilities towards Europe tells it that “The time of thinking small is past” and that it needs to “take an assertive position in defending western values”.

Sir, I content that little is so “thinking small” than thinking that by allowing banks to hold much less capital against assets perceived as safe; and therefore allowing banks to earn much higher risk-adjusted returns on equity on these assets when compared to what they earn lending to the risky; can somehow make banks more stable, like if these lived in a vacuum isolated from the real economy, will.

And Sir, I vehemently hold that such silly risk aversion is not part of our western values, much the contrary. “God make us daring!”

And so what the Western world (including Germany) first needs to urgently realize, is that those bank regulations dooms it to stall and fall, no matter how much QE-ing, fiscal-deficiting or infrastructure constructing it does... following Martin Wolf’s instructions.