December 29, 2017

Favoring government borrowings with quantitative easing and statist capital requirements for banks, dooms the sovereign to default.

Sir, Michael Hasenstab writes about how as a result of the US Federal Reserve’s “$3.6tn Federal reserve money-printing exercise [that] has financed approximately 20 per cent of the government’s net borrowing per year since 2008…and cutting interest rates to record lows” has distorted “the price of money, along with key metrics for valuing both financial and real investments” “Fed risks a sizeable hangover as it begins ‘the great unwind’” December 29.

Correct, but to really understand the magnitude of the distortions, we also must include those produced by the risk weighted capital requirements for banks... like the 0% risk weighting of sovereigns.

Allowing banks to hold different levels of capital against different assets means the risk-adjusted returns on bank equity are not solely cleared by markets but also by regulations. If one now decides that was a truly bad idea that dangerously distorts the allocation of credit to the real economy…how do you work yourself out of this hole?

For a starter, let us suppose you shoot for banks having to maintain 10% in capital against all assets, including sovereign then: how much additional capital need banks to have, or how much sovereign assets need banks to shed from their balance sheets? Either figure is bound to be mindboggling.

To be able to do so without freezing up the whole bank credit machinery, would perhaps require settling an important part of all bank credits, with some unredeemable negotiable bank shares.

Upsetting? No doubt, but the real costs of keeping going down that pro sovereign distorted route is domed to be filled with sovereign defaults.

Hasenstab begins with “In response to the global financial crisis, the US Federal Reserve took extreme but necessary measures to protect the American economy from collapse.” That is the conventional truth, I am not sure it is the whole truth and nothing but the truth. Sir, in August 2006 you published a letter I wrote titled “Long-term benefits of a hard landing” It would have hurt, not doubt, but I sincerely believe we would all have been breathing easier now had not the Fed protected the American and the world economy so much… and of course regulators having corrected what brought us that crisis to begin with… namely the so credit allocation distorting risk weighted capital requirements for banks.