January 08, 2018

The worst problem with the dangerously growing debt is what it has not financed

Sir, Pascal Blanque and Amin Rajan write: “for central banks, global debt is like the sword of Damocles — an ever-present danger. It stands at about 330 per cent of annual economic output, up from 225 per cent in 2008… No one knows all the cracks into which excess liquidity has seeped — or what risks are being stored up”, “Beware the butterfly: global economies are on borrowed time” January 7.

Sir, if central bankers are only now waking up to this fact, then you must agree with that we are in much bigger problems that we thought.

Central bankers, lacking in character and not wanting to live up to their own responsibilities, dared not do anything but to push the 2007/08 crisis cart down the road, with their QEs and low interest rates. For someone who argued back in 2006 the benefits of a hard landing, that is bad enough.

But it’s so much worse than that. Blanque and Rajan argue that “Debt means consumption brought forward while low rates mean the survival of zombie borrowers and companies… High debt is not intrinsically bad so long as it is used to fund investments that deliver profits or create financial assets worth more than the debt. Data on this score are hard to come by.”

And there lies the fundamental problem. Because of risk weighted capital requirements for banks, bank credit has been used to finance “safer” present consumption; to inflate values of mostly existing assets; and way too little to finance “riskier” future production. It amounts to having placed a reverse mortgage on our past and present economy, in order to extract all of its value now, not caring one iota about tomorrow, and much less about that holy social intergenerational contract Edmund Burke spoke about.

It is clear the experts Blanque and Rajan have yet not understood what happened as they write: “The origins of the current worries predate the 2008 crisis which was caused when lending standards went from responsible to reckless: the siphoning of money into dodgy ventures such as subprime mortgages, covenant-light loans or sovereign lending based on creative accounting.”

The truth is that without truly reckless regulatory standards, those which allowed banks to leverage over 62.5 time to 1 with securities rated by human fallible rating agencies AAA; and, at least in Europe, allowing banks to lend to a 0% risk weighted sovereign like Greece against no capital at all, nothing of the above would have happened.

What to do? In my mind, in order to extricate the world of this problem, we need first to rid us completely of the credit distorting risk weighted capital requirements; and second, to be able to manage the transition to for instance a 10% capital requirements against all assets, including sovereigns, without freezing the whole credit machinery, perhaps bank creditors would have to accept, in partial payment of their credits, negotiable non redeemable common fully voting shares issued by the banks. If that helps to bring back undistorted bank vitality, it might be the best shares to have ever.

PS. Blanque and Rajan reference “S&P 500 corporates… stashing cash reserves outside the US.” What cash? Treasurers have not stacked away cash under corporate mattresses. Those surpluses are all already invested in assets, of all sorts, and which could suffer losses just like any other assets.