Central banks and regulators cancelled the creative part of destruction.

I refer to Martin Wolf’s comments on Philippe Aghion, Céline Antonin and Simon Bunel’s “The Power of Creative Destruction”, “The innovation game” FT June 11, 2021 

John Kenneth Galbraith in “Money: Whence it came where it went” of 1975 wrote: “For the new parts of the country [USA’s West]…there was the right to create banks at will and therewith the notes and deposits that resulted from their loans…[if] the bank failed…someone was left holding the worthless notes… but some borrowers from this bank were now in business...[jobs created]” That’s creative destruction in action.

The current risk weighted bank capital requirements allow banks to earn much higher risk adjusted returns on equity when financing what’s perceived (or decreed) as safe e.g., loans to the government and residential mortgages, than when lending to the “risky” small businesses and entrepreneurs. That’s creative destruction inaction. 

Would the development Galbraith describes have been possible with these regulations? No! Such risk-averse regulations do not help promote innovations.

Sir, in august 2006, in reference to an FT editorial mentioning the possibilities and impact of a “global housing slowdown”, you published a letter I wrote in which I referred to “The long-term benefits of a hard landing.” When the global financial crisis erupted in 2008, there was too much interest in trying to avoid collecting any of these benefits, and the crisis-can was kicked forward... and then much upward with QEs. 

The result? Way too little creative destruction and way too many surviving zombies… and here we are, on a much higher mountain of public and private debt. That will cause pure destruction.

“Risk weighted bank capital requirements”. Sir, if that’s not sophisticated technocratic demagoguery, what is?

Regulators impede many who represent the driving force of capitalism from competing for bank credit in fair terms

Sir I refer to John Thornhill’s interesting discussion of organizations’ internal obstacles to competition and innovation “The path to enlightenment and profit starts inside the office” February 2.

Thornhill states “As the driving force of capitalism, competition gives companies a purpose, a mission and a sense of direction” but unfortunately “The incentive structures of many companies are to minimise risk rather than maximise opportunity. “Innovation is often a young company’s game.”

But let me pick up on that to remind you, for the umpteenth time, of the nasty consequences of current credit-risk-weighted capital requirements for banks. These allow banks to leverage more with exposures to the safe than on exposures to the risky; and so banks are therefore able to earn higher expected risk adjusted returns on equity when lending to the safe than when lending to the risky. And so the current regulatory incentives given to banks are set in order to minimize their exposure to any “risky” assets, rather than to maximize the opportunities that could easier result were banks free to allocate their credit to the real economy without distortions.

Thornhill mentions: “Innovation is often a young company’s game.” Yes and it is precisely “young companies” that usually are perceived as “risky” and are therefore now blocked from competing for access to bank credit in fair terms.

PS. Thornhill also refers to Herman Hesse’s “Knowledge can be communicated. Wisdom cannot.” In 2003, as an Executive Director of the World Bank, and in relation to the financial sector I wrote the following in a formal statement delivered at the Board:

“As the financial sector grows ever more sophisticated, making it less and less transparent and more difficult to understand for ordinary human beings, like EDs, it is of extreme importance that the World Bank remains prudently skeptical and vigilant, and not be carried away by the glamour of sophistication. In this particular sense, we truly believe that the World Bank has a role to play that is much more important than providing knowledge per-se and that is the role of looking on how to supply the wisdom-of-last-resort.”

Unfortunately, even though the World Bank is the world’s premier development bank, it has not yet explained to the world that risk-taking is the oxygen of any development.

@PerKurowski ©

And the winner of the denovation prize is… The Basel Committee for its risk weighted capital requirements for banks!

Sir, I refer to Tim Harford’s discussion of the role of prizes in fostering innovations “Eyes on the innovation prize” November 28.

Personally I have often argued for establishing a prize for promoting innovative ideas about how to regulate banks, without interfering with their purpose of allocating credit efficiently to the real economy.

As is, current bank regulations that so much favor what is safe from a credit risk point of view, usually what already exists, over that which is risky, usually that of which the future is built of, is as a powerful blockage of innovations that one could think of.

In this respect, bank regulators would no doubt be declared winners of any denovation prize, if it existed. They would in fact be the unchallenged denovation champs ever since Basel II of 2004, most probably, no certainly, already since Basel I of 1988.

@PerKurowski ©

The credit-risk weighted capital requirements for banks should never even have been on the table as an alternative.

Sir, Dominic Rossi writes “Negative real interest rates on bank deposits cannot be the road to prosperity, yet the promise of low nominal returns on traded securities looks risky… It is only by investing in innovation that we can escape this otherwise humdrum nominal world”, “Don’t look for escape routes when the third deflationary wave hits” September 3.

And I just ask: Are current credit-risk weighted capital requirements for banks helpful or not when it comes to allowing fair access to bank credit to finance innovations? Or is it only borrowers with high credit ratings who should be allowed to innovate?

The global deflationary wave that is hitting our economies is very much caused by the retrenchment of bank credit to whatever is perceived as risky, caused by the risk weighted capital requirements being applied to scarcer bank equity.

It is amazing to read how many claiming for less government austerity are simultaneously ignoring or even claiming for more bank credit austerity. 

If we want to get out of this we must realize that since risk taking is the oxygen of any development, we must get rid of that loony risk aversion of regulators that hides behind the risk-weights. God make us daring!

@PerKurowski

Edmund Phelps, Europe has not run out of ideas, it has run out of the will of trying these out… "it’s too damn risky”

Sir, I refer to Edmund Phelps, the 2006 Nobel laureate in Economics’, the director of the Center on Capitalism and Society at Columbia University’s “Europe is a continent that has run out of ideas” March 3. He argues Europe “needs to fight for an economic life worth living”. Indeed but perhaps it is not because a lack of ideas.

In Europe bank credit is one of the main sources for implementing ideas, and any continent which allows its banks to leverage more on what is “safe” than on what is perceived as “risky”, which means allowing its banks to obtain higher risk adjusted returns on equity on safe than on risky assets, is simply a continent that does not want ideas to be tried out, as new ideas quite often signify more risks.

Professor Phelps, in Europe, banks are refinancing the past and not financing the future.

Professor Phelps, I am sorry but I must inform you of the sad fact that the banks of the Western world have been castrated.

When regulators exorcised primal risk-taking from the banks, they doomed our economies to decadence.

Sir, Edmund Phelps writes that “Nations with once-dynamic economies will be helpless to recover their prosperity as long as they misunderstand what causes economic progress”, "Free innovators from the state’s deadening hand”, January 31.

Indeed before it is realized that primal risk-taking is what leads to innovations and start-ups, and which is what keeps the economy sturdy muscular. Any economic growth based on risk-aversion leads only to economic obesity. Unfortunately, bank regulators, with their loony capital requirements based on ex ante perceived expected losses exorcised such risk taking from the banks.

And Edmund Phelps also correctly states “The state is no better suited to take a big role in the technical innovation than in artistic creation”. But Phelps might not be aware of how bank regulations are stacked in favor of the state assuming such role. Currently when a bank gives a loan to a “risky” innovator, let’s for example call it a Solyndra; it is required to have much much more capital than when lending it to the “infallible sovereign”, and so that instead a bureaucrat can relend that money to an innovator, like a Solyndra.

Private innovation needs government help, but it also needs not to be blocked by regulators

Sir, of course nations need to be bold, and take risks, in order to have a better future. That is, or at least was, why we used to go to our churches and pray “God make us daring!”

And so of course most of us would wholeheartedly support Marianna Mazzucato’s call for more government financed basic research; especially if this resulted from redirecting to it other governmental waste; and this even though we suspect the argument will, as usual, be exploited by those who 

just want to increase taxes, “Why private innovation needs government help”, August 22.

But, that said, the fact is that currently, if a bank lends directly to a innovation project, like the failed solar power company Solyndra in the US, then it is required to hold about 8 percent in capital, but, if it instead lends that money to the government, so that a bureaucrat can relend it to a Solyndra, then it has to hold no risk-weighted capital... which skews all too much in favor of the government.

I do understand the importance of Mazzucato´s call, but, frankly, to me, it is of secondary importance when considered in relation to the fact that bank regulators, with their risk-weighted capital requirements, are effectively castrating our banks, making them sing in fAAAlsetto.

State and private entrepreneurs are neither alike nor equal

Sir, I refer to Martin Wolf’s comments on Mariana Mazzucato’s “Debunking Public vs Private Sector Myths”, “The State is the real engine of innovation”, August 5.

In these Wolf writes “the state is also an active entrepreneur taking risks and of course accepting the inevitable failures”. This entirely fails to recognize that state and private entrepreneurs are neither alike nor equal.

Currently, under Basel II bank regulations, if a bank lends to a private entrepreneur, it needs to hold 8 percent in capital/equity, but, if it lends to the state entrepreneur, then it does not have to hold any capital/equity... zero!

Also if the private entrepreneur is unsuccessful in his undertaking he will suffer the consequences, while if the state-bureaucrat-entrepreneur wastes away taxes, he will most likely not suffer at all.

I do not understand how one can ignore those differences, and conclude that “the entity that takes the boldest risks and achieves the biggest breakthroughs is not the private sector; it is the much-maligned state”, and especially so when extremely little of public spending really goes to take bold risk to achieve breakthroughs.

To describe the financing of innovation as “a parasitic [system] in which the most loss-making elements are socialized, while the profitmaking ones are largely privatized”, is to completely confuse the losses incurred when lending to safe-non-entrepreneurial activities, such as financing real estate and sovereigns, with losses derived from investments in innovation. In fact, the socialized losses in innovation financing that most comes to mind, are those which originate in loans given to entrepreneurs by the state, like that to Solyndra.

We do of course not object to the state lending a much needed helping hand in basic research but, if it goes overboard doing so, that will only guarantee this will be abused by those entrepreneurs who specialize in the extraction of rents from the state.

Wolf concludes “The failure to recognize the role of the government in driving innovation may well be the greatest threat to rising prosperity”. Wrong! The greatest current threat is the silly risk-aversion imposed on banks by regulators who fail to understand what brought our economies to where they are. 

God make us daring! 

Discrimination against “The Risky”, in America, “the Home of the Brave”, is pure tragedy.

Gillian Tett quotes Peter Thiel concerns about that American innovation is slowing, sapped by the financial boom and a risk-averse culture. “There might be a great deal to gain in sharing the pain” November 24. To that Kenneth Rogoff had retorted that it was the implosion of the debt bubble – not lack of innovation that hurt American growth. 

Ms Tett finds Mr. Thiel’s comment fascinating in how it reflects America as “a country founded with an optimism that anything could be done, and had little sense of resource constraint” 

Yes, that might have been true but currently the US, like Europe, have introduced severe constraints on one of the most important elements of innovation and development, namely that of risk-taking. 

The debt bomb-that imploded has absolutely nothing to do with credits given to entrepreneurs or other risk-taking innovation ventures, but exclusively with credits given to what was officially considered to be absolutely safe. 

It was the direct result of extremely confused and risk-averse bank regulators who by allowing the banks to leverage their equity many times more for exposures considered as part of “The Infallibles” effectively locked out “The Risky” from access to bank credit, as these could not provide the banks with similar returns on equity. 

The Risky” are already sufficiently discriminated against by Mark Twain’s banker, he who lends you the umbrella when the sun is out and wants it back, fast, when it looks like it is going to rain. That the regulators has layered on additional discrimination against “The Risky” in a land that prides itself being called “the land of the brave”, is pure tragedy. 

A nation that worries more about history, what it has got, “The Infallible”, the old, than about the future, what it can get, “The Risky”, the young, is a nation that is stalling and falling.

If you insist on killing it, even limited growth will be over.

Sir, I refer to Martin Wolf´s “Is the age of unlimited growth over?" October 3. It includes a recount of an interesting paper written by Robert Gordon on the slowing rate of innovations, and that should naturally also lead into the theme of how we account for growth. That when women work that is growth but when they stay home not, is only one of the many questions. 

That said, I just know that whenever a society instructs one of their primary resource allocations agents, the banks, to forget the “risky” and go exclusively for the not-risky, with an “if you do so we will allow you to hold much capital and you will be able to leverage much more and thereby obtain a higher return on your equity”, then even the age of limited growth can come to its end. 

And of course, if growth is over, there are going to be more pressures for the Martin Wolf´s of this world, those in the 1 percent of the job markets, to quit their jobs earlier, so as to allow younger generations a chance for a job, albeit for a shorter and shorter period… that is of course unless he suggests they should haul water for fun, and he wants to pay for it.

And the truths are the needed seeds for its reconstruction

Sir Martin Wolf gets to set the tone in the series on “The future of capitalism” and titles his opening article “Seeds of its own destruction” March 9. I object that for reasons I cannot explain he leaves out what some of us consider the fundamental causes for this crisis.

Wolf writes about “frenetic financial innovations”, “innovative financial systems” and of “how little banks understood of the risks they were supposed to manage” without even mentioning the fact that the Basel Committee ,with their minimum capital requirements for the banks, innovated to such an extent that banks were duly authorized to leverage their capital for instance in the case of corporations rated AAA and AA- to a never before heard astonishing level of 62 to 1; and that it was these capital requirements that gave way to the mother of all the regulatory arbitrage booms.

Also when Wolf writes on how “huge capital flows…largely ended up in a small number of high-income countries and particularly in the US” among other he suggests the US government programs but finds no place at all for the credit rating agencies. Wolf does simply not want to accept that the big explosion in the growth of the subprime mortgage market had very little to do with a FHA or a Fannie Mae and all to do with the excessively empowered credit rating agencies stamping their AAA sign on securities fabricated on Wall Street. Wolf simply refuses to ask himself why for instance Europe financed more subprime mortgages in the US than the US itself.

The current crisis is a remarkable fertile ground for all type of other-agenda-pushing and I have already heard arguments attributing it to Israel/Palestine, genetically modified seeds, increased narcotic production in Afghanistan, the military control of the political apparatus of the world and other similar mindless arguments. The only way we can avoid this crisis from degenerating into something even worse is to defend the truth and the whole truth about it.

And which is the ‘real’ market of the Financial Times?

Sir I am sorry to say that as an end of this particular 2008 year editorial “The return of the ‘real’ economy” December 31 is, simply put, bad. You base it on “It is mistaken in seeing finance as unproductive. . . Nor is financial innovation mistaken in principle” and frankly I do not know anyone of importance who would contradict you on this.

That said many areas of finance might in fact be truly unproductive, for instance I harbour serious doubts on the validity of much of the financing of consumption; and much of the financial innovation, although perhaps valid in principle and theory, has resulted in disasters that makes it obvious that we need to reign our tendency to give any innovation the full benefit of doubt.

The Financial Times does a lot better defending the financial sector when it points to the real connections between the financial and the other sectors of the economy but, if that results in a shrinkage of the financial sector so be it, that in itself does not mean it is bad.

Finally your humble acknowledgement that “finance is riddled as it is always has been, with gamblers using other peoples money, chancers taking risks but calling it genius, and worthy people following the crowd into collective insanity” but completely leaving out the regulators who with their excessive empowerment of the credit rating agencies laid all the foundation for this crisis has nothing to do with “Without fear and without favour”. Perhaps the Financial Times needs to reflect a bit more on its own real market.

The system was not overwhelmed by innovation it was overwhelmed by negligence

Sir I bet that Clive Crook does not know of anyone who knows of anyone who knows of anyone that has lost a single dollar giving a subprime mortgage on too generous or outright stupid terms to anyone who classifies as belonging to a subprime sector.

But I do bet that Clive Crook knows of many persons or institutions that have lost fortunes investing in securities collateralized with mortgages just because these securities were rated AAA by one, two or even three of the three credit rating agencies that everyone, including the financial regulators uses.

In this respect unless Clive Crook classifies a mortgage given on stupid terms as an innovation he is absolutely wrong about “A system overwhelmed by innovation”, October 13. The system was overwhelmed by the sheer negligence of those sentries that the regulators appointed and empowered, the credit rating agencies, and the negligence of the regulators and the market participants who thereafter went to sleep in the belief they no were safe.