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.

@PerKurowski

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.

@PerKurowski