March 08, 2014

And what if the captain of the Titanic had unwittingly directly set the course on an iceberg?

Sir, I refer to Tim Harford’s “Let’s have some real-times economics” March 8.

Let’s suppose we have parents who like cookies and chocolate and dislike broccoli and spinach so much they want to make certain their kids eat cookies and chocolate and stay away from broccoli and spinach.

And so, ignoring that kids already share their taste preferences, they reward their children with chocolate if they eat cookies and punish them with spinach if they eat broccoli.

And of course the result is their children grow into a generation much more obese than their parents who, in their younger days have been told to eat broccolis and spinach too.

The above describes the risk-weighted capital requirements that, one way or another, especially since 2004 when Basel II was approved, have distorted the allocation of bank credit to the real economy.

Banks are told that if they lend to the “safe”, something which they already liked, they need to hold less capital and will therefore be rewarded with higher risk-adjusted returns on their equity than if they lend to the “risky”. 

And, as a result, the “infallible sovereigns”, the housing sector and the AAAristocracy receive too much bank credit in too lenient terms; while the “risky” medium and small businesses, entrepreneurs and start-ups receive too little credit in too onerous terms. And as a result the banks grow dangerously obese with “safe” fats and carbohydrates, all while the real economy becomes weakened from the lack of “risky” proteins.

And so, if Harford can express the “frustration of watching… Titanic… The ship is doomed, yet our heroes suspect nothing ”, when reading the recently published transcripts of the Federal Reserve’s Open Market Committee held on September 16 2008, to me it is worse. 

I see no evidence of that, at least with respect to bank regulations, "our heroes" show they knew they were setting the course on an iceberg. Worse yet, they might still not know it, and so our banks and our economies are set on the course of crashing into new icebergs.