The invisible hand was and is slapped by the not so visible hand of the Basel Committee.

Sir, Subitha Subramaniam’s writes: “the biggest distortion facing financial markets today comes from the repression of interest rates by the world’s central bankers. Under a laissez-faire approach, advanced economies with huge debt burdens that reduce long-term growth potential could be allowed to default as a self-correcting mechanism to restore growth.”, “The rise of the visible hand in economic policy” FTfm May 4.

That is indeed a source of distortion, and in a letter to FT in August 2006 “Long-term benefits of a hard landing”, I argued in favor of the self-correcting option. But the visible hand began acting and producing big distortions much earlier.

In 1988 the Basel Accord (Basel I) introduced risk-weighted equity requirements for banks. In 2004, with Basel II, these were, for example:

AAA to AA rated sovereigns 0 %; AAA to AA rated corporations 20 %; Unrated corporations 100 %; Below BB- rated corporations 150%

And for the Basel Committee’s basic 8 percent equity requirement, that translated into equity requirements that went from zero to 12 percent; which allowed for the leverage of bank equity, and of the support banks receive from the society, to range all the way from infinite down to 8 to 1; which of course allowed banks to earn much higher risk-adjusted returns on equity on what had a low equity requirement than on what had a high equity requirement.

This completely distorted the allocation of bank credit to the real economy; and this is what happens when you regulate banks without defining their purpose.

Understanding that source of distortion is essential in order to understand what has happened and what is happening. That was what dangerously overpopulated safe havens as AAA rated securities, sovereigns like Greece and real estate like in Spain. Currently one of the drivers of the ultralow interests on sovereign bonds is precisely that there the parking equity requirement tariffs are the lowest for the banks.

@PerKurowski