Bank Debt, Sovereign Debt and the Dogs That Did Not Bark

Maurice Allais, one of only two French Nobel prize winners in economics, is a champion mathematician but has rather less time for plain horse sense. He considers, for example, that banks should be obliged to match the maturities of their assets to their liabilities. If they make a one-year loan, they must set it off by a deposit fixed for one year. Thus banks will always be safe havens.

The truth of the matter, of course, is that a bank is a bank if it borrows short and lend long. If this were prohibited in the sacred name of security, the clever innovations of Italian Renaissance goldsmiths and 17th century English wool merchants would have been for nothing. To be able to borrow short a lot and do so at little cost, they must be above all suspicion like Caesar’s wife. Ordinary profit-maximisation (“greed”, as we are now asked to call it) would induce them to look prudent and opulent and selective in the risks they take. (Compulsory deposit insurance is the first link in a chain of regulatory measures that reduce the need to look prudent and selective.) Despite the confidence a bank may manage to inspire at some cost to itself, it still needs some ready reserve in hand to meet large cash withdrawals. The reserve may be minute, because if one bank is running short of money, others must be running long by roughly the same amount and the first bank can borrow it back on the interbank market. This remains true, and liquidity is not a problem of availability and willing help by the lender of last resort, but only of cost as long as unreasoning general panic does not overcome all confidence. Depositors nowadays do not take home billions in plastic grocery bags.

General panic hits solvency rather than liquidity, (though the two shade in to one another and cannot really be separated). When professional pundits are influential and the media are loud and both live by chilling our blood, general panics may become more frequent. Such a panic was set off in August 2007 by inordinately blowing up the dangers to the world financial system inherent in a mere $400 to $600 billion of securities backed by U.S. subprime mortgages. On these mortgages, the lending banks might have recognised some losses depending on the likely recovery value of the ones that failed. Transformed into marketable securities, they might have fallen under the FASB regulations, “marked to market,” and as the market was both inexperienced and spooked, the carnage among banks holding, or even suspected of holding, CDOs (Collateralized Debt Obligations) was gory—as we remember.1 Paper losses were estimated in astronomical numbers and denials were disbelieved; prophecies of doom were, in the nature of the case, self-fulfilling. Banks were said to be casinos, bankers bashed as greedy thieves. Many were in fact a bit foolish and dim, relying on the rating agencies2 and the regulations that would protect them from anything really bad. Many or most were solvent in reality while the accounting rules and the house-of-cards character of artificial safeguards struck them down as insolvent.

This inglorious tale began with a moderate house price bubble blown up by cheap money, continued with government encouragement of mortgage lending to credit-unworthy debtors, and finished by governments saving the banking system from insolvency with cash injections that totaled vastly more than the likely loss of value of the part of the housing stock that was “in hock” to the banking system. All this was volubly explained as the result of insufficient regulation of an inherently unstable free market system. Blaming the result on excessive regulation and interference sounds no less likely and no more capable of proof.

The received wisdom now is that the banks did not have enough capital. The new Basel 3 regulations will oblige them progressively to raise their solvency ratio from an average of 4 per cent of total liabilities to 7 per cent.3 If their own capital remained unchanged, they would have to cut their lending and other asset holdings practically by half to get from 4 to 7 per cent of own capital—an absurd result. Instead, they will have to raise new capital by siphoning it away from the non-bank sector of the economy—a result that governments must dread only a little less than a savage reduction of bank credit to the economy. The irony is that if another “bubble” rose up and then burst, banks with 7 per cent of their own capital could become technically insolvent almost as easily as with 4 per cent, and would in any event find themselves in breach of regulations as their solvency ratio started to shrink from 7 per cent towards zero.

One way out of these dilemmas could be to forget about Basel 3 and the rest of the rigmarole of controls and leave it to the banks’ discretion to adapt their posture to the conditions of survival dictated by the market. There would be casualties, but the net outcome might be much better.

After the banks, the forthcoming chapter is on sovereign debt. The yield on German ten-year government bonds is now 2.2%, on French ones about 2.6% and on U.S. treasuries about the same, all absurdly low even if the world were heading toward the mother of all depressions. In the 1930-34 Great Depression, the ten-year rate moved in a range between 3% and 4.5%. Currently, Irish and Portuguese government bonds yield nearly 6% and so do investment quality European corporate bonds. European common stocks sell at 12 times current earnings, which translates into an earnings yield of 8.5. These yields, taken together, tell a strange story. Something looks very wrong. Government debt is unlike bank debt and indeed any other private debt in that the debtor is sovereign and cannot be hauled into any bankruptcy court. It is backed by no assets except the government’s ability, often severely limited, to tax its subjects. It can always service the debt it owes in its own currency by printing more money, but foreign currency debt owing to non-residents is more problematical, particularly if its balance of payments is also uncomfortable. Much the same is true of euro debt owed by eurozone countries that have no way of printing more of it for their own use. If the debtor government services such debt, it is because it wishes to. The consequences of defaulting on the debt are unpleasant and boil down mainly to trade finance and future government borrowing becoming difficult and extremely expensive. Russia in 1998 and Argentina in 2001 nevertheless defaulted and in later years made mostly good on their obligations without lasting damage to themselves.

Greece in 2009 might well have defaulted, abandoning the euro and adopting the old drachma again at a deeply depreciated rate. There were some fairly good reasons for taking this course. It was pre-empted by the richer European countries in the last minute bailing out Greece with loans costing only a charitable 5.5% and no doubt destined to be rolled over in some fashion as they fall due. The ostensible reason for bailing out Greece was to forestall domino effects, with Portugal, Ireland, Spain and (rather unlikely) even Italy defaulting, abandoning the euro and engaging in competitive devaluations. The real reason probably was and remains officialdom’s fear of the unknown, of what might happen if market forces are “let loose”.

Like the banking “crisis”, the sovereign debt “crisis” can be ascribed to many complicated reasons that still leave certain aspects unanswered. One of these is the question: how come that things have gone this far, that no countervailing forces were set off to slow them down and at least mitigate the “crisis”, and that things reached crisis level before anybody noticed how bad they were?

A story will furnish, not the full answer, but an inkling of it. A man had a dog. The dog, having the job of guarding the house in his genes, broke into furious barking each time someone passed outside along the fence. The excited barking drove the master mad, he was losing his sleep and the neighbours were also complaining. He undertook to teach the dog better manners, punishing him if he barked before some stranger actually started to fiddle with the front door. The training worked well enough and the master was never disturbed by barking before the break-in was definitely in progress.

The dog had been treated and trained as European, particularly German culture and official practice treat the speculator. Selling “short”, i.e. without prior ownership, is severely frowned upon and for government and certain financial securities periodically prohibited. Using derivatives except for bona fide insurance is regarded as devilry itself. In fact, any purchase and any sale in anticipation of an up or down price movement is loudly condemned as immoral and threatened with sanctions ranging from punitive taxation to ostracism by peers and denunciation by the press. Mr. Volcker is telling the banks that they must choose between banking and speculating.

There is little excuse for failing to understand that since the speculator must sell high and buy low, if he is successful he must willy-nilly attenuate price movements that would take place if he were not speculating. In other words, if he survives, he must have an albeit involuntary stabilising effect. Moreover, as he adopts the “long” or “short” position that will in due course yield him a profit when it is undone, he acts as an early warning siren that, like the barking of the dog, signals that something may be amiss and needs attention. It is a pity that like the dog that is bred to bark but punished when he does, the speculator is so unanimously condemned for doing what the market calls upon him to do. But then we do not trust markets do we?