ECONOMIC PERSPECTIVES 20 – August 2017

 

BUFFERS FOR DUFFERS!

Mark Carney, Governor of the Bank of England, tells us that “this time it’s different” because the capital “buffers” (amounts that lending banks must retain in their free reserves) now imposed by central banks will prevent a banking crisis similar to the sub-prime implosion that occurred exactly 10 years ago this month.

In the same breath, however, he warns that spiralling consumer credit represents a growing and serious threat to the financial system’s stability.

I ask you: what on earth did he expect? The cerebral disconnect is breathtaking – for all these years consumers have been lured by dirt-cheap credit to join the crowd in acquiring new vehicles, installing new kitchens, re-modelling their living spaces, you name it – incurring debts that will greatly exceed their ability to repay them as soon as the rate of interest rises, as it must, by even a tiny margin.

Now whose idea was this? The “follow-my-leader” automatons that call themselves central bankers (Yellen, Draghi, Carney, Kuroda et al) no doubt considered the matter deeply and concluded that, this time round, the tired old demand-management formula would somehow do the trick of stimulating their economies and getting production out of its sluggish rut.

 

Mania for cheap borrowing is endemic

 

Actually, it is far worse than that. It’s not just the customers that have been duped: the retailers, and even their suppliers, are similarly trapped in the tendrils of the same credit maze. Gleaming forecourts packed with the latest models; multiple appliance and furniture stores; kitchen and bathroom centres – just take a walk in Burlington Arcade in London’s West End and eye the wristwatches with price tags of £40,000 plus! – all that stylish stock didn’t get there by magic. It’s all part of the very same debt extravaganza, induced by the mania for cheap borrowing right through the trading chain.

Left to markets, an interest rate negotiated by parties to a transaction is simply a function of respective time-preferences for liquidity. As a behavioural phenomenon arising from the human action of ordinary trading, it is unnecessary, and seriously harmful, for a central bank to impose a theoretical rock-bottom interest rate, effectively destroying any incentive to save. Result? Capital destruction. No capital, no production. Yet it would be difficult to invent policies less conducive to capital accumulation.

The bubble created by the Treasury and central bank policies cannot be sustained indefinitely. Like any contrived panacea it has a payback time: it must unwind, and the pain will be all the greater for having left it far too late already. In essence, the debt crisis at the core of every central banker’s current warnings has arisen precisely because the folly of 10 years ago was never properly grasped, still less addressed – beyond allowing Lehman to serve as whipping boy for all the others.

 

Refusing to face the music

 

Ten years ago, rather than managing an orderly unwinding, and confessing to the full measure of their ill-conceived policies, the heroic league of central bankers preferred to save face and delay the wrath: they closed ranks and invented “quantitative easing” – their wimpish euphemism for printing money, coupled with near-zero interest rates.

The widening disequilibrium between rising price levels and stagnant wages, itself a by-product of that same bubble, is a growing threat to our social fabric – and this time the gathering forces of destruction give unintended new meaning to Mr Trump’s phrase “fire and fury”!

The policies pursued since the last crisis carry inescapable consequences. The central banks’ relentless destruction of incentives to save has succeeded in bribing consumers to incur higher and higher levels of cheap debt by exploiting “bargains” in stores, and “maxing out” on their credit card limits. After all, if saving money gives you no return, and debt is dirt cheap, why not spend?

 

The core problem: banking delinquency

 

The raised capital buffers in which Mark Carney now reposes so much faith were imposed by central banks to protect the economy in the event of a future financial crisis – a crisis induced, of course, by the irresponsible practices of banks themselves. Carney’s comment was effectively an admission that the welter of regulations imposed in response to the last crisis amount to little more than the hoarding by banks of still more cash as a safeguard – without having tackled the real problem: the irresponsible conduct itself.

The act of forcing banks to raise the level of their capital levels has merely frozen cash that would otherwise have been available for lending based on sound and realistic risk evaluation. Regulations such as the Frank-Dodd law were knee-jerk reactions to the irresponsible lending practices of the banks.

 

Useless risk rating by corrupted agencies

 

It is a veritable sign of the times that risk evaluation, the very essence of the banker’s art, has been given over to rating agencies whose performance has been dangerously corrupted by their terms of business and, unsurprisingly, has been little short of pathetic.

Here’s a brief reminder of what happened last time banks lent money to people who have no hope of being able repay those loans. The banks resorted to that well-worn device of rogues – statistics.

Recognising that not all the debtors would default on their mortgage repayments, they invented the device of “averaging” the default risk. They shuffled them all together and bundled them up into “packages”, and called them “collateralised debt obligations” (CDOs). [You really must hand it to them for inventive lexicography. After all, “dicey dross” is somewhat less impressive - even if more accurate!]

The ratings agencies lapped it up, and awarded AAA status to even those securities known “NINJA” mortgages, given that in most cases the borrowers had “No Income, No Job or Assets”. But the ratings lacked even remote credibility: whenever a pack of NINJA instruments were traded the agencies were paid only if the deal went through. If a low rating scuppered the deal, the agency received nothing. [See if you can invent a system more susceptible to criminal abuse!]

 

Wishful thinking underlying the policies

 

Let’s end by coming back to root causes. The wishful thinking underlying these universally applied policies is that this time, somehow, the formula of stimulating demand will work its magic! After all, it is the essence of the Keynesian message.

Amazingly, its purveyors persist in responding to failure by applying more of the same. If your doctor told you that the pain of banging your head against a brick wall would be alleviated by banging it even harder, you might question his credentials – yet serious economists and central bankers, bemused by the failure of near-zero rates, are now advocating the balm of “negative” interest rates!

Why has this philosophy never worked? And why can it never work?

The answer is that stoking demand merely induces frustration if it does not lead to gratification; and production is the essential precursor to gratification.

All the demand in the world cannot actually produce anything. Say’s law declares a golden rule: we produce in order to consume. We do not consume in order to produce. Sounds basic, even obvious. But few economists (and even fewer central bankers) have thought through the full implications of this magnificent truth!

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[August 2017]