Instability: Macro, Banking and Agency:

Thirty years of prosperity, falling interest rates, rising stocks and bonds, moderate inflation and widening inequality of wealth within nations had led to an unstable position. While inequality has receded between countries, it had increased within countries regardless of their economic model or system of politics.

The financial industry was not alone in seeing greater inequality of remuneration and reward but it was the extreme example that stood out when matters came to a head in 2008. The financial crisis was not the simple product of these imbalances which included imbalances within economies and between them. The current account imbalance between East and West, the export dependency of China and other Asian economies, the consumption dependency of he Western economies were contributors to the instability in the system, but no single factor precipitated the crisis. Neither was 2008 such a milestone in the dynamics of this theme in history. It was certainly no terminal point, more of an important node. What it did do was to expose the failure of principal agent relationships by focusing public attention on their particular manifestation in the financial industry.

Leverage in the banking system had increased steadily over multiple decades. There are a number of reasons for this including greater diversification of business within banks, a great moderation of volatility resulting in higher model prescribed optimal leverage, a non-trivial dose of complacency, and diminishing marginal returns to scale. The Basel framework for prescribing appropriate levels of capital to be held in order to absorb the riskiness of assets was a reaction to reign in excessive leverage. Central banks recognized that in the event of a sufficiently large bank failure they would have little choice but to bail out the errant bank in order to secure the system as a whole. This was a reality not lost on the banks.

The intellectual capacity dedicated to the financial industry is considerable. Banks, insurance companies and hedge funds hire mathematicians, physicists and engineers among a wide array of scientists to help them make money. They also hire legal and regulatory minds of the highest calibre to help them to engage with regulators. No wonder then that regulators efforts to control the behavior of financial institutions have been confounded at every turn.

An example of this was the growth of the so-called Shadow Banking industry, a system of financial institutions which operate largely beyond he control of regulators by eschewing deposit taking and other retail investor interface. In the years leading to the 2008 crisis banks created massive off balance sheet entities such as SIVs, which were little more than off balance sheet banks with complex capital structures designed to run unregulated, and CDOs which had a similar structure with a few additional stabilizing constraints. These structures allowed the application of almost boundless leverage which escaped he regulators’ control if not scrutiny. As a system therefore, leverage surged beyond he estimation of the regulators and conventional metrics.

The attraction of the financial industry was precisely this leverage seen from a different angle. For a given capital base the financial industry offered the highest per employee assets of any industry. Since labour is compensated with a proportion of its marginal product, labour naturally seeks such industries out which deploy more assets per person. Pay levels and bonuses in the financial industry surged attracting he brains which would perpetuate the increase in assets per employee.

Diminishing marginal returns afflict even the financial industry. It is necessary to increase assets per employee but it is not sufficient. In order to generate high levels of pay and bonuses returns on equity capital need to be maintained, grown and maximized. This is the principal agent contract. Shareholders will only tolerate high payouts if the custodians of their business are generating sufficient returns on their equity capital. As the size of the system’s combined balance sheet grew, too much money was chasing too few opportunities. Returns on assets understandably fell or moderated leading managers to increase leverage in order to maintain returns on equity. The principal agent compact is incomplete in that it fails to address the prospect of losses. An agent is paid a basic salary to cover living expenses, or so the theory goes, and paid a share of profits. In order to retain talent and to align interests a portion of the years bonus is retained for a number of years usually 2 to 3 years. Unfortunately there is usually no clawback so contracts do not prescribe for losses. Traders who lose a sufficient amount of money are either fired or incentivized to leave the firm rather than work for free. Since contracts provide agents with upside but no downside they resemble call options and option pricing theory advises that the value of an option is highly dependent on the volatility of the underlying instrument or asset. Agents are therefore incentivized to increase the riskiness of their portfolios in order to maximize the value of the option which they hold.

In the wake of each crisis come regulations to prevent recurrence. Glass Steagall which was enacted during the Great Depression was repealed during the Clinton administration as the world came to accept the Great Moderation. The 2008 financial crisis has led to reconsideration and the introduction of Dodd-Frank with similar content and intent. Basel 3 is another piece of regulation intended to stabilize the banking system, among a slew of other regulations. Each new regulation comes with its own complications and unintended consequences. Basel for example, starves the economy of credit while governments are trying to reflate their flagging economies. Gradually, the shadow banking industry is expected to rise again as mainstream banks are hobbled by regulation. Talent can be expected to bifurcate to the safest banks and to the unregulated shadow banking institutions, at least until a clearer future emerges.

In early 2012 it gradually became apparent that the world was slipping into a synchronized slowdown. At least it became gradually apparent to slower minds like this one. By mid 2012 it became quite clear that the US recovery which started in August or September 2011 was petering out, Europe had never really picked up since the Summer of 2011 when Greece first exposed the vulnerability of the Union, and China’s slide was gaining momentum. In the last month we have seen better numbers from China, continuing weakness in Europe and in the US, a rebound in the real estate market if nowhere else in that economy.

What are governments hoping for and working to? The scale of the debt problems whether in the West or in Asia are too much not to enlist the aid of time. Some call this kicking the can down the road. Its not a good strategy, on its own, but its not a bad strategy if it buys sufficient breathing space to address more fundamental problems. The problem in Western democracies is that the gestation of such policies extends beyond the election cycle.

Lets make a to do list for a garden variety sovereign in a bit of a tight spot.

1. Increase real GDP growth. This is hard to do. Increase nominal GDP growth. This is also not easy without fiscal intervention which is constrained by budgetary issues. Keeping a low but positive real or nominal GDP growth seems to be the easiest best that one can do.
2. Reduce unemployment. This depends on the success of 1 above.
3. Keep inflation high as long as it does not surface in official statistics or lead to social unrest. This should debase debt without damaging officially measured real GDP growth.
4. Keep the banking system functioning. Only Europe has a real problem on this point. The US has recapitalized its banks and Asia looks healthy for now. The opacity and complexity of banks’ financials mean that this problem never ever truly goes away. Vigilance is required at all times.
5. Keep interest rates low. Facilitate the refinancing of the government and other credit strapped institutions. QE suffices for now in achieving this aim. Ideally there will be sufficient demand for government debt that debt monetization can stop. Low interest rates are necessary for an over-indebted world. If interest rates rise the implications for large swathes of the economy are highly negative.
6. Keep a competitively low exchange rate. The world’s economies cannot all simultaneously operate this strategy successfully. Yet attractive terms of trade are necessary to keep the export sector supported. In a sufficiently globalized world excessive success of one country can likely lead to instability for its trading partners making any such success short lived. Low FX volatility is good for all.
7. Balance the budget. This is almost intractable but it needs to be addressed at some point. By addressing refinancing risk in 5 above, central banks have bought time for governments to at least turn the budgets in the right direction. The longer term goal of balancing the budget is of course to reduce the outstanding amount of government debt and improve.

The above is a realistic, practical and feasible strategy to pursue, subject to a few limitations.

1. The time bought by debt monetization might not be well spent. There are many issues to address and the extra time obtained by debt monetization is finite. Many things can go wrong.
2. The scale of the problem might be bigger than everybody thought. This is a serious risk and one that can come from the banking system or sovereigns hiding the scale of their solvency issues.
3. Central banks are unable to reduce the banking system’s balance sheets sufficiently quickly in the face of accelerating inflation or recovery. Point 3 above is a risky strategy as it assumes that a desired level of inflation can be sustained without accelerating beyond targets.
4. Investors’ patience runs out before the root causes of the sovereign crisis are adequately addressed. This can lead to higher interest rates even in the absence of inflation or recovery and can threaten the cash flow solvency of sovereigns. Companies’ cost of debt would likewise rise. Given the current low levels of interest rates, the immediate impact on debt service could be severe. The stock market may also give up which would damage sentiment and cause a recession or depression.
5. Debt monetization and fiscal reflation are redistributive policies. The proposed redistributions may prove unpopular and precipitate a reaction.

The strategy is not entirely without merit and not completely hopeless, but there are serious risks, some of which have been understated above.

The yield on high yield bonds is not very high.

The ability of an insolvent concern to raise debt can stave off insolvency.

• I’m sorry, I can’t pay you in silver or gold, will you take an IOU?
• But that’s what you said last time. Can you pay off the last IOU?
• Will you take paper money? 

• Who is going to lend us money?
• Well, we are.
• What? We are going to lend us money? Why? How?
• Its simple really. You ask for a loan and we will give you one.
• With what money?
• With the money you borrowed from us.
• I see. Quite elegant if I may say so. How will we repay it?
• You’re going to have to balance the budget.
• That’s problematic. We can’t raise taxes.
• We don’t want you to. Can you spend less?
• We could but if we did I’m afraid that apart from healthcare being completely underfunded, unemployment benefits and other social welfare costs are not likely to abate.
• In that case you’ll need to raise taxes.
• We can’t. If we did the drag on the economy would put us back in recession. And tax receipts might fall. As it is we have cash flow problems. That’s why we need to borrow some money. The problem is no one will lend us any.
• Don’t worry, we will. But you will have to balance the budget.
• That’s problematic…

The better game show host won.

Since the great transfers following the great crisis of 2008 and the realization that debt levels had surged out of control, inflation has seemed like a tantalizingly viable and easy solution to the debasement of debt.

It is clear that central banks and governments would be encouraged to create as much inflation as possible as long as this inflation is not picked up in official data. So far their efforts have led to an asset bubble in bonds and emerging market assets and currencies. It seems as though the results of quantitative easing are invariant to the perpertrators of QE, that is, you can print but you cannot direct. The liquidity will flow to where the liquidity will flow. For emerging markets this has been a painful side effect of Western government’s efforts to save their own skin. For Western governments this has been frustratingly like blowing up a punctured balloon.

Those who support these inflation policies should understand that economics is not physics or chemistry and that inflation targeting and debt erosion tactics are a bit like running a nuclear reactor. A controlled chain reaction in a nuclear reactor provides heat energy which is harvested. The key word here is “controlled”.

Given their explanatory and forecasting track record of economists and central bankers, would anyone like to entrust an economic nuclear reactor to them?

How does one put an economy in order? An economy is like a business, but it is a lot more complex, with more stakeholders. Still, a business in distress is a good starting point to try to find a way out.  

Let’s look at a generic economy with

• Large quantity of public debt
• Slow economic growth
• A global recession and thus a sluggish external sector
• Persistent unemployment
• Shrinking private debt
• Stagnant housing market
• Independent central bank
• A non partisan government (for simplicity)
• Strong intellectual property capabilities.
• The country’s currency is the de facto global reserve currency.

What are the problems we seek to solve?

• Lower unemployment
• Raise economic growth
• Pay down public debt

Let us clarify the problem somewhat.

• Government deficits are rising as the government attempts fiscal reflation, for example through tax cuts and the limited provision of such public goods as healthcare.
• The central bank has so far been able to monetize government debt so as to keep interest rates low. The private sector has sterilized most of the monetary expansion. That said, the size of the monetary base presents a precarious position for the central bank in terms of price stability. The internal and external purchasing power of the currency may be questioned.

An initial solution:

• The government should raise as much long term debt as it can and quickly. It needs to remove all refinancing risk for the next 5 to 7 years. Once it has fixed its borrowing costs for a sufficiently long period into the future, it will no longer face the discipline of the bond market. It does not face this discipline today, but it may in future. It needs to lock in financing while it pursues unconventional fiscal policy (as opposed to unconventional monetary policy, which was required to bootstrap the unconventionally fiscal policy in the first place.)
• Operate an open door policy for business and capital. This may be unpopular and expensive at first. Expensive: It involves cutting marginal income tax rates and corporate tax. This may create a larger deficit in the short term but the tax elasticity of domicile will reverse the deficit given more time. This strategy is proven but it takes resolve as the initial finances deteriorate. Unpopular: Tax reform has to be designed to attract foreign capital and talent. This is a beggar-thy-neighbor policy which will be unpopular with trading partners and other countries as well as with incumbent residents who may see a deterioration of wealth and income equality. The current situation sees major economies competitively pushing capital and human resources away, counter to the more rational strategy of attracting capital and human resources.

A longer term solution:

• A government should only provide goods and services which the free market is unable or unwilling to provide. This defines the scope and scale of government, not political ideology. Shrink the government to fit. Ideally, taxes will be kept low. This is a mathematically sound approach but it does leave open the question about the use of taxation as a redistributive policy. We have noted before that the free market tends to increase the level of inequality in the system. This is outside the scope of this discussion.
• Address the major areas of moral hazard in the economy. Central banks and regulators should be responsible for the long term stability and sustainability of the financial system, to promote efficient allocation of resources, to promote full employment and most of all, to ensure a level playing field for all participants. Long term stability sometimes requires short term volatility to condition participants to the risks of participation. Efficient resource allocation requires minimum price distortion which will also require central banks to reexamine their role in the determination of interest rates, arguably the most important price of all.
• Economic reform in labour markets, particular industries, professions, banking and finance, public goods, etc etc are all well and good, but lets not be too ambitious. It is far from clear that we will even get to the initial solution let alone the longer term solution.
• A reexamination of the capitalist system of economics. Since the death of communism, capitalism has spiraled out of control without a nemesis or counterbalance. This economic soul searching can be pre-emptive or it can wait until a sufficient proportion of the global population is sufficiently disenfranchised by the particular distributive nature and inequality of wealth, income and opportunity of the current capitalist system.

Looking at how we have progressed thus far, some countries still have the means to refinance themselves sufficiently far into the future to employ the above strategy. Others do not. For these, the future is grim. Where countries have been given time and the benefit of the doubt by the capital markets, the time to act is decaying quickly.