Thursday, July 28, 2011

Solvency, US debt ceiling and European Solvency Crisis

It appears that it has become much more difficult for politicians to buy time in face of the solvency crisis that began in 2007.

Faced with a global solvency crisis, governments on both sides of the Atlantic chose to buy time through a combination of bailouts for the banks, socialization of some of the losses in the financial system and massive economic stimulus packages.

As a result of this decision, in the US there is a debate over whether to permanently end the role of US government debt as the risk-free asset off of which all other financial assets in the world are priced.  This debate takes the form of a partisan debate over whether to raise the US debt ceiling or not and, if the debt ceiling is raised, whether the additional debt should be paid for by the middle class or by the rich.

As a result of their kick the can down the road decision, European countries are facing a sovereign debt crisis of their own.

I am not going to debate whether buying time was a good decision or not.  What is much more important is the issue of what do you do to address the solvency problem with this very expensively purchased time.

From an economic perspective, it was used to pray for a miracle.  Paul Krugman summarized this miracle in his NY Times column as
Everything might still have been O.K. if other major economic players had stepped up their spending, filling the gap left by the housing plunge and the consumer pullback. But nobody did. In particular, cash-rich corporations see no reason to invest that cash in the face of weak consumer demand.
This blog has documented why this miracle was made even more unlikely by the strategies adopted by the governments.

For example, the central bankers pursued zero interest rate policies.  As Walter Bagehot pointed out a century ago, when interest rates drop below 2%, prudent individuals adjust their behavior (as previously discussed, there are three types of individuals - those who spend everything they earn, those who earn so much they cannot spend it all and those who are prudent and save for retirement).  In this case, faced with the loss of earnings on their savings that they need for retirement, prudent individuals cut back on current consumption to make up for the shortfall.

While zero interest rates make it cheaper for corporations to expand, the incremental benefit of lower financing costs in no way offsets the impact on their investment decision of the drop in demand for their product(s) corporations are currently experiencing.

The fact that central bankers are praying for the miracle of corporations to hire employees and invest with no demand in sight means that central bankers should at a minimum pursue policies that increase demand not reduce it.

From a regulatory perspective, the time purchased was used to increase the regulators' role in the financial system.  The Financial Stability Oversight Council's 2011 annual report describes this as:
The challenge of maintaining a stable financial system is exacerbated by the difficulty of
balancing the benefits of regulation against the costs of excessively restraining prudent risk
taking behavior. If we were to set the overall combination of margin, liquidity, and capital
requirements too high, we could handicap the ability of the financial system to support
economic growth. Further, financial activity would inevitably move more quickly to firms,
markets, and countries where the intensity of regulation is weaker. So we need to continue
to strive for a careful balance between the imperatives of creating a more stable system and
promoting a level of innovation and dynamism.
With all of these new powers, shouldn't the financial system be safer?

In Europe, the regulators recently ran stress tests that suggested that a de minimus amount of equity was needed to maintain the solvency of over 90 banks.  Why is it if the regulators are on top of everything that the European governments needed to step in subsequently with another bailout?  

Regular readers know that the bank solvency crisis has not been addressed.  If it had, disclosure under the FDR Framework would have been adopted and implemented.

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