Saturday, January 21, 2012

With effectiveness of additional liquidity diminishing, central banks show they are not answer to solvency crisis

Mohamed el-Erian wrote an interesting column for Project Syndicate in which he observed that the financial system's credit pipes have remained clogged since the beginning of the crisis in 2008 despite central banks providing massive amounts of liquidity to unclog them.

He then makes several recommendations for how to unclog the credit pipes whose adoption and implementation are independent of the central banks and under the control of global policymakers and regulators.

Several of these recommendations appear in the blueprint for saving the financial system.

More than three years after the global financial crisis, the world still has a nasty plumbing problem. Credit pipes remain clogged, and only central banks are working to clear them. 
But their ability to do so is waning, posing yet another set of risks for western economies blocked by too little growth, too much unemployment, deepening inequality, and debt in all the wrong places. 
Fortunately, it is not too late to build broader pipes that complement and replace the damaged infrastructure.... 
Central banks providing liquidity only buys time for the underlying solvency problem to be addressed.  By itself, liquidity does not fix the problem.  Mr. el-Erian confirms this with his observation that the credit pipes are still clogged despite all the liquidity central banks are providing.
The current situation embodies two narratives that seem contradictory, but are not.
One speaks to the reality that most large companies with access to capital markets have no problem securing new funding. In fact, they have been remarkably successful in lengthening their debt maturities, accumulating cash, and lowering their future interest payments. In sum, they now have "fortress" balance sheets. 
The other narrative speaks to an opposing, but equally valid reality. Too many small companies and households still find it difficult to borrow at reasonable terms. This includes those reliant on bank credit, as well as many mortgage holders with very high legacy interest rates and balances that exceed their homes' market value. 
From every angle, the extremity of this state of affairs – in which those with access to credit do not need it, and those who do cannot get it – is highly problematic.... 
In the next round, as the system slowly implodes, even those with healthy balance sheets would be impacted, accelerating their disengagement from a deleveraging world economy.
All of this slows social mobility, tears already-stretched safety nets, worsens inequality, and accentuates genuine concerns about the functioning and sustainability of today's global economic system....

At the beginning of the financial crisis, your humble blogger observed that until opacity was eliminated in the financial system, we would continue in a downward spiral.  Mr. el-Erian confirms this and describes how he sees the mechanism behind the downward spiral working.

Central banks have recognised all of this for some time, prompting them to take enormous reputational and operational risks to slow the process. They have implemented a host of "unconventional policies" that previously would have been deemed unthinkable, even outrageous – and that can be seen in the enormous growth in their balance sheets. 
In the last four years, the United States Federal Reserve's balance sheet has more than tripled, from under $1 trillion (£645bn) to a mammoth $3tn. The growth relative to the size of the economy is even more stunning – from slightly more than 5% of GDP to 20%. The Bank of England's balance sheet is also at 20% of GDP. And both seem to be itching to do even more. 
The European Central Bank is often viewed as a laggard. No longer. Its balance sheet has now doubled, to a whopping 30% of GDP – and it, too, appears set to do even more. Mario Draghi, the ECB's new president, recently said that he expects heavy take-up on the next three-year long-term refinancing operation, a powerful tool to pump cheap liquidity into the banks. 
Unfortunately, the economic outcomes have come nowhere close to matching the intensity of these efforts. Effectively, the central banks have been unconventional bridges to nowhere, owing mainly to their imperfect tools and other government agencies' inability or unwillingness to act. At some point – and we are nearing it – bridges to nowhere become a standalone risk: they can topple over....
The financial system is facing a solvency problem as the result of its credit bubble bursting.  As Japan has shown after 2+ decades of unconventional central bank policies, liquidity does not fix a solvency problem.

With its blueprint for saving the financial system, this blog has laid out how the solvency problem could be fixed.  What follows is Mr. el-Erian's proposed cures.
It is high time to move on five fronts, simultaneously: 
• Countries such as Spain and the US need to be more forceful in unblocking the housing sector by making overdue decisions on burden sharing, refinancing, and conversion of idle and foreclosed housing stock.
• Countries with excessive debt, such as Greece and Portugal, need to impose sizeable "haircuts" on creditors to have a reasonable chance of restoring medium-term debt sustainability and growth.

Under this blog's blueprint, Wall Street rescues Main Street by stepping up and absorbing the losses on the financial excesses whether these excesses be mortgage-related or sovereign debt.

There are a number of reasons that Wall Street should absorb these losses including 1) it is the responsibility of a lender to be prudent in their credit judgments and not to extend more credit than the borrower can repay; and 2) banks are beneficiaries of both deposit insurance and access to central bank liquidity and therefore are in a position to recapitalize themselves through retention of future earnings.

• In several western countries, public-private partnerships should be formed to finance urgently needed infrastructure investment.
Under this blog's blueprint, banks recapitalize themselves through retention of future earnings.  This frees up governments to spend money on stimulating economic growth including making infrastructure investments.
• Regulators should stop bickering about the future configuration of key financial institutions, and instead set a clearer multi-year vision that is also consistent across borders.
Requiring banks to adopt ultra transparency is the only regulation that needs to be globally adopted.  There is no ambiguity in banks disclosing on an on-going basis their current asset, liability and off-balance sheet exposure details.

With ultra transparency, financial institutions become subject to global market discipline.  This discipline, through higher cost of funds based on the risk of the individual financial institutions, will force the financial institutions to reduce their complexity and risk profile.
• Finally, governments should inform their electorates explicitly and comprehensively that a few contracts written during the inadvisable "great age" of leverage, debt, and credit entitlements cannot be met, and must be rewritten in a transparent way that strikes a balance between generations, labour and capital, and recipients and taxpayers.
See Wall Street absorbing losses on financial excesses above.
Such policies would allow healthy balance sheets around the world, both public and private, to engage in a pro-growth and pro-jobs process. They require leadership, focus, and education. Absent that, plumbing problems will become more acute, and the repairs more complex and threatening to virtually everyone – including both the "one percenters" and those who worrisomely are struggling at the margins of society.

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