Harvard's Carmen Reinhart: "The crisis isn't over in the US or Europe"

In her Der Spiegel interview, Harvard economist Carmen Reinhart makes the point that the financial crisis isn't over and the best way to solve it is if debt is written-off.

Furthermore, she points out that the policies that have been pursued to address the problem of too much debt in the financial system are placing the cost of the financial crisis on the real economy and everyday savers.

If this sounds like what your humble blogger has been saying since the beginning of the financial crisis, well....

SPIEGEL: Ms. Reinhart, central banks around the world are flooding the markets with cheap money in order to spur economies and support governments. Are these institutions losing their independence? 

Reinhart: No central bank will admit it is keeping rates low to help governments out of their debt crises. But in fact they are bending over backwards to help governments to finance their deficits. .... 

SPIEGEL: Is that true of the European Central Bank as well? 

Reinhart: Less than for other central banks, but yes. And the crisis isn't over yet -- not in the United States and not in Europe.... 

SPIEGEL: As a historian who knows the potential long-term consequences very well, doesn't such short-sighted decision-making frighten you? 

Reinhart: I am not opposing this change, I am just stating it. You have to deal with the debt overhang one way or the other because the high debt levels are an impediment to growth, they paralyze the financial system and the credit process. One way to cope with this is to write off part of the debt. 

SPIEGEL: You mean some kind of haircut? 

Reinhart: Yes. But we are in an environment where politicians are very reluctant to do write-offs.

Please re-read the highlighted text as Ms. Reinhart has explained both the Swedish Model (where banks  absorb upfront the losses on the excess debt in the financial system) and the Japanese Model (where bank book capital levels and banker bonuses are protected at all costs).

As Ms. Reinhart says, politicians have chosen the Japanese Model.  As a result, the burden of the excess debt is place on the real economy and savers.

So what happens is that money is transferred from savers to borrowers via negative interest rates....

SPIEGEL: So what should be done? 

Reinhart: The best way of dealing with a debt overhang is to never get into one. Once you have one, what can you do? You can pray for higher growth, but good luck! Historically it doesn't happen -- you seldom just grow yourself out of debt. ... 

And the way to ensure that you don't get into a debt overhang is to bring transparency to all the opaque corners of the financial system.  Then, market participants can assess the risk of each of their exposures and limit their exposures to what they can afford to lose.  This puts a cap on how much debt can be in the financial system.

SPIEGEL: But is it not a declaration of bankruptcy for democracy if central bankers, who haven't even been elected, have to step in to fix the problem in the end? 

Reinhart: I think the biggest mistake that European policy-makers are now making is not to put debt restructuring more explicitly on the table. 

Ms. Reinhart calls for adoption of the Swedish Model.

SPIEGEL: Are you referring to Greece? 

Reinhart: Greece has had its restructuring, that's history. But look at Ireland and Spain. Private senior bank debt has not been written off, despite the fact that underlying asset prices in those countries have collapsed and are still collapsing. 

SPIEGEL: So closures of some banks would be helpful? 

Please note that banks recognizing the losses on the excess debt in the financial system may or may not lead to bank closures.

Banks are designed to be able to absorb these losses and continue to operate and support the real economy.  They can do so because of deposit insurance and access to central bank funding.  With deposit insurance, the taxpayers effectively become the banks' silent equity partners when the banks have low or negative book capital levels.

A bank can continue in operations so long as the interest income it generates on its assets exceeds the interest expense on its liabilities plus its pre-banker bonus operating expenses.  The excess earnings can be retained and used to rebuild bank book capital levels.

The only banks that need to be closed are those that where the interest income on their assets is less than the interest expense on their liabilities plus their pre-banker bonus operating expenses.

Reinhart: What is sacrosanct about bank debt? 

SPIEGEL: Well, the bankruptcy of banks can have a considerable effect on the financial system. 

Reinhart: Let me be a little blunter: A haircut is a transfer from the creditor to the borrower. Who would get hit by a haircut? French banks, German banks, Dutch banks -- banks from the creditor countries. So you can see why this is politically torched. This is why it is not done, it's a redistribution. But ultimately it is going to happen, because the level of debt is too high. 

As Ms. Reinhart says, ultimately the Swedish Model will be adopted and banks will be required to recognize their losses.  The question is how much damage to the real economy and the social contract will occur before politicians accept this fact.

IMF's Lagarde: big banks "more dangerous than ever"

Oops.  It appears that the global policymakers and financial regulators decision to protect bank book capital levels and bankers bonuses at all costs since the beginning of the bank solvency led financial crisis might not have been the right decision.

The Telegraph reports that the IMF's Christine Lagarde sees big banks as "more dangerous than ever".

And why are they more dangerous than ever?  Because

"many banks are still in an early stage of repair – not enough capital and too many bad loans on their books. Even outside the periphery, there is a need to shrink balance sheets, reduce reliance on wholesale funding, and improve business models,” she said. 

Because the banks are broken, cheap credit is not getting through to the parts of the economy that need it. 

“Because of insufficient financial repair, monetary policy is “spinning its wheels” – meaning that low interest rates are not translating into affordable credit for people who need it,” she said. 

“So the priority must be to continue to clean up the banking system by recapitalising, restructuring, or – where necessary – shutting down banks.” 

Please re-read Ms. Lagarde's comments as she has confirmed what you humble blogger has been saying since the beginning of the financial crisis about why the policy response doesn't work and what it takes to fix the global economy.

The necessary first step is to fix the global banking system by requiring it to recognize upfront all the losses on the excess public and private debt in the financial system.

Banks can absorb these losses because they are designed to continue operating and supporting the real economy even when they have low or negative book capital levels.  Banks can do this because of deposit guarantees and access to central bank funding.  Deposit guarantees effectively make the taxpayers the banks' silent equity partner when they have low or negative book capital levels.

After absorbing the losses, the banks whose interest income exceeds their interest expense and pre-banker bonus cost of operating can rebuild their book capital through retained earnings.

To ensure that these banks don't take on too much risk while rebuilding their book capital, they must be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this disclosure, market discipline will restrain banks gambling on redemption.

After absorbing the losses, the banks whose interest income is less than their interest expense and pre-banker bonus cost of operating should be resolved.

Please note that this solution, what I call the Swedish Model for handling a bank solvency led financial crisis, results in the bankers paying for the losses in the financial system that they created.

A banking reboot would create necessary condition for economic growth

In his Telegraph column, Liam Halligan lays out the argument for rebooting the banking sector as this creates the necessary condition for economic growth.

Mr. Halligan effectively calls for the end of the Japanese Model for handling a bank solvency led financial crisis under which bank book capital levels and banker bonuses are protected at all costs.  Instead, he calls for adoption of the Swedish Model where banks are required to recognize upfront their losses on the excess debt in the financial system.

Where Mr. Halligan refers to the UK, please feel free to substitute EU, Japan or US.

Five years on from this sub-prime collapse, though, and ... 

The debate about how the UK escapes from this economic torpor remains deeply entrenched, largely along party lines. Our politicians are locked in a "growth versus austerity" soap opera, trading ideological jibes as they argue over tax and spending plans that are, anyway, largely fiction. 

The truth is that, if the UK economy is to fire on all cylinders again, our banks badly need to raise fresh private sector capital, then extend finance to the creditworthy businesses that will generate sustainable recovery. 

A little bit of extra government spending here, a new "scheme" there, while driving endless political spats, will have zero impact on growth compared with forcing a banking sector reboot. 

Debates over tiny dabs of unaffordable state largesse amount to posturing and political parlour games. Such energy-sapping policy tweaks don't affect our growth trajectory in the slightest, but are mere exercises in temporary media management. 

Sorting out the opaque, wealth-destroying mess that is the UK banking system, by contrast, requires courage and a sustained determination to face down powerful vested interests. 

I wonder, after decades of relative prosperity and the complacency that breeds, if the UK and much of the Western world has leaders who are willing and able to do this. I see much evidence to the contrary....

Please re-read the highlighted text as Mr. Halligan has nicely summarized the current situation under the Japanese Model and just how difficult it will be to adopt the Swedish Model.

The British economy is suffering not from a lack of government spending, as the Keynesian spend-a-holics would have it, but from a chronic lack of private sector investment.... 

An even more significant explanation, though, of why our capital stock is stagnating – it grew by just 1.1pc in 2012, a 20-year low – is that our banks are failing to extend commercial credit to SMEs, or are often doing so only on terms so harsh as to kill stone dead what would otherwise be feasible business plans. 

If the UK economy is to recover, our banks need to raise capital and then extend the finance needed to kick-start investment and commerce. 

One reason this isn't happening is that banks are doing nicely lending out small volumes at high rates. 

More fundamentally, their capital raising is stymied as investors don't trust banks' financial statements, given that risks are often understated and huge, smouldering sub-prime related losses remain buried off-balance sheet. 

Bank of England policymakers recently warned that UK banks need to raise additional capital of £25bn. Market estimates put the figure at nearer £50bn. 

The banks insist that refinancing themselves would make lending even more difficult, but the truth is that no one really knows the state of our banking system. 

Politicians remain deeply reluctant to push the big banks into "full disclosure" for fear of what will be found.

Please re-read the highlighted text as Mr. Halligan has nicely summarized the current global state of the banks.  No one knows whether they are solvent or not.

The only way to know the true condition of a bank is if it provides full disclosure, what I call ultra transparency, and discloses on an ongoing basis its current global asset, liability and off-balance sheet exposure details.

With this information, market participants can assess the solvency of each bank and its risk.

Please note, as your humble blogger has said repeatedly, banks are designed so they can continue to operate and support the real economy even when they are insolvent.  A bank is insolvent if the market value of its assets is less than the book value of its liabilities.  However, this is not necessarily a permanent condition.

What is important to focus on with a bank is the question of whether the interest income generated by its assets on a fully performing basis (after all losses have been realized) exceeds the interest expense on its liabilities plus operating expenses before banker bonuses.

If the answer is yes, then the bank is capable of generating and retaining earnings so that it can become "solvent" in the future.

If the answer is no, then the bank should be closed.

The UK may avoid a triple-dip recession. But banking sector gridlock is turning our country – once a shining example of industry, ingenuity and enterprise – into a low-investment, low-productivity basket case. Something has to give.

Dean Baker: confusion between saving financial industry and saving financial system

In his post, economist Dean Baker looks at how both the Bush and Obama administrations confused and still confuse saving the financial industry with saving the financial system.

The source of this confusion is the policy of financial failure containment and its corollary, the Geithner Doctrine, that was adopted by the US Treasury and the Federal Reserve.  Under this policy, the Japanese Model for handling a bank solvency led financial crisis and its twin goals of protecting bank book capital levels and banker bonuses at all costs was adopted.

By definition, this policy was designed to protect the status quo including the existing banks and sizable banker bonuses.

In contrast, there is the policy of financial failure prevention on which the global financial system is based.  Under this policy, the Swedish Model for handling a bank solvency led financial crisis is adopted and banks are required to absorb upfront the losses on the excess debt in the financial system.

By definition, this policy is designed to protect the real economy, the taxpayers and the social contract at the cost of greatly reducing banker bonuses.

The Washington Post published excerpts from reporter Neil Irwin's new book,The Alchemists: Three Central Bankers and a World on Fire, under the headline, "three days that saved the world financial system." 

The headline is seriously misleading since it may cause readers to believe the world somehow would have lacked a financial system if the central bankers in Irwin's story had not succeeded in their efforts. 

This is not true. 

Had a financial collapse actually been the outcome, the central banks had the ability to take over failed banks and restart the system. (This is what the FDIC does all the time.)... 

While the immediate hit from the financial collapse would have almost certainly been worse than what Europe and the rest of the world saw in the immediate wake of the initial euro zone crisis, the euro zone and world economy would almost certainly be much better off today if the central bankers had simply allowed the system to collapse. (This assumes that they are as competent as the economic policymakers in Argentina.) 

In this sense, the heroes in Irwin's book can be seen as saving the bankers, who would have been wiped out in a financial collapse, but not really doing much to benefit the rest of society.

Guardian's Seamus Milne calls for change in policy to save real economy

In his Guardian column, Seamus Milne channels what your humble blogger has been saying since the beginning of the financial crisis and makes the case for adopting the Swedish Model for handling a bank solvency crisis to save the EU and UK economies.

Europe's flesheaters are back. The claim that the worst of the eurozone crisis is behind us now looks foolish.

Please recall that your humble blogger predicted at the beginning of the financial crisis that until transparency was brought to all the opaque corners of the financial system that the global economy would spiral downwards (despite the best efforts at economic stimulus by central banks and governments).

The deal forced on Cyprus by the German-led Troika at the weekend isn't a bailout: it will effectively destroy the island's economy. Instead of getting a grip on its grossly inflated banks, it will impose a brutal credit contraction, combined with sweeping cuts and privatisations, wiping out perhaps a quarter of Cyprus's national income. Ordinary Cypriots, not Russian oligarchs, will pay the price. 

Of course Cypriot politicians are to blame for having allowed the country to be turned into an adjunct of a bloated financial sector and a refuge for hot Russian money. 

But what tipped the divided island over wasn't foreign investors' sharp practices, but the impact of Europe's wider crisis on its banks: in particular, their exposure to devastated Greece, currently also in the Troika's tender care. 

Some have hailed the fact the raid was carried out on Cypriot bank deposits over €100,000, rather than the public purse. 

At last the rich and those responsible for private banking failures are being made to cough up, it's been said. Which would have been a good thing. But it's savers, not bankers or shareholders, who are taking the 40% hit.  

And many of the targeted depositors, such as pensioners, are scarcely rich – or are small businesses which will now go bust. 

The Cypriot government should instead have learned from Iceland: taken over the banks, isolated the bad loans, protected deposits, imposed losses on the wealthy, and used a publicly owned banking sector to rebuild the domestic economy. That would have offered its citizens a better future, almost certainly outside the eurozone. 

But it would have also encroached on private capital's privileges and clearly couldn't be tolerated. ...

Please re-read the highlighted text as Mr. Milne has nicely summarized the benefits of the Swedish Model and why bankers are vehemently opposed to its adoption.

As the Greek economist Costas Lapavitsas argues, Cyprus has "reactivated" the European banking crisis. 

Not that it had been resolved. Only last month the Dutch government was forced to nationalise the Netherlands' fourth biggest bank, SNS Reaal, partly because of its over-exposure to losses in Spain.... 

Now the Troika's decision to help itself to Cypriot savings has paved the way for a new contagion. In the short term that may be contained because of the island's minuscule proportion of eurozone output. 

But the move has demolished confidence in bank deposits – a point rammed home by the Dutch finance minister's blundering signal that the deal had set a precedent. That could easily turn into bank runs in states likely to need new bailouts, as investors move cash to safer locations.

Safer locations like German government debt and not Deutsche Bank deposits.  Safer locations like money market mutual funds invested in UK or US government debt and not EU or UK banks.

Given the spectacular failure of austerity across the continent to overcome the crisis, rather than deepen it as output shrinks and debts mount, more such breakdowns are clearly on the cards.

The choice of austerity or stimulus didn't matter for ending the financial crisis.  If stimulus, all that was going to happen is the stimulus would ultimately be swallowed by the burden of debt service on the excess debt in the financial system.

Stimulus could buy a short-term reprieve from the downward spiral, but once the stimulus ended, the real economy would resume its contraction as money needed for growth and reinvestment was diverted to debt service on the excess debt.

The eurozone has now become a zombie zone.... 

Whatever the focus of the meltdown in each country – banking in Cyprus, property in Spain – all flow from the same crisis that erupted in 2007-8 out of a deregulated profit-hunting credit boom across the western world and has delivered a prolonged depression....

In Britain, the power and weight of the City of London are a particular block on sustainable recovery. 

But across Europe, people are being held to ransom by banks, bondholders and corporations determined to ensure that it's not they who bear the costs of the crisis they created – and politicians who regard it as their job to oblige them. 

Please re-read the highlighted text as Mr. Milne nicely summarizes why we have made no progress to addressing the underlying issues that caused the financial crisis and why the financial crisis continues.

Michael Pettis: When do we call it a solvency crisis

In a very interesting column, Michael Pettis looks at how there can be a bank solvency crisis going on for years before the banks and regulators are willing to publicly acknowledge that there is a bank solvency crisis.

The example that Mr. Pettis focuses on is the handling of loans to Less Developed Countries (LDC).

Regular readers know that your humble blogger has written about the LDC experience extensively.  The key takeaways were market participants knew that from a book value perspective the banks were insolvent, this did not matter and banks can operate for years while rebuilding low or negative book capital levels.

Why did market participants know the banks had negative book capital levels as a result of the LDC loans?

Because the banks disclosed the size of their exposures to each Less Developed Country.  By simply taking the price that the loans traded for in the market, market participants had a way of approximating the value of these exposures and what the true book capital level was for each bank.

Compare and contrast this with the current situation where banks do not disclose their exposures.

There is no way for market participants to know just how negative the true book capital levels are for each bank.

To take one possibly illuminating example, I started my trading career during the Latin American debt crisis, which officially began in August 1982. 

I joined the market in 1987, when bankers and policymakers were still assuring everyone that the problem Latin America was facing was a liquidity problem.

Nobody believed them nor because of disclosure of the LDC loans did anyone have to believe them.

I have referred to the handling of the LDC loans and the Savings & Loans as Fed Chairman Paul Volcker's regulatory legacy.  He believed in handling solvency issues behind closed doors.

This philosophy ultimately resulted in what I refer to as the policy of financial failure contagion and its corollary, the Geithner Doctrine (via Yves Smith:  do nothing that will harm the profits or reputations of big and/or politically connected banks).

This policy is built on the notion that financial contagion is minimized by hiding the truth behind closed doors.

As discussed above, this policy was absolutely the wrong conclusion to draw from the LDC loan experience.

The conclusions to have drawn are that markets understand that banks can operate with low or negative book capital levels and that markets can handle the truth.

As long as we could keep rolling loans over, they earnestly explained, the problem would eventually resolve itself at little to no relative cost (well, Latin America was struggling with unemployment, capital flight, hyperinflation and political turmoil, but I guess that doesn’t really count). 

It wasn’t until 1990 that the first formal debt forgiveness took place – known as the Mexican Brady Bond restructuring – and before the end of the decade nearly every country except Chile and Colombia had their own Brady bonds. 

Even those two countries, and all the others, had managed to obtain for themselves a significant amount of informal debt forgiveness through debt-equity swaps and debt repurchases at huge discounts from face value (some legal and some not quite legal). 

Why did it take so long for bankers and policymakers to recognize the truth – that this was not just a liquidity problem? 

Actually it didn’t. Most bankers knew by 1985-86 that the region was actually suffering from a generalized solvency problem, and among the big banks JP Morgan had been taking substantial provisions all along. 

No one could formally acknowledge the possibility of insolvency, however, because to have done so would have required that all of banks take much greater provisions than they already had. 

This would have created a problem. Of the top ten banks in America, only JP Morgan would not have been technically insolvent had the banks been forced to mark their LDC loan portfolios to market.

Mr. Pettis is confusing having negative book capital levels with being technically insolvent.

The banks all were technically insolvent as the book value of their liabilities exceeded the market value of their assets (the definition of technical insolvency).

Recognizing their losses would have had two impacts.  First, it would have in fact made the banks reported book capital levels negative.  Second and far more importantly, it would have hammered banker bonuses.  These bonuses couldn't be paid when banks have low or negative book capital levels.

In May 1987 Citibank, after many years of replenishing its capital, was able to announce suddenly and to the great surprise of the entire market that it had decided to take a huge amount of provisions against dodgy sovereign loans.

When it did so, Security Pacific became the poster bank for everyone knowing that its "true" book capital levels were massively negative.

However, everyone knew it would not be closed as it had a franchise that was capable of generating a significant amount of earnings even with a negative book capital level.

By 1989-90 the rest of the big American banks were also able to accept the write-offs without becoming technically insolvent. That is when everybody formally “discovered” that in fact the LDC debt crisis was a lot more than just a liquidity crisis.

No, this is when the regulators and bankers were willing to formally acknowledge the LDC debt crisis was a solvency crisis. It was well known by the market that it was a solvency crisis since 1982.

This is the key point. The American bankers weren’t stupid. They just could not formally acknowledge reality until they had built up sufficient capital through many years of high earnings – thanks in no small part to the help provided by the Fed in the form of distorted yield curves – to recognize the losses without becoming insolvent.

American bankers were not stupid.  They knew that formally acknowledging reality would end their lucrative bonuses.

This is exactly what has happened globally during our current bank solvency led financial crisis.  

And this matters to Europe. There is simply no way European banks, especially in Germany, can acknowledge the possibility of sovereign insolvency until they, too, have built up enough capital to absorb the losses. 

They have, unfortunately, been painfully slow to do so, even with yield-curve help from the ECB, and so I suspect that this is going to remain a “liquidity” problem for many more years. 

While it does, the debt-burdened countries of peripheral Europe are going to suffer a decade of weak growth, high unemployment, and contentious politics, all the while the debt growing faster than the economy.

Mr. Pettis re-iterates a series of points that your humble blogger has previously made.  These points boil down to two simple observations:

1. when bankers are allowed to pay themselves bonuses, banks cannot rebuild their book capital levels quickly; and
2. when banks are not required to recognize their losses on the excess debt in the financial system, the real economy and the borrowers suffer as a result.

FSA's Lord Turner: policymakers and regulators inherited "50 year long, large intellectual policy mistake"

In a must read Telegraph column, the FSA's Lord Turner attempts to place the blame for the failure of global policymakers and financial regulators to prevent and adopt a successful policy response to the global financial crisis on an over-reliance on markets.

Five years later, and as Lord Turner prepares to leave the FSA at the end of the month, few would have thought that the unprecedented events of that fateful year [2008] would still be reverberating throughout the developed economies.

For the record, your humble blogger publicly stated in late 2007 and throughout 2008 that without the right policy response, we would be facing a long-term Japan style economic malaise if not outright contraction.  This prediction has been borne out for the last 5 years as clearly, given the economic problems that we face today, the policymakers and financial regulators have not adopted the right policy response.

But, then again, who am I to be listened to on this matter.  After all, my track record includes predicting the financial crisis and subsequently predicting on this blog with the same degree of accuracy which policies were not going to work.

But hey, who cares about a track record when the entire economics profession continues to offer up recommendations despite having not predicted the financial crisis (my apologies to William White and his group at the BIS who did foresee the financial crisis).

In previous recessions, the route back to growth has been quicker. 

This time, a toxic mix of unsustainable levels of public debt and private-sector deleveraging has left the British economy in a long-term funk....

It is not the de-leveraging that has the economy in a funk.  It is the excess debt in the financial system and the policy responses to this excess debt that are causing the financial funk.

Banks are still in the dock. The City still feels friendless.

Oh please.  The City doesn't care about friends.  It is buying and selling policymakers left and right. Witness the UK government dashing off to Brussels to try to head off a regulation limiting banker bonuses.

Remuneration is still headline news.

As it should be given that the policy response that Lord Turner is so proud of was to protect banker bonuses at all costs.

New regulations on financial services are spewing out of Parliament, Europe and the Basel III process....

The number one lesson of the financial crisis is that the combination of complex rules and regulatory oversight does not prevent a financial crisis.

If it did, we would not have had a financial crisis and the banks would have avoided it.

“If you go back to March 2009, which is the point where all of us had gone through the crisis and were coming up for air and saying 'how do we put things right for the future?’ – if you look at all the forecasts, Bank of England, Treasury, the IFS [the Institute for Fiscal Studies], IMF, World Bank, they all suggested a much faster and more robust recovery of the developed-world economies than has actually occurred,” says Lord Turner. 

“I think that’s because we were slow to realise that once an economy has become overleveraged, once either corporates or households are over-leveraged, they will devote whatever disposable income they have to trying to get their balance sheets down, and therefore the demand for credit is depressed.”

Nice example of complete intellectual capture of a regulator by the bankers.  This is not surprising as Lord Turner is trying to defend the indefensible:  protecting banker bonuses and tearing up the social contract to pay for these bonuses.

The demand for credit is not depressed because of repayment of existing debt.

Demand for credit by business is depressed because of a lack of revenue growth.  Businesses simply don't borrow to expand when they don't see revenue growing.

Demand for credit by individuals is depressed because credit is now only provided to individuals who can actually afford the debt service payments.

And until the economy recovers, the financial crisis will cast its shadow over everything that happens....

The financial crisis will continue to make economic recovery impossible so long as policymakers and regulators refuse to require the banks to recognize upfront their losses on the excess public and private debt in the financial system.

Until this is done, the burden of the excess debt falls on the real economy where it diverts capital needed for growth, reinvestment and social programs to debt service and banker bonuses.

“I think we – as the authorities, central banks, regulators, those involved today – are the inheritors of a 50-year-long, large intellectual and policy mistake,” he says. 

“We allowed the banking system to run with much too high levels of leverage, inadequate levels of capital, and we ignored the development of leverage in the financial system and in the real economy. 

“And not only did we ignore it but we had a pretty overt intellectual philosophy that we could ignore it, because we knew the financial system was just a market like any other and whatever it did was bound to be for the good because that’s what markets are. 

“That was a huge mistake. 

“People just fall into the habit of believing that the system is stable. I think, unfortunately, there was the development of a set of intellectual ideas – efficient market hypothesis and rational expectation hypothesis – which provide an apparently sophisticated intellectual argument for why this whole system is safe.

I appreciate the fact that Lord Turner just said the economics profession is worthless and that economists should not be listened to.  It is hard to argue with this given that economists did not see the financial crisis coming and they were the ones promoting the large intellectual mistake.

However, by looking under the surface just a little, one can redeem the economics profession and discover what the real cause of the financial crisis was:  the assumption of transparency in a financial system that became dominated by opacity.

Adam Smith laid out the necessary condition for the invisible hand of the market to work properly:  buyer and seller must have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess and make a fully informed decision.

Without transparency, the rest of economics professions set of intellectual ideas is not just worthless, but downright dangerous.  As shown by the economic crisis.

However, with transparency, the financial system actually works reasonably closely to how the economics profession thinks it should work.

“[But] I think the response to it, the emergency response in Autumn 2008, was very good and I’m proud to have been a part of that process.”

The response in Autumn 2008 and since could not have been worse from the perspective of the real economy, taxpayers and society.

On the other hand, it has been great for the bankers.

When he walked into the FSA, the organisation was already changing, desperately trying to catch up with a financial-services sector that had left it for dead, a sloth trying to catch up with a tiger. 

It wasn’t until the FSA’s own, reluctantly authored, RBS report of 2011 on the collapse of Fred Goodwin’s bank that Lord Turner fully realised how dysfunctional the system had become. 

“I was very surprised that, despite the fact that we had 3,000 people, the allocation on the direct supervision of RBS was five people,” he says. 

“I was more surprised the more I looked at the liquidity standards that we’d been applying and the capital standards we’d been applying. 

“I was surprised at the supervisory approach. I’d been on the board of a bank, I’d been involved in banks, I’d dealt with banks back in the 1980s and 1990s, and I, throughout that, had accepted the existing capital regime as a given, right? 

To his credit, Lord Turner acknowledges why the combination of complex rules and regulatory oversight doesn't work as a substitute for transparency and market discipline.

With transparency, all the market participants, including banking competitors, look at a bank and not just the limited resources available to a regulator.

“I had never gone back to basics and said, 'why do we allow banks to run with 30, 40, 50 times leverage?’. And neither had anybody else, funnily.”

It is not leverage that kills a bank.  It is the risk that a bank takes that kills a bank.

Talk about bank capital ratios misses the important point that the way to prevent a bank from imploding is by restraining its risk taking.

The way to restrain risk taking as JP Morgan's Jamie Dimon has demonstrated is by letting the market see the bank's current global asset, liability and off-balance sheet exposure details.

Why not? critics may scream – or, more precisely, there were some people warning of calamity, why weren’t they listened to? 

“Well, it’s partly the frog in the boiling water, isn’t it?” Lord Turner says. “It slowly happens over time. It doesn’t happen immediately so the frog doesn’t leap out. The frog dies.” And while the frog is slowly dying, everyone is living it up on the debt-fuelled proceeds.

My question is:  why aren't we listening to the people who warned of a calamity now?

As the Bank of England's Robert Jenkins said, it is amazing that policymakers and regulators turned to and still rely on the bankers who brought about the financial crisis.

In 2009, Lord Turner famously said that a lot of banking activity was “socially useless”, a phrase that became the standard around which many critics of the City gathered. Has his opinion changed? 

“Before the crisis, there was too much trading activity in unnecessarily complicated structured credits going on,” says Lord Turner. “We have seen a very significant shrinkage in some of the trading books of our major banks. 

“And I think, when all that deleveraging of trading books is completed, we will find that the real economy never needed this stuff in the first place, and in a sense we’re better off without it. 

“Secondly, I think if you look at Barclays’ decision to radically reduce the size of its tax structuring activity, that is an end of a socially useless activity.”

All of this would permanently go away if banks were required to provide ultra transparency.

Barry Ritholtz: Bankistan vanquishes America (and the EU, Japan and UK too)

From Barry Ritholtz blog, the Big Picture comes a terrific summary of exactly where the global financial system is currently:

Is there a single doubt left in your mind? 

Are you still a believer in Rufus T. Firefly Jamie Dimon as the world’s smartest banker? 

Is there a scintilla of wonder left in your mind that the giant banks are legitimate? 

Have you come around to understanding — finally — what some of us have long understood about banks? 

Are you willing to accept the truth about these corporate behemoths — that they are a horrific combination of economically dangerous, criminally inept, led by pathologically lying CEOs? 

Do you harbor any doubts that the giant banks are anything less than ruthlessly efficient criminal enterprises? 

Can you — finally — admit that our bank-created financial crisis of 2008-09 has led us to where we are today? 

Do you understand the only options presented as a result of that — either corporate bankruptcy and nationalization or a completely artificial Fed driven recovery? (The third option was a Japan-like multi decade recession). 

Do you realize that the feeble recovery, the slow, deleveraging-driven process of gradual economic healing was the result of how our policy makers chose?

Our policy makers chose the Japan-like multi decade recession in which bank bonuses are protected at all costs and society, particularly through cuts in social programs like Medicare and Social Security, pays the cost.

Do you recognize that the world of banking is divided into two camps? 

On one side, there are those who understand that the giant banks must be broken up. They are dismayed at the large banks  under-capitalization, over-leverage and opacity.  

These folks have figured out that these banks are not only too big to fail, but are so large that they are too big to succeed, and that the best route is to let insolvent banks fail. They are unhappy that our finance sector is a trillion dollar black box. 

Insert call for banks to provide ultra transparency here.

They know that the majority of giant banks’ profits come from bailouts, and subsidies. This group is dismayed at the corruption of our political system by financiers.

Insert Jeff Connaughton and the Blob (aka, politicians, regulators, lobbyists and Wall Street) here.

They understands huge banks are anti-competitive, a blaspheme against capitalism.

Insert that we need to adopt the Swedish Model and require the banks to recognize the losses on the excess debt upfront here.

They are shocked about  corruption of even the most fundamental measures of interest rates such as LIBOR.

Insert bankers behaving badly behind a veil of opacity and the need for ultra transparency as sunlight is the best disinfectant and the source of confidence in the financial system.

They are stunned that bankers have overturned a bedrock, fundamental principle of our society — the rule of law rule — with the threat of disrupting the world’s economy if prosecuted for their crimes.

Insert need for requiring ultra transparency as it is only the market that can discipline the banks as they are too big for individual nations to control.

On the other side lay the bank apologists, corrupted politicians, and crony capitalists.  

They advocate the Big Lie of the financial crisis. They choose to ignore the facts and data that disprove their narrative. 

They continue to push the lies that the bailouts were a good investment. (They weren’t). 

They work against the Bipartisan consensus that the giant banks should be broken up.

Insert if banks provided ultra transparency, market discipline in the form of higher cost of funds would force them to reduce their risk and complexity (closing those thousands of subsidiaries that only exist to arbitrage regulations and taxes).

A likely outcome of reducing risk and complexity is that the banks would shrink significantly in size.

They ignore the many former bank CEOs who call for thebreak up of “Too Big to Fail” banks. 

They mandated that GSEs were banned from Lobbying, but they made sure that the big banks retained their influence peddling and hold on Washington DC. 

They no longer represent the voters of their districts, but instead are the elected representatives of Bankistan. 

And unless we do something — and soon — they will vanquish America.

This is also true of the EU and UK.

In the EU, we had the appointment of technocrats to carryout austerity in countries that should have had the banks take losses on their sovereign debt holdings. 

In the UK, we had the chancellor pleading with the EU not to limit bankers' bonuses.

WSJ: misguided faith that rules and regulators can prevent next financial crisis

The Wall Street Journal added its support to your humble blogger's argument that the combination of complex rules and regulations will not prevent the next financial crisis.

The misguided faith that rules and regulators can prevent the next financial crisis is hard to shake, but this week brought a glimmer of hope.

Regular readers know that the combination that will prevent the next financial crisis is transparency and market discipline.

The parts of the financial system that failed in our current financial crisis are those that feature complex rules and regulatory oversight (think banks) and/or opacity (think structured finance securities).

The parts of the financial system that continued to function throughout the financial crisis without government intervention feature transparency and market discipline (think stock or non-financial corporate bond markets).

The chairman of the Basel Committee on Banking Supervision signalled that regulators might be starting to understand how their rules contributed to the 2008 financial crisis—and the damage these rules could do in the future.

It is not the rules that do the damage.

It is the regulators' information monopoly that does the damage.

The regulators' information monopoly prevents market participants from accessing all the useful, relevant information in an appropriate, timely manner when it comes to financial institutions.

As a result, market participants cannot see how the rules are distorting the risk of the banks or, more importantly, how the banks are gaming the rules and adding risk.  Both lead to a financial crisis.

The Basel rules are the global standards that encouraged banks to hold mortgage-backed securities before the crisis and have since been re-written to favor investment in sovereign debt (such as Italian or U.S. bonds). 

Perhaps realizing how terrifying that sounds to taxpayers, Chairman Stefan Ingves said on Tuesday that the committee, whose members include U.S. financial regulators, has created a "high-level task force" to study the issues raised by Basel critics. 

Reformers like Andrew Haldane at the Bank of England and Thomas Hoenig at the U.S. Federal Deposit Insurance Corporation have pointed out that the complex Basel rules have been enormously costly yet were of little use before the crisis in determining which banks would run into trouble....

The failure of the Basel capital requirements in the run up to our current financial crisis should have forever ended the faith that the combination of complex rules and regulatory oversight can prevent a financial crisis.

The failure of the combination of complex rules and regulatory oversight in the run up to our current financial crisis should have caused us to look for an alternative.

The alternative that would have been found is the combination of transparency and market discipline.

Why would the combination of transparency and market discipline have been found?

Because our financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  Which is simply the combination of transparency and market discipline.

Instead of relying on a straightforward calculation of how much capital banks hold, Basel has embraced complicated methods for assigning "risk-weights" to the various assets held by banks. 

The opportunity for banks is either to lobby regulators to favor particular assets, or to simply wait until regulators bless certain types of investments for political reasons, and then figure out how to construct the most Basel-friendly balance sheet. 

Either way, guess which firms are best at navigating this byzantine regulatory architecture?...

The combination of transparency and market discipline puts an end to banks gaming the rules.

It ends this gaming as the market is only concerned with the risk that banks are taking and not how the banks manipulate some meaningless rules.  If the banks are required to provide ultra transparency, the market will exert discipline based on the actual exposure details of the bank regardless of how the banks game the complex capital rules.

Mr. Ingves and his colleagues have a long way to go. 

Actually, Mr. Ingves and his colleagues will never get to the point where they acknowledge that the combination of complex rules and regulatory oversight will not prevent the next financial crisis.

They are regulators and this would be acknowledging a significant limitation to their capabilities.

UK Guardian: Policy response to financial crisis wrong

In a column by its editors discussing why the Funding for Lending Scheme has failed, the Guardian exposes why the entire policy response to the financial crisis has been wrong since the very beginning of the crisis.

The problem with the government's funding for lending scheme – and indeed its entire strategy for growth – can best be expressed in an old cliche: you can lead a horse to water, but you cannot make it drink. 

With its policy of monetary activism, the coalition has concentrated on laying on the H2O of credit.

Please re-read the highlighted text as the justification used by each of the western governments and Japan for bailing out its banks was to preserve their ability to extend credit.

Regular readers know that this justification was built on a number of false assumptions.

One false assumption was that banks had to have capacity on their balance sheets if they were to be able to extend the credit that the real economy needs for growth.  Your humble blogger has documented why this is assumption is wrong.  The simple fact is that lending and funding for loans are completely separate as for at least the last 4 decades banks have had the alternative of selling the loans that it originates to buyers like insurance companies and pension funds.

The Guardian editorial focuses on a different false assumption.  It focuses on the assumption that there is a great unmet need for credit in the presence of an economy facing a major shortfall in demand.

Ministers have exhorted banks to lend, the Treasury has signed up to the Merlin agreement with financiers – as well as encouraging the provision of £375bn of quantitative easing and the £80bn scheme of funding for lending. 

These wheezes have cost hundreds of billions of pounds and taken up months of policymakers' time – and the net result has been sorely disappointing....

They have been good for banker bonuses though as they have enhanced bank profitability.

Faced with a major shortfall in domestic demand, he has depressed demand still further by laying out the biggest programme of spending cuts ever seen in peacetime Britain. 

And to spur growth, he has relied instead on trying to offer as much credit as possible. Put another way, an unthirsty horse has been offered gallons of surplus water.

Please re-read the highlighted text as it nicely summarizes why the response to the financial crisis has not worked to date (even when there was some stimulus as in the US).

Going by reports this week, Mr Osborne will next week announce yet more policies to boost lending to small and medium-sized businesses; perhaps by more closely targeting the funding for lending scheme administered by the Bank of England. 

This could once be chalked up as foolishness, but now it surely goes beyond that – it is wilful, damaging blindness on the chancellor's part....

Willful, damaging blindness about the ineffectiveness of the policy responses to the financial crisis that began on August 9, 2007 are not limited to the UK's chancellor.  This extends across countries and central banks.

As a group, they choose to implement the Japanese Model that Japan deployed for handling its bank solvency led financial crisis.  As a group, they apparently believed they would get a different result than  a Japan-style economic slump.

As a group, they are unwilling to admit that their experience parallels the Japanese experience and they have pushed their economies into a Japan-style economic slump.  A result predicted by your humble blogger.

One of the reasons that your humble blogger has advocated for adopting the Swedish Model for handling a bank solvency led financial crisis is that it avoids the Japan-style economic slump.  It does this by requiring the banks to recognize upfront all the losses on the excess debt in the financial system.

As a result, the burden of servicing the excess debt is not placed on the real economy where it would divert capital needed for growth and reinvestment.

But it must surely be evident by now that the main problem is not the lack of loans available to firms; it is that businesses do not see the growing markets or buoyant economy that would justify them spending and borrowing to invest.

The chief executives and managing directors can hardly be blamed for this: as Tuesday's industrial production figures and bleak forecasts from the National Institute of Economic and Social Research indicate, the economy is still stuck in the doldrums. 

While this remains the case, the government's focus on credit is misplaced.

The Guardian editors have eloquently summarized the current state of the global economy and why the policy response to the bank solvency led financial crisis was and still is wrong.

Banks saved, but a generation may have been lost

Since the beginning of the financial crisis, your humble blogger has been talking about the adverse impact on society of the choice of the Japanese Model for handling a bank solvency led financial crisis and protecting banker bonuses at all cost.

In a Reuters' article, the President of the European Parliament suggests that the cost of protecting bank book capital levels and banker bonuses might be a "lost" generation.

The cost is not limited to this lost generation.  The lost generation is being counted on to have the earnings needed to support the social welfare programs of the older generations.

If the lost generation doesn't have these earnings, then the social programs, like Medicare and Social Security, for the older generations will have to be cut back.

Reducing the promise of the social programs creates economic headwinds.  Just like the Retirement Plan Death Spiral, savers will attempt to offset the decline in promised benefits by cutting back on current consumption.  This makes the situation worse for the lost generation and increases the size of the needed social programs cuts in a negative self-reinforcing feedback loop.

Having either a "lost" generation or reducing the social programs is unacceptable given that there is a proven alternative to the Japanese Model, the Swedish Model, that protects the real economy, the social programs and society.

Under the Swedish Model, banks are required to recognize upfront the losses on the excess debt in the financial system.  This protects society and the real economy by not forcing the diversion of capital that is needed for growth, reinvestment and social programs to cover the debt service on the excess debt.

The Swedish Model could still be adopted today and bring an end to the financial crisis that began on August 9, 2007.

Since the Swedish Model could still be adopted, policymakers have to make the decision every day to continue pursuing the Japanese Model and its related policies like austerity and zero interest rates.

Since the Swedish Model could still be adopted, every day since the financial crisis began policymakers have chosen to put protecting banker bonuses ahead of protecting the real economy and society.  Apparently even at the cost of a lost generation.

While the article talks about Europe, the same is true in Japan, the UK and the US.

Europe has spent hundreds of billions of euros rescuing its banks but may have lost an entire generation of young people in the process, the president of the European Parliament said. 

Since the region's debt crisis erupted in Greece in late 2009, the European Union has created complex rescue mechanisms to prop up distressed countries and their shaky banking sectors, setting aside a total of 700 billion euros. 

But little has been done to tackle the devastating social impact of the crisis, with more than 26 million people unemployed across the EU, including one in every two young people in Greece, Spain and parts of Italy and Portugal. 

That crippling level of unemployment has led to protests and outbreaks of violence across southern Europe, raising the threat of full-scale social breakdown, including rising crime and anti-immigrant attacks that can further rattle unstable governments. 

"We saved the banks but are running the risk of losing a generation," said Martin Schulz, a German socialist who has led the European Parliament, the EU's only directly elected institution, since January last year. 

"One of the biggest threats to the European Union is that people entirely lose their confidence in the capacity of the EU to solve their problems. And if the younger generation is losing trust, then in my eyes the European Union is in real danger," he told Reuters in an interview.

Please re-read the highlighted text as the risk of losing an entire generation and the stability of society is simply too high a price to pay to protect banker bonuses.

Schulz, 57, who finished high school but did not go to university and began his career as an apprentice bookseller, said he had recently taken part in a debate where he was challenged by a Spanish woman over the issue of young people being abandoned for the sake of rescuing wealthy banks. 

"She effectively raised the question: 'You have given 700 billion euros for the banking system, how much money do you have for me?'" he said. "And what is my answer?
"If we have 700 billion euros to stabilize the banking system, we must have at least as much money to stabilize the young generation in such countries," he said. 

"We are world champions in cuts, but we have less idea ... when it comes to stimulating growth."...

The way to stimulate growth is to have the banks absorb the losses on the excess public and private debt.

This frees up the capital that is currently being used for debt service on this excess debt to be reinvested.

This ends the need for economic policies that stifle demand like austerity or zero interest rate policies.

This also eliminates economic distortions from zombie companies whose loans were restructured by banks engaging in extend and pretend.

In short, by making it harder for bankers to be paid cash bonuses, the real economy can resume growing and the social safety net can be protected.

"Greece, Spain and Italy have perhaps the best educated generations they have ever had in their countries, their parents invested a lot of money in the education of their children, everything they did was right," said Schulz.

"And now they are ready to work the society says, 'No place for you'. We are creating a lost generation."

Sheila Bair is not a substitute for market supervision

In his NY Times Economix column, Professor Simon Johnson argues that it is important to appoint Sheila Bair to the vacant post of Fed Vice Chairwoman for Supervision because without filling this vacancy the Fed faces a potential crisis of legitimacy for its handling of the Too Big to Fail banks.

While there is much to recommend his column, Professor Johnson misses two critical facts.

First, a major reason for the financial crisis was the failure of regulatory supervision.  There is little that has happened since the beginning of our current financial crisis to indicated that the reasons that regulatory supervision is not a viable substitute for market discipline, including regulatory capture, have been fixed.


Second, the Fed has a long running policy of financial failure containment and its corollary the Geithner Doctrine (from Yves Smith, nothing should be done that hurts the profits or reputation of a big or politically connected bank).

As regular readers know, banks are not subject to market discipline because they are, in the words of the Bank of England's Andrew Haldane, "black boxes".  When market participants do not have the information they need to independently assess the risk of the banks, they cannot exert discipline on the banks by adjusting both the amount and price of their exposure based on each bank's risk.

Leading up to the crisis and even now market participants rely on the regulators' representation about the riskiness of the banks.  This reliance is the result of the simple fact that the regulators have access to all the useful, relevant information on each bank in an appropriate, timely manner and investors don't.

Unfortunately, this reliance is misplaced as the regulators have to both correctly assess this information and accurately communicate the results of this assessment to the market.  By definition, regulators cannot accurately communicate the results because of concerns over the safety and soundness of the financial system (the regulators won't say anything bad about the banks).

This problem is compounded by the moral hazard creating Dodd-Frank Act mandated stress tests.  Each year, the Fed performs a stress tests on the banks and pronounces them solvent under extreme economic conditions.  This announcement effectively makes the taxpayer obligated for bailing out the investors for any solvency related losses.

Why?  Where is there the investor who is going to argue with the Fed given that the Fed has better access to information than the investor?

That the government making investment recommendations creates moral hazard has been well known since the 1930s.  FDR warned about it and specifically said that the government should stay out of the business of making investment recommendations as this create a moral hazard to bailout investors who relied on the government's recommendation.  The Fed's stress tests are nothing less than the government making an investment recommendation.

More troubling is that former Treasury Secretary Tim Geithner pledged the full faith and credit of the US to provide the banks with all the capital they need as a guarantee to investors that they would not suffer any losses from investing based on the stress test findings.

The policy of financial failure containment was in place back when I worked for the Fed and can be seen in the handling of Continental Illinois and the Savings & Loan crisis.

This policy has already destroyed the Fed's legitimacy when it comes to dealing with the Too Big to Fail banks.  Everyone knows the Fed will not do anything to control them and prevent them from taking outsized risks.

Rather, the Fed will come along and try to "mop up" after one of these banks blows up again.

If the Fed were truly interested in having the Too Big to Fail banks subjected to appropriate levels of supervision, the new Vice Chairwoman for Supervision would be leading the charge to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With ultra transparency, the banks would be subjected to both market supervision and market discipline.  Supervision that would be far superior in terms of both manpower and resources than anything that our regulators can offer.

The Dodd-Frank Act created the position of the Vice Chairwoman for Supervision at the Fed precisely because Wall Street knows that the Fed will never support ultra transparency.  Supporting ultra transparency means giving up its information monopoly.

It also means that the market could exert discipline on the Fed in its performance of is supervisory duties.  The last thing the Fed and its economists would ever be willing to do would be to put themselves in a position where they could be held accountable for their actions or lack thereof.

BoE's Mervyn King: Lesson from history is to adopt Swedish Model for handling banks

As reported by Bloomberg, the Governor of the Bank of England, Mervyn King, laid out in his testimony before the Parliament's Commission on Banking Standards that the lesson from history on how to handle a bank solvency led financial crisis is to adopt the Swedish Model.

He contrasted Japan’s failure to restructure its banking system with Sweden’s nationalization, overhaul and rapid return of its lenders to private ownership in the 1990s. 

RBS has crimped lending and growth in the U.K. since its bailout, King said. 

“The lessons of history show very clearly that it is not a good idea to have banks in the public sector for very long,” King said. “The financial markets realized that the losses out there don’t go away. It’s better to face up to it.”...

“The arguments for a restructuring sooner rather than later are powerful ones,” King said. “I’d be willing to lend my support. We shouldn’t worry about the consequential impact.”

Please re-read the highlighted text again as Sir Mervyn King has just championed your humble blogger's call for adoption of the Swedish Model for handling a bank solvency led financial crisis.


It is unnecessary given the design of a modern banking system to take a bank into public ownership (which is what any form of bailout is) to restructured them and recapitalize them quickly.

By design, banks can operate and continue to support the real economy when they have low or even negative book capital levels.

Banks can do this because of the combination of deposit insurance and access to central bank funding.  Deposit insurance effectively makes the taxpayers the bank's silent equity partner when they have low or negative book capital levels.  This is what lets banks continue to operate and support the real economy.

What would force banks to restructure quickly is if banks were required to provide ultra transparency and disclose their current global asset, liability and off-balance sheet exposure details.  This level of disclosure is needed so that banks are subject to market discipline.

With this information, market participants can assess the risk the banks are taking and link the amount and price of their exposure to each bank to the risk it is taking.  It is this linkage between cost of funds and risk that is the driver of market discipline.

And why would market participants link the cost of funds to the risk each bank is taking?

Market participants know they are responsible for all losses on their investments as a result of having access to all the useful, relevant information in an appropriate, timely manner to independently assess and make a fully informed investment decision.

Joseph Stiglitz: Path to Prosperity

Nobel Prize winning economist Joseph Stiglitz observed that the only thing lying between the real economy and the path to prosperity was the excess debt in the financial system.

Regular readers know that this is precisely what your humble blogger has been saying since the beginning of the financial crisis.

And, the path could be easily unblocked by having the banks perform the role they are designed to perform and recognize upfront the losses on the excess debt in the financial system.

‎"Gone through the crisis... we should realize that the resources in our economy, in the United States, in Europe, today is the same as it was five years ago. We have the same human capital, the same physical capital, the same natural capital, the same knowledge... We have the same creativity that has led to the unprecedented increases in standard of living that the world has never seen before. So, we have all these strengths, they haven't disappeared. 

What has happened is, we're having a fight over claims, claims to resources. We've created more liabilities... but these are just paper. 

Liabilities are claims on these resources. But the resources are there. 

And the fight over the claims is interfering with our use of the resources. 

So, the point is the following: we should recognize that if we could only get our resources back to work, we ought to be back to prosperity. In fact, we ought to have more prosperity than we had before, because before our economy was distorted... by a bubble in the United States, by a financial sector that was overbloated... We had a distorted economy. 

So, today if we could only get our resources back to work in ways that enhance the well-being, to use the creativity of the citizens of Europe and America then we will have unprecedented prosperity." - Joseph Stiglitz

Please re-read the highlighted text as it is always nice to have a Nobel prize winning economist confirming your humble blogger's blueprint for economic recovery.

Too Big to Fail and Too Big to Manage

In his Guardian column, Joris Luyendijk does a wonderful job of outlining the issues with the Too Big to Fail and Too Big to Manage global financial institutions.

The Lloyds and RBS press conferences were strikingly similar and, as they wore on it became hard not to think of them as dull, rather sophisticated but above all extremely effective rituals.

Given that these banks do not provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, earnings releases are simply elaborate rituals.

With the information provide by ultra transparency, there is no way to know if anything represented about a bank's financial condition is true.

As the Bank of England's Andrew Haldane says, banks are "black boxes".

Other than the financial regulators, nobody knows what is lurking on and off their balance sheets.

On one side of the table were men (Lloyds had one woman, who said nothing) in suits projecting an image of control. 

Yes, they were presiding over banks with tens of thousands of employees engaged in very different and often wildly complex activities across the globe. Yes, they had been caught out by scandal after scandal somewhere in their vast empires and yes, in the past their books had given a wildly inaccurate picture of the risks they were running. 

Without ultra transparency, there is no way of knowing what risks they are currently running.  So the critical issue is why trust what the bankers have to say?

But all of this was now in the past and firmly under control, they implied, as they fired off endless numbers and percentages and ratios, and said things like "We remain very confident of our capital position," or "Our strategy remains centred on taking into account the interests of all of our stakeholders", or some other cardboard PR phrase CEOs learn to use when they want to deflect a question they know can't be followed up.

Here is one of the dangers of the easily manipulated Basel III capital ratios, because the financial regulators are blessing them it is easy for banks to hide their true condition.

Their vocabulary had been sanitised to a startling degree, with PPI and other schemes that cheated tens of thousands of trusting Britons out of their money becoming "legacy issues" requiring "customer redress". (HSBC referred to its huge fines in the US for massive drug money-laundering as "regulatory and law enforcement matters".)...

The PPI scandal continues to grow.  Last year, the UK's Financial Ombudsman saw its case load of PPI claims grow by almost 300,000.

The ability of the banks to use vocabulary to sanitize their past actions is directly related to how the financial regulators are reaching settlements with the banks.

As regular readers know, financial regulators have adopted the policy of financial failure containment and its corollary the Geithner Doctrine (do nothing that hurts the profitability or reputation of big or politically connected banks).

The pursuit of these policies results in settlements where the banks do not have to admit quilt for their actions.

It is not surprising when banks reach an agreement where they don't have to admit guilt to ripping off their customers that they would choose to try to sanitize and gloss over their activities.

What if bonuses and privatisation are diversions and the real issue is "too big to fail" in combination with too big to manage? 

If you believe that CEOs knew nothing about the scandals taking place under their watch, what reason is there to believe that this time they are on top of things? 

Over the past 18 months I have interviewed more than 150 people working in finance in London, most of them in junior functions. Many of them believe that the top of their organisation has no idea what's really going on. 

They are equally scathing about the regulators.

This is the debate Britain [and the rest of the world] refuses to have.  

Please re-read the highlighted text as Mr. Luyendijk captures the problem presented by Too Big to Fail and Too Big to Manage who operate behind a veil of opacity.

Opacity prevents market participants from knowing what is going on inside these banks.  As a result, the banks are subject to regulatory and not market discipline.

Regulatory discipline that is lacking for a number of reasons.  This includes the ability of the regulators to actually assess what is going on.  The bigger problem with regulators is that even if they do properly assess what is going on, they are designed to make it virtually impossible to communicate this to other market participants or to get the regulator to take action.

The top of the shop for financial regulators are political appointees.  This means they are susceptible to lobbying efforts by the banks.

The upper levels of the financial regulators tend to experience the revolving door between regulator and industry.  As a result, there is a tendency to give the banks the benefit of the doubt.

Your humble blogger has repeatedly said that the only way to truly address the problem presented by Too Big to Fail and Too Big to Manage is to require them to provide ultra transparency.

With this information, market participants can exert discipline on these global financial institutions.  This discipline takes several forms including linking each bank's cost of funds to the risk they are taking.

Naturally, banks that are more complex because of thousands of subsidiaries will be perceived as riskier.

Naturally, banks that engage in proprietary bets will be perceived as riskier.

It is these banks that will face a higher cost of funds and pressure to simplify their organizations and reduce their risk exposure.

The timing and conditions of the privatisation of Lloyds and RBS are vital to the British government's financial health, and it makes for powerful and simple-to-produce stories, especially if these banks continue to pay high salaries and bonuses. 

But Lloyds' and RBS's return to private ownership is ultimately a question of secondary importance when both banks continue to be too big to fail – and so effectively remain a public liability.

Today, the banks are a public liability because they are opaque.  As a result, market participants are dependent on the regulators who have access to all the useful, relevant information in an appropriate, timely manner for properly assessing this information and accurately communicating the risk to the market.

When regulators fail to do this and they will whenever there is concern over the safety and soundness of the financial system, there is a moral obligation to bailout the investors.  After all, the investors relied on the regulators who had better information.

One of the benefits of ultra transparency is that it ends the banks being a public liability and the moral hazard caused by reliance on the financial regulators.

With ultra transparency, investors know they are responsible for all losses on their exposures to these banks as they have the information they need to independently assess the risk and solvency of each bank.

It is this responsibility for losses that will drive investors to exert market discipline.

While this idea persists, Britain remains hostage to the health of banks over which it has only very limited influence. Knowing that your vital interests are affected by factors beyond your control is a recipe for stress. It's not what democracies should be about. 

But it has become the new normal. The big issue today is not whether British taxpayers get their money back. It's whether British citizens get their sovereignty back.

Getting their sovereignty back simply requires the banks to provide ultra transparency.

Any bank that is unwilling to disclose on an ongoing basis its current global asset, liability and off-balance sheet exposure details is not a bank that the British citizens would want to support in any fashion.

After all, an unwillingness to provide ultra transparency is the equivalent of waving a giant red flag and announcing to the world that the bank has something to hide.

British citizens would be better off asking banks that are unwilling to provide ultra transparency to leave and become some other country's headache.  Why should British citizens be responsible for the losses of a bank that refuses to disclose the risks it is taking?

Is slow growth America's and western economies' new normal?

In his very interesting Washington Post blog post, Jim Tankersley asks the question of whether slow growth is the new normal?

Your humble blogger has said since the beginning of the financial crisis that based on the policies pursued by the global policymakers the answer is "yes".

In fact, I predicted in 2007 that the policies being pursued would leave the global economy at best in a Japan-style economic slump, more likely in a downward spiral and at worse in a depression.

Perhaps more importantly, your humble blogger has discussed at length what policies have to be adopted to end this period of slow growth and restore a higher level of growth across the global economy.

Good economists are great storytellers. They sculpt narratives .... Like a novel, a good economic forecast has action and characters and, in the end, helps you make a little better sense of the world. 

Unless it turns out to be wrong.

Fortunately for my regular readers, I have been right about both what is happening to the global economy and why it is happening.

Consider the dominant story that economic forecasters have been telling you for years now: The U.S. economy just can’t catch a break. 

It has been poised time and again to rocket back to a growth rate that would recapture all the ground lost in the Great Recession, while delivering big job gains. But every time, some outside event scuttles things. 

The euro crisis flares up. A Japanese tsunami scrambles global supply chains. Lawmakers play chicken with the federal debt limit....

This is the dominant story of economic forecasters who failed to predict our current financial crisis and/or have a vested interest in promoting the current mix of policies.

Now consider the possibility that the can’t-catch-a-break story gets it backward. What if the economy isn’t particularly unlucky? 

Actually, the real economy is horribly unlucky.

It is horribly unlucky in that it has economists who failed to predict the financial crisis offering opinions on what it will take to recover from the financial crisis.  Opinions that policymakers for better or worse appear to rely on in setting policy.

Having a Nobel Prize in Economics does not convey the right to open one's mouth in absolute ignorance.

In fact, having a Nobel Prize in Economics conveys the responsibility for truthfully answering the Queen of England when she asked the economics profession if everything was going so wonderfully, how did the economics profession miss seeing the crisis coming.

The answer is that the economics is known as the dismal science because of its track record in forecasting financial crises.

As a result, any suggestion that an economist makes based on a model that missed the financial crisis is highly unlikely to actually positively address the problem that caused the financial crisis in the first place.

What if it’s basically doing what we should expect it to?

It is performing as I predicted.

What if something has changed, thanks to fallout from the recession, or a string of bad policy choices, or both, and growth has shifted into a lower gear?

It is a string of bad policy choices that has caused growth to shift into a lower gear.

You don't need to be an economist to predict that if the burden of the excess debt in the financial system was placed on the real economy it would negatively impact growth.

Placing the burden on the real economy means that capital that is needed for growth, reinvestment and support of the social programs is diverted to debt service payments.

This diversion of how capital generated by the real economy is used guarantees a negative impact on economic growth.

What if this slow and fragile expansion is as good as we’re likely to get for a while? 

Until policymakers abandon the current policies that are damaging the real economy (think zero interest rate policies and austerity for example), this slow growth is as good as it will get.

This is an alternative story that economists across the ideological spectrum have begun to explore. If it’s correct, the implications for economic policy are big....

It has taken five years to realize that maybe we should examine the policies that were adopted in response to the financial crisis to see if maybe they were fundamentally flawed.

Your humble blogger could save economists a great deal of time.  They can simply read my earlier posts and see why the policies were fundamentally flawed.

More importantly, by reading the earlier posts, they can see what policies need to be adopted.

Where our stories diverge is on the reasons those forecasts were wrong.

Please note, your humble blogger's forecasts weren't wrong and I got the financial crisis.

Here’s the standard explanation, from a sharp economist named David E. Altig, the executive vice president and director of research at the Federal Reserve Bank of Atlanta. 

Altig says the economy would have grown faster if a bunch of unanticipated problems — most notably the European financial crisis, in all its iterations, and the now-frequent instances of fiscal brinkmanship in Washington — hadn’t popped up to rattle consumers and business executives. 

This is how many Fed and CBO economists view the past few years, and why they remain so optimistic that faster growth is just around the corner..... 

History explains their thinking: In past recessions, the economy has lost ground, only to roar ahead in later years to return to its historical growth trends. ...

“It’s still the story of the unlucky shocks” and of growth eventually bouncing back to make up its lost output, Altig says. He adds: “We’re keeping hope alive with our forecast.”

Even though the models didn't predict the financial crisis, the Fed is following policies that the models say should work.  And the reason that the models are still not predicting what is going on is a series of unlucky breaks.

Excuse me, but maybe the Fed's models don't work because the assumptions that go into the models are fatally flawed.  Oops.

For the gloomy story, meet Kevin Warsh, a former Fed governor .... 

It goes like this: U.S. policymakers have tried for several years to splash gasoline on the flames of growth in hopes of stoking a bonfire. They’ve thrown in the $800 billion of tax cuts and spending increases contained in the 2009 economic stimulus bill, as well as the extraordinary measures the Fed has taken in an attempt to boost employment: holding short-term interest rates near zero for years and buying an unprecedented amount of long-term securities such as Treasury bonds in order to push down long-term interest rates. 

Warsh’s story is that those efforts didn’t work, and to make matters worse, they dampened the economy’s longer-run growth prospects.... 

The reason the economy has been underperforming, Warsh says, is that policymakers responded poorly to the financial crisis.

Yes they did and Mr. Warsh was one of the policymakers involved in the response.

They focused on short-term growth boosts and neglected what you might call basic economic infrastructure investments. 

They didn’t open big new markets for international trade in order to expand exports, and they didn’t streamline the tax code to promote investment.

I guess Mr. Warsh needs to publicly reaffirm that he is a card carrying Republican and confirm that economists truly bring little to the table when it comes to discussing policies for recovering from a bank solvency led financial crisis.

Mr. Warsh would like to expand exports so that the real economy could generate more capital to be used to pay off the existing debts.  However, this policy choice assumes that paying off the existing debts is the right choice.

There is another better choice that was made by Iceland.  Rather than try to pay off the existing debts, Iceland made its banks recognize upfront the losses on the excess debt in the financial system.  As a result, its real economy was protected and has continued to grow.

Meanwhile, Mr. Warsh's policy has burdened the US real economy with the debt service payments on the excess debt in the financial system.  In addition, his policy has the US chasing after exports when every other country, like the UK and EU, that adopted similar policies is chasing after exports.  It is simply not likely that the US will prevail in the chase for exports.

So let's see, we could make the banks recognize losses and the real economy could return to its normal growth path or we could put the debt service burden of the excess debt on the real economy and hope we can win the chase for exports.

Meanwhile, Warsh said, lawmakers added new regulations to the financial system that solidified an oligopoly at the top of the banking industry, one that has served to restrict the flow of credit to small businesses and entrepreneurs....

I agree with Mr. Warsh's summary of what the policymakers have achieved in "reforming" the financial system.

Regular readers know that I would repeal all of the Dodd-Frank Act except for the Consumer Financial Protection Bureau and the Volcker Rule.  In place of all those complex rules and regulatory oversight contained in Dodd-Frank, I would put transparency and market discipline.

Specifically, I would require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  This information allows market participants to independently assess each bank, link a bank's cost of funds to the risk it takes and to exert discipline on the banks.

I would require all structured finance securities provide observable event based reporting on all activities like a payment or delinquency involving the underlying collateral and report these activities to all market participants before the beginning of the next business day.  This lets market participants know what they are buying and know what they own.

Slow growth is the consequence of those policies, Warsh says. 

He fears the consequence of prolonged slow growth is a drop in the economy’s potential to grow. ... Executives have lost confidence in the economy’s ability to expand and willingness to invest in it. 

“We’ve been in this period of the new malaise for so long that workers and companies have lowered their expectations for what the U.S. economy can do,” Warsh says. 

If that’s the case, it’s as if our fireball pitcher has undergone arm surgery, and instead of throwing 95-mph fastballs, he’s stuck at 85 mph. Warsh says an infusion of better, long-run-focused policies is the only way to bring that velocity back — a second surgery of sorts. 

Warsh concedes that there isn’t a lot of data to back up his case. ... To this, Warsh likes to quote one of his mentors, the great free-market economist Milton Friedman: “Milton used to say, ‘everything we know in economics we teach in Econ 1, and everything else is made up.’ ”...

Great quote.

I have written a number of posts on how the economics profession doesn't understand the most basic principle of Econ 1:  the necessary condition for the invisible hand to operate properly is that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

It was the opacity in the financial system that lead to the financial crisis and it is the opacity in the financial system that prevents a recovery.

Until this opacity is addressed, we are going to continue muddling along.

This brings us to a third story... Two ideas are central to this story. 

First is that the recession didn’t just dig a big hole for the economy to climb out of, it also messed with the ladder. This is the basic theory set forth by the economists Carmen Reinhart and Kenneth Rogoff in their book “This Time is Different”: Financial crises weaken the financial system, slowing growth for years until the system heals....

I realize this post is overly long, but it is necessary to once again debunk the work of Reinhart and Rogoff.

Their work ignores what I call the learning curve.  Specifically, there is a chance that we have learned over the centuries how to deal with a bank solvency led financial crisis.  So in fact, this time could be different.

This bank solvency led financial crisis has two elements present that allow for a quick recovery (see Iceland).

First is the notion of deposit insurance.  With deposit insurance, depositors no longer care about a bank's book capital level (depositors are taught this as kids when they open up an account and are reassured that the government guarantees they will get their money back).

As a result, banks are fully capable of operating with low or even negative book capital levels.  At these levels, the taxpayers are effectively their silent equity partners.

Second is the notion of central banks providing access to funds as a lender of last resort.  This assures that the banks have liquidity even when they have low or even negative book capital levels.

Together, deposit insurance and lender of last resort, position the banks to protect the real economy from the burden of the excess debt in the financial system.  Specifically, the banks can recognize upfront the losses on the excess debt.

Then, over the next several years, the banks can retain their earnings to rebuild their book capital levels.

I realize that this might be bad for banker bonuses, but it is very good for the real economy as it keeps the real economy on a higher growth path (diverting capital from the real economy to debt service on the excess debt is what puts the real economy on a lower growth path).

This has prompted some wondering aloud, and it has given rise to perhaps the most interesting new story you hear from economists: Um, there’s a lot we don’t know about the economy. ... 

When you miss so regularly on your forecasts, Altig says, “it’s easy to think we have to rethink everything we think we know.” But, he adds, “You can be wrong for a very long period of time and still have the underlying structure and story about the economy correct. That’s not crazy. I guess that’s where I would be right now. It’s not like you have to throw out how you think about these things. You just have to have the same humility you always have.”

Economists and humility are not two words that go together.

Humility would imply that economists state clearly that they don't know what is going on and missing regularly on their forecasts confirms this.  Humility would further imply that economists then say that they will refrain from offering any policy recommendations until such time as they can demonstrate through their forecasts that they do have some insight into what is going on.