Friday, November 4, 2011

Government Incentives Do Matter--The European Case

Gillian Tett’s essay in the Financial Times this morning gives us another example of how government policies can create incentives that have very serious consequences on an economic system, consequences that are very often detrimental to the health and welfare of the economic system.  Tett’s excellent piece “Subprime moment looms for ‘risk free’ sovereign debt,” ( examines the consequences of European bank regulators assuming that all sovereign debt in Europe were “risk free”.

“When regulators drew up the Basel I capital adequacy framework in the 1980s, they gave western sovereign bonds a ‘zero’ risk weighting, in terms of how capital is calculated.  This was subsequently modified in Basel II, to give banks some theoretical discretion to raise reserves against sovereign risk.  In practice, this zero-risk weighting policy has prevailed.

In some senses it has been actually reinforced in the past five years because regulators have demanded that banks raise their holdings of liquid, safe assets, following the subprime turmoil.  Those ‘safe’ assets have been—you guessed it—mostly government bonds.”

Furthermore, one can add that in both applications of stress tests to judge the vulnerability of European banks to a financial crisis, no allowance was made for the writing down of sovereign debt in financial simulations.  Obviously, European banks came out looking pretty good.

And, in the “deal” constructed last week by officials of the eurozone, only ‘private’ holders of Greek debt were required to write down the debt by 50 percent, ‘public’ holders of the Greek debt, the ECB and other governmental organizations, did not have to write down the debt at all.  The ‘private’ holders represented only about 60 percent of the total amount of the Greek debt outstanding.

Of course, assuming that the sovereign debt of many of the eurozone countries was “risk free” allowed the governments to issue much more debt than they might have otherwise at the cheapest rates possible. 

In the essay, Ms. Tett also makes reference to the fact that assuming that sovereign debt is ‘risk free’ is one of the most basic assumptions of modern finance.

The result?

“If regulatory systems had not encouraged banks and investors to be so complacent about sovereign risk in the past, markets might have done a better job of signaling that structural tensions were rising in the eurozone—and today’s crunch would not be creating such a convulsive shock.”

Ms. Tett compares this “mis-pricing” exercise to the earlier experience of the subprime market.  In the latter case, subprime securities were repackaged into bonds that the rating agencies gave Triple A ratings to.  Again, this pricing facilitated the purchase of these securities and allowed many financial institutions to acquire the securities, comfortable that they were holding assets of the highest quality.  But, one cannot ignore the pressure put on mortgage originators, lenders, rating agencies and such, by governmental officials pushing hard to provide home ownership to more and more people.   And, this situation, too, resulted in “a convulsive shock.”

My point is that in both cases, the financial institutions and their executives have been blamed or are being blamed for the mess and are assessed the title of “greedy bastards”!

As many people know from reading my blog posts over the past three years, I feel the same way about the credit inflation created by governments in the eurozone and in the United States.  I have argued over and over that the credit inflation that has existed over the last fifty years has provided incentives for banks, businesses, and individuals to leverage up their balance sheets to excessive levels.   This credit inflation has also promoted excessive risk taking and the financing of long-term assets with short-term liabilities.  And, this credit inflation has created perhaps the most desirable environment possible for financial innovation. 

Yet the consequence of people responding to these incentives has resulted in the worst financial and economic collapse since the Great Depression of the 1930s. 

In addition, these incentives have also produced the most skewed income/wealth distribution in the history of the United States since the 1920s.  The wealthy, top executives, and people with access to information and markets can protect themselves from inflation or even take advantage of inflation.  The less wealthy, etc., cannot even hold their own against inflation.

Again, those that responded to the incentives created by this extended period of credit inflation and benefitted from them are labeled “greedy bastards.”

And, nothing is said about the politicians, another set of “greedy bastards” that originally created the incentives because they wanted to get re-elected!

Ms. Tett is correct in wondering what might happen if people change their assumptions about the sovereign debt, assuming now that all sovereign debt is not “risk free”.

She argues that “more realistic assessments” of the debt “would probably fore banks to hold more capital, and raise borrowing costs.”

More realistic assessments might “force the central banks to change how they conduct money markets operations, and impose tougher haircuts not just for obviously impaired debt, but bonds carrying potential risk, too.”

Or, “The other 800 lb—or $500 trillion—gorilla in the room is the derivatives market.  Until now, sovereign entities have generally ot posted collateral for derivatives, partly because of that risk free tag.  But, Manmohan Singh, an economist at the IMF, believes that this anomaly has helped to create a severe under-collateralization problem, worth $1.5 trillion--$2.0 trillion for the 10 largest banks alone.  If ‘true’ counterparty risk were ever recognized in derivatives, in other words, the implications could be brutal.” 

One of the reasons why European public officials are denying that the problem they face are ones of solvency is because someone might discover that a good deal of the blame for the insolvency is due to what they have done in the past.   One of the nice things for politicians about economics is that the consequences of economic policies usually take a long time to work themselves out.  Because of this people find it difficult to connect the policy with the consequences of the policy or may even fail to identify any sort of a connection. 

This is where work like that provided by Ms. Tett is so enlightening and helpful.      

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