After the global financial crisis there has been much talk of the need to tighten our belts. Most is hypocritical as it is used to justify cutting other peoples income or benefits. It is also misguided because the paradox of thrift tells us that it if we all cut spending everyone's income decreases by the same amount and we all just become poorer as a result. However there is one group of people who definitively should be tightening their belts, namely bankers. The current financial mess is the result of banks becoming insolvent because of excessive, risky lending. Banks, unlike any other business entities, operate with incredibly low levels of equity*, at around 2-3%. This means that a tiny (i.e. 4%) drop in the value of their assets (e.g. a small number of defaults on mortgages) can make them insolvent, at which stage taxpayers usually have to step in to rescue them to avert contagion, imposing a large costs on the rest of the economy.
It makes no sense at all for such systemically important parts of the economy to operate with far thinner equity cushions than other businesses. If anything they should be higher. So you would have hoped that bankers would be required to increase their equity cushion to a more reasonable thickness such as 20-30% of assets, which is what most businesses and individuals use. They can easily do this by simply retaining their considerable profits. But banks have strenuously resisted such an adjustment and instead banks executives have distributed these profits out to themselves in the form of very high salaries and obscene bonuses. As a result their equity cushions are still very thin and they remain at higher risk of collapse, which will require an expensive rescue. This is completely insane. How can we allow them to get away with such extraordinarily antisocial behaviour so soon after they almost destroyed our economies?
[*equity is difference between your debts and your assets, usually expressed as percentage of assets. Assets of £100 and debts of £97 mean equity of £3 or 3%. Equity allows businesses to absorb losses without becoming insolvent, acting as a cushion. The thicker they are the more robust the businesses are to shocks like a customer defaulting on it debts]
Sunday, 28 April 2013
Saturday, 6 April 2013
An important speech proposing a major change in macroeconomic thinking and policy
A few days ago Adair Turner, former chair of the Financial Services Authority, made a bold speech in which he made a number of points already made in many of my previous posts about the causes and ways of tackling the global financial crisis. For example, he stated that:
-the global financial crisis was the result of an unsustainable increase in the private sector debt to GDP ratio driven by excessive bank lending, which was mistakenly ignored by mainstream economists and policymakers, who claimed it did not matter. This inflated asset prices bubbles which inevitably burst, causing financial mayhem.
-the subsequent recession is a result of the fact that the private sector are deleveraging, and that government deficits are required to enable this deleveraging. Trying to cut them is therefore seriously misguided and counterproductive.
-deficit spending is healthy when there is a deficiency in demand and should be encouraged as a way of regulating aggregate demand
-efforts to restore growth by increase bank lending are unlikely to succeed and are potentially hazardous as they recreate the problem that cause the financial crisis in the first place.
-banks need to be much more tightly regulated and should have much higher capital and reserve requirements. He makes the important points that all these lessons were learnt following the great depression, but have been forgotten.
Interestingly, he argues that government deficits are financed directly by central banks creating money - also called helicopter money. The reason he advocates this is that deficit spending financed by government borrowing results in a growing government debt. He thinks this is a bad thing because it will have a psychological impact on the private sector. They will worry about the fact that the resulting debts will eventually need to be repaid, and that this will require higher taxes, which will cause people to save now, depressing demand. This is called Ricardian equivalence. A solution to this psychological problem is to explain that government debt just represents net private sector savings, which is a benefit not a burden, and there is no reason why these savings need to be decreased in future. Provided that the government has its own currency and central bank it can set the interest rate on this debt and cannot default on it. In fact it is the safest place for the private sector to keep savings. Government debt serves a useful purpose as a safe asset for banks and investors such as pension funds.
The real difference between deficit spending financed by the central bank and deficit spending accompanied by issuing government debt is that instead of the extra money created by the deficit being kept in non-interest bearing reserve accounts at the central bank it is moved into interest bearing savings accounts at the central bank.
-the global financial crisis was the result of an unsustainable increase in the private sector debt to GDP ratio driven by excessive bank lending, which was mistakenly ignored by mainstream economists and policymakers, who claimed it did not matter. This inflated asset prices bubbles which inevitably burst, causing financial mayhem.
-the subsequent recession is a result of the fact that the private sector are deleveraging, and that government deficits are required to enable this deleveraging. Trying to cut them is therefore seriously misguided and counterproductive.
-deficit spending is healthy when there is a deficiency in demand and should be encouraged as a way of regulating aggregate demand
-efforts to restore growth by increase bank lending are unlikely to succeed and are potentially hazardous as they recreate the problem that cause the financial crisis in the first place.
-banks need to be much more tightly regulated and should have much higher capital and reserve requirements. He makes the important points that all these lessons were learnt following the great depression, but have been forgotten.
Interestingly, he argues that government deficits are financed directly by central banks creating money - also called helicopter money. The reason he advocates this is that deficit spending financed by government borrowing results in a growing government debt. He thinks this is a bad thing because it will have a psychological impact on the private sector. They will worry about the fact that the resulting debts will eventually need to be repaid, and that this will require higher taxes, which will cause people to save now, depressing demand. This is called Ricardian equivalence. A solution to this psychological problem is to explain that government debt just represents net private sector savings, which is a benefit not a burden, and there is no reason why these savings need to be decreased in future. Provided that the government has its own currency and central bank it can set the interest rate on this debt and cannot default on it. In fact it is the safest place for the private sector to keep savings. Government debt serves a useful purpose as a safe asset for banks and investors such as pension funds.
The real difference between deficit spending financed by the central bank and deficit spending accompanied by issuing government debt is that instead of the extra money created by the deficit being kept in non-interest bearing reserve accounts at the central bank it is moved into interest bearing savings accounts at the central bank.
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