Arnold Kling  

Today on the Eurozone Crisis

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Perry Mehrling writes,

Now comes the latest deal over eurozone fiscal rules, presumably the deal that ECB President Draghi asked for last week. It is a deal about sovereign budget discipline. But if I read Draghi's speech right, we should not expect him to be buying sovereign debt. (That will be the IMF's job, if anyone's, and with strict conditionality; details to be sorted later.)

Instead, he'll be buying bank debt, specifically the debt of the banks that hold the sovereign debt. Banks currently borrowing from their own national central banks will therefore be able to repay, and consequently the national central banks will be able to repay the ECB. This takes national central banks out of the picture on the asset side.

Thanks to Mark Thoma for the pointer.

So, in terms of the two-drunks model, the fact that the European Central Bank will buy bank debt rather than sovereign debt means that the ECB will support only one of the drunks. Of course, this drunk (the banks) will in turn be trying to prop up the other drunk (the deficit-spending governments). Thanks to our wise technocrats, the two drunks will continue to lean on one another and stagger along.

The challenge for the imminent Eurozone summit is to come up (once again!) with an agreement that sounds definitive to the markets and yet is not truly binding on current political leaders. The markets want maximum certainty. The politicians want maximum vagueness. As for the outcome of the summit, my money is on the politicians. (Actually, if I were really putting my money on that outcome, I would be shorting the stock market. Instead, I am just trying to maintain a portfolio with a low beta.)

In other news Tyler Cowen points to a Business Week story on the dilemma faced by international bank regulators.

"One of the central pillars of the Basel III framework is the notion of a risk-free asset class," said Matthew Czepliewicz, a banking analyst at Collins Stewart Hawkpoint Plc in London. "That central pillar is disintegrating. Basel is quite clearly going to have to be revised."

Remember my view of financial intermediaries. The nonfinancial sector wants to issue long-term risky liabilities and hold short-term riskless assets. The financial sector accomodates that by doing the reverse. The problem now is that the financial sector has gotten too big. The amount of supposedly risk-free liabilities that have been issued far exceeds what is actually possible, given the real investment opportunities that are available. If the regulators do not want to shrink the financial sector, then they have to try to prop it up, in part by labeling securities as low risk when they are not.

Which is how the financial sector got to be to big in the first place. The regulators labeled mortgage securities as low risk when they were not. Then they labeled sovereign debt low risk when it was not.

Since 2008, it has seemed to me that it is imperative for the financial sector to shrink. Instead, the world's bank regulators have managed to maintain the size of the financial sector. In the technocrats' view, they have saved us from an awful cataclysm. I worry that they are mistaken.

Have a nice day.

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CATEGORIES: Eurozone crisis

COMMENTS (4 to date)
Mike Rulle writes:

The current Euro crisis brings to mind Marx's famous quip about Hegel.

"Hegel remarks somewhere that all great world-historic facts and personages appear, so to speak, twice. He forgot to add: the first time as tragedy, the second time as farce."

Randy writes:

So the financial sector is too large but its role is to accommodate the demands of the nonfinancial sector to hold safe assets. Is that not implicitly saying that the quantity of the demand for checking and savings accounts is too large to sustain? If so, it seems like that would be where the shrinkage needs to occur. I can understand the thinking on how to do that from the perspective that income inequality is driving this demand for financial assets. I'm less sure how that would fit into the PSST perspective but would be interested to hear.

"The problem now is that the financial sector has gotten too big."

There is little question about that, although one could argue that servicing big customers requires big balance sheets. Nevertheless from an ethical or public policy standpoint, I don't see why anyone other than low to moderate income individuals or small business owners should continue to enjoy the Nirvana of 'risk-free return'.

"So the financial sector is too large but its role is to accommodate the demands of the non-financial sector to hold safe assets. Is that not implicitly saying that the quantity of the demand for checking and savings accounts is too large to sustain?"

No, it's just saying that too many people/corporations who should be grown-up enough to shoulder their own risk are insisting on borrowing from what Paul McCulley would term the US Government "Bank of Dad" -- without also honoring their reciprocal obligation to serve the public interest.

It seems clear that the banking sector (shadow and otherwise) has substantial overcapacity. How can we fix this with the least pain to those who will be devastated by a second major depression/recession?

What's happened in the past is only useful as it leads to better policy. So, here are four forward-looking questions for pundits and policy makers:

1. What new regulations/tax structures/policy can move banking and shadow-banking corporations (BSBC) towards a more rational and functional assessment of risk?

2. What regulations, etc. will most effectively protect the most vulnerable in our society from the misdeeds or miscalculations of the BSBCs?

3. What mechanisms such as government bankruptcy and resolution authorities, collective trusts gleaned from industry taxes, and/or other backstop plans will most effectively protect the global economy in the event that the BSBCs once again screw up their risk assessment and hedging?

4. To what extent have Dodd-Frank and the latest Basil accords already reduced risk enough so that governments and taxpayers and/or sovereign bond holders have less to worry about?

My guess is that if you effectively answer and implement regulations that address the above four questions you will automatically encourage the BSBCs to gradually downsize and/or simplify their balance sheets to the point where risk is more manageable.

Shayne Cook writes:

To Mary Ellen McCarthy:

Your questions are interesting, but are based on several "conventional wisdom" perspectives that are at worst fully defective and at best misleading. Specifically, those defective/misleading perspectives are:

1.) That risk is somehow binary - assets are either riskless or risky. As an investor you are aware of the fact that risk is a probability distribution, not a single state.

2.) That there is or even can be such a thing as a "riskless" asset/investment. The current European situation (as noted in Arnold's post on the Basel dilemma) makes it abundantly clear there are no riskless assets/investments.

3.) That somehow banks (your BSBC entities) are, or even should be, fully and solely responsible for assessing risk. Banks (the financial system) are fundamentally an intermediary - effectively a "broker" - between potential creditors and potential debtors. Ultimately, it is the potential creditors' responsibility to evaluate and bear the burden of risk of lending to/investing in any asset. Note that the various "bailouts" of the past few years, bailed out creditors, not banks, per se.

4.) That there supposedly is - or even can be - some ideal state of regulation that can eliminate or even reduce risk. Not possible! Risk, to whatever extent it exists relative to any asset, exists blissfully independent of any and all regulation. See MF Global. As Arnold notes often, enhanced regulation merely hides risk, and/or provides a path to inflict it on non-participants in the creditor/debtor contract. Your question 4 is a precise example of the myth of regulation - neither Basel, nor Dodd-Frank, nor any other regulation "reduced risk".

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