Gold – the final bubble, page-3749

SP,

For sure something has to happen to bring some stability onto the financial system. China starts to learn how to play the currency wars, and trillions get written off, markets into spasms...etc etc LOL.

Below is a discourse from Rigoff, on a suggestion of Martin Wolfs (and others), that will be unpopular amongst the banking fraternities, but somehow they have to be dragged into the world of everyday accountabilities, like normal businesses. [Just been into the Imperial Treasury in Vienna, and so reassuring to see the Habsurgs, who had a remarkable empire for 1200 years those were the days .., had a great allure to gold and silver, and its all still there? http://www.kaiserliche-schatzkammer.at/en ]

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The genesis of the crisis, of course, was an enormous build-up of credit in the financial sector,
much of it funded by borrowing that was either explicitly or implicitly government-guaranteed.
Unfortunately, the public nature of some “private borrowing” only becomes apparent when a crisis unfolds, as Carmen Reinhart and I have emphasised in our work. Wolf gives a wide-ranging analysis of the policy issues, including critical but complex topics that he cannot afford to visit too regularly in his Financial Times columns.
In many ways, financial regulation and design are the whole ballgame, perhaps even more than Wolf seems to recognise as I shall later explain. Wolf tackles everything from the dense Basel accords (intergovernmental agreements that set standards for international banks) to the thoughtful UK Vickers Commission (Wolf was a member), to Anat Admati and Martin Hellwig’s 2013 book, The Bankers’ New Clothes, where they argue that banking regulators could bypass a lot of
ponderous problems by simply requiring banks to finance themselves more like normal firms (SHOCK HORROR !!!!). Admati and Hellwig, in particular, argue that forcing banks to move away from their near exclusive reliance on debt finance to more conventional plain equity finance would work wonders.
(Publicly traded companies can raise money from the public either by issuing stock or by selling bonds and other forms of debt. Banks almost entirely rely on the latter, which is precisely why they are sometimes so vulnerable.) Admati and Hellwig would triple or even quadruple current capital requirements.

There are a number of plans for increasing bank capital. One influential scheme, trialled by Swiss regulators, that is a halfway house between equity and debt, is to introduce “contingent convertible bonds.” These are like regular bonds except that they change to equity if banks are suffering a “systemic crisis” that threatens the larger financial system. Wolf is right to worry that contingent convertible bonds involve extremely arbitrary and political decisions—what exactly, is the threshold for a “systemic crisis”? He seems to come down in favour of banks funding themselves more with simple equity, though he rightly worries that there is no magic formula that tells us quite how much is enough.

One problem, of course, is that banks can ingeniously come up with ways to increase the risk
they take even faster than regulators can come up with ways to increase the default cushions they are supposed to have. As a result, there is a real chance that taxpayers would still sometimes find themselves making huge transfers to banks.

An important idea to get around this “moral hazard” problem is the clever proposal of Jeremy
Bulow, Jacob Goldfield and Paul Klemperer. They would require banks to fund themselves
through equity and a new kind of debt that, like contingent convertible bonds, is a sort of hybrid that allows banks to make payments in kind instead of in cash when their share price falls too far.

In the end, Wolf concludes quite plausibly that all these ideas address the symptoms of bank
instability, but not the ultimate cause. He argues that any real long-term fix has to end the financial sector’s ability to generate money and near-money alternatives. Banks tend to make loans that are long-term, such as mortgages, but finance these loans with short-term debt arrangements. It is precisely this so-called “maturity mismatch” created by short-term debt that exposes the system to runs and losses of confidence. The most direct way to eliminate this vulnerability, Wolf argues, has to start with some form of “narrow banking” where all short-term debt liabilities have to be fully backed by government assets (!!!, real businesses do not do this???).

Ordinary small business loans would have to be handled through instruments that are explicitly risky, for example through mutual funds that hold pools of loans.
Although narrow banking and short-term debt restrictions would be a sea change in how the
financial system works in practice, the idea is straightforward in theory.
Indeed, International Monetary Fund (IMF) economists Jaromir Benes and Michael Kumhof
offered a detailed analysis in their 2012 paper “The Chicago Plan Revisited,” named after the
original Chicago Plan advanced in the 1930s by Frank Knight, Irving Fisher and Henry Simons. In his 2011 book Jimmy Stewart is Dead, Laurence Kotlikoff offers another modern-day variant of the Chicago Plan. As these authors show, there is no reason in principle why such a system cannot work in our era, though there are many subtleties.

For one thing, there will always be innovators trying to skirt government regulation and issue
money-like securities. Finding ways to avoid regulation is arguably a large part of what is going on in the virtual currency world, with Bitcoin a leading example. There is also a great deal of genuine innovation in this space. The bottom line, though, is that as long as the government periodically clamps down before financially disruptive innovations reach systemic proportions, countries should be safe from massive financial crises. True, history suggests that the typical government rarely exhibits backbone in good times when risks are hidden. Yet this self-awareness is hardly an excuse for fatalism.

As Wolf notes, by extending its monopoly over monetary instruments, the government would
gain massive funding and revenue potential, since the issuance of money-like instruments is a
highly profitable business. Narrow banking would certainly go a long way to ameliorating the
long-term public debt problems we will come to later. It might mean bank stocks are worth much less, similar to the way in which the minicab app Uber is likely to reduce the worth of taxi licenses (!!!)

There are also serious issues of transition to a Chicago Plan world, not least because most of the largest banks are multi-national and answer to multiple regulators. Moreover, it is important to remember that addressing banking crises does not address all forms of debt crises. Creating a giant super-monopoly government bank with a balance sheet an order of magnitude greater than anything that exists today raises many governance questions.

Although Wolf makes a coherent case for considering this radical reform, he is rather
circumspect on just how bad things will be if we don’t do it. For one thing, he seems to agree with Chicago economist Robert Lucas (whom he otherwise sharply critiques) that if the US financial firm Lehman Brothers had not been allowed to fail, the financial crisis would have been far less acute. But if one really believes this, then why take all the risks of radical change? Anyone advocating a radical fix, as Wolf does, needs to convert the many politicians, financiers, regulators and even academics who conclude that the
real lesson of the crisis should be to never let big banks fail. (This is certainly not my position.)

Let’s face it, any policymaker who could go back in time would try to find a way to save Lehman. But would that have been enough? The subprime housing market was already collapsing well before Lehman’s fall in September 2008. After rising dramatically for many years, US housing prices had already started to fall in late 2006 and the trend was accelerating by 2008. Hundreds of billions, if not trillions of dollars in bad loans had to be absorbed, and the badly under-capitalised US financial system could not do that without massive taxpayer assistance. Indeed, as early as March 2008, the Federal Reserve had to intervene to prevent a default by the financial firm Bear Stearns, precisely because it had lost so much money on subprime loans. Technically, Bear Stearns was bought by another bank, JPMorgan, but there was huge taxpayer assistance as the Fed took over part of its junk debt portfolio.

The government had also bailed out the supposedly private mortgage giants Freddie Mac and
Fannie Mae at the beginning of September 2008. Suppose it had then bailed out the financiers at Lehman. Would the bailouts really have stopped there? Who would the government have had to bail out next? Merrill Lynch, Citibank, American International Group? Does anyone seriously think a continuing series of financial bailouts would have been politically feasible? Without question the best and most effective approach to the problem would have been to bail out the subprime homeowners directly, forcing banks to take losses but keeping them manageable.

For an investment of perhaps a few hundred billion dollars, the US Treasury could have saved
itself from a financial crisis whose cumulative cost, counting lost output, already runs into many, many trillions of dollars. Instead of “saving Wall Street,” a subprime bailout would have been targeted, almost by definition, at lower-income households. But unfortunately, this approach too would have been politically impossible prior to the crisis.

By mulling whether the crisis could have been mitigated simply through better tactics during the weekend of 13th-14th September 2008, Wolf undermines his own case for radical reform. To be clear, I think that a major financial collapse would have been very difficult to avoid regardless of how Lehman was handled. Thus Wolf is fundamentally right: radical change is needed.​