Is Extend and Pretend Coming to an End?

I can't remember where I first saw the phrase 'extend and pretend' (so apologies to the originator for not citing them), but it is a good expression to the reaction to the economic crisis. Another good one is 'kicking the can down the road'. Both expressions concern the endless (and often hidden) bank bailouts, the fiscal stimuli and the monetary policy that has been the reaction to the economic crisis. What they have been attempting to bury with their policy levers is debt. Or rather, debt that is not going to be repaid. Consumer debt accumulated in the build up to the crisis, sovereign debt built up in the aftermath (and to some degree in some states before the crisis). Tied in with the rise in debt, was the rise in asset prices, as floods of borrowed money created booms.

In Europe, to add another metaphor to the many, the wheels look like they may be about to fall off the Euro bus. Yet another metaphor is contagion, but (as I mentioned before) a better metaphor is that the financial doctors have become better at diagnosis. It is not a contagious disease that is hitting Europe, but the cancer of debt fuelled consumption. We had a bust back in the days of Lehman's and, instead of taking the pain at the time, the reaction was to extend and pretend. Whatever happened, intoned our policy gurus, we must not repeat the Great Depression. And, with the magic of their policy levers, that is what they claim to have done. Avoided another Great Depression. The European Central Bank has thrown everything but the kitchen sink at the Euro crisis. The IMF and the EU, and even the Federal Reserve, have bailed out, and the bailees have to varying degrees tried to reduce their consumption.

If only we had not imposed 'austerity' is the cry of many. But who was going to continue to fund the borrow and spend policies? In Europe, the only taker stepping up was the ECB, who lent money to insolvent banks so that they could buy the debt of their insolvent governments. You may note here that there is something very wrong with the concept of austerity; it still includes huge amounts of borrowing by governments. No country is stopping their borrowing, they are just trying to decrease their rate of borrowing. That borrowing is going to support ongoing unaffordable consumption. In the meantime, the background is one of accumulation of mountains of debt.

Alongside the attempt to reduce the rate of borrowing, there has been shrinkage in many economies. As the economy shrinks, so does the ability to service the existing debt. It is not, as the growing legions of anti-austerity commentators claim, that austerity is causing the crisis. Their answer is to return to growth in the rate of debt accumulation in order to hide, for a little longer at least, the underlying fundamental problem. Many countries are consuming more than they produce, and have no real prospects of being able to pay back the money they have borrowed to over-consume, or to continue to live at the level they have become used to. They are, to quote my first ever post, poorer than they think. They mistook debt for wealth, and must now learn to live based on their own productive output.

The only real step that can solve the European crisis is to just stop borrowing. Alongside this, there needs to be a recognition that many countries have, in the most basic terms, an unaffordable lifestyle. It is very simple. They must accept that they are poorer than they think. In order to return to stability, that relative poverty must be accepted. In crude terms, over the economy as a whole, the borrowed and consumed money is the equivalent of adding to the salary of every individual within that economy. As the borrowed money flows through the economy, it is adding unaffordable goods and services for consumption. The borrowed money indirectly subsidises consumption, and in some cases does so directly.

The solution is simple, and always has been. Stop borrowing money. The Greeks complain of Germany forcing them into austerity by diktat. However, Germany is not forcing any country into anything. It is saying that, if you wish to continue to borrow, you must do something to ensure that you can repay the money. If Greece wishes to restore its sovereignty, the answer is to stop borrowing. It really is that simple.

However, in Greece, and in so many countries, there is a reluctance to accept this. The standard of living that they have enjoyed on borrowed money is seen as a right. Civil servants protest, unions protest, and anti-austerity leaders demand the lifestyle that the country cannot afford. They all demand the status quo of pre-crisis borrow and consume, but just do not accept that the lenders are no longer there. They are all demanding the impossible, and their populations believe that the impossible is possible. We can see how seductive the calls for greater borrowing and spending are. If you are a civil servant thrown out of work, and you have a mortgage and family to support, it just seems unfair.

However, when faced with pay cuts, the same civil servants will protest, even though their collective salaries are unaffordable. The same with the workers throughout the economy. They simply are not, collectively, productive enough to support their lifestyle. The answer is unpalatable. It is cuts in wages and benefits to the point where the economy as a whole returns to competitiveness. How these are spread over the economy is an issue of politics, but the reality is that this is the only answer. The reality is that, for all but the most productive economies, the price of labour must fall. There is a glut of labour in the world, and this is resultant from the emergence of the emerging economies. Unless labour is exceptionally productive, there is no other way out.

If we take the example of Germany and Spain, German workers and Spanish workers are in direct and indirect competition with one another. German workers are, in aggregate, more productive than their Spanish counterparts, but this is not reflected in the costs of workers. If it were, then Spain would be able to balance their trade with Germany. There are no trade barriers, and we have to just conclude that, in aggregate, Spain's companies cannot compete with those of Germany. I am not just talking about wages here, but the overall structure and cost of the economy as a whole. This is why I included benefits in my earlier point. The many benefits provided by governments are an indirect cost of labour. The cost of labour in the economy is a critical factor in competitiveness. It is the productivity of the collective output of the economy in relation to competing economies.

These underlying differences in the real productivity and competitiveness of economies were both obscured by debt accumulation. They can continue to be obscured by debt accumulation, but this simply prolongs the moment when reality must finally emerge. At this stage, we cannot know whether the ECB, EU or IMF might just pull some new lever to extend and pretend a little longer. However, it is starting to look like extend and pretend has reached the limits. It is starting to look like there is no road left to kick the can down. The cuts in wages and benefits looks to be the next step. This process looks likely to be disorderly, and that is the real pity. It could have been gradual, controlled, and less painful. The way it will take place, the degree of pain, can be laid directly at the door of extend and pretend. 

Regulation and the EU crisis

The current spat between the UK and France over whose economy is in worse shape is like two people, one with both arms broken and the other with both legs broken, arguing about who is in better condition to play a game of tennis. All they are achieving is to focus attention on the fact that both of them are not in a fit condition. In doing so, to mix metaphors, they are both placing each other further into the firing line. As it is, the firing line is already broadening:

Bank of America Corp., Goldman Sachs Group Inc. and Citigroup Inc. had their credit grades cut by Fitch Ratings as the impact of financial regulation and market turmoil weighed on the industry.

The lenders’ long-term issuer default ratings were cut one level to A from A+, Fitch said yesterday in a statement. Barclays Plc, based in London, Credit Suisse Group AG, Deutsche Bank AG and BNP Paribas SA also had their grades lowered.

[and] Credit ratings of the world’s biggest lenders have come under pressure amid weak economic growth and doubts about whether European regulators have done enough to end the sovereign-debt crisis. Lenders in the region must raise about 114.7 billion euros ($149 billion) in capital to help address the turmoil, the European Banking Authority said last week.

Fitch downgraded Barclays and Zurich-based Credit Suisse to A from AA-, while lowering France’s BNP Paribas and Deutsche Bank to A+ from AA-. Fitch corrected an earlier version of its statement to announce that Frankfurt-based Deutsche Bank was cut one level instead of two. Morgan Stanley’s long-term issuer default rating was affirmed at A.

And, of course, sitting underneath all of this is sovereign debt exposure. In 2008, I wrote a post which clearly lays the blame for this debacle in the right place; the banking regulators. I used a Bank of England paper on the impacts of the Basel accord framework (from the Bank for International Settlements, BIS) to highlight the problems the regulators were causing; in particular the idea that risk could be identified and codified by a group of experts. This is what I had to say about the first Basel Accord:

So here we have a determination of risk which assumes that, for example, OECD based banks are safe. We now see that this is not the case, and many of the banks in the OECD would, without government support, now be bankrupt. We also see that lending into government securities is also 'safe' but, as I have argued elsewhere in this blog, countries such as the UK are extremely unsafe at present.

So here we have the essential problem. A bunch of very smart people got together and said that they were able to determine levels of risk. Their conclusions have been shown to be wrong. In particular, OECD banks have demonstrably been shown to be, in a very large number of cases, unsound. I will reiterate this point once again - they were wrong.

Another point in the Basel I accord was that it creates a perverse incentive to lend to governments. Investing in government debt means that money is not being invested into potentially wealth creating investments in the private sector. It also virtually guarantees that government will have access to credit, regardless of whether the governments are acting responsibly or irresponsibly. Such guaranteed provision will almost certainly have been a factor in the growth in Western government / OECD debt. However, it would be impossible to prove one way or another.

 For Basel II, I had the following to say (the quote is from the BoE paper):

Another interesting feature of Basel II is that the accord put the credit rating agencies centre stage in the assessment of risk:

Under the standardised approach banks will slot assets into weighting bands according to ratings from ligible rating agencies (ie recognised by national
supervisors in accordance with specified criteria).

The BoE paper acknowledges that the rating agencies may be no better than the banks at assessing risk, but fails to acknowledge that there is a central conflict of interest - that the ratings agencies are paid for conducting the rating by the banks themselves. The importance of the poor preformance of these ratings in the current financial crisis can not be overstated. However, they were critical to the entire Basel II system:

Exposures to borrowers without a credit rating will be placed in an unrated band that will carry a 100% weight (ie 8% capital charge), but regulators are requested to review the default experience of the particular market (and individual bank) to decide whether this is sufficient. Undrawn facilities to corporates of less than one year, which currentlycarry a zero weight, will be weighted at 20%.

At the heart of all of this regulation is an unfounded belief that, somehow, there are a bunch of people with sufficient wisdom to determine risk, and therefore create a system in which risk of failure is abolished. Such a point view can only do one thing - create complacency. It creates a situation where, provided you meet the rules, you must be sound.

So here we are, years later, with banks having gorged on mountains of 'safe' sovereign debt (as a note, in some financial jurisdictions, they continued to ask banks to report based upon Basel I), and the ratings agencies playing 'catchup' with reality in their issuance of downgrades. Just to add to this wonderful array of regulation, the Basel III accords, a response to the crisis, are now about to be implemented and will require banks to hold larger capital buffers (see here for a summary from BIS). Although market pressures were already leading to banks increasing their buffers, the impact will be for banks to conserve capital to meet the new requirements with implementation of the rules in 2013. In light of the problems of 2008, this might seems like a good idea, but is closing the stable door after the horse has bolted. Or if I can stretch the metaphor, slamming the stable door shut whilst the horse is half way out of the door.

What really worries me however is the tweaking of the principles of Basel II into the overall structure of the Basel II accords (see full document here, note 1). For example, the new accord places greater emphasis on stress testing, but remember this:

When the European Banking Authority (EBA) published the results of ‘stress tests’ on 90 banks across 21 countries in the EU in July 2011, Franco-Belgian bank Dexia was given a clean bill of health. Barely three months later, however, Dexia needed a €4bn bailout package. The bank had been unable to raise the cash it needed on the financial markets, largely due to concerns about its ability to withstand losses on its €3.4bn exposure to Greece.

Also, for the external rating of assets, they seek to mitigate what they call 'cliff effects' (which I have understood to be 'falling off'), but the ratings agencies are still front and centre alongside the bank's internal risk assessment. The internal risk assessments are seen as an additional check:

Finally, the proposal will seek to reduce to the extent possible reliance by credit institutions on external credit ratings by: a) requiring that all banks' investment decisions are based not only on ratings but also on their own internal credit opinion, and b) that banks with a material number of exposures in a given portfolio develop internal ratings for that portfolio instead of relying on external ratings for the calculation of their capital requirements.

Just to add to the interest and conflicts of interest, for example Moody Analytics boasts that their systems are used by the major banks in supporting Basel I, II and III:

We also provide an integrated economic capital solution for Pillar II ICAAP requirements, as well as an internal rating framework with proprietary and customizable models and scorecards. Additionally, we also provide solutions that allow you to allocate and price risk more effectively and to integrate risk management into the business at the point of origination, increasing operational efficiency and optimizing risk and return, which will be critical in a world with higher capital requirements. Our products are complemented with comprehensive analysis and stress testing tools and expert advisory, implementation and customization services to assist you in all phases of your project.

This will be the same organisation that has, in recent times, been an exemplar of effectiveness in spotting high risk assets, as well as objectivity. For those of you unfamiliar with Moody's I pulled this story up from the WSJ to illustrate the point:

Yuri Yoshizawa, managing director of global structured credit, intends to leave the Moody's Corp. unit at the end of June, a person familiar with the situation said Friday. This person said Ms. Yoshizawa made the decision to step down. She couldn't be reached for comment.

The operation overseen by Ms. Yoshizawa was criticized as an example of what went wrong when rating firms analyzed CDOs and other mortgage-related deals before the worst of the financial crisis. Lawmakers and other critics say ratings firms like Moody's awarded their highest ratings to questionable mortgage bonds in order to win business from issuers of the bonds.

Collateralized debt obligations were among the hardest-hit investments during the crisis, causing tens of billions of dollars in losses for investors, many of whom were attracted to their high ratings.

At a Senate hearing last April, Ms. Yoshizawa was prodded about the back-and-forth between analysts and bond issuers as the analysts worked on ratings for new bonds. "There was always pressure from banks," she said, noting that the relationship could get contentious and "very abusive."

Emails between Ms. Yoshizawa and Moody's colleagues emerged during the investigation by the Financial Crisis Inquiry Commission, a panel formed to explore the causes of the crisis.

An October 2007 email showed that the firm's market share in CDOs had fallen to 94% from more than 98%. In her reply, Ms. Yoshizawa asked colleagues to "take a look at the deals we didn't rate … to double check the information and to let me know any of the 'stories.' "

Some critics cite the email as an example of pressure on Moody's analysts to win business. Ms. Yoshizawa told lawmakers last year that she couldn't recall ever removing an analyst from a transaction as it was being rated because of arm-twisting by banks, though she said future deals might be assigned to a different analyst.

So here we have the situation. Banking regulations determined that OECD sovereign debt was safe, banks gorged on the debt, and the debt was not safe. As Basel was adapted, it placed ever greater influence in the hands of ratings agencies who have a track record of being hopeless at assessing risk, have chronic conflicts of interest, and who only manage to downgrade assets at the point at which they are about to collapse (if not after they have collapsed). On top of this, the internal risk assessment looms large. It is hardly inspiring of confidence.

Most worrying is that, those who are determining policy think that this is all a good idea. Now that really does present a worrying picture.......


Note 1: I have not read the whole document (not an easy read, but interesting in places), but summaries can be found elsewhere.

A Crescendo of Crisis - Explained?

Even though I have a hectic schedule at the moment, I could not resist the urge to post. I opened up Reddit, and several news sources, and it was interesting to see the brewing of so much potential crisis. For the sake of ease, and a sample of the point, I will use the Daily Telegraph to illustrate the point. The headlines and quotes are as follows:

Euro Reaches its Eleventh Hour

The German chancellor and the French president were barraged with pleas from political and financial leaders to reach agreement on bailing out Greece – or risk the collapse of the single currency.

The leaders have been told that today's crucial summit in Brussels was the "last chance saloon" for the euro project.

Wall Street Paralysed by US Debt Talks

The White House and Republicans and Democrats in Congress have 10 days to raise America's $14.3trillion debt ceiling. Failure to do so would see the government default on its debts, which Federal Reserve chairman Ben Bernanke has warned would be a catastrophe.

Investors' confidence that politicians would avoid that outcome has dwindled as the deadline approaches.

And for the UK, we have a commentary titled 'Britain's deleveraging nightmare threatens its triple A rating'. This is a quote from this commentary, and a chart from the same article follows:

Yet a substantial part of the Chancellor’s plans for eradicating the deficit rely on quite brave assumptions about the scope for future economic growth. With nine months of economic flatlining now under our belts, these assumptions are looking ever less credible. The Office for Budget Responsibility will almost certainly have to trim its forecast of 1.7pc growth for this year in its next update, and many will begin seriously to doubt its independence if it doesn’t adjust longer term forecasts down too.

In other words, the whole economic strategy hangs on a quite slender thread which could easily break and plunge the UK into the same vicious cycle of one austerity programme after another that has been forced on the European periphery. Now look at the graphic below, from a recent update to the McKinsey Global Institute’s study into the economic consequences of the credit bubble.

It is really not difficult to see the commonalities in these stories, all of which are about the problems of sovereign debt. The most interesting point in the story above is that the author, Jeremy Warner, recognises the real problem; that paying off the debt has hardly begun (in fact all the countries in question are still running up more debt).

In the wake of the so-called 'financial crisis', governments and central banks have sought to borrow money and flood the world with money as their respective solutions to the problems that they saw developing as a result of the crisis. These were the magic bullets that would pull the world back from the brink of another great depression. Lined up behind both policies was a mainstream economics profession that sought to justify these actions, with argument isolated to the extent, breadth and detail of the policy. There were, of course, some exceptions, notably the Austrian economists, who railed against the policy solutions and were largely ignored by policy makers.

What we have seen since is a roller coaster ride. As the policymakers pulled their macroeconomic levers, they would promise salvation and that they would 'fix' the world economy. The same theoretical models that failed to see the oncoming problems would now fix the world economy. Well, I have a question for these titans of economic theory; does it look like it is working, or are the scale of the problems just getting larger and larger? The most extraordinary thing about the mainstream economics profession is that they simply refuse (as an economics professor described to me) 'to look out of the window at the world around them'. They are firmly fixated upon models which have already failed, and continue to fail as even as they keep on using them.

At the heart of the problem is that they have forgotten what economics is supposed to represent, which is the exchange of labour (however subjectively that labour might be valued). If person A uses their labour and makes item X, and person B wants item X, person B must offer something from their own labour which person A wants in exchange. Whilst it is quite possible that person A will give item X on credit, at some point person B must start giving person A something that they want. If not, it is likely that person A will no longer give person B credit (unless they are a charity or a fool). It is really not that difficult to understand.

If we scale up these simple principles, it is apparent why the macroeconomic levers are causing more harm than good.

Lets say that person A is making item X and they are willing to exchange two of item X for one of item Y made by person B. When they exchange two of item X for one item Y, all is well and good. However, if we see that person A is regularly exchanging three of item X for one of item Y but ask that in the future person B will give additional item Ys, then they are giving credit. This is all ok, as long as person B is able to return the additional item Y in the future. The problem arises when this is the situation:

• Person B is buying 12 item X per year.
• Person B can make 5 item Y per year for exchange, unless they reduce their own consumption of item Y (4 per year).

What we see is a shortfall in the capacity to ever return the owed item Ys - unless of course the following take place:

• They reduce or forgoe their consumption of item Y
• They reduce of forgoe their consumption of item X
  

Now, it is quite possible that person A will provide item X on credit for a good long while. However, unless person B is able to dramatically increase their output of item Y, there is a point at which they must reduce their consumption of item X or Y. When credit is offered, it is done so on the basis that it will be repaid at some time in the future (+with interest). This is completely obvious.

The problem for person B is that their lifestyle has been based upon consumption that can not be sustained in the long term. In fact, they must reach a point at which their overall consumption equals their total output of Y minus the number of Ys owed to person A (according to how the repayment is structured). Prior to this, their consumption was total output of Y + the credited amount of Xs. If we think on this a little, we can see that the move from taking credit to repayment of credit is problematic for the quality of life of person B. They either have to reduce consumption, or increase the amount of labour that they do in order to continue to consume as much as they did when they were taking credit. The only other possibility is that person B manages to find a new technology or process which will allow them to make item Y faster, or a new item which, relative to person B's total input of labour, is valued more highly by person A.

In absence of the last option, there is no escaping the fact that person B will see their quality of life negatively impacted; either through less consumption or through more labour. In both cases, person B is poorer than they thought that they were.

So how do the macroenomic solution stack up against this fundamental reality of economics?

First of all, let's look at printing more money and other monetary solutions. Do these in any way increase the overall capacity to produce Y, or create a new item which will be valued more highly by person A? The answer is: 'No'. What it does do is to reduce the amount of Ys that are owed to person A, thereby cheating person A (they use the devaluation to reduce person A's capacity to buy item Ys, as the credit is held in abstract monetary units rather than in units of Y). The knock on effect of this will be that other people will see person A being cheated, and will no longer trust person B with credit. In all cases, as person B refuses to give any further credit to person A, there will be less of item X for person A to consume.

However, there is something interesting in this option. In printing money, the value of the medium of exchange between person A and B has shifted. In the real world, person A and B represent a large number of people consuming more variety of goods than X and Y, with money acting as the medium to reduce complexity in transactions. In reducing the value of the money for exchange with persons B, the ability of persons A to individually exchange their Y products for X products is reduced. In this way, they have been made poorer and are less able to consume X products. In the real world, if I am paid in £s and the value of £s reduces in relation to Euros, I am less able to buy as much Belgian beer as I was before - unless the amount of £s that I am paid is increased in relation to the fall in value in relation to the amount of X goods that I buy. For example, in the UK, inflation is eroding spending power, as wages are falling behind inflation.

This is a way of adjusting the consumption of X goods by individuals, and reducing the amount of debt growth as a result of reducing consumption of X goods. It is simply another mechanism to reduce the quality of life of person Bs, but doing so in a way that is less directly obvious.

How about borrowing more? This appears ok in the short term but is just making the problem worse in the long term. For a while longer, it is possible for person B to consume as much item X and item Y as before, but only at the cost of greater reductions later. I think that there is no need at this stage to point out the obvious dangers in this approach. However, it is worth noting that the borrowing takes place without the explicit expression of the future cost to quality of life. This is the way that politicians buy votes of voters now, at the cost of quality of life in the future. It is simply dishonest. The voters will have a poorer quality of life in the future - unless person A who is giving credit is cheated (see earlier discussion). In either case, the politicians are not telling the truth.

Whilst it is possible that somehow Person B will find some way to increase output/create a new item to exchange at higher value, this is (at best) a gamble. Also, if this outcome were achieved, without the overhang of debt, everyone would be better off in proportion to the improvements in output that this represents. This improvement in quality of life will be diminished by the necessity to repay past debts + interest.

I really do not think that any of this very complicated. There are complexities in the systems that are operational in economies, but the underlying principles upon which those systems rest are relatively simple. The complexities of the operations simply serve to hide/obscure the very simple principles. In the case of the mainstream macroeconomists, they are buried in the complexity, and never seem to pause to think about what sits underneath the complexity. This is why their solutions are so fundamentally wrong. They simply do not understand what they are looking at, and never look out of the window at the world.

Note: This is a hurried post, and I hope that the logic follow, and more importantly is expressed in such a way that my intended meaning is conveyed. Please feel free to point out errors in logic/expression where you find them. Also, if you disagree, as ever, feel free to point out why.