Thursday, 21 November 2013

What are you smoking? The macro-economists supreme weakness: flows vs. balance sheets

In 2008, the financial sector was on the brick of collapse. Even if it accounted for only 4% to 10% of GDP (depending on the country), you could not let it implode. It's not the size of a sector itself that is relevant for assessing its economic importance. It is its connectivity with the rest of the economy. And no other sector is more at the centre of the economic system in a market economy than the financial sector. A feature it arguably shares with the electricity grid. So unless you think that because the electricity industry only accounts for 2% of GDP you can let the electricity grid collapse without causing a devastating damage on the rest of the economy, you cannot let the financial sector implode either (that instead of rescuing it via bail-outs you should rather do it via bail-ins is another story). This is the point that Larry Summers very correctly made at the latest IMF conference (8 November 2013). So far, so good.

But then he goes further and argues that monetary policy became ineffective in the developed world ("liquidity trap") because the equilibrium real interest rate is actually negative! Meaning: the FED, BoE, ECB & Co should keep their ultra-loose monetary policy for many years to come and try to create asset bubbles as without them there isn't any hope for economic growth to take place. On top of it, governments of developed countries should run large deficits and launch a massive programme of public investment financed by central banks monies for many, many years.

Here Larry Summers' "performance" in all detail:
- the video:
- the text version:

Paul Krugman, even goes further. He argues that it would be desirable for the private corporate sector to invest in all kinds of projects, even when their rates of return were likely to be negative at inception (and way, way below their cost of capital), because it would generate employment.

Here Paul Krugman's "performance" in all detail:
- Paul Krugman:

Negative real interest rates as the ideal asset allocation mechanism in a market economy? Asset bubbles as a way to generate sustainable economic growth? The government as a better investor and resource allocator than the private sector? Private companies pursuing projects with negative rates of return to generate demand and employment in the short-run and forgetting the mid-term consequences of it, i.e., sound companies today going bankrupt tomorrow as a result of bad investment decisions and....well...creating unemployment?

Larry Summers' and Paul Krugman were some of my heroes as I was an economics student. What happened? What are you smoking, guys?

To be fair, I don't think that they are smoking anything that they were not smoking years ago. But we all are the product of our education, training and experiences. Paul Krugman and Larry Summers included. And they happen to be academic (macro-)economists by education and training. Their views are simply the result and perfect example of macro-economists' supreme weakness: excellent at analyzing flows, terrible understanding balance sheets.

The reason why US and European monetary policies are ineffective is because the economies are over-leveraged. Balance sheets are impaired across the whole economy. When that happens no matter how low interest rates are, no one is neither willing nor able to take on more debt. The absolute priority is to de-leverage. Banks are impaired (even if they say otherwise) as a high percentage of the credits they conceded are de facto non-performing loans as a result of having been used to finance projects that turned out to have negative rates of return - why else would the borrowers not have been able to pay them back and in fact had to increase their levels of debt over time?

In such a scenario, a debt restructuring across the board is the only quick and effective solution. Followed by a recapitalization of the banking sector via-debt-to-equity swaps (bail-ins). Once this is done, all the problems are solved and monetary policy becomes effective again. Interest rates will start functioning, again, as the signaling mechanism for financial resource allocation across the economy they are supposed to be. Or would anyone not borrow money if he/she suddenly had no debts and lending rates were 2%?

Putting it differently: increasing leverage is a powerful economic growth accelerator until over-leverage is reached. When leverage turns into over-leverage is an interesting academic discussion for which there is no clear ex-ante answer. However, it is very easy to spot when that point is reached.....once it is reached: monetary policy becomes ineffective ("liquidity trap") and debt restructuring across the board is needed.

You don't solve the problem of an impaired balance sheet by trying to artificially increase the value of the assets - if a balance sheet is impaired that must mean that the quality of the assets is bad, i.e., they were not and are not able to generate sustainable positive returns. The result of bad investment decisions. You solve the problem of an impaired balance sheet by accepting that the assets are worth much less than they are accounted for and restructuring the balance sheet's right side, where equity and debt sit.

That public investment in areas where clear positive externalities exist, able to generate a positive impact on the economy's supply side (improvement of education system, internet / telecom infrastructure, transport infrastructure, R&D) and lead to an increase of potential GDP does make sense is undisputed. No one with a reasonable degree of common sense challenges that. But it has to be a complement to a comprehensive balance sheet restructuring in the private and public sector. Not a substitute for it.

PS Look at the Japanese total level of debt (both public and private) at the beginning of the 1950s and in 1989, when the country's two lost decades started. Do the same for the US and Europe: in both cases starting at the beginning of the 1950s up to 2007.

What do you see? A continuous increase in total debt as a % of GDP and since 1989 in Japan and 2007 in US / Europe a completely ineffective monetary policy in terms of generating economic growth. These were the points in time were over-leverage and impaired balance sheets finally revealed themselves.


  1. Bingo!

    Although I think it is a bit superfluous to add to your analysis since I agree with it, but I would like to suggest supplementing bail-ins with an extra set of measures. Balance sheets should be restructured by starting with debt-for-equity swaps at the asset side of banks' balance sheets; bail-ins follow afterwards, that is, if necessary.

    Thusfar, discussions surround the if's and how's of the impact of wounding down insolvent banks through the liability side but that's not where the losses are. The liability side only answers questions to which parties these losses are shifted off to. Stress testing banks and wounding down insolvent ones is perfectly fine with me but if the plurality of structural problems of excessive indebtedness in the real economy are to be addressed, then there is an absolute need to effectively clean up the asset side first. If that is not reason enough, it is the only way of containing losses for creditors so that they are minimized. If you haven't already read it, see Luigi Zingales' "Plan B" for example.

    I am curious for your thoughts on the principles of Zingales' plan / debt-for-equity swaps starting at the asset side of (insolvent) banks' balance sheets. (..on a note aside, in order to adapt his plan to national circumstances some tweaks may be necessary).

    Anyhow, thanks for this post (and your other posts); it is a comforting thought that sanity has not been lost on all.


    Ps. It is not what they smoked, it has much more to do with who granted them finance. After all, Gresham's Law also applies to economic analysis.

    1. I agree with much of the above. The problem I have is it solves only the Banking balance sheet problem. First I would argue this should be done by recapvia equity issuance and then bail in when that was exhausted. The more difficult problem is the consumer. Households don´t have the option to bail-in and if their asset price and income are undermined by the market recognising the true facts. Sure default help, but only for a minor element & one that does not emerge as a renewed consumer. The only solution I have heard was that of Steve Keen, which was too radical for now. That involved not printing money to feed the dead banking system and make the rich richer, but to pay it directly to households with the condition that it automatically came off their debt until/uless they were debt free. This would release the consumer and dissolve the banks over levered customer base.

    2. First off, I agree that Steve Keen's plan is too radical and frankly, I oppose it. No matter how I look at it, Keen argues to artificially create demand while forgetting supply. Eventually, all that freshly minted money, despite it lifts the burden of debtors, leads to one form of inflation or another. And whether this expresses itself in a new asset bubble or in the form of (a potentially extremely inflationary) escape velocity, all this money helps all but one group at the expense of other groups. I agree with Keen that it makes economic sense to help debtors escape a trap of excessive indebtedness, but I disagree and oppose helping out debtors this way.

      What I especially liked in Zingales' plan* is that in a very generic manner, both the balance sheets of banks and households are restructured, possibly leading to bail-ins of bank creditors. Contrary to what you suggest, households do have a bail-in possibility, namely, they can bail in their bank through handing over a stake in the underlying asset (the house) in return for a reduction of mortgage principle. Technically, households own the deed to a house (which is mortgaged) and they have the ability to amend the deed so that their end of the bargain is that they put forward a financial upside to the creditor. This way, a household that is not in need of a principle reduction will not want one because they do not have or feel a financial need to give away a portion of ownership. Moral hazard can be tackled if only it needs a legal framework that manages it. For banks, this is the cheapest and most effective way to clean up their mortgage portfolios.

      Recapitalizations through equity issuance, although an option, is hardly possible given the financial environment. In the current mode of industry-wide undercapitalisation and hidden losses, a bank that announces it will issue new equity is in a way inviting Mr. Market to its funeral and asking market participants to make some arrangements for that funeral to happen. Zingales thought of this and offered a solution for this as well: bail-ins. Basically, equity holders are provided with options to make up their mind what to do once banks enter a (nation-wide) program like this.

      To sum it up, distressed households are helped; banks limit losses which is in the interest of creditors of banks; taxpayers will be happy because they are left out entirely; local housing markets are helped both in terms of price formation (towards a sustainable dynamic) as well through improved supply and demand conditions. Moreover, the government stays out of the market and in my book that's a win-win-win-win-win situation. If this mechanism needed a catchy sound bite, I would call it "qualitative easing": without resorting to inflationary measures, parties are given the framework needed to reduce excessive leverage on their balance sheets.

      Why this approach hasn't been tried is a matter on its own (think MERS in the US; think politics and a lack of a resolution mechanism in Europe).


  2. 1. A first rate analysis.

    2. Secondly; responding to your thought:
    "When leverage turns into over-leverage is an interesting academic discussion for which there is no clear ex-ante answer."

    This raises an important consideration with implications for a lending bank's policies. I would argue that leverage turns into "over-leverage" when new borrowing is needed just to service the existing debt.