In this issue of The Institutional Risk Analyst, we examine the strange worlds of Basel III and US fiscal policy. These are but two examples of questions which ought to be simple matters of addition and subtraction, but instead operate in the realm of mysticism - that is to say, economics.
Last week US regulators finally capitulated and announced a delay in the implementation of the Basel III bank capital rules. We hear that a serious reassement is underway. The reasons for the delay are many, but more than practical concerns about how to implement the complex rules is the realization that higher capital rules and other regulatory initiatives will likely put the western economies into a prolonged recession.
For several decades now the US and other industrial nations have been engaged in a collective delusion. The fantasy says that public and private debt can be employed to maintain nominal economic growth without any downside effects such inflation or falling real incomes. The corollary to this democratically agreed escape from reality is that global financial institutions can be managed in a safe and sound manner even as the governments which regulate (and sponsor) them behave more and more recklessly when it comes to fiscal policy.
The conflict between the policies of the G-20 central banks and the Basel III capital rules is striking and, to us at least, an obvious example of how the scientific is instead mystical. Nobody ever asks, for instance, whether implementing Basel III will not work against the purposes of QE3 and the other anti-deflation policies being pursued by the US central bank. Even as the G-20 governments pursue fiscal and monetary policies that can only undermine the soundness of banks and other entities, we try to comfort ourselves by taking tough about bank capital.
Former FDIC Chairman Sheila Bair, for example, often asks us if we don't need to increase US bank capital levels. Our answer is not really. The US banking system is de-leveraging at an alarming rate and causing effective capital levels to rise. With the grey market, non-bank financial sector running off and most banks also making fewer loans than are required to keep pace with credit redemptions, the overall credit picture in the US is deflationary. To paraphrase the great American economist Irving Fisher, without private credit growth you cannot create jobs.
Indeed, the capital levels in the US banking system are already so high in historical terms that the SEC is increasingly at odds with US bank regulators over releasing loan loss provisions as default rates decline. Adding to bank capital levels will only intensify the debate over whether banks are artificially understating earnings by keeping capital levels above the level required to absorb likely losses. But bank earnings are just the first concern.
The more profound question that nobody seems to discuss is whether higher bank capital levels would have made any difference in the dark days of 2008, when the lack of liquidity in the financial markets almost cratered the global banking system. The answer to that question is no. In that timeframe, let us recall, bank capital securities were trading at a fraction of book value. Preferred bank paper, for example, was trading at less than 10% of par value, even though virtually all of these securities were money good. But nobody wanted them at any price.
Moving bank capital up to 7 or 10 or 20 or 50 percent of total assets would have provided no additional buffer to protect depository institutions from what was essentially a liquidity shock, a disaster caused by reckless housing policies in Washington. In such a situation, only 100% capital levels would have sufficed to protect the banking system, but then we'd have no credit growth. Perhaps the real, unspoken truth about Basel III is that higher capital levels are meant to restrain credit creation and nominal growth in America.
When you look at credit loss rates during from 2008 to 2012, the picture is likewise one of capital adequacy, at least in the US. Most US banks had more than ample capital and earnings to absorb even the record loss rates recorded in 2008 and 2009. The fact of the leverage ratio in the US kept banks safe and sound, not the ridiculous Basel II rule. Mega kudos to Chairman Bair and her colleagues at the FDIC, all of whom fought to retain the leverage ratio. The Basel II rules, let us not forget, actually enabled the bad acts of securities fraud that are the root cause of the financial crisis. Just take a look at the Q3 2012 disclosure from JPMorgan Chase and Bank America regarding putback claims on toxic RMBS (See Alison Frankel, Reuters, "Banks should fear ominous new rulings in Fannie/Freddie MBS cases.")
If the Fed and other regulators really wanted to protect the US banking system they would junk the Basel III rule and go back to a modified Basel II regime with the leverage ratio and revised risk-based asset weightings as the central features. But of course none of the economists who populate the Fed, BIS and other agencies can bring themselves to admit that their beloved bank capital construct is really the problem. Most people who work in Washington, never forget, cannot function in the private sector. Defending incomprehensible bank regulatory regimes like Basel II/III is a matter of livelihood for thousands of economists, consultants, lobbyists and bureaucrats.
The other point that needs to be made is the relationship between bank regulatory actions and the global economy. The cover of Barron's this week asks: "Are we headed for a recession?" No, we are already there, thank you. The regulators in the US and abroad have been decreasing leverage and funding sources available to banks for several years, this in order to placate politicians who like to talk tough about bank capital. The lack of credit currently available to business and consumers virtually assures a recession in 2013. But this situation is just part and parcel of the schizophrenia seen in American politics between fiscal policy and bank regulation.
The extent of the self-delusion regarding US fiscal policy extends to some of the most respected Americans. In a comment in the New York Review of Books, former Fed Chairman Paul Volcker says that "At the beginning of this century, we actually had a balanced federal budget," mouthing the canards of former Treasury Secretary Robert "Deficit Hawk" Rubin and his policy stooge Larry Summers. But this is completely wrong.
Presumably former Chairman Volcker understands the difference between raising revenue to eliminate a deficit and merely borrowing money from the Social Security trust fund to finance a deficit. At the start of the 2000s the cash surplus from Social Security was financing the federal budget deficit, a situation that is now reversed. The federal budget deficit actually grew in those years. Today Treasury is compelled to borrow cash in the public debt markets in order to redeem earlier borrowing from the Social Security trust fund in order to pay recipients.
Paul Volcker knows better - or should. But like most partisan Democrats, Chairman Volcker is trying to rationalize an economy that is shrinking and a federal debt load that must inevitably lead to default. Indeed, a default is already in process via inflationary Fed policies, the ultimate tax on working people. Democrats like Paul Volcker support higher taxes for the 1%, but they will never admit that the biggest tax on the 100% is galloping inflation c/o the Fed to accommodate growing federal debt.
Paul Volcker earned his reputation by taming inflation for a little while a few decades ago, but now price increases are killing the US economy -- and all of our dreams for a better future. When will Volcker and his peers among Fed Chairman admit that the central bank is the main culprit in this growing national economic crisis? Is not the Fed the enabler for a national Congress literally out of control? The only sane choice is default and debt restructuring, but you will never hear Volcker or Greenspan or Bernanke ever speak such truth in public. Instead they take the cowardly path of default quietly, via the printing press.
In a presentation to the annual Bank Credit Analyst conference in New York last month, former Office of Management and Budget Director David Stockman noted that in 2002 the Congressional Budget Office projected that US public debt would reach $2.7 trillion by the end of this year. The actual public debt figure for 2012 under President Barack Obama will be close to $12 trillion. Clearly the CBO estimates are not reliable predictions of the behavior of Congress. See the table below:
The CBOs's Budget Forecasts for 2012 - A Decade Gone Wrong
Source: Congressional Budget Office
It is interesting to note that a decade ago, US nominal GDP was projected by CBO to reach $17.5 trillion by 2012, but the actual figure is just $15.5 trillion. Total tax revenues likewise were expected to be $3.5 trillion or 20% of GDP compared to the actual revenue number of about $1 trillion less or about 16% of GDP. The explosion in public debt has not delivered even the nominal economic growth or expansion of tax revenues expected by US policymakers a decade ago. If you deflate the results with the true inflation rate (call inflation 2x the official stats) the results are abysmal and explain why real American income levels are falling. What else do you need to say to refute the neo-Keynesian socialist model which prevails inside the FOMC and White House?
In the face of such poor economic results, is there any wonder that a growing number of Americans and people around the world are losing confidence in the United States? There are a number of reasons for this situation, but the fundamental problem seems to be a complete inability of Americans to deal with reality. Reflecting our colonial, libertine roots, Americans want gratification today and have no interest in sacrifice. Thus our national debate on issues like fiscal policy or job growth or even bank capital has a fantasyland, mystical quality that defies rational explanation.
In his recent contribution to The New York Review of Books, "What Can You Really Know?," the renowned physicist Freeman Dyson discusses the dichotomy between science and philosophy. "At some time toward the end of the nineteenth century, philosophers faded from public life," writes Dyson. "Like the snark in Lewis Carroll's poem, they suddenly and silently vanished. So far as the general public was concerned, philosophers became invisible."
The decline of the importance of philosophical distinctions in public life may be interpreted as a decline in values more generally, making it nearly impossible to have a sane discussion about things like public spending or even bank capital. These public issues should be entirely cut and dry. Yet somehow the rise of the economist as the apologist for partisan political leaders renders even issues involving public spending or measuring bank capital entirely opaque.
The road to salvation for the US, it seems, requires a serious discussion about what parts of the public policy are rational and therefor based in scientific certainty and those parts which are speculative, subjective and therefore in the realm of politics and economics. It may be attractive politically for public exemplars like Paul Volcker to pretend that the federal budget was balanced in 2000, but spouting such nonsense does nothing to advance the public interest.
Likewise, when we pretend that Basel III will make banks safer and sounder, yet pursue policies in housing or public spending that undermine our economic stability and the soundness of the banking system, we are wandering in mystical realms. Economics, never forget, used to be considered a branch of sociology, not a hard science upon which to base rational public policy. Only when Americans become attuned to such distinctions and are able to separate truth from politically motivated fantasy will we truly begin to make progress as a nation.