Reflections from Europe
DECEMBER 5, 2011
Finance in Parrot Talk, Part II
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In a breath-taking "Note on the Reform of the International Financial and Monetary System in the Context Of Global Public Authority" issued by the Pontifical Council for Justice and Peace on 24th October 2011, this institution of the Holy See took it upon itself to urge the imposition of a tax on financial transactions (the notorious Tobin tax advocated mainly by Germany and France, dismissed by Great Britain and mostly ignored by the United States of America), the separation of retail and investment banking, and the strengthening of the equity capital ("recapitalisation") of the banking system. If the International Chamber of Commerce issued a statement calling for brotherly love and charity and the regular practice of the sacraments, we should find it incongruous and out of place. However, the Holy See has since Leo XIII's encyclical of 1891 accustomed us to Church advocacy of large departures from a laisser faire free contract economy. (The Catholic "Club Med" countries of Southern Europe are paying a heavy price for following this advocacy).
In last month's column in this place, I discussed the power of what I call "parrot talk" to establish dubious or downright false propositions by ever wider repetition as undisputed truths. In the present column, I will try and dissect two particularly noxious ideas taken up by parrot talk in government, academe and (as shown above) the Church, which are accepted by majority opinion, distort reality and do considerable damage.
German parrot talk has achieved the feat of uniting in a single word two much hated ideas that in other languages would take two or more to express.
There must be some people, though not very many, who would be happier as cavemen or nomadic herdsmen battling periodic famine and the cruelty of the elements than be denizens of our urban civilisation. For the rest of us, however, the populist dreams of abolishing the "dominance of money and the dictatorship of market", as well as seeking "production for real needs, not for profit" should and can be dismissed as irrational ranting. It would be rational if we harboured a strong streak of masochism that could be satisfied by self-inflicted economic and social pain. Such pain, best exemplified in the kind of life the people of the Soviet Union lived for far too long, is suffered when the attempt is made to eliminate finance from the so-called "real" economy. Finance and capitalism have always flourished together. Stretching ideas a bit, each can be imagined without the other. The result, though, looks painfully contrived. Quantitative economic planning by input-output matrices using only shadow prices, on the one hand, and market socialism on the other, are examples of such contrived monstrosities.
The steady steam of parrot-talk charges come under two headings. One is morality. Capitalism is immoral because it promotes immoral conduct in pursuit of a morally worthless objective, profit. It also generates inequality of material conditions among men, and relations of subordination. It is not realised that all economic systems, except perhaps subsistence farming, do these things and have done so through history. Where capitalism is superior to its real or putative alternatives is in its relation to morality. It is the only system where the optimal rule to follow to success is "honesty is the best policy", (though following a rule is not the only or necessarily the better road to success than not following one). Capitalism, as has been recognised by the more intelligent among its defenders, systematically economises morality. It achieves more with morally fallible human agents than other systems could hope to do by relying on the scarce supply of clean-handed, selfless, public-spirited people they could find. Capitalism shrinks the opportunity for corruption, pre-capitalist and socialist systems open them widely. The other, less high-minded parrot talk charge is that prosperity and well being are too precious to be left to the market. It turns out, though, that if they are not entrusted to the market, before long not much is left to be entrusted anywhere else.
The capitalist economies and in particular their financial service sectors prior to 2008 were too lightly regulated in the view of some, too heavily in that of others. They were in either view hybrid. There is no earthly way of telling, from the performance of a hybrid system, what the performance of a pure system would have been. Maybe putting the banks in straitjackets would have averted 2008, maybe setting them really free to swim or sink would have done it. Maybe neither would have made much difference. But pretending to know that more regulation was needed, as Mr. Volcker, Mr. Mervyn King, Dodd-Frank legislators and the Basel committee do and as incessant parrot talk to the same affect raises to the rank of a self-evident truth, should not be allowed to serve as an argument-stopper.
Strengthening the Banking System?
A bank is solvent if it can pay off its liabilities to third parties, some on demand, others on their due dates, by liquidating its assets. As long as the bank is believed to be solvent, the necessity to liquidate all its assets to pay off all its liabilities does not arise. In the perhaps laudable attempt to provide a tangible foundation for the belief in solvency, an all-European panel of central bankers and officials sitting in Basel is empowered to require banks to maintain certain fixed proportions between various classes of their assets and their liabilities. These requirements have been progressively tightened from the initial set known as Basel 1 to the present Basel 3. Greatly simplified, the requirements amount to a solvency ratio by which, under Basel 3, a bank is allowed to have 93 of third-party liabilities for every 100 worth of assets. This means that its own equity capital must be no less than 7 for every 100 worth of assets. Since the starting figure for the system as a whole was only 5, the average bank had to increase its solvency ratio by 2 to reach 7 before the deadline in 2017. Most banks were expected comfortably to surpass this level out of a few years' retained earnings. So far, so good.
However, behind this safe looking outcome there lurks a fundamental doubt. External liabilities are fixed in nominal value; 93 is unambiguously 93 in the currency, e.g. euros, in which it was denominated. However, whether an asset is valued at 100 in the balance sheet to match the 93 on the liability side and leave an equity of 7 is a matter full of ambiguity. An immensely complicated set of guidelines laid down by the International Accounting Standards Board (IASB) tells the auditors what method of valuation by the bank of its assets they may accept, but there is room for different interpretations of the guidelines. By and large, an asset must be "marked to market"; if it was bought for 100 and its market price declines to 80, it must be inscribed at 80 on the balance sheet. It may then serve to support only 74.4 of liabilities. Since the latter still figure at 93, something has to give.
Not all marketable bank assets must be "marked to market", and not all bank assets are marketable. Most, in fact, are not quoted and are exchanged only sporadically or not at all. Mortgages may not have been packaged into tradeable mortgage-backed securities, and industrial and commercial loans may be valued by the lending bank at par as long as they are "performing", i.e. as long as current interest due is being paid. However, while these asset classes may escape the letter of the "marked to market" rule, should they escape its spirit? When recession threatens, is it not reasonable to say that if these asset types were traded on a market, their price would decline by 10 per cent or more in a matter of months? Should the bank's balance sheet not reflect this? If half of the bank's assets are written down by 10 per cent, the bank's own equity capital shrinks from 7 to 2 per cent. Since Basel 3 says that for safety it should be 7 per cent, should depositors, especially the big wholesale ones, panic and start a run? Worse still, if the spirit of the "mark down to market" is not respected and assets are not written down but the large depositors, indoctrinated by parrot talk, think that they ought to have been, the balance sheet will no longer be trusted and the eventual panic could be much worse.
The irony of it all is that if it had not been hammered home to the public that a solvency ratio of 7 per cent is needed for safety, even the harsh "mark to market" rule could be endured without much damage—for the bank is solvent as long as it can pay off its liabilities, and technically it can do this with a solvency ratio of 0.
If the bank's solvency ratio were 7 but must not be breached, the effect is the same as having a 0 ratio.
Clumsy interference in misguided attempts to improve on matters knows no bounds, for even improvements can be further improved. No sooner did European banks get used to the idea that they must have at least 7 per cent equity that Mme. Lagarde, the new Director General of the IMF, in apparent haste declared that it was "urgent" to recapitalise them by raising their solvency ratio to 9 and the biggest banks to 10 per cent by July 2012, a mere 9 months. This was the classic case of bellowing "Fire!" in a crowded cinema. Some banks rushed to the stock market, raiding it for extra capital, leaving that much less for industry and commerce. All others began aggressively to reduce their assets, partly by dumping large chunks of their holdings of Italian, Spanish and other sovereign debt, and partly by denying credit to their less important small and medium business customers. Absurd situations arose. Airbus, up to its neck in aircraft orders, cannot step up production because its subcontractors cannot get the credit they need to raise more working capital.
While a recession of sorts is being artificially engineered, the public is convinced that it must be a good and prudent thing to recapitalise the banking system, for more financial strength is doubtless needed in this time of "crisis". May we remark that if the authorities in their zeal to manage the recession and parrot cries shriek "Crisis!", a 9 per cent solvency ratio would not give better support to the banking system than 7 per cent. What might help instead are fewer cries of "Fire!"
Anthony de Jasay
is an Anglo-Hungarian economist living in France. He is the author, a.o., of The State
(Oxford, 1985), Social Contract, Free Ride
(Oxford 1989) and Against Politics
(London,1997). His latest book, Justice and Its Surroundings,
was published by Liberty Fund in the summer of 2002.The State
is also available online on this website.
For more articles by Anthony de Jasay, see the Archive.