When Governments are Banks and Banks are Casinos

For those who think that financial system reform, either in the U.S. or in the Eurozone, has made the financial system safer, an article has been published in the February issue of the Atlantic which should dispel any illusions. See – What’s Inside America’s Banks? byFrank Partnoy and Jesse Eisinger (http://www.theatlantic.com/magazine/archive/2013/01/whats-inside-americas-banks/309196/). The piece examines, as near as is humanly possible, the business model of a long-thought-to-be conservatively managed American bank, namely – Wells Fargo. Without going into the mind numbing details, the conclusion of the article is that even this ‘old-style’ bank is operating as a casino with unknown – and perhaps unknowable – risks, and deriving much of its profit from these activities. This should come as a surprise to no one, except politicians who are in a willful state of denial about the financial industry. It is noteworthy that the American financial industry lobbies strenuously against meaningful reform arguing that reform would leave them unable to compete with other (read European, Japanese and Chinese) global banks. 

For those who wish to believe that Europe is somehow relatively better off with its financial industry, they should be depressed by the IMF’s most recentGlobal Stability Report(April 2012). Among many bits of uncomfortable data contained within, we find that financial sector debt in the Eurozone sits at 142% of GDP compared with 87% for the U.S. and 177% in Japan. Those numbers translate into leverage ratios of 11 times for the U.S. financial sector and 23 times for both the Eurozone and Japan. If more debt and more leverage don’t indicate more risk, then we have learned nothing from the events of 2007/8. In China the financial sector suffers from a host of problems, not the least of which is its seemingly permanent inability to write down bad loans. In Japan, well, stagnation has been the norm since 1990. Japan has the decided advantage that it mostly owes money to itself, while the U.S. has the advantage of issuing the world’s reserve currency.

Tying all this together in a strange way is the near universal fiscal crisis of governments. Governments issue more and more debt to make up for revenue shortfalls, bank bailouts, the extension of unemployment benefits, etc. Much of the debt has wound up sitting on the balance sheets of central banks directly or as collateral against lending. For example, according to the IMF the U.S. Federal Reserve owns 18% of all U.S. government debt outstanding, and the number is a bit more in the case of the Bank of England and British debt. The quoted U.S.number excludes a large portion of U.S. debt, also government owned, which is in other government accounts. Many fear the potential inflationary impact of this electronic version of printing money. The situation in Europe is different, but no less complicated. There, commercial banks hold 26% of all government debt. (In Japan, the central bank and the Postal Savings system together hold 37%.) These are the same European banks who borrow from the ECB in order to temporarily restructure their balance sheets while they try to raise private capital to improve their own stability (as required by Basel III regulations). The anti-inflation hawks everywhere scream for more austerity whatever the political result of that may be. However, there is a technical problem with governments reducing their issuance of debt.

A working paper published by the Bank for International Settlements (BIS Working PaperNo 399, December 2012, by Pierre-Olivier Gourinchas and Olivier Jeanne) sheds an interesting light on the problem. The modern, overleveraged and over-expanded financial system backs enormous amounts of lending with collateral of either cash or ‘safe assets’. Today, safe assets are deemed to be U.S. Treasury paper and perhaps German government bonds, and little else. So to feed the financial monster we have created, it may be that governments must keep issuing debt or the financial model of Wells Fargo and all the other global banks will not be supportable. The BIS analysis also goes a long way toward explaining why interest rates are so low in this environment of electronic money printing by central banks. In short, the demand for ‘safe assets’ is so high in the current system that low interest rates are the equilibrium condition (for countries which can print their own currency and are not unduly exposed to foreign ownership of their debt). At this point it is necessary to quote the BIS paper: “By providing a monetary backstop, the central bank can make government debt a safe asset in all dimensions: it removes the default risk in government debt without creating an inflation risk. The monetary backstop, in this case, can truly be called a form of lending in last resort.” And only the central bank can do this. That is, only public debt can approach the definition of a safe asset and the financial system can’t do without safe assets.

So we have a system in which governments bail out banks that hold government debt, and central banks bail out both by creating new money. Apparently the options for reducing the amount of new money created are much more limited than we previously had thought. Imagine governments balancing budgets and issuing new debt! Yet we have a reasonably low inflation environment. Low and behold, the largest commercial banks get to continue to operate as casinos.

A reasonable person might find modern finance bizarre. The economics profession might need to find a new line of work if it still believes in efficient financial markets. Politicians will continue to bury their heads in the sand. Pity them – it’s not possible for them to understand all of this. After all, try explaining it to that reasonable person mentioned above.