28 April 2012

IMF’s Suggestions for Dealing with Artificially Created Risks

When reading the April 2012 Global Financial Stability Report (GFSR) by IMF, I found myself (once again) wondering about the highlighted risks and the proposed ways for dealing with them. First, the focus is on risks that are artificially created and/or the reader simply gets a misleading impression about the causes of these risks. Secondly, while formulated using professional language, the suggested way for achieving global financial stability is basically sharing risks with those who do not understand or misprice them, or do not know the ways for “escaping” the consequences (such as “average” tax payers). Let me illustrate this with what I read from the above referred GFSR.

This time, particular attention was paid to:
(1) Risks related to banking sector deleveraging
(2) Risks related to sovereign debt
(3) Increasing demand and shrinking supply of safe assets
(4) Longevity risk (defined as the risk that people may live longer than expected – is better treatment of cancer a risk, btw?) and its financial implications

For making the case, it’s pretty much enough to stop on issue (1) only – maybe just to add that for solving the issues (3) and (4), even more complex financial instruments and schemes are being recommended (including private sector synthetically creating safe assets and the introduction of some difficult-to-understand pension schemes).

Risks related to banking sector deleveraging

To me, these risks remind this thought from the 2011 Zeitgeist movie: “It all goes back to the box.”  It would go unless some counter-intuitive measures are being taken...

The basic problem is that banks have too much debt and do little equity. Right now, the issue is the most acute in the European banking sector, but it is relevant for the other western economies as well. As I have explained in my earlier blog posts, running a bank with almost no capital has been encouraged by the Basel II capital adequacy framework. Suddenly leverage became a “headache for the many”, because trust was lost in the markets. To restore market confidence, EBA (the European Banking Authority) prescribed to the European banks that they have to meet a 9% Core Tier 1 capital target by the end of June this year. Now this is causing troubles.

Specifically, according to the IMF staff estimates, the 58 large EU-based banks could shrink their combined balance sheet by as much as $2.6 trillion (€2.0 trillion) through end-2013, or almost 7 percent of total assets. About one-quarter of the fall in assets occurs through a reduction in loans, with the remainder due to sales of subsidiaries, noncore assets and securities. What does it mean? Well, one doesn’t need to be a genius for making a guess: reduced lending, less credit and less money, falling asset prices and more bankruptcies. Apparently, this would hit first and severely the so-called emerging Europe where the presence of western banks is significant to say the least. Other regions would not remain untouched either.

In this light the proposed actions for risk mitigation seem very logical. But wait a minute...

IMF Staff’s suggestion: Accommodative monetary policy, which lowers borrowers’ debt service costs, supports asset prices, promotes dissaving by financially stronger households, and averts a possible slide into deflation.
Comment / Question: Isn’t the real risk that we are running out of natural resources? In this light, how can it possibly be a good thing to “promote dissaving by financially strong households”? In other words, is promoting excessive consumption really something that should be done?

IMF Staff’s suggestion: Targeted financial policies to ensure continued credit supply for viable borrowers
Comment / Question: The important implication of this suggestion is that the total credit supply should not decline (because otherwise the money supply would decline). I wonder from where to find this many “viable borrowers” soon enough, and if the demand for credit by such borrowers is suggested to be generated artificially.

IMF Staff’s suggestion: Fiscal support to aggregate demand in countries whose public finances are in relatively good health and not subject to market pressures
Comment / Question: Again, isn’t it basically wasting resources when someone is spending more than he/she actually needs?

IMF Staff’s suggestion: Structural reform to increase potential growth through better-functioning product and factor markets
Comment / Question: Ok, sounds good and vague enough to withstand any criticism. Anyway, how would it exactly prevent a “self-defeating deleveraging cycle?”

IMF Staff’s suggestion: Redistribution from financially strong to financially weak agents, including through targeted debt relief.
Comment / Question: This suggestion clearly encourages irresponsible behaviour and implies an unfair “solution”.

These risks are artificial because they derive from the fact that money is debt by our own definition (an “old song”, but still valid). It does not have to be this way. Money has been invented by humans; humans can change its definition or print it as much as they need. It’s not a problem; the problem is in wrong incentives to consume more (natural) resources than can possibly be re-created. The problem is in wrong incentives and in the (perceived) injustice. Accordingly, the proposed solutions for risk mitigation cannot be more than questionable. That’s just how it appears to work: the most beneficial way to look helpful is to first CREATE the problem and then offer/sell solutions to that (artificially created) problem. Most often, it “just happens” this way.

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