Sunday, October 10, 2010

Thoughts so far on "This Time is Different"

There are two financial history/economics books which I have found very rewarding to read, even if a tiring slog to get through. One is Kindleberger's Manias, Panics and Crashes, particularly the discussion of credit creation and contraction with the Minsky model (the financial instability hypothesis).

The other, though I'm still working through it, is This Time is Different. Part of the reason it is a slog is the very reason is it so rewarding - the loads of quantitative data and segways discovered, such as India's share of world GDP declining between 1913 and 1990 (though why that table didn't have 2007 figures is unknown to me). Debt intolerance though seems to be a main part of the book, the notion that certain governments have higher debt intolerance than others, and hence while one government can withstand a certain amount of debt to GDP, another can not withstand that same amount. Mental-model wise, it is very interesting to discover this in the quantitative data; and even more interesting to connect it qualitatively to the narrative of history in Walter Russell Mead's God and Gold, which offers a pretty good explanation of the rise of Anglo-Saxon institutions that have resulted in those countries having very strong financial systems that are debt tolerant (it may not seem like we have a strong financial system, on an absolute basis, based on the past crisis, but relatively speaking we do compared to non Anglo-Saxon countries). One of Reinhart and Rogoff's tables show that none of the colonial (as opposed to imperialist era holdings like India, South Africa and Zimbabwe) Anglo-Saxon spinoffs (Canada, Australia, New Zealand, and the United States) have explicitly defaulted on debt - we're very debt tolerant, a blessing for people needing to buy fixed income securities. (Covert defaults, including inflation, is another story, though we still fare pretty well on a relative basis.) Mead's analysis provides a good explanation of that quantitative anomaly revealed on Reinhart and Rogoff's analysis.

From a research perspective, This Time is Different reveals another curiosity - due to the lack of transparency regarding domestic debt of countries, most economic analysis of default and inflation episodes do not incorporate a discussion of domestic debt. As a result, Reinhart and Rogoff find that most analysis is seriously deficient in explanatory power of why a government would choose to default or inflate because most researchers are looking at a very incomplete picture (only external debt, which usually is less than half of the total debt of the average nation) with incorrect assumptions (that domestic debt is usually paid off in full, at face value, with no overt or covert defaults). The simple reason for this deficiency is partially that governments do not want to reveal their knickers (unfortunate because government ultimately should be accountable to their citizens) and partially that researchers might be becoming lazier. (For more on this, see Farnam Street's blog article: Does the Internet Make You Smarter or Dumber?)

And if we take a moment to engage in a thought experiment, we may be becoming even lazier as we become used to instantaneous access to information via our computers, mobile search and more. If that is the case, then any information that is not easy to find via online sources at all or online only if digging deeply (i.e page 200 of a 201 page document) will progressively become more and more ignored. Any decisions we make then will be based on even more incomplete and erroneous analysis. This is important - for example, if I remember correctly (key because I do not have the book in front of me at the moment), Reinhart and Rogoff go so far as to say that institutions advising on debt restructuring for nations are giving inadequate recommendations because of the propensity of research to improperly ignore domestic debt levels and the lack of transparency around a nation's domestic debt.

Combining the two books, I distinctly remember Kindleberger talking about capital levels throughout the 19th and 20th century at banks in the United States. Reinhart and Rogoff have a time-series analysis, I believe, of banking crises in the U.S. I think it would be quite interesting to overlay that analysis with the trend of bank capital levels from the 1800s to the present. I think it would make the case that whatever reform we're getting through Dodd-Frank and Basel III, it will only mitigate (at best ) future crises, not prevent them.

I'm including systemic risk in that assumption, by the way - I highly doubt that systemic risk buildup will be prevented by the regulators created and empowered in the legislation, since I wonder if they (or anyone) will know what the next systemic risk is. They might be fighting the last war when the next crisis comes. I'm not asserting that the systemic risk of the prior crisis was hard to discern, since investors like Jeremy Grantham, Mike Burry and others happened upon that risk, analysed it, and profited from it; I'm asserting that I find it hard to believe that the regulators will notice the systemic risk, given the prior track record, such as this remark from Bernanke in Oct 2005: "House prices have risen by nearly 25 percent over the past two years. Although speculative activity has increased in some areas, at a national level these price increases largely reflect strong economic fundamentals." 

After all, if you recall, the Bank of Scotland (now part of Lloyds Banking Group) on average had an equity capital ratio of 25% during the 1700s (i.e. every $4 of loans made by the Bank of Scotland were fund by $3 of deposits or bonds sold to investors and $1 of the Bank of Scotland's money). This, shall we say, is a rather high common equity ratio, especially compared to banks today where you may see 3% common equity ratios (a lot of European banks back in 2008). And yet, when the Royal Bank of Scotland was competing against the Bank of Scotland in the early 1700s, it pretty much caused a liquidity crisis for the Bank of Scotland by buying Bank of Scotland notes and then marching into a Bank of Scotland branch to redeem those notes for payment (in gold or coinage, I think). The Bank of Scotland was forced to call loans early and suspend payments in coinage from March 1728 to September 1728. Bear in mind that there was nothing wrong with the Bank of Scotland's book of loans. They just had an inadequate supply of coinage to cover redemption of all of their currency notes in circulation (a situation the Royal Bank of Scotland probably was in too). A high equity capital ratio did not prevent a liquidity crisis, a crisis of confidence. Even a 100% equity capital ratio (meaning that the bank is not a bank, but an investment vehicle) would not prevent a liquidity crisis if the assets are not easily salable. And legislation would probably not prevent a liquidity crisis in the future. (I realize that such a liquidity crisis for a bank, as opposed to a capital markets dependent financial company, would not happen now because of the Federal Reserve, the Bank of England, and the European Central Bank each offering banks access to liquidity at need, but I think the example still relevant if only to illustrate that there are more to financial crises than just bad loans eating away at a bank's capital. Also, I felt like bragging about what I learned when touring the old Bank of Scotland headquarters in Edinburgh last summer.)

As for a quality crisis (while I do not remember the exact nomenclature, what I mean by this is that the quality of assets/loans on the bank's books are a lot more suspect than stated), a higher capital ratio means that there is more of a buffer provided by the bank's money to absorb losses on loan writedowns before impacting depositors. But if a bank is stupidly underwriting, no capital ratio will ultimately prevent it from going under. Legislation does not prevent stupidity, herding, or a race to the lowest common denominator (and lowest quality) in lending. And when banks did not have federal backstops, there were still banking crises despite the incentive of the bank owners to ensure that the bank underwrote well because if it made a bad decision, they lost their net worth. So why does anyone think that the current legislation will prevent a future crisis? Any rational person willing to take the time (i.e. not be lazy) and look at the historical record will find that to be a delusion.

I realize this post is a bit incoherent - I hope not only to come back and edit it, but to provide some data, such as that time-series analysis of banking crises with capital levels if only to underscore that Basel III capital levels will not prevent a future crisis. In the mean time, I hope you enjoy these off the cuff thoughts (and email me with any thoughts on the deficiencies).

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