Monday, August 27, 2012

Paper Promises: Debt, Money and the New World Order by Philip Coggan

As its subtitle suggests, Philip Coggan's book examines the relationship between debt and money and its implications for the 21st century economy. Coggan takes us through familiar territory (the nature of money) and familiar debates (Keynesianism vs. monetaristm), yet offers a novel framing that make this book a valuable read.

Coggan has an unusual view of the fundamental divide in political economy. Rather than seeing class struggle everywhere, Coggan treats the conflict between creditors and debtors as the central fracture motivating politics, though he notes that -- all things being equal -- creditors tend to be wealthier (and fewer in number) than debtors.

In speaking of debt, Coggan slides (perhaps too easily) between private and public debt. The debt that interests Coggan is the burgeoning debt that tends toward default (as opposed to the under-remarked debt that is extinguished by repayment in the ordinary course). This is the persisting debt that in usual times is rolled over upon each maturation. He writes of unsustainable debt -- again, both private and public -- that will of necessity lead to some degree of default. In the case of public debt, the default scenarios include -- importantly -- devaluation, a course open to most states to reset the exchange value of the money in which a debt is expressed and thus unilaterally reduce the value of the debt (as expressed in some other value, such as gold or a harder currency).

For most states, there is a limit to this strategy. Devaluation has consequences. It may throttle domestic expectations, igniting inflation. And devaluation -- in a global society -- has consequences, distributing at least some of the lost value to other countries (by readjusting the terms of trade) as well as to the disappointed creditors. Devaluation will also make future borrowing more difficult.

But -- of late -- there appeared the possibility for at least one country to escape the devaluation trap. The United States has enjoyed an extraordinary privilege, in that its currency seemed to be highly valued notwithstanding its horrific trade deficits. This reflects its historical (though waning) primacy in world economic affairs. What matters now is the role of this particular national money as place for storage of value: China (as do Japan and others) continues to re-funnel its vast export earnings into dollar-denominated obligations of the U.S. Treasury, thus keeping prevailing U.S. interest rates low. Exchange values may reveal more about capital flows than trade balances, Coggan argues.

This perceived signal within the U.S. economy is a green light for expansion. Prior to the 2007 financial crisis, this green light released a frenzy of asset acquisitions, including the real estate bubble. And even now, the continued low interest rates may serve to mask the severity of the U.S. debt crisis. Confronting the debt crisis may be postponed (though not avoided) through the simple expedient of increasing the U.S. money supply.

Money today is simply debt, Coggan reminds us. Money has been detached from its historic anchors (precious metals), as each sovereign seeks to discover the sweet spot between too little and too much money. The likely course is one of oscillation, where the costs of each extreme is regularly felt. Post-crisis austerity, while an upright policy, may lead to a downward spiral, as consumers pull back current expenditure to service debt (their own and, via taxes, those of the state), magnifying economic contraction. And too much debt can drive away the creditors -- the monolithic bond market James Carville fears -- as they come to believe that 'borrowing' is just a ruse to transfer their accumulated stores of wealth to others. Better to hoard (if that remains possible).

Moving debt into the future has been a viable strategy - but it resembles a Ponzi scheme, in that success depends in part of an increasing number of new players, the upcoming generations. Their ability to work off the burdens of their grandparents may depend on the prospects of their grandchildren, and so on. But the intergenerational strategy seems to have limits as well, as advanced economies (such as the United States, Japan and Europe) feature extremely low population replacement rates. In an odd way, pushing the U.S. debt back onto China (through a devaluation of the dollar against the renminbi) has both an international and an intergenerational aspect, given China's continued projected population growth.

Coggan paints a rather bleak future, involving inevitable U.S. decline. More crisis is ahead, as the mountain of public and private debt is either devalued or postponed - or results in outright default.

Wednesday, August 22, 2012

Abandoning the Euro, Saving the Euro

The Euro crisis tests more than the viability of the current currency arrangements. The sovereign debt crisis affecting Greece and Ireland, Italy and Spain is also testing the limits of wider European democracy. The status quo will likely be abandoned. The open question is whether the Euro crisis will lead to deeper integration among the EU Member States (as an artifact of a Euro rescue) -- or whether a collapse of the Euro will signal a retreat from the past achievements of the European project.

The European Union began as a common market for goods and services. A common European currency space is a more recent development -- the Euro serves as the currency of most (but not all) EU Member States. Adoption of the Euro has reduced trading costs, and has led to more transparent prices.

The Euro crisis is first and foremost a sovereign debt crisis, initially affecting a handful of EU Member States running unsustainable deficits. The sovereign debt crisis is itself an artifact of the establishment of the Euro -- neither Greece nor Spain would have been able to borrow as much in their former currencies (or on such favorable terms) as they were able to using the Euro. Prior to the Euro crisis, the financial markets valued Euro-denominated Member State obligations similarly. As the crisis developed, lenders became far more discriminating, demanding much higher Euro interest rates from weaker Member States (such as Greece and Spain) than from others.

Monday, August 13, 2012

European Limits on Banker Bonuses

The EU's Council has prepared its draft legislative package implementing the Basel III banking reforms -- known as CRD IV. Attention now shifts to the European Parliament for its response, expected this autumn. A complex process of reconciliation will follow. On one point the Parliament has drawn a line in the sand: the eventual CRD IV must contain significant limits on contingent compensation paid to bankers. The Parliament's starting point is a one-to-one ratio cap: bankers' bonuses cannot exceed annual salaries.

Basel III did not impose any limits on bankers' compensation -- although several European members of the Group of 20 had sought bonus restraints during the negotiation. Nor does Basel III restrict the ability of Europe -- or any other Basel party -- from imposing additional requirements on its banks. Europe's imposition of bonus limits in CRD IV may be described as "Basel III Plus" -- an additional term beyond the basic Basel III mandates.

There is a broad perception that the bonus culture of New York and London contributed to the 2007 financial crisis. Bankers seduced by the prospect of large contingent payments caused their firms to undertake inappropriate levels of financial risk. New limits on bonuses, in this telling, are needed to eliminate the distortion in risk appetite generated by prevalent compensation practices. But bonuses have their defenders -- and not just the bankers who receive them. There remain policymakers (albeit more likely those overseeing markets in New York and London) who continue to believe that bonuses are necessary to attract the creative talent that will drive economic growth.

Monday, August 6, 2012

European Politics and the Regulation of Bank/Insurance Firms

On prior occasions, European implementation of the Basel bank regulatory system had proceeded rather mechanically. The Europeans actively participated in the Basel II process, reached agreement with the world's other major banking powers, and then faithfully enacted Basel norms into EU law. This has not been the case with the latest product of Basel: Basel III. While Europe once again exerted its influence during the negotiation, it has been decidedly less determined to give full effect to its Basel III undertakings in EU legislation. And the reason -- it should be no surprise -- is politics.

The linkage between Basel III and the European implementation (known as CRD IV) involves three levels of politics: global, European and national. The uncharacteristic European reluctance to carry out the Basel III mandates to the letter results from the varying distributions of influence at each level of the lawmaking game. A case in point: so-called 'bancassurance' -- financial conglomerates that are part bank, part insurance company. France's Societe Generale and Credit Agricole are two large examples of 'bancassurance'.

The treatment of bancassurance was a sticking point in the Basel III negotiations. The United States and others (including the United Kingdom, an EU member state) identified the problem of 'double counting' equity capital in bancassurance. Basel III requires banks to maintain adequate amounts of high-quality (Tier 1) equity capital. This capital acts as a loss-absorbing buffer, protecting depositors and other bank creditors. In a similar spirit, insurance regulators demand that insurers maintain adequate equity to protect policyholders in the event insurers experience losses.