The central constraint on economic recovery in the leading economies since mid-2009 has been officialdom’s pressure on banks to raise their capital/asset ratios. Also relevant – but to a lesser degree – have been the calls for higher ratios of liquid assets to total assets. Both the higher capital/asset and liquid asset/total asset ratio are part of the package of rules being drawn up by the Basle Committee on Banking Supervision (Basle III). The package is to be applicable in a number of ‘leading countries’ – the newspapers sometimes refer to 27 of them – which are unfortunate enough to have decided to belong to this international club.
The ongoing bargaining about the Basle III rules (which is mixed up in confusing ways with meetings of the G20 and the European Union) has ensured that banks have been shrinking risk assets and/or restricting asset growth. They have had to do this in order to comply with official demands, whatever their own business preferences. That has checked the growth of bank balance sheets, including the growth of the deposit liabilities which constitute the quantity of money. The pressure for higher capital/asset ratios has therefore been associated with virtual stagnation of the quantity of money (on the broadly-defined measures) in the USA, the Eurozone, the UK and Japan for about eighteen months. Because the growth of money and nominal GDP are related, the recovery has been disappointingly feeble. In most countries unemployment remains close to its peaks. Indeed, in the Eurozone, unemployment is still rising.
A salient feature of the world’s leading economies in the last year to eighteen months is that the growth of demand and output has typically run at trend or beneath-trend rates despite vast so-called ‘fiscal stimulus’ (i.e., increased government spending and budget deficits) and virtually zero interest rates. However, all is not lost. At its latest meeting the Basle Committee of Banking Supervision agreed to ease the definition of bank capital and, more important, to extend the transition period in which the higher capital/asset ratios would have to take effect. Reports vary, but the deadline now appears to be 2018 (or even ten years from the finalisation of an accord) instead of the end of 2012.
The deadline extension is hugely important for the likely growth rate of bank balance sheets – and hence the quantity of money – over the next few years. Some early talk was of a doubling of capital/asset ratios. If banks have to do that in two years with unchanged capital, they of course have to lose 25% - 30% of assets in each year. But – if they have ten years – the annual asset shrinkage is only 7%. Indeed, since banks can in practice both raise capital by bond and equity issues, and since they usually build up capital from retentions, they may be able over a ten-year horizon to meet a requirement to double their capital/asset ratios, and to expand their balance sheets, including their deposit liabilities, at a moderate pace, of perhaps 3% - 5% a year.
With less onerous capital targets for banking systems now in prospect and the more sensible deadline, it seems plausible that banks will resume growth of risk assets. All being well, the money stagnation of the last eighteen months may be replaced by moderate growth of bank loans and deposits from early 2011.
And that is not all. Since the calamitous period in late 2008 – when the foolish demands for higher capital ratios were imposed – central banks have offset the deflationary effects of their own regulatory actions by keeping short-term interest rates at more or less zero. Over the decades of financial liberalization before mid-2007, falls in banks’ capital/asset and liquid asset/total asset ratios had led to a narrowing of loan margins and a rise in the proportion of deposits paying interest.
Clearly, the desired ratio of interest-bearing money to expenditure and wealth depends partly on the rate of interest on the money balances. So in the thirty or forty years to mid-2007, interest-bearing deposits in broadly-defined money tended to rise faster – by, say, 2% to 3% a year – than nominal GDP. (And, in fact, broad money as a whole tended similarly to rise faster than GDP.) With interest rates now at zero on more or less all money balances, that process is going into reverse. People and companies want to reduce the ratio of money to expenditure and wealth. A 3% to 5% growth of broad money may therefore, in the new environment, be associated with a 5% to7% growth rate of nominal GDP.
In my article published in Critical Reaction last week, I argued against the view of Andrew Sentence, of the Bank of England Monetary Policy Committee, that such significant inflation pressures are emerging in the UK that an increase in interest rates is already needed. I maintain that output is well beneath its trend level, perhaps by 4% or so. Several years of above-trend growth could be recorded before over-heating would be evident in the labour market, shortages of plant capacity and office space would be widely reported, deliveries would be held up by transport bottlenecks, and so on. Even with a negative output gap of only 3% and a trend growth rate slashed (by such follies as offshore wind farms, the expulsion of high-valued-added financial service activities, excessive EU regulation, etc.) to 1 ½% a year, the UK could have two to three years of growth of above 2 ½% growth without big inflation risks.
Tim Congdon is the founder of International Monetary Research Ltd.