For whom should we feel more sorry, Greece or the rest of the world? Greece accounts for 0.4% of world gross domestic product, yet the American and British stock markets, and the even the stock markets of Latin American and Asian countries with negligible trade links with Greece, have tumbled 2% or more on the renewed prospect of Greek default. Well, actually, not Greek default, but a failure to meet obligations even larger than that envisaged at the European Union’s shambolic October ‘summit’.
So what to make of this? Surely the solvency of Europe’s banks depends on the value of the sovereign debt they hold, while the value of non-Greek Eurozone sovereign debt is influenced by the pricing of Greek government bonds and the extent of the Greek default? And aren’t we all aware that – if Europe’s banks are in trouble – then that will affect every bank in the world and perhaps renew the market turmoil in the wake of the Lehman collapse in September 2008? Another round of bank recapitalizations may be necessary after banks have marked their EU sovereign debt to market prices, in order to ensure that banks are – continuously and precisely – compliant with their Basle II/III capital ratios. Couldn’t the result of that exercise be the same as in late 2008 and early 2009, namely a collapse in world trade and output?
In fact, that’s hysterical and disproportionate. A very high share of the Greek government debt has now been ‘officialised’ (i.e., taken out of private hands, including the hands of the banks), and banks have often already made a provision on their Greek government bonds. The remaining damage from a Greek default is trivial relative to the global banking system’s capital. More fundamentally, the current attitude towards banking system capital – particularly in official circles – has become idiotic. (I am afraid the word is fully justified.) Banks are very odd organizations, although they lie at the heart of market capitalist economies. They are highly leveraged (i.e., they have very high ratios of assets to capital) and, because they economize on their non-earning stock-in-trade asset (i.e., cash), they are also ‘fractionally reserved’. An easy exercise is to show that, the higher is their leverage and the greater the fractional-reserving, the lower is the cost of the services they provide to non-banks. It has also long been known that a small shock to either capital or cash can have a geared effect on total balance-sheet size, including the deposit liabilities which – in a modern economy – constitute most of the quantity of money.
Because of the importance of the quantity of money to macroeconomic outcomes, a vital objective of public policy is to ensure that shocks to banks’ capital or cash do not affect the quantity of money. Roughly speaking, the capital should act as a buffer, with the ratio falling in recessions as bad debts are incurred and rising during booms. (Shocks to cash can be offset by the central bank acting as bank to the banking industry, in the manner set out in hundreds of textbooks.) Unfortunately, in the last 20 years or so officialdom – central banks, governments and regulators – has taken an increasingly ideological view of banking system capital. Instead of allowing the capital/asset ratio to vary during the cycle, it has taken a strict line that regulatory ratios must be met continuously and precisely. The effect of this rigour is very perverse, because capital-raising is most difficult in recessions. To comply with the rules, banks since 2007 have been shrinking assets and destroying money in a recession. Instead of capital acting as a buffer, the arrangements determining banks’ capital have amplified the balance-sheet effects of the downturn. And what a mess we are living through as a result!
The threat to the world economy in 2012 is not that Greece, accounting for 0.4% of world output, goes bust. Instead the big worry is that officialdom will repeat the blunders of autumn 2008. If officialdom again insists that banks meet capital requirements at all moments in time and by the amounts prescribed in the regulations, plus a (large) margin for supposed ‘safety’, and if it once more demands a Big Bang bank recapitalization, early 2012 could see another global recession. But let us be clear: the blame for that recession falls on the folly of central banks and regulators, not on the misfortunes of a financially very minor Mediterranean country.
Tim Congdon is the founder of International Monetary Research Ltd.