Sunday, October 30, 2016

Since bank regulators in 1988 decreed sovereign debt to be risk free, the market has not set the risk-free rates

In the discussion by Lawrence Summers and Adair Turner on secular stagnation in the Institute of New Economic Thinking INET, on October 28, I extract the following:

15:25 Lord Adair Turner

“The longer we have the slow growth and sub-target inflation, the more you have to think that there is something secular is at work. And the thing that makes me pretty sure that Larry is right in his hypothesis that something secular is at work, is to look at the 30, not the 10 year trend, but the 30 year trend, in real risk-free interest rates. 

Take UK’s 10 year yields on real index linked gilts. 

Take an average for each five year period, from 86-90, 91 to 95 and so six of those 5 year periods until the last

And the sequence is 3.8%; 3.6; 2.5%; 1.9%; 1.2%; minus 0.6%, and the value is now minus 1.5%. 

When you see a trend like that you begin to think that there may be something secular, petty strong, about that; with a dramatic fall even before the 2008 crisis, so you can’t put all this down to central bank intervention, quantitative easing.

So we seem to have entered a world where savings and investments only balance at very low or negative real interest rates. And of course those very low interests rates themselves, played a role in stimulating the excessive private credit growth which landed us with the debt overhang. 

But despite this those low interest we have low growth and below target inflation, and so it is vital we try work why is this… 

17:58 Well logically, the long term decline in real interest rates must mean that we have faced over the last 30 year either:

an increase in the ex ante desired aggregate global saving rate 

or a decline in the ex ante desired or intended global investment rate 

or a mix of both.”

Lord Adair Turner, the former chairman of the Financial Service Authority, FSA (2008-2013), and therefore supposedly a technocrat well versed in bank regulations, had not a word to say about: 

That extraordinary moment when, after about 600 years of “one for all and all for one” capital in banking, in 1988, with the Basel Accord, Basel I, regulators introduced risk weighted capital requirements for banks and, to that purpose, set the risk weight for the sovereign at 0%, while the risk weight for We the People was set at 100%.

That of course signified an extraordinary regulatory subsidy of sovereign debt, that had to set the UK’s 10 year yields on real index linked gilts, on a negative path.

From that moment on, since the regulators had decreed sovereign debt to be risk free, we can no longer really hold the market, using public debt as a proxy, can provide a reliable risk free rate estimate.

For now those artificially decreed risk-free rates can only go down and down and down… until BOOM!

The low “real” public debt interests might be the highest real rates ever, in that these regulations also make banks finance less the riskier, like SMEs and entrepreneurs, those who could provide us with our future incomes, and therefore governments with its future tax revenues.