A pre-reading it comment on Mercatus Center’s Tyler Cowen’s “The Complacent Class”

Note: I have not read Tyler Cowen’s “The Complacent Class: The Self-Defeating Quest for the American Dream” yet, as it is still not available. If it contains something that would contradict the following comment that would be great welcomed news. 

In Foreign Affairs we can read: “Tyler Cowen’s timely and well-written book points to a central feature of contemporary American life: since the 1980s, U.S. society has become less dynamic and more risk averse. The quest for safety and predictability has made the country both more and less comfortable than before. Although many (perhaps even most) Americans enjoy the stability and security that the status quo provides, increasing numbers feel thwarted by the lack of opportunity and slow economic growth that characterize their increasingly static society.” 

And I ask, how could that not be when bank regulators introduced risk weighted capital requirements for banks? That primarily happened in 1988 with Basel I and in 2004 with Basel II. 

And the risk weights imposed were such as: Sovereign 0%, AAA-risktocracy 20%, residential houses 35%, We the People, like unrated SMEs and entrepreneurs 100%, and below BB-rated 150%.

That clearly gives banks all the incentives (higher allowed leverages) to finance and refinance much more what is ex ante perceived, decreed or concocted as safe, most often what derives from something that already is known and exists; and to stop financing the unknown riskier future. In other words those regulations imposed risk aversion on the Home of the Brave. 

That, in the short term, not only guarantees a static society, but worse, medium and long term, it causes a falling society. 

It is perfectly understandable that those with Statist inclinations, and who in the 0% risk weight for the sovereign must see their wet dreams come true, don’t say a word about the distortions in the allocation of bank credit those regulations cause… and this even though this regulation actually decrees that inequality they so much tell us they abhor. 

But, that professors from a Mercatus Center at George Mason University that presents itself as “the world’s premier university source for market-oriented ideas”, keeps hush about this all, really makes me sad. 

But, that professors from a Mercatus Center at George Mason University that presents itself as “the world’s premier university source for market-oriented ideas”, keeps hush about this all, really blows my mind. What keeps them from seeing the problem? A peculiar confirmation bias?

PS. In 2011 I already commented about this to Tyler Cowen, when sending him by email what I wrote to Martin Wolf with respect to his "The Great Stagnation"

PS. Here is another occasion in which the Mercatus Center, in my opinion, failed to speak up.

PS. And there is enough evidence on the web about how I have commented on this issue, time after time, on blogs run by Professors of the Mercatus Center.

Mercatus Center, in order to reframe financial regulations, you must dig in much deeper into the current mistakes.

I refer to “Reframing Financial Regulation: Enhancing Stability  and Protecting Consumers” 2016, by the Mercatus Center at George Mason University, and edited by Hester Peirce & Benjamin Klutskey.

The book includes many wise suggestions but, since it does not seem to capture how incredibly faulty current regulations really are, it has gaps that make it more difficult to understand how sensitive the financial system, primarily banks, and the real economy as such, is to the process of implementing a “reframing”.

For brevity and because my main reservations with current financial regulations have to do with the issue therein discussed, I will limit my comments to Chapter 1: Risk-Based Capital Rules by Arnold Kling.

The author writes: “Risk-based capital rules dramatically affect the rate of return banks earn from holding different type of assets. Regardless of the intent of these rules they strongly influence capital allocation in the economy.”

That is correct, although referring to the ex-ante expected risk adjusted returns on equity would be more precise.

Then the author states: “They substitute even crude regulatory judgment for individual bank discretion and market mechanism”. 

That is not entirely correct. The real problem is that since banks already clear for ex ante perceived risks, when setting interest rates and the amount of their exposures, that regulators also use basically the same ex ante risk perceptions for determining the capital requirements, means that “ex-ante perceived risks”, will be doubly considered. What regulators missed entirely, is that any risk, even if perfectly perceived, will cause the wrong actions, if excessively considered.

The book identifies partly what the distortion in the allocation of bank credit could do to the safety of banks, but what it most misses to comment on, is what the risk weights actually calculated and used, really meant and mean to the allocation of bank credit to the real economy. 

For instance Basel I, 1988, applied to the United States, set the risk weight of 0 percent for US Treasuries; 20 percent for claims to for instance local governments; 50 percent when financing residential properties and revenue bonds; and 100 percent all other claims on private obligors.

0% risk weight for the sovereign? If that’s not in runaway statism what is? De facto it implies that regulators consider government bureaucrats will give better use to bank credit than the private sector.

In 2001 the Federal Reserve Board, the Office of the Comptroller of the Currency and the FDIC set the following risk weight depending on credit rating; AAA to AA 20 percent; A 50%; BBB (the lowest investment grade) 100 percent; and BB (below investment grade) 200%.

If that’s not runaway stupidity what is? The regulators really seem to have thought (and think) that assets perceived as extremely risky, are more dangerous to the bank system than assets perceived as safe. As if they never heard of Mark Twain’s “A banker lends you the umbrella when the sun shines and wants it back when it looks it could rain”; as if they never heard of Voltaire’s “May God defend me from my friends, I can defend myself from my enemies”. 

Worse though, they never gave any consideration to the possibility that millions of “risky” 100% weighted SMEs and entrepreneurs, so vital to the sturdy growth of the real economy, would see their credit applications negated only because of this. 

Mercatus Center, any reframing of current financial regulations that is not based on a full understanding of how statists and stupid current regulations are, will not be able to adequately deliver what we, especially the young, so urgently need.

For instance all those propositions of increasing the capital requirements for banks with higher leverage ratios but that would keep of the risk weighting in place fail to understand that the bigger the capital squeeze the more will the risk weighing distort the allocation of bank credit to the real economy. (Think of “The Drowning Pool”)

For instance to avoid imposing on the real economy the bank credit austerity that would result in the initial stages of capital increases the grandfathering of old capital requirements for existing assets until these are disposed would be a must.

Mercatus Center, you have clout that I as a citizen have not! Do all us a favor and request straight answers from the regulators on some very basic questions.