Nothing promotes secular stagnation as much as the regulatory promotion of risk aversion

J. Bradford DeLong, in “The Scary Debate Over Secular Stagnation: Hiccup ... or Endgame?” published October 19, 2015 in the Milken Institute Review, refers to that Martin Feldstein, at Harvard back in the 1980s, taught that "badly behaved investment demand and savings supply functions," could have six underlying causes:

1. Technological and demographic stagnation that lowers the return on investment and pushes desired investment spending down too far.

2. Limits on the demand for investment goods coupled with rapid declines in the prices of those goods, which together put too much downward pressure on the potential profitability of the investment-goods sector.

3. Technological inappropriateness, in which markets cannot figure out how to properly reward those who invest in new technologies even when the technologies have enormous social returns – which in turn lowers the private rate of return on investment and pushes desired investment spending down too far.

4. High income inequality, which boosts savings too much because the rich can't think of other things they'd rather do with their money.

5. Very low inflation, which means that even a zero safe nominal rate of interest is too high to balance desired investment and planned savings at full employment.

6. A broken financial sector that fails to mobilize the risk-bearing capacity of society and thus drives too large a wedge between the returns on risky investments and the returns on safe government debt.

J. Bradford DeLong points out that Kenneth Rogoff in his debt supercycle focuses on cause-six; Paul Krugman in “return of depression economics” focuses on five and six; and Lawrence Summers with “secular stagnation” has, at different moments, pointed to each of the six causes.

And then J. Bradford DeLong writes: “Rogoff has consistently viewed what Krugman sees as a long-term vulnerability to Depression economics as the temporary consequences of failures to properly regulate debt accumulation. Eventually, a large chunk of debt thought of as relatively safe is revealed to be risky, and financial markets choke on the lump. As the riskiness of the debt structure is revealed, interest rate spreads go up – which means that interest rates on assets already known to be risky go up, and interest rates on assets still believed to be safe go down."

And Rogoff is later quoted with "In a world where regulation has sharply curtailed access for many smaller and riskier borrowers, low sovereign bond yields do not necessarily capture the broader 'credit surface' the global economy faces,"

And here is when I just have to intervene: Of course, stupid credit risk weighted capital requirements for banks have impeded the mobilization of the so vital risk-taking willingness and capacity of the society, that which has traditionally been much exercised by its banking sector. That it did by driving a large wedge between the banks’ ROEs for risky investments, like loans to SMEs and entrepreneurs, and the returns on “safe” investments, like loans to governments, AAArisktocracy and the financing of houses.

And “stupid” it is: “Eventually, a large chunk of debt thought of as relatively safe is revealed to be risky, and financial markets choke on the lump”. The capital requirements, that are to guard against the unexpected, were based on the expected, the perceived credit risks.

Dare to read more here about the mind-blowing regulatory mistakes that have been ignored by the experts.

PS. Anyone who talks about low interest rates on public debt without considering the regulatory subsidy implied with: risk weight of sovereign = 0%, and risk weight of We The People = 100%, is either a full-fledged statist or has no idea of what he is talking about.

PS. #4 "the rich can't think of other things they'd rather do with their money" is one of the reasons I much favor the Universal Basic Income concept.

Here is the explanation for the genesis of the financial crisis of 2007-08 and of the secular stagnation since.

Getting the clue from Charles Goodhart’s “The Basel Committee on Banking Supervision: A History of the Early Years 1974-1997”, in Steven Solomon's “The Confidence Game” we read:

“On September 2, 1986, the fine cutlery was laid once again at the Bank of England governor’s official residence at New Change… The occasion was an impromptu visit from Paul Volcker… When the Fed chairman sat down with Governor Robin Leigh-Pemberton and three senior BoE officials, the topic he raised was bank capital…

Adequate capital – the bank’s buffer against bankrupting loss- was the keystone of a central banker’s mission to uphold financial system safety and soundness. It was the banks’ capital inadequacy that made LDC (Less Developed Countries) over-indebtedness so grave a threat; upgrading U.S. bank capital was Volcker’s strategy to extricate the world financial system from that crisis. 

At dinner the governor’s hopes had been modest: to find areas of sufficient convergence of goals and regulatory concepts to achieve separate but parallel upgrading moves… 

Yet the momentum it galvanized… produced an unanticipated breakthrough of a fully articulated, common bank capital adequacy regime for the United States and United Kingdom. This in turn catalyzed one of the 1980’s most remarkable achievements – the first worldwide protocol on the definitions, framework, and minimum standards for the capital adequacy of international active banks…

They literally wiped the blackboard clean, then explored designing a new risk-weighted capital adequacy for both countries… 

It included… a five-category framework of risk-weighted assets… It required banks to hold the full capital standard against the highest-risk loans, half the standard for the second riskiest category, a quarter for the middle category, and so on to zero capital for assets, such as government securities, without meaningful risk of credit default.”

But then in Alexis Rieffel’s “Restructuring Sovereign Debt”,‪ Brookings Institution Press, 2003 we also read:

“Countries don’t go bankrupt” seems to be the most frequently repeated sound bite associated with the broad subject of sovereign debt workouts. It is everywhere. Former Citibank chairman Walter Wriston is usually cited as the originator of the quip [An Op Ed in New York Times 1982]. This is almost certainly wrong. It was considered conventional wisdom in the international financial community at least a decade earlier”

And there you have it! The regulators completely confused ex ante perceived risks with ex-post realities. The LDC crisis did not result from banks taking large ex ante perceived risks.

And so what resulted? The pillar of current bank regulations, the risk weighted capital requirements for banks. More ex ante perceived risk more capital - less risk less capital.

Which allowed banks to leverage more with The Safe than with The Risky.

Which allowed banks to earn higher risk adjusted returns on equity with The Safe than with The Risky.

Which made banks lend more against less capital to The Safe… like AAA rated securities and sovereigns like Greece. Hence the Financial Crisis!

And which make banks lend less to The Risky, like SMEs and entreprenuers. Hence Secular Stagnation!

Which make banks finance more the basements in which kids can live with parents, than the jobs they need.

PS. And here are Paul Volcker valiant confessions in 2018

PS. Here is an aide memoire on many of the monstrous mistakes of such risk weighted capital requirements.

Bank regulators cause price of credit for the safe to be lower than usual than that of the risky. It costs us a lot!

Lawrence H. Summers writes about “the concept of secular stagnation, first put forward by the economist Alvin Hansen in the 1930s. The economies of the industrial world, in this view, suffer from an imbalance resulting from an increasing propensity to save and a decreasing propensity to invest. [And that] it is natural to suppose that interest rates – the price of money- adjust to balance the supply of savings and the demand for investment in an economy” “The Age of Secular Stagnation” Foreign Affairs March/April 2016.

But the intermediation between savings and investment, when carried out by banks, has now been distorted by the fact that banks are allowed to earn higher risk adjusted returns on equity when holding “safe” assets, than when holding “risky” assets? That is the de facto result of the risk weighted capital requirement for banks.

And so now the difference in the price of bank money for the safe, and the price of money for the risky, will be much larger than what would be the case without these regulations. And, consequentially, the demand for investment of the safe will be larger than that in an undistorted equilibrium, and the demand for investment of the risky, much lower.

One way to explain it is with houses and jobs. As is, the financing of houses has been considered much safer by regulators than the financing of job creation through “risky” SMEs and entrepreneurs. And so society is, faster than little by little, getting stuck with too many houses and too few jobs.

@PerKurowski ©

The Basel Committee, with Basel I, II and III, has condemned our grandchildren to secular stagnation and lack of jobs

Secular stagnation, a condition of negligible or no economic growth in a market-based economy, is explained in terms of investment demand falling relative to savings supply. 

Overall investment can be subdivided in: safe investments that can remain safe, safe investments that can become risky, risky investments that are in fact risky, and risky investments that turn out safe. The last group provides by far the most dynamism to our economies. 

The Basel Committee’s portfolio invariant credit risk weighted capital requirements for banks; more risk more capital – less risk less capital; allow banks to leverage their equity more when financing the safe; which allows banks to earn higher risk adjusted returns when financing the safe; which impedes the fair access to bank credit of the risky, among these the SMEs and entrepreneurs.

In short its credit-risk-aversion causes banks to over-refinance the safer past and under-finance the riskier future and thereby condemns our children to lack of opportunities, and our grandchildren to secular stagnation and lack of jobs.

And all for nothing since bank crisis are always caused by excessive bank exposure to something perceived as safe but that ex post turns out risky, and never because of excessive exposures to something perceived as risky.

This bank regulation was introduced with Basel I en 1988 and made much more distorting of credit allocation with Basel II in June 2004… and Basel III keeps the risk-weighting.

And the distortions they cause are not even discussed. In much because too many economists find it unworthy to dirty their hands with bank regulation technicalities. How vulgar! Keynes knew much about banks and finances, modern Keynesian do not.

God make us daring!

The Basel Committee, the Financial Stability Board and “The Parable of the Talents” Matthew 25:14-30

The governments, on behalf of us citizens, us taxpayers, support the banks in times of troubles, for instance by the Fed acting as a lender of last resort. And that can cost us citizens, us taxpayers, a lot.

But that risk of supporting the banks is not acceptable only in order to produce special profits to bank shareholders, or just to have the banks serve as a mattress where to safely stash away our money. It is accepted exclusively so that banks, by means of efficiently allocating bank credit, could help us to drive our economies forward.

And that willingness to support-the-banks-risk is, for its management, placed into the hands of bank regulators, like the Basel Committee and the Financial Stability Board.

But these regulators decided (on their own) that banks’ primary purpose was to avoid risks… something loony because that by itself would negate the reason for supporting the banks.

And so they concocted credit risk weighted equity requirements that made banks earn much higher risk-adjusted returns on equity when lending to those perceived as "absolutely safe", than when lending to "the risky".

And that regulatory risk aversion, besides stopping banks from lending to the risky, like to small businesses; also made banks lend excessively to what ex ante was perceived as absolutely safe, but that ex post turned out to be very risky, like AAA rated securities and Greece.

And that all resulted in a crisis that caused immense costs… this time without having generated sufficient and reasonable compensation in terms of creating sturdy economic growth.

And those risk adverse regulations now block our way out of the crisis... and might doom our young to become a lost generation.

And today in mass we were reminded of “The Parable of the Talents: Matthew 25:14-30, and of which I extract the following: 

14 “It will be like a man going on a journey, who called his servants and entrusted his wealth to them. 15 To one he gave five bags of gold, to another two bags, and to another one bag, each according to his ability. Then he went on his journey… 

24 “Then the man who had received one bag of gold came. ‘Master,’ he said, ‘I knew that you are a hard man, harvesting where you have not sown and gathering where you have not scattered seed. 25 So I was afraid and went out and hid your gold in the ground. See, here is what belongs to you.’

26 “His master replied, ‘You wicked, lazy servant! So you knew that I harvest where I have not sown and gather where I have not scattered seed? 27 Well then, you should have put my money on deposit with the bankers, so that when I returned I would have received it back with interest. 28 “‘So take the bag of gold from him and give it to the one who has ten bags. 29 For whoever has will be given more, and they will have an abundance. Whoever does not have, even what they have will be taken from them. 30 And throw that worthless servant outside, into the darkness, where there will be weeping and gnashing of teeth.’

And in today's sermon we later heard abut the dangers of caution and of playing it safe; and about the security that comes from risk-taking.

And there was a reference to Erikson’s Theory… with its Generativity that includes reaching out to others in ways that give to and guide the next generation, and a commitment which extends beyond self; versus Stagnation with its placing own comfort and security above challenge and sacrifice, and its self-centered, self- indulgent, and self-absorbed.

And we prayed for “courage so that we can walk in the way of the Lord”… and of course I was reminded of “God make us daring!”

And so I naturally identified with the “Master” in wanting to throw those “wicked lazy” bank regulators “outside, into the darkness, where there will be weeping and gnashing of teeth”

Pope John Paul II: Our hearts ring out with the words of Jesus when one day, after speaking to the crowds from Simon's boat, he invited the Apostle to "put out into the deep" for a catch: "Duc in altum" (Lk 5:4). Peter and his first companions trusted Christ's words, and cast the nets. "When they had done this, they caught a great number of fish" (Lk 5:6).

Bank regulators regulate based on the safety needs of the very old, and not on the risk-taking needs of the young.

On October 13 2014, in the International New York Times, Mary Williams Walsh, in “No smoke no mirrors” analyses comprehensibly the pension plan in the Netherlands.

And therein she writes that, after seeing what the financial crisis had done to the pension accounts: “Dutch young people found their voice. No matter their employment sector, they could see that their pension money was commingled with retirees’ money…[and] they realized that they and the retirees had fundamentally opposing interests. The young people were eager to keep taking investment risk, to take advantage of their long time horizon. But the retirees now wanted absolute safety, which meant investing in risk-free, cashlike assets. If all the money remained pooled, young people said, the aggressive investment returns they wanted would be diluted by the pittance that cashlike assets pay.”

Mary Williams Walsh describes precisely what should be the objection of all young people around the world to current bank regulations, but that the young, unfortunately, have not yet discovered.

The pillar of current bank regulations, is credit risk-weighted capital (equity) requirements for banks… in short more perceived credit risk more equity, less perceived risk less equity. 

And that causes banks to be able to earn much higher risk adjusted returns on assets perceived as “absolutely safe” than on assets perceived as “risky”… which leads banks to not financing the riskier future, but only to refinancing the safer past.

And given that risk-taking, not risk aversion, is what took the western world economies to become what they are, without it, they are bound to stall and fall.

And if that is not dumb short-termish regulations, which might perhaps benefit some of those baby-boomers sooner to pass away, but certainly hurt the young who risk becoming a lost generation, I do not know what is.

It would be great if the young Dutch kids also opened their eyes on this issue, and started a revolt against the banks being all castrated.

“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926

Secular stagnation, deflation, mediocre economy and all similar obnoxious creatures, are direct descendants of silly risk aversion.

Banks need to be regulated more in the interests of the advancees than in the interest of the retirees.