The tree god again

Some months ago the Governor of the Reserve Bank inaugurated his audacious bid to have his institution –  seen by most as a official agency created by, and accountable to, Parliament –  seen as some sort of local pagan tree god, with him (I assume) as the high priest in the cult of Tane Mahuta.  We’ve been told, by the Governor, that a people –  New Zealanders –  walked in economic darkness until finally the light dawned with the creation of the Reserve Bank.  It is pretty absurd stuff, not even backed by decent history or analysis, and one might be inclined just to ignore it, but the Governor seems serious.  In particular, he keeps returning to his claim. In fact, he was at it again –  claiming the mantle of Tane Mahuta –  yesterday with another little release that poses more questions than it offers answers (and which presumably means we’ll end the year still with no substantive speech from the Governor on anything he actually has statutory responsibility for).

Readers might recall that there was a damning report on the Reserve Bank as financial regulator, drawing on survey results of regulated institutions, released in April by the New Zealand Initiative.    This chart summed it up quite well

partridge 1

It has, presumably, been a priority for the Governor to improve the situation.   After all, even the Bank’s Board –  always reluctant to ever suggest any weaknesses at the Bank, even though their sole role is monitoring and accountability –  was moved to comment on this report, and the issues it raises, in their Annual Report this year.

And thus the Governor begins

In a step toward achieving the best “regulator-regulated” relationships possible, the Reserve Bank (Te Pūtea Matua) has established a Relationship Charter for working effectively with banks. The Charter will also be discussed with insurers and non-bank deposit takers in the near future.

One might question just how “best” is to be defined here –  after all, the public interest is not the same as that of either the Reserve Bank or of the banks, and there have been many examples globally of all too-comfortable relationships between regulators and the regulated.

But it was the next paragraph that started to get interesting.

Reserve Bank Governor Adrian Orr said the Relationship Charter commits the Bank and the financial sector to a mutual understanding of appropriate conduct and culture. “This is underpinned by the principle ‘te hunga tiaki’, the combined stewardship of an efficient system for the benefit of all,” Mr Orr said.

I’m not sure that understanding is necesssarily advanced when an institution operating in English introduces little-known phrases from another language to their press releases.  Here is how Te Ara explains “te hunga tiaki”

Te hunga tiaki

The Te Arawa tribes use the term ‘te hunga tiaki’ instead of kaitiaki, explains Huhana Mihinui.

The prefix ‘hunga’ is more common than ‘kai’ amongst Te Arawa, hence te hunga tiaki rather than kaitiaki. The essence of hunga is a group with common purpose. Hunga may also link with the sense of communal responsibilities. The same meaning is not conveyed with ‘kai’ … te hunga tiaki likewise invokes ideas of obligations to offer hospitality, but also to manage and protect, with the implicit recognition of the group’s mana whenua [customary authority over a traditional territory] role in this respect. 1

Which sounds pretty problematic frankly.  Banks and the Reserve Bank do not have a common purpose or a common set of responsibilities.  The Reserve Bank has legal responsibilities to the people of New Zealand, and the banks have legal responsibilities to their shareholders.  The two won’t always be inconsistent, but at times they will and there is little gained (and some things risked) from trying to pretend otherwise.  In both cases –  but particularly in that of the Reserve Bank –  there are limits on the ability of the principals (citizens and shareholders) to ensure that the boards and/or managers are actually operating according to those responsibilities.   Shareholders can sell.  Citizens are stuck with the Governor.

The statement goes on

“Writing it was the easy part. Operating consistently with the conduct principles is the challenge. We will regularly mutually review behaviours with the industry. Appropriate conduct is critical to the trust and wellbeing of New Zealand’s financial system, and the Reserve Bank – the ‘Tane Mahuta’ of the financial garden,” Mr Orr said. 

It is the tree god again –  a tree god that has some considerable way to go in improving its own conduct, be it around attempting to silence critics or whatever.

But this is also where I started to get puzzled.   In both those last two paragraphs from the statement, there is a suggestion that this document is some sort of agreed position between the banks and the Reserve Bank.   It is there in the charter document itself –  a one pager, complete with cartoonish tree god characters.

RBNZ-Relationships-Charter

(What I didn’t see was, for example, “we will avoid abusing our office and putting pressure on regulated bank CEOs to silence their economists when those economists write things we don’t like”.)

The word “mutual” is there twice, clearly suggesting that the banks have signed on to this.

But, if so, isn’t it a little strange that there are no quotes from any bankers, or the Bankers’ Association, in the press release, just the Governor’s own spin?   And when I checked the Bankers’ Association website, there was no statement from them. In fact, I checked the websites of all the big four banks and there was not a comment or statement from any of them.   Frankly, it doesn’t seem very “mutual”.   It looks a lot like gubernatorial spin.

And, to be frank, I don’t really see any good reason why there should be such mutual commitments.   Regulated entities don’t owe anything to the regulators.  They may often be intimidated by them, (privately) derisive of them, or even respect them.  But the regulated entities are just private bodies trying to go about their business in a competitive market.  By contrast, the Reserve Bank  –  the Governor personally –  carries a great deal of power over those entities, and they have few formal remedies against the abuse of that power.   What might reasonably be expected is unilateral commitments by the Governor as to how his organisations will operate in its dealings with regulated entities, standards (ideally measurable ones) that they and we can use to hold the regulator to account.      But that is different from what purports to be on offer in yesterday’s statement.

Of the brief specifics in the list of commitments, I don’t have too much to say.  There is a big element of “motherhood and apple pie” to them, and a few notable elements missing.  There is nothing about analytical rigour, nothing about transparency, nothing about remembering that the Bank’s responsibility is primarily to the New Zealand public, nothing about maintaining appropriate distance between the regulator and the regulated.  But I guess those would have been inconsistent with the fallacious claims about all being in it together and working for common goals.

It is at about this point that the Bank’s press release changes tone quite noticeably (not quite sure what happened to “one organisation, one message, one tone”).   Deputy Governor Geoff Bascand takes over and claims

Deputy Governor Geoff Bascand said the Reserve Bank’s recent announcement of a consultation with banks about the appropriate level of bank capital highlights the usefulness of the Relationship Charter.

And even in that one sentence he captures some of the mindset risks.  As I read the announcement the other day, it was a public consultation about the appropriate level of bank capital, and yet the Deputy Governor presents it as a “consultation with banks”.  If the Bank is going to run with this “Relationship Charter” notion, perhaps they could consider one for their relationship with the only people who give them legitimacy, Parliament and the public (having said that, perhaps I should be careful what I wish for).

And then weirdly –  in a press release supposed to highlight a new era of comity, open-mindedness etc –  the Deputy Governor launches into an argumentative spiel about the proposed new capital requirements.

“There is a natural conflict of interest. Banks will want to hold lower levels of capital to maximise returns for their shareholders. However, customers and society wear the full economic and social cost of a bank failure. We represent society’s interests and will naturally insist on higher capital holdings than any one individual shareholder,” Mr Bascand said.

Strange use of the phrase “conflict of interest”, which usually relates to a person or an organisation having two competing loyalties (perhaps personal and institutional), but even if one sets that point to one side for now, the rest is all rather one-dimensional and not terribly compelling.  He seems unaware, for example, that banks often hold capital well above regulatory minima –  creditors and rating agencies have perspectives too –  or that in most industries firms happily determine their own levels of capital, and somehow society manages (and prospers).  And, of course, there is not an iota of recognition of the way in which bureaucrats all too often serve bureaucratic interests (rather than societal ones), of the distinction between loan losses and bank failures, or of how the interventions of official and ministers often create the problems in the first place.

And then there is the final paragraph

“Following our Relationship Charter, we long signalled the purpose of our work and shared our analysis and consultation timetable. We have also committed significant time to engage with banks and provide a sensible transition period to make any changes we decide on. The Charter means what we are looking to achieve can be discussed professionally, while we continue to build appropriate working relationships. Outcomes will be superior and better understood and owned by society,” Mr Bascand said.

Of course, for example, whether the proposed transition period is “sensible” is itself a matter for consultation (one would hope –  and not just with banks).  Given the high probability of a recession in the next five years –  and the limited firepower here and abroad to deal with a severe recession –  some might reasonably wonder at just how wise it would be to compel big increases in capital ratios over that five year period, at a time when the Bank’s own analysis repeatedly suggests the banks are sound with current capital levels.   Credit availability might well be more than usually constrained.

One might go on to note that the level of disclosure in the consultative document is seriously inadequate for such a substantial intervention –  one that would take New Zealand further away from the international mainstream not closer to it.   As I noted in a post a few days ago, back in 2012 the Bank published a fuller cost-benefit analysis of the sorts of capital requirements that were then in place.  There is nothing similar in the consultative document issued last week, not even (I gather) any engagement with the previous cost-benefit analysis.  Given the amounts of money involved, that is simply unacceptable.  I’ve lodged an Official Information Act request for the (any) modelling and analysis they’ve done, but I (and others) shouldn’t have needed to; it should have been released as a matter of course.  In fact, even better they should have published a series of technical background papers over the year, held discussions with a range of interested parties (not just banks) before coming to the decisions they chose to formally consult on.      That is what good regulatory process might have looked like.

And then there is that bold final claim

Outcomes will be superior and better understood and owned by society

I’m all for effective and professional relationships between the Reserve Bank and the banks it regulates.  Perhaps that may even lead to better policy outcomes, but there is no guaranteee of that (after all, at the end of it all the law allows the Governor to make policy pretty much on a personal whim –  which is a lot like what the proposed higher capital ratios feel like).  But quite how a better relationship between the Reserve Bank and the banks will make outcomes “better understood and owned by society” is a complete mystery to me.   There are plenty of examples of regulators and the regulated ganging up against the public interest, and others of the regulators ramming through changes that might –  or might not –  be in society’s interest.  There is simply no easy mapping from a better relationship between the Bank and the banks, and good outcomes for society, let alone ones that –  whatever it means –  are “owned by society”.   Good outcomes rely heavily on very good and searching analysis.  And nothing in the Charter commits the Bank to that.

When one reads the argumentative second half of the press release it is little wonder the banks themselves wanted nothing to do with the statement.   I guess there isn’t much chance of the banks and the Reserve Bank getting too close to each other in the coming months as they (and the bank parents and APRA no doubt too) fight over the billions of additional capital Adrian Orr thinks they should have.

Meanwhile, the Governor can play at tree gods.  But it would be much better for everyone, including most notably citizens, if he were to engage openly and (in particular) more substantively on the issues he has legal responsibility for.   Cartoons and glib statements don’t build confidence where it counts.

 

 

 

Bank capital proposals: a few initial comments

I wasn’t planning to write today about the Reserve Bank’s proposed new bank capital requirements, announced yesterday.  I’ll save a substantive treatment of their consultative document until (after I’ve read it and in) the New Year.   But I found myself quoted in an article on the proposals in today’s Dominion-Post, in a way that doesn’t really reflect my views.  Perhaps that is what happens when a journalist rings while you are out Christmas shopping and didn’t even know the document had been released. But I repeatedly pointed out to him that, despite some scepticism upfront, I’d have to look at documents in full and (for example) critically review any cost-benefit analysis the Bank was providing before reaching a firm view.

The gist of the proposal was captured in this quote from Deputy Governor Geoff Bascand

“We are proposing to almost double the required amount of high quality capital that banks will have to hold,” Bascand said.

Or in this chart I found on a quick skim through the document.

capital requirements

These are very big changes the Governor is proposing.   As I understand it, and as reflected in my comments in the article, they would leave capital requirements (capital as a share of risk-weighted assets) in New Zealand higher than almost anywhere else in the advanced world.

These were the other comments I was reported as making

The magnitude of the new capital required by banks surprised former Reserve Bank head of financial markets, Michael Reddell, who now blogs on the central bank.

A policy move of this scale would have an impact on the value of New Zealand banks, though ASB, BNZ, Westpac and ANZ are all owned by Australian companies listed on the ASX sharemarket.

“If these were domestically listed companies, you would see the impact immediately,” Reddell said.

That would be through a fall in the price of their shares.

Many KiwiSaver funds own shares in the Australian banks.

I think the journalist got a bit the wrong end of the stick re the first comments –  perhaps what happens discussing such things, sight unseen, in a carpark.  In many respects the magnitude of the increase isn’t that surprising given that the Governor had already indicated –  a week or so before –  his desire to have banks able to resist sufficiently large shocks that, on specific assumptions, systemic crises would occur no more than once in 200 years.  That is much more demanding than what previous capital requirements have been based on –  the same ones the Reserve Bank produced a cost-benefit analysis in support of only five or so years ago, and which have had them ever since declaring at every FSR  how robust the New Zealand banking system is.

As for the second half of the comments, they were a hypothetical in response to the journalist’s question about whether higher bank capital requirements would be felt in wealth losses by (for example) people with Kiwisaver accounts who might hold bank shares.  He was uneasy about the line the Bank used that the increased capital requirements were equivalent to 70 per cent of estimated/forecast bank profits over the five year transitional period (of itself, this isn’t an additional cost or loss of wealth).  My point was that if the New Zealand banks (subsidiaries of the Australian banks or Kiwibank) were listed companies, such an effect would be visible directly, because (rightly or wrongly) markets tend to treat higher equity capital requirements as an additional cost on the business, and thus we could have expected the share price of the New Zealand companies to fall, at least initially.    As it is, I’d have thought it would be near-impossible to see any material impact on the share price of the parents (or thus on the value of any shares held in Kiwisaver accounts).

My bottom-line view remains the one I expressed here a couple of weeks ago

Time will tell how persuasive their case is, but given the robustness of the banking system in the face of previous demanding stress tests, the marginal benefits (in terms of crisis probability reduction) for an additional dollar of required capital must now be pretty small.

And, thus, I’m looking forward to critically reviewing their analysis, including in the light of that previous cost-benefit analysis.   Is it really worth compelling banks to hold much more capital than the market seems to require (even from institutions small enough no one thinks a government will bail them out)?

In thinking through this issue, there are some other relevant considerations to bear in mind.  The first is to reflect on just how unsatisfactory it is that decisions of this magnitude are left to a single unelected individual who, in this particular case, does not even have any particular specialist expertise in the subject.  And his most senior manager responsible for financial stability only took up his job a year ago, having previously had no professional background in banking, financial stability or financial regulation.   The legislation is crying out for an overhaul –  big policy decisions like these really should be made by those we can hold to account (elected politicians).    And note that banks have no substantive appeal rights in these matters, even though the Governor is, in effect, prosecutor, judge and jury, and (in effect) accountable to no one much.

The other is to note that there is likely to be very considerable pushback from Australia on these proposals –  both the parent banks of the subsidiaries operating here and, quite probably, from the Australian regulator (APRA) itself.   The proposed new capital requirements here are far higher than those required in Australia (and for the banking groups as a whole).  APRA has adopted a standard that Australian banks should be capitalised so that the system is “unquestionably strong”, but their Tier 1 capital requirement is apparently “only” 10.5 per cent.       Of course, subsidiaries operating in New Zealand are New Zealand registered and regulated banks, and our authorities should be expected to regulate primarily in the interests of New Zealand.   We won’t look after Australia, and they are unlikely to look after us, in a crisis (and coping with crises are really what bank capital is about).  But you have to wonder why we should be inclined to place such confidence in our Reserve Bank’s analysis, relative to that of APRA –  an organisation with (especially now) much greater institutional depth and expertise.  Given the legislated trans-Tasman banking commitments, and the common interests of the two sets of authorities in the health of the banking groups, one can’t help thinking that it would have been more reassuring to have seen the two regulators (and the two governments for that matter – limiting fiscal risks in the event of bank failure) reach a rather more in-common view on the appropriate capitalisation of banks in Australasia.

But perhaps the Governor really is leading the way, supported by compelling analysis.  More on that (superficially unlikely) possibility in the New Year.   In the meantime, for anyone interested, there is a non-technical summary of their proposal (although not of any supporting analysis) here.

Don’t legislate depositor preference

The government has underway a fairly comprehensive review of the Reserve Bank Act.  The first phase –  around monetary policy –  was pretty narrow in scope, rushed, and has resulted in not very good provisions now about to be legislated by Parliament.  I was always a bit sceptical about Phase 2, partly because of the way Phase 1 was handled and partly because the Minister of Finance had never displayed any particular interest in the issues.

But, for the moment anyway, I’m willing to revise my judgement.  Earlier last month a 100 page consultative document was released, the first of three as the Treasury and the Bank (aided by a somewhat questionable, secretive, independent advisory panel) work their way through the numerous issues involved in overhauling the Reserve Bank legislation and institutional design.

Yesterday, I attended a consultative meeting at The Treasury on the issues in the current document.  It was an interesting group of people and quite a good discussion, although even 2.5 hours is barely enough to do much more than scratch the surface on the wide range of issues in the document –  everything from the role of the Board to regulatory perimeter issues (including whether banks and non-bank deposit-takers should be subject to the same regulatory regime – most people seemed to think so).  Truly keen people can spend their summer preparing written submissions (due in late January).

What was striking –  part of what leads me to provisionally revise my view –  is just how much official resource is being put into this one review.  At yesterday’s meeting there were six members of the review team, and that wasn’t all of them –  and even they only report to their masters in the Reserve Bank and Treasury, many of whom will probably engage quite extensively on the issues. And the process has at least another year to run.  Despite having long championed the cause of reforming the Reserve Bank, I couldn’t help wishing that the same level of resource was being devoted to getting to the bottom of the causes, and compelling remedies, for New Zealand’s astonishingly poor long-term productivity performance.    There is little sign The Treasury has any resources devoted to that issue, the one that has the potential to make a huge difference to the lives of all New Zealanders.

But in this post I wanted to touch on just one specific issue that came up yesterday which surprised quite a bit and worried me quite a lot.   Chapter 4 of the document is devoted to the question of “Should there be depositor protection in New Zealand?”.  Of course, to the extent it adds in value at all, prudential regulation does help the position of depositors (reducing the probability of failure, and limiting the potential chaos if a major failure happens), but New Zealand’s legislation is unusual in that there is no explicit depositor protection mandate (the legislative goals are about the financial system, not individual institutions or their creditors).  Linked to that, we are now very unusual among advanced economies in having no system of deposit insurance.

I wrote about some of these issues, in response to a journalist’s queries, when the consultative document first came out.  But my focus then was on deposit insurance, and in particular on the realpolitik case I see for instituting deposit insurance, to give us the best chance that when a bank gets into serious trouble it will be allowed to fail, and its wholesale creditors –  the ones who really should know what they are doing –  can be allowed to lose their money.   Without deposit insurance, my view is that big banks will always be bailed out.  Perhaps they will even with deposit insurance, but by separating the interests of retail creditors from others, at least political options are opened.

But in focusing on deposit insurance, one thing I hadn’t really noticed in the chapter was the idea of providing depositors with additional protection by legislating depositor preference.  Depositor claims on the assets of a bank rank ahead of those of any other creditors.   Such a provision exists in the Australian legislation –  for Australian depositors.  It was a big part of the reason why New Zealand eventually insisted that Westpac’s retail business in New Zealand be locally incorporated (ie conducted through a New Zealand subsidiary).

To the extent I’d noticed the discussion of the depositor preference option, I’d assumed it was a bit of a straw man, there for completeness perhaps.  Surely, I thought, no one would seriously suggest that New Zealand adopt such a legislative preference.   But, going by the discussion at yesterday’s meeting, it seemed I was wrong and that officials are actually seriously considering this option.   They seem to see it as a complement to a deposit insurance scheme.  I think it would be quite wrongheaded.

In my incomprehension, I asked why  –  starting with a clean sheet of paper – anyone would think legislated depositor preference was a sensible route to consider.  The response seemed to be that it would be a way of reducing the cost of deposit insurance, and increasing the credibility of a deposit insurance scheme.  Both seem weak arguments, especially in the New Zealand context.

One argument sometimes advanced against deposit insurance is that in the event of a systemic financial crisis the cost could be so overwhelming that it would either over-burden public debt, potentially triggering a fiscal crisis, or lead to governments retrospectively walking away from the insurance commitment (simply legislating to not pay out).  In fact, we know that for reasonably governed countries that practical limits on the ability to take on new public debt are not very binding at all.   And we know that New Zealand has (a) very low levels of net public debt by advanced country standards, and (b) a banking system of only moderate size (relative to GDP) by advanced country standards.    Total household deposits with all registered banks are about $175 billion.  Not all of those would be covered by a deposit insurance scheme, even one that capped cover at a relatively high $200000.

Now lets assume something really really bad happens: banks lend so badly over multiple years that when the eventual reckoning happens loan losses are so large that 30 per cent of all bank assets are written off.   This would be absolutely huge –  far far beyond anything in Reserve Bank stress test, for beyond advanced country experience for retail-oriented banks.  But one can’t rule out by assumption utter disasters.  30 per cent of bank assets is currently about $175 billion as well.  There is about $40 billion of equity to run through, and then the creditors start bearing the losses.  Household deposits are about a third of non-equity liabilities, so in this extreme scenario the deposit insurer (and residual Crown underwriter) would face bills of up to perhaps $50 billion (a generous third of $135 billion of losses to be distributed across creditors and insurers).    And remember how extreme this scenario is: it assumes every bank in the system fails, and fails dramatically (not just slightly underwater), and that every household deposit is fully covered by deposit insurance.  In this really really bad, highly implausible scenario the bill presented to the depositor insurer is equal to less than 20 per cent of GDP.

Reasonable people can, of course, differ on whether deposit insurance is a good idea at all, just better than the likely alternative (my view), or something to be eschewed at all costs.  But in no plausible world would even a commitment of 20 per cent GDP overwhelm New Zealand public finances, or cast doubt on the ability of the New Zealand government to honour its obligations.   And none of this takes into account the likelihood that any deposit insurance scheme would be set up funded by insurance levies  Levy depositors, say, 20 basis points a year and you’ll be collecting (and setting aside) $350 million a year.  As I recall it, prudential policy (bank capital requirements) are currently set with a view to expecting systemic crises no more than once in a hundred years (the Governor the other day talked of extending that to once in 200 years).    If the really really bad systemic crisis hits in year 1, the government needs to borrow more upfront (recouped over time by the annual insurance fees).  If the really really bad crisis hits in year 150, there is a large pool of money standing ready, accumulated from those same annual insurance fees.

(Of course, in any scenario in which banks have lent so badly –  and regulators regulated so poorly –  that 30 per cent of all assets are written off, the economy is likely to be performing very badly for a while, and the public finances will be under some pressure anyway.  But those problems are there regardless of the resolution method chosen.)

The other argument I heard advanced for a legislated depositor preference is that it would reduce the cost of deposit insurance.    That might look like a superficially plausible argument, but it is almost certainly wrong in any economically meaningful sense.   Sure, if your bank is funded 50/50 by retail depositors on the one hand and wholesale creditors on the other, the chances that a deposit insurance fund will ever have to pay out to the depositors of that bank, in the presence of legislative preference, is very small (roughly speaking, losses would have to exceed 50 per cent of all the assets for depositors to be exposed to loss –  and thus the deposit insurer).    But if you don’t pay for your insurance one way you will pay for it another way.   If depositors have first claim on bank assets and all other creditors are legislatively subordinated, over time depositors are likely to earn lower interest rates than otherwise (less risk to compensate for) and other creditors more).   It might be hard to show this effect in the case, say, of the big Australian banks, but then no one seriously thinks the Australian government would do anything other than bail out those banks in the event of a crisis.  But we can see the pricing on existing subordinated debt issued by banks around the world – it yields, as you would expect, more than deposits.  It is much riskier.

Of course, it is true that legislating a depositor preference largely shifts the problem from the Crown balance sheet (underwriting the deposit insurer) to those of banks and their creditors.  That might look like a smart thing to do  –  internalising the issue and all that –  but in fact it is a subterfuge: trying to meet a public policy priority (depositor protection) by forcing banks to change their entire business model.  Much better to do things in a direct and transparent way: if you want deposit insurance, charge for it directly, and allow banks to determine how they operate their businesses (funding structures etc) given the insurance levies they face, and the market opportunities.  Doing so also operates more fairly – and efficiently – across different types of banks.  Depositor preference accomplishes nothing at all  in a bank that is 100 per cent deposit-funded, and such institutions should be competing on a competitively neutral basis with other banks with different mixes of funding.

In the consultative document, and again in the discussion yesterday, officials seemed to see a model in which wholesale creditors are exposed to more risk as a “good thing”, conducive to effective market discipline.  I’m with them on that point in so far as people -especially wholesale creditors –  who lend to banks should face a real risk of losing their money.  But depositor preference in effect says that the only way non-depositors can lend to banks is through instruments on which the losses mount extremely rapidly if anything goes wrong.  There is no good case for that (even if, as some do, you think it is reasonable to require banks to issue some tranche of subordinated or convertible debt).   It is a doubly surprising argument to hear mounted in New Zealand where for years –  and especially since 2008 –  we have been repeatedly reminded of the heavy exposure of our banks to offshore wholesale funding markets.   None of those holders has to take on exposure to New Zealand or New Zealand banks.   Legislate depositor preference and what you will do is to significantly increase the risk of those funding markets, for New Zealand, freezing, and yields on secondary market instruments going sky-high, at the first sign of any trouble, or even just nervousness.    Retail runs are one issue to think about, but as we saw globally in 2008 wholesale runs can be just as real, and perhaps more threatening (and lightning fast) –  I discussed the Lehmans story here.

I hope the legislated depositor preference option is taken off the table quickly.  It has the feel of clever wheeze intended to ease the path for deposit insurance.  Much better to make the case –  and there is a sound one –  for a properly funded deposit insurance scheme on its own merits.

On a totally different subject there was a surprising article in the Herald yesterday in which a former MPI official was discussing openly concerns held in 2008/09 about the potential financial health of Fonterra.   I was involved in this work at the time, working at The Treasury, and have always been a bit surprised that there wasn’t more open analysis of the issue at the time.  Just drawing on public information, the combination of:

  • a quite highly indebted cooperative,
  • largely frozen international credit markets (not just for banks),
  • highly-indebted farmer shareholders,
  • a model in which shareholder farmers could redeem their shares in Fonterra when their production dropped,
  • a drought the previous year (reducing production) and
  • low product prices, encouraging some farmers to further reduce production, and
  • the potential for some highly-indebted farmers to be sold up by their banks

was a pretty obvious basis for some vulnerability.    Fortunately, the particular extreme combination of risks never really crystallised.   One aspect of the 2008/09 crisis that was always interesting was –  in the words of one investment bank CEO at the time –  “one of the few markets that remain open is the New Zealand corporate bond market”.  That was because it was, and always has been, primarily a retail market, different from the situation in many other countries (reflecting regulatory differences).  In early 2009 Fonterra was able to run a highly successful domestic retail bond issue.  Subsequent changes to the Fonterra capital structure mean that in future serious downturns, redemption risk is no longer a consideration.  That, however, leaves more of the (liquidity) risk on farmers themselves.

What?

In the press release for last week’s Reserve Bank Financial Stability Report, the Governor commented that

Our preliminary view is that higher capital requirements are necessary, so that the banking system can be sufficiently resilient whilst remaining efficient. We will release a final consultation paper on bank capital requirements in December.

In commenting briefly on that, I observed

Time will tell how persuasive their case is, but given the robustness of the banking system in the face of previous demanding stress tests, the marginal benefits (in terms of crisis probability reduction) for an additional dollar of required capital must now be pretty small.

There wasn’t much more in the body of the document (and, as I gather it, there wasn’t anything much at the FEC hearing later in the day), so I was happy to wait and see the consultative document.

But the Governor apparently wasn’t.  At 12.25pm on Friday a “speech advisory” turned up telling

The Reserve Bank will release an excerpt from an address by Governor Adrian Orr on the importance of bank capital for New Zealand society.

It was to be released at 2 pm.   The decision to release this material must have been a rushed and last minute one –  not only was the formal advisory last minute, but there had been no suggestion of such a speech when the FSR was released a couple of days previously.

And, perhaps most importantly, what they did release was a pretty shoddy effort.    We still haven’t had a proper speech text from the Governor on either of his main areas of responsibility (monetary policy or financial regulation/supervision) but we do now have 700 words of unsubstantiated (without analysis or evidence) jottings on a very important forthcoming policy issue. which could have really big financial implications for some of the largest businesses in New Zealand and possibly for the economy as a whole.

The broad framework probably isn’t too objectionable.  All else equal, higher capital requirements on banks will reduce the probability of bank failures, and so it probably makes sense to think about the appropriate capital requirements relative to some norm about how (in)frequently one might be willing to see the banking system run into problems in which creditors (as distinct from shareholders) lose money.  At the extreme, require banks to lend only from equity and no deposit or bondholder will ever lose money (there won’t be any).

But what is also relevant is the tendency of politicians to bail out banks.  Not only does the possibility of them doing so create incentives for bank shareholders to run more risks than otherwise (since creditors won’t penalise higher risk to the same extent as otherwise), but there is a potential for –  at times quite large –  fiscal transfers when the failures happen.  Politicians have more of an incentive to impose high capital requirements on banks when they acknowledge their own tendencies to bail out those banks.  If, by contrast, they could resist those temptations –  or even manage them, in say a model with retail deposit insurance, but wholesale creditors left to their own devices –  it would also be more realistic to leave the question of capital structure to the market –  in just the same way that the capital structure of most other types of companies is a mattter for the market (shareholders interacting with lenders, customers, ratings agencies and so on).

But nothing like this appears in the Governor’s jottings.  Instead, we have the evil banks, the put-upon public and the courageous Reserve Bank fighting our corner.   I’d like to think the Governor’s analysis is more sophisticated than that, and one can’t say everything in 700 words, but…..it was his choice, entirely his, to give us 700 words of jottings and no supporting analysis, no testing and challenging of his assumptions etc.

There are all manner of weak claims.  For example

We know one thing for sure, the public’s risk tolerance will be less than bank owners’ risk tolerance. 

I think the point he is trying to make is about systemic banking crises –  when large chunks of the entire banking system run into trouble.  There is an arguable case –  but only arguable –  for his claim in that situation, but (a) it isn’t the case he makes, and (b) I really hope that (say) the shareholders of TSB or Heartland Bank have a lower risk tolerance around their business than I do, because I just don’t care much at all if they fail (or succeed).  Their failures  –  should such events occur –  should be, almost entirely, a matter for their shareholders and their creditors, with little or no wider public perspective.

There are other odd arguments

Banks also hold more capital than their regulatory minimums, to achieve a credit rating to do business. The ratings agencies are fallible however, given they operate with as much ‘art’ as ‘science’.

Bank failures also happen more often and can be more devastating than bank owners – and credit ratings agencies – tend to remember.

And central banks and regulators don’t operate “with as much ‘art’ as ‘science'”?   Yeah right.   And the second argument conflates too quite separate points.  Some bank failures may be “devastating” –  although not all by any means (remember Barings) –  but the impact of a bank failure isn’t an issue for ratings agencies, the probability of failure is.   And I do hope that when he gets beyond jottings the Governor will address the experience of countries like New Zealand, Australia, and Canada where –  over more than a century –  the experience of (major) bank failure is almost non-existent.

The Governor tries to explain why public and private interests can diverge (emphasis added)

First, there is cost associated with holding capital, being what the capital could earn if it was invested elsewhere. Second, bank owners can earn a greater return on their investment by using less of their own money and borrowing more – leverage. And, the most a bank owner can lose is their capital. The wider public loses a lot more (see Figure 2).

But what is Figure 2?

figure 2

Which probably looks –  as it is intended to –  a little scary, but actually (a) I was impressed by how small many of these numbers are (bearing in mind that financial crises don’t come round every year), and (b) more importantly, as the Governor surely knows, fiscal costs are not social costs.  Fiscal costs are just transfers –  mostly from one lots of citizens (public as a whole) to others.  I’m not defending bank bailouts, but they don’t make a country poorer, all they do is have the losses (which have arisen anyway) redistributed around the citizenry.  If the Governor is going to make a serious case, he needs to tackle –  seriously and analytically –  the alleged social costs of bank failures and systemic financial crises.  So far there is no sign he has done so.  But we await the consultative document.

There is a suggestion something more substantive is coming

We have been reassessing the capital level in the banking sector that minimises the cost to society of a bank failure, while ensuring the banking system remains profitable.

The stylised diagram in Figure 3 highlights where we have got to. Our assessment is that we can improve the soundness of the New Zealand banking system with additional capital with no trade-off to efficiency.

and this is Figure 3

capital chart

It is a stylised chart to be sure, but people choose their stylisation to make their rhetorical point, and in this one the Governor is trying to suggest that we can be big gains (much greater financial stability, and higher levels (discounted present values presumably) of output) by increasing capital requirements on banks.

I don’t doubt that the Bank can construct and calibrate a model that produces such results.  One can construct and calibrate models to produce almost any result the commissioning official wants.  The test will be one of how robust and plausible the particular specifications are.  We don’t know, because the Governor is sounding off but not (yet) showing us the analysis.  Frankly, I find the implied claim quite implausible.   Probably higher capital requirements could reduce the incidence of financial crises.  But the frequency of such events is already extremely low in well-governed countries where the state minimises its interventions in the financial system, so I don’t see the gains on that front as likely to be large.    And, as I’ve outlined here in various previous posts I don’t think that the evidence is that persuasive that financial crises themselves are as costly as the regulators (champing at the bit for more power) claim.  And many of the costs there are, arise from bad borrowing and lending, misallocation of investment resources, which are likely to happen from time to time no matter how well-capitalised the banks are.

There are nuanced arguments here, about which reasonable people can disagree. But not in the Governor’s world apparently.

He comes to his concluding paragraph, the first half of which is this

A word of caution. Output or GDP are glib proxies for economic wellbeing – the end goal of our economic policy purpose. When confronted with widespread unemployment, falling wages, collapsing house prices, and many other manifestations of a banking crisis, wellbeing is threatened. Much recent literature suggests a loss of confidence is one cause of societal ills such as poor mental and physical health, and a loss of social cohesion.

Oh, come on.  “Glib proxies”……..    No one has ever claimed that GDP is the be-all and end-all of everything, but it is a serious effort at measurement, which enables comparisons across time and across countries.  Which is in stark contrast to the unmeasureable, unmanageable, will-o-wisp that the Governor (and Treasury and the Minister of Finance) are so keen on today.

As for the rest, sometimes financial stresses can exacerbate unemployment and the like,  but the financial crises typically arise and deepen in the context of common events or shocks that lead to both: people default on their residential mortgages when they’ve lost their jobs and house prices have fallen, but those events don’t occur in a vacuum.  And anyone (and Governor) who wants to suggest that mental health crises and a decline in social cohesion can be substantially prevented by higher levels of bank capital is either dreaming, or just making up stuff that sounds good on a first lay read.

The Governor ends with this sentence

If we believe we can tolerate bank system failures more frequently than once-every-200 years, then this must be an explicit decision made with full understanding of the consequences.

As if his, finger in the dark, once-every-200 years is now the benchmark, and if not adopted we face serious consequences.   Let’s see the evidence and analysis first.  Including recognition that systemic banking crises don’t just happen because of larger than usual random shocks –  the isimplest scenario in which higher capital requirements “work” –  but mostly from quite rare and infrequent bursts of craziness, not caused by banks in isolation, but by some combination of banks and (widely spread) borrowers, often precipitated by some ill-judged or ill-managed policy intervention chosen by a government.   Higher capital ratios just aren’t much protection against the gross misallocations that arise in the process –  in which much of any waste/loss is already in train (masked by the boom times) before any financial institution runs into trouble (the current Chinese situation is yet another example).

Perhaps as importantly, under the current (deeply flawed) Reserve Bank Act the choice about capital is one the Governor is empowered to make.  But his deputy, responsible for financial stability functions, had some comments to make on this point in a recent speech (emphasis added)

And Phase 2 of the Government’s review is an opportunity for all New Zealanders to consider the Reserve Bank’s mandate, its powers, governance and independence. The capital review gives us all an opportunity to think again about our risk tolerance – how safe we want our banking system to be; how we balance soundness and efficiency; what gains we can make, both in terms of financial stability and output; and how we allocate private and social costs.

It may be that the legislation underpinning our mandate can be enhanced, for example, by formal guidance from government or another governance body, on the level of risk of a financial crisis that society is willing to tolerate.

These are choices that should be made by politicians, who are accountable to us, not by a single unelected and largely unaccountable (certainly to citizenry) official.  We need officials and experts to offer analysis and advice, not to be able to impose their personal ideological perspectives or pet peeves on the entire economy and society.

We must hope that the forthcoming consultative document is a serious well-considered and well-documented piece of analysis, and that having issued it the Governor will be open to serious consideration of alternative perspectives.  But what was released last Friday –  700 words of unsupported jottings –  wasn’t promising.

(I should add that I have shifted my view on bank capital somewhat over the years, partly I suspect as a result of no longer being inside the Bank. It is somewhat surprising how –  for all one knows it in theory –  things look different depending on where one happens to be sitting.  But my big concern at present is not that it would necessarily wrong to raise required bank capital, but that the standard of argumentation from a immensely powerful public official seems –  for now – so threadbare.)

Implicit admissions and bids for resources

The Reserve Bank’s Financial Stability Report was released earlier this morning.  The headline, of course, was the easing in the loan to value restrictions on mortgage lending, although perhaps what should get more attention was the Governor’s suggestion that the avowedly “temporary” restrictions” will be in place for at least “the next few years”.     There was no good case for them –  putting a bureaucrat between willing borrowers and willing lenders – in the first place, and there is no good case for having them in place now.  Other than, of course, the interest that isn’t the public interest at all –  more discretionary power for an unelected unaccountable public official.

(Given the Bank’s repeated unease about dairy debt, it has also never been clear to me why LVR limits were appropriate for people buying houses but not for people buying farms. I used to raise the point while I was still at the Bank, and have never heard a satisfactory or persuasive response.)

Two other small things in the press release warrant just brief mention for now:

The first was this

Our preliminary view is that higher capital requirements are necessary, so that the banking system can be sufficiently resilient whilst remaining efficient. We will release a final consultation paper on bank capital requirements in December.

Time will tell how persuasive their case is, but given the robustness of the banking system in the face of previous demanding stress tests, the marginal benefits (in terms of crisis probability reduction) for an additional dollar of required capital must now be pretty small.

And the second was this

Aside from CBL, the insurance sector as a whole is meeting its minimum capital requirements. However, capital strength has declined and a number of insurers are operating with small buffers. The insurance industry must ensure it has sufficient capital to maintain solvency in all business conditions.

That is quite a shot across the bows of the sector, but it is worth remembering that when the solvency standards were set up the Reserve Bank consciously chose not to require insurers to hold sufficient capital to remain solvent in all circumstances. I vividly recall the day I asked, at the internal Financial System Oversight Committee, whether the solvency standards were demanding enough that they would have prevented the AMI collapse, and was told no.

But two other things caught my eye in the full document.

The first was that the Bank no longer seems to be claiming that LVR controls –  coming between borrowers and lenders for five years now –  have done anything to improve the soundness of the financial system (while they have inevitably impaired the efficiency of the system).  Those are the statutory goals the Bank is required to use its powers towards, and yet in the document today we find this (in the cartoon summary at the front):

The restrictions have reduced the number of borrowers who would be forced to sell their houses or significantly reduce spending if they ran into financial problems.

But, even if true, that is not the same –  at all – as improving the soundness of the financial system. It is about “nanny knows best” customer protection, which is no part of the Bank’s mandate.   You can’t be forced to sell your house if the Bank’s action prevented you from getting into one in the first place.

And here is the claim from the body of the document

The Reserve Bank’s LVR restrictions have leaned against the build-up in risks from high household debt by increasing the amount of equity borrowers have in their homes. The restrictions have seen the proportion of outstanding mortgage debt to households with loans larger than 80 percent of the value of their houses fall from over 20 percent in 2013 to under 7 percent. This extra equity provides households with more room to avoid cutting consumption or defaulting on their loans if economic conditions deteriorate or if interest rates rise.

Nannying again, not (apparently) focused on the soundness of the financial system.  As a reminder, the two diverge because (a) even if LVR controls modestly reduced housing lending risks, we never get a good sense of what other risks banks have taken on to maintain profits, and (b) because less risky lending means banks need to hold less capital.  Capital relative to (properly assessed) risk-weighted assets is the key issue when it comes to solvency.

From the text there is no way of telling whether the Bank’s focus has really changed or just the marketing. But marketing –  from a powerful public agency – should be aligned with, and disciplined by, mandate.

And then there is climate change.  In the Governor’s press release there was this

In the medium-term, an industry response to a variety of climate change-related challenges appears likely, requiring investment.

Which is pretty cryptic, perhaps even empty.

But in the full document there is a two page spread on “The impact of climate change on New Zealand’s financial system”.   There is lots of text, and very little substance.  It smacks of the Governor bidding for relevance – signalling to his buddies on the (political and business) left –  and involvement in the wider whole of government programme, and perhaps worse, it looks like a bid for more budgetary resources (a case we know the Bank has been making) or amended legislation to do things like

The Reserve Bank is developing its own climate change strategy. The strategy focuses on ensuring that climate risks are appropriately incorporated within the Reserve Bank’s mandate. The Reserve Bank also stands ready to collaborate with industry and government to help position New Zealand for the challenges ahead.

This for a body with two city offices, and a balance sheet full mostly of exposures to New Zealand government debt and overseas government debt.

The text burbles on about possible risks, but it all adds up to very little.     There are numerous risks banks and borrowers face every decade, every century.  Relative prices change, trade protection changes, external markets change, exchange rates change, technology changes, economies cycle, land use law changes.  Oh, and the climate changes.

If one looks at the structure of New Zealand bank (or insurer balance sheets) it just isn’t credible that climate change poses a significant risk to the soundness of the New Zealand financial system (that pesky law again).   Some individuals are likely to face losses from actual and prospective sea-level rises, but banks (and insurers) typically have diversified national portfolios.   People can’t have mortgage debt without insurance, and so the insurers are likely to be constraining people first.   Much the same surely goes for the rural sector?   Sure, adding agriculture into the ETS at the sort of carbon price some zealots have called for would be pretty detrimental to the economics of a dairy debt portfolio, but then freeing up the urban land market probably wouldn’t be great for residential mortgage portfolios, and we don’t see double-page spreads from the Reserve Bank on that issue, or the Governor trying to play himself into some more central role in that area.     It smacks of politics –  signalling the Governor’s green credentials –  more than anything legitimately tied to financial system soundness.

But then we probably should not be surprised. The Governor sells himself as head of tree god (fortunately there was none of that stuff in today’s document), and gives speeches on climate change, but eight months into his term still hasn’t managed to give a speech on either of his main areas of statutory responsibility (monetary policy or financial supervision/regulation/stability).

 

LVR restrictions: towards the FSR

The Reserve Bank’s latest Financial Stability Report is due out on Wednesday.  Perhaps we will see some further articulation of the Governor’s strange vision of the Bank as a tree god, but I guess the main interest will be in what, if anything, the Governor does with the loan to value controls rushed into place, and then frequently amended, by his predecessor a few years ago.  It is as well to recall that although legislation is going through Parliament at present that will, at least on paper, modestly weaken the Governor’s personal power over monetary policy, in respect of banking regulation his statutory powers remain untrammelled, and unchannelled.  There are few legal constraints on what he  –  an unelected official whose appointment was controlled by unelected and unaccountable academics and company directors –  can do.

Market economists are, understandably enough, focused on the narrow question of whether there will be any changes to the rules announced this week. You can read a summary of their views here.   I remain less interested in that (forecasting) issue than in the cases for and against having such controls in the first place.   They are a new thing: we never had some legal restrictions in the bad old days of a heavily regulated financial system prior to 1984.  But, like weeds or wilding pines, once regulatory controls get in place people come to treat them as normal, the only debate tends to occur around the edges, and it takes huge effort to do something serious about fixing the problem.  Years ago, when the LVR restrictions were first introduced, we were assured they would be temporary (I was still inside the Bank at the time, and as far as I could see senior people genuinely believed it) but now the very idea that willing lenders and willing borrowers should be free to contract on mutually agreeable terms seems to be becoming lost.

The Herald’s economics columnist Brian Fallow used his column last Friday to argue to “Keep the brakes on houses”.  I can’t see the column on line, but the gist of his article is that house prices are high and household debt is high and that unless that combination changes the Reserve Bank shouldn’t think of lifting the LVR controls.  It doesn’t matter that stress tests repeatedly show that banks can cope with big falls in house prices and even big rises in the unemployment rate.  It doesn’t matter that our banks came through the last serious recession –  when household debt to GDP was about as high as it is now –  unscathed. It doesn’t matter that high house and land prices are mostly a phenomenon of the artificial scarcity created by land use restrictions (with high construction costs into the mix).  It doesn’t even seem to matter than there is no evidence that the LVR controls have made banks safer (banks with fewer individual risky loans also need to hold less capital) or the economy more stable.  It doesn’t seem to matter that the LVR controls have acted to favour established (cashed-up) buyers over new entrants to the housing market.  No, even though there is no threat to financial stability, and everyone recognises that LVR limits impede the efficient functioning of financial markets  (and those are the only two criteria the law allows the Bank to act under), the call is simply to leave the controls in place.

It was a bit like people in earlier decades who opposed removing import licenses or exchange controls because of the “foreign exchange constraint” (imports might increase if we took the controls off): papering over symptoms rather than tackling causes is rarely a sensible approach to policy.  Sadly, this government, like its predecessor, seems to be doing almost nothing to fix the underlying problem (and when I heard the UDA announcement over the weekend cited as something that had “worked well” in the UK and Australia one was reminded a new of just how obscene house prices in the UK and Australia remain).  But if the government isn’t doing anything serious, they will no doubt be grateful for the cover the Reserve Bank provides, claiming that somehow it is “doing its bit”, when it has no responsibility (there is “our bit”) for the fundamental problem.

But, of course, with no evidence whatever, the Governor is convinced that he knows best, the banks and markets are too “short-sighted” and so no doubt the controls will remain.  If the Governor is really so convinced he should at least really go to the effort of persuading the Minister of Finance to agree to extend the restrictions to other non-bank lenders.  The LVR controls only apply to banks because they are the only lenders the Reserve Bank Governor himself can order round in this way –  restrictions on other non-bank deposit-takers require the agreement of the Minister of Finance.  We have been fortunate in the last few years that there has been less disintermediation of mortgage business to non-bank lenders than most (including Reserve Bank staff doing the evaluation) had expected.   But if we learned anything from the decades of heavy controls prior to 1984, over time risk-taking will gravitate to institutions where it can occur.  Putting in place a competitively-neutral regulatory framework (treating banks and non-banks similarly) was a huge step forward in the 1980s, and it is unfortunate that the Reserve Bank now treats the same risks differently depending on whether an institution wears a “bank” or “non-bank” label.

At the press conference a few weeks ago for the Monetary Policy Statement, the Governor and his deputy (once a fairly market-oriented economist) indicated that in the forthcoming Financial Stability Review the Bank was planning to outline a more disciplined framework or road-map for assessing when, and whether, adjustments should be made to the LVR controls.  In principle, that sounds sensible and welcome. In principle, it should involve the Bank setting out some markers against which they can be held to account when the next decisions/reviews come round.  Whether it is so in practice only time will tell, but I was disconcerted when I heard them talking of this new framework as something similar to what they have for OCR decisions.

While we have a Reserve Bank there have to be regular monetary policy decisions.  That isn’t so for LVR restrictions, and it would be unfortunate if the initiative the Bank has foreshadowed was also about entrenching LVR controls as a permanent feature of New Zealand’s financial system.  Capital and liquidity requirements, backed by regular and robust stress tests, should remain the heart of our banking regulatory framework, rather than having bureaucrats reach into private businesses –  well-run over decades –  and tell them who they can and can’t lend to, or who they can and can’t employ.  But bureaucrats have incentives to build up their bureau and are typically reluctant to give up powers they’ve once got their hands on.  They are just human, and in their shoes you and I might face similar temptations.  We need banking regulation and supervision –  mostly, in my view, because politicians will bail out large banks in crises and everyone knowing that efforts need to be made to limit the risks –  but its appropriate place is distinctly limited, accountable, and kept in fully in check.   Instead, those paid to hold the Bank to account –  ministers, the Board, FEC –  mostly just accommodate the regulators, at times even egging them on.

On a totally different matter, for anyone interested in a some snippets of New Zealand economic history, you might want to try the latest Newsroom/Radio New Zealand Two Cents’ Worth podcast, which was built around the odd coincidence that –  if you look at the data a bit loosely and from the right angle – for several decades in a row, years ending in 8 had also seen a New Zealand recession.  I did an interview with Bernard Hickey for the podcast, in which he had me run quickly through aspects of the New Zealand economy in each “8” year since 1918.   As I noted to Bernard, there is now a rather large hole in the market for a up-to-date economic history of New Zealand (the last full one appeared in about 1985 and much has been done, much has happened, since then).  Brian Easton’s long-awaited history of New Zealand from an economics perspective – his framing –  is still awaited.

More thoughts on financial crises and economic performance

In my post yesterday, focused specifically on Geoff Bascand’s speech on financial stabilty, financial crises etc, I used this chart

crisis costs

to, again, raise questions about just how much of the poor economic performance over the last decade or so can really be ascribed specifically to the financial crisis (bank failures, large loan losses etc).  After all, the US was the epicentre of the crisis, and my other group of countries (long-established advanced countries, also with floating exchange rates –  Australia, Canada, New Zealand, Norway, Israel, and Japan)  didn’t have domestic financial crises.

I’d been playing around with that data with a view to writing a post about an article in the latest issue of Foreign Affairs, The Crisis Next Time: What We Should Have Learned from 2008″, by Carmen and Vincent Reinhart (she an academic researcher, and he a senior market economist and formerly a senior Fed official).    The Foreign Affairs website is having open access this month, so the link should work for anyone wanting to read the (accessible and not overly long) article itself.

I thought the article was a bit of a mixed bag (and this post ends up only partly being about the article).  Carmen Reinhart, in particular, has been at the forefront of efforts to remind that recessions associated with financial crises are often more severe than other recessions.  That is a useful reminder, but hardly surprising.  Mild recessions tend not to generate many loan losses, and even if the banking system wasn’t rock solid in the first place, nothing too serious is likely to follow.  But if resources have been severely misallocated in the first place, supported by ample new credit, then when the correction occurs –  and views about what is profitable have to be revised –  it isn’t surprising that the associated recession can be deep and the financial system can come under stress.  In New Zealand, for example, it wasn’t the financial system crisis (failure of DFC, repeated near-failures of the BNZ) that made the 1991 recession so serious; rather than pressures on the financial system were part of the same aftermath of excess –  over-inflated expectations – that the entire economy was caught up in, combined with some serious efforts to break the back of high trend rates of inflation.

As the Reinharts point out, the problems can then be particularly severe in a country that has few or no macro policy levers left open too it –  a fixed exchange rate or a common currency, tied to the fortunes of a group that may not share the particular problems you did (thus, for example, Ireland in a euro-area in which Germany is the largest economy).  Adjustment can be a lot slower without the ability to adjust the nominal interest and exchange rates.  Perhaps more than the authors, I’m a sceptic on the euro.

For my purposes, there is a convenient couple of sentences in the Reinhart article

Financial crises do so much economic damage for a simple reason: they destroy a lot of wealth very fast. Typically, crises start when the value of one kind of asset begins to fall and pulls others down with it. The original asset can be almost anything, as long as it plays a large role in the wider economy: tulips in seventeenth-century Holland, stocks in New York in 1929, land in Tokyo in 1989, houses in the United States in 2007. 

It usefully highlights a key difference between, say, the US (or Ireland or Iceland) late last decade, and the experiences of the group of non-crisis floating exchange rate countries whose experience is reflected in that first chart above.   Stock markets in those latter countries took a short-term hit, of course, but there was no sustained loss of (perceived) wealth akin to what happened in the crisis countries.

It isn’t entirely clear from the article how much the authors want to focus mostly on the depth of the initial recession and how much on the disappointing economic outcomes in many countries over the last decade.  But both are mentioned, and there seems to be a tone that conflates the two in a way that I’m not surely is overly helpful (given the goal of learning lessons that can help better prepare us for future severe adverse events).  There also seems to be a very strong focus on the demand side, and none at all on the supply side (no mention at all of productivity growth).

And yet, if we look across the OECD as a whole, the unemployment rate was right back down to where it had been in 2007.  If (and there is) a disappointment about the last decade as a whole, it can’t be now about excess labour supply (unemployed workers) –  slow as the unemployment rate was to come down, it did eventually.  As it happens, the unemployment rate in the US (epicentre of the crisis) is now lower than in the median of my non-crisis floating exchange rate group –  which wasn’t the case in the years running up to 2008.

I have plenty of criticisms for the way many central banks (including our own) handled the years after the 2008/09 crisis and recession.  In some cases, actually tightening when it wasn’t necessary or appropriate, and often a hankering for some sort of return to “normal” interest rates (that may have prevailed in the previous couple of decades) when as has become increasingly apparent something about what is “normal” has changed.  Throw in the lack of any pro-activity in addressing the existence of the near-zero lower bound on nominal interest rates (itself arising from regulatory and legislative choices), and it is clear that more could –  and should –  have been done in many countries.

But even if such changes (in macro policy) had been made, the differences in economic outcomes would probably have been at the margin:  helpful (eg in a New Zealand context, getting core inflation back to 2 per cent, and getting unemployment down to the NAIRU perhaps two or three years earlier), but it is unlikely that it would have made much difference to productivity growth, or indeed to levels of real GDP per capita today.

In yesterday’s post, I showed a chart comparing labour productivity growth trends in the US (epicentre of the financial crisis) and in the group of non-crisis floating exchange rate advanced economies.  But what about multi-factor productivity?

The OECD only has MFP data for a subset of member countries.  Of my sample of non-crisis advanced countries, they don’t have data for Norway and Israel.  But here is the comparison for the US and the group of four non-crisis advanced countries, all normalised to 2007.

MFP crisis.png

In both cases –  although perhaps more starkly so for the non-crisis countries –  it is clear that the slowdown in productivity growth was underway well before the recession (and crisis).  The financial crisis (centred in the US) cannot be to blame for something that is (a) apparent across crisis and non-crisis countries (especially when the non-crisis countries are less productive than the US to start with), and (b) when the phenomenon got underway before the crisis or recession did.

(The Conference Board Total Economy database does have MFP estimates for my full group of non-crisis countries.   They use a different model to estimate MFP, but the same two key observations hold in their data: the slowdown was apparent in both lots of countries well before the crisis/recession, and (if anything) the US has done better than the non-crisis group both before and since its crisis.)

But what about some of the euro-area countries you ask?  And the Reinharts themselves rightly point out how poor the economic performance of Italy (and Greece) has been.  The OECD doesn’t have MFP estimates for Greece, but here are the estimates for three other embattled euro-area countries: Portugal, Spain, and Italy.

MFP crisis 2

All three countries have been in deep trouble for a long time now –  the estimated level of MFP peaking around 2000.   On this score, the trends don’t look materially different over the last decade than over the years leading up to 2007.    Whatever the cause of their problems with productivity, it can’t have been the financial crises these countries went through.

And perhaps nor would you expect it.  Readers might recall a wrenching financial crisis that Korea went through in 1998.   And here is the OECD estimate of multi-factor productivity for Korea.

mfp crisis 3

You can see the 1998 crisis/recession in the data, but as a short-term blip.  In the decade after the crisis, Korea productivity growth kept on at much the same rate experienced in the decade prior to that crisis –  before (presumably) joining in the global slowdown this decade.  (That had also been the experience of the United States in earlier crisis episodes –  estimates suggest that the 1930s, for all its problems (around demand shortfalls) was a period of strong MFP growth.)

There is lots to learn from the searing experience of crisis, recession, and slow growth in the advanced world over the last decade or more.   But I still reckon there needs to be a much more careful unpicking of the different strands of the story than central bankers –  who tend to see the world through money and finance lenses, and who are often keen to champion their future role –  are prone to.  To me, the cross-country evidence just doesn’t square with a hypothesis in which the financial crisis itself plays any large part in the sustained disappointing performance of so many countries over what is now such a long time.

Central bankers meanwhile might be better off rethinking the merits of arrangements like the euro, or of the continued passivity around the near-zero lower bound, both of which look as though they have the potential for causing very major problems the next time there is a serious economic downturn.