Monday, August 24, 2015

Too much debt, part II

"China to flood economy with cash" reads today's WSJ headline. When you read the article, however, you find it's not quite true. China to flood economy with debt is more accurate.
The expected move to free up more funds for lending—by reducing the deposits banks must hold in reserve—is directly aimed at countering the effects of a weaker currency,

The People’s Bank of China’s latest planned move, which could come before the end of this month or early next month, would involve a half-percentage-point reduction in banks’ reserve-requirement ratio, potentially releasing 678 billion yuan ($106.2 billion) in funds for banks to make loans.
I had hoped the world learned this lesson in the financial crisis. Equity is great. When things go bad, shareholders lose value by prices falling, but they cannot run and the firm cannot fail if it does not pay equity holders.

Financial crises are always and everywhere about debt, especially short term debt. Lending more, encouraging more bank leverage, reducing reserves and margin requirements, means that when the downturn comes a needless wave of runs and defaults follows.

Inevitably, it seems, another downturn will come, another set of books will have been found to have been cooked, and then we will find out who lent too much money to whom. US investment banks, 2008, strike one. Greece, 2010, strike 2. China, 2015, strike 3? Do we no longer bother closing the barn doors even after the horse leaves?

This story should also give one pause about the wisdom of "macro-prudential" policy, by which wise central bankers are supposed to presciently open and close the spigots of leverage to manage asset prices.

13 comments:

  1. This comment has been removed by the author.

    ReplyDelete
  2. Debt is a problem when the collateral and cash flow behind it are inadequate. That's where the wheels fall off the cart. On the consumer side you see it in 120% LTV car loans and Conn's lending to room-temperature-FICO borrowers so they can make purchases.

    If interest rates are distorted as severely as they have been for the past 6 years it's nearly impossible to accurately value collateral (or invest intelligently in anything).

    Disclaimer: Intelligence in this post may be smaller than it appears.

    ReplyDelete
  3. Hi John.

    How do you, yourself, quantify and define bank capital, the capital scrutinized under the regulation of regulatory capital.

    ReplyDelete
  4. Strikes me there’s some not bad arguments for almost outlawing corporate debt, i.e. imposing high capital ratios on non-bank corporations just as the recent crisis has induced regulators to impose higher capital ratios on banks.

    Debt is essentially a promise by a corporation to creditors that “if we can’t pay you, we’ll go into insolvency, i.e. blow our brains out, to put it figuratively”. What exactly is achieved by that promise to commit suicide and how does that benefit the economy?

    Come to think of it, that might make a good exam question.

    ReplyDelete
    Replies
    1. I think the standard "blow our brains out" covenant is worth 50 basis points, ceteris paribus.

      Delete
    2. Corporate debt isn't suicide. It's delay of the inevitable restructuring through chapter 11.

      Delete
  5. Maybe it looks more like "Monument with Standing Beast" Jean Dubuffet in front of the James R. Thompson Center in the Loop

    https://en.wikipedia.org/wiki/Monument_with_Standing_Beast

    ReplyDelete
  6. Sorry Mr. Cochrane. Wrong Post.

    ReplyDelete
  7. It's too much to ask, but it would be good if people could put models and the wise men's remarks in western newspapers away and consult the Sinology literature on this. We have seen this many times before. Chinese monetary policy of course works by direct loans to its state and regional banks. It is highly effective, a command from Beijing gets very quick results - but too much. It is a result of a lot of their old command system remaining intact. It makes uninformed people in the west think that high Chinese growth over the long term has come to an end every time they put on the breaks on monetary policy.

    There are institutional weaknesses in the Chinese system which results in high inflation every time they ease up, and busts every time they put the breaks on. But the fundamentals for continued high growth are absolutely there.

    What you will see is a very quick recovery. And growth in this country of over a billion people has got a lot of steam left in it yet.

    ReplyDelete
  8. You wrote:"Financial crises are always and everywhere about debt, especially short term debt. Lending more, encouraging more bank leverage, reducing reserves and margin requirements, means that when the downturn comes a needless wave of runs and defaults follows."


    These are the symptoms of a crisis, the effects of the economic problems, not the causes. In a capitalist economy growth occurs when capital is created. Capital is created when profits can be realized by that creation. So long as more profits can be had, capital will expand. At some point further capital expansion fails to yield more profits and capital expansion stops. When this happens the economy contracts. Then various companies face difficulty paying their debt, especially their short term debt. The problem become publicly visible at this point but had been gestating for some time.

    ReplyDelete
  9. John,

    "Equity is great. When things go bad, shareholders lose value by prices falling, but they cannot run and the firm cannot fail if it does not pay equity holders."

    Equity is good only when security holders retain the right to affect the performance of the enterprise that issues the equity.

    Equity without a voting stake is worse than debt.



    ReplyDelete
  10. I agree with this post.

    The PBoC can print money and China is well below inflation targets. Not only that, their producer prices are falling.

    Why China authorities do not simply give tax breaks and print more money I do not know. Perhaps the People's Bank of China has succumbed to the dogma of present-day western central bankers, that printing money is always a bad idea.

    In 1992, when the inflation rate in the US was at 3%, Milton Friedman bashed the Fed for being too tight.

    China should un-peg from the US dollar also. If the Fed wants to suffocate the US economy, that is no reason for the People's Bank to also suffocate the Chinese economy.

    ReplyDelete
  11. Valter Buffo, Recce'd, MilanoAugust 28, 2015 at 6:08 AM

    Much more than "one pause": we need much much more. A new set of theories is required, on which then elaborate a new set of policy tool. "Finance is macroeconomics", someone presciently wrote a few years ago wrote: that strong intuition has been disregardes at least. Policy makers around the world are targeting financial market LEVELS, as if distorting market prices has no other consequence for the real economy than an alleged "wealth effect". The interaction between financial market prices and real variables is where we should start again. But still, we are very late.

    ReplyDelete

Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.