Saturday, 21 January 2012

Contagion?... Armageddon?... Why?

Big companies go bust every now and then, and in the process some of their smaller suppliers may go bust too. But the cascade/wave of bankruptcies is usually pretty limited. In the run up to the company failure, you never hear politicians desperately trying to prop-up the company on the grounds that contagion is going to trash the world economy (though they may wish to prop up the company for other reasons). So why are politicians so frightened to let any major banks go under? Is there a difference between a bank failure and the failure of any other kind of business? The answer is yes, and the reason the situation is so precarious is down to our crazy and unstable monetary system.

Most people imagine that money works as a system of tokens (either paper or electronic) that get passed from person to person as trade is carried out. They imagine that the total amount of money would be constant, were it not for occasional money printing by governments. Indeed money could work this way should governments have chosen such a system (known as full reserve banking), but currently our monetary system works in a surprisingly different way.

Under the current system, money has a life cycle, it is continuously being created and destroyed. Money comes into existence when private banks make loans, and money disappears back out of existence when the loans are paid back (OK, I am simplifying here, but this is the gist of it). In order for the total amount of money in the economy to be held approximately constant, the rate of new money creation via loans needs to be approximately the same as the rate of money destruction through loan repayments. If there were a pause, or slowdown, in the rate of money creation, then there would naturally lead to a decline in the total money supply as existing loans were paid back.

A significant contraction in the money supply is a dismal prospect... A shrinking money supply makes the repayment of loans harder and is generally a horrible economic environment, as anyone who lived through the great depression would testify. So now we need to consider the following question:

Is there any reason why banks should suddenly be prevented from making new loans?

Sadly, and frighteningly, the answer is yes. It all boils down to the rules governing how much money banks are allowed to lend, the so called “Basel accords”. The rule makers decreed that banks should only be allowed to lend out, at most, a fixed multiple of the current value of their capital. The ratio of loans that are made, to the value of a bank's capital is known as the “capital adequacy ratio”. The system is all well and good so long as there are no sudden changes in the value of those assets… and herein lies the problem. Under certain circumstances, assets can lose value precipitously. One particularly awkward example is government bonds. The Basel committee decided that government bonds should be valued, for the purpose of assessing capital adequacy, as if there was zero chance of default. We shall see why this is dangerous in a moment…

Banks are deemed as bust when their capital adequacy falls below the prescribed limits. Currently, Greek government bonds are held by assorted banks as part of their capital and (according to the regulations) valued at 100% of their face value. If Greek bonds are defaulted on, then the banks that hold them as a significant part of their capital, are instantaneously bust. Any attempt to restart the bank - perhaps under new ownership, or government ownership, will involve a choice between using taxpayer’s money to make up the capital shortfall (which is becoming increasingly difficult for governments to do) or a shrinkage of the money supply by an amount far greater than the value of the bonds. For example of the capital adequacy ratio was 5%, then a default of 10 billion Euro would lead to a reduction in lending ability (and hence a shrinking money supply) of the bank, in the region of 200 billion. A smaller money supply makes loans generally harder to repay and increases the likelihood of further defaults, hence the contagion effect.

Government bonds are not the only form of capital tied up in the Armageddon scenario.. a shrinking money supply necessarily leads to a reduction in the price of assets in general (deflation), including share prices. So a bonds default may be the trigger but the cascade/wave can be carried on by falling prices of almost any asset.

The rules of our current monetary system directly leads to a multiplier effect on defaults. This is what makes defaults in the banking sector so different to the collapse of ordinary businesses. The Armageddon scenario is a cascade of loan defaults, each one leading to ever larger reductions in banks ability to make loans and hence each leading to further reductions in the money supply.

Another way of looking at this issue is to consider the better-known phenomena of monetary expansion, where a small increase in the value of a banks capital leads to a large increase in the amount of money a bank is allowed to lend out. All I am doing here is pointing out the corollary to this, i.e. a small amount of capital loss causes a large amount of money loss.

If we instead had a monetary system in which money was indeed simply tokens that got passed from person to person as trade was carried out (known as full reserve banking), then there would be no default-multiplier-effect, no contagion and no Armageddon scenario. I think its time to move to full reserve banking.