As the European debt crisis deepens, the blame game is getting more acute. German politicians blame perks-loving, tax-cheating Greeks. Southern governments protest that the crisis is worsened by Germans' stinginess. Markets blame the European Central Bank for refusing to go all-in with unlimited purchases of PIIGS debt. Occupy Wall Street and indignados see the crisis as a plot from the 1% to further impoverish the 99%.
Yet, the biggest culprit has so far avoided public indignation.
The Basel 2 agreement for financial stability, published in June 2004, laid the ground for the crisis.
The agreement was supposed to prevent the next financial crisis by ensuring that banks carried appropriate buffers of capital. In my opinion, it did exactly the opposite. A key feature of the agreement is that banks' assets had to be risk-weighted. Risky assets, such as equities, should be backed by more capital than safe assets, such as government bonds. Banks do not need to put any collateral for government bonds rated AAA to AA. This essentially amounts to giving banks a free pass to speculate on sovereign debt with our deposits. Note that even after last month's downgrade to AA-, Spanish sovereign debt still falls in the "zero collateral" category. Government bonds rated A+ to A-, such as Italy's (A-rated) only carry a 20% risk weight.
Even worse, the agreement stipulates that "at national discretion, a lower risk weight may be applied to banks' exposures to their sovereign (or central bank) of incorporation denominated in domestic currency and funded in that currency." As long as bank's national government says its debt is safe, banks are invited to load up on its bonds without putting any collateral. I am yet to see a national government publicly announce that its debt is junk.
The agreement contained more blatantly self-serving provisions: debt of OECD banks only carry a 20% risk-weight. According to the agreement's twisted logic, the debt of Greek banks (an OECD member) carries less risk than that of Singaporean banks (despite having one of the highest GDP per capita in the world, Singapore is still technically a developing economy).
The first consequence of the agreement was to promote the rating agencies to the status of gatekeepers of global capital. Because rating agencies have been under heavy fire lately, I will stick to fact-based objective arguments:
- Rating agencies never wanted that responsibility
- Rating agencies are unelected bodies that are solely responsible to their shareholders
- Agencies' ratings of mortgage-backed securities proved extremely inaccurate in the 2008 crisis and led to massive losses for investors who relied on them
The second consequence is a lot more pernicious. The agreement essentially subsidized banks to buy government debt. Every time an asset is subsidized, its supply increases and its quality deteriorates. This is exactly what happened with real estate debt in the prior bubble. Because Western governments could rely on banks' captive demand, they were able to finance gigantic deficits at ridiculously low yields for most of the past decade.
Because capital is scarce, the subsidized sector grew at the expense of the un-subsidized sector. In this case, banks diverted lending from consumers and corporations to over-indebted governments. This created a vicious cycle: the lack of credit for consumers and corporations choked the recovery and depressed tax collections, leading governments to increase their reliance on debt financing. The prospect of a lengthy recession pushed investors to rush into the "safe" (and subsidized) government bonds. The current economic misery is the logical consequence of this vicious circle: bankrupts governments, over-leveraged banks that will require more bailouts and lack of hiring from credit-starved businesses.
The responsibility for this monstrous bubble ultimately lies with monetarist economic theory. Monetarists in the 70s insisted that central banks had to be independent and could not finance governments' deficits. But they failed to see that sovereigns would never resist the temptation to monetize public debt (their right of seigniorage).
Governments paid lip service to monetarist ideology while devising more sophisticated ways to print money. By putting absurdly low risk weighting on government bonds and by allowing banks to discount their sovereign bond holdings for cash with central banks, governments essentially recreated the money press. The only difference is that the current process is a lot less transparent and greases many more (bankers') hands than good-old fashioned money-printing.
In an imperfect world, the money press may be the least bad solution. Straightforward money-printing eases the recovery by reducing the real burden of debt (Keynes' famous "euthanasia of the rentier"). Ultimately, voters in developed countries have to make a decision on how much inflation they are willing to tolerate to de-lever their balance sheets. Letting central banks print money is a lot more transparent and democratic solution than subsidizing banks to buy sovereign bonds and bailing them out once we realize that the king was naked all along.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.