{"id":10866,"date":"2010-07-26T16:28:50","date_gmt":"2010-07-26T06:28:50","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=10866"},"modified":"2010-07-26T16:28:50","modified_gmt":"2010-07-26T06:28:50","slug":"counter-cyclical-capital-buffers","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=10866","title":{"rendered":"Counter-cyclical capital buffers"},"content":{"rendered":"

\t\t\t\tRecently (July 2010), the Bank of International Settlements released their latest working paper – Countercyclical capital buffers: exploring options<\/a> – which discusses the concept of counter-cyclical capital buffers. This is in line with a growing awareness that prudential regulation has to be counter-cyclical given the destabilising pro-cyclical behaviour of the financial markets. Several readers have asked me to explain\/comment on this proposal. Overall it is sensible to regulate private banks via the asset side of the balance sheet rather than the liabilities side. The countercyclical capital buffers proposal is consistent with this strategy and would overcome the destabilising impact of a reliance on minimum capital requirements that plagued the first two Basel regulatory frameworks. However, I would prefer a fully public banking system which can deliver financial stability and durable returns (social) with much less risk overall.
\n
\nBackground<\/strong><\/p>\n

Some of section and the next is based on a paper I wrote with Luke Reedman in 2002. Here is a link to the working paper version of the paper – Fiscal policy and financial fragility: why macroeconomic policy is failing<\/a>.<\/p>\n

What parades now as macroeconomic policy is a mishmash of half-truths and fallacy. At present governments around the world are being hectored by the IMF and other organisations into pursuing pro-cyclical austerity policy stances – which are an abuse of their fiscal policy capacity and responsibilities. In their latest latest paper<\/a> on restoring growth in the Eurozone, the IMF model various public surplus debt profile scenarios.<\/p>\n

The aim is to get public balances back into surplus as soon as possible, despite their being no sign that bank lending and private spending is picking up.<\/p>\n

Unless a nation enjoys a strong trading environment, governments that pursue public surpluses are relying on the increased indebtness of the private sector to maintain economic growth. This strategy is unsustainable because private agents eventually increase saving to restore their balance sheets. Economic growth then falters, unemployment rises and the automatic stabilisers generate a public deficit.<\/p>\n

To elaborate, we define involuntary unemployment as labour unable to find a buyer at the current money wage. In the absence of government spending, unemployment arises when the private sector, in aggregate, desires to spend less of the monetary unit of account than it earns. Nominal (or real) wage cuts per se do not clear the labour market, unless they somehow eliminate the private sector desire to net save and increase spending.<\/p>\n

The non-government sector depends on government to provide funds for both its desired net savings and its tax obligations. The private sector cannot by itself ‘net save’ because saving is a signal to lend and so savers are always in an accounting sense matched by a borrower.<\/p>\n

To obtain these funds, non-government agents offer real goods and services for sale in exchange for the needed currency units. This includes, of-course, offers of labor by the unemployed.<\/p>\n

Thus, unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save. In general, deficit spending is necessary to ensure high levels of employment.<\/p>\n

Persistent budget surpluses also force the private sector into increasing indebtedness. The sectoral balances (private, public and external) in the national accounts are:<\/p>\n

(1)\t(S – I) = (G – T) + (X – M)<\/p>\n

Equation (1) says that total private savings (S) is equal to private investment (I) plus the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)), where net exports represent the net savings of non-residents.<\/p>\n

Thus, when an external deficit (X – M < 0) and public surplus (G - T < 0) coincide, there must be a private deficit. While private spending can persist for a time under these conditions using the net savings of the external sector, the private sector becomes increasingly indebted in the process.\n\nSo when the IMF is recommending a return to public surpluses they are really implying (though they do not say this) that private debt is better than public debt (given the stupid arrangements that governments have to issue debt when they net spend).\n\nPublic surpluses just introduce fiscal drag (a draining of aggregate demand) to the economy. They do not provide a government with any 'saving\" which can be used later to fund future public expenditure. \n\nIt is a total neo-liberal myth that one budget position (a low deficit or surplus) provides a nation with more capacity to engage in a fiscal expansion that a higher deficit.\n\nTo disabuse you of that myth, here is a quote from a paper I wrote with Warren Mosler in 2002:\n\n\n

\nGovernment spends by crediting a reserve account. That balance doesn’t ‘come from anywhere’, as, for example, gold coins would have had to come from somewhere. It is accounted for but that is a different issue. Likewise, payments to government reduce reserve balances. Those payments do not ‘go anywhere’ but are merely accounted for. In the USA situation, we find that when tax payments are made to the government in actual cash, the Federal Reserve generally burns the ‘money’. If it really needed the money per se surely it would not destroy it. A budget surplus exists only because private income or wealth is reduced.\n<\/p><\/blockquote>\n

In a recent FT article written by ECB boss Trichet, which was described in – this article<\/a> – as exhibiting all the passion of a new religious convert” – Trichet “derides the previous economic panacea of boosting government spending to soften the economic downturn”. He said:<\/p>\n

\nWith the benefit of hindsight, we see how unfortunate was the oversimplified message of fiscal stimulus given to all industrial economies under the motto: “stimulate”, “activate”, “spend”! A large number fortunately had room for manoeuvre; others had little room; and some had no room at all and should have already started to consolidate … [there is] … little doubt that the need to implement a credible medium-term fiscal consolidation strategy is valid for all countries now.\n<\/p><\/blockquote>\n

The budget surplus may be applied to running down debt (that is, forcing the private sector to liquidate its wealth to get cash) but this strategy is finite. So budget surpluses destroy liquidity (debiting reserve accounts) which is deflationary. The weaker demand conditions force producers to reduce output and layoff workers with rapid increases in joblessness. Investment irreversibilities driven by uncertainty of future demand conditions then retard capacity growth and prolong the downturn.<\/p>\n

So the austerity measures are really setting the world up for the next crisis. At the best of times, for economic growth to occur, the pursuit of public surpluses necessitates an increase in the net flow of credit to the private sector and increasing private debt to income ratios.<\/p>\n

At some point a threshold is reached where the private sector, by circumstance or choice, becomes unwilling to maintain these deficits? For this reason, the reliance on rising indebtednesses to underwrite private spending is ultimately, an unsustainable growth strategy. <\/p>\n

The private sector (and the spending the debt has supported) becomes increasingly vulnerable to interest rate increases, declining asset values and lost incomes.<\/p>\n

This insight is at the heart of Minsky’s Financial Fragility Hypothesis and has implications for the latest offering from the Bank of International Settlements on countercyclical capital buffers<\/a> as a preventative measure to offset future financial crises.<\/p>\n

Of-course, with bank credit so weak at present, the austerity measures being implemented will more than likely stifle growth much earlier than would be the case if the private sector was embarking on a new wave of borrowing.<\/p>\n

Minksy Financial Fragility hypothesis<\/strong><\/p>\n

Two questions are raised by the aggregate demand structure above. First, what motivates and enables the private sector to run deficits over extended periods? Second, how long can this process continue? Minsky’s Financial Fragility hypothesis provides insight into these two questions.<\/p>\n

The type of economic system envisaged by Minsky is a modern capitalist system consisting of long-lived, expensive, and privately owned capital assets with sophisticated financial arrangements (debt contracts) designed to fund the acquisition of such assets.<\/p>\n

For Minsky, it is the processes and consequences of the investment in such capital assets in a modern capitalist system that forms the theoretical crux of the Financial Fragility hypothesis.<\/p>\n

The Financial Fragility hypothesis has two fundamental propositions noted in the introduction:<\/p>\n