The IRA | Basel III, Fiscal Cliffs and Economic Mysticism

rcwhalen's picture


Below is a cross-post from The Institutional Risk Analyst of my latest rant, "Basel III, Fiscal Cliffs and Economic Mysticism."  Given all of the hype and fuss about "fiscal cliffs" and the very appropriate yowling regarding Basel III, thought we should have an everygreen copy of this on ZH.  Will Congress go over the fiscal cliff?  Yes, we've been going for decades, really since the social unrest of the 1970s.  If you don't understand that last sentence, read my 2010 book "Inflated: How Money & Debt Built the American Dream."  The threat of social unrest is why the Fed has kept interest rates artifically low for so long, but now even that expedient has run its course. -- Chris


"Socialism is to become rich, together"

Deng Hsiao Ping


Basel III, Fiscal Cliffs and Economic Mysticism

The Institutional Risk Analyst

November 12, 2012


In this issue of The Institutional Risk Analyst, we examine the strange worlds of Basel III and US fiscal policy. These are but two examples of questions which ought to be simple matters of addition and subtraction, but instead operate in the realm of mysticism - that is to say, economics.

Last week US regulators finally capitulated and announced a delay in the implementation of the Basel III bank capital rules. We hear that a serious reassement is underway. The reasons for the delay are many, but more than practical concerns about how to implement the complex rules is the realization that higher capital rules and other regulatory initiatives will likely put the western economies into a prolonged recession.

For several decades now the US and other industrial nations have been engaged in a collective delusion. The fantasy says that public and private debt can be employed to maintain nominal economic growth without any downside effects such inflation or falling real incomes. The corollary to this democratically agreed escape from reality is that global financial institutions can be managed in a safe and sound manner even as the governments which regulate (and sponsor) them behave more and more recklessly when it comes to fiscal policy.

The conflict between the policies of the G-20 central banks and the Basel III capital rules is striking and, to us at least, an obvious example of how the scientific is instead mystical. Nobody ever asks, for instance, whether implementing Basel III will not work against the purposes of QE3 and the other anti-deflation policies being pursued by the US central bank. Even as the G-20 governments pursue fiscal and monetary policies that can only undermine the soundness of banks and other entities, we try to comfort ourselves by talking tough about bank capital.

Former FDIC Chairman Sheila Bair, for example, often asks us if we don't need to increase US bank capital levels. Our answer is not really. The US banking system is de-leveraging at an alarming rate and causing effective capital levels to rise. With the grey market, non-bank financial sector running off and most banks also making fewer loans than are required to keep pace with credit redemptions, the overall credit picture in the US is deflationary. To paraphrase the great American economist Irving Fisher, without private credit growth you cannot create jobs.

Indeed, the capital levels in the US banking system are already so high in historical terms that the SEC is increasingly at odds with US bank regulators over releasing loan loss provisions as default rates decline. Adding to bank capital levels will only intensify the debate over whether banks are artificially understating earnings by keeping capital levels above the level required to absorb likely losses. But bank earnings are just the first concern.

The more profound question that nobody seems to discuss is whether higher bank capital levels would have made any difference in the dark days of 2008, when the lack of liquidity in the financial markets almost cratered the global banking system. The answer to that question is no. In that timeframe, let us recall, bank capital securities were trading at a fraction of book value. Preferred bank paper, for example, was trading at less than 10% of par value, even though virtually all of these securities were money good. But nobody wanted them at any price.

Moving bank capital up to 7 or 10 or 20 or 50 percent of total assets would have provided no additional buffer to protect depository institutions from what was essentially a liquidity shock, a disaster caused by reckless housing policies in Washington. In such a situation, only 100% capital levels would have sufficed to protect the banking system, but then we'd have no credit growth. Perhaps the real, unspoken truth about Basel III is that higher capital levels are meant to restrain credit creation and nominal growth in America.

When you look at credit loss rates during from 2008 to 2012, the picture is likewise one of capital adequacy, at least in the US. Most US banks had more than ample capital and earnings to absorb even the record loss rates recorded in 2008 and 2009. The fact of the leverage ratio in the US kept banks safe and sound, not the ridiculous Basel II rule. Mega kudos to Chairman Bair and her colleagues at the FDIC, all of whom fought to retain the leverage ratio. The Basel II rules, let us not forget, actually enabled the bad acts of securities fraud that are the root cause of the financial crisis. Just take a look at the Q3 2012 disclosure from JPMorgan Chase and Bank America regarding putback claims on toxic RMBS (See Alison Frankel, Reuters, "Banks should fear ominous new rulings in Fannie/Freddie MBS cases.")

If the Fed and other regulators really wanted to protect the US banking system they would junk the Basel III rule and go back to a modified Basel II regime with the leverage ratio and revised risk-based asset weightings as the central features. But of course none of the economists who populate the Fed, BIS and other agencies can bring themselves to admit that their beloved bank capital construct is really the problem. Most people who work in Washington, never forget, cannot function in the private sector. Defending incomprehensible bank regulatory regimes like Basel II/III is a matter of livelihood for thousands of economists, consultants, lobbyists and bureaucrats.

The other point that needs to be made is the relationship between bank regulatory actions and the global economy. The cover of Barron's this week asks: "Are we headed for a recession?" No, we are already there, thank you. The regulators in the US and abroad have been decreasing leverage and funding sources available to banks for several years, this in order to placate politicians who like to talk tough about bank capital. The lack of credit currently available to business and consumers virtually assures a recession in 2013. But this situation is just part and parcel of the schizophrenia seen in American politics between fiscal policy and bank regulation.

The extent of the self-delusion regarding US fiscal policy extends to some of the most respected Americans. In a comment in the New York Review of Books, former Fed Chairman Paul Volcker says that "At the beginning of this century, we actually had a balanced federal budget," mouthing the canards of former Treasury Secretary Robert "Deficit Hawk" Rubin and his policy stooge Larry Summers. But this is completely wrong.

Presumably former Chairman Volcker understands the difference between raising revenue to eliminate a deficit and merely borrowing money from the Social Security trust fund to finance a deficit. At the start of the 2000s the cash surplus from Social Security was financing the federal budget deficit, a situation that is now reversed. The federal budget deficit actually grew in those years. Today Treasury is compelled to borrow cash in the public debt markets in order to redeem earlier borrowing from the Social Security trust fund in order to pay recipients.

Paul Volcker knows better - or should. But like most partisan Democrats, Chairman Volcker is trying to rationalize an economy that is shrinking and a federal debt load that must inevitably lead to default. Indeed, a default is already in process via inflationary Fed policies, the ultimate tax on working people. Democrats like Paul Volcker support higher taxes for the 1%, but they will never admit that the biggest tax on the 100% is galloping inflation c/o the Fed to accommodate growing federal debt.

Paul Volcker earned his reputation by taming inflation for a little while a few decades ago, but now price increases are killing the US economy -- and all of our dreams for a better future. When will Volcker and his peers among Fed Chairman admit that the central bank is the main culprit in this growing national economic crisis? Is not the Fed the enabler for a national Congress literally out of control? The only sane choice is default and debt restructuring, but you will never hear Volcker or Greenspan or Bernanke ever speak such truth in public. Instead they take the cowardly path of defaulting quietly, via the printing press.

In a presentation to the annual Bank Credit Analyst conference in New York last month, former Office of Management and Budget Director David Stockman noted that in 2002 the Congressional Budget Office projected that US public debt would reach $2.7 trillion by the end of this year. The actual public debt figure for 2012 under President Barack Obama will be close to $12 trillion. Clearly the CBO estimates are not reliable predictions of the behavior of Congress. See the table below:

The CBOs's Budget Forecasts for 2012 - A Decade Gone Wrong

The CBOs's Budget Forecasts for 2012 - A Decade Gone Wrong

Source: Congressional Budget Office

It is interesting to note that a decade ago, US nominal GDP was projected by CBO to reach $17.5 trillion by 2012, but the actual figure is just $15.5 trillion. Total tax revenues likewise were expected to be $3.5 trillion or 20% of GDP compared to the actual revenue number of about $1 trillion less or about 16% of GDP. The explosion in public debt has not delivered even the nominal economic growth or expansion of tax revenues expected by US policymakers a decade ago. If you deflate the results with the true inflation rate (call inflation 2x the official stats) the results are abysmal and explain why real American income levels are falling. What else do you need to say to refute the neo-Keynesian socialist model which prevails inside the FOMC and White House?

In the face of such poor economic results, is there any wonder that a growing number of Americans and people around the world are losing confidence in the United States? There are a number of reasons for this situation, but the fundamental problem seems to be a complete inability of Americans to deal with reality. Reflecting our colonial, libertine roots, Americans want gratification today and have no interest in sacrifice. Thus our national debate on issues like fiscal policy or job growth or even bank capital has a fantasyland, mystical quality that defies rational explanation.

In his recent contribution to The New York Review of Books, "What Can You Really Know?," the renowned physicist Freeman Dyson discusses the dichotomy between science and philosophy. "At some time toward the end of the nineteenth century, philosophers faded from public life," writes Dyson. "Like the snark in Lewis Carroll's poem, they suddenly and silently vanished. So far as the general public was concerned, philosophers became invisible."

The decline of the importance of philosophical distinctions in public life may be interpreted as a decline in values more generally, making it nearly impossible to have a sane discussion about things like public spending or even bank capital. These public issues should be entirely cut and dry. Yet somehow the rise of the economist as the apologist for partisan political leaders renders even issues involving public spending or measuring bank capital entirely opaque.

The road to salvation for the US, it seems, requires a serious discussion about what parts of the public policy are rational and therefor based in scientific certainty and those parts which are speculative, subjective and therefore in the realm of politics and economics. It may be attractive politically for public exemplars like Paul Volcker to pretend that the federal budget was balanced in 2000, but spouting such nonsense does nothing to advance the public interest.

Likewise, when we pretend that Basel III will make banks safer and sounder, yet pursue policies in housing or public spending that undermine our economic stability and the soundness of the banking system, we are wandering in mystical realms. Economics, never forget, used to be considered a branch of sociology, not a hard science upon which to base rational public policy. Only when Americans become attuned to such distinctions and are able to separate truth from politically motivated fantasy will we truly begin to make progress as a nation.


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OneTinSoldier66's picture

"Presumably former Chairman Volcker understands the difference between raising revenue to eliminate a deficit and merely borrowing money from the Social Security trust fund to finance a deficit."


You mean, I'd have to presume that unelected bureaucrats are honest?


"Is not the Fed the enabler for a national Congress literally out of control?"


Yes. So can we abolish it now? :D

OneTinSoldier66's picture

"...we try to comfort ourselves by talking tough about bank capital."


If I were to ask, "what is bank capital?", is that the same thing as asking "what is money?".

geno-econ's picture

No longer possible to "make progress as a nation" when we are in a Global Economy driven by Consumerism which Banks, Government, Big Biz and Polititians have a vested interest in preserving.  In fact there is no longer economic policy----just deficits until the capitalistic fiat system collapses.  Then and only then can you have" progress as a nation" in building a balanced economy 

GCT's picture

A great article thanks for posting this.

Spooz this is the problem most people think the financial markets are the capitalist economy and they are not.  They are financial markets.   AI agree there is looting goning on and people need to go to jail.  But the stock market in my small mind is not the capitalist economy we are speaking of. 

spooz's picture

Oh the stock market is so squeaky clean, huh? Pay no attention to the bought and paid for legislators getting wealthy on legal insider trading.


dolph9's picture

I admire Whalen for pointing out the elephant in the room:  that Americans, are, for the most part, selfish adolescents who think they can eat their cake and have it too.

Americans simultaneously want big military, big welfare, and big free market capitalism.

Because, we're America!  We can do it!

spooz's picture

right.  Pay no attention to the banksters and their continued looting.  Its all about those greedy peasants.

Oh, and Americans DON'T want big military; unfortunately leaders on both sides of the duopoly ignore this.

And "big free market capitalism" has taken a beating in the public eye from Libor/muni bond rate rigging, MF Global and Peregrine Financial, the London whale, flash crashes and high frequency co-location trading. Free for the few.

spooz's picture

I'm not so confident that banks are not rigging their risk-weighting to meet capital levels. Bank of England’s Andy Haldane warned:

“The range of capital held for the same asset can differ by a factor of three or four or more between banks. As long as those inconsistencies exist, Basel III faces fundamental problems.


Haldane also argued that the technological capability now exists for a radical shift to a utilities model of banking. He wants all deposits held in one location, with banks servicing customers who are free to shift from one to another, in the same way as energy electricity and gas firms operate."

Personally, I would like to see the IMF's revisiting of The Chicago Plan fleshed out.  It seems like a much better way to resolve the ill effects of financialization of our economy. It would be interesting to see Whalen's take on it.  The Mises follower who guest posted on it here on ZH was a big fail on the propaganda front.

Things that go bump's picture

Funny, it sounded like Argentina to me.  I'm so glad I'm not holding anything in a bank.  

spooz's picture

Argentina's crisis was a result of their US dollar currency peg.  What correlation do you see with that? Also, they had withdrawal caps for deposits.  Nothing like that I can see in TCP. I guess if you're an elite with vast stores of uninsured wealth in the banks, you might have some worries, but maybe not. Now if you have bank stocks or bonds, that could be a problem.



koncaswatch's picture

“The decline of the importance of philosophical distinctions in public life may be interpreted as a decline in values more generally,…    …the rise of the economist as the apologist for partisan political leaders renders even issues involving public spending or measuring bank capital entirely opaque.”

There it is, how we got here.

Philosophers tell us, you cannot have your cake and eat too. Political “economists” tell us yes we can. Our own lack of self discipline allows us to lie to ourselves and follow the “economists”.

Scisco's picture

Sorry I am confused. How can a capital ratio be calculated without assets being marked to market? I thought one was dependent on the other.

NEOSERF's picture

It really is time for reset an Iceland Reset 3.0...prepare for a default, allow everyone to hoard and banks to get ready to deal with it and then assign a day...July 24, 2014 that we will just set off the wave of defaults and see where the chips fall. 

Get the Borrow's picture

How can  bank capital ratios be so strong when they got 250 Trillion in derivative exposure


Carl Spackler's picture

Those derivative exposures are concentrated in a few "money center" banks.  Much of that $250 T is offset exposure, not to mention money changing hands like at the horse track but with no economic value created.

Some of it is naked exposure to some institutions.

Bank capital ratios are relatively stronger when you go below the U.S. Basel-mandatory banks (the "too big to fails") in terms of asset size.

Whalen makes a great point.  The Fed is the real enabler of the fiscal mis-management and fiscal political mess in this country.

YET, the Fed calls itself "independent."  That is a real knee-slapper of a joke.

Winston Churchill's picture

Offset.Really ?

Lehman Bros. net exposure was only $8bn

That worked out well didn't it ?

Net is only good if EVERY counterparty is good for the money.

I will wake up tomorow having grown three heads overnoght ,if that happens.

Dream on.....

LawsofPhysics's picture

In this case, "they" have a printer and "they" could simply agree to vaporize all derivative contracts.  Of course, this is much akin to a group of people with loaded pistols all pointed at each other's heads mutually agreeing to put down their weapons.  Don't forget about "mark to fantasy" accounting.

Got physical?