Some Observations on Austerity (pdf)
I’m at the Omni Shoreham on business the next few days, and all I’m hearing about is salary freezes here, and bank debt conditionality programs in Europe. “Austerity” seems to be all the rage. Problem is we don’t even know the meaning of the word. Let’s face it: most of us are pretty coddled when it comes to belt tightening.
Austerity is not flashy. Nor is it fun. And it isn’t hopeless. It is characterized by:
- Ambiguous property rights
- Extreme income inequality
- And often enough, violence
So I found some data long forgotten and collecting dust to shed some light on the subject. The data comes from a survey of 2,910 households, randomly chosen in clusters of 30 households, stratified across 32 of the 39 provinces in 1964. The only region of this country not included in the survey was the Central Highlands, because the surveyors would surely have been killed as soon as night fell. Half of the hamlets surveyed were “secure”, meaning that it was reasonably safe to travel there in daylight hours. Whether or not the hamlets surveyed were under tight Viet Cong control is unknown, but they averaged around 16 miles from the nearest provincial town. It covered all rice growing areas and most areas of commercial activity. The country was South Vietnam.
What clarity does this data provide? It gives you glimpse of a world where people live without safety nets. How similar economic life is a broad class of settings. More importantly, it shows that austerity does not mean hopelessness. Life goes on after a debt binge.
In terms of income distribution, it is not much different than the United States… except that it is more egalitarian. Richer people live in urban areas, and the poorest live out in the sticks.
There was a heavier reliance on agriculture, of course. But the majority of income came from wages and salaries, business income (entrepreneurship), and return on capital.
Even in a politically unstable, poverty-stricken, and violent environment… life goes on. Even the poorest people spend money, some even sacrifice (7% of income), to educate their children. Most Americans do this mostly through indirect subsidies via tax policy. People buy big things even when ownership rights are tenuous. But the take-away message is that austerity means little leverage, which implies people spend most of their money on subsistence goods like food and beverages. Even the richest people in South Vietnam spent nothing near the affordability thresholds that banks use in issuing loans. Most people spent less than 15% of their total income on housing.
Note that the poorest spend relatively more of their income on subsistence goods.
And even the wealthiest spend only 20% of their income on housing. This is a function of the depth of financing, or the lack of it. Banking matters to everyone, and a banking system that takes credit risk and manages that risk without backstops increases societal wealth. Financial intermediation makes everyone better off.
While we are on the subject, the most substantive difference between South Vietnam and United States—the “developed” and “emerging” worlds lies in the finanical system. We live in a coddled world that won’t understand austerity until it crushes the life out of our naivety. At the same time, modern banks have been so used to easy money that they don’t really understand the origins of intermediation anymore. For the record, intermediation didn’t begin nor end with a central banking cartel.
Financial sophistication is all about funding modes.
Wholesale Bank Funding and Roll Risk
Financial intermediation is premised on acquiring pools of cheap funding and a lending to credit risk/reward profiles that create profits. This funding consisted of deposits before we got a nutty professor as Fed chairman. Intermediation meant this funding combined with assets held to maturity—loans and government securities—a safe business with reasonable margins. As margins compressed, leverage become the common method to sustain profits. Additional sources of financing drove down funding costs. Wholesale funding was born.
Wholesale funding providers are money-market mutual funds (households), corporations, and other financial institutions, with excess cash to deploy on a short-term basis. Wholesale funding instruments are repos, commercial paper, CDs, Fed fund borrowings and the like. These instruments fuelled a lending model that borrowed at short durations with implied low risk and lent at longer term to greater credit risk profiles. Banks extended leverage by accepting collateral that had value only so long as interest rates are subsidized by the central bank. This is the chief reason for credit easing… it is the only way to control the long end of the yield curve. To fall back on bank deposits as the chief funding source implies deleveraging: the pool isn’t large enough to sustain current lending levels.
When bank solvency is assumed and roll is assured at refinancing, wholesale funds are similar to deposit funds. But when this house built of tarot cards collapses, refinancing aggressive short-term funding becomes incrementally more costly for banks.
Wholesale funding markets become sensitive to information and often are subject to maturity mismatches. Information sensitive money markets mean the potential for acute roll risk. Default implies that money market investors now know that they are not immune to loss of capital and liquidity. Without precise information about specific institutions, refinancing becomes more difficult for all banks. This can be seen when interbank rates, paper-bill spreads, and other spreads blow out.
Bear Sterns is a case in point. 48% of their liabilities were short-term collateralized funds. When refinancing became impossible, high quality liquid assets plunged from $18.1 billion (March 2008) to $2 billion three days later.
Why do you think that the government established a legal right to freeze money market accounts?
The problem is somewhat intractable. So the tail-risk killers do what they do best: throw money at the problem. Hope that it allows for sufficient healing time before there is no more kicking the can down the road.
The George Costanza Moment
Perhaps the best course of action for Bernanke is a George Costanza moment: doing exactly the opposite of what is expected. The benefits of market-based interest rates are clear and obvious to everyone but the guys in charge of propping up the status quo. It is probably clear to them to… not even they believe their bullshit anymore. You may just get an Asian Miracle, meaning:
- Savings will rise. If you compensate depositors for their risk, deposit pools and wholesale funding will stabilize, minimizing roll risk.
- Institutions levered in all the wrong places will go the way of the dodo.
- Things will heal in time, maybe sooner than anyone thinks.
South Korea was one of the poorest countries in the world in the mid-20th century. It was absolutely impoverished by colonial powers and then devastated by civil war. When Park Chung Hi acquired power, he went about subsidizing heavy industry and trying then then-conventional economic reconstruction programs.
Maybe it worked after enough time elapsed, but all the data suggests all it created was inflation and misallocation. Perhaps out of despair of anything better, Korean interest rates on deposits were allowed to rise. The De-Reconstruction and return to the basics of rewarding risk and helping the prudent seem to me the real start of the Asian miracle.
Capital accumulation outstripped money supply growth and inflation.