Timmy elsewhereJune 5, 2012June 5, 2012 Tim WorstallTimmy Elsewhere8 CommentsAt the ASI. Goerge Soros says the euro mess is all down to the regulators\’ mistakes in the orginal design…. previousDr Ha Joon Chang appears not to know his economic historynextThis is going to piss off some lefties 8 thoughts on “Timmy elsewhere” Gareth June 5, 2012 at 10:49 pm Soros states: “When the euro was introduced the regulators allowed banks to buy unlimited amounts of government bonds without setting aside any equity capital” There is no need to have such a limit. The limit is a naturally enforced one based on how much money the banks can obtain from somewhere else (savers, interbank lending, etc) to lend to governments. I don’t see the connection between a zero capital requirement for government bonds and mis-pricing the cost of lending to governments. Had the prices been better set then banks *might* not have indulged so heavily. The zero capital requirement does not get banks off the hook for failing to do due diligence in their investments and failing to price them accordingly. From the very first sentence of Soros’s piece: “Ever since the Crash of 2008 there has been a widespread recognition, both among economists and the general public, that economic theory has failed.” Beyond Iceland where has economic theory been applied properly? Elsewhere it has been lots of hand waving. bailing out bad businesses and making a politically partial interpretation of Keynes. It is also quite galling for the suggestions coming things and fast from all quarters that a bigger problem than governments and households borrowing too much and banks lending too much and at too cheap a rate is not having a properly federal monetary/fiscal union in Europe. The US has that and got into at least as much trouble with its banking. Soros goes on saying that this is not a fiscal crisis but a banking one so why is he angling for a fiscal crisis solution? Frances Coppola June 5, 2012 at 11:59 pm Gareth Availability of reserves does not constrain bank lending, as you seem to think. Soros is quite correct to state that it was the lack of capital requirement for sovereign debt that encouraged banks to buy far too much of it. It is also incorrect to suggest that banks “mispriced” Eurozone government debt. The effect of the single currency was to create an implicit guarantee for all Eurozone debt from the whole Eurosystem, regardless of the actual country of issuance. For that reason, the debt of smaller/weaker countries was sold at a higher price than the economic strength of those countries justified. Now we know that the Eurosystem does not wish to guarantee the debt of its weaker members, the implicit Eurosystem guarantee has been removed and prices are correcting themselves in the light of this. This is unbelievably painful both for the sovereigns concerned, which are finding their borrowing costs rising to unsustainable levels, and for the banks that bought their debt, which are finding the value of their assets dropping to unsustainable levels. Hence the near-bankruptcy of sovereigns and in my view the ACTUAL bankruptcy of Eurosystem banks. The two go together. Clearly, since the original mispricing of Eurozone government debt was caused by expectation that there was a full union that did not actually exist, the obvious solution would be to create that union. Hence the various ideas about pooled debt issuance, common banking systems, Eurozone-wide deposit insurance – all of these in effect are ways of recreating the implicit guarantee that enabled weaker countries to borrow at too high a price. Therefore the Eurozone debt crisis is an entirely different matter from the US. The US is a real fiscal and monetary union, and its banking problems in my view largely arose from its failure to understand, let alone regulate, the interconnections between its commercial and shadow banking networks. The Eurozone is not, and its problems arise from the fact that the single currency alone was insufficient to create the type of union that markets expected. That’s why Soros insists the solution is fiscal. Personally I don’t think any sort of fiscal union is viable while Germany remains in the driving seat, and I think things have now gone far too far for rescue of the Euro in its current form. The best hope now would be a planned and managed breakup. Richard Allan June 6, 2012 at 1:17 am It wasn’t the low capital requirements for gov’t bonds in and of themselves, but the fact that they were lower than other asset classes, that caused the distortion. Serf June 6, 2012 at 8:34 am ….Now we know that the Eurosystem does not wish to guarantee the debt of its weaker members, the implicit Eurosystem guarantee has been removed…. In my dealings with money managers, it is my belief that they lack a true understanding of politics. It seems to a political junkie, that it was always obvious that the implicit guarantee was nothing more than wishful thinking. Yet people managing billions of Euros, managed to miss that reality. Frances Coppola June 6, 2012 at 12:35 pm Serf Absolutely. The idiocy of Eurozone investors beggars belief. Gareth June 6, 2012 at 1:04 pm Frances Coppola said: “Availability of reserves does not constrain bank lending, as you seem to think. Soros is quite correct to state that it was the lack of capital requirement for sovereign debt that encouraged banks to buy far too much of it.” Individual banks have to have money in order to buy government bonds. They can get that from their savers, interbank lending or wherever else but they still have to have it before they can invest it. How much money a bank can get access to and how much it wants to divert from other forms of investments into government bonds would be for each bank to decide for themselves. In Soros’s piece he wrote “When the euro was introduced the regulators allowed banks to buy unlimited amounts of government bonds without setting aside any equity capital; and the central bank accepted all government bonds at its discount window on equal terms. Commercial banks found it advantageous to accumulate the bonds of the weaker euro members in order to earn a few extra basis points. That is what caused interest rates to converge…” I took this to mean Soros is ascribing the mis-priced debt to the zero capital requirement. The zero capital requirement does not sidestep the responsibility of banks to price their investments appropriately and manage them sensibly. I can’t see how it explains the convergence. Greece would have represented a significantly higher risk than Germany regardless of them sharing the same currency. Have I misunderstood and what he means is the activities of the discount window caused the convergence? The zero capital requirement is not specific to the euro either. It is a Basel rule. The Basel Accord (pdf) said this in 1998 “36. This decision has the following consequences for the weighting structure. Claims on central governments within the OECD will attract a zero weight (or a low weight if the national supervisory authority elects to incorporate interest rate risk); and claims on OECD non-central government public-sector entities will attract a low weight (see (iii) below). Claims on central governments and central banks outside the OECD will also attract a zero weight (or a low weight if the national supervisory authority elects to incorporate interest rate risk), provided such claims are denominated in the national currency and funded by liabilities in the same currency. This reflects the absence of risks relating to the availability and transfer of foreign exchange on such claims.” The problem there is that their is no eurozone nation with a central government to back up the currency. Eurozone bonds should not have attracted a zero capital requirement. Surreptitious Evil June 6, 2012 at 1:23 pm The problem there is that their is no eurozone nation with a central government to back up the currency. Eurozone bonds should not have attracted a zero capital requirement. But there are no “euro zone bonds” yet. There “Claims on central governments within the” euro-zone (which is within the OECD), denominated in Euros. So they fall within the Basle rule. Note the quite specific differences between the OECD and non-OECD rules. Frances Coppola June 6, 2012 at 6:20 pm Gareth The price at which banks invest in the debt of Eurozone member states is the market price. The market price for Eurozone member states’ bonds has been distorted by the single currency, which as I explained above created an implicit guarantee for weaker states. You may regard it as negligent that investors in Eurozone countries’ debt simply bought at the market price, which had that assumption built into it. I would argue that the assumption was rational, because other currency unions DO have common backing for individual debt built in. The fact that the Eurozone, under pressure, turned round and said “actually we don’t want to support each other” is what is causing the markets to correct the price. Each of the Eurozone member states has its own central government and central bank. They meet the criteria for sovereign zero weighting as defined in the Basle accord that you quote. In each case the Euro is their national currency, so even those that aren’t members of the OECD (Cyprus, San Marino) would attract a zero risk weighting. You are still incorrect that banks have to have the money before they invest it. No they don’t. They have to have it by the time of settlement, which can be up to five days later. Leave a Reply Cancel replyYour email address will not be published. Required fields are marked *Comment Name * Email * Website Save my name, email, and website in this browser for the next time I comment.