Oct 13/15 – Just surprised anyone expects it to work

2015-10-13 10am EDT  |  #2008 crisis #regulators

What’s the saying about regulators? They always manage for the last crisis….

I understand this is part of human nature. To expect some bloated bureaucracy to steer in a different direction than the previous crisis would be naive. Yet I don’t understand why the relationship between this increased regulation and the general slow growth of our economy is not better understood amongst market watchers.

Leading up to the 2008 financial crisis, banks and brokers levered up their balance sheet with sordid real estate deals that would have made Caligula blush. When the credit cycle turned, their irresponsible actions almost brought down the entire global financial system. A few of them went bankrupt, a handful of them needed to be sold to stronger suitors, but on the whole, governments saved most financial institutions for fear their failures would usher in a 1930s type depression.

The cost of these bailouts was a new determination from governments that never again would the public be forced to come to the rescue of the large financial institutions. Regulators set about altering the capital requirements to ensure large banks would always have an adequate cushion to get through the most severe of storms – after all, no one had expected 2008, and who knows if another crisis was right around the corner.

Well I don’t know much, but I know the chances of another 2008 style crisis in the next couple of decades was virtually nil – even without the regulators changing a single rule. Markets are far from perfect, but they are self adjusting. With the scars of 2008 burned into so many investors minds, there was no way the same mistake would be repeated. Just like after 1987 every investor was petrified another single day 20% crash was right around the corner, in the years and decades following 2008, the fear of another real estate crisis would keep bank executives from over extending themselves.

Yet the governments didn’t trust the markets to self adjust. And to be fair, why should they? A fervent belief in free markets was the main reason banks were allowed to take the stupid risks in the first place. Unfortunately, instead of acknowledging the markets were already headed in the direction of toning down their exposure on their own and the boat needed little more weight on that side, regulators did the exact opposite. They piled on – forcing banks to put aside massive amounts of new capital. They also became overly strict about lending criteria.

JP Morgan’s CEO Jamie Dimon summed it up perfectly in this Fortune article:

The JPMorgan CEO said that his bank was “under assault,” and questioned whether the increased scrutiny by regulators of banks since the financial crisis has gone too far.

JPMorgan Chase CEO Jamie Dimon still thinks the way banks are treated these days is un-American.

Jamie Dimon said that JPMorgan JPM -0.34% was “under assault,” and questioned whether the increased scrutiny by regulators of banks since the financial crisis has gone too far.

“In the old days, you dealt with one regulator. Now it’s five or six,” Dimon said, referring to instances when multiple regulators have sought to punish JPMorgan for the same issue. “You all should ask the question, how American that is.”

It’s not the first time Dimon has questioned the American as apple pie-ness of banking regulation. In 2011, Dimon called an earlier version of capital rules contemplated by international bank regulators in Switzerland un-American. “I’m very close to thinking the United States shouldn’t be in Basel any more. I would not have agreed to rules that are blatantly anti-American,” Dimon told the Financial Times at the time. “Our regulators should go there and say, If it’s not in the interests of the United States, we’re not doing it.‘”

Dimon’s Wednesday comments came in response to a question about a new proposal from the Federal Reserve that would require JPMorgan, the biggest bank in America, to hold more capital in reserve to protect against losses, even compared to its other mega-bank rivals. The Fed has said the new proposal adjusts capital rules to account for the fact that risks at some banks are more complex than others, and maybe harder to detect. But Dimon effectively said the proposal shows that regulators still don’t get his bank.

Don’t misunderstand me. I hate defending these Wall Street banksters. I think the governments should have let way more of these firms go lights out during 20089.

But let’s not let our hatred of the inequity of the financial system confuse the basic economic principles that affect our economy. We still use a fractional reserve banking system, and like it or not, these banks are the main financial intermediaries.

What do you think happens when you increase the banks’ capital requirements and apply greater scrutiny to the loans they are making? Uh doh…. They make less loans. And what do you think happens when there are less loans being made? The velocity of money falls. Therefore it is no surprise that in the years following the 20089 crisis the velocity of money has plummeted.

Don’t forget the equation made famous by Friedman (so much so, he made himself a licence plate to celebrate it):

There is much debate about this equation, but let’s just admit that in a broad sense, it holds true.


M is the supply of money, while V is the velocity. While P is the general price level and Q is output. PQ is therefore the nominal level of output.

If we hold the supply of money constant, but put in regulation and capital requirements that discourage banks from making loans, then it is obvious that the nominal level of GDP will fall.

This decline in the velocity of money is why the Federal Reserve and other Central Banks had to crank the supply of money with quantitative easing just to keep the economy treading water in the years following the 2008 crisis. Without an increase in the quantity of money, the declining velocity would have overwhelmed the right hand sight of the equation.

Now I understand the argument QE actually causes money velocity to fall on its own. I don’t want to bother arguing about the chicken or the egg. I am also unsure how much weight to assign the increased capital requirements and tighter regulations for the fall of the velocity of money, but I am confident it isn’t anywhere near zero.

I had to laugh this morning when I awoke to headlines from the Switzerland’s finance minister (from Bloomberg):

Switzerland’s finance ministry will require the country’s biggest banks to have capital equal to about 5 percent of total assets after UBS Group AG and Credit Suisse Group AG sought to win easier terms, according to people briefed on the deliberations.

The decision would mimic the U.S. leverage ratio for its biggest banks, which exceeds the 3 percent minimum set in a global agreement by the Basel Committee on Banking Supervision, according to the people, who asked not to be identified because the talks aren’t public. The Swiss government will also align its calculation of the ratio with the method employed in the U.S., resulting in fewer types of debt counting toward capital,

one of the people said.

I don’t expect the Swiss to let their banks get away with more leverage than the rest of the world’s banks, but to think that cranking capital requirements will do anything except exacerbate the current global slowdown is funny.

Let’s step back and think about what is happening. We have the highest debt burden ever recorded in the developed nations’ history. Against this backdrop the regulators are tightening lending conditions of the largest banks. Not only that, but governments are collectively worried about previous irresponsible spending, so they are refusing to make smart (and needed) infrastructure investments. The Central Banks are trying to offset all of this with QE, but after half of dozen years of this shit, there is an increased monetary policy fatigue.

And I don’t blame the Central Banks one iota. They can’t be expected to carry the ball while all the other government entities engage in contractionary policy.

You might be saying to yourself, the governments should be spending less. Not only that, the banks should be reigned in. I hear many arguments with this sort of Austrian bend to them. That’s fine, that is certainly a valid point of view. But if argue this route, then be prepared for the mother of all asset crashes. The amount of debt perched on the financial system make this sort of contractionary reset terrifying. I understand that from a moral point of view it seems like the right thing to do. Yet there is no way our society has the stomach to sit through this sort of reset.

No, I am convinced that inflating our way out of this mess is the most likely outcome. But as the regulators, governments and now Central Banks refuse to accept this reality, then disinflation and slowing growth will be the result. It is no surprise that this is the weakest recovery since the great depression. The economy is already handcuffed enough through the massive debt that any external force slowing down the economy will have an outsized effect.

Given that governments are like generals always fighting the last war, I am not surprised we are trying to solve the previous problems with more regulation, increased bank capital requirements and refusal to expand government spending. I am just surprised anyone expects it to work….

Thanks for reading,

Kevin Muir

the MacroTourist