Sunday, 18 January 2009

Borrow, borrow, borrow

Just as we have been discussing levels of debt, Robert Peston informs us that the UK government will be guaranteeing billions of pounds more of corporate and consumer lending, starting tomorrow. This is somewhere between the US government's guarantees of Citigroup and Bank of America's debts, and a giant credit default swap (CDS). Quite clever, in that respect.

CDSs were a good business for lots of insurance companies for a long time, and now that the worst of the losses have probably been written off by banks already, they could be a good business again. CDSs do, I believe, increase economic efficiency by aggregating a portfolio of risks and allowing capital to flow to the most productive destination without being hampered by the "one bottle of poison" problem.

The state is by far the best provider of these services, because there is no counterparty risk, and because control is correlated with a positive return. That is, because the government has the ability to directly contribute to keeping businesses from going under.

The only real risk of public involvement in this business is that it might lead to underpricing of the risks; but the government has a genuine cost advantage over private companies in providing this service, so that is unlikely.

But I do object to Peston's characterisation of the situation:
"the paradox is that the Government wants to make more credit available to reduce the severity of a recession that was caused by a decade-long, crazy lending binge."
In fact, I am coming round to the view that the recession was not caused at all by lending, but by the contraction of lending - and that the appropriate level of debt may well be higher than it is. See my last post for a more detailed discussion of this point.

And on the other moral hazard issue - the idea that we are bailing out banks which should be suffering for their reckless decisions - let's remember two things:
  1. We are now substantial shareholders in several of these banks, and we will benefit too if they return to health
  2. We are being paid an insurance premium in return for these guarantees
  3. "The banks" are not an evil cabal who are the deadly enemies of the rest of the economy. They are an integral part of it, and their success enables and contributes to the success of all other companies. Punishing the banks would be cutting off our nose to spite our faces. At most, we may want to further dilute the equity of bank shareholders, and perhaps regulate the rewards of some bank executives; but even that is far from a proven case.

6 comments:

Anonymous said...

Of course the recession was caused by a contraction of lending! The build up of excessive debt was engendered by super low interest rates held for far too long. Any risk adverse banker was overwhelmed by the wall of cheap credit sloshing from his less choosy cousins. As mr prince said, when the musics playing, you have to dance..

Leigh Caldwell said...

But where is the evidence that the debt was "excessive"? That's my question. Just because it was higher than the long-run average doesn't mean it was excessive... lots of things are higher than their long-run average - like GDP or wages. It doesn't mean we should aim to cut them.

Taxpayer said...

Now I'm no expert in finance but surely you see the debt had to be excessive; the lenders could not cover a fraction of risk they were taking.

Anonymous said...

Debt used for consumption would be one example. Debt that could never feasibly be repaid. These two are closely related. The problem has been caused by people who have been saying "deficits don't matter" to people, companies, institutions and governments that are already hugely indebted. Of course they do, unless you have no intention of paying back what you owe. The presumption has been that debt can just be rolled over indefinitely.

There has been little or no due dilligence by some creditors. As well as mass borrowing by what can only be called debt junkies. What is needed is investment. Which can only happen when there is certainty in the state of the economy; namely where the debts are held, the true value of this debt (what it can be sold for).

Anonymous said...

Debt used for consumption would be one example. Debt that could never feasibly be repaid. These two are closely related. The problem has been caused by people who have been saying "deficits don't matter" to people, companies, institutions and governments that are already hugely indebted. Of course they do, unless you have no intention of paying back what you owe. The presumption has been that debt can just be rolled over indefinitely.

There has been little or no due dilligence by some creditors. As well as mass borrowing by what can only be called debt junkies. What is needed is investment. Which can only happen when there is certainty in the state of the economy; namely where the debts are held, the true value of this debt (what it can be sold for).

Anonymous said...

well, an indication of 'excessive' debt could possibly be 'excessively' risky behaviours as investors chase yield. covenant lite deals? mexican field workers with 750k mortgages? 125% mortgages?