“The problem of leverage, the sheer volume of debt in the economy, is still very large and this poses massive macro-economic challenges. I think these macro-economic challenges will last many years.”
So says Bank of England Governor, Mervyn King.
Meanwhile, in Happyville, Eric Johnston informs readers of The Age:
“Westpac has delivered a seven per cent increase in first-half cash profit to $3.17 billion as charges for bad debts fell away sharply in a further sign the worst of the financial crisis is behind the banking sector.”
He’s right. It is behind the banking sector. Close behind. And catching up fast. We have an urge to say “Behind you”, pantomime style!
It’s not often we agree with central bankers. But on this occasion we’ll agree with Mr. King.
Of course, you need to take his comments in context. Because he also said:
“The economic consequences of high-level indebtedness now would become more severe if rates were to rise.”
Which is why he voted to keep the Bank of England interest rate at a record low of 0.5%.
It’s the economic equivalent of refusing to step on the brakes as your car is travelling at 200km/h towards a brick wall, because you’re afraid of wearing out the brake pads!
The truth is, touching the brakes may not stop the economy hitting the wall, but it’ll certainly slow the car down.
But what Mr. King’s comment reveals is central bankers have played the odds. They figure it’s more important to have a long economic depression that “will last many years” rather than allow a sharp and temporarily damaging bust.
Why would they take that view?
Take the pain now
Simple: a short and sharp bust is damaging in the short term to individuals and corporations – including banks. But in the long term, it’s positive for individuals and most corporations – excluding banks.
In contrast, a long economic depression supported by taxpayer funded bailouts is great for individuals and corporations – including banks – in the short term. But in the long term it’s only positive for the banks… individuals and most corporations will ultimately lose out.
The reason is it prevents bad loans being purged from the economy.
Individuals and businesses that would otherwise have gone bust are – in effect – prevented or disinclined from doing so.
Instead, their credit is extended, the interest rate is cut, and the incentive to declare bankruptcy or default is lessened.
That may seem like a good thing.
But it isn’t. At a higher rate of interest, the “bad” borrower just pulls the pin and cops it on the chin. Simply because they can’t afford to keep going. Perhaps they forfeit some assets to repay the debt, but that’s it. They move on.
OK, we know it’s not as clean cut. We’re sure going bust is a painful experience for anyone that’s gone through it. But we’re illustrating a point. And that is, the “bad” borrower is punished for his or her foolishness in borrowing a bunch of money they couldn’t afford to repay.
Part of the punishment is they’ll find it harder to get another loan in the future. Hence the disincentive to take out a loan in the first place if they feel they may not be able to repay it.
And the lender is punished for lending money to the individual or business.
If the lender has a diversified loan book they should have more than enough “good” loans on the books to outweigh the bad loans. Unless of course, the bank has been reckless with lending because it believes the lender of last resort (the central bank) will bail it out.
Oh, and by the way, being reckless with lending doesn’t just mean subprime mortgages. Australia’s banks are as leveraged as US or European banks.
Just remember, even good borrowers can turn bad when the proverbial hits the fan. Especially in an economy that’s built on the resources sector supplying funds for the banking sector to lend to the service sector.
Once the resources profits dry up, where will the service sector and consumer get the money from then?
It’s not as though there’s a productive economy in place to create additional profits – look at the lack of profit growth from the non resources and banking sectors.
Anyway, when interest rates are kept low, there’s less of an incentive to default. The cost of keeping the loan is reduced and the borrower considers it worthwhile muddling through.
Creating a zombie economy
The trouble is, it creates a zombie economy where the economy is full of debtors trying to repay debt. Rather than an economy of entrepreneurs trying to innovate.
But even in cases where debtors do walk away, you’ve still got the central bank backstopping the default. Again, this prevents punishment for mistakes. It means there’s no incentive for the banks to be more cautious in the future as there’s no dire consequence for them.
It means there are no direct losers from the bad loans.
The borrower wins and the lender wins. The only losers are the indirect ones – the taxpayer.
In contrast, without taxpayer funded bailouts, in the short term everyone loses from a credit bust… or mostly everyone. The borrowers have to default and their access to credit is withdrawn.
The banks go bust as they are unable to recover the loans. And, as savers fear the safety of their deposits, a run on the banks is caused, sending them into actual bankruptcy.
That means of course that savers are punished too.
Which is how it should be. That’s right, one of the major reasons for the Australian and global banking bailouts was to protect savers. Now, you may think that’s a good thing.
After all, saving is good. Surely savers did the right thing compared to borrowers who overextended themselves.
That’s only partially true.
While savers may not have overextended themselves by taking out huge loans, they’re still culpable. For the simple fact that they kept savings in a bank savings account in return for interest.
Savers didn’t care how the bank was managing its loan book. They didn’t care they were helping to inflate the housing bubble. Savers just wanted the best interest rate. How many savers connect a higher savings rate with the possibility the bank is taking a higher risk with its loans?
Not many we’d wager.
And that’s the ultimate reason why the banks were bailed out. A failure to bail them out would have destroyed faith in the banking system. And this would have made it hard for the surviving or new banks to attract depositors.
And naturally that would make it hard for those same banks to extend credit – which would be disastrous for them given the engorged size of their loan books. How would they keep the Australian housing Ponzi scheme going then?
That’s why banks worldwide had to be bailed out at all costs. Failure to do so would have resulted in the end of the current banking and money system. And when housing markets crashed overseas, the banks needed more bailouts.
Without it, it would have meant an end to the privileged position of the bankers and central bankers… no wonder they prefer a long rather than a short depression.
Ignorance leads to more problems
Trouble is, while the bankers make happy sucking in ignorant dollars from savers in order to lend money to even more ignorant borrowers, it prevents the cleanout the economy needs.
A good example of the trouble the banks have gotten into can be seen if we take another look at banking history. In this case we’ve picked out the 1973 ANZ Bank annual report.
Several readers replied to yesterday’s letter to point out Aussie banks operated as separate entities until the early 1980s – trading banks and savings banks. And that much of the home lending was done through the savings bank.
“You’ve misled your readers”, was the accusation. Not so…
The following snapshot will give you a good indication of the respective bank balance sheets in 1973:
Look, we’re not saying the banks were angels. But the fact is, this was still a time when borrowers and lenders still had a concept of what real money was.
It was a only a few years before 1973 that the Australian 50 cent coin contained 0.34 of an ounce of silver – incidentally, one of those old coins is worth about $12 in today’s money, that shows you how much the currency has been devalued.
Not only that, but for bankers, bank runs were still a fairly recent memory.
Which is why in 1964, the ANZ Bank Savings Bank only had $83 million of loans outstanding against $369 million of deposits. That’s a 4.4:1 ratio. Even by 1973, after the world had gone of the US dollar gold exchange standard, the ratio was still 3:1.
Although clearly the expansion of credit had begun.
Now, if we factor in the Trading Bank and Savings Bank combined, if we say the Trading Bank loan book was 25% to “persons” (as it was in 1978), that works out as $505 million of loans.
Add that to the $382 million of loans for the Savings Bank, and you’ve got a 20% exposure to “persons” – much of which we’ll guess was for mortgages.
In other words, ANZ Bank’s exposure to the mortgage market in the 1970s was actually less than we’d given them credit for yesterday! For every $1 in deposits it loaned just 20 cents to “persons”.
A banking reversal
And so the shift from financing productive industry to unproductive housing has been even greater than we’d thought.
If you compare those numbers to today’s ANZ balance sheet you’ll see the transformation. In 2010 ANZ Bank had $349 billion of loans and $311 billion of deposits. That’s a ratio of 1:1.1.
In other words, more loans outstanding than deposits. For every $1 in deposits, the ANZ Bank lends $1.10 to “persons”!
Now, we understand the bank gets funding for its loans from other sources, but it gives you a clear idea of how banking has been transformed from a warehouse that looks after your savings, to a highly leveraged hedge fund that punts on the housing market.
It marks a complete reversal of the position of 38 years ago. And remember that today retail lending comprises 59% of the bank’s loan book, three times the 1973 amount.
Yet still, we read comments such as this in a Goldman Sachs note this morning, “the earlier run-up in [Australian house] prices was not associated with the usual symptoms of a ‘speculative bubble’ (looser lending standards, higher LVRs, rapid credit growth).”
They could have fooled us. It sure looks like a speculative bubble fuelled by rapid credit growth.
A rapid growth in credit that has shifted from financing productive industry and innovation in favour of piling onboard the easy money of blowing up a property bubble.
So we’ll say it again. The housing bubble is a result of a speculative credit-fuelled bubble.
A bubble that has caused harm to the Australian economy by focusing investment on consumption (housing) at the expense of innovation.
For Markets and Money Australia