John Kay’s article on 2nd December in Financial Times more than once accentuates the potential impact of moral hazard, but also in patches emboldens the argument that it is an exaggeration of some sorts to believe that it could be the sole harbinger of current and future behavior towards risk taking. Actually there is a far more insipid reason that when the very core of all economic mobility is guided by incentives that favor speculation over risk management by forcing stocks to be the preferred mold incentivized by the government, it is only natural that the die would attract the flow of funds, which in turn bloats the paradigm of instruments that channelizes flow in the same direction. The inter-connectivity of the instruments under government oversight actually tried to securitize the flow of funds into a situation that assigned zero probability of a tail risk; this assignation was actually incentivized through no-holds on monetary supply, an expansionary policy all through the decade that stymied any upward movement of the interest rates. Moral hazard is a continuation of this alignment. The whole book, ‘Too big to Fail’ is a tribute to this notion.
However the government and the Federal Reserve did quite a bit to save the situation, when the probability zero event happened and like a pack of cards the superbly inter-connected mesh of securitized debt instruments collapsed when a few of the banking institutions could not cover their positions for want of adequate cash. How would they when they were having leverage of up to 40 times their own capital holding?
The Federal Reserve took unprecedented steps to curb the effects of the liquidity crisis by injecting into the financial system some broad measures through a mix of short term and long term actions (refer 21st July Federal Reserve Monetary Report to the Congress) that ranged from quantitative easing to various programs like Term Asset Backed Securities and Loan Facility (TALF), Capital assistance programs, Public –Private Investment Programs, etc, that finally culminated in resuscitating the blood flow of the financial system when inter-bank lending and lending to businesses could be restored; the lowering of the interest rate (PLR) to near zero level served as the most decisive factor in fostering the growth of credit and easing the money supply, both simulatenously acting in tandem to stop any further free-fall or shocks in the period that spanned from Lehman Brothers collapse to the middle of the 2009.
These measures to increase liquidity was essentially to make the banks start lending again to all the sectors of the economy and it did start the process as is evident in some of the growth of assets of the banks. The growth of the bank assets have been phenomenal today after one year has passed, with the lead bank of U.K. The Barclays now holding more than 100% of the UK GDP, BN Paribas holding equivalent for France and Spain’s Santendar holding similar amounts. The Banks of U.S. however have not reached to these levels, although the increase in assets after the storm settled in the U.S. banks is still in the region of 20% compared to the European Bank’s 25% (refer article on the same subject in Bloomberg, 2ndDecember).
It would be interesting to see where these assets are held? Are they held in capital expenditure programs that is intended to tackle the demand side of the problem, or are they involved in securing solutions to the supply side problem? I would argue that the current problem of the economies is that due to the output gap during a downturn, aggregate demand needs to be raised through government efforts and the entire banking institutions must work to see that this could be done by lending to the right institutions that help to raise aggregate demand. The governments in the European Union have done it through a mix of actions starting with protecting jobs through a short time work scheme, and through investments in infrastructure, which helped to curb the effects of lower aggregate demand. Unfortunately not every nation has seen such actions, and U.S. is the leading proponent.
The money given to the banks by the Fed at virtually zero interest rates is equivalent to transferring power to these banks to print their own money (again an example of moral hazard being extended as banks get a free hand in spite of their track record that is filled with blemishes) and this limitless power should have had strings attached. Unfortunately this free flow of cheap money helped to bloat the bank assets into those categories of assets that could hardly be the driver of aggregate demand growth. I would like to single out the commodities category where the flow of funds have helped to increase the prices, with limited impact on the economies in terms of aggregate demand growth. Let me explain the case in Gold.
In the last one year we have seen unprecedented rise in the price of Gold. Clearly this is at the bottom of the pyramid in terms of the hierarchy of wealth creation instruments and in a downturn it is only to be expected that surplus money would be moved to Gold till any other better performing instrument could be found. This essentially means that money could be moved from existing assets locked in stocks, securities, bonds, etc to the safe haven of Gold. This would actually mean that the investment demand for Gold would exponentially increase. As is evident in the chart extracted from the World Gold Council data in the next page.
It shows that while all the consumption demand for Gold slumped, the investment demand surged by 73%, thus fueling a surge in prices. This surge is more influenced by Gold Selling by the IMF and Gold buying by some economies to hedge risks against the dollar, as also by the large scale movement of retail investment by the fund managers who moved their assets because Gold as a collateral could be funded by banks much easily than other commodities in a downturn, wheras in an upturn the banks would find many other opportunities much more safe (for example mortgage backed security or leveraged buy-outs !).
But actually dollar provided an icing on the cake. A trader could borrow from the bank in dollars at near zero interest rate and convert it in Euros and then buy Gold and horde it for a few days. In a rising market it would give him a 2% return in 30 days and by that time dollar would slump further by 1% thus making his interest rate virtually negative. This ‘carry trade’ in dollars is best invested in Gold and other commodities including Aluminum, which has helped to increase prices in both these commodities.
The question is does it help to increase aggregate demand, I doubt. And the fact that this incentivizes a flow of money making a debt spiral for collaterized debt on commodities a very risky proposition for the future. For Gold it could be a sustainable proposition, for Aluminum it is not and could bring in a lot of peril to all participants of the market. The banks however are insulated by moral hazard.