Note: This is an edited transcript of a wide-ranging conversation I had with Bill in April 2013 over coffee in Hong Kong
Sony: This is Sony Kapoor of Re-Define talking to Bill White of BIS fame. Bill, we are in this global situation where there is a huge amount debt in the system and central banks have flooded the system with money. At the same time, OECD countries are facing a structural slow-down of which the demographic time bomb is a part. They also have the highest levels of public and private debt. Simultaneously, power in global governance structures is starting to shift towards the East. Not to mention recent ructions in emerging markets.
Given that we are facing the triple challenge of the changes in governance, the structural break in growth rates, and unprecedented levels of credit and debt, particularly in OECD economies, how does the landscape look going forward? What is the best we can hope for?
Bill: To be honest, the landscape looks rather scary. Clearly, when you talk about this credit bubble we are at the end in the advanced markets, of a very long period of excessive credit creation. This has now crept over into the emerging markets as well. I think that in a certain way they have inherited it, through more or less the fixed exchange rate system, the imbalances of the advanced market economies; we have a global problem here. It is, however, most obvious in many of the advanced market economies.
So, we have a problem. Now the question is, what do we do to deal with the problem? I do not think that the quick fix, for example, the idea that you can use base money to expand government spending in a cost-less manner, or quantitative easing. I think these quick macro-fixes really are totally illusionary as a general solution. I believe that what we do have to focus on is the search for things that will actually work.
What I mean by that is that we should be using macro-stimulus in cases where countries really do have room. That is to say that they do not have too much debt to begin with, and there are a number of countries that find themselves in that situation.
Sony: For instance?
Bill: I would say as a general rule, all of those countries that have current account surpluses could count themselves in those set of countries that could be doing more. I would include countries like China, Korea, Germany and Japan in the context of the balance of payments problem we have in Europe. Not a debt problem, it is a balance of payments problem.
So, solution number one is that you should use whatever macro potential you can. Number two I guess is that there is a lot of room for more public and private investment. You can sell to the markets that public investment is an asset, it is not just money that is poured down the drain, it is an asset to go with the liability, and it should be considered more acceptable.
Sony: So does this mean a reallocation from current spending to capital spending in public budgets?
Bill: Yes. I do not think I would go so far as Keynes, well, maybe I would – it is not completely crazy to suggest that capital expenditure my government should be treated in a very different way from current expenditure.
Sony: As they are for firms.
Bill: Yes, because you have got an asset that provides a rate of return. In social terms, when you think about some infrastructure investment in some countries, social return may actually be very high. There is a recent book that shows that infrastructure spending in the US in the 1930s actually brought along with it a little bit later on an enormous amount of private sector investment.
Sony: So the crowding in of private investors.
Bill: Yes, the crowding in, as opposed to a crowding out.
Sony: What is happening, for example, in Europe today, is the exact opposite. Capital investment levels have fallen precipitously in countries like Spain and Italy, as has private investment.
Bill: Yes. But, having said that, there are countries like Spain where I think, personally, that public sector infrastructure investment got a little out of hand in the boom period. As a general rule, I think there is more room for public investment and there would be more room for private investment if there were a more welcoming political environment for business spending.
But the third point, that would be part of a policy package to get us back out of this current mess, would be explicit debt reduction. I think there are a number of places where you just have to look at it and say that the credit expansions and the associated debt is so great that it will never be paid back. What we know is that the sooner you recognize a bad debt, the better off you will be. That would involve, certainly in Europe, the recognition of joint difficulties in the banks and some sovereigns. Then the question is: who is going to take the hit? This is to recognize the money that is gone.
The last thing, of course, is the structural reforms. I would say that the OECD is very interested in product market reforms, labour market reforms, freeing up the service sector in many countries. In particular, this is where the structural gets together with the macro; there are a lot of countries like Germany where they have consciously (whether they recognize it or not) constrained the service sector. They have somehow considered it to be bad in the interest of encouraging exports, which are considered good.
Sony: And there is an implicit subsidy to the product, particularly export market; the same in China too.
Bill: I think there are other ways out of the mess we find ourselves in, other than the quick fix of ‘just print the money’. The difficulty – and this is where you get back to the whole question of political egitimacy and he shifting influence of power – is that the political mechanisms are not yet tuned up to do the things that need to be done. I think that internationally the general comment that I would make is that countries are not yet prepared to give up the degree of sovereignty that they need to give up in order to get the international cooperation that would help us move forward, particularly the cooperation between creditors and debtors.
I guess if you want to see a real example of that, it would be in Europe.
Sony: And this is a group of countries with a shared history, shared culture and an institutional structure where trust building opportunities have existed for decades.
Bill: And it is still not quite working. So one should not be at all surprised that when you get to the global level, where you have the US on one hand, and China on the other, the idea of sitting down at the table and coming up with a truly cooperative solution in everyone’s best interest is not very likely.
The second thing is, if that is the political impediment to international cooperation, I think at the national level there are enormous problems as well. I just came out of a presentation that Tom Ferguson was making, which was absolutely shocking (if robust). He showed that the linear relationship between the proportions of votes gained in any given election – let us say the House of Representatives in 2011 – and proportion of money mobilized, in the form of political contributions, is absolutely frightening. It is linear and a very, very tight fit. Basically, what it comes down to is that if you raise the most money, you win the most votes. The shocking part of that, of course, is that it basically means that the politicians have to raise the money. You need not go much further than that to recognize the kind of cancer at the heart of the system.
I suspect that in a lot of places the vested interests (the people that are gaining the rents and are going to resist the forms of structural changes that are required to contribute to getting out of the mess) are going to put up a fight.
Sony: And this is a different set of factors in different countries. For example, in countries that have had dominant banking sectors you have the banking sector. There are countries, such as Germany and China, where it may be the export or manufacturing sectors. Within Europe, at a creditor level, this is the creditor countries versus the debtor countries. It is exactly where the rents and the resources and the creditors are pulling the shots.
Bill: They will all be different people in different sectors. But the one thing that unites them is: I have got the money, and I intend to keep it.
Sony: Exactly. So (disentangling what you said and taking from your point three, which was that there is a need for debt reduction in the system), for every debtor there is a creditor and at an aggregate level it is just a distributional issue, there is no excessive debt in the system – it is the counterpart of excessive credit.
Bill: It all nets out. Though there are a lot of dangers in looking at net figures, you have to look at the gross figures and see what that entails.
Sony: Exactly, and that is a lesson I learned when Enron was my biggest counterparty when I traded derivatives. Our net exposure was actually relatively limited, but it was the much larger gross exposure that mattered.
So what we need now is that the losses fall on those who have the capacity to absorb them. But it is exactly those with the capacity to absorb losses who actually have the most political power and will resist it the hardest. What we are seeing increasingly is that the burden of adjustment, be it the burden of debt reduction, or the implicit economic loss that you incur if you do not adjust debt that needs to be adjusted, is falling on the poor, and on those without a voice. It is falling on those with the least capacity to actually absorb it. This is not only unfair; it is macro economically extremely problematic, because this has a terrible impact on the aggregate levels of growth.
Bill: Well, I was going to say, Sony, that it is even worse than what you describe it as. With the creditors trying to force the debtors to adjust in the end, given Keynesian multipliers and the rest of it, as you say may actually be counterproductive. But, if they start off from a position where they cannot actually pay what they have to pay, then you push them into a position where they have even less means of paying. In the end the creditors wind up, through this punitive behaviour, getting even less than they would have got. If they had accepted 50 cents on the dollar, they would have done better than when in the end they get 25 cents on the dollar.
Sony: What part of this is fallacy of composition effects and what part of this pure short termism? The way I look at it, if you look at what is going on in Europe, it is interesting to look at if Germany were to ask a simple question, which is how to minimize German taxpayer losses. The answer that you get, if you are asking the question over a six-month horizon is very different from the answer you would get if you are answering over a ten-year horizon. Over a ten-year period the macro-economic effects leave you worse off.
So one part of it is short-termism, and one part of it is that while one creditor may squeeze a particular debtor and may be able to get better terms than they otherwise would, but, if all of this is happening at an economy-wide level, it is self-defeating. So, how important are these two effects?
Bill: I think that one aspect of it is that most people are not very good at thinking about the medium and longer-term consequences of their actions (both government and financial markets). I think it is just human nature. There is a great quote of von Mises where he says that any fool can see the short-term implications of his actions, but the job of an economist is to see the unintended consequences and whether in fact you are making things worse, as opposed to better.
I think this is precisely the situation we find ourselves in. It is not so much wickedness that informs their actions; it is just they cannot see through the full implications of what they do and that, of course, is a real problem. There is, of course, a second dimension. You could perhaps call it the ‘moral dimension’, and maybe you see it in Europe more than elsewhere (I think again it is human nature). Apparently, the word for debt and guilt in Germany is the same, and this is not uncommon – it is the same in Aramaic. This goes a long way back, mentioned in the Bible: ‘forgive us our debts, forgive us our sins.’ These are different interpretations of the Aramaic. So this is really, really deep and there are a lot of people, as creditors, who really do feel that it is the debtor’s fault and that it is the debtor who has got to adjust.
A more rational, economic way of looking at it – maybe it even goes beyond rational and economic and into the morality of it – is that the debtor was given the money, willingly and freely, by a creditor who misjudged the capacity of that debtor to repay. That makes the creditor equally culpable. So, everybody ought to be in this together. Plus the fact that if they do a deal, maybe the creditor can get 50 cents on the dollar, as opposed to 25.
Sony: How seriously can this, very deeply emotional or moral problem, be addressed through a debt-equity swap rather than a debt write down? Part of the problem is that you do not want, as a creditor, the debtor to get better terms, and you can presumably structure equity contracts in a way that everybody benefits (if there is an upside). And it has got optionality, because the worst-off you will be the percentage that you agree to; you are basically putting a floor. Is that possible, is it being considered, how can it be made macro-economically significant? Should it be done for countries?
Bill: My recollection is that when the Argentineans did their GDP debt restructuring, they did this. There is also an element of this in the Cyprus deal, because the big depositors are going to get shares in the bank and then we wait and see whether they benefit or not. At least this was discussed as an option. I certainly feel that these kinds of conditional contracts allow the person who feels aggrieved (the creditors) to get something back – an upside.
Sony: Is this something that needs to be considered at a broader level? So, if you look at the trend over the past few years, what we have been seeing is an increase in leverage in the system, across the board. We have been seeing an increase in what were implicitly or explicitly equity contracts shrinking and a growth of debt contracts instead. So, does this aggregate growth somehow take away from the resilience of the financial system and does it also pit economic interests, the debtors versus creditors, against each other and worsens a situation where equity like arrangement would have shared interests?
Bill: In a sense it does, but I am not a great student of this. It brings you back to Islamic banking, which is the whole idea that it is probably better for everybody if we all have a stake in this thing, as opposed to you owe me and it goes on forever.
Sony: Of course, Islamic banking is now moving in the opposite direction. It’s increasingly using esoteric derivative structures that are essentially debt contracts but are portrayed as equity contracts in conformance with Islamic law.
Bill: We keep talking about all of these ancient people so I will go back to the Greeks and the golden mean. I am sure that, given the advantages of both debt instruments and equity instruments, there is room for both. The worry I have (and you were already talking about ways of restructuring debts ex-post), it seems to be that the problem really is ex-ante. The question really is the degrees of government interference in the financial system, which encourages the use of debt. The fact that virtually everybody encourages debt by allowing people to write off interest on debt strikes me as being very odd.
Sony: There is also the regulatory element; fiduciary investors as well as risk weights encourage the holdings of debt over equity.
Bill: Exactly, particularly with respect to sovereigns which have zero risk weights – which again strikes me as a bit odd. There are a number of ways in which we should be reevaluating the role of government in biasing the financial system towards doing the sorts of things they do. Another example is the influence on housing in the United States, which was encouraged from the highest level. Congress was ever so keen on having every American have his or her own house. In the end I think that these particular government policies have wound up hurting the people they were supposed to protect and support. One does get back, on a general level, to Hayek, and the concept of the fatal deceit, which is to believe that the policy makers have got so much understanding, intelligence and insight that they can make things significantly better over time. We have had so many examples of the unintended consequences that I think we ought to be giving more attention to those sorts of things when we start to consider economic activism.
Sony: On that pessimistic note of caution – Bill thank you so much for talking to Re-Define. In the dark days when I was banging my head against brick walls trying to work on financial reform when no one was interested you and your colleagues at the BIS reassured me I was not crazy. Thanks for your insights.
Bill: The pleasure is all mine. It’s always wonderful to talk to you Sony.