Tuesday, July 10, 2012

549 Richard A. Werner: solutions to the European & Japanese internal debt crises

Richard A. Werner: solutions to the European & Japanese internal debt crises

(1) Debt-Deflation Depression the result of Deregulation, misallocation
of Capital - London Banker
(2) Richard A. Werner: solutions to the European & Japanese internal
debt crises
(3) ECB keeping the threat of financial Armageddon alive, to coerce
Europe into a deeper union

(1) Debt-Deflation Depression the result of Deregulation, misallocation
of Capital - London Banker


Fisher's Debt-Deflation Theory of Great Depressions, and a possible

London Banker Blogsite

Friday 1 August 2008

“Panics do not destroy capital; they merely reveal the extent to which
it has been destroyed by its betrayal into hopelessly unproductive works.”

- Mr John Mills, Article read before the Manchester Statistical Society,
December 11, 1867, on Credit Cycles and the Origin of Commercial Panics
as quoted in Financial crises and periods of industrial and commercial
depression, Burton, T. E. (1931, first published 1902). New York and
London: D. Appleton & Co

I have been both a central banker and a market regulator. I now find
myself questioning whether my early career, largely devoted to
liberalising and deregulating banking financial markets, was misguided.
In short, I wonder whether I contributed - along with a countless others
in regulation, banking, academia and politics - to a great misallocation
of capital, distortion of markets and the impairment of the real
economy. We permitted the banks to betray capital into “hopelessly
unproductive works”, promoting their efforts with monetary laxity,
regulatory forbearance and government tax incentives that marginalised
investment in “productive works”. We permitted markets to become so
fragmented by off-exchange trading and derivatives that they no longer
perform the economically critical functions of capital/resource
allocation and price discovery efficiently or transparently. The results
have been serial bubbles - debt-financed speculative frenzy in real
estate, investments and commodities.

Since August of 2007 we have been seeing a steady constriction of credit
markets, starting with subprime mortgage back securities, spreading to
commercial paper and then to interbank credit and then to bond markets
and then to securities generally. While the problem is usually expressed
as one of confidence, a more honest conclusion is that credit extended
in the past has been employed unproductively and so will not be repaid
according to the original terms. In other words, capital has been
betrayed into unproductive works.

The credit crunch today is not destroying capital but recognising that
capital was destroyed by misallocation in the years of irrational
exuberance. If that is so, then we are entering a spiral of debt
deflation that will play out slowly for years to come. To understand how
that works, we turn to Professor Irving Fisher of Yale.

Like me, Professor Fisher lived to question his earlier convictions and
pursuits, learning by dear experience the lessons of financial instability.

Professor Fisher was an early mathematical economist, specialising in
monetary and financial economics. Fisher’s contributions to the field of
economics included the equation of exchange, the distinction between
real and nominal interest rates, and an early analysis of intertemporal
allocation. As his status grew, he became an icon for popularising 1920s
fads for investment, healthy living and social engineering, including
Prohibition and eugenics.

He is less famous for all of this today than for his one statement in
September 1929 that “stock prices had reached a permanently high
plateau”. He subsequently lost a personal fortune of between $6 and $10
million in the crash. As J.K. Galbraith remarked, “This was a sizable
sum, even for an economics professor.” Fisher’s investment bank failed
in the bear market, losing the fortunes of investors and his public

Professor Fisher made his “permanently high plateau” remark in an
environment very similar to that prevailing in the summer of 2007.
Currencies had been competitively devalued in all the major nations as
each sought to gain or defend export market share. The devaluation
stoked asset bubbles as easy credit led to more and more speculative
investments, including a boom in globalisation as investors bought bonds
from abroad to gain higher yields. Then, as now, many speculators on
Wall Street had unshakeable faith in the Federal Reserve’s ability to
keep the party going.

After the crash and financial ruin, Professor Fisher turned his
considerable talents to determining the underlying mechanisms of the
crash. His Debt-Deflation Theory of Great Depressions (1933) was
powerful and resonant, although largely neglected by officialdom, Wall
Street and academia alike. Fisher’s theory raised too many uncomfortable
questions about the roles played by the Federal Reserve, Wall Street and
Washington in propagating the conditions for credit excess and the debt
deflation that followed.

The whole paper is worth reading carefully, but I’ll extract here some
choice quotes which give a flavour of the whole. Prefacing his theory,
Fisher first discusses instability around equilibrium and the influence
of ‘forced’ cycles (like seasons) and ‘free’ cycles (self-generating
like waves). Unlike the Chicago School, Fisher says bluntly that “exact
equilibrium thus sought is seldom reached and never long maintained. New
disturbances are, humanly speaking, sure to occur, so that, in actual
fact, any variable is almost always above or below ideal equilibrium.”
He bluntly asserts:

“Theoretically there may be — in fact, at most times there must be —
over- or under-production, over- or under-consumption, over- or
under-spending, over- or under-saving, over- or under-investment, and
over or under everything else. It is as absurd to assume that, for any
long period of time, the variables in the economic organization, or any
part of them, will “stay put,” in perfect equilibrium, as to assume that
the Atlantic Ocean can ever be without a wave.”

While disturbances will cause oscillations which lead to recessions, he

"[I]n the great booms and depressions, each of the above-named factors
has played a subordinate role as compared with two dominant factors,
namely over-indebtedness to start with and deflation following soon
after; also that where any of the other factors do become conspicuous,
they are often merely effects or symptoms of these two.”

This is the critical argument of the paper. Viewed from this perspective
we may see USA and UK decades of under-production, over-consumption,
over-spending and under-investment as all tending to a greater imbalance
in debt which may, if combined with oscillations induced by
disturbances, take the US and UK economies beyond the point where they
could right themselves into a deflationary spiral.

Fisher outlines how just 9 factors interacting with one another under
conditions of debt and deflation create the mechanics of boom to bust
for a Great Depression:

Assuming, accordingly, that, at some point of time, a state of
over-indebtedness exists, this will tend to lead to liquidation, through
the alarm either of debtors or creditors or both. Then we may deduce the
following chain of consequences in nine links: (1) Debt liquidation
leads to distress selling and to (2) Contraction of deposit currency, as
bank loans are paid off, and to a slowing down of velocity of
circulation. This contraction of deposits and of their velocity,
precipitated by distress selling, causes (3) A fall in the level of
prices, in other words, a swelling of the dollar. Assuming, as above
stated, that this fall of prices is not interfered with by reflation or
otherwise, there must be (4) A still greater fall in the net worths of
business, precipitating bankruptcies and (5) A like fall in profits,
which in a “capitalistic,” that is, a private-profit society, leads the
concerns which are running at a loss to make (6) A reduction in output,
in trade and in employment of labor. These losses, bankruptcies and
unemployment, lead to (7) Hoarding and slowing down still more the
velocity of circulation.

The above eight changes cause (9) Complicated disturbances in the rates
of interest, in particular, a fall in the nominal, or money, rates and a
rise in the real, or commodity, rates of interest.

Evidently debt and deflation go far toward explaining a great mass of
phenomena in a very simple logical way.

Hyman Minsky and James Tobin credited Fisher’s Debt-Deflation Theory as
a crucial precursor of their theories of macroeconomic financial

Fisher explicitly ties loose money to over-indebtedness, fuelling
speculation and asset bubbles:

Easy money is the great cause of over-borrowing. When an investor thinks
he can make over 100 per cent per annum by borrowing at 6 per cent, he
will be tempted to borrow, and to invest or speculate with the borrowed
money. This was a prime cause leading to the over-indebtedness of 1929.
Inventions and technological improvements created wonderful investment
opportunities, and so caused big debts. * * *

The public psychology of going into debt for gain passes through several
more or less distinct phases: (a) the lure of big prospective dividends
or gains in income in the remote future; (b) the hope of selling at a
profit, and realising a capital gain in the immediate future; (c) the
vogue of reckless promotions, taking advantage of the habituation of the
public to great expectations; (d) the development of downright fraud,
imposing on a public which had grown credulous and gullible.

Fisher then sums up his theory of debt, deflation and instability in one

In summary, we find that: (1) economic changes include steady trends and
unsteady occasional disturbances which act as starters for cyclical
oscillations of innumerable kinds; (2) among the many occasional
disturbances, are new opportunities to invest, especially because of new
inventions; (3) these, with other causes, sometimes conspire to lead to
a great volume of over-indebtedness; (4) this in turn, leads to attempts
to liquidate; (5) these, in turn, lead (unless counteracted by
reflation) to falling prices or a swelling dollar; (6) the dollar may
swell faster than the number of dollars owed shrinks; (7) in that case,
liquidation does not really liquidate but actually aggravates the debts,
and the depression grows worse instead of better, as indicated by all
nine factors; (8) the ways out are either laissez faire (bankruptcy) or
scientific medication (reflation), and reflation might just as well have
been applied in the first place.

The lender of last resort function of central banks and government
support of the financial system through GSEs and fiscal measures are the
modern mechanisms of reflation. Like Keynes, I suspect that Fisher saw
reflation as a limited and temporary intervention rather than a long
term sustained policy of credit expansion a la Greenspan/Bernanke.

I’m seriously worried that reflationary practice by Washington and the
Fed in response to every market hiccup in recent decades was storing up
a bigger debt deflation problem for the future. This very scary chart
(click through to view) gives a measure of the threat in comparing
Depression era total debt to GDP to today’s much higher debt to GDP.

Certainly Washington and the Fed have been very enthusiastic and
innovative in “reflating” the debt-sensitive financial, real estate,
automotive and consumer sectors for the past many years. I’m tempted to
coin a new noun for reflation enthusiasm: refllatio?

Had Fisher observed the Greenspan/Bernanke Fed in action, he might have
updated his theory with a revision. At some point, capital betrayed into
unproductive works has to either be repaid or written off. If either is
inhibited by reflation or regulatory forbearance, then a cost is imposed
on productive works, whether through inflation, higher interest,
diversion of consumption, or taxation to socialise losses. Over time
that cost ultimately hollows out the real productive economy leaving
only bubble assets standing. Without a productive foundation, as
reflation and forbearance reach their limits, those bubble assets must

Fisher’s debt deflation theory was little recognised in his lifetime,
probably because he was right in drawing attention to the systemic
failures that precipitated the crash. Speaking truth to power isn’t a
ticket to popularity today either

London Banker has been a central banker and securities markets regulator
during a varied and interesting career in global financial markets.


TUESDAY, 29 MAY 2012

"Heads I win, tails you lose."

I was at a private lunch in the City some 15 years ago discussing
whether hedge fund investments should be considered a new and distinct
asset class. A very prominent hedge fund trader was asked his opinion.
Surprisingly, he said that hedge funds were less a new method for
investment, than a new method for higher remuneration. The appeal of
hedge funds was in the outsize fees rewarding the fund managers rather
than any superior returns for investors.

I was reminded of that lunch again this morning by two pieces in my
inbox. The first referenced a paper from the Bank of England estimating
the public subsidy of the UK's largest banks at more than £220 billion
during the past couple years. These banks secure a funding premium in
wholesale and deposit markets from the implicit state guarantee of
obligations attaching to their too big to fail status. The subsidy
distorts competition and risk taking, storing up even more future draws
on beleaguered taxpayers. The second was a blogpost summarising recent
comments of a Bank of England executive to the effect that all the cost
savings generated by technology advances and automation in the banking
sector had been paid away in increased bonuses and remuneration. IT
efficiency gains fund bonus payments. The financial sector's appetite
for technology investment is not driven by a desire to provide more
efficient services, but to secure ever larger remuneration packages. In
fact, rapid financial innovation and technology transformation has led
to less efficient intermediation if evaluated on a cost basis.

Regulation has had a pernicious effect in driving technology and
complexity. As Chris Skinner observes,

Put another way, in the first iteration of the Basel Accord there were
seven risk metrics requiring seven calculations; by the time we get
around to implementing Basel III, over 200,000 risk categories will
require over 200 million calculations.At some point policy makers will
need to turn their efforts from reinforcing and bailing out the bankers
who use any and every opportunity to take public support as private
bonuses and instead evaluate much simpler, lower cost models of
financial intermediation likely to yield domestic investment in domestic
businesses and assets.

I can almost hear the shouts of "socialist" from the usual defenders of
banks and markets. I am not advocating state nationalistion of banks,
but state withdrawal of explicit and implicit bank subsidies.

It is a conservative principle that the state should intervene when
markets fail. If the banking system has failed (and it has) and requires
a taxpayer subsidy to continue to operate (which it does), then
conservative principles dictate that the state must intervene to secure
a resolution in the public interest. More of the same is not a
conservative policy, but social welfare for bankers.

We currently have a system of excess regulatory complexity, hidden
market distortions and public subsidies. Moving away from the status quo
requires state action to identify and reduce subsidy through promotion
of business models that are simpler, more transparent and more directly
aimed at securing public benefit.

Posted by London Banker at 07:23

(2) Richard A. Werner: solutions to the European & Japanese internal
debt crises


pdf version:

Richard A. Werner (2012), How to End the European Crisis, University of
Southampton, CBFSD Policy Discussion Paper 2-12 | Centre for Banking,
Finance and Sustainable Development University of Southampton

{p. 1} How to End the European Crisis – at no further cost and without
the need for political changes

by Richard A. Werner, D.Phil. (Oxon)
Professor of International Banking
Centre for Banking, Finance and Sustainable Development

University of Southampton
31 July 2012


Executive Summary: True Quantitative Easing p. 2

1. How to solve the bad-debt problem in the banking system most
efficiently and cost-effectively. p. 3

2. Enhanced Debt Management: How to solve the sovereign funding problem
in the bond markets – and at the same time stimulate domestic demand p. 9

Further Reading p. 11

{p. 2} Executive Summary

There is a solution to the twin problem of large non-performing loans in
the banking systems and the funding crisis for sovereign borrowers that
is affecting especially Spain, Portugal, Ireland, Cyprus, Greece, but to
some extent also Italy and other countries.

The needed policies constitute 'true quantitative easing': I argued in
1994 and 1995 in Japan that there was no need for a recession in Japan
due to the bad debt problems in the banking system. Necessary and
sufficient condition for a recovery is an expansion in credit creation –
which I called 'quantitative easing', an expression that was later used
by central banks to refer to the type of traditional monetarist policy
(bank reserve expansion) that I had warned would fail.

True quantitative easing can be achieved quickly and without extra costs
in a two-part process as follows:

1. The central bank purchases all actual and likely non-performing
assets from the banks at face value (book value) and transfers them to
its balance sheet. In the case of non-securitised loans, if needed a law
should be passed to allow compulsory purchase by and reassignment to the
central bank.

2. The government stops the issuance of government bonds. Instead, it
funds any future borrowing requirement (including all scheduled 'roll-
overs' of bonds) by entering into loan contracts with the domestic
banks, borrowing at the much lower prime rate.

Ideally, these two measures are combined, and part and parcel of a
larger policy package. For a fuller list of measures, see our CBFSD
Discussion Paper No. 1-12.1

But they can also be implemented separately, so if ECB and national
central bank support cannot be gained for measure 1, national
governments can end the negative vicious cycle and end their sovereign
debt problems by going ahead on their own with part 2.

1 Richard A. Werner (2012), The Euro-Crisis: A to-do list for the ECB,
University of Southampton Centre for Banking, Finance and Sustainable
Development, CBFSD Policy Discussion Paper No. 1-12.

{p. 3} How to End the European Financial Crisis – at no further cost and
without the need for political changes

There is a solution to the twin problem of large non-performing loans in
the banking systems and the funding crisis for sovereign borrowers that
is affecting especially Spain, Portugal, Ireland, Cyprus, Greece, but to
some extent also Italy and other countries.

The needed policies constitute 'true quantitative easing': I argued in
1994 and 1995 in Japan that there was no need for a recession in Japan
due to the bad debt problems in the banking system. According to the
Quantity Theory of Credit, which I had introduced in 1991, and which
enabled me to predict the Japanese crisis and recession, I also pointed
out that it was avoidable if the right policies were taken: 2

Necessary and sufficient condition for a recovery is an expansion in
credit creation – which I called 'quantitative easing', an expression
that was later used by central banks to refer to the type of traditional
monetarist policy (bank reserve expansion) that I had warned would fail. 3

Sadly, the Japanese government did not adopt the recommended policies.
Neither did the Japanese central bank, which insisted on continuing to
rely on interest rate policies or, later, bank reserve expansion
policies (which it misleadingly called 'quantitative easing') – policies
I had warned would fail.

I believe the empirical record speaks for itself: Japan remains mired in
its twenty- year recession, soon to commence its third decade, while
national debt has topped 200% of GDP.

Fortunately for Europe, we now have the hindsight of the Japanese
experience and there is even less reason why one should adopt failed and
hugely costly policies, and turn down effective and costless policies.

In the following sections we discuss the two main pillars of the
policies I am recommending. For a full set of policies, please refer to
CBFSD Discussion Paper No. 1-12. 4

2 Richard A. Werner (1992). A Quantity Theory of Credit, University of
Oxford, Institute of Economics and Statistics, mimeo. See also Richard
A. Werner (1997), Towards a New Monetary Paradigm: A Quantity Theorem of
Disaggregated Credit, with Evidence from Japan, Kredit und Kapital, 30,
2, pp. 276-309. Available at http://eprints.soton.ac.uk/36569/

3 Richard A. Werner (1995). How to create a recovery through
'Quantitative Monetary Easing'. The Nihon Keizai Shinbun (Nikkei), 2
September 1995 (morning edition), p.26 (in Japanese). English
Translation available at http://eprints.soton.ac.uk/340476/ . For
further details of the policies proposed, see Richard A. Werner (1998),
Minkanginkoukarano kariire de keikitaisaku wo okonaeba issekinichou,
Economist (Japan), 14 Jul., 1998 and Richard A. Werner (2002), 'How to
Get Growth in Japan', Central Banking, vol. XIII, no. 2, November 2002,
pp. 48-54 4 Richard A. Werner (2012), The Euro-Crisis: A to-do list for
the ECB, University of Southampton Centre for Banking, Finance and
Sustainable Development, CBFSD Policy Discussion Paper No. 1-12.

{p. 4} 1. How to solve the bad-debt problem in the banking system most
efficiently and cost-effectively.

The current approach adopted by the European and IMF leadership of how
to handle large and growing bad debts in the banking system, for
instance in Spain or Greece, is to ask the affected states to borrow
even more money. This is further use of public i.e. tax money (either
national, European or international), which is then used to recapitalise
banks and help them write off bad debts. This is a very expensive method
and adds to the already major problem of excessive sovereign debt.

Economics tells us that a zero-cost alternative is available, and has
indeed been adopted successfully in the past.

We must remember that the problem of insolvent banks, due to bad debts,
is fundamentally a standard accounting problem: the balance sheet of
banks shows a hole on the asset side: Instead of the original value of
assets of, say, 100, the market value of the assets has dropped. This
quickly produces a bust banking system, since already a fall in asset
values by ten percent means that most banks would have used up all
equity and thus would be bankrupt. Due to the nonperforming loans banks
have also become highly risk-averse and unwilling to grant new loans. As
a result, bank credit growth has slowed to zero or negative in many
European countries. This is why domestic demand will stay weak in Spain,
Ireland, Italy, Greece – if nothing is done to kick-start bank credit
growth. 5

How can this accounting problem of non-performing assets be solved? If
only we could use an eraser, rub out the nonperforming asset entries in
the accounts, and write in a market value of 100 again!

Actually, this can be done without suspending any accounting conventions
by one particular player: the central bank. Spain and Italy have
national central banks that have, according to the ECB, some discretion
over their asset purchases.

My proposal is for the national central banks to purchase all
nonperforming assets (actual, not official, since the official figures
understate the scale of NPLs) from the banks at face value (100).
Immediately the health of the banking sector would be fully restored.

Let's assume the market value of the NPLs is 20, but the central bank
has bought them for 100. While we have solved the problem for the banks,
have we not just shifted the problem onto the central bank balance
sheet? In other words, does the central bank not now face insolvency,
with a loss of 80 on its purchases of assets for a face value of 100
although they only have a market value of 20?

No, we have not just shifted the problem, we have solved it – and at
zero cost to the tax payer at that. Firstly, central banks do not need
to mark to market. Secondly, the central bank could in reality not
possibly make a loss of 80 on this transaction. Instead, it makes a
profit of 20. The reason is that the central bank has zero funding costs
for this operation, yet obtains something worth 20 – a gain, then, not a

5 The Quantity Theory of Credit tells us that a necessary and sufficient
condition for an economic recovery is an increase in credit creation
used for GDP transactions.

{p. 5} If it's so simple and costless, why has no central bank done this
before? Actually, three major central banks have done it before: the
Bank of England, the Bank of Japan and, most recently, the US Federal
Reserve. The result: the operations were a complete success, as was to
be expected. No inflation resulted. The currency did not weaken. Despite
massive non-performing assets wiping out the solvency and equity of the
banking sector, the banks' health was quickly restored. In the UK and
Japanese case, bank credit started to recover quickly, so that there was
virtually no recession at all as a result.

Details: The UK Case

It is August 1914. Britain has just declared war on Germany and its
allies (the Austro- Hungarian empire and the Ottoman Empire). However, a
substantial proportion of international financial transactions between
these Empires and the rest of the world were transacted through London,
so that upon the declaration of war, major parts of British banks'
assets consisted of securities and loans that could not be called and
were, due to the state of war, legally in default. The British banking
system was bust – and in a much worse situation than in 2007 or 2008
when most recently British banks became insolvent.

But since the Bank of England had no interest in creating a banking
crisis and credit crunch recession, it simply bought the non-performing
assets from the banks. There was no credit crunch, and no recession.
Problem solved. At zero cost to the tax payer.

Details: The Japanese Case

In August 1945 the balance sheet of Japanese banks was far worse than
their balance sheet in the 1990s or 2000s: non-performing assets
amounted to virtually 100% of assets (since assets consisted mainly of
forced loans to munitions companies and forced purchases of war bonds).
The firms were bankrupt. The government defaulted on the war bonds.

But in 1945 the Bank of Japan had no interest in creating a banking
crisis and a credit crunch recession. Instead it wanted to ensure that
bank credit would flow again, delivering economic growth. So the Bank of
Japan bought the non-performing assets from the banks – not at market
value (close to zero), but significantly above market value. The banks
were healed again. Together with some other measures, bank credit growth
recovered and so did the economy. 6

Details: The US Case

The Federal Reserve has been the central bank most active in
implementing this policy in recent decades. It purchased several
trillion dollars worth of non- performing assets from the US banking and
financial institutions. This drastically improved their balance sheets
and avoided default of many banks.

6 For more details on the Japanese case, see Werner, Richard A. (2009).
Financial crises in Japan during the 20th century. Bankhistorisches
Archiv, 47, 98-123, available at

{p. 6} How could the Federal Reserve have come up with this idea?
Chairman Ben Bernanke was an active participant in the wide-ranging and
intense policy debates in the 1990s in Japan which I was also active in,
and during which time I first proposed these and related policies under
the label of 'quantitative easing'. He had been one of the more
open-minded voices and often joined my criticism of the Bank of Japan
and calls for more drastic central bank action. He may also have read my
2001 book Princes of the Yen, an illegal, Bank of Japan-translated
English version of which circulated widely in Washington as early as
2001. The US State Department at the time also took an interest in my work.

In the original version of Princes of the Yen, I warn of how Alan
Greenspan was creating a massive boom-bust cycle that will burst,
causing financial dislocation in the US. 7 In the English Version of
Princes of the Yen I also warn of a major boom- bust cycle in Europe,
with the European asset bubbles caused by an excessively powerful and
unaccountable ECB. 8

In my 2005 book I again warned of the next bout of massive banking
crises, especially in Europe.


The immediate objection to this proposal is usually that it will produce
inflation. However, this cannot happen: inflation can only come about,
when those who are able to create money (the central bank and the banks,
collectively forming the banking system) inject money into the rest of
the economy (which is not able to create money). The asset purchases by
the central bank merely constitute transactions between the central bank
and the banks, re-ordering matters within the banking system. As a
result, not a single dollar is injected into the non-banking sector.
Hence there could not possibly be inflation.

This prediction has been borne out by the facts. When the Fed multiplied
its balance sheet size through its non-performing asset purchases, many
observers thought this would create inflation and sharply weaken the
dollar. Neither happened, for the same reason: no new money was injected
into the non-banking economy. So all kudos to Ben for his courage.
Incidentally, having averted a melt-down Dr. Bernanke now needs to
follow part 2 of my advice (see below), otherwise he could still face a
long recession.

7 Excerpts from Chapter 19 of the Japanese original of Princes of the
Yen: "When the US stock market collapses and overextended banks veer on
the brink of bankruptcy, individual savers will not lose their
livelihood, as they did in the 1920s. America now has a deposit
insurance system. The problem is, however, that due to financial
deregulation, the money is not in the bank anymore. Over the past 25
years, a dramatic shift of savings has taken place, from bank deposits
to the equity market. Whether directly or via mutual funds, up to 50% of
individual savings are now invested in the stock market. And there is no
insurance against capital losses in the stock market yet.” … "Alan
Greenspan knows that the economic dislocation that will follow his
bubble will let previous post- war economic crises pale by comparison.
Individual savers will lose their money. In the words of Alan Greenspan
(1967): "The financial policy of the welfare state requires that there
be no way for the owners of wealth to protect themselves.” Large losses
will be incurred by most Americans, when the Fed changes its policy and
sharply and consistently reduces credit creation, as it ultimately will.
A Great Depression is possible. Of course, it could be avoided by the
right policies.” Richard A. Werner (2001). En no Shihaisha (Princes of
the Yen), Tokyo: Soshisha

8 Richard A. Werner (2003), Princes of the Yen, Japan's Central Bankers
and the Structural Transformation of the Economy, M. E. Sharpe – with
the last chapter on Europe and what I saw was the likelihood of a
massive boom-bust cycle created by a too-independent ECB. Richard A.
Werner (2005), New Paradigm in Macroeconomics, Palgrave Macmillan

{p. 7} Another objection was voiced to me by Jörg Asmussen, executive
director of the ECB, on 18 June 2012, as a fellow-panellist during a
public debate in Berlin. Obviously not having heard this proposal
before, and pushed by me and the audience to respond to my proposal and
the question why governments prefer to waste billions of tax money, when
the banks could be capitalised at zero new costs to the tax payer – the
highest ranking German official at the ECB responded by saying that such
a solution could not exist, 'because there is no free lunch'.
Admittedly, given the unimpressive set of policies we have been
presented with over the past two years, this almost sounds too good to
be true.

I was not given the chance to retort, and my response would have been:
make no mistake, this is no free lunch. We have experienced a massive
multi-year credit expansion in the banking systems in Ireland, Portugal,
Spain and Greece, which have produced asset bubbles and vast resource
misallocations, including millions of bankruptcies and home
repossessions. These are real and high costs to society. The collapse
that followed has greatly burdened government budgets and fiscal
expenditure on the non-banking part of the economy, such as welfare,
health and education, have been drastically cut. Unemployment has risen
to record levels in many periphery countries. These are massive real
costs – so I don't see how we can talk about a 'free lunch'. And
precisely because this crisis has been so immensely costly to society it
makes no sense whatsoever to further add to these costs through
misguided banking bail-out policies.

Finally, one often hears the objection that if we bail out the banks in
this way, won't they just get onto the same old tricks very soon – the
moral hazard argument. Well, we are bailing out the banks – using tax
money. And the moral hazard argument says that we should not use tax
money, for it was not the tax payers that have been responsible for the
bad debts. The principle is that who messes up should own up. So we do
need to ask the question of just who is responsible for the banking
crises that has befallen Ireland, Spain in particular, as well as
Portugal and Greece.

So who is responsible for the 25%, 30% or even 40% bank credit growth
that was recorded for months on end, until about 2007, in countries such
as Ireland, Portugal, Spain and Greece? Whose job is it to monitor and
rein in bank credit expansion? It is the job of the European Central
Bank. Did the ECB have the powers and tools available to prevent this?
It certainly did. The most powerful and independent central bank in the
world has complete freedom to choose its policy instruments and policy
targets. It chose to allow a vast credit bubble, which must result – as
these bubbles always do – in massive non-performing loans in the banking
systems. So since the ECB has been responsible, it should also pay up.

Political Obstacles

This policy is only possible with the cooperation of the central bank.
So if governments have given up control or influence over central banks,
as is the case in the European Union, the central bank has to be
convinced by rational economic argument of the superiority of this
measure in order to adopt it voluntarily. The reader is asked to
contribute to this up-hill battle by forwarding this report to anyone in
senior positions in society, business, academia, think tanks, parties,
bureaucracies or the political leadership.

Since independence is a great privilege that imposes the moral
responsibility on central banks to be transparent and accountable for
their policies, the ECB needs to explain to us why it is not inclined to
adopt such a policy. If national central banks

{p. 8} cannot be persuaded to voluntarily use their national discretion
to implement it, they should be asked to explain in great detail why
they oppose such a policy. My feeling is that the ECB leadership is
aware of the possibility of such a policy, but has (too early, in my
view) committed itself to a different course of action. Senior ECB
officials have squarely stated that they favour the adoption of a
banking union, Eurobonds, fiscal union, a European Finance Ministry and
even the creation of a United States of Europe. Quite a few ECB leaders
were personally connected to the people who co-authored the Maastricht
Treaty of 1991, or were, as is the case with Jean-Claude Trichet,
outright co-authors.

Their argument has so far been justified by the claim that, in
Thatcherite manner, 'there is no alternative'. This is why I want to
state categorically that there is an alternative that is economically
superior, will maintain the euro and does not require any of these
European centralisation measures.

Bloomberg has even raised the possibility that the ECB may cherish the
current ongoing slow-motion type of crisis, as it might consider it the
best opportunity to convince national politicians and the general public
to support the goal of the creation of a United States of Europe.

"Central bank officials may be hoping that by keeping the threat of
financial Armageddon alive, they can coerce the region's people and
governments into moving toward the deeper union that the euro's creators
envisioned." 9

Since this would suggest an extreme degree of cynicism on behalf of the
ECB, this interpretation is hard to swallow for those inexperienced in
central banking matters. In any case, the ECB needs to be asked to
explain why it is opposed to any bank bailouts that do not require
further tax money nor a banking nor fiscal union. My baseline scenario
is that the ECB is likely to oppose this proposal, although we do look
forward to hearing the details of any counter-arguments – as they will
be easily disproven.

We thus suggest as the main thrust of national-level government policy
to opt immediately for Part 2 of our proposal. While that does not get
rid of the bad debts in the banking system in one stroke at zero
additional cost, as Part 1 does, it will achieve the same ultimate goal,
and likely do so very quickly: namely to boost domestic demand,
especially in affected countries such as Ireland, Portugal, Spain, Italy
and Greece.

9 Bloomberg, Editorial, 25 October 2011, accessed at
Their argument follows mine in Princes of the Yen, 2003.

{p. 9} 2. Enhanced Debt-Management: How to solve the sovereign funding
problem in the bond markets – and at the same time stimulate domestic demand

Today (24 July 2012) Spain paid a new post-euro record high interest
rate on its newly issued government bonds. Borrowing rates in the bond
market have risen to unsustainable levels. This was also the problem in
Greece, Ireland and Portugal, and could also easily become a problem for

Observers are well aware of the negative feedback loops: the troubled
banking systems, when dealt with through government money and not
central bank money, worsen the fiscal situation of the government
drastically. It is expensive to bail out a banking system. Ireland
boasted a strong fiscal position, until its government offered to bail
out the banking system. It subsequently teetered on insolvency and
called in IMF (and European) funding.

As speculators know when bonds mature and large tranches need to be
refinanced, they can usually earn money by shorting bonds around these
dates, hence pushing up interest rates. This makes it a self-fulfilling
bet, since higher rates worsen the fiscal position of the government.

A further negative feedback loop occurs via the credit rating agencies
and alternating downgrades of banks and sovereigns.

All these problems can be avoided altogether: they are the result of the
government borrowing in a securities market characterised by a large
number of short-term speculative transactions.

This was similarly a problem for banks and their funding. But the ECB on
8 December 2011 rightly decided to allow banks to become less reliant on
securitised and traded debt, by substituting direct credit lines from
the ECB (the long-term refinancing operation, LTRO). This happened after
we had presented to about 50 senior staff members at the ECB our
proposal of how governments could similarly sidestep their funding
problems, and at the same time solve several other problems. Why should
the government rely on the bond market for its funding needs, under
current conditions? It is a fact that the prime rate for borrowing from
banks is far lower than the benchmark sovereign issuance yield. This is
an anomaly resulting from the current financial crisis. Governments need
to respond to this anomaly by exiting the bond market.

We advise governments to stop issuing government bonds. So when the next
tranche of government bonds are about to mature, where will governments
obtain the funding from?

Many commentators have proposed to ask the ECB to step in. However, this
is problematic for many reasons, and far less efficient than our
proposal. It also renders governments at the mercy of the ECB and its
European unification agenda. But why do many observers anyway think the
central bank should step in? Because they believe that the central bank
is the main creator of the money supply. This is simply not true. The
fact is that central banks only create about 3% of the money supply. A
full 97% of the money supply is created by the private sector: the
ordinary commercial banks in each country. This ability to create the
bulk of the money supply makes them far superior to the bond market

{p. 10} We thus advise governments to enter into loan contracts with the
commercial banks in their country. In other words, governments should
not borrow via the issuance of tradable securities, but through direct
credit lines from their banks. 10

Some observers believe that banks could not do this, because they 'do
not have the money'. Well, that's true. But this is true for any loan
granted by a bank. Which is why banks do not lend money, they create it:
banks are allowed to invent a deposit in the borrower's account
(although no new deposit was made by anyone from outside the bank) and
since they function as the settlement system of the economy, nobody can
tell the difference between these invented deposits and 'real' ones.
Actually, those 97% of the money supply are invented in this way.

Others object that a mere switch from government bonds to bank loan
contracts would not change much, or even anything. Well, in that case
they could not possibly object to trying it out. And if they did try it
out, they would be surprised at the significant difference it makes – a
difference of night and day:

This simple switch in funding, which I call 'enhanced debt management'
has a number of major advantages:

1. The borrowing rate is substantially lower. Governments receive,
according to Basel banking regulations, the lowest risk-weighting
(zero). Thus they can borrow from banks at their favoured-client rate,
which is the prime rate. The prime rate has been substantially lower
than the sovereign bond rate throughout this financial crisis. In the
case of Italy, we estimate that about E10bn can be saved in the next two
years alone on lower interest charges. Furthermore, governments will
deal with stable borrowing rates that are fixed throughout the loan
contract period (say 3 years). Movements in the bond market become far
less relevant.

2. The banks do not have to mark these loans to market. Moreover, they
are not affected by downgrades from credit rating agencies. This severs
the vicious negative feedback loop between banks and governments. At the
same time, however, the banks can use these loans fully as collateral
with the ECB for funding, as the ECB's announcement of 8 December 2011
makes clear.

3. Instead of a negative feedback loop, there is now a positive feedback
loop: banks will be happy to lend to governments, for one, because
sovereigns carry a zero risk weighting according to BCBS rules. This
means that banks will need zero new capital to back these loans.

10 I have presented this proposal in Japan in the 1990s: Richard A.
Werner (1998), Minkanginkoukarano kariire de keikitaisaku wo okonaeba
issekinichou, Economist (Japan), 14 July, 1998; It was also published in
English in the FT: Richard A. Werner (2000). Japan's plan to borrow from
banks deserves praise. Financial Times, 9 Feburary 2000; I also
personally explained it to government officials in Japan, among others,
to Hirohiko Kuroda, then vice-minister of international finance, who
liked it enough, as he told me, to pass it on to Andrew Smithers on his
visit to Tokyo – who in turn wrote it up in his reports, whence it
circulated in the City. It then came to be endorsed by Tim Congdon as
well as Martin Wolf. It is explained in greater detail in Richard A.
Werner (2005), New Paradigm in Macroeconomics, Palgrave Macmillan; A
recent application to Europe is in: Helmut Siekmann and Richard Werner
(2011), Eine einfache und gerechte Lösung der Schuldenkrise,
Börsen-Zeitung, 09.12.2011, Nummer 238, page 7.

{p. 11} 4. The main business of banks is to lend, but they are not
lending to the rest of the economy due to their risk aversion. Thus they
do not generate earnings to retain and rebuild their balance sheets.
Through my enhanced debt management, banks will rapidly grow their
balance sheets and earn decent income. Instead of primary market bond
underwriters, such as Goldman Sachs, earning large fees in cosy
relationships with semi-privatised public debt management agencies,
banks will be the beneficiaries of this business. 5. Despite the above
major advantages, which alone would make this a no- brainer, the single
most important advantage of switching public funding to loan contracts
from banks has not yet been mentioned: it will boost domestic credit
creation – turning bank credit growth from zero or negative growth to
positive growth (of about 3% in the case of Italy). This will increase
demand and the money supply, ending the current debt deflation spiral,
and generate nominal GDP growth, in the case of Italy between 3% and 4%
above the growth otherwise possible. (This is the result of our
empirical nominal GDP model based on our Quantity Theory of Credit).

Enhanced debt management that exits securitised debt markets and relies
on bank credit from the commercial banks will trigger an economic
recovery. It is the necessary second half of the policy that would
render the ECB's LTRO successful: as we have seen, bank credit is
currently still contracting, despite the LTRO. This would change

The economic recovery, triggered by a recovery in bank credit creation,
will increase tax revenues. Suddenly the negative spiral will be turned
into a positive one.

There is also a historical precedent for this type of policy: the
economics is the same as that of the system of short-term bills of trade
issued by semi-public entities in the years from 1933 onwards in
Germany, which were bought by the German banks, hence increasing bank
credit creation. These are known as 'Mefo Wechsel', after one of the
issuers, the Metallurgical Research Corporation. This method was
introduced by Dr. Hjalmar Schacht, President of the Reichsbank, the
German central bank, in 1933. 11

The method, which he called 'silent funding', was highly successful. As
I have argued elsewhere, the sharp German economic recovery from over
20% unemployment in early 1933 to virtually full employment by the end
of 1936 was the result of the ensuing expansion in bank credit creation
– in other words, it was the funding of fiscal policy through credit
creation that caused the recover, not fiscal stimulus per se. Japan's
experience of the 1990s has proven how even far larger fiscal expansions
will not boost the economy at all if they are not funded by credit
creation (see Werner, 2003, 2005).

In the 1930s the bills of trade were a preferable method at the time,
instead of direct loan contracts with banks, since banks did not have to
mark securities to market, and credit rating agencies did not exist. The
method I have suggested, of direct loans by banks to governments, is a
modern version that is more suitable to today's regulatory and financial
market environment. The effect of stimulating a recovery will be the same.

11 For further details, see Werner (2003).

{p. 12} Further reading:

Werner R. A. (1995). How to create a recovery through 'Quantitative
Monetary Easing'. The Nihon Keizai Shinbun (Nikkei), 2 September 1995
(morning edition), p.26 (in Japanese). English Translation available at

Werner R. A. (1997). 'Towards a new monetary paradigm: a quantity
theorem of disaggregated credit', with evidence from Japan. Kredit und
Kapital, Duncker and Humblot, Berlin, 30, pp. 276–309. available at

Werner R. A. (2002), 'How to Get Growth in Japan', Central Banking, vol.
XIII, no. 2, November 2002, pp. 48-54

Werner R. A. (2003), Princes of the Yen, Japan's Central Bankers and the
Structural Transformation of the Economy, M. E. Sharpe

Werner R. A. (2005), New Paradigm in Macroeconomics. Palgrave MacMillan.

Werner, R. A. (2009). Financial crises in Japan during the 20th century.
Bankhistorisches Archiv, 47, 98-123, available at

(3) ECB keeping the threat of financial Armageddon alive, to coerce
Europe into a deeper union


Euro’s Self-Styled Saviors Could Be Its Greatest Enemies: View

By the Editors - Oct 25, 2011

Europe’s leaders urgently need to convince the market that they can
prevent financial distress in Greece and elsewhere from bringing down
the banking system and infecting bigger countries such as Italy and France.

Instead, as they meet today for their second summit in four days,
they’re engaged in a high-stakes game of chicken.

On one side, French President Nicolas Sarkozy has proposed raising the
money needed -- at least 3 trillion euros ($4.2 trillion), by Bloomberg
View’s calculations -- from the European Central Bank, the only
institution that can credibly pledge such a large sum.

On the other side, central bank officials, with the backing of German
Chancellor Angela Merkel, are holding out. They don’t want to pony up
for a full rescue without first fixing key flaws in the euro area, such
as the lack of a unified fiscal authority with the power to impose
budget discipline on member countries. Such reforms require treaty
revisions that could take years to push through, suggesting the ECB
won’t be providing the firepower Europe needs to end its crisis anytime

As a result, barring some miracle, Europe’s leaders will test markets’
patience with yet another inadequate bailout -- if they reach a deal at
all. Early reports suggest private creditors might be pushed to write
down Greece’s debt by about 50 percent, not quite the full reckoning
required to draw a line under sovereign defaults. Plans to enhance the
European Financial Stability Facility might boost its lending or
guarantee capacity to 1 trillion euros or so, far short of what is
needed to recapitalize banks and protect solvent governments from market

Keeping Armageddon Alive

Central bank officials may be hoping that by keeping the threat of
financial Armageddon alive, they can coerce the region’s people and
governments into moving toward the deeper union that the euro’s creators
envisioned. If so, they’re making an extremely risky bet. Market turmoil
is pushing up borrowing costs for banks and companies at a time when
economic indicators are pointing toward a recession, making the
financial positions of otherwise solvent governments increasingly

Consider Italy. If its nominal economic growth averages 2.6 percent, as
the International Monetary Fund forecasts, it must run a primary budget
surplus (excluding debt-service payments) of 1.9 percent of gross
domestic product to keep its debt burden from growing -- a target it is
on track to meet next year. If the average growth rate falls to 1
percent, however, the required surplus rises to 3.6 percent of GDP --
roughly an added 26 billion euros a year.

At some point, the ECB will inevitably have to step in, as it already
has done by buying some 169.5 billion euros in government bonds. The
longer the crisis lasts, the greater the cost will be, and the greater
the chance it will overwhelm even the central bank, triggering a global
meltdown far worse than what the world suffered in 2008 and 2009.

To be sure, ECB officials do have a point. To reassure markets, the
central bank would have to put up enough money to guarantee all new
bonds issued by Greece, Portugal, Ireland, Spain, Italy, France and
Belgium. In doing so, it could encourage governments to act even more
irresponsibly. As Bloomberg View has pointed out, only by giving up some
fiscal sovereignty can the highly divergent economies of the euro area
make their currency union work in the long run. Aside from enforceable
budget controls, a closer union should include the kind of federal
transfers, such as unemployment insurance and infrastructure spending,
that can help struggling countries as they try to get back in sync.

Ideally, Europe’s leaders would find a way to fast-track the deeper
reforms. There won’t be much left to fix, though, if they don’t succeed
in forestalling financial disaster in the meantime. It would be a cruel
irony if, in their efforts to build a better union, Europe’s central
bankers ended up destroying it.

To contact the Bloomberg View editorial board: view@bloomberg.net

No comments:

Post a Comment