Financial Armageddon Approaches: U.S. Banks Have 247 Trillion Dollars Of Exposure To Derivatives

Stock Market Crash

Did you know that there are 5 “too big to fail” banks in the United States that each have exposure to derivatives contracts that is in excess of 30 trillion dollars? 

Overall, the biggest U.S. banks collectively have more than 247 trillion dollars of exposure to derivatives contracts.  That is an amount of money that is more than 13 times the size of the U.S. national debt, and it is a ticking time bomb that could set off financial Armageddon at any moment.  Globally, the notional value of all outstanding derivatives contracts is a staggering 552.9 trillion dollars according to the Bank for International Settlements.

The bankers assure us that these financial instruments are far less risky than they sound, and that they have spread the risk around enough so that there is no way they could bring the entire system down.  But that is the thing about risk – you can try to spread it around as many ways as you can, but you can never eliminate it.  And when this derivatives bubble finally implodes, there won’t be enough money on the entire planet to fix it.

A lot of readers may be tempted to quit reading right now, because “derivatives” is a term that sounds quite complicated.  And yes, the details of these arrangements can be immensely complicated, but the concept is quite simple.  Here is a good definition of “derivatives” that comes from Investopedia…

A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. The derivative itself is a contract between two or more parties based upon the asset or assets. Its value is determined by fluctuations in the underlying asset. The most common underlying assets includestocks, bonds, commodities, currencies, interest ratesand market indexes.

I like to refer to the derivatives marketplace as a form of “legalized gambling”.  Those that are engaged in derivatives trading are simply betting that something either will or will not happen in the future.  Derivatives played a critical role in the financial crisis of 2008, and I am fully convinced that they will take on a starring role in this new financial crisis.

And I am certainly not the only one that is concerned about the potentially destructive nature of these financial instruments.  In a letter that he once wrote to shareholders of Berkshire Hathaway, Warren Buffett referred to derivatives as “financial weapons of mass destruction”…

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

Since the last financial crisis, the big banks in this country have become even more reckless.  And that is a huge problem, because our economy is even more dependent on them than we were the last time around.  At this point, the four largest banks in the U.S. are approximately 40 percent larger than they were back in 2008.  The five largest banks account for approximately 42 percent of all loans in this country, and the six largest banks account for approximately 67 percent of all assets in our financial system.

So the problem of “too big to fail” is now bigger than ever.Nuclear War - Public Domain

If those banks go under, we are all in for a world of hurt.

Yesterday, I wrote about how the Federal Reserve has implemented new rules that would limit the ability of the Fed to loan money to these big banks during the next crisis.  So if the survival of these big banks is threatened by a derivatives crisis, the money to bail them out would probably have to come from somewhere else.

In such a scenario, could we see European-style “bail-ins” in this country?

Ellen Brown, one of the most fierce critics of our current financial system and the author of Web of Debt, seems to think so…

Dodd-Frank states in its preamble that it will “protect the American taxpayer by ending bailouts.” But it does this under Title II by imposing the losses of insolvent financial companies on their common and preferred stockholders, debtholders, and other unsecured creditors. That includes depositors, the largest class of unsecured creditor of any bank.

Title II is aimed at “ensuring that payout to claimants is at least as much as the claimants would have received under bankruptcy liquidation.” But here’s the catch: under both the Dodd Frank Act and the 2005 Bankruptcy Act, derivative claims have super-priority over all other claimssecured and unsecured, insured and uninsured.

The over-the-counter (OTC) derivative market (the largest market for derivatives) is made up of banks and other highly sophisticated players such as hedge funds. OTC derivatives are the bets of these financial players against each other. Derivative claims are considered “secured” because collateral is posted by the parties.

For some inexplicable reason, the hard-earned money you deposit in the bank is not considered “security” or “collateral.” It is just a loan to the bank, and you must stand in line along with the other creditors in hopes of getting it back.

As I mentioned yesterday, the FDIC guarantees the safety of deposits in member banks up to a certain amount.  But as Brown has pointed out, the FDIC only has somewhere around 70 billion dollars sitting around to cover bank failures.

If hundreds of billions or even trillions of dollars are ultimately needed to bail out the banking system, where is that money going to come from?

It would be difficult to overstate the threat that derivatives pose to our “too big to fail” banks.  The following numbers come directly from the OCC’s most recent quarterly report (see Table 2), and they reveal a recklessness that is on a level that is difficult to put into words…


Total Assets: $1,808,356,000,000 (more than 1.8 trillion dollars)

Total Exposure To Derivatives: $53,042,993,000,000 (more than 53 trillion dollars)

JPMorgan Chase

Total Assets: $2,417,121,000,000 (about 2.4 trillion dollars)

Total Exposure To Derivatives: $51,352,846,000,000 (more than 51 trillion dollars)

Goldman Sachs

Total Assets: $880,607,000,000 (less than a trillion dollars)

Total Exposure To Derivatives: $51,148,095,000,000 (more than 51 trillion dollars)

Bank Of America

Total Assets: $2,154,342,000,000 (a little bit more than 2.1 trillion dollars)

Total Exposure To Derivatives: $45,243,755,000,000 (more than 45 trillion dollars)

Morgan Stanley

Total Assets: $834,113,000,000 (less than a trillion dollars)

Total Exposure To Derivatives: $31,054,323,000,000 (more than 31 trillion dollars)

Wells Fargo

Total Assets: $1,751,265,000,000 (more than 1.7 trillion dollars)

Total Exposure To Derivatives: $6,074,262,000,000 (more than 6 trillion dollars)

As the “real economy” crumbles, major hedge funds continue to drop like flies, and we head into a new recession, there seems to very little alarm among the general population about what is happening.

The mainstream media is assuring us that everything is under control, and they are running front page headlines such as this one during the holiday season: “Kylie Jenner shows off her red-hot, new tattoo“.

But underneath the surface, trouble is brewing.

A new financial crisis has already begun, and it is going to intensify as we head into 2016.

And as this new crisis unfolds, one word that you are going to want to listen for is “derivatives”, because they are going to play a major role in the “financial Armageddon” that is rapidly approaching.

Government electrifies 20% more villages

The government has electrified 20 per cent of the villages that were without power at the start of this financial year, according to an analysis by The Hindu of the data provided by the Deendayal Upadhyaya Gram Jyoti Yojana (DDUGJY).

As of January two,2016 the DDUGJY had electrified 3,656 or 20 per cent of the 18,452 villages without power at the start of this financial year.

In July last year, the DDUGJY said it aimed to provide round-the-clock power to rural households and adequate electricity to agricultural consumers.

The scheme had an outlay of Rs 76,000 crore out of which the Centre committed to provide a grant of Rs.63,000 crore.

Of the remaining 14,796 villages that still had to get electricity, work had started in only 1,843 (12 per cent) of them.

Out of the 5,522 villages inspected by the DDUGJY officials, 13 per cent had missed the milestones set for them for electrification.

Power Prices fall by 22% in 2015, demand remains stagnant

Power Prices fall by 22% in 2015, demand remains stagnant

With 2015 being an epoch making year for improvement in fuel availability, the supply position and prices eased considerably. The power prices fell as much by 22% in the spot market as compared to year ago. The average power price in 2015 was Rs 2.81 per unit as against Rs 3.59 per unit in 2014.

The power market witnessed a healthy reduction in prices in 2015 with increase in supply of power due to capacity addition and increased generation during the year, said market analysts. The peak demand summer months of June, July and August witnessed prices reducing by 34%, 27% and 37%, respectively.

According to monthly report of Central Electricity Authority (CEA), power generation during April to October 2015 was 646 billion units with energy deficit of 2.4%. The power generation during the same period last year was 617 billion units while energy deficit was 4.1%.

The fuel constraints which prevailed in 2014, especially coal shortage, eased significantly in 2015. The average coal stock position has also increased to 21 days as on 30th Nov 2015 from 7 days as on 30th Nov 2014, said India Energy Exchange (IEX), one of the country’s leading power exchange platform.

“The power demand was not very high during the peak summer months as well. Only in September, the market saw peak demand of 153GW. More coal availability and 24GW capacity addition last year, resulted in surplus capacity,” said Rajesh K Mediratta, VP- Business Development, IEX.

However, tepid demand from the beleaguered state power distribution dampened the demand. Power market trackers said the country’s power situation is an ironical state.

According to CEA’s October report, coal production in the current year (Apr-Nov 15) has been 321 MT an increase of more than 8% over previous year when it was 295 MT, but there was no change in demand pattern.

“Three years back in 2012, when the peak demand was around 130GW the cumulative installed capacity was 200GW. But when in the last 3.5 years, the country added 80 GW capacity, demand increased by 33GW only during the same period, offsetting the increase in power production,” said a Delhi based expert.

The central government offered coal blocks to state and private sector power plants of around 28,000 Mw. Cheap domestic gas was also made available to gas based power plants totaling 14,000 Mw.

IEX said that inter-state transmission system congestion was eased significantly, especially towards the North, however southern states continue to witness power deficit.

“The exchange lost 3,887 million units in 2014 as compared to 2,445 million units being lost to congestion in 2015 (as on 16 Dec’15),” said Mediratta.

Month 2014 2015 % change**
January 3.14 2.82 -10
February 3.29 2.85 -13
March 3.03 2.82 -7
April 3.61 2.68 -26
May 3.28 2.62 -20
June 3.89 2.56 -34
July 3.76 2.74 -27
August 4.49 2.82 -37
September 4.18 3.68 -12
October 4.17 3.03 -27
November 3.01 2.67 -11
December 3.21 2.45* -24
Year’s average 3.59 2.81 -22

GAIL to buy 5% stake in consortium building TAPI pipeline


State-owned GAIL India Ltd will take 5% stake in the international consortium building the $8.7 billion Turkmenistan-Afghanistan-Pakistan-India (TAPI) gas pipeline.
The four nations building the pipeline had in August agreed to co-own the project and a joint venture company with participation of each country is to be set up to build and operate the 1,814-kilometre line.
“Turkmenistan’s state-owned TurkmenGaz will be the leader of the consortium and shall take 85 % equity. India will be represented by GAIL, which will take a 5% interest”, a senior government official said.
ISGS of Pakistan and Afghan Gas Enterprise (AGE) will also take 5% stake each.
The TAPI pipeline will have a capacity to carry 90 million standard cubic metres a day (mmscmd) gas for 30 years and is planned to become operational in 2018. India and Pakistan were originally to get 38 mmscmd each while the remaining 14 mmscmd was to be supplied to Afghanistan.
But Kabul is now willing to take only 1.5-4 mmscmd. So, the share of India and Pakistan will go up to 43-44.25 mmscmd each, he said.
TAPI will carry gas from Turkmenistan’s Galkynysh field, better known by its previous name South Yolotan Osman that holds gas reserves of 16 trillion cubic feet.
From the field, the pipeline will run to Herat and Kandahar province of Afghanistan, before entering Pakistan. In Pakistan, it will reach Multan via Quetta before ending at Fazilka (Punjab) in India.
Turkmenistan on December 13 began work on the 214-km section of the pipeline in its territory. The pipeline will travel 773 km in Afghanistan and 827 km in Pakistan before touching Indian border.
For the security of the pipeline, the official said an inter-government Joint Security Task Force (JSTF) will be raised which will serve as nucleus of the security programme.

Exact role and responsibilities in each host country are being worked out, he said adding a team would also be established to ensure operational continuity and which is capable of rapid repair of critical facilities and equipment in case of sabotage or accident.

The four-nation consortium was stitched as no reputed international firm was willing to take lead in construction and operation of the pipeline.
French giant Total SA had initially shown interest in leading a consortium of national oil companiesof the four nations in the TAPI project. It, however, backed off after Turkmenistan refused to accept its condition of a stake in the gas field that will feed the pipeline.

Institutions for Climate Change

The deal is done. Contrary to the expectations of the skeptics, negotiators in Paris agreed on a final text to climate change accord. It is, I think, an historic agreement if for no other reason that it brings all members of the international community into the climate change tent.

Lest we become inebriated by the euphoria of the moment (and the celebratory champagne), however, we need to cast a sober eye to the challenges ahead.

The agreement commits governments to emission-reduction targets and subjects these targets to review and compliance monitoring. That is good progress. But if the climate change challenge is akin to the optimal provision of a public good, as suggested in a previous post,here, some enforcement mechanism is required. Countries will, inevitably, have an incentive to misreport progress and free ride on the efforts of others. The simple fact is that, if pressed, sovereign states that jealously guard their independence will choose the welfare of their own citizens here and now over the welfare of future generations of global citizens.

This somewhat pessimistic assumption reflects that meeting these targets will not be easy. If it were so, there wouldn’t be difficult decisions to make. Of course, we can hope that technological and scientific innovations will so greatly enhance the competitiveness of non-carbon energy sources that the economic problem becomes trivial — we can have both growth and lower CO2 emissions. (Think of technology pushing out the production possibility frontier of societal choices so that resources are better utilized to create wealth without accelerating climate change.)

Technology will undoubtedly help, of that I have absolutely no doubt. Yet, here’s the rub: that technological “fix” won’t materialize without investments in research and development. That investment will come from the public and/or private sectors. At the end of the day, both public and private investment will have to be mobilized: publicly-financed R&D to generate the basic research that can be distributed as a public good; private research (which is focused on increasing private returns for the firms undertaking it) to hone applications and spread the use of new technology. Regardless, we are back to the question posed in the previous post: who will pay?

If the investment comes from the public sector, taxes will have to be increased. And since the theoretical non-distortionary lump-sum taxes of Welfare Economics are not available in practice, those taxes will entail distortions — if levied on wages, labour supply decisions will be affected; if applied on capital, private investment decisions will change. Make no mistake: this is no reason not to impose taxes; if taxes are the price of civilization (as Ben Franklin observed), taxes imposed to prevent climate change may be the price of saving civilization. The issue is balancing the costs of the distortions against the benefits of the investment.

If the investments that could provide the technological “fix” are to be made by the private sector, however, firms must have an incentive to undertake them. That is the underlying point of the last (or previous) post.

So, is there a way to minimize the distortions induced by the funding of public investment while creating incentives for private investment? By happy coincidence there is.

Carbon taxes would both generate revenues for governments that implement them and increase the relative returns from green investments. An effective global strategy for climate change will be based on carbon taxes. Moreover, it should be possible to assemble a broad carbon tax coalition that spans both poles of the political spectrum. Here in the United States, Republican economists in the thinking wing of the party, who support carbon taxes as a tax on Pigovian “bads” (or negative externalities), can sit next to Democrats; the same can be said of the politics in other countries. The political sweetener is the fact that taxes on productive inputs (labour and capital) can be reduced (or increased less than would otherwise be required). This is a growth-enhancing strategy.

Carbon taxes should be a key element of a global response to climate change—that much is clear. This is, obviously, a big part of the “who will pay?” question. However, there is a separate, equally important issue to resolve: how do we ensure that countries have an incentive to introduce carbon taxes and don’t “defect” from the cooperative equilibrium?

A basic result of game theory is that cooperative equilibria dominate non-cooperative outcomes. The heuristic proof is the “folk” theorem — if a non-cooperative outcome is inferior to a potential cooperative result, the parties would voluntarily negotiate until there is equilibrium that dominates the non-cooperative outcome. The “catch” is that cooperative equilibria must be supported by some kind of enforcement mechanism; otherwise one of the players will have an incentive to defect from cooperative play to achieve a higher private return at the expense of the other players. This isn’t the case with respect to non-cooperative equilibria, which incorporate the potential for non-cooperative play with strategies that penalize defection. Institutions are either created de novo or ‘evolve’ endogenously, through practice, to support cooperative outcomes. They do this through monitoring of individual plays and enforcing penalties.

All to say, some institutional structure will likely be required. But what shape will this institution take?

Although trade policy purists will undoubtedly recoil in horror there is an existing institutional apparatus that could be mobilized. Rather than create some new monolithic supranational tax administration body, which in any event would be viewed as an entirely unacceptable infringement on national sovereignty and thus a nonstarter, why not use the existing WTO framework? As I will argue in a follow on post, the WTO has the economic and legal frameworks to enforce an internationally-binding agreement on carbon taxes and an established appellate procedure.

Who Will Pay?

As might have been expected before the talks began, reports on the eve of the expected conclusion of the Paris climate change negotiations suggest that the talks have become bogged down over who will pay the costs of adaptation. (See The New York Times, here.) Advanced countries want the rising middle-income countries, China and India particularly, to share more of the burden. Poor and emerging nations, which will likely incur the greatest costs of climate change, should do more to address the problem they argue.

Needless to say, these countries are balking at the prospect. They justifiably argue that the advanced rich economies got that way (i.e., rich) because their economic development over the past century has been fueled on carbon. Asking middle-income countries to pay for adaptation on an equal basis with the advanced rich countries, they contend, fails a basic equity test. While the marginal social cost of the CO2 emissions they create in their quest for riches may be high, their ability to pay is less that of rich countries.

Many years ago, well before the global financial crisis, a former IMF colleague, Peter Heller, and I shared a table at a G20 dinner hosted by the IMF in the Fund’s headquarters in Washington. At the time, he was (presciently) writing a book on the fiscal implications of the aging baby boom generation and the looming costs of climate change. His book is entitled,Who Will Pay? and in it Heller pleads for forward-looking policies, as he puts it: “to prepare responsibly for an uncertain future.”

The point here is that, if the science is right, there will be substantial costs from climate change to be borne. But these potential costs will not be shared equally — some countries are more susceptible to, say, rising sea levels than others. And, because these costs reflect negative externalities, there is an incentive to free ride — think of climate change as a public “bad” for which the private negative harm done to one doesn’t reduce the private harm inflicted on another. Climate change is a threat.

The challenge for any society is to mobilize resources to combat external threats. History and experience teaches that successful societies are marked by the ability to respond effectively to such challenges. The thing is, achieving the needed degree of coordination requires institutions (which Brad DeLong of Berkley refers to as the “secret sauce” of growth) to assuage the free-rider problem. In third century BCE China, the Emperor and an efficient administration made possible the Great Wall. In 1940, it was the leadership of Winston Churchill and Westminster Parliamentary democracy, which facilitated the smooth transfer of power, that mobilized the British people to resist Nazi aggression. These threats were clearly identifiable, however.

The threat from climate change is less tangible. Moreover, if the past is any guide, future generations will be wealthier than the current generation, so inter-generational equity considerations might suggest that the unborn should pay the costs. But as Heller’s book strives to make clear, the future is uncertain, and the further out into the future we look, the greater the uncertainty. What if the costs are greater than currently anticipated? And what if the costs are incurred sooner so that unborn generations are bequeathed less capital?

It is possible that, in those circumstances, the implied tax increases are so great that individuals’ incentives to invest in human and physical capital are distorted. Apart from the hypothetical lump-sum taxes of Welfare Economics, all taxes entail distortions. Lacking the capital to generate the wealth needed for future adaptation, societies settle into a long process of slow, secular immiserization.

Those less affected by climate change and with the resources to do so may opt to build physical and virtual walls to prevent the Hobbesian world outside their borders from spilling over. While such a response to this dystopic vision seems far-fetched, previews of it are clearly visible in the U.S. Republican primaries. As the outside world becomes nastier, more brutish and shorter, the costs of maintaining these walls will increase. Even those countries who believe they are immune to such spillovers will face higher costs–think of the costs to public infrastructure (bridges, sewer systems, etc.) designed to once in century standards when the reality suddenly changes to once a decade.

The simple fact is that the bill for climate change adaptation will have to be paid. The question for the international community is how to mobilize the resources. The COP negotiations represent the international community’s attempt to build the institutions needed to respond effectively to the threat posed by climate change. As the debate over who will pay for adaptation reveals, it will be a messy, protracted process. Time will tell what the agreement looks like. But, whatever the outcome, Paris will not be the last such time the question “who will pay?” is raised.

Modigliani-Miller for Climate Change Financing

In recent years, attention has focused on alternative instruments to finance projects to combat climate change. Advocates of these so-called “Green Bonds” sometimes argue that the bonds result in the financing of more “green” projects and are thus a critical weapon in the battle against climate change. While this claim may be true, it doesn’t necessarily follow.

Projects that are economically viable would get funding from traditional sources just as easily as from non-traditional Green Bonds. After all, profit-seeking investors hoping will finance projects offering higher returns. So, in this perspective, the issue is whether Green Bonds allow projects that don’t offer as high private returns (but generate high social returns) to go forward.

It is possible, for example, that Green Bonds attract socially-minded investors that are prepared to accept lower rates of return. But if the buyers of Green Bonds are mandated to finance green projects, it isn’t at all clear that more projects would be undertaken–those projects could just as easily be financed by plain-vanilla bonds. In this case, the issuance of Green Bonds merely displaces plain vanilla with the same number of green projects undertaken.

The only way to increase the number of projects is to increase the rate of return on them or reduce the rate of return investors are prepared to accept. Trust funds that provide “sweeteners” to a financing package do the latter. But, if we are serious about addressing climate change and really want to expand the volume of projects undertaken, the relative returns of carbon-based projects have to fall relative to green alternatives. That is to say, the way a project is financed is less important than the underlying stream of returns on that project.

Fifty years or so ago, Modigliani and Miller (M-M) made an analogous argument with respect to corporate finance. Given the strong assumptions they invoked, whether a firm is financed more by debt or equity is irrelevant to the value of the firm. What matters for firm valuation is the underlying profit stream.

Looking at Green Bonds though the Modigliani-Miller lens is useful because of the importance of the challenge the international community faces. Now, it might be the case that Green Bonds are worthy of the claims made of them; in particular, they could they address information asymmetries that prevent investors with a mandate to invest in green projects finding them. This would be consistent with the original M-M result, which assumes full information and perfect certainty. But I suspect that investors with green mandates have a surfeit of investment opportunities. And, if Green Bonds are merely as a fashion statement and are viewed as a substitute for measures to alter the relative return on carbon-based and green projects, through carbon taxes, for example, questions could legitimately be raised whether they are worth the effort.

Are we safer?

The Brookings Institution hosted a conference last week on the regulatory response to the global financial system with that provocative title. The conference featured former Fed Chairman, Ben Bernanke, and other prominent speakers, including professor Gary Gorton of Yale University and Fed Governor, Dan Tarullo. See the conference program, here.

The title could be considered provocative in light of the massive amount of new regulations introduced since the global financial crisis exploded in 2007. The Dodd-Frank act alone runs to over 2,300 pages. “Surely,” you might think, “all of that regulation means a more resilient financial system; one that is better able to absorb the kind of shocks that I very nearly brought global collapse.” As the conference discussion revealed, there are some who would argue with you.

As noted previously, before the crisis, international banking was incredibly efficient in terms of transforming a small of capital into a much, much larger volume of assets. Unfortunately, the system was also very unstable. The metaphor I used to describe the situation was an inverted pyramid.

In the immediate aftermath of the global financial crisis I wondered if we would see a ‘pole switching’ problem–that is, a jump from too little regulation to  too much regulation in a “never again!” reaction. That response might be understandable, but it would not be without potential costs: a financial system that is impervious to shocks by virtue of holding a surfeit of capital is unlikely to be in a position to finance the investments that will be needed to deal with the challenges of climate change or meet the infrastructure needs of the 21st century. As in most fields of human endeavor, the optimal outcome is unlikely to be a so-called “corner solution.” If we want a financial system that is capable of funding risky investments supporting innovation (that lead, ultimately, to higher growth), we need to accept some degree of fragility.

To some extent, the story of the past decade is a lax regulatory regime that led to crisis, which in turn triggered a regulatory response. That response has included higher capital and liquidity requirements. The question is whether those higher standards have had unintended effects.

For example, while regulations have largely driven out the Structured Investment Vehicles (SIVs) that played a role in the run up to the crisis, they may have fostered the growth of shadow banking. As Gary Gorton put it, regulations determine whether an activity is carried out in the formal (regulated) banking sector or in the shadows of unregulated banking. Darrell Duffie, meanwhile, argued that regulations have inadvertently equalized capital requirements on safe assets (collateralized by Treasuries) with, say, real estate loans. Since the expected returns on real estate loans exceed the return on safe assets, one effect has been to increase the relatively risky activity.

All of this isn’t a fatal criticism of regulations. After all, every (well-designed) constraint changes behavior in the way it was intended;  and sometimes in subtle ways that are not anticipated. The issue is whether the negative unintended effects are greater than the ills that the regulation was designed to prevent. That is the $15 trillion question, the estimated cost of the global financial crisis.

A follow up post will tackle that question.

Preventing Sovereign Debt Restructuring

At a recent private conference on sovereign debt restructuring, an old friend argued that, in addition to talking about what to do once a country has crossed a tipping point and needs to restructure its debt, efforts should also be made at prevention. It is, of course, a good point; one on which I have written in the past. His comment got me thinking about an idea I had a decade or so ago, in those halcyon days before the global crisis.

The concern then was that debt relief initiatives, which improved the debt-carrying capacity of many highly-indebted countries, created space for others to fill. Export credit agencies and private sector lenders, recognizing an opportunity to grow their balance sheets, rushed to lend to these countries, leading to widespread concerns that a number of countries whose longer-term growth prospects had been constrained by high levels of indebtedness prior to debt relief would, once again, take on too much debt and encounter debt-servicing problems when the global economy slows, interest rates rise, and commodity prices fall.

As things turned out, the global crisis of 2007-2010 didn’t play out the way many observers (including me) thought it would. The crisis was met with extraordinary counter-cyclical stimulus measures, with China leading the way. This stimulus kept the global commodity ‘super cycle’ going, fueling a quick recovery for developing countries. At the same time, the crisis led advanced country central banks to take equally extraordinary measures to prevent the global financial system seizing up. Global interest rates fell to (effectively) zero. All things considered, it was a good crisis for developing countries and emerging markets.

That being said, the policy issue I was pondering in the spring of 2006 was how to prevent export credit agencies (ECAs) from excessive lending that could impair future development. At the time, there were fears that some ECAs may have been pursuing non-economic (or “strategic”) objectives, such as securing control of natural resources or market share. If other ECAs didn’t play the game, the argument goes, they would lose access to key resources or find markets closed to them.

I wanted to address the collective action problem associated with lending to countries that had low levels of indebtedness owing to debt relief initiatives, but whose medium-term economic prospects remain uncertain. By taking on too much debt, the borrower increases the probability of default on all lenders. Moreover, because the return on previously issued fixed rate debt does not respond to this deterioration in the expected return, the borrower has an incentive to take on too much debt to invest in excessively risky projects. The collective action problem arises because, while lenders have a collective incentive to limit new lending, each has an individual incentive to lend as much as quickly as possible before other lenders do so. In this environment, the likelihood of a misallocation of investment resources must be judged to be high.

Of course, this problem is not new: it is encountered in virtually every lending situation. In the domestic context, legal arrangements have evolved to attempt to align incentives such that borrowers are penalized for taking on excessive debt loads. These include contractual provisions, such as parri passu and acceleration clauses, bond covenants restricting the range of investment projects financed by borrowing, and the enforcement of priority of claims. Such legal restrictions binding the interests of private lenders are reasonably successful domestically, though not without the threat of protracted legal disputes.

At the international level, however, contractual provisions are much less effective given the absence of a mutually agreeable process for the timely restructuring and adjudication of conflicting claims. The question is whether some form of ex ante government action.

One option to deal with this problem would be to secure agreement among ECAs on priorities of claim in the event of future debt-servicing difficulties. The idea would be to relax the “joint and several” rule that has governed past Paris Club restructurings by tying restructurings of particular ECAs to their relative contribution to the debt load. The earlier a credit is made, the greater the “protection” it would receive in any subsequent debt restructuring. Conceptually, the process is relatively straightforward. Paris Club members would agree on the extent of NPV reduction needed to restore sustainability (on the assumption that the country in question maintains a debt-servicing moratorium on non-Paris Club creditors). This quantum of debt relief to be provided by Paris Club creditors would then be distributed on a sliding scale that punishes creditors that came into the game late, pushing the country over the sustainable debt threshold.

This approach has a number of noteworthy features:

  • First, it would tend to align incentives by forcing lenders to consider the potential consequences of their lending. This would hopefully result in a rising cost of capital schedule faced by potential borrowers. A higher cost of capital, meanwhile, would create incentives for the borrower to ration excessive debt accumulation and take actions to ensure that the funds are invested wisely.
  • Second, it provide strong incentives for lenders to exercise due diligence in monitoring the use of borrowed funds-including adopting a probabilistic approach to loan evaluation (what is the probability that current high commodity prices will fall over the life of the loan, etc.).
  • Third, it would create an incentive for borrowing countries to be more forthcoming in revealing their outstanding obligations.
  • Fourth, it would provide an incentive for non-members of the Paris Club to cooperate with the international community (given the fact that Paris Club debt relief would be predicated on a continuing standstill on interest payments to non-members).

At the same time, however, the proposal could be criticized as not giving borrowers sufficiently strong incentives to observe the bonding role of debt. This is indeed the case. But it is also true of the status quo. The suggestion here, if successful, would at least result in a rising cost of capital to the borrower. Moreover, the proposed arrangements could be further strengthened by securing ex ante agreement among Paris Club members that any country that does seek debt relief from the Club automatically goes off cover for some specified period of time. Member countries could make loans (as at present) but they could not call on Paris Club “solidarity” in recovering amount owing when the country goes back on cover.


The discussion here is obviously an abstraction, given its static nature. Debt-servicing capacity changes over time in response to both external (commodity price) shocks and domestic factors (policy frameworks, the nature of the investments made, etc.). Regardless, a very large stock of debt has been contracted over the past decade; some of it will not be repaid. How quickly and efficiently it is restructured will have an impact on the global economy. This fact underscores the ongoing efforts to improve the framework for restructuring sovereign debts. At that same time, it should also focus efforts on preventing the need for future sovereign debt restructuring going forward by better aligning incentives.

Fallen Shibboleths and Victorian Virtues

I was a discussant at a CIGI-Institute for Policy Dialogue conference on sovereign debt restructuring at Columbia University in September hosted by Joe Stiglitz and Domenico Lombardi. In my remarks on one of papers, I identified a key challenge in the global economy: insufficient global aggregate demand that generates deflationary pressures.

This challenge partly reflects the inter-temporal optimization decisions of aging populations in the advanced economies who are saving, as they must, to sustain consumption levels in retirement. These savings reflects an equilibrium condition and it is not clear that there is a role for policy.

In the prevailing environment of uncertainty, which some might refer to as a “New Age of Uncertainty,” these savings are being sucked into the so-called “safe assets” of highly rated, liquid issues of sovereign issuers that form the collateral foundations on which the modern international financial system is built. The result is record low interest rates on U.S. Treasuries, German Bunds and the Swiss Bonds. These low interest rates are clearly beneficial for those governments, but they create problems for the pension plans that discount their future pension obligations at a lower rate. For pension funds (life insurance companies) these low interest rates create a gap between the actuarial value of liabilities and assets.

In normal times, this situation wouldn’t be particularly problematic; higher demand fueled by low interest rates would close output gaps and eventually generate inflation that would raise nominal interests. But, as pointed out previously, here, inflation today isn’t a problem. Indeed, inflation-targeting central banks in the advanced economies are struggling to raise inflation to their pre-announced inflation targets. Central banks are at risk of losing credibility not from temporizing with too much inflation, but from failing to raise inflation to their target levels.

The world is, seemingly, not in normal times. The explanation might be that insufficient aggregate demand that I spoke of at the conference in Columbia. In the New Age of Uncertainty private investment is down as firms exercise the option value of waiting. And rather than investing in productive public infrastructure that would stimulate demand and generate growth, governments mindful of aging populations and high debt-to-GDP ratios have balked. The result has been a Keynesian paradox of thrift, as higher savings contributes to insufficient global aggregate demand: What is rational on the individual level is collectively irrational.

Here’s the rub: efforts to prevent higher debt ratios in the short-term may be harmful to fiscal sustainability over the long-term, as growth remains uneven and economic prospects clouded by uncertainty. A ratio can be reduced by working on both the numerator and the denominator. Unfortunately, fiscal austerity to reduce the former weakens the latter. In the current state, governments able to issue very long-dated debt at very low interest rates could invest in the infrastructure and help break the paradox of thrift that seems to be gripping advanced economies.

If not them, who? If not now, when?

Seventy years ago, economies were similarly suffering from the paradox of thrift. At the time, Keynes attributed the problem to a misguided faith in Says Law—the fallacy that supply creates its own demand—and Victorian virtues of household economy. Seven decades later, facing similar circumstances, the problem may be the ‘echo’ of the fallen shibboleths of Say’s Law and Victorian virtues of household economy.