When Vito Corleone Runs Your Government

This story from the CNBC reports on one of the most reprehensible practices of public finance ever invented:

US and European regulators are essentially forcing banks to buy up their own government’s debt—a move that could end up making the debt crisis even worse, a Citigroup analysis says. Regulators are allowing banks to escape counting their country’s debt against capital requirements and loosening other rules to create a steady market for government bonds, the study says.

Let’s take a step back. Two weeks ago, while explaining how the new Basel III bank regulations could lead to a global recession, I reported that:

In a nutshell, Basel III forces banks to reduce their holdings of risky assets and increase their holdings of “common equity”. This means, of course, that banks will run away from assets that are risky or have a rising risk to them.

I also gave an example of what this would lead to:

[The] required half-trillion dollar increase in common equity holdings will more than likely exclude treasury bonds from several European countries. The reason is a combination of two factors: the mess that these welfare states have created by over-spending for many years and the fact that we are heading in to a global recession.

So the world’s welfare states, who are recklessly irresponsible with other people’s (taxpayers’) money, tell banks to be even more responsible with their own money. As a result banks would have to sell off treasury bonds of those same deficit-spending governments. Now, of course, that dirty little secret has dawned on the spendoholic politicians in charge of governments on both sides of the Atlantic Ocean. So what do they do? Well, let’s get back to the CNBC story and find out:

While that helps governments issue more and more debt, the strategy could ultimately explode if the governments are unable to make the bond payments, leaving the banks with billions of toxic debt, says Citigroup strategist Hans Lorenzen. “Captive bank demand can buy time and can help keep domestic yields low,” Lorenzen wrote in an analysis for clients. “However, the distortions that build up over time can sow the seeds of an even bigger crisis, if the time bought isn’t used very prudently.”

In other words, to permanently cut back spending and stop using borrowed money for permanent expenditures. As Mr. Lorenzen hints at, there is no chance under the sun that governments would use this coerced credit to resturcture their spending. Quite the contrary:

“Specifically,” Lorenzen adds, “having banks loaded up with domestic sovereign debt will only increase the domestic fallout if the sovereign ultimately reneges on its obligations.” The banks, though, are caught in a “great repression” trap from which they cannot escape. “When subjected to the mix of carrot and stick by policymakers…then everything else equal, we believe banks will keep buying,” Lorenzen said.

In plain English: governments have made it more costly for banks to refuse government debt than to close their eyes, buy government bonds and hope governments will bail them out when governments can no longer pay those same banks what government owes them. And the cost of not complying with the Basel III regulations is, well, the end of business as you know it.

Don Vito Corleone as Secretary of The Treasury.

The CNBC report also confirms a point I have been making for quite some time now, namely that the European bank crisis is caused by the fact that banks have bought massive amounts of European treasury bonds:

Institutions both in the U.S. and abroad have been busy buying up their national sovereign debt for years, he found. Spanish banks bought 90 billion euros worth while Italian firms picked up 86 billion euros just between November and March. Even in the UK, which has avoided a debt crisis as it is outside the euro zone and able to set its own monetary policy, banks have increased holdings of gilts by 100 billion pounds over the past few years. And in the U.S., banks, though having “comparatively low holdings” of Treasurys, have bought $700 billion of American debt since 2008.

Historically, government bonds have been a rock-solid safe haven for investors. That has changed over the past year, which means that under the Basel III capital consolidation requirements banks would be selling off massive amounts of less-than-perfect bonds to comply with government regulations. So in order to avoid this the very same governments that need to borrow money are giving the banks a pass on the regulations – but only so that they can buy more government bonds.

Not even The Godfather could have come up with a better scheme to make people an offer they can’t refuse.

The consequences of this are, of course, that governments will keep spending borrowed money. Let’s not forget that the very same European governments that are now strong-arming banks into lending them more money, adopted the Maastricht Treaty some 20 years ago. That Treaty put in place very clear rules for government budget policies that – we were told – would permanently eliminate deficit spending and out-of-control government debt. We can now see how much those rules were good for.

There are four lessons in this for Americans to learn:

1. Never put Vito Corleone in charge of government.

2. Our politicians are just as spendoholically reckless when it comes to using borrowed money to pay for regular expenditures. Therefore, we can expect this new method for robbing banks to perpetuate the spending spree on Capitol Hill.

3. Anyone who says that he has come up with a brilliant way to permanently do away with deficit spending without doing away with the welfare state is a complete ignoramus when it comes to political economy.

4. End the welfare state now.