I have mentioned, in passing, the possibility of transforming debt into equity as a solution for many of the troubles in the global financial system.
I borrowed the idea from Nassim Taleb and Mark Spitznagel, who floated it in 2009. It is unfortunate that the idea has not yet been taken very seriously. There are probably two reasons for this: firstly Taleb and Spitznagel never fully fleshed it out, and secondly because the political and media punditry don’t really recognise the graveness of the present situation. Largely it is hoped that we can muddle through; radical solutions tend to get left on the shelf.
It is my view that it is much better to fix the system in a fundamental way, rather than clobber together solutions piecemeal. The latter approach has been the norm — from the bailouts of Greece and euro austerity, to the bailout of AIG and the wider financial system, to quantitative easing and LTRO, to Obama’s stimulus package — the focus has been on keeping a system that is falling apart at the seams from crumbling completely into dust.
So what is the problem that governments fear so hugely?
As we learned a long time ago, big defaults on the order of billions don’t just panic markets. They congest the system, because the system is predicated around the idea that everyone owes things to everyone else. The $18 billion that Greece owes to the banks are in turn owed on to other banks and other institutions. Failure to meet that payment doesn’t just mean one default, it could mean many more. The great cyclical wheel of international debt is only as strong as its weakest link. This kind of breakdown is known as a default cascade. In an international financial system which is ever-more interconnected, we will soon see how far the cascade might travel.
The concept of too big to fail — and thus the justification for all the bailouts — comes out of these default cascades; if a default were to trigger such a cascade, the cycle of payments would break down. Thus, the logic goes, if a bankruptcy would break the system, then the government should step in and prevent that bankruptcy. Thus, the system can continue operating. Alas, this is the road to a zombie economy. If bad companies can succeed just as easily as well-run ones, then the market mechanism is rendered meaningless. Why innovate and create when instead you can run on government largesse? Why seek efficiency when inefficiency gets you cash just as easily? Furthermore, this government largesse starves new businesses of opportunities and cash. Every dollar taxed to pay for bailouts is a dollar that could have instead been invested in a startup. And every juggernaut that is saved is a hole in the marketplace that could instead have been filled by a new and better company.
The problem then, is the huge overhanging cyclical structure of debt and interest. In a free market — without bailouts and largesse — it would have collapsed into the sand long ago. That would have been painful and contractionary, but after the storm there would have been aggressive new growth; without the debt overhang, new lending would have been easier. There would be holes in the market to fill. But governments have determined that it must be saved, that there is no alternative to this strange mess.
It is not good enough to imagine a new beginning, either. For we already have this mess, and we have to get out of it. A route out — toward a place where the system is no longer so fragile. If we ignore the mess, our route out of it will be messy — systemic collapse, currency crises, trade breakdown, war or worse.
Now, I believe that the most significant factors in robustifying society are economic, as opposed to financial. The West’s greatest fragilities stem not from its weak financial system, but from its energy dependency and susceptibility to energy costs (for example, the financial crisis in 2008 might never have been so severe had there been such a huge spike in energy costs), its deteriorating infrastructure, and its imperial largesse (the cost, the blowback, the shortage of manpower). Simply, if America and the West were fuelled by decentralised domestic energy production (e.g. solar), and decentralised local production and resource extraction, the ululations of the global financial system would be irrelevant to the common people.
But, in reality, we live in a globalised and interdependent system. So anything that might robustify the financial system would be welcome.
Here’s what Taleb and Spitznagel originally wrote:
The core of the problem, the unavoidable truth, is that our economic system is laden with debt, about triple the amount relative to gross domestic product that we had in the 1980s. This does not sit well with globalisation. Our view is that government policies worldwide are causing more instability rather than curing the trouble in the system. The only solution is the immediate, forcible and systematic conversion of debt to equity. There is no other option.
Our analysis is as follows. First, debt and leverage cause fragility; they leave less room for errors as the economic system loses its ability to withstand extreme variations in the prices of securities and goods. Equity, by contrast, is robust: the collapse of the technology bubble in 2000 did not have significant consequences because internet companies, while able to raise large amounts of equity, had no access to credit markets.
Second, the complexity created by globalisation and the internet causes economic and business values (such as company revenues, commodity prices or unemployment) to experience more extreme variations than ever before. Add to that the proliferation of systems that run more smoothly than before, but experience rare, but violent blow-ups.The only solution is to transform debt into equity across all sectors, in an organised and systematic way. Instead of sending hate mail to near-insolvent homeowners, banks should reach out to borrowers and offer lower interest payments in exchange for equity. Instead of debt becoming “binary” – in default or not – it could take smoothly-varying prices and banks would not need to wait for foreclosures to take action. Banks would turn from “hopers”, hiding risks from themselves, into agents more engaged in economic activity. Hidden risks become visible; hopers become doers.
The strongest advantage, though, goes unmentioned. Systematically transforming debt into equity would end the problem of financial entities being too big to fail, as failure would no longer lead to a breakdown in the debt cycle. This is because insolvent positions would simply default to a majority-minority equity position, and — if the debtor’s equity position were high enough, say about 33% — liquidation could be avoided.
A huge philosophical problem is that such a complete transformation would alter (violate?) a huge number of existing contracts. It would be a top-down and coercive solution, and that is always open to legal challenge. Furthermore, curtailing the issuance of debt means curtailing the freedom of society and individuals to enter into any contract seen fit.
But the larger picture is rather intriguing — in a world where all debt has become equity, there is no such thing as a default, because an equity position is one of ownership, and thus a claim on future earnings.
Simply, lending would be done through lenders buying a share in a person or company’s or government’s future earnings, rather than through creating debt. Loan contracts could still be structured precisely the way they are today. But, as Taleb and Spitznagel insinuate in saying that “banks would turn from “hopers”, hiding risks from themselves, into agents more engaged in economic activity”, lenders would have much more of an incentive to assist in the development of their equity position, as this would surely be the best way to get back their initial investment. And — as an equity position, rather than a cast-in-stone lending contract — terms could be far more easily renegotiated.
Of course, this new system would surely pose a whole new universe of challenges and moral and regulatory quandaries, not least the moral and philosophical problems of government effectively banning debt-based lending.
But, if we are looking to avoid the moral hazard of bailouts, and the dangers of default cascades, the architects of the global financial system — including banks themselves, who could of their own volition choose to cease debt-based lending, and adopt equity-based lending — could do much worse. While systematically transforming debt to equity is too difficult and controversial (not least for contractual reasons), we must remember that in a purely free-market, all of those debt-based lenders would have gone bust a long time ago.
Very good. hope Max and Stacey pick this up!
Send it to them.
Your best article ever. No kidding.
Yeah, brilliant, brilliant. A true pleasure to read.
About your “(for example, the financial crisis in 2008 might never have been so severe had there not been such a huge spike in energy costs)” idea …
perhaps you’re aware of this, but just in case you’re not,
Dr Faber shows in his “Mirror, Mirror On the Wall, When Is The Next AIG to Fall?” lecture that …
at least in part, but probably mainly, it was the FOMCs response to 2008 which caused the huge spike in energy costs
Thanks. I am probably going to have to do a few posts on the 2008 energy spike. Right now my position is that the two were only loosely connected — the energy spike came off the back of years of loose money and easy credit but as soon as the huge money printing as a response to 2008 — QE, etc — started, energy prices fell away. Even priced in gold, crude oil experienced a hump before the banking crisis, and a slump when the money printing started.
and (ps), regarding decentralised, environmental, localised agricultural type evolutionary type thinking thru (sustainable!) sustainability … here is some thing i wrote connected to these ideas, actually citing thomaz jefferson i think … don’t worry, it’s far clearer than my truly appalling attempt at fiction…
i titled it ‘a meditation on american art and modernity’ because i was feeling all existential and stuff! 😛
Very interesting paper.
Whilst I agree in principle, I note your comment:
“A huge philosophical problem is that such a complete transformation would alter (violate?) a huge number of existing contracts. It would be a top-down and coercive solution, and that is always open to legal challenge. Furthermore, curtailing the issuance of debt means curtailing the freedom of society and individuals to enter into any contract that seen fit.”
Just trying to implement this from a practical point of view will be very difficult and a lengthy process. The training of front line & back office staff staff, the laws changed in parliament/congress, etc.
I mentioned in an earlier post the notion of Islamic Finance. I know it is more of an equity stake. Also German financing takes on a quasi equity flavour.
But this idea will avoid the technical default and credit writedown, that threatens the systemic credit default cascade.
When financiers approach lending from an equity standpoint, they will fund assets that relate to long term projects like a family home or a piece of business equioment. Not car loansm consumer credit cards or investment property hoping to be flipped at a profit.
Well, I think the best choice is clearly implementing this through the private market. Simply, it gives lenders a means to profit without being part of the huge wheel of debt that is bound to fall over again soon.
By the way, Buddy, I intend to do a post on Islamic finance soon. Just to clarify: I think Islamic finance (in its original form) is a very good intent, but not as robust as this new form of equity-based lending that I am advocating. In its current form — where Goldman Sachs are issuing sukuk bonds — it is just a form of semantic trickery to get around the stipulations of Islam.
Yes this will be interesting. I note Halal butchering in its pure form is quite humane. Current abbatoir Halal techniques would not meet original intent.
I am sure Islamic finance is the same.
This needs to be taken much, much more seriously.
Call me a cynic but I doubt it will be.
The problem for banks is that equity does not cash flow. So, for example, if a borrower can’t meet their debts for a mortgage, let’s say, a bank could take equity in the house, but there’s 0 cash flow. The cash, for highly leveraged banks, is needed to pay expenses. I would say equity is a completely different beast from debt. I would have no idea how you would convert it if done involuntarily. If done voluntarily, then you don’t need to have any major changes – lenders can already freely make new deals with borrowers (minus any regulation limiting that)!
I don’t think you’re calling for total elimination of debt. If you were, then that would be quite a mess turning debt into equity. I’m sure shareholders would love all the dilution that would have to occur! ‘
I understand the problem, but I think a return to a 100% reserve standard would be far preferable. Then, you would eliminate the concept of “systemic risk” while at the same time allowing fully for debt in the form of equity lending or time deposit lending,.
Why should it be just equity in the house? Why not equity in the person, like a guarantee on a proportion of their future earnings (up to the point of repayment) in exchange for a much greater likelihood they can keep the house in case of temporary default? At the very worst, if a bank absolutely needs cash flow they can sell the position to a bank that doesn’t.
This is the most (only?) viable way to do it, really.
In reality though, you’re simply hiding from the problem.
Lets say I’m an old man, I’ve saved hard all my life an have £500,000 in the bank.
My banks loan book collapses, and instead of being owed money, its owns a 70% share in a vast collection of houses.
The banks cash pile is quickly wiped out in a bank run, I slept in that morning so didnt take part.
My £500,000 is transfered into 500,000 common shares, nominaly valued at a pound, but currently trading at 5p
The banks may “survive”, but the creditors will all suffer their own speedy failures straight afterwards, with their creditors becoming equity partners in a failed venture.
Money borrowed cant be paid back, and seizing assets cannot cover the losses.
Someone needs to be burnt, and its gong to be horrific for whoever that is.
I never really suggested we should repeal depositors’ insurance, but for the sake of argument, if we take your scenario to its logical conclusion, it seems very unlikely that those shares — backed by real assets that the bank is holding — would be trading at such a discount. A huge problem with today’s hyper-fragile system is banks are juggling abstract dynamite (e.g. CDS, MBS) and various toxic waste products that completely blow up sans cash flow, as opposed to holding equity in real world assets, which sans cashflow just depreciate in the way a real-world asset typically depreciates (i.e. wear and tear).
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Interesting article – but as you stated there would be many obstacles to implementing this new system, as well as potential issues when it is implemented.
Banks as they are now are not in the business of owning equity, but rather managing (and increasing) cash flows. A bank does not wish to own equity in a business that fails to repay as this would require it to devote significant ressources to managing it’s equity interests in the failed company. A positive to the idea though is that banks and other “lenders/investors” would have to do quite a bit more homework before agreeing to lend to any company… after all, a default wouldn’t simply be a matter of liquidating assets to recover funds, but instead the bank would now become involved in all of the failed company’s obligations!!!
Not to mention what percentage of ownership “lenders/investors” would get : if a bank ends up with a 20% stake in a business, they would not even have enough control to affect any decisions made by the company and would not be able to get any of their funds back (not even by liquidatiing assets as a debt based system does).
No, I think As it stands now, investment firms are “equity lenders” and perhaps they are best suited to take on the risks of equity lending. It would be too much to force this system on everyone (not to mention personal lending – I am surprised to hear you propose corporations should have equity stakes in individuals’ incomes!!!)
The system as it stands now is based on cash flow, and the main problem as stated above is unlimited cash being printed. Without the printing presses, the too big to fails would not have been bailed out, as the capital would have to be raised instead of being printed out of thin air. I think humanity has always tried to switch to a fiat based monetary system, and this has always failed. It’s just that we are human, and prey to corruption and self interests – those in power will always alter the system to their advantage. Limit the creation of money somehow, and the problem is fixed in my eyes.
Again, appreciate the blog.
Well that would certainly be an improvement — but the problem is that it is very hard to limit the creation of money/monetary instruments. Even when we had the gold standard, we still had credit bubbles (nothing as extreme as this, though).
Yes, and maybe that’s the problem. It has worked out very well in the last 10 years, no? They increase cash flows until they hit a credit event (again, it is important to note that this kind of thing happens even with the gold standard) at which point the system crashes. Lending should be about more than managing cash flows – it should be about creating value.
Banks that adopt this lending approach voluntarily may not be as profitable in the short term, but in the long term they will not be subject to credit squeezes in the way the debt-based lenders are.
The answer is not the forcible conversion of debt to equity (too many legal and contractual problems) but the voluntary adoption of equity-based lending.
“The answer is not the forcible conversion of debt to equity (too many legal and contractual problems) but the voluntary adoption of equity-based lending.”
So Aziz, if you want to buy a home, would you voluntarily go to an equity bank to get the funds to purchase the home? Ok, forget the real estate reference, just assume you want to by An asset, any asset and you need funds.
Would you go to an equity bank? A bank that would get an equity stake in your personal income for X number of years? that puts way too much onus on the individual “borrower”. I would rather think it would be better – both for the bank and for the individual – for the bank to repossess the asset for which the funds were used. That way the individual could simply walk away and start anew and the bank is left holding the asset (a risk they agreed to take in the first place).
Let’s not confuse money printing and corruption and unbridled derivatives with debt based money system as one problem… they are all issues and inter-related, but I am of the opinion that it is possible to have a debt based system without the other issues (if the currency is properly managed and restricted and the system has PROPER laws).
Not to mention that an equity based system woudl most likely make the inter-connected problem even worse – banks might end up owning an equity share in thousands of companies!!
No, the debt based system now is one that uses an asset as security – and I think that works just fine as long as the assets aren’t pie-in-the-sky derivatives promised to 10 people at once.
Yeah, I would, so long as I could find a bank with the right expertise to assist me. I know a lot about economics, but my experience in business is limited, and as a young guy I could use some help and guidance if I ever chose to start one. A lot of businesses end up going bust because borrowers can’t get the right help and guidance. It would bring a whole new moral dimension into banking — one that is very much missing today where the lender just makes the loan, and gets into securitised into an MBS, and lets go. The bank would no longer just be a creditor — they would be a partner in the business, and it would create a greater co-responsibility for the success/failure of the business.
Yeah, this is probably true. I was just floating this idea, but the more I think about it, the more I like it.
The problem isn’t the interconnection per se so much as the problems with the interconnection of debt and cashflow. The problem today is that a bank that goes bust and misses payments to other banks, making them go bust, and so on. With equity-based lending, whenever there is a default it just reverts to an equity position. The worst that can happen is that lots of things revert to equity positions, which are then renegotiated.
“The problem isn’t the interconnection per se so much as the problems with the interconnection of debt and cashflow. The problem today is that a bank that goes bust and misses payments to other banks, making them go bust, and so on. With equity-based lending, whenever there is a default it just reverts to an equity position. The worst that can happen is that lots of things revert to equity positions, which are then renegotiated.”
I’m sorry, but under your system, wouldn’t banks also work on cash flow? If bank A doesn’t get funds from their clients, they get an equity position in their clients. Then, bank A isn’t getting any money, so bank A can’t pay bank B, who then in turn owns some of bank A. Now bank B can’t pay bank C since it’s not getting any funds from bank A, so then bank C in turn owns some of bank B.
Multiply that by real-world complexity and you have the same situation as now. When you think about it, your equity system would still depend on cash flow, and once that seizes up all hell breaks loose and everyone owns a little bit of everyone else.
You are basically advocating a change in our security structure. Instead of using a home as security, you would be using equity as security. Now, it may just be me, but if I am a business owner and I borrowed to buy a new dump truck, and I default, I would rather loose the dump truck to the bank than have the bank suddenly part owner of my company and telling me what to do. But hey, that’s me, I like free enterprise.
Higher end banking relationships (say over $500,000) are more complex than regular banking relationships – the banks doesn’t want inventory, a dump truck, paper clips, or account receivables that is has to pawn off – so it already has an interest in ensuring that the company is able to pay its loan back. It’s just that in the small-scale banking relationships its not feasable for banks to “help” and provide tailored advice to EVERY small business or individual out there. Just not possible.
Well (unlike Taleb) I’m not necessarily advocating banning debt-based lending. I just think there should be a choice, and competition between the two systems, and then we will see what works better. I personally can theorise all day about what the outcome might be, but we won’t really know ’til we see it in action.
As far as I can tell a succession of defaults-to-equity is more easily renegotiable and more flexible (and thus less likely to bring down the whole credit system) than a succession of defaults-to-liquidation, but we will not really know ’til we see it in action.
Well then, hasn’t an equity based system already been existing in tandem with the existing system for the last 2000 years?
After all, if you wanted to do an equity based loan to someone in the year 1593 in venice, you could. If I want to do an equity based loan with someone now, I can. It’s a contract like any.
And by that admission wouldn’t you also be admitting that one system has already been preferred over the other?
I think one system won a huge victory a few hundred years ago, and now the other one isn’t even considered in certain domains. I am just raising the possibility that it may be better for today’s world, and that it is worth trying.
I’m curious now, has an equity based system every been widely used in the past? If I were a bank (or a lender) I would preffer asset based security as its MUCH less risky. When you become partner in any venture, you never know what you are getting involved in – banks and most lenders are just not interested in that. My 2 cents, thanks for the chat (heading home now).
“Even when we had the gold standard, we still had credit bubbles (nothing as extreme as this, though).”
I would argue that in those cases the bubbles were either asset bubbles (where euphoria attracted too much capital in any asset) or credit bubbles as you said. Now, isn’t that last one somewhat contradictory? If a money system were truly gold-backed (no fractional creation or fake gold — “multiplying” gold reserves to issue paper) how could a credit bubble exist? the credit bubbles existed because the banks issued too much paper relative to their gold reserves.
I’m not indicating going back to a true gold backed currency, just saying that credit bubbles happen because of uncontrolled creation of money. You should not be able to lend out more than you have to lend out. If you do, you risk a run on the bank. simple.
Here’s the thing: even if you have a fully-gold-backed currency what’s stopping a bank from creating paper gold derivatives? And what’s stopping them from creating lots and lots of that paper gold?
The central bank might try and regulate this behaviour out of existence, but lawyers would find a way around it. People just love to create monetary derivatives. This kind of credit bubble has happened many times in history, even with a gold standard in place. When it comes to preventing damage to society that results from financial misdeeds, we need to look at the credit system as well as the monetary system.
Are you saying that a non-fractional based monetary system is simply impossible? That there is no way to ensure banks and individuals only lend what they have? Even with today’s techonology?
We are in the dawn of a major change in the banking system – the switch to a digital currency. Once that is (unfortunately) fully traceable and controllable.
I am not a fan of digital currencies, because they have a lot more counter-party risk than gold. They can be compromised in many, many ways, not least algorithmically. I thought about buying some bitcoins a few months after Mt Gox crashed when they were really cheap, but I don’t really have any use for them. Most of the websites that take them are just selling drugs.
Bit coins is a really bad example of a digital currency in my opinion. There is a set maximum to the supply of them, an amount that could never be increased. Now, that would be a problematic currency – no growth in money supply AT ALL. IE, deflation FOREVER. I like deflation once in a while, wish we had it now, but that system is just doomed to fail. Besides, for a currency to work ANY currency has to be backed by some kind of authority – preferably one with an army and fixed borders.
Digital currencies are already being used in the Uk where you live, the US, and most of the western world. I don’t see any significant breaches by hackers. When you use online banking to pay a bill, you’ve just used a digital currency. It will be very interesting to see how that phenomenon will evolve. Just like paper in the medieval days, digital currencies will change the way we do business (pay with your Iphone, or have funds deducted automatically by a store if you leave the store with goods, etc).
Now we’re into the really interesting topic.
Personally I think these kinds of currencies — because they have essentially zero production and transaction costs — tend toward hyperinflation.
agreed – kind of like how paper money was when compared to coin-based money. Was a huge shift towards potential problems at the time… Imagine, you didn’t need to cast coins!!! This is very much the same. That’s why im interested in how it will evolve.
Credit is the backbone of a mdeorn monetary system. Banks were created by the constitution as a great vehicle to have both capitalism and full employment. The private sector by itself cannot create full employment because of financial constraints and needs buffer for uncertainty and the government has to step in. Banks hold a unique position, else credit will be difficult and pricey. Banks have this unique ability to lend by expanding out its balance sheet. Preventing an easy expansion of the balance sheet will just increase the loan rates. The settlement balances at the Federal Reserve have just two roles settlement and help satisfy the household need for currency notes. The central bank is also the lender of the last resort and can lend as much as possible. The whole system is designed wonderfully so that entrepreneurs, academicians, scientists, engineers, artists, advertisers, sales persons, managers, HR, unskilled laborers can make use of this and increase the quality of life for themselves and others. If the households permanently decide to use more cash, the central bank can help banks slowly reach that state where they keep more settlement balances, lending in unlimited quantities in the meantime. Its a misunderstanding of the system and poor economics which led to the crisis. Economic advisors to governments have no concept of domestic private sector deficit in their analysis. If they had noticed that the private sector was getting weak, they would not have allowed a credit boom to have happened. Instead they supported the boom and ignored reports showing scams and forgeries. It is neither low interest rates or low reserve requirerments which caused this crisis. Blaming the crisis for these two things is like blaming the invention of fire instead of blaming the fire prevention system.
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Furrealz? That’s malvoleusry good to know.
Thought it wouldn’t to give it a shot. I was right.