Waiting for interesting offers

In this update, I am attempting to introduce a general concept of social sciences, namely that of pooled risks, and, associated with them, pooled resources, and combine it with my research regarding collective intelligence. I open up by connecting to my last update, namely that titled ‘My NORMAL and my WEIRD’. Things happen all the time. Some of that happening we deem as normal, and anything outside normal is weird. We, humans, we have built a whole civilization around saving stuff for later. We started by saving bodily energy for later, and thus we invented shelter as a complex method of saving and investment. Today, we build shelter, and thus we expend more energy than strictly needed for survival, and yet the whole business pays off, because shelter allows us to save even more energy on the long run (lower heat loss when sleeping and resting, more stable conditions for keeping a fire up etc.). As we started building shelters for ourselves, we figured out that food could be conserved for later, too. Once again, spend a little bit more energy today, bro, to conserve that beautiful sabre-tooth tiger, as well as that root, which your distant descendants will call turnip, and tomorrow you will have food which you do not have to run after nor away from.

Over thousands of years, we, humans, have developed that pattern of countering adverse events by saving resources for later and investing them in something that pays off. At some point in time, we noticed, withing the realm of all the nasty s**t that happens, different grades of normality and weirdness. There is daily adversity, such as cold in winter, or the basic need for food (all year long), which needs to be addressed recurrently and sort of locally. Everyone needs local protection from cold, right? If, in a city, there is one shelter, it can work just for a tiny handful of homeless people, not for all the citizens. The latter need their individual places. Still, there is a different type of adversity, such as a flood, a hurricane, or a wedding, which all happen incidentally and are randomly local: they hit a specific subset of population, in a specific place. Although these events are abnormal, they happen abnormally with a pattern. The Black Swan theory, by Nassim Taleb (Taleb 2007[1]; Taleb & Blyth 2011[2]; see Black Swans happen all the time), argues that we, humans, have developed an otherwise amazing skill of incorporating into our collective culture the memories of unusual, catastrophic events so as to be prepared for the next time the s**t hits the fan. A lot of our structures and institutions are made for countering and compensating the sudden, and yet somehow predictable advent of those Black Swans. One of the simplest examples are buildings. The toughest architectural structures have historically developed, a bit surprisingly, in places with an abundant history of warfare and sieging, and not, as someone could expect, in places haunted by hurricanes and earthquakes. I could see that sort of in my front yard, when, in the early 2000s, I met Croatians who migrated abroad. Their default expectation for a building was reinforced concrete, brick was barely acceptable, and the American wooden structure was completely out of the question. It wasn’t until 2004, when I went to Croatia for the first time, and I saw the still-standing corpses of buildings damaged by bombs, that I understood where that preference for reinforced concrete was coming from.

What is even more puzzling is that abundant history of warfare and sieging has developed in places, where heavy construction materials, such as stone, lime, clay for making bricks, and wood for fuelling ovens to bake bricks, were just as abundant. In other words, we historically developed big, solid buildings in places where we used to destroy those buildings a lot through our own military effort, and, apparently, we used to destroy them a lot because we had a lot of raw materials at hand for rebuilding them. That’s what I call incorporating Black Swans in a culture.

Anyway, we have that thing about purposefully investing our resources in structures and institutions supposed to shield us against big, catastrophic events. There is another thing about those Black Swans: they happen in sort of a floating manner. If you know your climate, and that climate is prone to floods, you know there will be floods, you can estimate the magnitude of damage they are likely to inflict, you just don’t know where and when exactly it is going to flood. What you need is a s**t-shielding structure akin to an immune system: a lot of resources, hanging around, sort of held at the ready, able to channel themselves into the specific place where damage occurs.

Now, I jump. Like really. Intellectually, I mean. You probably know that governments of many countries are borrowing lots of money, this year, to counter the adverse impact of the COVID-19 pandemic. You can read more about it in the Fiscal Monitor published by the International Monetary Fund in September 2020, under the title ‘Fiscal Monitor: Policies for the Recovery

September 2020’ (https://www.imf.org/en/Publications/FM/Issues/2020/09/30/october-2020-fiscal-monitor ). I think this is the right move to make, right now, and right now, you, my readers, are, as we say in Poland, in your holy bandit’s right to ask ‘WTF?’. What does public borrowing have to do with floating adversities? Hold on, dear readers. One step at a time. We have those governments borrowing money, right? The first interesting thing is the way they borrow. When I borrow money from a bank, I do it against a written promise of paying back, possibly backed with a conditional claim I grant to the bank on some assets of mine. When governments borrow, they prevalently do it by issuing tradable financial securities called sovereign bonds AKA treasury bonds, which incorporate the government’s obligation to pay back the capital borrowed in more than 12 months. A minor part of public borrowing takes place through the issuance of sovereign notes (treasury notes), which differ from bonds just by their time of maturity, always shorter than 12 months. Hardly any public borrowing takes place in the form of classical loans, the kind which me or any other, non-political mortal could contract. Why is it so?

The first basic difference between a classical bank loan and a loan extended in exchange of tradable securities is that governments can do the latter, cities can do it, too, as well as large corporations. On the other hand, if I go to a bank and I propose to borrow money from them in exchange of bonds which I will issue, they will tell me: ‘Mr Wasniewski, with all the due respect, you have no business issuing any bonds, for one, and even if you had, no one would be really interested in buying your bonds from us, and so there is no point for us to accept bonds from you. If you really like making securities, you can sign a bill of exchange, if it is all the same for you, yet it will be just an additional collateral in the framework of a normal lending contract’.

I could go bitching and ranting about those horrible bankers. Yes, I could. Yet, I prefer understanding. Why can governments borrow in exchange of bonds, and I cannot? ‘Cause their bonds are wanted, whilst mine are not. This is called demand, and when demand pertains to a financial instrument, we call it liquidity. Financial institutions willingly buy sovereign bonds, thus give them liquidity, because these bonds have very low credit risk attached to it. Most governments are good payers, especially when they can schedule those payments way in advance.

Thus, we have a new concept in this update: credit risk. If you are a bank, and you extend 1000 loans of $5000 each, to 1000 different clients, some of them will simply not pay, or, as bankers say, will default on their loans. Realistically, you can expect between 4% and 7% of them to default. Let’s make it average between 4% and 7%, thus 5,5%, which makes 5,5% * 1000 borrowers = 55 loans in default, or 55 * $5000 = $275 000. When someone doesn’t pay, someone else has to pay for them, and the basic financial strategy is to spread those $275 000 over the remaining 94,5% of customers, dutiful and solvable. In other words, those remaining 945 customers will have to pay, in the interest the bank charges them, those $275 000 in default. That makes $291 per customer, over the top of the $5000 principal capital borrowed, or 5,82% of that capital. In even more other words, in this specific population of customers, there is a floating credit risk amounting to 5,82% of capital engaged in lending, or $275 000 for each $5000 000 of credit extended. The interest charged on each individual loan comprises, among other things, those 5,82% of spread credit risk.

The strategy of spreading credit risk is common sense, yet a bit unfair and easily tiltable out of its base. When credit risk in a population of clients rises sharply, e.g. when there is a wave of insolvencies and bankruptcies among small businesses, that spread credit risk starts spiralling up in an uncontrolled manner, and soon enters into a dysfunctional loop. Each additional 1% of customers defaulting on their loans creates the need to make credit even more expensive for all the others, which makes those others more likely to default etc. Someone could say that it is all because of bad banking. Just don’t lend to customers who default, that’s all. Yes, cool, it is an excellent advice and yet it is functional just in a certain number of cases. The historically accumulated wisdom of finance is that credit risk is essentially exogenous, i.e. it is a characteristic of the entire market rather than bad credit decisions in individual cases.

Banks lend to the non-financials the money they have borrowed from other banks. This is something to remember: when a bank extends you credit, they are trading you that money, not producing it. Banks don’t lend out of their equity; they lend out of their liabilities vis a vis other banks. That’s why there is a big market of interbank credit. If you are a bank and another bank asks you for a loan, you will easily do it. Instead of dealing with 1000 small loans of $5000 each, you just deal with one big loan of $5000 000, extended to another bank, thus to an organization which, you, a bunch of bankers, can much better predict the financial stance of than it is the case with the non-financial businesses. You just need to see that this other bank has financial reserves for credit risk, i.e. they do not rely exclusively on the market in managing its own credit risk. You’ve got 5,82% of credit risk, bro? Cool, happens all the time. Still, show me, in your official accounts, that you have secured a financial reserve for that, and the next thing you know, I lend you, no problem.

Thus, when you are exposed to credit risk, and you inevitably are, as a bank, you should keep financial reserves for that risk. Risk is a quantity, see? Now, you can be smart and do something else. You can invest part of your total capital in financial assets which are technically lending, and yet are way away, in terms of credit risk, from your average loan. Most governments are good payers, especially when they can schedule those payments way in advance. Lending to them, especially in exchange of tradable sovereign bonds, is low risk, usually estimated way below 1%. Let’s suppose that you, a bank, can buy sovereign bonds with a credit risk at 0,5%. You lend to all the others with a risk coefficient of 5,82%. You spread your total lending so as to have 30% extended to governments, at 0,5% risk, 30% to other banks, let’s say at 1% risk, and the remaining 40% lent to all them other folks, at a credit risk of 5,82%. Your compound weighted average credit risk amounts to 0,3*0,05% + 0,3*1% + 0,4*5,82% = 2,78%. See, with that portfolio of financial assets, you need to make financial reserves for just 2,78% of your total lending, instead of 5,82%. Moreover, in the distinguished company of government bonds, the baseline credit risk to be spread over loans granted to ordinary clients gets driven down from the initial 5,82% to just 0,4*5,82% = 2,33%. By acquiring and holding solid government bonds, you can stop and revert the upwards spiral of credit risk in the times of economic trouble among your clients. Government bonds suck in and hold part of the baseline credit risk induced by the market.

Governments know all that, and we all know there is a price to pay for anything valuable. Thus, when a government approaches you with an initial, usually unofficial proposal of credit against sovereign bonds, you are likely to hear something in the lines of: ‘Look, man, we offer those bonds with an interest rate of 2% a year, and those bonds have a credit risk of 0,5%. We know your baseline credit risk is 5,82%. Thus, by lending us money in exchange of our bonds, you gain 2% in the nominal interest we offer, and 5,82% – 0,5% = 5,32% of reduction in your nominal credit risk. That makes you a total gain of 2% + 5,32% = 7,32%. C’mon, man, let’s share 50/50. Out of that total gain of 7.32%, you take 3,66% and we take 3,66%. How do we take it? Simple. Nominally, we hand you bonds for $10 000 000, but you actually advance to us, in cash, $10 000 000 * (1 + 3,66%) = $10 366 000. Yes, that 3,66% is called discount and you give us that discount because we give you lower credit risk’.

You can take that proposal such as it is or you can bargain. If you take it, you will get 2% in nominal interest on those bonds and you will give away 3,66% in discount. At the end of the day, you get those sovereign bonds at a negative yield of 2% – 3,66% = – 1,66%. Ridiculous? Not at all. You can go through Fiscal Monitors, published by the International Monetary Fund (https://www.imf.org/en/Publications/FM ), and you will see by yourself: the total value of sovereign bonds endowed with a negative yield, after all is said and done as regards discount for low credit risk, has been growing rapidly over the last decade. You can also consult http://www.worldgovernmentbonds.com/ and see the actual numbers. The French government currently borrows at -0,339% on 10 years, and at -0,715% on 3 years. Germany is the big boss of that lot: they borrow at – 0,619% over 10 years.

You can bargain, too. Instead of accepting that initial proposal of 3,66% discount, you say: ‘Look, government. We like each other, and we acknowledge your bonds give us lower risk. Still, please remember that your bonds have that low risk attached to them just as long as we, all the banks, give you a high credit rating. When we decide to downgrade your rating, your credit risk will go from 0,5% to 1,5%, and that will be bad for everyone. Let’s stay reasonable and share 70% for us and 30% for you, instead of 50/50. You get a discount of 7,32% * 0,3 = 2,2%, which, with the nominal interest of 2,5% you offer, gives us a real positive yield of 2,5% – 2,2% = 0,3%, and then we don’t look as total losers’.

You bargain or you don’t, thus. As a banker, you can bargain with a government when you are strong and they are weak. In the world, there are two completely different markets of public debt. The debt of strong governments, which have a lot of political and economic leverage on banks, is something very distinct from the debt of weak, economically wobbly governments, who are clients to banks rather than equivalent players. Against that background, there is that claim: ‘Our children will have to pay the debts we are contracting now’. Let’s discuss it.

You are a bank. You have lent money to a big solid government, who sort of raped you financially, into negative yield on their bonds, and yet you stay on the top of it with the low credit risk they give you, their bonds. That government comes to you, one day, and they say: ‘Time’s up. The maturity of our bonds was 5 years, which have just elapsed, and thus we are buying our bonds back. Here is the cash. Bye, bye. Have fun’. For you, as a banker, it is a disaster. For years, you have been constructing that financial portfolio where sovereign bonds were compensating the credit risk attached to risky business loans, and all that thing sort of kept itself together. Now, you stay with a pile of cash, which you need to invest into something, only anything you will invest it in will have a higher credit risk, and thus you will have to charge a higher interest, and thus you will be less attractive as lender, and you will be more and more doomed to work with people really desperate for cash, and that will drive your overall credit risk even higher, and here the loop spirals into hell.

What you can do is to agree, with the government, for a deal called ‘roll-over of debt’. When sovereign bonds come to their maturity, the government can offer you to swap them against a next generation of bonds, just to keep your balance sheet stable risk-wise, and to keep their cash-flow stable. In that roll-over swap, the same game of nominal interest and discount recurs. When you, as a bank, deal with a strong government with a solid economic base, they are very likely to swap like $100 of face value in bonds against $98 of face value in the next generation of bonds, or 2,5% of nominal interest a year against 1,9% a year etc. At the end of the day, those strong governments, as long as they stay within the limits of reasonable, can keep borrowing without burdening any future generation with the necessity of paying back the debt, because no one really wants to see it paid back. On the other hand, weak governments, ruling over wobbly economies, are in the opposite position. They have to roll their debt over at systematically worse financial conditions than the previous generation of bonds was based on. Those ones, yes, they fall into a true debt trap.

The key, thus, is to have a strong economy. When business runs well, everything else runs well, too. A strong economy, today, means an innovative one, with a lot of real technological change going on. By ‘real’ I mean technological change which actually develops your national technological base and doesn’t just outsource to China. Technological change involves a lot of uncertainty, and therefore a lot of business risk to face, which, at the level of banks, translates into a lot of credit risk. The latter needs to be compensated by low-risk sovereign bonds, which bear the lowest risk when they come from the government sitting on an economic base endowed with quick technological change. The loop closes. Strong economies generate a lot of credit risk, and their governments can alleviate that risk by borrowing from their national banks. As long as the money borrowed by governments supports technological change, directly or indirectly, and as long as neither party in that game goes feral, the whole thing works. This is an old intuition, which was already phrased out by Adam Smith, in his ‘Inquiry Into The Nature and Causes of The Wealth of Nations’ (Book V, Chapter III): substantial public borrowing appears when there is a substantial amount of private capital accumulated and waiting for interesting offers.

I made a video lecture, mostly addressed to my students of Economic Policy, as those in the course of Managerial Economics, with active reading of selected passages in the Fiscal Monitor September 2020 (https://youtu.be/ODY6zl1Z1r4 ).

[1] Taleb, N. N. (2007). The black swan: The impact of the highly improbable (Vol. 2). Random house.

[2] Taleb, N. N., & Blyth, M. (2011). The black swan of Cairo: How suppressing volatility makes the world less predictable and more dangerous. Foreign Affairs, 33-39.