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Our lofty central bankers and regulators have forgotten that finance is a derivative of the real sector. If the real economy is sick, fixing the derivative won't solve the problem. Photo: Bloomberg

Six years on, we still haven't learned the real lessons from Lehman collapse

Andrew Sheng says regulators fail to understand that the world needs equity, not more debt

On Monday, it will be six years since the collapse of Lehman Brothers. With the US economy still operating below par and Europe struggling to stay above water, the question is whether the right medicine was given after 2008.

The mainstream diagnosis was that the problem lay in excess credit and there was a need to control banks and shadow banks through more regulation and capital. Since politicians were not willing to push fiscal policies to the limit, central bankers opted for massive quantitative easing to stimulate the economy and simultaneously tighten regulation to restrain the naughty bankers.

But who allowed the excess credit in the first place to create asset bubbles at excessively low interest rates before 2007?

One can fully understand that, under crisis conditions, we need to stimulate the economy and control bankers. But in controlling the bankers, why have banks spent more than US$100 billion so far in legal settlements, with another estimated bill of US$150 billion, after quantitative easing subsidised them to the tune of US$300 billion, according to estimates?

These lofty central bankers and regulators have forgotten that finance is a derivative of the real sector. If the underlying asset (the real economy) is sick, fixing the derivative (finance), won't solve the problem. Fixing finance is like strengthening the cart but ignoring the horse. If the horse is overleveraged, giving it more debt won't make it run faster. Thus, it makes more sense to inject capital into the real economy, rather than the banking system.

Indeed, asking bankers to top up capital does not make any sense. If the government has to increase debt, let it inject capital into small and medium-sized enterprises and infrastructure to push for real growth.

In other words, the world is short of equity, not more debt. There are several culprits for our mistake of favouring debt over equity.

The first is ideology. One of the foundations of modern finance theory, the Modigliani-Miller theorem, suggests that the value of a firm is indifferent to whether its capital structure is debt or equity. This assumes no bankruptcy, perfect information and no tax differences. Theoretically, this is brilliant, but practically, it says the market should be indifferent to whether a person lives as a drug addict or a pastor, as long as you assume that there is no death.

The second is tax biases against equity. Both interest on debt and provisions against non-performing debt are tax-deductible, whereas dividends are taxable and capital losses are non-deductible. Indeed, US cash-rich companies prefer to keep their billions abroad and borrow to pay dividends purely for tax reasons.

The third is the inherent hierarchy of finance. Monetary policy is exercised through central banks at the apex, providing liquidity (debt) when needed to a select core of too-big-to-fail banks, which will lend to the masses depending on the right incentives. If central banks lend to banks at near-zero interest rates and banks can buy risk-free government securities which rise in price when they buy, are you surprised they are not lending to the real sector?

Furthermore, if bankers take risks and lend to those at the bottom of the pyramid with higher credit risks, they are likely to be admonished by their regulators for allowing non-performing loans to rise and therefore should provide more regulatory capital.

It is not surprising that credit to real businesses is still stagnant six years after the crisis.

The hierarchy of finance fundamentally means that helicopter money from central banks inherently exacerbates social inequality. Central bank provision of low interest rate funds to a small circle of banks and fund managers who buy government securities from the central banks is de facto 1 per cent subsidising the 1 per cent, not the 99 per cent.

Note that instead of buying government securities, the People's Bank of China recently injected liquidity back into the real economy through lending 1 trillion yuan (HK$1.26 trillion) to the China Development Bank to help finance shanty town reconstruction. This is exactly what central banks in Europe should be doing to get growth back into the system - get money or housing to the people who need funds.

It is amazing that, after six years of painful stagnation, Europe is still debating the need for more austerity. The only way that Greece and other crisis economies can get out of recession is to revive growth.

Central bankers are still pushing quantitative easing and lower interest rates because politicians won't act faster on structural reforms.

As we have yet to recover to pre-2007 growth levels, the only thing that seems to be supporting the buoyant financial markets is loose monetary policy. Clearly, when the US Federal Reserve starts calling for an end to quantitative easing and US interest rates rise, the markets are already preparing for some rather rude shocks. Watch the smart money being taken off the table through the tech bubble.

This article appeared in the South China Morning Post print edition as: Six years on, we still haven't learned the real lessons from the Lehman collapse