T+1 will raise volatility.  Often increases in the technical efficiency of information or trading systems increase volatility, because people can act precipitously on information, all at the same time.

There was an effort in the early 2000s to make almost all securities settle as a rule in one day.  Three days was the rule for most markets then, as it is now.  Government bonds settle differently, and some other securities as well.  The effort to settle transactions more quickly failed, and we still settle trades in three days.

I was glad when the move to T+1 failed.  There were efforts to move to T+0 behind it.  Not that I had many trades that I needed to break as a bond manager (I had one, the phone call to do so made me ill), but I knew there were settlement failures even at T+3, and the stress on the back office would be considerable.  Better to go slower, and have fewer failures.

I prefer stability over efficiency.  Efficient systems tend to require high attention.  Stable systems have redundancy.  Not everything has to go right for the system to work.  In my example above, T+1 required a lot more accuracy, and T+0 would be unimaginable.  We would need angels to clear trades.

That’s one reason why I am not crazy about market efficiency.  Yes, efficiency is a good thing as far as it goes, but when it begins to impact stability I part ways with efficiency.

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It is inefficient to have a balance sheet.  All of the slack capital that you don’t need all of the time.  Far better to be a trader with no significant balance sheet, the profits will be greater.

I disagree.  Though this is an extreme example, look at Buffett with his purchase of Bank of America preferred stock with warrants.  In a single stroke, he protected the downside, and allowed for the participation in the upside.  He probably understands that his credibility can move markets.  The preferred stock can be stuffed inside an insurance entity with little capital cost, while the warrants can be held at the holding company.

Bank of America entered into expensive financing with Buffett who had cash at a critical moment.  Give the Buffster props for his cleverness in the tub — he understood their need of capital, and gave it to them in away where they could deny the need for new capital.  Brilliance.

Brilliance, so long as the losses never reach down into the preferred equity portion of their balance sheet.

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Having a balance sheet allows for modest losses to occur and the system does not fail.  But it means that some capital is not deployed; it is there in reserve for disasters.

That is why financial systems with excess capital survive better.  Yes, it is inefficient to carry capital that does not earn much, but it is more inefficient to fail.  Think of the Baumol model, where there is an economic order quantity.  The same can be applied to finance, where the is a level of efficiency below which we should not go, because of ordinary volatility.

Volatile markets require intermediaries, or at least, systems that slow settlement.   Slack in the system is not wasted, but is there to protect against catastrophes.  That is a benefit to all, even those that seek to make markets more efficient.

There has been a boatload of articles arguing how the US is going the way of Japan.  I know, I have added to the crowd.  Tonight’s piece is meant to nuance my views, because there are similarities and differences between the US and Japan (20 years ago).

Similarities

• High private debt levels leading to high government debt levels, as the government “rescues” selected areas of the private sector
• Asset bubble deflating
• Desire for security drives government interest rates lower
• Intractable government deficits
• Both have warped monetary policy to try to deal with the problem.
• Slow to fix banking problems; reluctance to take big banks under.
• An unwillingness to note that the problems are structural, not cyclical.
• Failure to recognize that growth is not a birthright.  Proper policies must be maintained.
• Slow response from legislators.
• Low growth is anticipated, because of high private debt levels.

Differences

• Japan’s deficit is self-funded for now.
• Demographics in the US are far more favorable.
• US Economy more open to global competition.
• No Tohoku tsunami in the US.
• Japanese politics don’t care as much about their problems.
• Japan’s debts were debts of over-production, rather than over-consumption.

Michael Pettis argues that increases in productive capacity will be more harshly treated than over-consumption.  Quoting his most recent piece:

These – with the possible exception of the debt – are not the problems from which the US or Europe are suffering. They suffer from a typical debt-fueled overconsumption boom, whereas Japan suffered from a typical debt-fueled over-investment boom, and Japan’s period of over-investment was much, much more extreme (centralized investment booms can last much longer and go much further than decentralized consumption booms). This is why I think the Japanese experience tells us almost nothing about what Europe and the US will go through.

On the other hand, it might tell us a lot about what China will go through. In fact we can make a more general point. Command economies (Japan, the USSR, Brazil and many others during their “miracle” periods) tend to have much more rapid investment-driven growth during the good times and much more difficult and longer-lasting adjustments. Capitalist democracies are more prone to consumption-driven booms, which aren’t as extreme and don’t last as long, and their adjustments tend to be brutal but relatively quick.

This is a great generalization, of course, and every specific country departs from the generalization in very specific ways.

I think the right answer to the question of whether the US is going the route of Japan is no, but there are similarities, and significant differences.  In Japan, they entered their troubles with corporations and banks overly indebted, whereas in the US it was consumers and banks. A lot depends on how much US consumers reduce debt, making them more capable of buying goods and services in the future.

With a over-production there is no guarantee that the world will ever get up to the level where they demand all the capacity that was developed.  With over-consumption, many debts will get compromised, lenders may be in a funk for a time, but there should be cleaner ways of clearing away and paying off the overindebtedness.

In the Great Depression, the US was in the position of being the over-producer.  Other nations indebted to the US came through the experience better.  Japan was the over-producer of the 1980s.  This time, the US will probably come through the crisis better than China and other creditors of the US.  No guarantees, but foolish lenders eventually get their comeuppance.  We’ve seen that recently… if somewhat short-circuited by the government/Fed.