Tuesday, 23 December 2008

Repost from 06/06/08: Reagan and Obama - Reforming the Welfare State

In Britain a national election lasts just three weeks and spending by each candidate is strictly capped. Campaigning between elections is not permitted. Accepting so much as a hotel stay from a lobbyist is a resigning offence. As a result, our news is full of the American campaigns to make up for the deficit in newsworthy political conflict locally. I follow the American election, as does most of the world given the potential for good and ill that proceeds from it. Please indulge me in ruminating on one aspect of the Obama candidacy that intrigues me.

Ronald Reagan came to power on a popular backlash against the welfare state. It appears that Barack Obama may come to power on a similar backlash against the welfare state. The difference is the identity of the welfare claimants.

Ronald Reagan inflamed the public’s righteous anger against a stereotyped ghetto “welfare queen” who raised a brood of illegitimate, proto-criminal children on public funds. Barack Obama will inflame the public’s righteous anger against the corporate welfare queens who have raised a brood of profiteering executives and lobbyists in the generation since. Under Reagan and succeeding presidents, including Clinton, the K Street lobbying machine transformed Washington DC into a government by the lobbyists, of the lobbyists and for the lobbyists. Subsidies, market distortions, tax breaks, earmarks, selective protectionism, regulatory forbearance, cost-plus government contracts, relaxed accounting oversight, criminal and civil immunity, war profiteering and other policy depredations promoted a corporate welfare state beyond the dreams of ghetto avarice.

Ronald Reagan partisans demonised citizens who paid no taxes but claimed public housing, medical care and food stamps as their right. Barack Obama appears prepared to challenge corporations who pay no or nominal taxes (worth clicking through just for the graph) but claim government subsidies, earmarks and tax breaks as their right. Corporations have further stripped the US tax base by outsourcing or relocating jobs abroad, leveraged speculation rather than productive capital investment, and transfer pricing to avoid US tax. If Obama does parallel Reagan, both campaigns will tap a deep well of public anger against the perceived injustice of those who degrade the nation’s future prosperity while claiming too much from its taxpayers.

The bankers of Wall Street now toasting the Fed’s recent largesse from their Hamptons beach houses and yachts are the latest in a long line of American corporate welfare queens who have lobbied for and secured generous federal contracts, subsidies and regulatory forbearance. As noted two weeks ago in Looting the Vaults, more has now been lent to banks by the Fed under opaque new facilities than has been appropriated for the war in Iraq. Both the Fed’s new facilities and the war appropriations arguably benefit corporate welfare queens rather than serve the public interest.

The contrast between McCain and Obama on lobbyists alone is striking. Obama has banned contributions from lobbyists to his presidential campaign, even returning $500 donated by Thurgood Marshall, Jr. Instead, Obama has built a novel fundraising machine that reaches out to millions of working class Americans. McCain’s campaign relies almost entirely on wealthy contributors and lobbyists for finance. He has recently suffered a series of staff purges as high-ranking campaign officials - all of them lobbyists - were linked to large corporations and dictatorial regimes. Obama has committed to opening his fundraising events to the press pool. McCain insists on holding his fundraisers behind closed doors, no press allowed.

Obama as the presumptive Democratic nominee and party leader is preparing to drive the contrast home. Yesterday Obama enforced his opposition to special interest money on the wider party. Obama announced that from now on the Democratic National Committee will return cheques from lobbyists and political action committees, mirroring the Obama presidential campaign. This is a significant initiative in positioning the Democrats as the party to reclaim government from the corporate welfare queens.

The media pundits will use the reliable rhetoric of identity politics, religious strife, class war, patriotism and national security, but they are merely masking the fundamental policy conflict that divides the presidential candidates: Should government serve the people or the corporate elite? When Obama invokes Reagan, as he does very effectively in his elegantly crafted speeches, he is tapping the same vein of public outrage against a government promoting the comfort of those who contribute too little to the nation’s wellbeing.

A recession would clarify the public policy choices. When the economic pie is shrinking, fairness becomes a surer focus. The eyes of the hungry are watchful as the slices served get smaller.

Can Obama successfully challenge the K Street machine? He encourages us to hope, but we should be realistic. The K Street machine will not sit idly by as their unfettered control of the corporate welfare state is threatened by the upstart junior senator from Illinois who would not “wait his turn”.

Ghetto welfare queens were powerless to forestall the legislative and regulatory reforms that cut their subsidies. Corporate welfare queens are very far from powerless. We see new evidence of their power to claim public funds and direct public policy every day as the credit crisis closes off private finance options and squeezes profits. Whether the American public can elect enough reform-minded representatives to successfully challenge the corporate welfare queens may be the political test of this generation and may well determine whether the American economy recovers its powerhouse status.

Also on Thursday, Obama introduced legislation on the floor of the Senate to expose the corporate welfare queens hiding in the federal budget: The Strengthening Transparency and Accountability in Federal Spending Act of 2008 (pdf).

Is JP Morgan a welfare queen for the Fed subsidised Bear Stearns buy-out? Discuss.

Next week I promise to stick to economic and regulatory policy.


Post Script on 22/12/08:
JPM's paltry $37 billion subsidy from the Fed back in the Spring seems like chicken feed compared to the over $5 trillion the corporate welfare queens have looted from the Fed and Treasury since then. Worse, I am now sceptical that Obama will be any different to Bush in terms of restraining taxpayer largesse to corporate elites. He seems to endorse every bailout and stimulus, regardless of merit. We shall just have to wait and see what happens, but so far Obama is looking only marginally more fiscally sound than Bush.

Monday, 22 December 2008

Robert Paterson's Boyd 2008 Summary - Hope!

From Robert Paterson's blog on Boyd 2008:

* The goal for us all to work to is clear - that we have to build back into the system Resiliency. This means that each region has to work to become largely energy, food and financially self sustaining and that each region needs to network into the others. In effect we shift from an efficient machine to a resilient network

* That the leadership model is no longer the dominant hero but the ego-less servant

* That we cannot wait to be saved. We have to all do our part to make our place "Home"

Many are desperate that somehow President Obama save us and importantly turn the clock back. Take us back to consumer heaven of 2006. Even if he could, would this be the right thing to do? To take us back to a world that is a fantasy?

What got us to this place?

The Dark Side of a Mindset. The Machine/Institutional/Newtonian/Engineering Mindset that created most of the wealth of the 19th and 20th century tipped over into the dark side. Where not only did we give up all our power to institutions but gave the few that ran them the license to use these institutions for their own benefit.

So we spend nearly a trillion on defense but not on what the troops really need. We spend billions of health and America is on a par with Cuba. We spend billions on education and more than 50% of Americans are functionally illiterate. We spend billions on food and we eat crap. We see that the leadership of these institutions live in a bubble. The gap between the rich and poor has never been greater. The middle class is being squeezed. We don't make anything anymore. We make no progress toward energy independence.

Wednesday, 17 December 2008

Re-Post from 30/05/08: Famine Futures: Deregulated Markets and Food Insecurity

Originally published at RGE Monitor on 30 May 2008.

In a week when Hormel celebrates another surge in Spam sales, my preferred indicator of US food insecurity, it is appropriate to raise the market and regulatory failures that are driving global food insecurity.

Like so much that we have observed in the past eight years of the Bush administration, the origins of the current food crisis can be traced to the recycled policies of the Nixon White House. Henry Kissinger stated the premise succinctly in 1970: "Control oil and you control nations; control food and you control the people."

With credit, oil and food markets spiralling out of reach of the poor and straining the middle-class, it is worth exploring whether similar policies underpin similar problems. In each industry, a small handful of global companies control supply and a massive increase in ill-transparent speculation acting on pricing in exchange markets forces prices up regardless of the fundamentals of supply and demand. The risks for famine and political instability are huge. One doesn’t need to be a conspiracy theorist invoking the Trilateral Commission to feel that something is very wrong with policies leading to simultaneous crises in credit, oil and food that threaten not just the wealth but the wellbeing of most of the world’s population.

Two or three generations ago, most of us would have been directly involved in food production as a hedge against food insecurity. My parents’ generation kept a garden in the back yard, putting to me to work each summer to raise corn, tomatoes, cucumbers and other fresh foods for the table, sending me to pick berries and fruits in season from our own and the neighbours’ bushes and trees. My grandparents’ generation kept chickens as well as a garden behind their house in the middle of a large industrial city. The garden and chickens helped my mother survive the Great Depression at a time when my father suffered stunted growth from rickets. My great-grandparents’ generation were almost entirely farmers working the land.

Today global agriculture is dominated by eight multi-national corporations. The policies promoted by successive governments and international institutions including the IMF, World Bank and WTO have aimed at undermining local production, distributed commercial networks, and diverse local markets in favour of mass production, streamlined supply chains and concentrated global market pricing.

As with other areas of our lives, the policies of “free market fundamentalism”, as George Soros styles it, have not diminished risks but increased them. My children are hostages to food insecurity, as are yours and billions of others. A disruption in global food supplies or surge in prices that puts food staples beyond the reach of many low income or middle-class families cannot be offset from the back garden. The exposure of food to pricing in markets open to manipulation and excess speculation puts the lives of millions at risk.

Mack Frankfurter at Seeking Alpha has written a compelling review of how we got where we are.

The Commodity Conundrum: Securitization and Systemic Concerns (Part I)

The Commodity Conundrum: Securitization and Systemic Concerns (Part II)

The Commodity Conundrum: Securitization and Systemic Concerns (Part III)

Mr Frankfurter reviews the history of “securitized commodity products” and the development of commodities as speculative investments, distinct from their role in production and consumption within the economy. He suggests that something “systemic and possibly more insidious” has altered the benign role of speculators as providers of market liquidity and ties this change to the ill transparency of OTC derivatives arising from The Enron Loophole. I recommend reading the whole series.

We begin to see a pattern emerging. Free market policies and liberalised regulatory regimes promoted rapid concentration of a sector into a global oligopoly which could control supply. Free market doctrines and trade liberalisation enabled predatory targeting of markets to undercut domestic production and smaller producers, reinforcing the concentration of the market and the pricing control of the oligarchs. Free market ideologies and innovative financial derivatives promoted domination of market pricing mechanisms by speculative investors able to accelerate steep price gains regardless of supply and demand fundamentals.

Whether it is credit, oil or food, we are all going to suffer from bad policies which promoted free markets as risk reducing rather than risk enhancing. In the US and the UK we may hope that our food insecurity does not worsen to the point of riots, looting, political instability and the starvation of children, but many parts of the world will not be so fortunate. If there is a backlash against free trade, against free market doctrines, against the domination of big banks, big oil and big food, perhaps it will not be unenlightened but enlightened. Perhaps it is overdue.

We can live without credit. We can live without oil. We cannot live without food.

Credit and oil prices are also feeding the food price bubble. The Kansas City Fed highlighted risks confronting the agricutural sector from higher credit costs for infrastructure, fuel and margin calls on hedged exposures in its report Survey of Tenth District Agricultural Credit Conditions.

The role of market mechanisms and deregulation in fuelling the commodity price rises is coming under increasing scrutiny as the markets themselves now fail to meet their basic function of matching buyers and sellers of commodities.

Bloomberg News:

The divergence between CBOT futures and the underlying commodity is so great that some grain merchants have stopped bidding for new crops, said Niemeyer, a member of the National Corn Growers Association board. Others won't guarantee a price for more than 60 days. ''We have a fundamental problem with the markets,'' said Kevin McNew, president of researcher Cash Grain Bids Inc. in Bozeman, Mont., and a former Montana State University economist. ''It is very difficult to operate a grain business when the cash prices are below the futures'' by such a wide margin, he said. The price gap should converge when futures contracts expire and deliveries are settled. Instead, the average premium for CBOT wheat has quadrupled in two years to 40 cents a bushel, compared with 10 cents the prior five years, McNew said. For James McReynolds, who farms 2,000 acres of wheat outside Woodston, Kan., futures aren't worth the risk. ''The differential of what the market should be and what you can actually sell is so far out of line that you aren't willing to do it,'' McReynolds said. ''This is a tough situation. Agriculture is not as healthy as we'd like to think it is.''

One of the drivers of the Commodity Exchange Act of 1936 was a desire to have regulators responsible for ensuring that commodity markets serve the legitimate hedging needs of producers and consumers in the economy and not merely speculators. The Enron Loophole devastated regulation of commodity markets. Once again, legislators and regulators have failed to protect the public by discharging their mandate in favour of protecting the speculators who bid higher for influence.

Monday, 15 December 2008

Re-Post from 15/05/08: Looting the Vaults of the Central Banks

Originally published on RGE Monitor.

When I was a young central banker, we often spent our lunchtimes debating how best to rob our employer. Tempted by the thought of great mounds of gold ingots far beneath us in the third sub-basement, nestling deep in bedrock, we would speculate on the viability of various plans for plundering our nation’s store of wealth. The presence of sufficient security forces to defend a medium size city and enough steel around the vault for a battle cruiser only spurred our youthful imaginations. After some months of fantasy gold robbery, I began to assert to my colleagues that stealing the gold would be foolish as it would be impossible to get away with enough gold in city traffic to make the attempt worthwhile, and selling it in any sizeable amount would lead to instant detection. I argued instead in favour of stealing the wheelie bins of cash conveniently lining the hallway to the loading ramp. Cash would be faster and easier to steal and more liquid to spend than gold.

I see now that I was a central banker of very little brain – and lacking ambition. The way to rob a central bank efficiently is to be a bank executive so skilled in financial engineering that I take my bank to the edge of extinction. I can then swap all my unpriceable, illiquid, engineered credit instruments for good central bank cash and Treasuries. That’s larceny without risk, making the central bank a complicit partner in the looting of its vaults, and earning gratitude and bonuses instead of audits and indictments.

Since the credit crisis was first diagnosed last fall, the Federal Reserve has advanced more cash and Treasuries than the entire five year cost of the Iraq war – over $400 billion. It has plundered more than half its holdings of US Treasuries, taking impaired asset-backed securities collateral in their place. It has overseen the devaluation of the dollar to third world levels of instability and inflation. And all of this debasement has as its objective the re-financing of those bank and shadow-bank executives who have so looted their own institutions that they hold the global financial system hostage to their incompetence, malpractice and greed. Without consultation or review, the Federal Reserve was able to chuck out decades of transparency and accountability in favour of secret facilities, secret loans favouring secret beneficiaries of secret largesse.

The Term Auction Facility (TAF), the Primary Dealer Credit Facility (PDCF) and the Treasury Securities Lending Facility (TSLF) are all ill-transparent conduits funnelling central bank cash to bankers in the private sector free of oversight, audit or scrutiny. The recent liberalisation of collateral by the Fed means that it is now officially the market maker of last resort for securities which are unmarketable in the private sector.

And the creepy thing is that most of the establishment thinks the Fed is doing a great job. Because there will never be an independent investigation or audit, we will never know whether they are policy geniuses or criminally complicit accomplices. Perhaps it makes no real difference to either motivation or outcome.

Now the Fed wants powers to enable it to create even more credit to finance failure. It is said to be seeking Congressional authority to pay interest on bank reserves (via Forbes with a hat tip to Steve Waldman). While this might sound benign, especially in a modern era when American banks hold no non-borrowed reserves, the expanded powers are potentially very dangerous. Paying interest on reserves would permit the central bank to extend hundreds of billions more in TAF, PDCF and TSLF credit without the inconvenience of having to sterilise the monetary expansion through further sales of its increasingly meagre inventory of Treasuries.

Spies and weapons, whether real or imaginary, are asserted by the military-intelligence complex as justifying more spies and weapons. If no attack occurs it is because they are so efficient at protecting us and pre-empting many unpublished threats. If an attack occurs, it was because they were under-funded or over-constrained. In the same way, financial excess and bad credit have been used by the banking system to justify more financial excess and bad credit in a self-reinforcing loop of financial and supervisory indulgence and forbearance. If no crisis occurs, it is because there is a new paradigm and risk management models are more reliable. If a crisis occurs, it is because banks lacked access to adequate liquidity and were over-regulated. For too long the cycle has reinforced monetary laxity, permissive deregulation and regulatory forbearance on accounting and capital adequacy, with all accountability and market discipline excused by the need to forestall contagion and systemic failure.

Any crisis now accelerates the trend toward greater public laxity, private excess and central bank secrecy. A crisis, real or manufactured, is most useful to increase the amount of public money clandestinely extended and diminish public oversight and administrative review of outcomes. This has been the pattern for at least 25 years, and may continue for some time to come before a taxpayer or creditor revolt ends the American spiral downwards towards bankruptcy and corporate tyranny.

It used to be the realm of conspiracy theorists to assert that policy makers in Washington were aligned with the military-intelligence complex in promoting international conflicts for profit or that the Federal Reserve was the tool of Wall Street banks in promoting irresponsible bubbles. Now it is accepted policy, defended openly in the media as right and inevitable, as providing an efficient means for America to meet the “threats” to security and financial stability in a changing world.

The danger of embracing the spin is that the productive economy shrinks from underinvestment and distortions as an increasing share of a slower growing pie gets diverted to government and the cronies who direct government policies.

The thrift failures in the 1980s were followed by financial deregulation and increased mortgage subsidies, enabling the massive misallocation of credit and leveraging of balance sheets on an even greater scale. Further deregulation, forbearance, subsidies and bailouts can only lead to more frightening misallocation of scarce capital in zero-savings America and more fragile over-leveraged banks, but now presenting a danger of contagion to the rest of the world. It is the savings of the world’s productive economies funding American misallocation and excess, and the world’s poor that suffer the contagion of inflation from a devalued dollar.

Already the ECB and Bank of England have followed the Fed in extending good central bank funds against questionable collateral under rapidly liberalising lending facilities. While they appear slightly more resolute on prudential supervision and inflation-fighting, they are nonetheless compromised and constrained by the policies and practices of bankers and central bankers across the Atlantic. As American banks receive forbearance and largesse, the European banks shout, “Me too!”

Globalisation of banking and regulatory “best practice” was once seen as raising standards, but may be at risk now of lowering them. Just as Japanese zero-interest rate policy flooded the world with cheap liquidity from the carry trade, fuelling speculative bubbles and providing cover for low rates elsewhere, Federal Reserve forbearance and credit accommodation may flood the world with warped management incentives and credit distortions which pervert the banking sector and financial markets, undermining rationales for savings and productive investment.

Without transparency of central bank facilities and policies, there can be no accountability for misuse of public resources and abuse of the public trust. Transparency provides an essential check on bank mismanagement, even for central bankers.

When Bloomberg revealed this week that Ben Bernanke lunched with [JPM's Matt] Dimon at the New York Fed on March 11 with key Wall Street bankers just three days before the emergency $14 billion financing for Bear Stearns and five days before the sweetheart $30 billion financing of JPMorgan’s acquisition of Bear (again, the acquired assets the Fed received for the cash are secret), it made me very uneasy. Suspicious minds might think the public interest and integrity of market mechanisms, including the corrective of the occasional failure, weren't foremost in their discussions.

Whether cock-up or conspiracy, recent reforms set the scene for looting of the central banks on a scale never imagined by my younger self.


As some regulars to Professor Roubini’s blog will know already, I am a mere commenter on the blog who has been elevated to posting by invitation of the Professor. Having seen the list of new posters who will be joining us here, I can assure you that I am deeply honoured to be among them.

London Banker will continue to post anonymously. It permits me to be more forthright than I could be otherwise.

Despite being a poster, my commitment to this site is as a commenter, and I hope to see many comments from my blog buddies below so that we can continue the dialogue I have enjoyed on this site for so long.

Being new at this, I will also welcome ideas and guidance at londonbanker ( at ) btinternet.com.

Sunday, 14 December 2008

Re-Post from 23/05/08: Capital-ist Economies to Capital-less Economies

I'm going to cross-post early RGE posts that weren't published here over the coming week so I'll have all my writing up here somewhere for the record.

It's an interesting exercise in reviewing my perceptions from earlier in the year for me, and I hope for you too.


Originally posted on RGE Monitor.

A farmer who eats the seed corn over the winter must borrow to plant in the spring. He must repay the loan from the harvest, leaving him with even less to live on come the following winter if the crop does not yield a greater harvest. The misfortune of one bad harvest can start a cycle of decline that leads to permanent penury. Sharecropper plantation owners have exploited and impoverished sharecropper farmers on this principle for centuries.

Is it different for nations?

"It is the aim of good government to stimulate production, of bad government to encourage consumption." - Jean Baptiste Say

In the classical conception of economics, capital is the surplus of production over consumption. Only by consuming less than is produced can a person, or a company, or a nation accumulate capital for reinvestment, growth and continued prosperity. Capital cannot be borrowed, because borrowing implies repayment from the proceeds of the endeavour at a rate which – on the whole – precludes accumulated surplus.

A gambler might get lucky and make enough to both repay the debt and hold a surplus over his consumption, but gambling erodes investment discipline and prudence, and so over time proves a poor basis for economic management in the home, the boardroom or the Treasury.

A thief or con-artist might steal or defraud enough to repay the debt and hold a surplus over his consumption, but theft and fraud erode commerical confidence and invite retribution, and so over time prove a poor basis for economic management in the home, the boardroom or the Treasury.

A defaulter can simply refuse to repay the debt, and keep any surplus for himself, but defaulting erodes investors’ confidence and leads to bankruptcy, and so over time proves a poor basis for economic management of the home, the boardroom or the Treasury.

Borrowing implies risk, for both the lender and the borrower.

Somehow neo-classical economics was able to finesse this principle to convince a generation of consumers, bankers, regulators, legislators and investors that debt should be considered capital too, and that more debt than savings could be good for economic growth and prosperity.

For a time, the neo-classical economists appeared to have found a financial perpetual motion machine. As consumers, companies and governments borrowed more, they appeared to prosper more. Leveraging the accumulated equity in their homes, the consumers got bigger houses and bigger cars. Leveraging their fixed assets and future revenues, the companies got bigger balance sheets, bigger executive remuneration and bigger shareholder dividends. Leveraging their power of taxation and monetary creation, the governments got bigger militaries, bigger bureaucracies, bigger scope for patronage projects. The bankers intermediating all this debt got bigger too, with bigger bonuses for “loan origination”, bigger fees from M&A, bigger commissions and income from securities and derivatives dealing, and bigger influence with their supervisors to loosen any inconvenient accounting, reporting, audit, scope or expansion rules that might have impaired their freedom to keep the party going.

Free Market became the rallying cry of those who believed in perpetual motion. They passionately decried regulation as impairing the market’s freedom to allocate “capital” to the best likely return. They passionately decried taxes as diminishing the “capital” held by those who would reinvest it in growth. They passionately exhorted consumers, businesses and governments to borrow as much “capital” as they could possibly bear, and to err on the side of profligacy, so that more “capital” would be working to grow their revenues and balance sheets in the “free market”.

But the problem with this perpetual motion machine was that it was all the time grinding the seed corn. The “capital” it was pumping out was not the surplus of production over consumption, but the borrowed surplus of greater fools who believed in the hawkers’ pitch of perpetual motion and laid their meagre savings and accumulated assets on the barrelhead in faith the machine would return them multiplied.

The reality of the American, UK and other heavily leveraged economies is that we have eaten our seed corn and eaten the seed corn of those who have financed our profligacy. Over the past twenty-five years there has been a quiet conspiracy among those bankers profiting from the process to promote gambling, stealing, fraud and default as solutions to disguise the implications of a failure of perpetual motion.

Financial markets have morphed over this time from mechanisms for efficient allocation of scarce investment capital to promote greater production through rewarding foresight and diligence into casinos that reward those with a system that beats the unwary and beats the house. Leverage has been used to overcome bad judgement, rewarding those willing to risk more at the expense of the prudent. Modern markets have arguably never been less transparent, with fragmentation, off-exchange dealing, derivatives, structured finance, hedge funds and other ill-transparent innovations making it all but impossible for the average Joe Investor to assess activity and prospects with any confidence.

Companies were urged to borrow for sprees of mergers and acquisitions, and then either declare bankruptcy to shed their inconvenient pension liabilities or move production offshore to reduce expenditure on labour or both, emerging from these contortions as desirable prospects for more mergers and acquisitions. Any setback resulted in the generous retirement of one incompetent executive and the more generous appointment of another that would borrow the company into future prosperity.

Consumers and consumer finance companies were urged alike to feed the machine by overstating house values, overstating incomes, understating debts, juggling credit cards, and continually recycling any proceeds from the mania’s inflation of asset prices back into more accumulated debt through regular refinancing. Workers were forced to give any surplus savings from labour to the machine as mandatory pension contributions or cajoled into it through tax breaks on 401Ks and other ruses funnelling seed corn to the machine.

Governments were urged to finance wars, social welfare spending, police state intelligence technologies, infrastructure and excess, defaulting through loose monetary policy, defrauding through massaged official statistics, and deregulating the financial sector and capital markets when credit constraint threatened to stem the tide. A government that got into trouble was urged to "privatise" by leveraging or selling government assets, the seed corn of past accumulations, or to put services out to tender in the private sector so that they could pay more to receive less through the miraculous efficiencies of free market fulfillment of social needs. Any difficulty or disruption was overcome with tax breaks, subsidies and public underwriting of yet more debt creation - with mortgage interest deductions, corporate debt interest deductions, FNMA, FHLC and other ploys all feeding more seed corn to the machine.

All of this will someday unwind. It may be this year. It may be next year. It may be several years hence if central bankers can scrape together more seed corn from ever greater fools to keep the perpetual motion machine turning over. At some point, indebted societies must revert to the discipline of consuming less than they produce to repay their debts, or these societies will suffer the even worse consequences of the social dislocation and commercial disruption that follows gambling, theft, fraud and default.

Globalisation has allowed the bankers to hawk their perpetual motion wares to a wider pool of greater fools. This is a dangerous policy. Warren Buffett has long warned that as long as the US has major foreign trade deficits, it has to "give away a little part of the country" each year. He warned America was becoming a "sharecropper economy," where Americans largely work for foreign-owned firms – or governments. The profusion of sovereign wealth funds represents the rational diversification of states with surplus production over consumption – capital – to preserve that wealth through equity investment that unlike debt will be secure from the debtor’s attempt to inflate away his obligation through the expedient of monetary laxity. Owning equity means a permanent claim on American production. Like the sharecropper, foreign equity ownership implies permanent want and decline to penury for the borrower nation.

Worryingly, globalisation has increased the likelihood that debt will lead to political instability and international conflict. The wars for resource, long a “Great Game” but now increasingly a violent and expensive gamble, are only one outcome. Food riots and inflation encourage governments to resort to intervention and oppression. Internal economic decline and dissent reinforces calls to patriotism, theocracy and militarism over reason. Lately I find myself wondering if the “beggar thy neighbour” policies of the 1930s weren’t a result of a similar dynamic, following, as they did, a similar era of massively irresponsible bank-fuelled credit growth and deflation.

When I was young and in debt, an old mentor of mine enjoined me to pay off my loans and my credit cards and to never again “borrow for consumption”. Investment that would confidently yield a good return, such as buying an education in a profession or purchasing a home for the long term, could be financed, but a new TV or a holiday must always be earned and paid for from present income.

Strange to say, but his advice shocked me. I had grown up with debt. My parents were always in debt. My earliest memory of economics is my father explaining to me that he loved inflation because his salary would get bigger and his debts would get smaller.

Nonetheless, I took my mentor’s advice and have lived within my income, whether large or modest, ever since. Perhaps I have missed out on having a grander house, or a flashier car, or the trendiest gadgets, but I have slept remarkably well for over twenty years and feel confident of withstanding the challenges and profiting from the opportunities that the future may bring.


Hat tip to Capone (the blogger formerly known as JMa) for suggesting the title in his comment on Professor Roubini's blog on2008-05-13 14:39:49.

I've been given a regular Friday slot here on Finance & Markets Monitor. This allows us to carry on the chitter chatter over the weekend when the Professor's blog is quiet for the most part. There may be some weeks when I don't post, but the team at RGE now has enough depth that there will always be something worth reading here.

Friday, 12 December 2008

Deflation has become inevitable

For a while now I have been on the fence on the inflation/deflation issue – whether the massive monetisation of bad debts by central banks and governments will lead to rapidly escalating inflation as currencies are debased or, alternatively, lead to deflation as bad debts and illiquidity undermine all commercial and financial activity in the economy. I’m now coming down on the side of deflation for a very simple reason: there is no longer any incentive to save or invest, and so debt and investment cannot increase much beyond current bloated levels.

In Lombard Street, Bagehot’s seminal tome on fractional reserve central banking, Bagehot advises any central bank facing a simultaneous credit crisis and currency crisis to raise interest rates. By raising rates they will ensure that foreign creditors remain incentivised to maintain the general level of credit available while the central bank resolves the local liquidity crisis through liquidation of failed banks and temporary liquidity support of stressed banks.

The very opposite policies have been pursued by central banks in the US, Europe and UK since the beginning of the sub-prime crisis in August 2007. They have cut policy rates drastically, and as the crisis escalated and spread, the yield on government debt has dropped to negative territory. Meanwhile they have shielded those responsible for the creation of record levels of bad debt from any regulatory accountability, relaxed transparency of accounts, and provided massive taxpayer-funded financial infusions to prevent failure and liquidation.

While in the short term these policies have expediency and the maintenance of market “confidence” on their side, in the longer term these policies must undermine any confidence a rational and objective saver or investor might have that savings or investment in the US, EU or UK will be fairly remunerated at an above-inflation rate, or that savings and investments will be protected by effective oversight and regulation from the sorts of executive debasement and outright misappropriation and fraud that are beginning to colour our perceptions of the past decade.

Anyone sitting on a pile of cash now is unlikely to want to either (a) place it in a bank, or (b) invest it in the stock market. As a result, the implosion of the financial and real economy must continue no matter how big the central bank’s aspirations for its balance sheet or the treasury’s aspirations for its deficit.

If US, EU and UK had substantial domestic savings to fund their banks (as in Japan in 1990), then perhaps the consequences would not be so imminently disastrous. Lacking sufficient domestic savings, however, their actions will likely make foreign creditors in Japan, China, the Gulf and elsewhere question whether it is worthwhile to keep pumping scarce savings into such flawed and reckless economies.

During the reckless boom years, savings collapsed in bubble economies as retail and commercial and financial actors alike chased speculative yields with greater and greater leverage. During the reckless bust years, savings will collapse further as retail and commercial and financial actors chase safety by hoarding their meagre remaining assets from further erosion by refusing to lend at negative returns and refusing to finance failed corporate and investment models that only enrich poltically-connected management and intermediaries.

The determination to avoid any accountability for failed banks, failed business models, failed regulatory systems and failed academic rationales for all the above invites anyone with spare cash – an increasingly select crowd – to withhold it from further depredations. It is this instinct, more than confidence in the government, which is driving so many to seek the temporary safety of short-dated government securities.

The result of discouraging domestic and foreign creditors and investors must be inevitable deflation as debt levels become increasingly hard to finance and ultimately contract. Irresponsible central banks and governments can try to bail out the failed banks, businesses and municipalities at the centre of every popped bubble, but the bubble economies are ever more certain to deflate with each bailout. Each bailout further undermines the market discipline which is bedrock to a saver or investor’s decision to part with hard-earned cash by trusting it to the intermediation of the management of a bank or business.

It’s this simple: I won’t invest in a country that bails out failure and punishes savers. I won’t invest in the US or UK until they change course and protect savers and investors, ensuring a reasonably predictable positive return. In the EU, I will be very selective, preferring those conservative states like Germany that never embraced the worst excesses, although sadly still have fall out from individual banks' stupidity in buying into foreign excess. I will know when it is safe to reinvest when policy interest rates, bank/intermediary oversight and accounting standards give me confidence I am better protected than the corporate or financial elite.

While it may take the Asian and the Gulf State investors longer to embrace my analysis, I have no doubt that they too will eventually conclude that parting with their savings under the terms now on offer will only deepen their losses. They would be better off keeping the money at home, investing locally under local laws and vigilance, and letting the US and UK implode.

The argument against this has always been that with trillions already invested in the US during the deficit years, the Chinese and Gulf States would suffer even more horrible losses from a collapse of the western economies. This is accurate, but not complete, as it ignores the relative value of cash investment at the top and bottom of a bursting bubble. Once the collapse has bottomed out, so long as a globalised economy survives, there will be even better opportunities for those with savings to invest selectively in businesses with clearer prospects and more certain profitability under regulatory frameworks which have been restored to a proper balance of investor protection and intermediary oversight.

Right now survival of businesses in the West depends largely on political pull and access to regulatory forbearance and central bank or treasury finance. The market has failed, and officialdom is collaborating in perpetuating that failure.

Should the western economies implode in deflation, however, there will be new opportunities to return to market-based policies that reward effective, efficient management and punish corrupt, debased management. Until that happens, those that invest will continue to lose money. Once deflation is exhausted, then those that invest can expect to make and retain profits again.

I think it took me so long to feel confident about predicting deflation because the floating currency system under dollar hegemony and Bretton Woods II distorts the workings of both inflation and deflation. Despite the US being the epicentre of all the failed debts, failed securitisations, failed credit derivatives, failed rating agencies, failed banking businesses, failed corporate governance, failed accounting standards, failed capital adequacy models, and failed regulatory forbearance, the US dollar has recently strengthened as deflation globalised. The US exported inflation in the boom years, and now exports deflation in the bust years.

Since spring 2008, as US investment banks sold off assets, imposed margin calls, and used access to unsegregated wholesale assets in custody in the rest of the world to upstream liquidity to their US-based parents and affiliates, the dollar has strengthened relative to other currencies. The media reports this as a “flight to quality”, but it is more like a last looting of the surrounding countryside before dangerous brigands hole up in their hilltop fortress. The brigands appear temporarily wealthy compared to the peons left stripped and penniless and facing winter. When the brigands have eaten all the stolen grain and livestock, however, they will have no means to replenish except to use force to raid the countryside again. The peons can always hunt, forage, farm and carefully husband a surplus to gradually increase their wealth. If the brigands raid too thoroughly or too regularly, the peons have no incentive to grow crops or keep herds (negative savings returns) and everyone starves (deflation).

In the meanwhile, the peons just might wise up, hide any surplus more securely and organise mutual defense against further attacks to ensure that their peon children prosper and the brigands die off. That would be the end of Bretton Woods II, and the rise of China, India, the Gulf and other productive and/or resource rich states which invest surplus in domestic productivity and regional growth.

I reread my piece on Fisher’s Theory of Debt Deflation in Great Depressions the other day. One of the more confusing aspects is his assertion that the dollar “swells” as debt deflation takes hold. What he meant, of course, is that deflation increases the quantity of assets and the likely investment return each dollar purchases as deflation wrings debt and misallocation of capital out of the economy.

It is now clear to me that policy makers in the West are determined to apply every available resource to underpinning failure, misallocation and executive excess. As this discourages the honest saver from parting with cash, policy makers are ensuring that deflation will wreak its havoc on the financial and real economies of the world. Only when that deflation has played out and rational policies that reward market-based management and returns are restored will it be worthwhile to invest again. In the meanwhile, any wealth saved securely from state seizure will "swell" to buy more assets in future - a key aspect of deflation and a key means of restoring the control of the economy into the hands of more farsighted savers and investors.

I have quoted Mr John Mill before, but it bears repeating: ““Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.” The extent to which capital has been betrayed in the past quarter century under Bretton Woods II, bank deregulation and the Basle Capital Adequacy Accords is unrivalled in the history of fiat banking. The bankers, lawmakers, regulators and academics who collaborated in the betrayal still hold power, like the well-armed brigands in the fortress, and their continued collaboration to prevent accountability must inevitably discourage honest savers from risking further loss. Even so, it is the savers/peons who hold the ultimate power as they can starve the brigands.

Some day soon savers will revolt at financing further depredations. They will refuse to buy even government securities, gagging at the quantities of issue forced upon them under terms of only negative return. When that final massive bubble bursts, deflation will follow its harsh corrective course and clean out deficit-financed “unproductive works”.

When that happens, if reason is restored in markets with effective oversight, I might consider investing again, very selectively, in whatever productive works might then be on offer and only when secure in realising - and retaining - a positive yield.


Apologies for not posting last Friday.

Writing for this blog has been a great experience, forcing me to refine my views about current events and the principles which should underpin financial market interactions and supervision. In parallel, I have been forced to re-evaluate whether I should commit to sorting out some of the practical aspects of the future of banking in the global economy. Writing takes a lot of time and passion, and these are limited commodities for any of us.

I have accepted a full time executive position which will take all of my time and passion going forward in 2009, so the blogging has to be suspended at year end. The job will enable me to put into practice the principles I’ve illuminated here, hopefully mitigating some of the impacts of financial instability. I’ll still lurk, and maybe comment on Professor Roubini’s thread from time to time.

Wish me luck!

Friday, 28 November 2008

What We Value Is What We Save In a Crisis

“When a woman thinks that her house is on fire, her instinct is at once to rush to the thing which she values most. It is a perfectly overpowering impulse, and I have more than once taken advantage of it. . . . A married woman grabs at her baby; an unmarried one reaches for her jewel-box.”

-- Sherlock Holmes from A Scandal in Bohemia, by Arthur Conan Doyle

When a central bank thinks its house is on fire, it too will rush to save the thing valued most. In the United States, the central bank has rushed to save the bonuses and dividends of its Wall Street clientele by hiding away the bad assets that can no longer be foisted on gullible investors. In Europe too the response of central banks has been to save the wholesale banking and securities industry rather than the consumers and businesses underlying the real economy’s longer term productive strength.

For a comparative of what is valued elsewhere, it is worthwhile to look at what is being saved. I received in my inbox yesterday documents outlining the efforts being taken by the Hong Kong and Chinese authorities to address the liquidity crisis in their respective jurisdictions. They are available online here (Hong Kong) and here (PRC). The contrasts with the West are striking, and humbling.

Hong Kong is swiftly introducing a scheme to guarantee credit to SMEs (small and medium enterprises) and exporters. China is introducing controls to limit bank credit to over-extended speculative sectors, accelerate rebuilding in the regions affected by the earthquake earlier this year, and promote improvements in local infrastructure, education and economic adjustment.

Holmes would have been disgusted by a married woman who grabbed her jewel-box in preference to her baby. In the same way, I am disgusted by the central banks preserving the privileges of the financial elite in preference to the jobs, incomes and businesses powering the real economy. The US and UK authorities may criticise the banks for their inaction in freeing up lending to commercial businesses constrained by the credit crunch. The Hong Kong and Chinese authorities are implementing guarantee schemes and innovating initiatives to rapidly address the problem.

As Holmes would have considered a child’s life worth more than jewels, I consider the workers and businesses in the real economy as meriting greater protection than the financial elite. It is not merely that I think the financial elite little better than criminals for their irresponsible excesses of recent years, but that I fear long term harm and political instability will come from neglecting the needs of the real economy.

Shortsightedness is a peculiar affliction of the Western economies. We cannot seem to project the consequences of our actions beyond the next quarterly report, fiscal year or - at most - election cycle. Eastern policy makers have a capacity for longer vision – and longer memory – which makes them appreciate sooner the potential consequences of bad policy. Perhaps this is a consequence of the longer term dedication required to gain political ascendancy in their less cyclical heirarchy.

That China's leadership is concerned with the implications for the real economy – and political stability – was confirmed this morning in an unusually blunt public statement by the chairman of the National Development and Reform Commission. From the Financial Times:

The downturn in the Chinese economy accelerated over the past month and could lead to high unemployment and social unrest, the country’s top economic planner warned on Thursday.

Zhang Ping, chairman of the National Development and Reform Commission, said the government needed to take “forceful” measures to limit the slowdown in the economy, which included Wednesday’s large cut in interest rates and a sharp increase in fiscal spending. The rate cut was the fourth since September.

“The global financial crisis has not bottomed out yet. The impact is spreading globally and deepening in China. Some domestic economic indicators point to an accelerated slowdown in November,” Mr Zhang said on Thursday at a rare news conference.

Mr Zhang’s warning about the potential for social unrest as a result of factory closures underlined the mounting concern in Beijing about the fallout from the global financial crisis.

“Excessive production cuts and closures of businesses will cause massive unemployment, which will lead to instability,” Mr Zhang said.

As Jim Rohm observed, “Failure is not a single, cataclysmic event. You don't fail overnight. Instead, failure is a few errors in judgement, repeated every day.”

The crisis in debt markets has been rolling since the sub-prime collapse of August 2007. The increasing illiquidity of commercial paper, trade credit, municipal finance and other debt markets was foreseeable and inevitable. And yet the central banks and treasury authorities of the Western nations have done nothing to shield these essential sectors from the ill effects of the financial sector implosion while giving virtually unlimited funds to the banks authoring the collapse.

Any discussion of China always invites criticism of its anti-democratic governance. It is worth remembering that the philisophical defense of democracy lies in the proposition that it is more likely over time to serve the interests of the electorate than a system which disenfranchises the people from the determination of their leadership. If the democratically elected governments - through their appointed executives and central bankers - are free over an extended timespan to ignore the interests of the people, then how is a Western democracy superior to a Chinese bureaucracy? From looking at the policies and practices of the past year, the merits of Western democracy are not immediately apparent in ensuring that policy responses to the financial crisis are aligned with the interests of the people. Even over the past decade, it is not clear that the policies of the democratic Western governments have aimed to strengthen and broaden the economy to benefit of the electorate rather than a narrow, self-serving elite.

According to Brad Setser, the World Bank is projecting increases to China’s trade surplus in 2009 as falling commodity prices lower production costs. Those unelected bureaucrats are doing something right.

If China and Hong Kong recover sooner, prosper more, and gain global political and economic authority in consequence, it will be because they made fewer mistakes and made them less persistently than their Western counterparts. If the promoters of democracy want to strengthen their case, they might best do so by ensuring that their leadership adheres to policies which promote the longer term health and well being of the economy as a whole rather than the short term enrichment of an undemocratic elite.

Friday, 21 November 2008

Dollar Strength Sustainability

Coincident with the passage of the Paulson Plan in early October, the top prime brokers (MS, GS, JPM) issued margin calls on hedge funds which raised the average margin required from about 15 percent to about 35 percent. At a time of fragility in global markets and global confidence, this was equivalent to the sudden contraction of global market liquidity by a trillion dollars or so. A huge sell off in quality assets followed as hedge fund managers struggled to meet the margin calls.

Because hedge funds are unregulated, and prime brokerage credit isn’t well reported for aggregation, there is no obvious way to compile exact data. Nonetheless, it would be rational to assume that simultaneous global margin calls on a vast cross-section of hedge funds would have a dramatic effect on global markets. Hedge funds accounted for well over half of all market transactions in 2007, so are a huge driver of maket trading and liquidity.

Trillions of dollars of value were wiped off the balance sheets of the world’s investors over the next few weeks as forced selling forced prices lower and lower. Adding to the selling pressure, many hedge funds were simultaneously raising cash for redemption demands of investors also squeezed by margin calls by their creditors.

I’m sure none of this was intentional (wink, wink). I’m sure there was no coordination among the prime brokers (nudge, nudge). I’m sure it would never occur to anyone in the Wall Street prime brokerage banks that manipulation of leverage could create profitable trading opportunities (cough, cough).

The result was a collapse in global prices for equities, debt and commodities. FIRE SALE! Everything must go!

As the margin calls got met, the dollar strengthened. It strengthened hugely against the pound. From $2 to the pound earlier this year, Sterling has slid to below $1.50. This is likely because there are such a lot of hedge funds and private equity funds here in London, all struggling to meet their margin calls in New York.

At the same time, we observed a huge expansion in the monetary base as the Fed doubled its balance sheet and Paulson doled out taxpayer largesse to Wall Street. The banks began to accumulate massive reserves and Treasury yields crashed lower, especially at the short end. Treasuries gained value as the prime brokers parked the incoming margin cash in the safest, most liquid asset - the primary collateral for all interbank obligations too. These reserves and Treasuries are just sitting in the Fed and not contributing one iota to the stimulation of the economy.

All of this is interesting recent history. Now what happens when some of these trends reverse?

What happens to the global markets when the deleveraging stops? What happens when there are no more global margin calls on the surviving hedge funds? Will anyone want to buy dollars when they don’t need them to repay dollar debt?

Will there still be inflows to US Treasuries when few need a place to park cash for short term liquidity? What will prop up demand for the Treasuries then?

What happens when banks begin to use reserves to lend or speculate in the now crashed assets available globally at fire sale prices?

With most of the growth still projected to occur outside the USA, will some of those Treasuries be sold to take advantage of the many equity investment deals on offer? How will that affect the dollar?

We are observing huge swings in asset markets. We are observing huge swings in foreign exchange markets.

I’m not going to make any recommendations, but I predict we haven’t seen the end of volatility. The rapid rise of the dollar, the massive demand for Treasuries, are hugely convenient for the US Treasury as it finances the expansion of the Fed balance sheet and the giveaways to the corporate welfare queens on Wall Street and elsewhere in the last days of the Bush administration. It seems unlikely, however, that the conditions can be long sustained.

When they reverse, we may see a fair sized bounce in global equity markets, a loosening of credit conditions in global debt markets, a revaluation of commodities, and a revaluation of the mighty dollar. Many will call the bottom and pile back in.

I wonder how long that will last . . .

Hat tip to FTAlphaVille where the team gives me much to think about every day and the analysis of trends is superb. Picks for this week include:

M3, where are thou?

Fill your boots!

Dollar *danger* ahead

Friday, 14 November 2008

Systemic Risk, Contagion and Trade Finance - Back to the Bad Old Days

Back in the old days (pre-1980s), the term systemic risk did not refer to contagion of illiquidity within the financial sector alone. Back then, when the real economy was much more important than low margin, unglamorous banking, it was understood that the really scary systemic risk was the risk of contagion of illiquidity from the financial sector to the real economy of trade in real goods and real services.

If you think of it, every single non-cash commercial transaction requires the intermediation of banks on behalf of – at the very least – the buyer and the seller. If you lengthen the supply chain to producers, exporters and importers and allow for agents along the way, the chain of banks involved becomes quite long and complex.

When central bankers back in the old days argued that banks were “special” – and therefore demanded higher capital, strict limits on leverage, tight constraints on business activity, and superior integrity of management – it was because they appreciated the harm that a bank failure would have in undermining the supply chain for business in the real economy for real people causing real joblessness and real hunger if any bank along the chain should be unable to perform.

As the “specialness” of banks eroded with the decline of the real economy (and the migration globally of many of those real jobs making real goods and providing real added-value services to real people), the nature of systemic risk was adjusted to become self-referencing to the financial elite. Central bankers of the current generation only understand systemic risk as referring to contagion of illiquidity among financial institutions.

They and we all are about to learn the lessons of the past anew.

We are now starting to see the contagion effects of the current liquidity crisis feed through to the real economy. We are about to go back to the bad old days. Whether the zombie banks are kept on life support by the central banks and taxpayers of the world is highly relevant to whether the zombie bank executives pay themselves outsize bonuses and their zombie shareholders outsize dividends with taxpayer money. It appears sadly irrelevant to whether the banks perform their function of intermediating credit and commercial transactions in the real economy along the supply chain. The bailout cash and executive and shareholder priorities do not seem to reach so far.

The recent 93 percent collapse of the obscure Baltic Dry Index – an index of the cost of chartering bulk cargo vessels for goods like ore, cotton, grain or similar dry tonnage – has caused a bit of a stir among the financial cognoscenti. What is less discussed amidst the alarm is the reason for the collapse of the index – the collapse of trade credit based on the venerable letter of credit.

Letters of credit have financed trade for over 400 years. They are considered one of the more stable and secure means of finance as the cargo is secures the credit extended to import it. The letter of credit irrevocably advises an exporter and his bank that payment will be made by the importer's issuing bank if the proper documentation confirming a shipment is presented. This was seen as low risk as the issuing bank could seize and sell the cargo if its client defaulted after payment was made. Like so much else in this topsy turvy financial crisis, however, the verities of the ages have been discarded in favour of new and unpleasant realities.

The combination of the global interbank lending freeze with the collapse of the speculative, leveraged commodity price bubble have undermined both the confidence of banks in the ability of a far-flung peer bank to pay an obligation when due and confidence in the value of the dry cargo as security for the credit if liquidated on default. The result is that those with goods to export and those with goods to import, no matter how worthy and well capitalised, are left standing quayside without bank finance for trade.

Adding to the difficulties, letters of credit are so short term that they become an easy target for scaling back credit as liquidity tightens around bank operations globally. Longer term “assets” – like mortgage-back securities, CDOs and CDSs – can’t be easily renegotiated, and banks are loathe to default to one another on them because of cross-default provisions. Short term credit like trade finance can be cut with the flick of an executive wrist.

Further adding to the difficulties, many bulk cargoes are financed in dollars. Non-US banks have been progressively starved of dollar credit because US banks hoarded it as the funding crisis intensified. Recent currency swaps between central banks should be seen in this light, noting the allocation of Federal Reserve dollar liquidity to key trading partners Brazil, Mexico, South Korea and Singapore in particular.

Fixing this problem shouldn't be left to the Fed. They aren't going to make it a priority. Indeed, their determination to accelerate the payment of interest on reserves and then to raise that rate to match the Fed Funds target rate indicates that the Fed are more likely to constrain trade finance liquidity rather than improve it. Furthermore, the Fed may be highly selective in its allocation of dollar liquidity abroad, prejudicing the economic prospects of a large part of the world that is either indifferent or hostile to the continuation of American dollar hegemony.

If cargo trade stops, a whole lot of supply chain disruption starts. If the ore doesn’t go to the refinery, there is no plate steel. If the plate steel doesn’t get shipped, there is nothing to fabricate into components. If there are no components, there is nothing to assemble in the factory. If the factory closes the assembly line, there are no finished goods. If there are no finished goods, there is nothing to restock the shelves of the shops. If there is nothing in the shops, the consumers don’t buy. If the consumers don’t buy, there is no Christmas.

Everyone along the supply chain should worry about their jobs. Many will lose their jobs sooner rather than later.

If cargo trade stops, the wheat doesn’t get exported. If the wheat doesn’t get exported, the mill has nothing to grind into flour. If there is no flour, the bakeries and food processors can’t produce bread and pasta and other foods. If there are no foods shipped from the bakeries and factories, there are no foods in the shops. If there are no foods in the shops, people go hungry. If people go hungry their children go hungry. When children go hungry, people riot and governments fall.

Everyone along the supply chain should worry about their children going hungry.

When that happens, everyone in governments should worry about the riots.

Controlling access to trade finance determines who loses their jobs, whose children go hungry, who riots, which governments fall. Without dedicated focus on the issue of trade finance and liquidity from those in the emerging world most interested in sustaining the growth of recent years, little progress can be expected.Trade finance is rapidly communicating the stress on bank liquidity to the real economy. It presents a systemic risk much more frightening than the collapsing value of bits of paper traded electronically in London and New York. It could collapse the employment, the well being and the political stability of most of the world’s population.

The World Trade Organisation hosted a meeting on trade credit in Washington Wednesday to highlight the rapid and accelerating deterioration in trade finance as an urgent priority for public policy.

I look at the precipitous collapse of the Baltic Dry Index and I wish them Godspeed.

Further reading:

WTP warns of trade finance ‘deteriorating’ amid financial crisis

Cost of some trade finance deals up sixfold – WTO

Shipping holed beneath the water line

Shipowners idle 20 percent of bulk vessels as rates collapse

Friday, 7 November 2008

The Fed doubles its balance sheet - above $2 trillion in just 5 weeks

Think about that. If any commercial or investment bank had been seen to do that, it would become an instant leper in the credit markets. It is a truism that banks go bust by writing business that wiser banks rejected, and so grow their balance sheets faster. As a young bank supervisor I was told that the surest way to spot a potential bank failure was to look for outliers in asset growth.

Had anyone at the Fed or FSA been brought up in the old school, they would have seen Countrywide and Northern Rock coming a mile off. Perhaps they did, but in the new Friedmanite culture of forbearance and free markets, and Basle II risk models, they decided to let capitalism run its disastrous course rather than take unpopular decisions about constraining the prerogatives of over-compensated executives and shareholders.

And now we have the Fed doubling its balance sheet in just five weeks. It is exactly by taking on the assets of the banking sector that are otherwise unmarketable that the Fed has grown its balance sheet. And it is by doing this while indulging the banks in continued oversized dividends and executive bonuses that leads me to believe the policy must ultimately fail to either correct the problems in the US banking sector or sustain the credibility of the Federal Reseve as a prudential supervisor and lender of last resort.

Dallas Fed President Richard W. Fisher has speculated that the balance sheet could expand to $3 trillion by January:

“You can see the size and breadth of the Fed’s efforts to counter the collapse of the credit mechanism in our balance sheet. At the beginning of this year, the assets on the books of the Fed totaled $960 billion. Today, our assets exceed $1.9 trillion. I would not be surprised to see them aggregate to $3 trillion—roughly 20 percent of GDP—by the time we ring in the New Year.”

At the same time the Fed has equalised the interest it pays on reserves deposited in the Fed and the Fed Funds target rate. That undermines any incentive to interbank lending, virtually ensuring that banks will prefer to hold their cash as reserves at the Fed rather than as lending exposures to one another. On the other hand, according to a Fed research note from August, it allows the Fed to supply greater liquidity for market needs without the risk of pushing lending rates below target rates.
In contemplating the anomalies of this policy, it occurred to me that it might be aimed at reinforcing the dollar by drawing reserve balances to the Fed in preference to other central banks as they follow the Fed by cutting rates this week. Perhaps the Fed is pre-emptively combating dollar capital flight, or perhaps it is a further extension of the "ring fence" tactic of drawing assets to the US in contemplation of future insolvencies to secure advantage for US creditors over global peers.

As Sam Jones at FTAlphaVille commented yesterday:

There’s a big danger here for the Fed: that it is trying to catch a falling knife. The Fed is risking things it’s never risked before. That’s not to say we’re in apocalyptic territory at all; consider the firepower the Fed has behind it. It is though, to use a hackneyed, but apt phrase, paradigm shifting.

In Japan, where quantitative easing failed, the central bank’s balance sheet swelled to a size equivalent to 30 per cent of GDP. The Fed’s balance sheet is currently equivalent to 12 per cent of GDP.

This is uncharted territory for a central bank of a reserve currency. I suspect, however, that these moves play into the strategy of the Paulson Plan survivor bias. As someone reminded me recently, Mr Paulson's primary objective at Goldman Sachs was to outperform peers in both good times and bad times. If profits were to be made, he wanted Goldman to have more of them. If losses must be booked, he wanted Goldman to have less of them. He seems to have taken the peer outperformance strategy global with the Paulson Plan.

Hat tip to FTAlphaVille for posting relevant Fed insights yesterday and today:

The mother of all balance sheets

Fed capitulates: the central bank is broken

Change I can't quite believe in

I wanted Obama to win. I really, really, really wanted Obama to win. McCain/Palin gave me nightmares. Just about the whole world held it’s collective breath willing Obama to win on Tuesday.

Obama’s election is powerful confirmation that America remains a land of opportunity, a democracy where power is allocated at the ballot box. It reassured the world that despite the lawlessness and arrogance of the past eight years, Americans are capable of enlightened, rational self-determination. It restores hope in much of the world that America can reorient itself toward tolerance and dialogue.

For all of that, I haven’t been happy since watching Obama’s acceptance speech live Wednesday morning on the BBC.

I have a bad feeling that America has just elected its Tony Blair. The package of Change the voters ordered isn’t what is being delivered to the White House.

The appointment of Rahm Emanuel as White House chief of staff didn’t ease my mind. Like Mr Blair’s close advisors Lord Goldsmith and Baron Levy, Mr Emanuel may inflame the suspicions in the Middle East that the agenda for the region under Obama will be no different than under Bush. The credibility of the United States as an honest broker and agent for peace will be further eroded if Obama’s gatekeeper is viewed as pre-disposed to more of the same policies which have fuelled hostilities. I hope it is not anti-Semitic to make the point that objectivity and fair dealing will be suspect with a chief of staff who is the son of an militant Israeli, who served as a civilian volunteer for the Israeli Army, and who has used his public positions in American politics – except for a brief stint at Dresdner Kleinwort Wasserstein – to promote Israel’s interests.

Those who know Mr Emanuel suggest that because his devotion to Israel is unquestionable, he will be able to push Israelis toward moderation. Perhaps the combination of a Kenyan goat herder's son with an Irgun terrorist's son will be a winning combination for crafting a durable peace. But many in Israel, the Middle East and Washington will expect that future acts of aggression by Israel against Iran or other neighbours will be defended – if not promoted – by the man at Obama’s elbow.

It is now emerging that Mr Emanuel was also a director of Freddie Mac when it stands accused of misreporting profits and ignoring red flags.

The rumours that either Larry Summers or Tim Geithner will be made Treasury Secretary made me even queasier. The appointment of either of these architects of the current global financial disaster, these arch-deregulators and serial-forbearance artists, would be a great middle-finger to America’s foreign creditors and the global investors suffering asset deflation. Both men have been instrumental in, first, the Fed’s exported inflation via massive monetary bubble-blowing and, now, the Fed/FDIC/SIPC exported deflation through Chapter 11 and margin call orchestrations ensuring more pain abroad than at home.

Summers would be particularly egregious. Not only did Summers promote the Friedmanite export of toxic debt to the rest of the world at the Clinton Treasury, at the World Bank he promoted the export of toxic pollution to underdeveloped nations to add poison to poverty. To quote from his 1991 memo, "I think the economic logic behind dumping a load of toxic waste in the lowest wage country is impeccable and we should face up to that."

The much bandied idea that Robert Gates, former deputy director of the CIA under President G.H.W. Bush, architect and financier of Saddam’s military machine and Bin Laden’s Al Qaida, might be kept as Secretary of Defense under Obama “for continuity’s sake” after six years of failed and callous military adventurism in Iraq and Afghanistan, with occasional illegal forays into Pakistan, Georgia, Syria and Iran, makes me frankly nauseous. If America is ever to restore its fiscal balance, cuts in the bloated military/security/intelligence apparatus will have to be implemented. A career insider central to the creation and export of the bloat is the wrong man for the job.

Maybe the problem in America is not a struggle between rich and poor. Overtaxed and undertaxed. Empowered and disenfranchised. Educated and illiterate. Insured and uninsured. Law abiding and lawless. Godless and God-fearing. Republican and Democrat. Red and Blue.

Maybe the problem in America is there is no struggle about the fundamental mechanisms of American oppression and aggression: debt and threat.

American policies promote debt and force as the hammer and anvil for shaping the economy and the political dialogue. What cannot be financed into penury must be crushed into submission. The bulk of the economy is designed to prosper either the bankers or the police/prison/military/intelligence industries at everyone else’s expense. Propped up on these twin pillars of debt and threat, America remains staunchly and irrevocably American whoever wins the elections.

The restoration of fiscal prudence has been swiftly repudiated post-election in favour of more debt-financed “stimulus” and “stabilisation”.

The restoration of the rule of law and holding those who committed crimes accountable – both within America and internationally – has received no post-election endorsement from Obama.

I asked the asylum Iraqis at the local kebab shop last night what they made of the American election. They follow the news, and I’ve always found them knowledgeable and articulate. The kebab chef (a former civil engineer from northern Iraq) looked glum. “It makes no difference. They are all the same.” I fear his well-informed cynicism is sound.

Our unglamorous and unelected British prime minister, Gordon Brown, called for more international cooperation “with American leadership central to its success” – as he toured the Arab Gulf with his begging bowl. He was physically following American “leadership” as he trailed Deputy Secretary of the Treasury Robert Kimmet’s pilgrimage to the Gulf last week. American leadership got us successfully into this debt crisis, and Brown appears determined to follow it even deeper.

The central banks in the UK, EU and Switzerland obliged yesterday by following the Fed toward negative real interest rates, discouraging savers and lenders alike by cutting 150bps, 50bps and 50bps respectively. Jean-Claude Trichet spoke of the cooperation of the central banks as a “brotherhood”. He made me think of the mafia or the Freemasons. Perhaps he meant to.

Obama’s election still inspires me. I still hope for change.

Obama demonstrated good judgement throughout the campaign, and good management of the people working for him. That in itself will bring major change to the White House.

Better managed American debt and threat policies under Obama will be an improvement over the horribly managed debt and threat policies under Bush. Some hope.

Friday, 31 October 2008

Byways and Tribal Capitalism

I have been indulging in leisure again. For nine days I backpacked along the ancient Ridgeway, the superhighway of Neolithic Britain and a trade route into the modern era. Starting about 6,000 years ago, (roughly the time Sarah Palin imagines Adam and Eve holding hands in a newly wrought Eden) the Britons occupying the plains either side of the Ridgeway were settling the river valleys to raise crops and herd animals. As the crops and herds increased, and the Iron Age and Bronze Age opened trading opportunities in new technologies, these Britons took strides that set them and their heirs on the road to market capitalism.

The road they followed is the road I walked – the Ridgeway Trail.

The Ridgeway is a geographic feature of Jurassic and Corallian limestone, an 87 mile long spine of rocky downs running through Southern England from Ivinghoe Beacon in Buckinghamshire to Overton Hill, near Avebury in Wiltshire. It was linked by other routes to ports in the South and on the Channel. The Ridgeway was admirably suited as a commercial highway in early times because the limestone was porous, draining rain away from the high pathway to the plains below. When the tracks below were impassable mires of mud for man and beast, the Ridgeway remained a quick and easy road from one region to another. Being high, with excellent views down the slopes and over the plains, it was also possible to detect and defend against brigands who might beset unwary travellers, with ring forts provided to secure travellers and goods along the route.

Neolithic Britons were secure enough to form large agrarian tribes, planting and harvesting grains and herding sheep. They were prosperous enough to have excess grain and sheep to trade for iron and bronze tools and gold jewellery and other valuable trade goods. They were economically advanced enough to have specialisation, with certain tribes and regions known for their skill in producing iron or bronze or pottery. They were politically advanced enough to have organised militias, with a ‘warrior aristocracy’. They were wise enough to promote collective security and agree byways for safe passage with neighbouring tribes to enable commerce along the Ridgeway.

The Ridgeway reminded me every day we walked along that it is infrastructure, transparency and mutually-enforced rules which secure and grow markets for productive capitalism. Infrastructure provides a common framework for trade to take place. Transparency allows those trading in markets to evaluate each other’s wares and defend against brigands who might wish to ambush the unwary. Rules of safe conduct and fair dealing promote the confidence which encourages those with excess production to bring it to market to trade for their present and future needs. Mutual enforcement ensures that the temptation of any tribe to loot its neighbours is curbed by the risk of finding itself precluded from the trade routes and from access to markets.

I imagine that like many small, agrarian, tribal states, England of the pre-Roman period was organised into settlements relying on militias with only small dedicated military elites. This arrangement, as exists in modern Switzerland, allows the civilian militia to contribute most of its energies under secure conditions to increasing production, growing the surplus which sustains collective prosperity. Although a professional military or ‘warrior aristocracy’ can be useful in providing skilled leadership, if that military gets too large, or the aristocrats too greedy, the incentive to produce a surplus is removed and tribes tend to weaken, grow poor and fail. Prosperity and security require a delicate balance in the social contract.

The Ridgeway also reminded me that prosperity invites looting by aggressors. By the Roman era, England was producing a large enough surplus to be exporting across the Channel, with trade goods from as far afield as the Mediterranean. This has been substantiated by findings of pottery, jewellery, coins and other goods in early Celtic settlements.

It was the prosperity of England as a grain exporter that led Julius Ceasar to covet it for the Roman Empire.

A professional military demands a large production surplus from the civilian population to sustain it. The state expropriates the surplus production and provides it to the military. If the military can secure more resources and more production to the state, the expropriation can increase prosperity of its tribe – or at least the elite that commands it. But if the military fails to secure more resources, then the expropriation from those producing a surplus will gradually erode the incentive to produce a surplus – leading to decline and increasing poverty and political strife.

Ceasar understood that securing the large agricultural surplus of England to finance and feed his armies would help underpin the military strength of the Roman Empire. Naturally, the Romans secured and settled the most prosperous agricultural regions. As a result, there are Roman traces along the Ridgeway – improvements to the roads, the forts, and the commercial links to market towns and ports on the coasts. We walked Roman roads last week too - straight, raised and solid even 2,000 years later.

Following the Romans, the Danes, the Angles, the Saxons and the Normans invaded and occupied the same lands. Throughout the changing political and ethnic mix of tribes and elites, the Ridgeway continued to function as a trade route through prosperous middle England.

Modern markets could usefully reflect on the durable Ridgeway model of market infrastructure. Transparency of assets – whether sheep or shares or CDOs – is critical to the effective function of markets for price discovery and investment. Those who have secured a surplus are unlikely to risk taking their wealth to a market where assets are not open to inspection and proper valuation. Security of trade routes and market towns for merchants and traders is essential to encourage those with a surplus to bring it forward, promoting effective allocation of assets and underpinning growth in production. Mutually-enforced rules of conduct, fair dealing and safe passage are key to building a reputation that attracts both buyers and sellers and ensures a sustained market prosperity.

The modern ‘warrior aristocracy’ could usefully reflect on the fate of societies that deplete the incentives to surplus production and fail to secure commensurate returns from a costly military. Whether a Neolithic tribe, a Celtic settlement, the mighty Roman Empire or the Soviet Union, history proves that a tendency to excess expropriation by the state undermines any incentive to investment and surplus production. Excess expropriation will ultimately weaken the economy supporting the elites and the professional military that secures their privileges and interests.

As the global elites meet in the coming weeks to address the current economic crisis, they could do worse than contemplate the lessons I gleaned from the Ridgeway. Those who provided poor transparency, promoted dishonest market practices, looked the other way or collaborated in the robbing of passing merchants and investors, and otherwise violated the precepts embodied in the Ridgeway model should be held accountable for their failings. The global model going forward must return to the principles embodied in the ancient stone backbone of English commerce.


The Ridgeway (Wikipedia)

The Ridgeway National Trail

Neolithic, Iron Age and Bronze Age Britain (BBC)


Congratulations to Rich H (Miss America) who was to cover for me last Friday and instead secured his own position in the RGE blogroll.

Friday, 17 October 2008

We had to burn the village to save it

The title of this diary is a quote from the Vietnam era that sums up for many the arrogance and pointlessness of American aggression in Asia two generations ago. It keeps coming to mind each time I read President Bush’s (paraphrased) statement this week: We had to nationalise the banks “to preserve the free market.”

There is no free market when the government owns the actors and sets the terms of transactions. There is no village once it has been burned to the ground.

The collapse of the financial sector is unacceptable. It is unacceptable to bankers who have vested careers, status and equity wealth in the disproportionate expansion of the financial sector. It is unacceptable to politicians who have risen to high office doing the bidding of the financial sector in ceding progressively more generous taxpayer subsidy and regulatory forbearance to its chieftains.

And so in the US, UK and EU we have politicians appropriating more petrol to hand to the arsonists who started the conflagration which is consuming our economic and political fabric. The regulators whose forbearance is a root cause of the current conflagration are handing the arsonists fresh zippo lighters. The policies adopted in these debtor nations will fail, must fail, because they destroy what remained of market economies. In the meanwhile, however, the bankers and the politicians and the regulators cannot conceive of failure and so insist on more of the same – ordering hundreds of billions in more incendiaries to fuel the blaze. The same tax breaks. The same housing subsidies. The same regulatory forbearance. The same ill-transparent, off balance sheet, accounting sleight of hand. The same eradication of market incentives to productive, disciplined saving, investment and labour.

Those who would prudently save will be punished with negative real interest rates and asset deflation. Those who would prudently invest in productive industry will be starved of scarce capital and forced into liquidation. Those who would prudently labour for a decent wage will be slowly robbed by inflation and kept docile by the threat of unemployment.

There can be no more iniquitous alliance than to have the politicians at the service of the bankers, unless perhaps it is to have the military at the service of the bankers too. The US seems to have committed itself to this worst of all possible combinations, with Congressmen threatened by the imposition of martial law if they failed to acquiesce to the Paulson Plan. Thankfully the British and EU militaries are too small and ineffective to be leveraged into a similar threat to global or domestic peace and security.

Subsidised banking seems a faster method of going bust than military adventurism, but the two together will see the US bust even more certainly. The $700 billion appropriated for the Paulson Plan and the $840 billion extended in parallel by the Federal Reserve last month are together more than three times the expenditure on US wars for the past five years. The federal borrowing requirement for 2008 is now in excess of $1.02 trillion, and for 2009 is now estimated between $1.5 and $2 trillion.

Such hyperbolic growth in the fiscal deficit and debt is unsustainable, even with such very tolerant creditors as the Japanese, Gulf Arabs, Russians and Chinese. They can see that each dollar added to the Fed’s balance sheet is tinder for burning those already held or denominated in their reserves. They can project the curve forward. At some point, they must react and restrain further debasement of their reserves and investments, either by collectively raising the prices charged for the resources and products they export, the interest charged on existing and future debt, or the forced exchange of debt for equity ownership of real economic assets.

Or all three.

The cycle of debt deflation is just getting rolling. The banks were only the first bailout and already the federal deficits are ballooning unsustainably. What will be the recourse when municipalities and states face default through catastrophic tax and revenue shortfalls? What will be the recourse when large commercial employers, industries and infrastructure confront failure from collapsing consumption expenditure? What will be the consequence when unemployment, homelessness, political disaffection and crime are resurgent and threaten the political fabric?

We are at the end of the beginning. Hank Paulson has played a clever game for the past decade of exporting dodgy paper to the US creditors abroad while forcing a middle class subsidy of the tax exempt corporatists at home. Now he plays a clever game of devaluing all currency and paper assets, exporting the pain to foreign taxpayers and investors. But this is not a game that America can win without the debasement of everything America once represented as holding value in its formerly prosperous market economy.

In my experience, there is nothing so permanent as a temporary expedient. It is hard to see how partially nationlised banks will ever be more than the means of political redistribution of wealth and power, and so corrupt both the economy and political system.

We had to burn the village to save it.

Perhaps someday we will hear a remorseful Mr Paulson or Mr Brown echo Robert McNamara, early architect and aggressive propagator of the Vietnam War: “We were wrong, terribly wrong.”


I will be out of touch for most of the next nine days, but will check in as and when I can. There may be a guest blogger here next Friday who I'm confident will be enthusiastically received, if he accepts.