Goldenfreude? how about Bankenfreude

Cheer if you will Goldbug bashers, but I suspect if Gold starts another swan dive, it won't be alone.  There may even come a time when you wish Gold would rise.

"Triumphalism," Paul Krugman opined in a 1997 New Republic article, "presents its own problems." Under the, dare I suggest, ironic headline, Superiority Complex, Mr. Krugman completed his thought: " though the "American model" has scored some important successes, it continues to fail in other respects, above all in generating an ever-increasing level of inequality. And we won't begin to address those failures if the national mood remains dominated by self-congratulation." He closed the article with sage advice for his readers: "The truth is that nothing in the experience of the last few years contradicts the idea that we could have a kinder, gentler economy that preserves the main virtue of the American system--high employment. All it would take is compassion. And a little less gloating."

Compassion, and a little less gloating might also help Mr. Krugman understand, rather than mock, Goldbugs- a label which, contra Krugman's caricature thereof, denotes a group exhibiting a very wide range of economic/investment views- while they are nursing their recently suffered monetary wounds. I imagine for every gold hoardin', gun totin', doomsday preppin' angry white male proclaiming the end of the world (they annoy me too),there's at least one confused, upset and perhaps unemployed person who's fed up with Wall Street's "head's I win, tails you lose" investment strategy, (or one, like myself, who believes structural reform-blocking rigidities in the developed world won't be overcome easily leaving only 2 eventual paths for excess liquidity, inflation or default). Those confused and unsettled Goldbugs, having witnessed a succession of bursting investment bubbles at home and more recently read about bank runs abroad might, not without justification, have decided to save in Gold, rather than a bank, or his mattress.

Mr. Krugman, alas, is not gloating alone over Goldbug's recent misfortunes. One clever soul coined the term Goldenfreude to describe his state of mind. Joe Weisenthal proclaims, EVERYONE Should Be Thrilled By The Gold Crash- a view echoed by Felix Salmon. Barry Ritholtz leavened his disdain for Goldbuggery with a sliver of compassion, I do not want to engage in Goldenfreude — the delight in gold bugs’ collective pain — but I am compelled to point out how basic flaws in their belief system has led them to this place where they are today. Gold, he avers, has no fundamentals and those who buy are engaging in the ultimate greater fool trade.

While living in SE Asia during their late 90s crisis I witnessed first hand one of Gold's great virtues- when a nation's banking system, and almost always coincidentally, currency, comes under pressure Gold holds its value. The haircut recently forced on Cypriot savers was far less than that inflicted on Gold by the market. In other words, despite recent declines I'd rather be holding Gold in Cyprus than waiting in an ATM line to withdraw my daily allotment of currency.

America, the gloaters might retort, is not Cyprus. No, it isn't, and I (casting off one aspect of Krugman's Goldbug caricature) sincerely hope we don't find ourselves in their financial straits. My bet is that such can only be avoided by further monetization AND, in the absence of rapid real sector productivity gains which don't exacerbate income inequality induced domestic tensions (unlikely given right wing intransigence on welfare state expansion or a domestic Modest Proposal a la Swift), wage and price inflation.

"A ha," Krugman, beating his gloating compatriots to the punch, would likely argue, "you Goldbugs are always talking about runaway inflation. Didn't you read my recent article mocking your inflation worries thusly: "But the runaway inflation that was supposed to follow reckless money-printing — inflation that the usual suspects have been declaring imminent for four years and more — keeps not happening."

I agree, and the absence of broad based inflation given the stimulus in an environment of limited structural reform outside the developing world is my concern. I suspect if Mr. Krugman would stop gloating, it might be his too (more on this below).  If the recent decline in Gold signals, as many gleefully hope, a decline in inflation expectations, might the US, and, I suspect, other mature industrial economies (Europe and Japan) be drawing ever nearer to a stall in growth followed by a liquidity crunch?

Consider this potential catalyst for the Gold crash. "Macroeconomic stimulus," said a US Treasury FX Report chiding Japan for the recent, now reversed, Yen slide, "...cannot be a substitute for structural reform that raises productivity and trend growth." We'll return to structural reform momentarily after a look at market reaction. The Yen's rapid recovery following this report's release was coincident with the Gold crash- perhaps both price adjustments represent market belief that inflation games (currency debasement either externally or internally) won't be tolerated.  With austerity the rage in European policy circles (we aren't far behind in that regard, thanks to the Republicans), competitive devaluation verboten and Gold signalling, to the cheers of many, declining inflation expectations, I'd be surprised if yet another liquidity crunch isn't around the corner.

Factors Behind the Forecast:  Structural Rigidities and Over-Leveraged Finance

Despite recent record profits, the US financial system, still dependent on a few highly leveraged (how else to achieve such profits in a low interest rate environment) TBTF banks, is far from stable. Many mortgaged home-owners are still looking up at the zero-equity line. Those cheering the absence of inflation simply, it seems to me, because such makes Goldbugs look stupid, might want to consider that in a highly leveraged economy, the cascading defaults of deflation- the "it" Bernanke assured us wouldn't happen here- always loom in the background.

Cheer if you will Goldbug bashers, but I suspect if Gold takes another swan dive, it won't be alone. As we've seen over the past few days, Gold price declines are mirrored to various degrees by oil, other commodities, and equities. Declining prices, if such becomes the trend, will lead to higher unemployment and, amplified by the former, declining house prices and rising foreclosures. In the teeth of such an event, some might be yearning for the days when Gold was rising and inflation was assumed. I'll admit, such a scenario favors the dollars-saved-in-a-mattress strategy rather than Gold ownership but both tactics are anti-investments ridiculed by Goldbug bashers.

The elephant in the room for the Goldenfreuders is the lack of structural reform in the developed world- an omission perhaps due to a focus on high frequency and exclusion of low frequency economic factors. Structural reform, for those unfamiliar, refers to changes in the capital structure (factories, transport systems, education programs, agricultural methods, etc.) that hope to produce more for less. China's rapid economic growth over recent decades is, in large part, an effect of these reforms such as the shift, in 1978, from communal to industrial farming.

Significant structural reforms are often resisted.  Consider the resistance some individuals display when asked to eat less, drink and smoke less, and exercise more.  Note, "when asked."  Change is much easier (but not guaranteed) when it's wanted.  Consider, for example, the rapid adoption of computers and cell phones.  I doubt even severe coercion could have done half as much in twice the time.  Fortunately the benefits of these new technologies were readily apparent and despite some resistance by, e.g., book store owners to Amazon, those individual losses were smaller than the aggregate productivity gain.  Those productivity gains created an environment where jobs were plentiful, further easing stress caused by the destruction economic creation usually entails- agriculturalists rarely coexist harmoniously with hunter gatherers but they produce more food per acre meaning, if the latter adapt to the new system, both groups can survive.

In cases when reform calls for the destruction of wealthy industries with government ties, substantial legal changes, or labor downtime and re-education for a significant portion of the work-force (especially in the absence of a decently funded welfare state), resistance can effectively block what would likely be widespread productivity gains.  Pre WWII rail transport in continental Europe seems a case on point.  International disagreements over railway standards and routes (an example of structural reform-blocking rigidities) kept the continent from reaping the productivity gains a fully connected rail system promised- and delivered, after a devastating war cleared away both dissent and, sadly, large chunks of the old rail system.  Expanding on von Clausewitz for the modern world (which finds the more apt term, political-economy, too archaic) war is not just politics by other means but economics by other means- the worst means, in my view.

Structural reform-blocking rigidities are, in a sense, other words for productivity sapping rent seeking- e.g. from a bottom up perspective, Luddites breaking machinery or US autoworkers striking to avoid being replaced thereby, and from a top down perspective, trade barriers (tariffs) or de jure monopolies (Britain's BBC prior to 1955).  Profits and Investments in rent seeking industries, particularly when higher productivity methods are known and feasible, tend to be misdirected from entrepreneurial activity (why make a better or cheaper widget when it's cheaper to bribe a competition stifling official?).  Bribery doesn't seem to me a very economically productive activity although it obviously benefits some while irking others.

For an example of a structural rigidity overcome consider recent changes in US law which reduced regulations on where and how (think fracking) petroleum products can be extracted.  Fracking has changed N. Dakota from a deficit to a surplus state and driven unemployment to near zero.  Before you send me a nasty-gram, I'm not arguing such is an unalloyed good- insufficient profits are likely flowing to those who have been and certainly will be negatively affected (this is no environmentally neutral practice).  I'm merely pointing out the positive economic benefits thereof.

To digress for a moment, first with an apology to the economically literate for the rudimentary and likely (to some) unsatisfactory treatment of these issues and second with further explanation thereof: the ideological (and physical) battle between communism and capitalism over the past two centuries is the battle between productivity and people.  In my view, productivity is most effectively and durably enhanced at an imaginary "sweet spot" between radical laissez faire (think Ayn Rand) and communal ownership (Marx).  Transfer payments, whether private (charity) or public (government welfare) are, in my view, necessary to ensure social cooperation within the capitalist framework.  Domestic dissent is a sign that transfer payments are, whether as a result of insufficient funds or inefficient distribution, not performing their function.  Labor dissent in many developed economies (Occupy and austerity protests in America and Europe respectively) suggest to me a hopefully solvable but currently intractable transfer payment crisis.  The pendulum has swung too far right which isn't meant to obviate calls therefrom for greater transfer payment efficiency.

Cheers for the Gold crash sound to my ears like cheers for austerity in Europe and further dismantling of the welfare state in the US. If Japan needs inflation now, don't we as well? Perhaps we too should join the Euro? and give up our right to buy time with inflation?

I'll close with a look at another structural reform-blocking rigidity whose removal might justify a moment of schadenfreude. The phrase "Too Big To Fail" speaks to a de jure monopoly of sorts for those protected banks.  Potential competitors were blocked from taking over business which would have looked elsewhere for financial services absent government support.  Competition was stifled and the public debt increased.  I believe, but for delusional faith in the virtues of these institutions (more below), a less costly, competition enhancing solution could have emerged from the crisis of 2008 and resolving that rigidity would have eased tensions between labor and capital. 

Consider: Would current budget negotiations in the US be so contentious in the absence of the recent bail-out and additional debt incurred?

Returning to the delusion, TBTF banks remind me of Alchemists wasting labor and resources trying to turn lead into gold, or, more accurately, trying to squeeze more profit out of trade than trade generates.  Finance, at best, facilitates trade. In practice it records, analyses, calculates and communicates. What Amazon did to the local book merchant a similar company (or 5 or 20) can do even more effectively to finance.  Surely networked computing should decrease the cost of finance for the rest of the economy. 

On the bright side, the presence of rigidities suggests greater future productivity upon their resolution, although it would be tragic if such resolution comes via violence rather than diplomacy.  I believe a new cooperation enhancing agreement between labor and capital is possible.  Given the European example, I believe American energy efficiency can be increased.   As noted above, I believe American financial efficiency can be greatly enhanced through the dissolution of TBTF. 

When that happens I'll suggest a new word- Bankenfreude- and might even indulge in some myself.  I'll swap my Gold for currency and put it back in the game.  Until then, I'll remain a Goldbug.

Full disclosure (if it wasn't obvious) I own gold.

Imagine There's No Credit Market: Another Look At German Controls

Imagine there's no credit market
It's easy if your try
John Lennon (if he'd lived long enough)

[Money] is a machine for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it: and like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order. J.S Mill

Centuries ago there were these things called markets. At the end of a harvest farmers would take their produce to a common area and (hopefully) exchange their goods for other goods or money. In some cities remnants of this history still exist, like civil war battle re-enactments. We call some of these "farmer's markets".

Over time, the word, "market" was applied to any process wherein people exchanged things, even if there was no designated place to meet and most of the exchanges were done by proxy. Thus we use phrases like "credit markets", for instance, which, unlike today's farmer's markets, don't exist. There is no common place to go when one has savings one wishes to lend to meet up with borrowers and haggle over terms.

If I told some friends the financial capital of the nation was allocated in Narnia, Middle Earth or Hades, they might think I needed some time in a rubber room. Yet I could tell the same people the financial capital of the nation is allocated in credit markets, and seem wise despite the fact that Narnia and credit markets are both simply mental constructs. They don't exist.

One of Ludwig von Mises' great contributions to Economics was his focus on human action as the quantum of economics. Aggregates (like GDP), averages (like median income), and credit markets (like the US bond market) are mental constructs, nothing more. When people talk about the US economy, for instance, they are talking about an idea, for such a thing does not exist.

We, humans, exist (sidestepping valid, but for our purposes, irrelevant philosophical issues). We live, breathe, eat, sleep and act, and in so doing, we change the world, which also exists, and are changed by it. This idea we call "an economy" is a construct we imagine to be composed of the actions of millions of people, making, working, buying, selling, and saving.

Confusion over this key point is rife. Politicians talk about saving the economy and speculators talk about freeing the markets, but neither exists to be saved or freed.  People all over the world think their investments are worth what a bunch of intermediaries say it is worth, instead of what it eventually returns.

A general sense is seemingly shared by many- when an aggregate measure (GDP) expressed in currency, mind you, not tons of steel, bushels of wheat, etc. of a non-existent construct (the US economy) rises, times are thought to be good. It seems to me, however, there is no time but our time, lived individually, not collectively. The economy to each of us is the sum of our actions conditioned by the sum of all others'.

I had the above points in mind while devising yesterday's model of a grain market with speculators. Instead of conceiving of it as a motion picture- a series of frames projected faster than the human eye samples, thus creating an illusion of continuous motion, or reality- I focused on the frames, which, in the case of markets, are transactions or exchanges.

I wrote that the model could be used for any exchange and as I've gotten some requests, here's the model applied to monetary exchanges, what we call credit markets.

As in our grain market model, there are producers, consumers and middle-men. Producers have money, consumers want money, and the middle-men bring the two together. The producers lend their money to consumers in hopes of future repayment plus some profit, what we call interest. As in our grain market model, profits are allocated based on individual transactions. Usually producers lend their money to middle-men who, in turn, lend it to consumers.

Let's imagine a farmer who had such a bumper crop he ended up with 2000 pieces of silver. Let's imagine a town administrator who wished to borrow 2000 pieces of silver to pay workers to build a bridge over a nearby river and thus increase tax revenue during the local market season. The administrator bets he can collect an extra 2100 pieces of silver during next year's harvest market.

In a small town, the administrator might visit the farmer and agree to borrow his silver and repay it next year plus 100 pieces in interest (not a bad deal as the taxes would be collected each year the bridge was still working). In a larger town, the farmer might bring his money to a bank, and the banker might lend it to the administrator and take, say, 30 pieces of silver for his trouble.

As in our grain market model, the middle-man/banker doesn't increase the total profit of the transaction, nor does he decrease the risk the bridge won't be completed and tax revenues won't be collected. If the administrator defaults on his obligation, the banker is still obliged to repay the farmer, from his own pocket, if need be, or he goes out of business (unless, of course, he's a TBTF banker who gets government to impose an additional tax on citizens to pay for his errors in judgment).

In the above model, the banker provides "liquidity" to the farmer, borrowing his money at a rate somewhat lower than he believes he can lend it to the administrator. Today, hordes of commercial paper and bond traders do exactly the same thing. Perversely, their liquidity providing actions, as they trade with each other waiting for a new producer with money to lend, or consumer, wanting to borrow it, has come to be called "credit markets" when real credit market action only occurs when new money is lent.

Thus, when people speak of "rescuing the credit markets" they really mean to say rescuing the liquidity providers who failed to assess lending risks so profoundly they can't make required payments. When people talk of German restrictions killing the credit markets, they really mean killing the middle-men (which may or may not have a deleterious effect on government borrowing).

German restrictions on certain types of equity and credit transactions are not aimed at reduced government borrowing. They are aimed at reducing the amount (and means of capture) of profit "earned" by middle-men in the transaction- profits, mind you, as per our model, in the case of government borrowing, come either as a result of the money's original owner getting less interest than a direct deal would generate, the government paying more interest (which only comes from higher tax revenues) than a direct deal would generate, or some combination thereof.

Like all markets, credit markets create nothing (which I suspect, is a big problem with naked CDS, from whence do the profits come in the event of default?), they merely distribute.  As per J.S. Mill, their purpose is increased efficiency of a task that would otherwise occur.

If all of the TBTF banks were put of business tomorrow by government decree, and forced to distribute whatever capital and deposits they could, there would still be people with money willing to lend, and borrowers willing to borrow (most likely at rates far higher than are apparent today).

Some might argue such would be the end of the credit markets, which, leaving aside debate over the termination of a figment of one's imagination, might not be such a bad thing.

Let's play along with John Lennon and imagine no market for government bonds. Let's imagine a government, like mine in the US, which, instead of announcing an auction of $113B in 2-year notes to be mediated by direct dealers (there's a neat contradiction in terms) simply lists its borrowing needs and potential terms on an internet site, which willing borrowers could view and perhaps post their desired terms. These days, an auction program could perform most of the same functions the direct dealers do- putting together sellers and buyers- at a small fraction of the
cost.

There are, of course, some things auction programs can't do, like sell toxic debt at low rates to unsuspecting people, but we might not really miss that.

Some eager bond traders would likely argue the above scenario would lead to more volatile interest rates. I agree. Prices of exchanges like the above would be much more responsive to current events. Countries like Greece would have gotten a much earlier warning of trouble ahead, which, in hindsight, seems a good thing.

In sum, liquidity providing actions of "credit market" middle-men has run amok. As per J.S. Mill, that credit markets are exerting a distinct and independent influence of their own means they are out of order. With increasing frequency, credit is mispriced or unwisely extended and liquidity, the raison d'être of these people, dries up when it is needed most. Yet the middle-men who fail in their tasks expect to be rescued from their failures, and given even more ways to profit from lending other people's money, while the pool of available savings shrinks.

Sad.

p.s. In one sense I'm quite happy about all of the financial sector bail-outs governments have provided these credit-market middle-men. Before the bail-outs, one had to argue that finance was like a tax on monetary exchange, now this point is clear, finance is, in fact, a tax- and a growing one at that.

Merkel Does Mahathir and Martin Luther: Tilting the Market Table

In theory, free markets provide "just" prices or a level market table and thus allocate profits such that all market participants are willing to exchange goods freely. This is the basis of the division of labor in a free economy. In practice, speculators are finding they can tip the table as well as any government or church, thus inspiring an increasing unwillingness to play their game.

In 1998, Malaysian Prime Minister, Mahathir Mohammed imposed capital controls ostensibly to protect Malaysia from speculators like George Soros. Then as now (with respect to German controls, also ostensibly to ward off speculative attacks) the financial press was full of quotes proclaiming the foolishness of such actions. The Church of Free Capital is, apparently, a dogmatic church- nation-states, according to the creed, have no right to impede the flow of holy money, or alter the terms of trade.

The Church of Free Capital's creed states that prices set by market speculators (i.e. big finance) are, in a sense, divinely inspired, leading to the best outcome. That big finance has been taking home an increasing share of decreasing profits has not shaken faith in the creed among speculators, but it has angered capital providers in Germany sufficiently to provoke a protest and policy schism.

This isn't the first time Germany has protested the policies of a major Church. Interestingly, both protests, in a sense, included the imposition of capital controls.

Roughly five hundred years ago, a monk named Martin Luther sent a list of complaints- the 95 theses- to his Catholic superiors. His main complaint was about indulgences, whereby a Catholic could buy redemption from sin. "Why does the pope," Luther argued, "whose wealth today is greater than the wealth of the richest Crassus, build the basilica of St. Peter with the money of poor believers rather than with his own money?"

Back then, the Renaissance Popes were rebuilding Rome. Men like Michelangelo, Bramante and Raphael were paid to work on St. Peter's Basilica (inter alia) with money raised, in part, from the sale of indulgences to northern Europeans. Germany, then as now, wanted to keep their money. Whether the current schism in capitalism becomes as widespread as the former schism in Christianity remains to be seen.

I, for one, think the Church of Free Capital is overcharging for its services about as much as the Vatican was then. To their credit, at least the Vatican left something for posterity. We'll have to wait and see if the Church of Free Capital leaves anything to posterity besides broken dreams.

Returning to Malaysia, by the time (15 months after the crisis hit Thailand) Mahathir imposed his controls in September 1998 (about which, more here, and here), the Ringgit had already lost about half its value vs. the US$. That is, most of the capital that could and wanted to flee the Asian crisis had already fled. Thus, I suspect, Mahathir imposed capital controls hoping to avoid "punitive" speculation, since he was about to put his second in command, Anwar Ibrahim, a favorite of Western Financiers, in jail.

One wonders, to the extent the analog holds, what surprises Germany has in store for the Free Capital faithful. Perhaps, alternatively, Germany is simply trying to ensure that profits made on any future EU bond issues remain in Europe, or at least accrue to EU bond holders.

I'm very interested in Germany's policy shift because it's the first time in decades a mature industrialized nation has protested the allocation of profits decreed by financial orthodoxy. At core, German bans of "naked" (held by those who don't own the securities) shorts, paraphrasing Ms. Merkel- perhaps unsurprisingly the daughter of a Lutheran Minister- stops people profiting from the destruction of their neighbor's house at cost of less liquidity in the restricted markets.

In a sense, the policy shift is akin to a theoretical banning of naked shorts, such as occurs in the futures markets, by grain speculators. In theory, grain speculators, by providing liquidity- more potential contract prices than would occur in a simple point of sale transaction- in grain markets, help producers (farmers) and consumers exchange goods more efficiently.

In practice, grain speculators charge producers and consumers a fee, in the form of speculative profits, to provide price liquidity. If the fee is small, producers and consumers will find that additional efforts, such as spending more time at market finding people willing to deal at their preferred price, cost more than the additional profits so produced. Additionally, speculators take on risks producers (who want high prices and thus fear a bumper crop) and consumers (who want low prices and thus fear a lean harvest) might wish to avoid. Importantly, speculation neither increases total profits nor decreases total risk, it merely distributes them differently.

For example, imagine a farmer who produces 5,000 bushels of wheat (one CBOT contract), a wheat speculator, and a bread maker willing to buy the wheat. Imagine the farmer's costs of production and transportation come to $3.50 per bushel while the bread maker can sell bread profitably so long as he can buy wheat below $5.25. Let's assume our speculator's costs come to $0.05 per bushel. Each bushel of wheat then provides a profit opportunity of $1.70.

Ideally, the farmer sells his wheat to the speculator for $4.20 and the speculator sells the wheat to the bread maker for $4.55. The farmer makes $0.70, the bread maker makes $0.70 and the speculator makes $0.30.

Sometimes, producers or consumers try to tilt the trading table their way. Farmers might get government to put a floor on prices, say at $5.00, and keep more of the available $1.70, which will eventually piss off the bakers. Bakers, alternatively, might get government to put a ceiling on prices, say at $3.75 and shift the profits their way, which will eventually piss off the farmers.

A third scenario, closer, I suspect, to the way things work now, might look something like this. Speculators, after getting government to bar farmers from speaking directly to bread makers, manipulate prices lower early in the growing season and scare farmers into selling their wheat at $3.75 and then manipulate prices higher late in the growing season forcing bread makers to pay $5.00. Under that scenario, the farmer and break maker split a $0.50 profit evenly while the speculator walks away with $1.20.

Over time, the third scenario leaves both farmers and bread makers short of capital and forces them to borrow from the speculator to make necessary capital improvements. Eventually, barring a revolution, the speculator owns both farm and bakery and has to manage disgruntled employees on both ends, which likely leads to both less wheat and inferior bread.

Hopefully, the above thought experiment explained some of the important work markets do in providing prices. When they work well, primary producers and secondary manufacturers both find it profitable to produce, and middle men are rewarded for managing the transaction risks. However, when the table is tilted too far in any participant's favor, the whole system, which requires willing cooperation from all for optimal results, risks deterioration.

The above model can be used to examine any market transaction, even government debt finance. German controls, in effect, reduce the share of profits (if any) of such borrowing going to middle men. We'll soon see if the service provided by those middle men was worth the cost.

500 years ago, the Germans defied orthodoxy and ushered in a revolution which moved the center of Europe from South to North. They are defying orthodoxy again, and I can't wait to see what happens next.

Brilliant Quants Beside Us and Their Perfect Quarter

In a sense, brilliance is like a fast computer with lots of memory, it can be used to manage a ponzi scheme like Madoff's without detection, or to devise a new drug to cure cancer. Brilliance is like atomic energy, it can either power the city or destroy it.

How it is aimed matters.

Imagine reading the news to discover a close friend was, in fact, a master-thief, serial-killer, or driving intellect behind schemes that would bankrupt whole nations.

This gut wrenching experience has lately manifested in millions of investors and politicians as it did in crime writer, Ann Rule, author of The Stranger Beside Me.

Ms. Rule, at Seattle's Suicide Hot Line, worked with a man she described as brilliant and handsome. His name was Ted Bundy (yes, that one). Despite an early, avid interest in crime-fighting, which led her to undergraduate minors in criminology and psychology, Ms. Rule failed to see the budding serial-killer in her co-worker.

Her positive impression was so strong that, even after multiple arrests (and escapes), she couldn't quite believe the man she knew was a killer. She describes the moment of revelation in an interview:

"To be absolutely sure about his guilt," Rule remembers, "I needed to see direct physical evidence, and there it was [the bite marks and dental comparison], no question. It made me sick to my stomach. I went down to the hall to the ladies' room and threw up. Yet he still maintained this suave, friendly look. It was a bad day for me."

To this day, the experience haunts her and she feels fortunate that there had never been a romantic attachment between her and Bundy. "I felt dumb, I felt fooled, and I thought that my perception, which I'd always counted on, was flawed. Ever since then, I've felt I can't really know anybody." But she wasn't the only one. "We had very rigid screening at the Crisis Clinic where we had worked together, to be sure we were well adjusted and could help people who called in. Bundy fooled everybody."

Bundy fooled everybody. So did Bernie Madoff. So did many other fund managers, financial quants (experts in financial mathematics) and, I'm sure many will soon discover, so did the CEOs of major banks.

But how?

Each of these people was "brilliant" (in their way). They read people like a genius reads books, quickly, yet thoroughly- providing the appropriate responses to create their desired self-image in the minds of those testing them, at schools, jobs, and in social situations. They looked like the image they wanted to create and people judged the book by its cover.

Brilliant, intelligent, smart. These words will keep popping up.

To wit, in a Harvard thesis, Anna Katherine Barnett-Hart asks, How could so many brilliant financial minds have misjudged, or worse, simply ignored, the true risks associated with CDOs?

To wit, Michael Lewis, in The Big Short, leavening his prose with sarcasm observes: There was a sense that these were brilliant men, men of force, not cruel, not harsh, but men who acted rather than waited. There was no time to wait, history did not permit that luxury; if we waited it would all be past us…. Things were going to be done and it was going to be great fun; the challenge awaited and these men did not doubt their capacity to answer that challenge…. We seemed about to enter an Olympian age in this country, brains and intellect harnessed to great force, the better to define a common good.

To wit, in The Quants, Scott Peterson notes: On Wall Street, they [the young math whizzes] were all known as "quants," traders and financial engineers who used brain-twisting math and superpowered computers to pluck billions in fleeting dollars out of the market. Instead of looking at individual companies and their performance, management and competitors, they use math formulas to make bets on which stocks were going up or down. By the early 2000s, such tech-savvy investors had come to dominate Wall Street, helped by theoretical breakthroughs in the application of mathematics to financial markets, advances that had earned their discoverers several shelves of Nobel Prizes.

Perhaps brilliance isn't all its cracked up to be.

In a sense, brilliance is like a fast computer with lots of memory, it can be used to manage a ponzi scheme like Madoff's without detection, or to devise a new drug to cure cancer. Brilliance is like atomic energy, it can either power the city or destroy it.

How it is aimed matters.

And invariably, brilliance aims itself, seeking its own self-interest.

Importantly, brilliance is not synonymous with omniscience or omnipotence. Knowing more than most is not knowing all. Brilliance used for deception inevitably fails. In the end, Bundy hadn't fooled everybody, nor had Madoff, nor will the quants and TBTF elite. Bite marks, missing funds and paper trails always catch up to brilliant deceivers, sadly after much damage has been done.

What are we mere mortals to do?

1) Remember that brilliant people are people. They suffer temptation, to lie, cheat, steal and (in some cases) kill, but unlike the average person, they aren't as constrained by a lack of ability. Temptation rises with ability and just as those with the gift of gab can baffle with words, those with the gift of numbers can baffle with math.

2) Remember that brilliant people live in the same world we all do. Tiger Woods, at his best, beats all other competitors, but he doesn't birdie every hole, and will post a bogie from time to time.

In other words, demystify brilliance, which admittedly is easier written than done. Things which are too good to be true, even when promised by brilliance, usually are. Financial speculation, at best, makes an economy more efficient, but does not create money from nothing.  Checks and balances necessary for mere mortals are even more- not less, as seems to be the American view about financial wizardry- necessary for brilliance.

To wit, the signs of Madoff's deceit were obvious to any who examined his record with a skeptical eye as this excerpt relates:

Michael Ocrant wrote a story in 2001 for MARHedge, which covers the hedge fund industry, about how some traders, money managers and financial consultants questioned Madoff's record of 72 winning months in a row. "When I spoke to them about something not being right … they were adamant — there's no way this could be real," says Ocrant, now at Institutional Investor. "There's no one in history with that kind of results."

72 winning months in a row. "There's no way this could be real. There's no one in history with that kind of results."

Hmmm, if 72 winning months in a row couldn't be real, what should we think when a financial institution (check that, 4 financial institutions) claims to profit from each and every day's trading over a full quarter?

Those guys must be brilliant, eh?

Money-Theism, The Faith That Failed

Future historians may well find post-modern man's faith in the power of money as perplexing as Cortes and his men found the faith of MesoAmerica. It is, I believe this curious faith in money's power that allowed finance to become as protected a practice as any in Christianity. How else could three men who kept markets functioning be proclaimed as "saving the world"? Why else, but for this faith, would politics allow their preeminent position to be usurped by banking?

Dedicated to Dr. Chan whose questions sparked this line of thought.

Human sacrifice. To the modern (i.e. late 15th Century on) mind, the notion of ritual human sacrifice earning the favor of the Gods seems absurd. While Hernán Cortés and his men had few qualms about killing people to achieve earthly goals, they were horrified by the MesoAmerican penchant for the practice during the Mayan and Aztec conquests.

Yet, I'm sure the Mayans and Aztecs "believed" in the virtues of human sacrifice, with some literally believing Gods' favor would follow while others, taking a more practical perspective, assumed the practice scared neighboring tribes or conditioned the population's acceptance of the regime's power.

Today, no doubt, some purists still pray to the money God, while others are motivated by more practical concerns, like Big Bonuses. So it is with all man's faiths.

Alas, for the MesoAmericans, their appeased Gods did not defend them from Cortés and his minions (or Cortés won them over with his greater blood-lust). The Gods failed.

Post-modern man has his Gods too. He worships, inter alia, technology, democracy and, in particular, money. The money worship to which I refer has little to do with the desire therefore, but rather, the faith in money's power over nationalist warfare and thus as means to world peace.

Future historians may well find post-modern man's faith in the power of money as perplexing as Cortes and his men found the faith of MesoAmerica. It is, I believe this curious faith in money's power that allowed finance to become as protected a practice as any in Christianity. How else could three men who kept markets functioning be proclaimed as "saving the world"? Why else, but for this faith, would politics allow their preeminent position to be usurped by banking?

Pedantic Pause:
One wonders how long it will be before an elected official complains, "Will no one rid me of this troublesome banker?" and then does penance at the slain man's tomb. My sense; if it doesn't happen quickly, the odds of seeking penance are small. Alternatively, some Jack Cade type might gain power and take the advice of a friendly butcher, but direct his ire at bankers instead of lawyers.

Paraphrasing the bard: Is not this a lamentable thing, that of the body of an innocent tree should be made paper? that paper, being scribbled o'er, should undo a man?

One can trace the growing faith in the money God in both the continued trend of US decisions in favor of monetary globalization at the expense of sound domestic growth and the rush to implement European Monetary Union (EMU) before political harmonization. A common money (call it money-theism), it was believed, would end centuries of European and even world conflict. Remember the joy of the Neo-Cons (inter alios) as the Russian and Chinese economies "dollarized"?

It was proclaimed to be The End of History.

You could almost hear the Neo-Cons chanting, Tolkein-fashion: One money to rule them all, one money to find them, one money to bring them all and in the darkness bind them.

History, a decade hence, might borrow a line from Mark Twain and suggest, "rumors of my demise have been greatly exaggerated."

Ironically, the Gods of Mount Olympus have demonstrated the weakness of money-theism. Greek dissatisfaction with EMU rules (20 years ago, Greek officials would have just let the Drachma slide) supports "economist" over "monetarist" visions of the power of money which emerged on the road to Euro.

In 1970, the Werner Report forged a compromise of sorts between these two groups debating the means to create EMU. As Matthias Kaelberer details:

The major policy clash was between the "monetarists" and the "economists". The "monetarists"- a position forcefully presented by France- argued in favor of quick progress on monetary cooperation, which would then serve as a tool to harmonize economic policies. The "economists"- reflecting the position of Germany- argued in favor of prior convergence of economic policies before moving to a monetary union.

His critique of the monetarist position (written in 1993) was prescient:

Had the monetarist position succeeded, it would have offered deficit and high-inflation countries a free ride: In a complete EMU, Germany would have either had to finance the balance of payments [BoP] of the deficit countries or it would have had to accept a higher inflation rate.

In the event, "monetarists" won the battle but "economists" won the war. The PIGS went on a free ride and Germany (and the rest of core Europe), to keep EMU, must either finance the PIGS' BoP deficits or accept higher inflation.

On a wider stage, the ongoing battle between China and the US over exchange rates is another sign that money-theism, the current theme of globalization, has failed. The virtues of unified money will have to wait unless and until national political system aims and means converge.  We might even discover the drive for monetary union ignites rather than extinguishes war, but I hope I'm wrong.

It is, I believe, the end of an era.

But, my psychologists/editors at Seeking Alpha (an inside joke) are probably saying, "Where's the beef? What action should our readers take?"

The days of banker-glorification will soon be behind us. Politicians will retake the high ground and bankers will no longer be protected from the technology revolution. How much do you pay in ATM fees each year? The division of national corporate profits will shift back in favor of the real sector. If I was still trading at a Hedge Fund, I'd be short all the big banks.

The intensifying battle between bankers and politicians will likely lead to increased sovereign funding problems. States, once again, will have to pay a fair price to borrow.

I wouldn't be surprised to see double digit western sovereign bond coupons in the not too distant future. (In other words, sell western sovereign bonds).

While the theme of globalization has been exposed as false, the virtues of increased trade (which should accrue at a faster pace, once cleared of banker-parasites) are clear. The world, in my view, is not yet ready for a common money, but begs a flexible international financial architecture. Specie, as the recent rallies in Gold and Silver demonstrate, is making a comeback and may yet be resurrected as a basis, in one manner or another, of the next system.

Full Disclosure: Long Gold and Silver
Time Disclosure: I'm no longer a "trader" but an "investor".  I think, when investing, in units of decades, not weeks, days or hours.  In other words, those looking for the next 10/32nds in bonds are in the wrong place.

Derivatives of Mass Destruction: From "Fat Man" to "Fat Finger"

I know not with what weapons World War III will be fought, but World War IV will be fought with sticks and stones. Albert Einstein

Deputy National Security Adviser John Brennan said Sunday that the White House does not believe Thursday's Wall Street nosedive was the result of a cyberattack. The Hill

Had Mr. Einstein lived long enough he would not have been ignorant of WWIII's weapons- they are financial in nature, and, instead of "Fat Man" and "Little Boy", modern WMDs are called Credit Default Swaps (CDS) and are ignited by a "Fat Finger".

The need to hedge derivative portfolio "delta" (sometimes in amounts far exceeding the underlying security's total value and often "computer driven") makes financial markets very vulnerable to "Fat Finger" problems (or any multi-standard deviation price changes). It's a WMD (not confined to CDS, hedging is common to all derivatives) waiting for a trigger.

We need to dismantle these WMD, instead of focusing all effort on stamping out the next lit fuse. 

Unconvinced?  Think I'm (falsely) "shouting fire in a crowded theater"?

Read on.

In theory, CDS provide securities' owners a means to cheaply insure against their default. By paying a (or series of) small premium(s) (usually far smaller than the security's yield) the risk of default is swapped to the CDS seller.

In theory, as with all derivatives (in a former life I used to trade these things), sellers can instantaneously hedge (for instance, by selling the security issuer's stock, bond, or currency) the assumed risks, deriving (sellers hope) profit from the received premiums less any hedging costs.

In practice, (as I learned, painfully) trying to maintain hedges in fast markets (and I traded foreign exchange- a pretty liquid arena) can be impossible. Worse, as price deviation from last hedged position grows, the amounts to hedge grow as well. A .5% move in the underlying might call for a 10% hedge, while a 2% move might call for 35% and so on.

Adding insult to injury, all those hedges may have to be unwound if prices come back to "normal". Among traders, market chasing as described above is called hedging "bad gamma" (which is about as fun as having "bad karma").

In practice, CDS are not primarily used as insurance. They are, more often, purchased "naked", not to hedge against a default, but to bet on it, and perhaps, as you'll see, to actually accelerate it, particularly if one could, through naked purchases in greater amounts than existing underlying securities, force hedgers into selling over-drive.

I suspect events like last week's panic in equity markets will become far more frequent so long as CDS (in particular) use, and thus necessity of hedging thereof, continues to grow.

Warren Buffett, before a Galileo-like recantation and rebaptism in the church of TBTF finance, was a pioneer in recognizing derivatives as financial weapons of mass destruction. Like the nuclear weapons of WWII, modern WMD are examples of tremendous leverage- tiny amounts of fissile material or premium, respectively, explode with enormous yield, wrecking horrific damage.

Unlike atomic weapons, whose direct effects are limited to a blast and radiation radius, modern WMD, like CDS use high speed connectivity and computer driven hedging as transmission mechanisms. The "Fat Finger" ignites a "critical price deviation" forcing hedgers of naked CDS to (try to) sell what might be many multiples of available securities.

Thursday's market action might in the future be seen as the Trinity test of the financial Manhattan Project, broadcast live to anyone in the world with an internet connection.

Fortunately, just as atomic weapons require radioactive cores, so too do our CDS WMD. In the latter case, the underlying core (financial entity) must be highly leveraged. Instability, either at an atomic or financial level, is key to explosive yield. Trying to force default in an unleveraged, highly solvent financial entity would be about as fun as using carbon-12 instead of uranium-235 in an atomic bomb.

In other words, while real world WMD deterrence might require a missile shield, financial WMD deterrence might require a solvency shield. The more solvent, and less leveraged a company becomes, the less it needs to respond to the whims of the markets.  It can just go about its business.

Highly leveraged financial companies like Lehman and Bear Stearns were prime "fissile" material- so unstable they needed daily financial stabilization. Unfortunately, there seems to me to be far more financially unstable material laying around than fissile isotopes- Wall Street finance being far more effective than, say, Iranian centrifuges.

On the bright side, fears of "Fat Fingers" igniting naked CDS into financial WMD might someday be seen in the same light as plans for mutually assured destruction (MAD)- as signs of the need to dismantle armaments. Perhaps Homeland Security should audit the Fed, and dismantle the highly leveraged and unstable financial cores we've strategically placed around the nation.

Either that or people of the future might visit New York as they now visit Hiroshima and Nagasaki- looking at a plaque commemorating the destruction caused by a "Fat Finger" instead of a "Fat Man" or a "Little Boy".

Who knows, maybe in addition to Arms Control, Capital Control will be a national security matter.

Bail-Outs for Screw Ups: Oil and Greece

In the not-to-distant future I wouldn't be surprised to read the following from the IMF: Negotiators over the weekend wrapped up details of the package, involving budget cuts, a freeze in wages and pensions for three years, and oil price increases to address British Petroleum's fiscal and debt problems as a result of the Gulf Oil Spill, along with deep reforms designed to strengthen BP's competitiveness and revive stalled corporate growth.

The above is paraphrased from the IMF's press release announcing the Greek Rescue Package. This, and other press releases, describe the crisis as "economic" when "financial' seems to me more apt (should we describe the oil spill as a "geologic" rather than "drilling" problem?), and proclaim the creation of a, fully funded, mind you, Financial Stability Fund. Greek Banks which failed to see the crisis coming are going to be shielded from the effects thereof.

Imagine if major Greek Banks, instead of investing anywhere from 2-3 times their equity into Greek Government Debt, had invested in safer securities. Just as deep-sea oil drillers have to devise safe (i.e. non-toxic) ways to extract oil, imagining some of the potential problems before they occur, shouldn't banks be devising safe (i.e. non-toxic) ways to extract profits from the seas of finance? If they fail in this task, should they be shielded from the effects of their failure?

One of the essential qualities of capitalist success, agreed upon after decades of careful study is the use of profits as arbiter for continued existence as a financial entity. Implicit in this view is belief that there will always be other competing firms/investors ready and willing to pick up the slack.

I'm pretty sure, just as there are many companies waiting to pick up the business slack caused by BP's error and potential financial distress, so too there are many Greek Banks with stronger balance sheets that would be willing to pick up the slack caused by the major banks' error in crisis forecasting.

Over at The Baseline Scenario Simon Johnson asks (of the decision to support too big to fail banks, instead of breaking them up): What is the basis for major policy decisions in the United States? Is it years of careful study, using the concentration of knowledge and expertise for which this country is known and respected around the world?

He suggests a possible (alternative) answer: I would not have a problem with the administration’s top officials saying, “we can’t take on the biggest banks because (a) they are too powerful in general, and (b) they would cut us off from the campaign contributions that we need for November.” This would at least be honest...

Honest, yes. Wise? not in my view.

BP's oil spill is horrific, but a fairly rare occurrence. Finance, at least in its current "liberal" form has a far worse track record. How long would the world tolerate current drilling techniques if such disasters occurred every couple of quarters all around the world? How long would public sector officials feeding from that trough survive?

Those in the public sector need to realize their interests are not aligned with TBTF finance. Can you imagine some BP-financed politician running in Louisiana any time soon?

Public sector monetization of financial sector errors coupled with support of the liberal banking techniques that created the problem will only accelerate currency devaluations in regimes that follow this policy and the brunt of the complaints will fall on the public sector and finance. In layman's terms, bail-outs for financial screw-ups will continue to cause higher prices, and higher prices will only inspire more anger.

Ideally, reward systems like capitalism should favor the prescient over the screw-up. Doing the opposite will likely have undesirable effects for all involved.

To wit; in an interesting irony, while the IMF is engaged in selling its gold it bails-outs the financial screw-ups who make it such a useful asset on a balance sheet.

I Cringe Thinking of a Time I Could Have Written This

Apparently (according to this blogger) there's a nasty email floating around Wall Street, written by a Wall Streeter.

Here's an excerpt [with my comments in brackets]:

We are Wall Street. It's our job to make money [actually the financial sector's job is to intermediate savings and investment, and only to get paid if they do so profitably]. Whether it's a commodity, stock, bond, or some hypothetical piece of fake paper, it doesn't matter [oh, but it does matter, that this point eludes you is part of the problem]. We would trade baseball cards if it were profitable. I didn't hear America complaining when the market was roaring to 14,000 and everyone's 401k doubled every 3 years. Just like gambling, its not a problem until you lose [or can't pawn the loss onto the rest of society, it seems]. I've never heard of anyone going to Gamblers Anonymous because they won too much in Vegas.

Well now the market crapped out, & even though it has come back somewhat, the government and the average Joes are still looking for a scapegoat [it isn't so much the weak market that inflames passions, it's the lack of accountability and humility for errors that cost many dearly]. God knows there has to be one for everything. Well, here we are.

Go ahead and continue to take us down, but you're only going to hurt yourselves [or find another group who will perform their function more profitably and cheaply than the current bunch]. What's going to happen when we can't find jobs on the Street anymore? Guess what: We're going to take yours. We get up at 5am & work till 10pm or later [the writer assumes only Wall Streeters work hard.  I'd like to see the author work so hard when overtime and bonuses are not part of the deal]. We're used to not getting up to pee when we have a position. We don't take an hour or more for a lunch break. We don't demand a union [no, Wall Street doesn't need a union, they have the Fed, the best lobbyist in Washington]. We don't retire at 50 with a pension. We eat what we kill, and when the only thing left to eat is on your dinner plates, we'll eat that. [I'd love to see a bunch of Wall Street guys try to steal the food off the plates of manual laborers' families, as I suspect, would the laborers.]

When I was a 22 year old "master of the universe" as Tom Wolfe so artfully described, I sometimes felt this way in the afterglow of a great trading day and a few scotches (but thankfully had sufficient empathy even then to realize expressing that sense would be a big mistake).  It's a cringe-worthy memory.

One of the reasons I'm an favor of greater financial regulation is my memories of me.  The last thing the world needs is a bunch of 22 year old hot-shots trading other people's money without proper supervision.

p.s. Sometimes truth is stranger than fiction, but I couldn't have written a better fictional letter to inflame people.

"Banging the Close" and Other Urban Truths

The CFTC said Moore's fund portfolio manager tried to manipulate platinum and palladium futures from at least November 2007 through May 2008 by entering trades in the last 10 seconds of trading in a manner designed to exert upward pressure on the settlement prices. The practice is known as "banging the close." Reuters

"The timing of the SEC's filing of a civil securities fraud action against Goldman Sachs has created serious questions about the commission's independence and impartiality," said Darrell Issa, the top Republican on the House Oversight Committee, in a letter to the SEC on Tuesday.  Reuters

I couldn't believe my eyes as I read the stories above. A Hedge Fund (and former employer), Moore Capital, caught manipulating closing prices and the SEC caught timing the release of GS fraud charges to further their agenda.

What's next? Will the experts soon assert, with somber gravitas, that life, in fact, exists....on Earth?

That is, the incredulous implication of the above articles (and many others these days) is to me, incredulous. Do we all really believe we take up no space? politicians and bureaucrats don't play politics? fund managers don't "window dress", "paint the tape" or "bang the close"?

Mr. Bacon of Moore Capital, for whom I have great respect as a trader, and from whom I learned a great deal during my short time there, is no fool. I'm sure he authorized the obligatory statement: Neither Moore Capital's principals nor its current management were involved in any improper trading, and none have been accused of any wrongdoing.

I'm just as sure he senses the absurdity therein.

Every big player in every market I've traded effects the price when they trade. Central Banks count on this effect when they "intervene"- a word that implies some deus ex machina instead of another institution with an ax to grind. Why should anyone care if a firm decides to make liberal use of the "Texas Hedge"- increasing exposure to push the price in their favor?

Ultimately, "Texas Hedging" requires a greater fool to relieve you of your position at the "manipulated" price, or the practice will generate losses. A Hedge Fund manager willing to give up 2% in the long run to get an extra 1% (and consequent (but temporary) increase in performance fee) at quarter's end is just making his job that much harder.

If "banging the close" is illegal how should we qualify the Fed and Treasury's decisions to buy hundreds of billions of dollars of non-performing mortgage debt and ring-fence other "toxic" assets from a dreaded mark-to-market?  Both aim to effect the market, and the state has a nasty habit of leaving the general public "holding the bag" on unwound Texas Hedges.

I'll take the former over the latter any day.

Where's the harm in the former? except to modern institutional myth belief. The myth to which I refer is the view that modern institutions both public and private are impartial and altruistic, peopled by angels, and not humans.

I've little doubt both the CFTC's and SEC's cases are "timed" for effect. The state is trying to dispel the mythic quality of finance- to change public perception thereof (the fines are mainly beside the point). After all, that is the game they play. Explicitly, politicians and bureaucrats through policy and media access aim to effect popular opinion. Are we next going to chastise judges who aim to "make an example" of someone? Isn't deterrence an aim of public policy?

Of course, the state takes a risk in their myth dispelling goal. Once myth-busting becomes a habit, who knows which myths are next to face apocalypse? If finance is revealed to be just a bunch of guys with axes to grind, so too, the public may soon learn, are politics.

The public might even learn the money in their pocket has no intrinsic value- Insha'Allah.

I hope this myth-busting leads, as it often does, to renewal. I'm aware, however, that the path of social myth-busting is often chaotic. Dashed dreams make for unhappy people. On the bright side, dashed dreams improve one's sense of reality, if one is strong enough to get over the disappointment.

In Hindu theology, Shiva, The Destroyer (of myths) leads Brahma, The Beginner. It is said nobody worships the Brahma phase of the Hindu Trinity, perhaps because worship requires the sense of awe destroyed by Shiva. After Brahma comes Vishnu, renewed worship and a period of institutional status quo. Old myths acquire new faces.

The cycle repeats.

Breaking Up Is Hard To Do: TBTF, the Euro and Gold

Perhaps this is one reason why Gold has not reacted in recently "normal" fashion to Greek crisis inspired Euro weakness. Perhaps, the new thinking may go: Monetary Union's loss (in its many forms) is Gold's gain. If the drive to a monolithic world currency has stalled and currency competition comes back into vogue, Gold's track record is tough to beat.

Recent news about Greece's financial travails reminded me of a conversation I had with Helmut Schlesinger as the Asian Crisis was unfolding in 1997. Over a few drinks at the Long Bar in Singapore's Raffles Hotel, Mr. Schlesinger regaled me with his views on inflation, monetary integration and "realignments" (devaluations).  I don't know whether it was the drinks, the ambiance of the historic Long Bar, or the impending realignment of Asian currencies to the US$, but Mr. Schlesinger was in a mood to talk, and I, to listen.

As President of the Bundesbank from 1991-93 Mr. Schlesinger had a wealth of experience on monetary integration (with East Germany), realignment within the ERM (European Exchange Rate Mechanism), and disintegration (as Britain left the ERM). On the side of the "economists" in the debates over EMU, he argued, presciently, as the Greek situation demonstrates, that the "monetarists'" view- monetary integration prior to complete political integration wouldn't be a problem- was not historically grounded. Nor was he sanguine about the German reunification of East with West- 13 years hence East Germany continues to lag the West.

For Mr. Schlesinger, "flexibility" was a key component of economic integration. Adjustments in the terms of trade between economic parts, he told me, would always be necessary. Thus integration which didn't maintain some potential for flexibility-which assumed the combined parts would always thereafter be a unified whole- risked disaster. Perhaps this explains, to some extent, his comments about potentially necessary ERM realignments in 1992 that acted as catalyst to the GBP (British Pound) and ITL (Italian Lira) devaluations, and withdrawal of the GBP from the ERM.

There seems to me a lesson to be learned from both the recent EU and TBTF problems on either side of the Atlantic- breaking up, in the sense of making necessary adjustments in the terms of trade (a phrase that usually refers to the relation between import and export prices between nations, but can more broadly refer to the agreed upon bases of exchanges (prices, credit access, etc.) between and amongst any and all economic units), is hard to do. Flexibility has been lost in the pursuit of economic monolithism (if you will).

Previously, situations like Greece, or the TBTF banks in the US, would have begged a period of disintegration and adjustment in the terms of trade, either via devaluation in the case of Greece, or disintegration (perhaps bankruptcy) of certain units of the TBTF banks, in the case of the US.

To wit, US financial sector reform, in my view, needs to, inter alia, restrict discount window borrowing privileges to commercial banking (i.e. adjust the terms of trade within finance), leaving derivatives and proprietary trading to stand or fall on their own merits.  This is virtually impossible within the current system of financial monolithism.

The cost of the new approach of economic monolithism, is increasing bailouts- dilution of the common currency- which distributes the losses system wide, and slows the necessary adjustments in the terms of trade.

It is not surprising to me that the Germans, where fears of a Weimar style inflation remain strong, are loathe to dilute the Euro to bail-out Greece. After Greece, who else will need a bail-out?

Perhaps what the EU needs is a divorce (perhaps temporary separation, might be more apt) clause- a means to make the necessary terms of trade adjustments. This, in a sense, is that US financial reform seeks- a procedure to disintegrate (temporarily, or permanently) the financial sector to make equally necessary terms of trade adjustments.

The issues noted above, Greece and the TBTF banks, combined with the broader issue of relations between sovereign states and the international whole suggest that the world has, for the time being at least, reached a point of diminishing returns on economic integration. We may need more currencies, and certainly greater economic flexibility between the parts than currently exists.

Perhaps this is one reason why Gold has not reacted in recently "normal" fashion to Greek crisis inspired Euro weakness. Perhaps, the new thinking may go: Monetary Union's loss (in its many forms) is Gold's gain. If the drive to a monolithic world currency has stalled and currency competition comes back into vogue, Gold's track record is tough to beat.

TBTF Requires a Controlled Demolition

If shareholders realized they they are getting the same shaft as depositors a major impediment to true bank reform could be swept away. Senior bank employees are using complexity of operations (which is more myth than reality) to hobble shareholder control and progressive era legislation to hobble depositor control.

Let the senior financiers keep their salaries and bonuses, and let them do with their banks what they will. If, however, their bank fails, let the bankers themselves fail. Let the value of their houses, cars, yachts, paintings, etc. be assigned to the firm's creditors. James Grant: Let the Bankers Fail

As the news of Wall Street's underhanded dealings goes mainstream thanks to the SEC's case against Goldman Sachs, the idea of letting the bankers fail never seemed so sweet to so many in recent history. Yet, failure might have nasty consequences. Just as one wouldn't want a skyscraper to topple over in a crowded city, one wouldn't want the TBTF banks to collapse. Better, I think, to effect a controlled demolition.

While he has been opining about finance more wisely and for far longer than I, Mr. Grant's ire may be somewhat misdirected (although the effect of his proposed renewal of the fear of God seems a wise idea) at shareholders, when senior bank employees are those whose behavior must be modified. They take the least risk and benefit the most.

Explaining the problem's emergence, Mr. Grant draws our attention to the FDIC, an institution ostensibly designed to benefit the man on the street whose limited life savings might be lost in a bank failure. An additional effect, however, was to shield bank owners from liability, at state expense.

Another key effect, particularly when the lender of last resort (in the US, the Federal Reserve) supports banks rather than credit markets more generally, was to dampen depositors' desire and hamstring their capacity to demolish a bank. It is no surprise that the vigor with which Big Finance worked to repeal Glass Steagle was not directed at FDIC or Federal Reserve legislation.

Banking is a curious business, as Louis Brandeis noted in Other People's Money: The goose that lays golden eggs has been considered a most valuable possession. But even more profitable is the privilege of taking the golden eggs laid by someone else's goose. Bankers, by which he meant bank shareholders, combined their equity capital with deposits, in 1929 at a deposit to equity ratio of roughly 10 to 1 and kept a majority of the profits thereof.

Prior to Fed support of banks, depositors had a significant controlling interest (whether they were aware of this is another issue). A bank run was the means by which they exerted this control. As noted, this control was greatly diminished (but not lost), and obscured by the Fed and FDIC.

Of course, what is good for the goose is good for the gander. Bank shareholders had it good for a while, but lately they too have been getting the shaft from senior bank employees, who may not have any investment in the bank. As noted here, (full article here) at the Big 4 US Banks (BAC, C, JPM, WFC) depositors were paid $25B on their investment of $2.5T, shareholders were paid $18B on their investment of $660B and employees were paid $111B for their time.

If shareholders realized they they are getting the same shaft as depositors a major impediment to true bank reform could be swept away. Senior bank employees are using complexity of operations (which is more myth than reality) to hobble shareholder control and progressive era legislation to hobble depositor control. Simon Johnson and James Kwak should take note. Explaining that shareholders' interests are aligned with depositors' might ignite the controlled demolition of TBTF.

Why should senior bank employees with the least "skin in the game" reap the largest benefits?

A controlled demolition of TBTF might proceed something like this:

1) Depositors could begin to reassert their lost control by withdrawing money from the Big Banks (there already is such a movement underway).

2) Minimally, shareholders could begin to reassert their lost control by wiser appointments to the Boards of Directors with the view that cost control includes direction as well as magnitude (to wit, why should shareholders pay for lobbying which enriches employees and not them). Preferably, sell the shares and reinvest the capital in various smaller banks, presumably some of whom might be the recipients of moved depositor funds and none of whom have significant derivatives' exposure. In a controlled demolition of TBTF, the numerous banks left standing should benefit significantly.

3) Depositors and shareholders could understand that institution size dilutes control and allows employees to usurp control leaving you (or the state) to deal with the risk.

4) If an aligned group of depositors (aka voters) and shareholders (aka those funding the lobbying) demanded action, change would come. One key change: The Fed would need to stop supporting banks and instead support markets mitigating collateral damage from the demolition. They should open lines of communication with the hundreds of banks with assets between $1B and $100B. They will also need to deal with foreign depositors at the TBTF banks and begin to unravel the nightmare of derivatives (admittedly a task easier said than done).

Instead of a full frontal approach, TBTF should be imploded from within. Those with "skin in the game" need to take back control. 

It's your money, and only your wisdom (not the government's or bank employees') will keep it safe and perhaps allow it to grow.  Concentration of money occurs when investment is passive.  Move Your Money!

One might even consider moving one's money out of the banking system entirely during the renovation through the purchase of Gold.

IMF Power Play: Capital Controls or Failed States?

Coincidences abound these days. GS calls for derivatives clearinghouses, as does the IMF. GS, and in the not too distant future, presumably other TBTF institutions face civil suits enforced by national states from many parties. The IMF declares the debt load of these states the biggest risk to the financial system.

The global financial system and the world economy are slowly regaining their health, thanks in large part to unprecedented interventions by governments, but the sharp rise in government debt during the economic crisis from already elevated levels helped create what the IMF says is the newest threat to the financial system: growing sovereign risk. IMF (April 2010)

2. Yesterday, October 10, the G-7 met and agreed the following plan of action:

• "Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure

3. Today the International Monetary and Financial Committee strongly endorsed the above commitments IMF (Oct. 2008)

On Christmas Day, 800 A.D., Pope Leo III crowned Charlemagne Emperor of the Romans. While scholars' views vary as to the Pope's intent, and Charlemagne's prior knowledge thereof, that the Vatican had thereafter a large effect on national politics in Christendom is without doubt. Concerns about the Vatican's continued influence almost 1000 years later, inter alia, led the framers of the US Declaration of Independence and Constitution to declare their sovereignty from, not only the mother country, but also such supra-national institutions.

Of course, that was then and this is now. The US Government, now hobbled by the debt load, incurred, in part, to support TBTF financial institutions- a policy urged by the IMF 2 years ago- is now being urged, by the same IMF, to reduce sovereign debt risks, which are the "newest threat to the financial system."

As the saying goes, with friends like these...

For decades, admittedly with varying intensity, the IMF has, in general, urged open capital markets- a policy at odds with the IMF's original mandate. Two years ago, the inevitable result of such national sovereignty abdicating policies in the absence of vigorous supra-national regulation brought the world's financial system to the brink of disaster.

With the benefit of hindsight, from one perspective, the IMF could be seen to have loudly urged national governments to "take as much (debt) rope as you'd like," and whispered, "to hang yourselves with."

How times have changed.

The dilemma which, in large part, led to the creation of the IMF- how to have the cake of international capital mobility and eat the cake of national sovereignty (yes, it's a stretch, but go with it), was, according to Louis Pauly, in his Who Elected the Bankers? confronted directly by Bretton Woods negotiators: They could see no way around the fact that states, if they valued economic stability as much as they valued their political independence, would have to maintain the capacity to deploy capital controls.

In the event, capital controls fell out of favor and thus capital sovereignty in the largest states was greatly diminished but the costs associated with supporting the banks profiting the most from the open environment have been shouldered by these same states. This seems, borrowing a term for yesterday's post, asymmetric.

Why should the state pay for what it cannot control?

Why, if the IMF supported the use of all available tools to restore financial stability but 18 months ago, does its most recent report highlight the risks of growing sovereign debt, but not the risks of private sector financial institutions whose failure to pilot the open capital market seas successfully played such a large role in the "risky" debt growth?

Louis Pauly asked, "Who Elected the Bankers?" If the IMF is taking its cue from Pope Leo III and playing for power with TBTF institutions, we have an answer. The IMF didn't Elect the Bankers, It Crowned Them.

Coincidences abound these days. GS calls for derivatives clearinghouses, as does the IMF. GS, and in the not too distant future, presumably other TBTF institutions face civil suits enforced by national states from many parties. The IMF declares the debt load of these states the biggest risk to the financial system.

The question of who is in control begs an answer. If the states aim to retain sovereignty, they will be forced to use the tool of capital controls. Indeed, in the current battle with GS, the US may find, if capital controls aren't imposed, that GS leaves a shell company to bear the brunt of any penalties. More broadly, if the national states don't impose control, they may soon find themselves, like Greece, California or New York, overly indebted entities with no power to solve their own problems, and thus waiting for hand-outs from the new supra-national institutions they created.

Let the games commence!

GS Case Begs the Volcker Rules (and Blankfein a lesson in asymmetry)

The core of the SEC’s case is based on the view that one of our employees misled these two professional investors by failing to disclose the role of another market participant in the transaction, namely Paulson & Co., and that the employee thereby orchestrated the creation of materially defective offering materials for which the firm bears responsibility. Goldman Responds

Using methods from theoretical computer science this paper shows that derivatives can actually amplify the costs of asymmetric information instead of reducing them. Working Paper on Information Assymmetry

As Mark Thoma explains in a recent post, the SEC's case against Goldman Sachs (assuming a strict reading of the statute) rests on the issue of asymmetric information- did GS disclose enough information about the offering such that the collateral manager of the CDO "knew or should have known that Paulson was on the other side of the transaction."

There is another aspect of the case, in light of the implicit support of TBTF financial institutions, that begs the Volcker Rules of proprietary trading separation from government supported activities, namely commercial banking, to which I'll return.

Asymmetric information is one of those phrases that makes common people hate economists. Uneven, deceptive or lying captures the essence of the issue.

To indulge a fantasy occasioned by the Goldman fraud, and explain the issue, let's imagine I found out that Mr. Blankfein liked to play a bit of ice hockey from time to time-nothing too strenuous, just for fun. Imagine, upon hearing the news, I invited him up for a skate with my spring hockey crew. "It's just a pick-up, no refs, no checking, lots of fun," I could tell him- "for us," I might say to my friends after hanging up the phone.

Imagine he comes up, suits up and hits the ice. At that point (or as soon as the first puck whizzes by his head), he'll realize that he's on the ice with 1-2 ex-Pros, quite a few ex-College players and we all play all year round, 4-5 times per week in the winter. There's no checking (well, almost, it gets you 2 minutes in the box), but there's quite a bit of contact. Slap shots are coming anywhere from 60-90 mph.

That's a little lesson in asymmetry I'd like to give Mr. Blankfein. Of course, there would be nothing sportsman-like about it. He'd be outclassed (but it would be fun).  It also would be entirely legal, as we may find to be the case with GS.

Getting back to reality, GS will argue that the collateral manager knew or should have known what he was getting into. We'll have to wait for the evidence to be presented to see if that claim is true.

The second issue I raised about such dealings begging the Volcker rules may prove quite important in the financial regulation debate. Currently, all public markets for finance are open to all, and, apparently, deserving of government support. Even if the collateral manager should have known the security was designed to fail, that such a security could be created strongly suggests to me that such dealings have no place in publically supported markets.

All participants in my men's hockey league sign waivers taking personal responsibility for injuries caused on ice. We cannot sue the rink, or the town, etc. We all love the game, so it's not a problem. Imposing costs on the rest of society for the risks we take would not be fair.  It would be assymmetric (if hockey players used such language).

Equally, it seems to me, trading activities such as are detailed in the GS case, should never lead to increased social costs. Not only, in my view, does socializing the costs of such trading activities negate their social virtue (price discovery becomes state sponsored price enforcement) such support drifts ever closer to tax funded gambling. What's next, tax credits for the losers in next year's World Series of Poker?

When a security can be designed to fail, it's time to separate the financial markets into socially protected and unprotected divisions. Just as I play socially unprotected hockey, I'm all in favor of socially unprotected trading- I just don't think my neighbors should have to pay when the risks become real.  Nor should the rink be shut down because we made a mistake.

I'll close with an ice hockey tip for the boys at Goldman: Keep Your Head Up Out There, Boys!

The Price of Gold Backed FX Reserves

While perusing the IMF's data set of Central Bank reserves I did a bit of calculating.  The graph below depicts the calculated $ price at which aggregated Central Bank FX reserves could be backed (100%, 35%, and 65%) by their holdings since 1980.

Currently, the IMF figures that Central Banks have 970M oz. of gold and $8,463B worth of FX reserves.  100% cover equates to a price of $8,720. 

Alternatively, they could just buy more.

Goldman Goes For The Jugular With Derivatives' Control

"Given that much of the financial contagion was fueled by uncertainty about counterparties' balance sheets," Goldman Chief Executive Officer Lloyd Blankfein and President Gary Cohn wrote in a letter at the beginning of the annual report, "we support measures that would require higher capital and liquidity levels, as well as the use of clearinghouses for standardized derivative transactions." Washington Examiner

I've spent countless hours taking Goldman (GS) "to the woodshed" for underhanded dealings (and I'll end this article that way) but they have always been astute traders. Their recent request for derivatives clearinghouses seems to me like a coup de grace administered to all other derivatives dealers.

When I was trading FX Options at Chase, J. Aron (owned by GS) was rightly regarded as one of the best derivatives dealers along side First Chicago (which was eventually swallowed up by UBS). They had the best models, and were religious about hedging away their risk.

I assume the past few years taught them that their biggest risk lies, not in the market, but in their counterparties. Their book might be well hedged, but if their counterparties default, they are doomed.

Thus, it seems to me, the request for clearinghouses. GS will force other dealers to use their models and risk mitigating tactics.

Let's assume they get their way. Other dealers, like JP Morgan (JPM), Bank of America (BAC) and Citibank (C), will likely find they haven't properly valued and hedged their books. The government, in its zeal to enact reform will likely be forced to pick up the cost of reducing these other banks' risk, and the banks themselves will likely find that GS is the last player standing.

Let's be cynical and assume that GS expects it will be the spring from which derivatives' regulators will be drawn.  That would be one way to avoid embarrassing fraud charges from the SEC, (the coincidence is striking) and a way to watch what other dealers are doing, in the bargain.

Death by regulation.

If I were sitting at the negotiation table I'd be willing to give GS what it wants, with one proviso, the government will pick up the tab of reducing sector wide risks in derivatives if and only if size limits on banks, and separation of commercial banking from proprietary trading activities (i.e. the Volcker rules) are part of the bargain.

It might not hurt to later impose some strict limits on the revolving door between GS and the public sector.

Without such a bargain, the creation of clearinghouses will only further concentrate pricing control of these instruments, in the hands of GS. However skilled the GS boys currently are, monopoly control of derivatives will beg abuse down the road.

One coup de grace deserves another.

Disclosure: No positions in GS, JPM, BAC, or C