Nor should you take seriously analysts claiming that we’re seeing the start of a run on all government debt. U.S. borrowing costs actually plunged on Thursday to their lowest level in months. And while worriers warned that Britain could be the next Greece, British rates also fell slightly. Paul Krugman, May 6, 2010
Not 12 months ago, Paul Krugman mocked Eugene Fama's Efficient Market Theory-based views on the Tech and Housing Markets via Larry Summers "ketchup economists" paper:
What this [Fama's tirade against the notion of "bubbles"] made me think of was an old paper by Larry Summers mocking finance economists as the equivalent of “ketchup economists”, who believe that they’ve demonstrated market efficiency by showing that two-quart bottles of ketchup always sell for twice the price of one-quart bottles.
Recently, however, as the opening paragraph (above) illustrates, Fama's efficient market theory- in brief (and without nuance): market prices quickly reflect all new information reasonably accurately- is now a sufficient basis from which to calm nerves over sovereign debt problems in the US and UK markets.
Perhaps Mr. Krugman doesn't like ketchup, tech stocks or houses, but does like cheap government debt issued by the US and UK (maybe that's where the Nobel prize money is invested?). Whatever the reason, Mr. Krugman can't have it both ways- either current market prices and recent reaction to news are not sufficient cause to dismiss "bubble" qualifications (which is my view) or they are (or there's an alternate theory which leads him to think US and UK debt is "safe" while Tech and Houses weren't).
If so, I'd love to read about it.
Given the recent kerfuffle between Mr. Sorkin and Mr. Krugman at the NYTimes over the nuances of Mr. Krugman's views on bank nationalization, I'm sure Mr. Krugman would argue I misread his meaning. Maybe so. Unlike, it seems, Mr. Krugman, I can understand how an author's intent wouldn't instantly manifest in a reader's mind (perhaps Krugman is an advocate of the efficient prose theory).
Your author meekly mining the economic press on a lovely Friday afternoon, signing off.
Friday, May 07, 2010
Dancing On A (Financial) Volcano
The bank lobbyists have the champagne out – the Brown-Kaufman amendment, which would have capped the size and leverage of our largest banks – was defeated in the Senate last night, 33-61. Simon Johnson
Mr. Johnson describes the pro-TBTF (Too Big To Fail) "victory" in a Pyrrhic sense and suggests their opponents, like Wellington, have fallen back to Waterloo.
It's an apt metaphor. Yet, I think the situation may be more dire than that (as, I suspect, does he, after all, we commentators only have so much time to mine for metaphors).
Just prior to the French Revolution of 1830, Talleyrand attended a ball, at which, he was reported to remark, "We are dancing on a volcano."
Moving back in time a few millennia, the flourishing Minoan civilization, inhabitants of which, ironically, liked to leap over bulls, actually were dancing on a volcano, on the island of what is now called Santorini. I don't know if the bull leaping was a mental reflection of their life on the volcano-beast but that beast did erupt (sometime around 1600 BC) and gore their civilization.
There are two aspects to the current volcano- popular unrest, such as was evident in Greece this week (discomforting, related note: one in 5 American men between 25-44 is unemployed) , and the increasingly volatile financial markets themselves. TBTF lobbyists, like the Minoan bull-jumpers, are engaged in risky business, risking both populist anger, and an eruption of the financial volcano (might rising market implied volatility be seen in a tectonic light?).
Those of us watching the spectacle, in delight, admiration, trepidation or horror, (depending on perspective) from afar may soon find, like the Minoans, worse things- deeper, more profound things- to fear, than the bulls.
Some might wonder if it would have been better to dance on the volcano as it erupted instead of, like the Minoan survivors of the eruption and resultant tsunami, trying to pick up the pieces afterward.
We'll see, soon enough.
Or not. After all, this is just a metaphor, my attempt, in a sense, to dance on the volcano, which may, in the event, not even exist (but my gold investment- my bet on the volcano- is an attempt to stay well clear of "Santorini")
Happy Dancing!
Here endeth the mind-bending Minoan metaphor. Next week (hopefully) I'll get back to more con-Crete (couldn't resist) analysis.
Mr. Johnson describes the pro-TBTF (Too Big To Fail) "victory" in a Pyrrhic sense and suggests their opponents, like Wellington, have fallen back to Waterloo.
It's an apt metaphor. Yet, I think the situation may be more dire than that (as, I suspect, does he, after all, we commentators only have so much time to mine for metaphors).
Just prior to the French Revolution of 1830, Talleyrand attended a ball, at which, he was reported to remark, "We are dancing on a volcano."
Moving back in time a few millennia, the flourishing Minoan civilization, inhabitants of which, ironically, liked to leap over bulls, actually were dancing on a volcano, on the island of what is now called Santorini. I don't know if the bull leaping was a mental reflection of their life on the volcano-beast but that beast did erupt (sometime around 1600 BC) and gore their civilization.
There are two aspects to the current volcano- popular unrest, such as was evident in Greece this week (discomforting, related note: one in 5 American men between 25-44 is unemployed) , and the increasingly volatile financial markets themselves. TBTF lobbyists, like the Minoan bull-jumpers, are engaged in risky business, risking both populist anger, and an eruption of the financial volcano (might rising market implied volatility be seen in a tectonic light?).
Those of us watching the spectacle, in delight, admiration, trepidation or horror, (depending on perspective) from afar may soon find, like the Minoans, worse things- deeper, more profound things- to fear, than the bulls.
Some might wonder if it would have been better to dance on the volcano as it erupted instead of, like the Minoan survivors of the eruption and resultant tsunami, trying to pick up the pieces afterward.
We'll see, soon enough.
Or not. After all, this is just a metaphor, my attempt, in a sense, to dance on the volcano, which may, in the event, not even exist (but my gold investment- my bet on the volcano- is an attempt to stay well clear of "Santorini")
Happy Dancing!
Here endeth the mind-bending Minoan metaphor. Next week (hopefully) I'll get back to more con-Crete (couldn't resist) analysis.
Thursday, May 06, 2010
Finding the Right Safe Haven For This Crisis
"Is it safe?"
That question still brings shivers up my spine as I recall the 1976 movie, Marathon Man, starring Dustin Hoffman, Roy Scheider, and Laurence Olivier. If you haven't seen the film, here's the scene in question on YouTube.
Terrifying.
That question, no doubt, is running through the mind of many an investor at the moment as they search for a safe haven. Like Dustin Hoffman's character in the movie, many financial advisors may well be telling clients this or that investment is "very safe, so safe you wouldn't believe it." Also like Hoffman's character, they may not know what they're talking about because, I suspect, experience isn't much of a guide these days.
You don't know if I do either, so I'll just lay out my arguments and you can decide if they make sense.
I believe the world is in the final stages of what has been the longest unanchored credit expansion (by which I mean a period of undefined monetary units) in modern history. Previous credit expansions ended, after a manic phase, with prices quickly finding some equilibrium in relation to the monetary anchor's price. In modern history that anchor has been gold and/or silver.
"Oh no," you might be thinking, "it's another lecture from a gold bug."
Yes and no.
I think the past 39 years has demonstrated the potential for an unanchored monetary system. In "The Fed Vs. Gold" I charted the US$/Gold price for each of the post 70s crisis Fed Chairmen, and prior to Mr. Bernanke's tenure (and the end of Greenspan's), even though the US$ was not convertible to gold at a fixed rate, the price behaved, more or less, as if it was.
The point being, convertibility isn't the key, rather, however one measures monetary stability, Central Bankers need to shoot at a target and the market needs to have some sense of what that target is. No commodity or inflation target, no bond vigilantes.
The target now, apparently, is to ensure that the world's big banks don't go bust, ergo the size and direction (to the banks and not the people, infrastructure projects, etc.) of "rescue" flows each time the increasingly frequent crises erupts.
The effect of this policy was readily apparent today, as it was during the last few months of 2008- nobody knows what anything is really worth. Traders, on their own or, more often, guided by computer models, act on "asset" price cues and sling around huge volume orders in markets suddenly thinned of price makers.
I sometimes wonder if, in part, the substantial increase in computer driven trading has kept this game going far longer than it otherwise would. After a while, you'd think, humans would begin to wonder what things are actually worth, instead of simply reacting to price cues. Of course, the answers to those questions might not be favorable to the big banks, or governments.
It's not safe.
Over the past few years the number of safe havens have been shrinking, and, in one key respect shifting. For the first time in many years, gold rose as traders looked to shed risk. This, to me, is a most interesting development. Historically, gold has been the premier safe haven, the ultimate store of value in times of financial confusion. I expect this to continue.
As I noted a few days ago (the timing was more fortuitous than a result of expertise), credit conditions are tightening and should continue to tighten. The authorities, most likely, will try to inflate their way out of the tightness. The Fed, as the supplier of global reserve currency liquidity will have to act as lender of last resort at a time when Fed Funds are already near zero.
They key, in my view, the last peg to the US$ standard, is the US bond market. Had bond prices fallen sharply today I would have qualified today as the terminal stage of the credit expansion, but prices rose. Prior to the 1987 crash, a substantial equity market decline would have, as today, led to thoughts of more liquidity and, unlike today, higher inflation.
If the argument laid out above is correct, at some point in the not too distant future, US bond prices will fall sharply along with equity markets, major currencies will slide against key industrial commodities, and gold will rally sharply.
When people don't know what money is worth, and have no faith in its stability, how can they know what anything else is worth in terms thereof?
At times when nobody knows what anything is really worth there is one answer historically to the question, "is it safe?"
It's safe, if it's gold.
An interesting observation: I spent the day playing golf and none of the televisions in the club house were tuned in to CNBC. That would not have been the case in 2000.
Full Disclosure: Long lots of Gold (thank you, Morgan Stanley, for those 1998 Golden Eagles at $275)
That question still brings shivers up my spine as I recall the 1976 movie, Marathon Man, starring Dustin Hoffman, Roy Scheider, and Laurence Olivier. If you haven't seen the film, here's the scene in question on YouTube.
Terrifying.
That question, no doubt, is running through the mind of many an investor at the moment as they search for a safe haven. Like Dustin Hoffman's character in the movie, many financial advisors may well be telling clients this or that investment is "very safe, so safe you wouldn't believe it." Also like Hoffman's character, they may not know what they're talking about because, I suspect, experience isn't much of a guide these days.
You don't know if I do either, so I'll just lay out my arguments and you can decide if they make sense.
I believe the world is in the final stages of what has been the longest unanchored credit expansion (by which I mean a period of undefined monetary units) in modern history. Previous credit expansions ended, after a manic phase, with prices quickly finding some equilibrium in relation to the monetary anchor's price. In modern history that anchor has been gold and/or silver.
"Oh no," you might be thinking, "it's another lecture from a gold bug."
Yes and no.
I think the past 39 years has demonstrated the potential for an unanchored monetary system. In "The Fed Vs. Gold" I charted the US$/Gold price for each of the post 70s crisis Fed Chairmen, and prior to Mr. Bernanke's tenure (and the end of Greenspan's), even though the US$ was not convertible to gold at a fixed rate, the price behaved, more or less, as if it was.
The point being, convertibility isn't the key, rather, however one measures monetary stability, Central Bankers need to shoot at a target and the market needs to have some sense of what that target is. No commodity or inflation target, no bond vigilantes.
The target now, apparently, is to ensure that the world's big banks don't go bust, ergo the size and direction (to the banks and not the people, infrastructure projects, etc.) of "rescue" flows each time the increasingly frequent crises erupts.
The effect of this policy was readily apparent today, as it was during the last few months of 2008- nobody knows what anything is really worth. Traders, on their own or, more often, guided by computer models, act on "asset" price cues and sling around huge volume orders in markets suddenly thinned of price makers.
I sometimes wonder if, in part, the substantial increase in computer driven trading has kept this game going far longer than it otherwise would. After a while, you'd think, humans would begin to wonder what things are actually worth, instead of simply reacting to price cues. Of course, the answers to those questions might not be favorable to the big banks, or governments.
It's not safe.
Over the past few years the number of safe havens have been shrinking, and, in one key respect shifting. For the first time in many years, gold rose as traders looked to shed risk. This, to me, is a most interesting development. Historically, gold has been the premier safe haven, the ultimate store of value in times of financial confusion. I expect this to continue.
As I noted a few days ago (the timing was more fortuitous than a result of expertise), credit conditions are tightening and should continue to tighten. The authorities, most likely, will try to inflate their way out of the tightness. The Fed, as the supplier of global reserve currency liquidity will have to act as lender of last resort at a time when Fed Funds are already near zero.
They key, in my view, the last peg to the US$ standard, is the US bond market. Had bond prices fallen sharply today I would have qualified today as the terminal stage of the credit expansion, but prices rose. Prior to the 1987 crash, a substantial equity market decline would have, as today, led to thoughts of more liquidity and, unlike today, higher inflation.
If the argument laid out above is correct, at some point in the not too distant future, US bond prices will fall sharply along with equity markets, major currencies will slide against key industrial commodities, and gold will rally sharply.
When people don't know what money is worth, and have no faith in its stability, how can they know what anything else is worth in terms thereof?
At times when nobody knows what anything is really worth there is one answer historically to the question, "is it safe?"
It's safe, if it's gold.
An interesting observation: I spent the day playing golf and none of the televisions in the club house were tuned in to CNBC. That would not have been the case in 2000.
Full Disclosure: Long lots of Gold (thank you, Morgan Stanley, for those 1998 Golden Eagles at $275)
Wednesday, May 05, 2010
The Market Ate My (Bear Stearns) Homework
Despite the efforts we made prior to 2007 to reduce our exposure to the subprime sector, the scale of our activities in other sectors of the mortgage market caused widespread concerns about Bear Stearns’ solvency. These concerns were unfounded. Our capital ratios and liquidity pool remained high by historical standards. Nevertheless, as a result of these rumors, during the week of March 10, 2008, brokerage customers withdrew assets and counterparties refused to roll over repo facilities. These events resulted in a dramatic loss of liquidity. The market’s loss of confidence, even though it was unjustified and irrational, became a self-fulfilling prophecy. Testimony of James E. Cayne before the Financial Crisis Inquiry Commission
Is today "Corporations' Day"? At his eponymous website, Lew Rockwell wonders why we can't feel sorry for BP and ex-Bear Stearns CEO Cayne testifies that he did no wrong, "the market ate his homework".
Of the two arguments, I have some sympathy for Mr. Rockwell's view (although to assert, as he does, It should be obvious that BP is by far the leading victim seems so silly he can't be serious). Deep sea drilling seems like tricky business and BP will, no doubt, become the "whipping boy" of the environmental zealots (which is to distinguish the radical fringe from those with justified, but more balanced concerns). Yet, I can't see why one should wax anthropomorphic. BP is a corporation. I feel for the workers who died on the rig, those affected by the spill, and those, in and out of BP, who will lose jobs as a result, but for BP itself? No.
There are risks to such activities and BP (and the governments that issued the permits) were aware of them. Given the precedent setting Exxon-Valdez case, BP knew what a mistake could cost them. If it leads to bankruptcy chalk it up as a fat tail (an event statisticians deem low probability with large risk). Moreover, corporate bankruptcy isn't death. The assets and expertise will be re-incorporated, like Frankenstein's monster, into a new or existing corporation.
Turning to another fat tail, let's consider the events that led to the collapse of Bear Stearns. While Mr. Cayne would have you believe that concerns about their solvency were unfounded and their demise, unjust, I think it's simply a case of not doing one's homework.
Bear Stearns management were surely aware that their high leverage ratio (according to Fortune Magazine, 35 to 1) was the means by which they posted profits sufficient to drive their stock price above $150. That same leverage became the market perceived Sword of Damocles over their heads as credit conditions tightened. If they had opted for less leverage from 2005-2007, their stock price might not had risen so high, but they may well have survived the crisis.
Surely Mr. Cayne's nearly 40 years at Bear were sufficient to inform him of the fickle nature of credit markets, and the financial sharks with whom he swam.
Maybe that info was part of the homework the market ate?
Is today "Corporations' Day"? At his eponymous website, Lew Rockwell wonders why we can't feel sorry for BP and ex-Bear Stearns CEO Cayne testifies that he did no wrong, "the market ate his homework".
Of the two arguments, I have some sympathy for Mr. Rockwell's view (although to assert, as he does, It should be obvious that BP is by far the leading victim seems so silly he can't be serious). Deep sea drilling seems like tricky business and BP will, no doubt, become the "whipping boy" of the environmental zealots (which is to distinguish the radical fringe from those with justified, but more balanced concerns). Yet, I can't see why one should wax anthropomorphic. BP is a corporation. I feel for the workers who died on the rig, those affected by the spill, and those, in and out of BP, who will lose jobs as a result, but for BP itself? No.
There are risks to such activities and BP (and the governments that issued the permits) were aware of them. Given the precedent setting Exxon-Valdez case, BP knew what a mistake could cost them. If it leads to bankruptcy chalk it up as a fat tail (an event statisticians deem low probability with large risk). Moreover, corporate bankruptcy isn't death. The assets and expertise will be re-incorporated, like Frankenstein's monster, into a new or existing corporation.
Turning to another fat tail, let's consider the events that led to the collapse of Bear Stearns. While Mr. Cayne would have you believe that concerns about their solvency were unfounded and their demise, unjust, I think it's simply a case of not doing one's homework.
Bear Stearns management were surely aware that their high leverage ratio (according to Fortune Magazine, 35 to 1) was the means by which they posted profits sufficient to drive their stock price above $150. That same leverage became the market perceived Sword of Damocles over their heads as credit conditions tightened. If they had opted for less leverage from 2005-2007, their stock price might not had risen so high, but they may well have survived the crisis.
Surely Mr. Cayne's nearly 40 years at Bear were sufficient to inform him of the fickle nature of credit markets, and the financial sharks with whom he swam.
Maybe that info was part of the homework the market ate?
Tuesday, May 04, 2010
Collapse of Occult Economics and US$ Based World
I see bad libor rising
I see trouble on the way
I see market crashes and (near) defaults
I see bad times today
Don't go 'round tonight
For it's bound to take your cash
There's a bad libor on the rise
Ex-Fed Chairman Greenspan has been accused of occulting (hiding from people's view) dissent from the Fed's panglossian housing market forecasts in 2004. While I'd love for that to be true, I'm with Felix Salmon, who, after reading the whole transcript (always a good idea before jumping to an opinion) discerned the offensive quote (see below) referred to debate over Fed transparency and not the housing market.
We run the risk, by laying out the pros and cons of a particular argument, of inducing people to join in on the debate, and in this regard it is possible to lose control of a process that only we fully understand. Fed Transcript
To my mind, a more interesting quote can be found in Ms. Minehan's discussion of US economic growth at the same meeting: And like everybody else, I don’t know why the pace of hiring has been as slow as it has been or whether it will get slower or speed up more quickly than we expect.
There's an admission worth noting, she, like everyone else at the table didn't know why the pace of hiring had been as slow as it had been (perhaps because Fed liquidity had gone more to overseas markets than at home would be my guess). In other words, the only occulting that occurred at Fed meetings was the far less sinister, but much more ominous blind leading the blind.
I think the same phenomenon lies behind TPM's discovery of occult practices at the US Treasury in their dealings with Congress (Ms. Pelosi has recently reported the meeting to first request funds came at her, not the Treasury's, request) prior to the request for TARP funds. It isn't sinister, it's just a case of enforced ignorance, as in, let's try whistling past the graveyard, it might work.
Neither Greenspan, nor Rubin, nor Summers (whose financial prescience was shown to be flawed at Harvard) nor Blankfein nor any other of the financial big wigs knows what's going to happen in the financial world because they believe this time is different. (If they did know they would have run for the hills long ago) They have thrown away the only tool that allows economic forecasting, the assumption that the rules of economics always operate (qualifying the proper conditions as they relate to the past being the tricky part of the game, whether I've done so accurately this time remains to be seen).
The collapse of occult economics to which I refer is the apocalypse (Greek for unveiling) of the US$ based system as operating under the same rules of finance that have always operated, specifically the fact that true provision of global liquidity can only come (in a US$ based trading system) through increased US$ supply, a.k.a. Triffin's Dilemma.
As I've previously discussed, Robert Triffin noted the dilemma at the heart of the US$ based global trading system- in order for the world to get the liquidity it wants US$ balances overseas will have to grow, thus eventually weakening the US$ such that it could no longer serve as global reserve currency.
Two events are conspiring to unveil Triffin's Dilemma to the world, the coming economic slowdown in China as a result of previous credit over-extension and current tightening and the current emerging crisis in the Euro periphery- the "G"-less PIGS (Portugal, Italy, Greece (who've gotten their bail-out), and Spain). The "G"-less PIGS must have felt a bit left out of the liquidity party for Greece this past weekend and are now clamoring for their own rescue package.
As an aside, I'm only partially facetious when I suggest a most profitable Hedge Fund theme, find liquidity deprived countries to invest in a fund that will blow out your spreads (CDS and swaps) and create the need for a bail-out. As an added bonus, the rescue deal will likely include a fully funded financial rescue package.
As always there are options available to policy makers. They could allow defaults to occur but that is the "it" (being deflation) Bernanke promised wouldn't happen here (in the US, and by extension, the world), and that option too would likely lead to the end of the US$ based trading system. The other option, the option that has become the rule is more liquidity, and in this case, barring a significant decline in the Euro and RMB vs. the US$, the Fed will have to supply that liquidity at a time when they would prefer to begin unloading some of the toxic securities they bought from the TBTF banks.
Unlike the 2008, 2000-2001 and 1997-1998 crises, however, Fed Funds are already near zero. Quantitative easing, in the form of continued declines in acceptable collateral for Central Bank discounting will be the tool- monetization of poor credit, in large amounts.
At that point, I suspect, Gold will begin to soar against all currencies, and the search for a new global international reserve will being in earnest.
The signs of impending crisis are already manifesting: 1) global stock markets are rolling over 2) credit default swap prices for the "G"-less PIGS are rising rapidly 3) the pace of decline in US$ swap rates has eased.
In the not too distant future, if stock markets continue to weaken, US$ swaps rates will rise. US$ liquidity will, once again, be in short supply and the Fed will be called on to rescue the world.
Let the unveiling commence.
p.s. the primary rule of economics that, in my view, has been occulted from view, because it is so distasteful (to some) is the no free lunch rule...just my, rapidly depreciating, two cents
p.p.s yes, I'm way out on a limb on this one, but what the heck, I'm just a pajama-wearing blogger
Full Disclosure: Long lots of Gold
I see trouble on the way
I see market crashes and (near) defaults
I see bad times today
Don't go 'round tonight
For it's bound to take your cash
There's a bad libor on the rise
Ex-Fed Chairman Greenspan has been accused of occulting (hiding from people's view) dissent from the Fed's panglossian housing market forecasts in 2004. While I'd love for that to be true, I'm with Felix Salmon, who, after reading the whole transcript (always a good idea before jumping to an opinion) discerned the offensive quote (see below) referred to debate over Fed transparency and not the housing market.
We run the risk, by laying out the pros and cons of a particular argument, of inducing people to join in on the debate, and in this regard it is possible to lose control of a process that only we fully understand. Fed Transcript
To my mind, a more interesting quote can be found in Ms. Minehan's discussion of US economic growth at the same meeting: And like everybody else, I don’t know why the pace of hiring has been as slow as it has been or whether it will get slower or speed up more quickly than we expect.
There's an admission worth noting, she, like everyone else at the table didn't know why the pace of hiring had been as slow as it had been (perhaps because Fed liquidity had gone more to overseas markets than at home would be my guess). In other words, the only occulting that occurred at Fed meetings was the far less sinister, but much more ominous blind leading the blind.
I think the same phenomenon lies behind TPM's discovery of occult practices at the US Treasury in their dealings with Congress (Ms. Pelosi has recently reported the meeting to first request funds came at her, not the Treasury's, request) prior to the request for TARP funds. It isn't sinister, it's just a case of enforced ignorance, as in, let's try whistling past the graveyard, it might work.
Neither Greenspan, nor Rubin, nor Summers (whose financial prescience was shown to be flawed at Harvard) nor Blankfein nor any other of the financial big wigs knows what's going to happen in the financial world because they believe this time is different. (If they did know they would have run for the hills long ago) They have thrown away the only tool that allows economic forecasting, the assumption that the rules of economics always operate (qualifying the proper conditions as they relate to the past being the tricky part of the game, whether I've done so accurately this time remains to be seen).
The collapse of occult economics to which I refer is the apocalypse (Greek for unveiling) of the US$ based system as operating under the same rules of finance that have always operated, specifically the fact that true provision of global liquidity can only come (in a US$ based trading system) through increased US$ supply, a.k.a. Triffin's Dilemma.
As I've previously discussed, Robert Triffin noted the dilemma at the heart of the US$ based global trading system- in order for the world to get the liquidity it wants US$ balances overseas will have to grow, thus eventually weakening the US$ such that it could no longer serve as global reserve currency.
Two events are conspiring to unveil Triffin's Dilemma to the world, the coming economic slowdown in China as a result of previous credit over-extension and current tightening and the current emerging crisis in the Euro periphery- the "G"-less PIGS (Portugal, Italy, Greece (who've gotten their bail-out), and Spain). The "G"-less PIGS must have felt a bit left out of the liquidity party for Greece this past weekend and are now clamoring for their own rescue package.
As an aside, I'm only partially facetious when I suggest a most profitable Hedge Fund theme, find liquidity deprived countries to invest in a fund that will blow out your spreads (CDS and swaps) and create the need for a bail-out. As an added bonus, the rescue deal will likely include a fully funded financial rescue package.
As always there are options available to policy makers. They could allow defaults to occur but that is the "it" (being deflation) Bernanke promised wouldn't happen here (in the US, and by extension, the world), and that option too would likely lead to the end of the US$ based trading system. The other option, the option that has become the rule is more liquidity, and in this case, barring a significant decline in the Euro and RMB vs. the US$, the Fed will have to supply that liquidity at a time when they would prefer to begin unloading some of the toxic securities they bought from the TBTF banks.
Unlike the 2008, 2000-2001 and 1997-1998 crises, however, Fed Funds are already near zero. Quantitative easing, in the form of continued declines in acceptable collateral for Central Bank discounting will be the tool- monetization of poor credit, in large amounts.
At that point, I suspect, Gold will begin to soar against all currencies, and the search for a new global international reserve will being in earnest.
The signs of impending crisis are already manifesting: 1) global stock markets are rolling over 2) credit default swap prices for the "G"-less PIGS are rising rapidly 3) the pace of decline in US$ swap rates has eased.
In the not too distant future, if stock markets continue to weaken, US$ swaps rates will rise. US$ liquidity will, once again, be in short supply and the Fed will be called on to rescue the world.
Let the unveiling commence.
p.s. the primary rule of economics that, in my view, has been occulted from view, because it is so distasteful (to some) is the no free lunch rule...just my, rapidly depreciating, two cents
p.p.s yes, I'm way out on a limb on this one, but what the heck, I'm just a pajama-wearing blogger
Full Disclosure: Long lots of Gold
Monday, May 03, 2010
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.
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.
Saturday, May 01, 2010
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.
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.
Friday, April 30, 2010
"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.
"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.
Wednesday, April 28, 2010
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.
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.
Monday, April 26, 2010
A Sophisticated, Glamorous Nation
Education is like drinking- the more you get the easier it is to forget who you were before you started. A. Burns
I have a confession to make. About 15 years ago, I was a well-educated ignoramus, from an Ivy League school of some renown. I don't blame the school for this. Had I spent my years there wisely I could have learned a great many things. What I learned instead was how to appear smart- how to fake it. Fortunately, I came to realize there were more benefits to "education" than appearance, like knowing what words really meant, how we got here (if not originally, at least historically), and how the world works.
I'm still, 15 years later, an ignoramus, but at least I'm aware of my condition.
It hasn't been, for me at least, an easy road, nor is my journey complete. As the Buddha said, there are two mistakes on the path of enlightenment- not starting and not going far enough. I've found many temptations to further enlightenment. Pride both tempts me to scorn those less well versed than I and forget that the only difference between me and them is the realization of my ignorance, good fortune in having the time to study, and the study itself. Pride of education is, for me, very self-defeating. It keeps me from being wonderstruck at the millions of others both now and in the past who know more (by making them invisible) and blinding me to my own past history of being ignorant of my own ignorance.
There are, it seems to me, two paradoxes at the heart of education that stymie the continuation thereof. 1) The more you learn, the more tempted you are to think you know, and the less likely you are to keep learning. 2) The more you learn, the more you realize you don't know. Paradox #1 is the "do loop" of ignorance (really a "don't loop") while Paradox #2 can be daunting, if you don't learn to love learning- heck, to get addicted to the process, not the result.
This rather long preamble was occasioned by a read of Don't ignore the Tea Party's Toxic Take on history. I was reminded of my own ignorance (and consequent misuse) of words like communism, socialism, tyrant and progressive. I was reminded of my own pride, after learning the meanings of those words, in arguing by anecdote: Take for instance the Tea Party demonization of "federal regulation" as the instrument of the tyranny that's been imposed on them. I would like every Tea Partier who has denounced federal regulation to write a letter to the widows and children of the coalminers in West Virginia who died because of the failure of "federal regulation" of mine safety. I was reminded of my own pride in seeing simple answers to complex issues: Historical fraudulence is like a disease, a contagious psychosis which can lead to mob hysteria and worse. Consider the role that fraudulent history played in Weimar Germany, where the "stab in the back" myth that the German Army had been cheated of victory in World War I by Jews and Socialists on the home front was used by the Nazis to justify their hatreds.
Tea Partiers who misuse words like communism, fascism and socialism fall into a trap I know all too well- assuming connotation (in this case, negative) equals meaning. It's a common error. To wit: sophistication has acquired a positive connotation. Not too long ago, I discovered its root referred to sophism, or the use of fallacious argument to win debate and previously had a negative connotation. Two wit: glamorous has acquired a positive connotation. Not too long ago I discovered its root referred to a magic spell- a glamour- which made things appear more desirable than they actually were. In years past, I've happily received the "compliment" of being sophisticated. And who knows, perhaps the speaker was equally ignorant of the meaning and meant to compliment? Ignorance all around, in that case, might have been bliss.
Language is a funny thing-both cause and effect, pushing and pulling, hiding and revealing.
Take the anti-anti-regulation argument above. Tea Partiers, according to the author, should contact the families of recently deceased miners. Makes sense, yes? If you are against regulations you must be for the things that occur without?
Like traffic deaths. Except that's a fairly well regulated area of human life.
I suspect the issues of driving and mining are more nuanced that either the Tea Partiers, the author, or myself could mentally unravel, which is a far cry from enacting (or removing) policies that would "improve" the world, if such a term could be defined.
Of course, faith in man's ability to impose macro improvement (instead of self-improvement) through political change seems strong in modern times, on both sides of the political aisle in the US. Or has politics degenerated into another spectator sport where team victory is all. Should I even use the term "degenerated"?
Perhaps education about our history is like peeling an onion, the more you peel, the more you cry.
I could argue; conflating Tea Partiers with nascent German National Socialists based on their ignorance might be an error. Ignorance is man's most common state, and given the amount of work required to have what is called good working knowledge of a subject, I'm not surprised.
The conflation basis of Tea Partiers with nascent German National Socialists of which I'm concerned is their (in both cases, justified) sense of getting "screwed" by some of those in power (and rather unfortunate belief that a new boss can set things right). Ignorance is common. Passion fueled by outrage about getting "screwed" is (thankfully) reasonably rare. The combination is almost always a disaster.
Thus, the key element of the Tea Partiers one shouldn't ignore is the outrage. Fortunately, this is, in a sense, an easier problem to fix. In systems of popularly elected government, the elite should work hard to not screw the common man.
Seems to make sense, to me. So I try to deal with people on the up and up.
Could such a view be made law and what would be the consequences thereof?
Tough, for me at least, to reason clearly on the subject as I have little knowledge of serious political reforms (as opposed to the more naked power/wealth grabs) that weren't informed by crisis. Law follows ethics, with greater or lesser lags.
I suspect the fix, if such were to manifest, will require us to first "touch the stove". How hot that stove will need to be remains to be seen.
As Santayana said: we learn from history that we learn nothing from history.
I have a confession to make. About 15 years ago, I was a well-educated ignoramus, from an Ivy League school of some renown. I don't blame the school for this. Had I spent my years there wisely I could have learned a great many things. What I learned instead was how to appear smart- how to fake it. Fortunately, I came to realize there were more benefits to "education" than appearance, like knowing what words really meant, how we got here (if not originally, at least historically), and how the world works.
I'm still, 15 years later, an ignoramus, but at least I'm aware of my condition.
It hasn't been, for me at least, an easy road, nor is my journey complete. As the Buddha said, there are two mistakes on the path of enlightenment- not starting and not going far enough. I've found many temptations to further enlightenment. Pride both tempts me to scorn those less well versed than I and forget that the only difference between me and them is the realization of my ignorance, good fortune in having the time to study, and the study itself. Pride of education is, for me, very self-defeating. It keeps me from being wonderstruck at the millions of others both now and in the past who know more (by making them invisible) and blinding me to my own past history of being ignorant of my own ignorance.
There are, it seems to me, two paradoxes at the heart of education that stymie the continuation thereof. 1) The more you learn, the more tempted you are to think you know, and the less likely you are to keep learning. 2) The more you learn, the more you realize you don't know. Paradox #1 is the "do loop" of ignorance (really a "don't loop") while Paradox #2 can be daunting, if you don't learn to love learning- heck, to get addicted to the process, not the result.
This rather long preamble was occasioned by a read of Don't ignore the Tea Party's Toxic Take on history. I was reminded of my own ignorance (and consequent misuse) of words like communism, socialism, tyrant and progressive. I was reminded of my own pride, after learning the meanings of those words, in arguing by anecdote: Take for instance the Tea Party demonization of "federal regulation" as the instrument of the tyranny that's been imposed on them. I would like every Tea Partier who has denounced federal regulation to write a letter to the widows and children of the coalminers in West Virginia who died because of the failure of "federal regulation" of mine safety. I was reminded of my own pride in seeing simple answers to complex issues: Historical fraudulence is like a disease, a contagious psychosis which can lead to mob hysteria and worse. Consider the role that fraudulent history played in Weimar Germany, where the "stab in the back" myth that the German Army had been cheated of victory in World War I by Jews and Socialists on the home front was used by the Nazis to justify their hatreds.
Tea Partiers who misuse words like communism, fascism and socialism fall into a trap I know all too well- assuming connotation (in this case, negative) equals meaning. It's a common error. To wit: sophistication has acquired a positive connotation. Not too long ago, I discovered its root referred to sophism, or the use of fallacious argument to win debate and previously had a negative connotation. Two wit: glamorous has acquired a positive connotation. Not too long ago I discovered its root referred to a magic spell- a glamour- which made things appear more desirable than they actually were. In years past, I've happily received the "compliment" of being sophisticated. And who knows, perhaps the speaker was equally ignorant of the meaning and meant to compliment? Ignorance all around, in that case, might have been bliss.
Language is a funny thing-both cause and effect, pushing and pulling, hiding and revealing.
Take the anti-anti-regulation argument above. Tea Partiers, according to the author, should contact the families of recently deceased miners. Makes sense, yes? If you are against regulations you must be for the things that occur without?
Like traffic deaths. Except that's a fairly well regulated area of human life.
I suspect the issues of driving and mining are more nuanced that either the Tea Partiers, the author, or myself could mentally unravel, which is a far cry from enacting (or removing) policies that would "improve" the world, if such a term could be defined.
Of course, faith in man's ability to impose macro improvement (instead of self-improvement) through political change seems strong in modern times, on both sides of the political aisle in the US. Or has politics degenerated into another spectator sport where team victory is all. Should I even use the term "degenerated"?
Perhaps education about our history is like peeling an onion, the more you peel, the more you cry.
I could argue; conflating Tea Partiers with nascent German National Socialists based on their ignorance might be an error. Ignorance is man's most common state, and given the amount of work required to have what is called good working knowledge of a subject, I'm not surprised.
The conflation basis of Tea Partiers with nascent German National Socialists of which I'm concerned is their (in both cases, justified) sense of getting "screwed" by some of those in power (and rather unfortunate belief that a new boss can set things right). Ignorance is common. Passion fueled by outrage about getting "screwed" is (thankfully) reasonably rare. The combination is almost always a disaster.
Thus, the key element of the Tea Partiers one shouldn't ignore is the outrage. Fortunately, this is, in a sense, an easier problem to fix. In systems of popularly elected government, the elite should work hard to not screw the common man.
Seems to make sense, to me. So I try to deal with people on the up and up.
Could such a view be made law and what would be the consequences thereof?
Tough, for me at least, to reason clearly on the subject as I have little knowledge of serious political reforms (as opposed to the more naked power/wealth grabs) that weren't informed by crisis. Law follows ethics, with greater or lesser lags.
I suspect the fix, if such were to manifest, will require us to first "touch the stove". How hot that stove will need to be remains to be seen.
As Santayana said: we learn from history that we learn nothing from history.
Friday, April 23, 2010
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.
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.
Tuesday, April 20, 2010
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!
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!
Monday, April 19, 2010
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!
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!
Saturday, April 17, 2010
Thought Reserves, Actionable Posts and Bukowski
We are
Born like this
Into this
Into these carefully mad wars
Into the sight of broken factory windows of emptiness
Into bars where people no longer speak to each other
Into fist fights that end as shootings and knifings
Born into this
Into hospitals which are so expensive that it’s cheaper to die
Into lawyers who charge so much it’s cheaper to plead guilty
Into a country where the jails are full and the madhouses closed
Into a place where the masses elevate fools into rich heroes
Charles Bukowski
Over the past few months the good folks at Seeking Alpha have been selectively publishing some of my musings. Their selection process involves the "action-ability" of the views (not a critique, just an observation).
Thus, this post will almost certainly be left on SA's cutting room floor (and rightly so).
When attempting to tailor my musings to their needs, I can't help but be reminded of my earlier incarnation as trader asking house economists to tell me me how to translate their views into trades.
I didn't need the theory, I thought, just the trade.
Eventually I ran into an economist who convinced me of the error of my ways. Alan Ruskin (a very bright economist, and man of great integrity) showed me the virtue of reserves of thought.
If you've spent the time understanding the theories, and creating a library of potentialities, events will "make manifest the theories".
I've spent the years since this epiphany studying theories and creating my own library. The blog you are reading is one repository of this process.
The longer it remains online, the more current events can be covered by referencing earlier thought experiments.
Now I'm on the other side of the issue, with others requesting actionable views.
Months ago, I wondered, "Will Goldman Sachs do it again?" They did. The earlier musings weren't a forecast, just a potential, waiting for an event.
Yesterday I wrote about The Price of Gold Backed FX Reserves. It's not a forecast, just a potential, waiting for an event.
If the event manifests, the work is already done.
Paraphrasing Bukowski,
the events are
born into theory
Born like this
Into this
Into these carefully mad wars
Into the sight of broken factory windows of emptiness
Into bars where people no longer speak to each other
Into fist fights that end as shootings and knifings
Born into this
Into hospitals which are so expensive that it’s cheaper to die
Into lawyers who charge so much it’s cheaper to plead guilty
Into a country where the jails are full and the madhouses closed
Into a place where the masses elevate fools into rich heroes
Charles Bukowski
Over the past few months the good folks at Seeking Alpha have been selectively publishing some of my musings. Their selection process involves the "action-ability" of the views (not a critique, just an observation).
Thus, this post will almost certainly be left on SA's cutting room floor (and rightly so).
When attempting to tailor my musings to their needs, I can't help but be reminded of my earlier incarnation as trader asking house economists to tell me me how to translate their views into trades.
I didn't need the theory, I thought, just the trade.
Eventually I ran into an economist who convinced me of the error of my ways. Alan Ruskin (a very bright economist, and man of great integrity) showed me the virtue of reserves of thought.
If you've spent the time understanding the theories, and creating a library of potentialities, events will "make manifest the theories".
I've spent the years since this epiphany studying theories and creating my own library. The blog you are reading is one repository of this process.
The longer it remains online, the more current events can be covered by referencing earlier thought experiments.
Now I'm on the other side of the issue, with others requesting actionable views.
Months ago, I wondered, "Will Goldman Sachs do it again?" They did. The earlier musings weren't a forecast, just a potential, waiting for an event.
Yesterday I wrote about The Price of Gold Backed FX Reserves. It's not a forecast, just a potential, waiting for an event.
If the event manifests, the work is already done.
Paraphrasing Bukowski,
the events are
born into theory
Air Traffic Congestion and The Flow of Funds
Imagine, instead of stranded passengers, stranded money. Imagine, instead of volcanic ash creating doubts about the safety of flying, a poor auction, bankruptcy, financial fraud charge, or regulatory change creating doubts about the safety of investments. Just as planes don't have to crash, concern itself is enough to stop the flow of passengers; investments don't have to go bust, concern itself is enough to stop the flow of money.
BRUSSELS (Reuters) - Disruption of air traffic because of the spread of volcanic ash from Iceland worsened on Saturday with no landings or takeoffs possible for civilian aircraft in most of northern and central Europe.
The European aviation control agency Eurocontrol said it expected about 5,000 flights in European airspace on Saturday, against 22,000 normally. This compared with 10,400 flights against a normal 28,000 on Friday it said, adjusting figures from an earlier statement.
During an Internet Chat with the In-Laws in Singapore I discovered that air traffic disruptions in Northern Europe had clogged Singapore's Changi airport with stranded travelers- a reflection, no doubt, of many busy airports around the world. This real world experience seems to me a great metaphor to explain disruptions in the flow of funds which operate on similar principles but don't manifest in such easily seen ways.
Due to the grounding of flights in Europe, passengers all over the world are stuck where they are. Whatever tasks await them at their destinations will either not get done or will have to be done by others.
Imagine, instead of stranded passengers, stranded money. Imagine, instead of volcanic ash creating doubts about the safety of flying, a poor auction, bankruptcy, financial fraud charge, or regulatory change creating doubts about the safety of investments. Just as planes don't have to crash, concern itself is enough to stop the flow of passengers; investments don't have to go bust, concern itself is enough to stop the flow of money.
Air traffic congestion brought on by safety concerns is one cause of a significant decline in the velocity of travel. Similarly, monetary congestion brought on by safety concerns is one cause of a significant decline in the velocity of money.
Stranded passengers mean work may be undone, meetings may be postponed, and dates may be cancelled. Stranded money means the same things- bills may be unpaid, investments may be postponed, and equity and security issues may be cancelled.
Due to the interconnectedness of the world through air travel, problems in one part of the world affect the whole. So it is with our interconnected world of finance.
One issue of concern, no doubt, for quite a few stranded passengers is their available reserves. Will the family at home have enough money to pay their bills while some members are gone? Will the stranded passengers have enough available cash to satisfy their needs?
Paraphrasing Warren Buffett, it's only when volcanic ash grounds planes that you find out who's been flying naked.
When the flow of funds is similarly disrupted, reserves are key. The nearer financial entities operate to insolvency the less able they are to deal with disruptions in cash flow. This is the principle behind reserve requirements in banking, and it applies to all financial entities, from a Professor stranded in London to a Hedge Fund waiting for settlement- without sufficient reserves, small defaults can cascade into global problems. Thus are some financial market crashes precipitated.
Indeed, we may well find that this round of air traffic congestion leads to a growing flow of funds disruption. The metaphor may become life.
Chaos theorists refer to the butterfly effect- how a butterfly's flapping wings may change the weather on the other side of the world. This would be the volcano effect- how volcanic ash precipitated a market crash on the other side of (or the entire) world.
There are three key determinants to the extent of this financial chaos effect: 1) the degree to which a critical mass of people are operating near insolvency 2) the degree of payment interconnectedness 3) the duration of the congestion.
In my view, the first two determinants are quite high, only the duration remains unknown.
If only there were Human Central Banks who could conjure up simulated people where needed in the same way Monetary Central Banks conjure up money. Conjuring up people to relieve declining velocity of travel, however, would over-populate the world with people in the same way that monetary stimulus to relieve declining velocity of money over-populates the world with money.
What was that about Death Panels.....
BRUSSELS (Reuters) - Disruption of air traffic because of the spread of volcanic ash from Iceland worsened on Saturday with no landings or takeoffs possible for civilian aircraft in most of northern and central Europe.
The European aviation control agency Eurocontrol said it expected about 5,000 flights in European airspace on Saturday, against 22,000 normally. This compared with 10,400 flights against a normal 28,000 on Friday it said, adjusting figures from an earlier statement.
During an Internet Chat with the In-Laws in Singapore I discovered that air traffic disruptions in Northern Europe had clogged Singapore's Changi airport with stranded travelers- a reflection, no doubt, of many busy airports around the world. This real world experience seems to me a great metaphor to explain disruptions in the flow of funds which operate on similar principles but don't manifest in such easily seen ways.
Due to the grounding of flights in Europe, passengers all over the world are stuck where they are. Whatever tasks await them at their destinations will either not get done or will have to be done by others.
Imagine, instead of stranded passengers, stranded money. Imagine, instead of volcanic ash creating doubts about the safety of flying, a poor auction, bankruptcy, financial fraud charge, or regulatory change creating doubts about the safety of investments. Just as planes don't have to crash, concern itself is enough to stop the flow of passengers; investments don't have to go bust, concern itself is enough to stop the flow of money.
Air traffic congestion brought on by safety concerns is one cause of a significant decline in the velocity of travel. Similarly, monetary congestion brought on by safety concerns is one cause of a significant decline in the velocity of money.
Stranded passengers mean work may be undone, meetings may be postponed, and dates may be cancelled. Stranded money means the same things- bills may be unpaid, investments may be postponed, and equity and security issues may be cancelled.
Due to the interconnectedness of the world through air travel, problems in one part of the world affect the whole. So it is with our interconnected world of finance.
One issue of concern, no doubt, for quite a few stranded passengers is their available reserves. Will the family at home have enough money to pay their bills while some members are gone? Will the stranded passengers have enough available cash to satisfy their needs?
Paraphrasing Warren Buffett, it's only when volcanic ash grounds planes that you find out who's been flying naked.
When the flow of funds is similarly disrupted, reserves are key. The nearer financial entities operate to insolvency the less able they are to deal with disruptions in cash flow. This is the principle behind reserve requirements in banking, and it applies to all financial entities, from a Professor stranded in London to a Hedge Fund waiting for settlement- without sufficient reserves, small defaults can cascade into global problems. Thus are some financial market crashes precipitated.
Indeed, we may well find that this round of air traffic congestion leads to a growing flow of funds disruption. The metaphor may become life.
Chaos theorists refer to the butterfly effect- how a butterfly's flapping wings may change the weather on the other side of the world. This would be the volcano effect- how volcanic ash precipitated a market crash on the other side of (or the entire) world.
There are three key determinants to the extent of this financial chaos effect: 1) the degree to which a critical mass of people are operating near insolvency 2) the degree of payment interconnectedness 3) the duration of the congestion.
In my view, the first two determinants are quite high, only the duration remains unknown.
If only there were Human Central Banks who could conjure up simulated people where needed in the same way Monetary Central Banks conjure up money. Conjuring up people to relieve declining velocity of travel, however, would over-populate the world with people in the same way that monetary stimulus to relieve declining velocity of money over-populates the world with money.
What was that about Death Panels.....
Friday, April 16, 2010
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.
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
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
Thursday, April 15, 2010
China, TBTF, and dancin' with the gal that brung ya'
QUESTIONER: Changing the part of the world and going to China. Yesterday I read a statement from Mr. Strauss-Kahn about the yuan, the currency, being definitely undervalued. I wanted to know if you had anything to articulate on this or to comment. Thank you.
MS. ATKINSON (IMF): We have said a number of times that the yuan appears to us to be substantially undervalued. We've also said that what's important is to think about the rebalancing of China's economy. More broadly it's important that the Chinese themselves are interested in boosting domestic demand and private consumption, and exchange rate movements would be just a part of that. It's also of course important to think about global rebalancing, and that means that deficit countries as well as surplus countries need to make some adjustments. IMF Press Briefing 3/18/2010
Perhaps because of my rebellious nature, I've always been attracted to the counter-trend trade. Back in my days as a Hedge Fund trader, I learned about the "max pain" (there are more colorful descriptions) trade. When the market is positioned for a currency price rise, IF (timing is everything, here) you can catch the changing winds of news, you can make a killing (or at least avoid getting caught in the slaughter). In Sorosian jargon, this is the bet against the false premise.
As James Chanos has been arguing: We’re all looking at -- one of the most obvious, obvious trades of the world right now is that the RMB, the Yuan is undervalued. Mr. Geithner, I think, is in Beijing tonight talking about whether or not China is a currency manipulator. Everyone is assuming China needs to peg its currency higher to avoid the export deflation going on.
Well, Chinese exports aren’t the problem here. And what if it turns out that by having to nationalize lots and lots of real estate, bad debts, the RMB is devalued?
These days, the mother of all "max pain" trades would be an RMB decline. How likely might such an event be?
Let me preface my view (with which, and $4.50, you can get a coffee at Starbucks) with my more general sense that China is in the midst of an amazing transformation which has many more years to run. I wouldn't bet against China in the long term (or at least until demographics catch up to them).
However, other countries which have similarly transformed have hit speeds bumps in the process. Rapid growth creates a financial environment that begs (usually temporary) over-extension. In China's case, their history of modern financial corporate governance is quite short (on that score, we, in the US still have more than a few kinks to work out). The burned hand, as they say, teaches best (or will after the stove is touched a few more times).
For the past few months China has been trying to slow the economy down, in particular the property market, probably in search of the elusive soft landing. I've never been much of a believer in the "soft-landing" thesis. There are too many unknowns in a huge economy so policy inevitably over-shoots (or never uncovers the excesses at all). At some point, a threshold will be reached and we'll find out just how sound Chinese property (et alia) lending has been.
My guess is, as almost always tends to be the case, there will be a big difference between viable credit levels of an economy growing at 8% (or, according to the latest data more than 11%) and one growing at 1-2%.
Given that the Chinese banking system totals upwards of $11.5T in assets, even a small "hair-cut" means a couple $100Bil.
China is now a key piece of our increasingly interconnected global economy. It certainly qualifies, in a more profound sense than the largest US banks, as Too Big To Fail. We may even find that China's economy has grown sufficiently to ensure that when China sneezes, the rest of the world gets a cold.
In the event of a speed bump, support, in one form or another, will certainly be forthcoming and that support will not be predicated on how the IMF or other nations wish China to develop but on the infrastructure already in place in the same way that TBTF banks were given support based on their infrastructure in place (i.e. continued prop. trading, continued derivatives, etc.) and not on the proposed models envisioned in reform plans.
In times of crisis, ya' gotta dance with the gal that brung ya'.
China is an export driven economy (net exports were 8.9% of 2009 GDP), and the best way to goose such an economy is by letting the currency slide. Moreover, China has been the recipient of substantial capital inflows (the cumulative current account surplus only accounts for roughly 65% of the growth in FX reserves over the past 15 years- just to give a flavor and sense of magnitude). During a crisis, these flows will tend to reverse (or minimally, stop flowing in).
In other words, I wouldn't be surprised to see a not insignificant RMB decline in the medium term, as palliative to a domestic credit problem, before it resumes its more general uptrend against the US$.
I leave for future essays questions of the impact of China's first "speed bump" as a maturing, and huge world power on the international financial architecture (and the impact of a necessary increase in China's current account surplus on the US). Suffice it to write that if such an event occurs (and it will sooner or later) I suspect many known, but currently politically intractable flaws in the regulatory arena (or lack thereof) will come into sharp focus. But they will have to wait.
To repeat, in times of crisis, ya' gotta dance with the gal that brung ya'.
And from a broader perspective, the gal that brung us all to the dance is the gal of monetary stimulus to fix all that ails us. I'm not, at the moment, arguing for a rethink of this policy, just observing.
MS. ATKINSON (IMF): We have said a number of times that the yuan appears to us to be substantially undervalued. We've also said that what's important is to think about the rebalancing of China's economy. More broadly it's important that the Chinese themselves are interested in boosting domestic demand and private consumption, and exchange rate movements would be just a part of that. It's also of course important to think about global rebalancing, and that means that deficit countries as well as surplus countries need to make some adjustments. IMF Press Briefing 3/18/2010
Perhaps because of my rebellious nature, I've always been attracted to the counter-trend trade. Back in my days as a Hedge Fund trader, I learned about the "max pain" (there are more colorful descriptions) trade. When the market is positioned for a currency price rise, IF (timing is everything, here) you can catch the changing winds of news, you can make a killing (or at least avoid getting caught in the slaughter). In Sorosian jargon, this is the bet against the false premise.
As James Chanos has been arguing: We’re all looking at -- one of the most obvious, obvious trades of the world right now is that the RMB, the Yuan is undervalued. Mr. Geithner, I think, is in Beijing tonight talking about whether or not China is a currency manipulator. Everyone is assuming China needs to peg its currency higher to avoid the export deflation going on.
Well, Chinese exports aren’t the problem here. And what if it turns out that by having to nationalize lots and lots of real estate, bad debts, the RMB is devalued?
These days, the mother of all "max pain" trades would be an RMB decline. How likely might such an event be?
Let me preface my view (with which, and $4.50, you can get a coffee at Starbucks) with my more general sense that China is in the midst of an amazing transformation which has many more years to run. I wouldn't bet against China in the long term (or at least until demographics catch up to them).
However, other countries which have similarly transformed have hit speeds bumps in the process. Rapid growth creates a financial environment that begs (usually temporary) over-extension. In China's case, their history of modern financial corporate governance is quite short (on that score, we, in the US still have more than a few kinks to work out). The burned hand, as they say, teaches best (or will after the stove is touched a few more times).
For the past few months China has been trying to slow the economy down, in particular the property market, probably in search of the elusive soft landing. I've never been much of a believer in the "soft-landing" thesis. There are too many unknowns in a huge economy so policy inevitably over-shoots (or never uncovers the excesses at all). At some point, a threshold will be reached and we'll find out just how sound Chinese property (et alia) lending has been.
My guess is, as almost always tends to be the case, there will be a big difference between viable credit levels of an economy growing at 8% (or, according to the latest data more than 11%) and one growing at 1-2%.
Given that the Chinese banking system totals upwards of $11.5T in assets, even a small "hair-cut" means a couple $100Bil.
China is now a key piece of our increasingly interconnected global economy. It certainly qualifies, in a more profound sense than the largest US banks, as Too Big To Fail. We may even find that China's economy has grown sufficiently to ensure that when China sneezes, the rest of the world gets a cold.
In the event of a speed bump, support, in one form or another, will certainly be forthcoming and that support will not be predicated on how the IMF or other nations wish China to develop but on the infrastructure already in place in the same way that TBTF banks were given support based on their infrastructure in place (i.e. continued prop. trading, continued derivatives, etc.) and not on the proposed models envisioned in reform plans.
In times of crisis, ya' gotta dance with the gal that brung ya'.
China is an export driven economy (net exports were 8.9% of 2009 GDP), and the best way to goose such an economy is by letting the currency slide. Moreover, China has been the recipient of substantial capital inflows (the cumulative current account surplus only accounts for roughly 65% of the growth in FX reserves over the past 15 years- just to give a flavor and sense of magnitude). During a crisis, these flows will tend to reverse (or minimally, stop flowing in).
In other words, I wouldn't be surprised to see a not insignificant RMB decline in the medium term, as palliative to a domestic credit problem, before it resumes its more general uptrend against the US$.
I leave for future essays questions of the impact of China's first "speed bump" as a maturing, and huge world power on the international financial architecture (and the impact of a necessary increase in China's current account surplus on the US). Suffice it to write that if such an event occurs (and it will sooner or later) I suspect many known, but currently politically intractable flaws in the regulatory arena (or lack thereof) will come into sharp focus. But they will have to wait.
To repeat, in times of crisis, ya' gotta dance with the gal that brung ya'.
And from a broader perspective, the gal that brung us all to the dance is the gal of monetary stimulus to fix all that ails us. I'm not, at the moment, arguing for a rethink of this policy, just observing.
Tuesday, April 13, 2010
The Big School and Convertibility Lost
As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!"
Why then was this forbid? Why but to awe,
Why but to keep ye low and ignorant,
His worshippers; he knows that in the day
Ye Eate thereof, your Eyes that seem so cleere,
Yet are but dim, shall perfetly be then
Op'nd and cleerd, and ye shall be as Gods
Milton: Paradise Lost
There are, it may seem to a new student of economics, more schools of thought in the field than stars in the sky. I sometimes wonder if David Bohm, author of, inter alia, The Qualitative Infinity of Nature, might have felt more comfortable as an Economist than a Physicist. While the physical sciences, according to Thomas Kuhn, exhibit totalitarian tendencies with violent revolutions, Economics is far more democratic, tolerating, albeit not without disputes, multiple coincident schools of thought.
Of late, however, one school of economic thought has become increasingly dominant in policy making circles. The Big School holds that the larger a financial institution becomes the more protected it should be, and vice versa, the smaller a financial entity is, the less protection it should receive.
As an example of this (somewhat) facetious claim, consider the views of JPM's David Lowman: Like all loans, mortgage contracts are based on a promise to repay money borrowed. Importantly, there is no provision in the mortgage contract, express or implied, that the lender will restore equity or reduce the repayment amount if the value of the collateral – be it a home, a car or a stock market investment – depreciates. If we re-write the mortgage contract retroactively to restore equity to any mortgage borrower because the value of his or her home declined, what responsible lender will take the equity risk of financing mortgages in the future? What responsible regulator would want lenders to take such risk?
In other words, the same bank (there were, of course, others) whose inability to meet its contractual obligations a few years ago was such that it needed loans from, and preferential swapping of toxic for performing securities with, the Fed, equity support from the Treasury, and a release from the onerous task of marking securities to market, NOW thinks contracts, regulations and agreements are sacrosanct.
I wonder if the issue up for debate was deriviatives regulation or marking toxic assets to market, would any person from a bank end a paragraph with "what responsible regulator would want lenders to take such risks?"
Big School Rules.
In a Jonathon Demme film appropriately (for our purposes) titled "Stop Making Sense", the Talking Heads' David Byrne asked, "Well, how did I get here?"
The Big School took its cue from Kuhn and engaged not in democratic debate, but totalitarian revolt. They appropriated Walter Bagehot's views on the Central Bank's Lender of Last Resort facility in times of crisis but perverted them in the process. Instead of the outline presented in Lombard Street of "very large loans at very high rates" which, in modern times, became, "lend freely at a high rate", the Big School preaches the doctrine of "lending freely (to the banks) at a very low rate" thereby relieving the Central Bank of its responsibility to enforce prudence.
I may, however, be wrong in assuming the Big School appropriated their "lend freely (to the banks) at a very low rate" doctrine from Bagehot (they may simply have thought "lots of free money would sure be nice"), because this implies a reading thereof. If they had read Lombard Street they would have found these lines of concern about big banks, and management practices obscured from review:
The second misgiving, which many calm observers more and more feel as to our largest joint stock banks, fastens itself on their government. Is that government sufficient to lend well and keep safe so many millions?
All that the best board of directors can really accomplish [in the largest joint-stock banks] is to form a good decision on the points which the manager presents to them, and perhaps on a few others which one or two zealous members of their body may select for discussion
There is no more unsafe government for a bank than that of an eager and active manager, subject only to the supervision of a numerous board of directors, even though that board be excellent, for the manager may easily glide into dangerous and insecure transactions, nor can the board effectually check him.
Our great joint stock banks are imprudent in so carefully concealing the details of their government, and in secluding those details from the risk of discussion. The answer, no doubt, will be, “Let well alone; as you have admitted, there hardly ever before was so great a success as these banks of ours; what more do you or can you want?” I can only say that I want further to confirm this great success and to make it secure for the future. At present there is at least the possibility of a great reaction. Supposing that, owing to defects in its government, one even of the greater London joint stock banks failed, there would be an instant suspicion of the whole system. One terra incognita being seen to be faulty, every other terra incognita would be suspected. If the real government of these banks had for years been known, and if the subsisting banks had been known not to be ruled by the bad mode of government which had ruined the bank that had fallen, then the ruin of that bank would not be hurtful. The other banks would be seen to be exempt from the cause which had destroyed it. But at present the ruin of one of these great banks would greatly impair the credit of all. Scarcely any one knows the precise government of any one; in no case has that government been described on authority; and the fall of one by grave misgovernment would be taken to show that the others might as easily be misgoverned also. And a tardy disclosure even of an admirable constitution would not much help the surviving banks: as it was extracted by necessity, it would be received with suspicion. A sceptical world would say, “Of course they say they are all perfect now; it would not do for them to say anything else”.
A read of Lombard Street would not have led to the Big School's conclusion that the Lender of Last Resort should, in times of crisis, lend only to the banks, and even insolvent ones.
Bagehot advised differently: A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to “this man and that man,” whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.
In other words, Bagehot argued the Central Bank's responsibility was to "the market", not the banks.
Further, he argued: the majority to be protected, are the “sound” people, the people who have good security to offer. He also speaks to the issue of unsound people, perhaps using a bit of wishful thinking: No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the “unsound” people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected;
While the fraction of business which is unsound today is likely larger than in Bagehot's England, I suspect most is sound. Unfortunately, the unsound elements, while small in practical classification (derivatives, mortgage backed securities, etc.) are huge in terms of currency relative to the whole economy.
Big School means Big Problems
Why, I wonder, did the other schools of thought so meekly submit to the Big School's totalitarian revolution? Perhaps the question might better be phrased, what problem(s) deemed intractable by most other schools of thought did the Big School solve.
My best guess; one of the problems the Big School solved is Triffin's Dilemma. Alternatively, a previous (temporary) "solution" of Triffin's Dilemma, the London Gold Pool, was brought back to life, a la Frankenstein's monster which begat Big School thinking.
Triffin's Dilemma states that when a national money is used as an international medium of exchange and international reserve there will be trade-offs between the national and global effects of the reserve currency issuer's monetary policy. Moreover, the reserve currency issuer nation would soon find that it had to run increasing current account deficits to provide liquidity to the rest of the world. This, in turn, would erode confidence in reserve currency convertibility, eventually leading to international currency instability and potentially a break down in world trade.
Robert Triffin forecast the breakdown of the Bretton Woods system based on this dilemma. Of late, his work has been cited by the PBOC.
Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries´ demand for reserve currencies. On the one hand,the monetary authorities cannot simply focus on domestic goals without carrying out their international responsibilities on the other hand,they cannot pursue different domestic and international objectives at the same time. They may either fail to adequately meet the demand of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists. Zhou Xiaochuan: hairman, Monetary Policy Committee of the People's Bank of China
Triffin, in the late 50s, called for the creation of a new global currency to act as international reserve, along the lines of Keynes' Bancor, or the IMF's SDR (deliberations for the creation of which were informed of his concerns), which, in my view, invites a whole new set of problems, but may still, barring a significantly large, in economic terms, country usurping the US$'s role, e.g. China (which invites similar problems, and leads to the US' loss of the exorbitant privilege), prove the best solution. A "free banking" system of competing moneys is another option.
As the US, not entirely without globally altruistic justification, did not want the Bancor in 1960 any more than it wanted it in 1945, the dilemma of convertibility fears was managed by illusion by way of intervention. The London Gold Pool was established in 1961 to keep the "market price" of Gold at $35 and thus reduce the incentive to demand promised convertibility from the Fed.
This worked until French demands for Gold were not satisfied. The cartel failed to maintain prices within the target and within a few years Nixon's closing of the Gold window ended US$-Gold convertibility.
I'll spare you the details of the 70s inflation and early 80s newfound stability. Suffice it to write that US$ reserves were accepted as semi-convertible- if not to Gold at a fixed price, at least to Gold and a basket of commodities with limited (until recently) fluctuations at new, higher prices.
In one (presumably easily accepted) respect, Big School banks that created and kept markets going in multiple new ($ based) investment vehicles helped sustain the sense of convertibility so long as those markets were trading. Markets to spend one's $s, even if one never shops there, engender a sense of stability.
Also coincident with this new found stability was the beginning of a business deal between J. Aron (purchased by Goldman Sachs in 1981) and Central Banks around the world. As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!" (pg. 258)
The book goes on to detail that J. Aron was actually making 8% on the deal with no money down, "it produced a nearly infinite rate of return." The book suggests they pulled a fast one on the central banks.
What Coyne may not have known was that at least some governments may well have done the deal for nothing. J. Aron offered to do what the London Gold Pool had done, and was willing to take the risk itself- a risk passed on in the merger to GS. An added benefit, assuming the deal worked as described, no gold had to actually be sold on the market, paper gold would suffice.
GS was not alone in this game. By the mid to late 80s when I was at Chase (now JPM), our Gold desk (fortunately positioned right behind the options desk where I worked) was playing the same game. Paper gold flooded the market.
One of the reasons I began working with GATA a decade ago was my observation (shared by them) of Gold's stubborn reluctance to rise in price despite the rapidly increasing external US$ reserves. If Gold was, as Triffin asserted, undervalued in the early 60s, surely, I thought, it was a steal in 2000 at $275.
Global US$ reserves have done nothing but rise since, at an increasing pace.
In 1978, Triffin and Mundell were warning of a sudden collapse of the US$ due to the growth of those reserves. Back then they wrote in astonishment of US$ reserves in the few hundreds of billions. Now, such reserves are measured in the trillions.
Without concrete data I can only speculate as to the extent of Central Bank gold leasing, or its effect on the price. In the past few years, the price of Gold has risen above $1000. Interestingly the price broke above the early 1980s high of $800 when problems began appearing in large US banks. The mid 2008 dollar squeeze in international markets capped its advance at that time, only to bring the US banking system to the brink of disaster.
How causal the coincidence proves to be remains a mystery. What seems certain is that, if Central Bank gold leasing is a policy aimed at extending the life of the US$ as global reserve currency, the banks so engaged cannot be allowed to fail, or the game is over.
Thus, I wonder how much effect, if any, the Gold leasing practices of the big NY banks had on the decision to make them too big to fail.
Have we dodged Triffin's dilemma by trying to maintain the illusion of convertibility only to invite a banking collapse worse than Bagehot's worse nightmare?
How will the US respond if an economy as large as China's needs a boost in international liquidity? How large might an IMF rescue package need to be to keep China from suffering a disastrous contraction? Would the US, as is its wont, allow the current account to widen further to ensure China repaid the IMF?
What if Japan needs IMF support?
How far off might such events be?
Big Questions for the Big School
Why then was this forbid? Why but to awe,
Why but to keep ye low and ignorant,
His worshippers; he knows that in the day
Ye Eate thereof, your Eyes that seem so cleere,
Yet are but dim, shall perfetly be then
Op'nd and cleerd, and ye shall be as Gods
Milton: Paradise Lost
There are, it may seem to a new student of economics, more schools of thought in the field than stars in the sky. I sometimes wonder if David Bohm, author of, inter alia, The Qualitative Infinity of Nature, might have felt more comfortable as an Economist than a Physicist. While the physical sciences, according to Thomas Kuhn, exhibit totalitarian tendencies with violent revolutions, Economics is far more democratic, tolerating, albeit not without disputes, multiple coincident schools of thought.
Of late, however, one school of economic thought has become increasingly dominant in policy making circles. The Big School holds that the larger a financial institution becomes the more protected it should be, and vice versa, the smaller a financial entity is, the less protection it should receive.
As an example of this (somewhat) facetious claim, consider the views of JPM's David Lowman: Like all loans, mortgage contracts are based on a promise to repay money borrowed. Importantly, there is no provision in the mortgage contract, express or implied, that the lender will restore equity or reduce the repayment amount if the value of the collateral – be it a home, a car or a stock market investment – depreciates. If we re-write the mortgage contract retroactively to restore equity to any mortgage borrower because the value of his or her home declined, what responsible lender will take the equity risk of financing mortgages in the future? What responsible regulator would want lenders to take such risk?
In other words, the same bank (there were, of course, others) whose inability to meet its contractual obligations a few years ago was such that it needed loans from, and preferential swapping of toxic for performing securities with, the Fed, equity support from the Treasury, and a release from the onerous task of marking securities to market, NOW thinks contracts, regulations and agreements are sacrosanct.
I wonder if the issue up for debate was deriviatives regulation or marking toxic assets to market, would any person from a bank end a paragraph with "what responsible regulator would want lenders to take such risks?"
Big School Rules.
In a Jonathon Demme film appropriately (for our purposes) titled "Stop Making Sense", the Talking Heads' David Byrne asked, "Well, how did I get here?"
The Big School took its cue from Kuhn and engaged not in democratic debate, but totalitarian revolt. They appropriated Walter Bagehot's views on the Central Bank's Lender of Last Resort facility in times of crisis but perverted them in the process. Instead of the outline presented in Lombard Street of "very large loans at very high rates" which, in modern times, became, "lend freely at a high rate", the Big School preaches the doctrine of "lending freely (to the banks) at a very low rate" thereby relieving the Central Bank of its responsibility to enforce prudence.
I may, however, be wrong in assuming the Big School appropriated their "lend freely (to the banks) at a very low rate" doctrine from Bagehot (they may simply have thought "lots of free money would sure be nice"), because this implies a reading thereof. If they had read Lombard Street they would have found these lines of concern about big banks, and management practices obscured from review:
The second misgiving, which many calm observers more and more feel as to our largest joint stock banks, fastens itself on their government. Is that government sufficient to lend well and keep safe so many millions?
All that the best board of directors can really accomplish [in the largest joint-stock banks] is to form a good decision on the points which the manager presents to them, and perhaps on a few others which one or two zealous members of their body may select for discussion
There is no more unsafe government for a bank than that of an eager and active manager, subject only to the supervision of a numerous board of directors, even though that board be excellent, for the manager may easily glide into dangerous and insecure transactions, nor can the board effectually check him.
Our great joint stock banks are imprudent in so carefully concealing the details of their government, and in secluding those details from the risk of discussion. The answer, no doubt, will be, “Let well alone; as you have admitted, there hardly ever before was so great a success as these banks of ours; what more do you or can you want?” I can only say that I want further to confirm this great success and to make it secure for the future. At present there is at least the possibility of a great reaction. Supposing that, owing to defects in its government, one even of the greater London joint stock banks failed, there would be an instant suspicion of the whole system. One terra incognita being seen to be faulty, every other terra incognita would be suspected. If the real government of these banks had for years been known, and if the subsisting banks had been known not to be ruled by the bad mode of government which had ruined the bank that had fallen, then the ruin of that bank would not be hurtful. The other banks would be seen to be exempt from the cause which had destroyed it. But at present the ruin of one of these great banks would greatly impair the credit of all. Scarcely any one knows the precise government of any one; in no case has that government been described on authority; and the fall of one by grave misgovernment would be taken to show that the others might as easily be misgoverned also. And a tardy disclosure even of an admirable constitution would not much help the surviving banks: as it was extracted by necessity, it would be received with suspicion. A sceptical world would say, “Of course they say they are all perfect now; it would not do for them to say anything else”.
A read of Lombard Street would not have led to the Big School's conclusion that the Lender of Last Resort should, in times of crisis, lend only to the banks, and even insolvent ones.
Bagehot advised differently: A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to “this man and that man,” whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.
In other words, Bagehot argued the Central Bank's responsibility was to "the market", not the banks.
Further, he argued: the majority to be protected, are the “sound” people, the people who have good security to offer. He also speaks to the issue of unsound people, perhaps using a bit of wishful thinking: No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the “unsound” people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected;
While the fraction of business which is unsound today is likely larger than in Bagehot's England, I suspect most is sound. Unfortunately, the unsound elements, while small in practical classification (derivatives, mortgage backed securities, etc.) are huge in terms of currency relative to the whole economy.
Big School means Big Problems
Why, I wonder, did the other schools of thought so meekly submit to the Big School's totalitarian revolution? Perhaps the question might better be phrased, what problem(s) deemed intractable by most other schools of thought did the Big School solve.
My best guess; one of the problems the Big School solved is Triffin's Dilemma. Alternatively, a previous (temporary) "solution" of Triffin's Dilemma, the London Gold Pool, was brought back to life, a la Frankenstein's monster which begat Big School thinking.
Triffin's Dilemma states that when a national money is used as an international medium of exchange and international reserve there will be trade-offs between the national and global effects of the reserve currency issuer's monetary policy. Moreover, the reserve currency issuer nation would soon find that it had to run increasing current account deficits to provide liquidity to the rest of the world. This, in turn, would erode confidence in reserve currency convertibility, eventually leading to international currency instability and potentially a break down in world trade.
Robert Triffin forecast the breakdown of the Bretton Woods system based on this dilemma. Of late, his work has been cited by the PBOC.
Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries´ demand for reserve currencies. On the one hand,the monetary authorities cannot simply focus on domestic goals without carrying out their international responsibilities on the other hand,they cannot pursue different domestic and international objectives at the same time. They may either fail to adequately meet the demand of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists. Zhou Xiaochuan: hairman, Monetary Policy Committee of the People's Bank of China
Triffin, in the late 50s, called for the creation of a new global currency to act as international reserve, along the lines of Keynes' Bancor, or the IMF's SDR (deliberations for the creation of which were informed of his concerns), which, in my view, invites a whole new set of problems, but may still, barring a significantly large, in economic terms, country usurping the US$'s role, e.g. China (which invites similar problems, and leads to the US' loss of the exorbitant privilege), prove the best solution. A "free banking" system of competing moneys is another option.
As the US, not entirely without globally altruistic justification, did not want the Bancor in 1960 any more than it wanted it in 1945, the dilemma of convertibility fears was managed by illusion by way of intervention. The London Gold Pool was established in 1961 to keep the "market price" of Gold at $35 and thus reduce the incentive to demand promised convertibility from the Fed.
This worked until French demands for Gold were not satisfied. The cartel failed to maintain prices within the target and within a few years Nixon's closing of the Gold window ended US$-Gold convertibility.
I'll spare you the details of the 70s inflation and early 80s newfound stability. Suffice it to write that US$ reserves were accepted as semi-convertible- if not to Gold at a fixed price, at least to Gold and a basket of commodities with limited (until recently) fluctuations at new, higher prices.
In one (presumably easily accepted) respect, Big School banks that created and kept markets going in multiple new ($ based) investment vehicles helped sustain the sense of convertibility so long as those markets were trading. Markets to spend one's $s, even if one never shops there, engender a sense of stability.
Also coincident with this new found stability was the beginning of a business deal between J. Aron (purchased by Goldman Sachs in 1981) and Central Banks around the world. As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!" (pg. 258)
The book goes on to detail that J. Aron was actually making 8% on the deal with no money down, "it produced a nearly infinite rate of return." The book suggests they pulled a fast one on the central banks.
What Coyne may not have known was that at least some governments may well have done the deal for nothing. J. Aron offered to do what the London Gold Pool had done, and was willing to take the risk itself- a risk passed on in the merger to GS. An added benefit, assuming the deal worked as described, no gold had to actually be sold on the market, paper gold would suffice.
GS was not alone in this game. By the mid to late 80s when I was at Chase (now JPM), our Gold desk (fortunately positioned right behind the options desk where I worked) was playing the same game. Paper gold flooded the market.
One of the reasons I began working with GATA a decade ago was my observation (shared by them) of Gold's stubborn reluctance to rise in price despite the rapidly increasing external US$ reserves. If Gold was, as Triffin asserted, undervalued in the early 60s, surely, I thought, it was a steal in 2000 at $275.
Global US$ reserves have done nothing but rise since, at an increasing pace.
In 1978, Triffin and Mundell were warning of a sudden collapse of the US$ due to the growth of those reserves. Back then they wrote in astonishment of US$ reserves in the few hundreds of billions. Now, such reserves are measured in the trillions.
Without concrete data I can only speculate as to the extent of Central Bank gold leasing, or its effect on the price. In the past few years, the price of Gold has risen above $1000. Interestingly the price broke above the early 1980s high of $800 when problems began appearing in large US banks. The mid 2008 dollar squeeze in international markets capped its advance at that time, only to bring the US banking system to the brink of disaster.
How causal the coincidence proves to be remains a mystery. What seems certain is that, if Central Bank gold leasing is a policy aimed at extending the life of the US$ as global reserve currency, the banks so engaged cannot be allowed to fail, or the game is over.
Thus, I wonder how much effect, if any, the Gold leasing practices of the big NY banks had on the decision to make them too big to fail.
Have we dodged Triffin's dilemma by trying to maintain the illusion of convertibility only to invite a banking collapse worse than Bagehot's worse nightmare?
How will the US respond if an economy as large as China's needs a boost in international liquidity? How large might an IMF rescue package need to be to keep China from suffering a disastrous contraction? Would the US, as is its wont, allow the current account to widen further to ensure China repaid the IMF?
What if Japan needs IMF support?
How far off might such events be?
Big Questions for the Big School
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