http://www.theatlantic.com/doc/200905/imf-advice/
Indeed.
Monday, March 30, 2009
Saturday, March 14, 2009
A coherent framework for Regulation
This financial crisis thing has been going on for quite a while now.
Many proposals have been made to solve the problems facing the financial system. Most of them have failed. This is a good thing, as the mainstream proposals were and remain uniformly poor.
Basically, most proposals have been designed to bring "bad" assets off bank balance sheets so that somebody else (first: other banks, now: the taxpayer) bears the cost of paying ridiculous compensation packages to bankers who made paper, ponzi profits by taking on risk without limit.
Of course we have to recapitalize the financial system. To not do so would be negligent. However, banks should offer something in return for getting using public wealth, and regulators should do something to impede this sort of thing from happening again (remember: savings and loan crisis happened in the '80's, and regulation was continuously eroded throughout the time since).
This should be the first point, obvious, but not respected in recent years:
> The regulator must be strong, independent and willing to regulate.
Throughout the western world, regulator positions have been filled by senior bankers. It doesn't work. If somebody has spent his life living for one system, he is unlikely to seriously criticize the system, especially as his social network will largely be among the regulated. Self regulation is also largely ineffective, for obvious reasons. Perversely, in places like the UK, the Financial Services Regulator was apparently pressured to adopt a "light touch" i.e. not to intervene in the free market! It is apparent that regulators need to take a step back and do some serious thinking about what their job actually is, and should be.
> If entities are systematically fundamental, they should not be private. If private entities are "too large to fail" they must be made smaller or nationalized.
In a system where companies are compensated from taking on too much risk, and know that the taxpayer will bail them out should the risk go bad, then the system bears a large incentive to abuse that position, and take on more risk than an entity would take on would they not have an implicit public insurance. The obvious answer to this appears clear: BREAK UP THE BANKS! Private risk taking, markets are great at allocating resources quite efficiently. They brought us everything from the Nintendo Wii to cruise ships to ... Therefore, any even semi capitalist system must retain a system where private risks can be taken and compensated accordingly. I think the area of private risk is currently adequately regulated: Investors can invest in stocks, bonds, alternative investment vehicles. If they make the wrong choices or trust the wrong people, the lose, and inversely, if they make the right choices, they win. The most important element is that the entities can lose and that bad investment choices are penalized. In a coherent framework for markets, the most important element is that there are no bailout, nor any need for bailouts. Private, non-state insured risk taking should therefore be encouraged.
Conversely, entities which hold insured deposits should not be allowed to take on excessive market risk. It appears obvious, but this is not the way things are being handled today. Large banks have taken on very large risks (RBS-ABN...) and when these risks have gone foul they have asked the state for help. Many have argued that the issue is with short term executive compensation. This may have contributed to excessive risk taking, but impeding this appears lees direct and more difficult to manage than impeding banks from taking on excessive risk in the first place.
What is excessive risk, and how to stop it? The easiest, naive way to stop excessive risk taking is with so called "capital adequacy ratios" whereby regulated banks are not able to take on more leverage/gearing than a particular amount. As a guideline, this should be closer to 3x than 30x. It should appear obvious, but apparently nothing is. Along the same lines, off balance sheet accounting which serves to hide risk from shareholders and regulators should be forbidden and recognized in law for the fraud that it is. Accounting rules should generally be revised to close loopholes and increase transparency.
Banks, and other risk takers should be given a choice: do they want to be systemically important small business lenders or do they want to be free to take on risk? I envisage a system whereby there is a regulated financial sector and an unregulated financial sector. In the regulated sector entities will have access to central bank liquidity and state capital guarantees. They will take deposits and may make loans to businesses at "market" rates, or invest in certain free market opportunities albeit in a highly regulated manner. Arguably these entities should be owned by the state due to their systemically fundamental nature and the strictly regulated way of operating. Another reason why these entities should not be freely owned is that they should not be subject to pressures to make short term profit by shareholders maximizing their short term wealth accumulation at the expense of future crisis. Basically, it would be difficult to make these regulated banks competitive with the free banks and therefore it may be best to exempt them from competition. It may be a good idea to have an artificial "market" whereby regulated bank executives have some of their compensation tied to their effectiveness in "competing" with the other regulated banks. This would however unlikely reach levels of star traders etc. in the free sector, except for cases of exceptional effectiveness or cost cutting in the regulated sector.
On the other hand, you will have the "free" unregulated financial system. "Banks" operating in this space will not be subject to regulation, will not have access to central bank liquidity and deposits will not be guaranteed by the state. It is very likely that deposits in the free sector will pay significantly higher interest thank insured deposits. This is desirable, as interest will reflect the higher risk taken on by free entities. Conversely, companies will face the choice of borrowing from the regulated or the non-regulated sector. This will be achieved by market mechanisms. Enterprises deemed to be less risky will be able to borrow from the regulated sector at lesser risk premia than risky enterprises forced to borrow from the free sector. Although the regulated sector will be compelled to take on some risk, this will be negligible compared to the risk taken on by the free sector.
The free sector will basically be characterized by funds (which can be called banks or investment vehicles or whatever). These will engage in lending, structuring, borrowing, trading, brokerage etc. These entities will be in competition with each other, will take on risk and compensate accountholders/investors according to their abilities in this highly competitive investment marketplace. The only role of the regulator in this market is one of atomization or the prevention of excessive consolidation. To impede the clout risk if entities becoming systemically important or "too large to fail" the regulator must break up entities or stop consolidation in the "free" financial sector. Although this is an obvious contradiction to the term "free", it appears the only way to impede the risky sector from consolidating risk and endangering public welfare. This also implies limits of financial technology - with the knowledge we have today, it appears clear that diversification is useful only on a single portfolio and not on a systemic level. Excesses such as "bond insurance" to generate cheap borrowing will not be attractive if insurance is sold at attractive premium. Rating agencies should be disenfranchised, or given some liability connected to ratings they give.
Implications to be noted:
Cheap liquidity caused the financial crisis. Private banks had such easy access to Central Bank liquidity that everybody with a business card could get "leverage" on their "diversified" investment products. This distorted risk premia, and basically rewarded short sightedness and led to the entire economy resembling a pyramid scheme. Should my suggestions be implemented, risk premia would no longer be distorted by excessively cheap liquidity, which in my eyes was the main factor contributing to the current malinvestment crisis.
This will make monetary policy less effective. This is a good thing, as recent history has shown that Central Bankers do not possess the foresight necessary to wield a tool as powerful pas determining financial system liquidity for any particular currency. This is an area where the market should be given more space, so that risk premia once again reflect risks taken.
What should be done right now:
Bankers want their firms to remain private so that they can continue to benefit from their privileged position in the financial system to syphon off public wealth for themselves. This is unacceptable.
The financial system is bust. For recapitalization to be durable, the financial system should once again reflect true values, and prices should not be determined in a political process (lest the financial sector mutate into an industry with soviet incentives with corruption, inefficiency and waste on an even higher scale than today). To achieve this, the entire system should be put into administration, and all liabilities laid bare to the regulator. Bankrupt firms should be identified, their equity and debt holders wiped out.
In the short term, operations could be consolidated into a mega bank which would then start organizing itself into free and regulated operations. Free operations would be sold off in small tranches to ensure competition and some upside for the taxpayer. Regulated operations organized as elaborated previously. Financial institutions which are not bust should generally be left alone, subject to the constraint that they would be required to remain smaller than "too large to fail". Certain deposit holding entities may elect to consolidate in the regulated sector.
That's about it for a short summary. I welcome debate on these issues, and look forward to any feedback anybody may have.
Many proposals have been made to solve the problems facing the financial system. Most of them have failed. This is a good thing, as the mainstream proposals were and remain uniformly poor.
Basically, most proposals have been designed to bring "bad" assets off bank balance sheets so that somebody else (first: other banks, now: the taxpayer) bears the cost of paying ridiculous compensation packages to bankers who made paper, ponzi profits by taking on risk without limit.
Of course we have to recapitalize the financial system. To not do so would be negligent. However, banks should offer something in return for getting using public wealth, and regulators should do something to impede this sort of thing from happening again (remember: savings and loan crisis happened in the '80's, and regulation was continuously eroded throughout the time since).
This should be the first point, obvious, but not respected in recent years:
> The regulator must be strong, independent and willing to regulate.
Throughout the western world, regulator positions have been filled by senior bankers. It doesn't work. If somebody has spent his life living for one system, he is unlikely to seriously criticize the system, especially as his social network will largely be among the regulated. Self regulation is also largely ineffective, for obvious reasons. Perversely, in places like the UK, the Financial Services Regulator was apparently pressured to adopt a "light touch" i.e. not to intervene in the free market! It is apparent that regulators need to take a step back and do some serious thinking about what their job actually is, and should be.
> If entities are systematically fundamental, they should not be private. If private entities are "too large to fail" they must be made smaller or nationalized.
In a system where companies are compensated from taking on too much risk, and know that the taxpayer will bail them out should the risk go bad, then the system bears a large incentive to abuse that position, and take on more risk than an entity would take on would they not have an implicit public insurance. The obvious answer to this appears clear: BREAK UP THE BANKS! Private risk taking, markets are great at allocating resources quite efficiently. They brought us everything from the Nintendo Wii to cruise ships to ... Therefore, any even semi capitalist system must retain a system where private risks can be taken and compensated accordingly. I think the area of private risk is currently adequately regulated: Investors can invest in stocks, bonds, alternative investment vehicles. If they make the wrong choices or trust the wrong people, the lose, and inversely, if they make the right choices, they win. The most important element is that the entities can lose and that bad investment choices are penalized. In a coherent framework for markets, the most important element is that there are no bailout, nor any need for bailouts. Private, non-state insured risk taking should therefore be encouraged.
Conversely, entities which hold insured deposits should not be allowed to take on excessive market risk. It appears obvious, but this is not the way things are being handled today. Large banks have taken on very large risks (RBS-ABN...) and when these risks have gone foul they have asked the state for help. Many have argued that the issue is with short term executive compensation. This may have contributed to excessive risk taking, but impeding this appears lees direct and more difficult to manage than impeding banks from taking on excessive risk in the first place.
What is excessive risk, and how to stop it? The easiest, naive way to stop excessive risk taking is with so called "capital adequacy ratios" whereby regulated banks are not able to take on more leverage/gearing than a particular amount. As a guideline, this should be closer to 3x than 30x. It should appear obvious, but apparently nothing is. Along the same lines, off balance sheet accounting which serves to hide risk from shareholders and regulators should be forbidden and recognized in law for the fraud that it is. Accounting rules should generally be revised to close loopholes and increase transparency.
Banks, and other risk takers should be given a choice: do they want to be systemically important small business lenders or do they want to be free to take on risk? I envisage a system whereby there is a regulated financial sector and an unregulated financial sector. In the regulated sector entities will have access to central bank liquidity and state capital guarantees. They will take deposits and may make loans to businesses at "market" rates, or invest in certain free market opportunities albeit in a highly regulated manner. Arguably these entities should be owned by the state due to their systemically fundamental nature and the strictly regulated way of operating. Another reason why these entities should not be freely owned is that they should not be subject to pressures to make short term profit by shareholders maximizing their short term wealth accumulation at the expense of future crisis. Basically, it would be difficult to make these regulated banks competitive with the free banks and therefore it may be best to exempt them from competition. It may be a good idea to have an artificial "market" whereby regulated bank executives have some of their compensation tied to their effectiveness in "competing" with the other regulated banks. This would however unlikely reach levels of star traders etc. in the free sector, except for cases of exceptional effectiveness or cost cutting in the regulated sector.
On the other hand, you will have the "free" unregulated financial system. "Banks" operating in this space will not be subject to regulation, will not have access to central bank liquidity and deposits will not be guaranteed by the state. It is very likely that deposits in the free sector will pay significantly higher interest thank insured deposits. This is desirable, as interest will reflect the higher risk taken on by free entities. Conversely, companies will face the choice of borrowing from the regulated or the non-regulated sector. This will be achieved by market mechanisms. Enterprises deemed to be less risky will be able to borrow from the regulated sector at lesser risk premia than risky enterprises forced to borrow from the free sector. Although the regulated sector will be compelled to take on some risk, this will be negligible compared to the risk taken on by the free sector.
The free sector will basically be characterized by funds (which can be called banks or investment vehicles or whatever). These will engage in lending, structuring, borrowing, trading, brokerage etc. These entities will be in competition with each other, will take on risk and compensate accountholders/investors according to their abilities in this highly competitive investment marketplace. The only role of the regulator in this market is one of atomization or the prevention of excessive consolidation. To impede the clout risk if entities becoming systemically important or "too large to fail" the regulator must break up entities or stop consolidation in the "free" financial sector. Although this is an obvious contradiction to the term "free", it appears the only way to impede the risky sector from consolidating risk and endangering public welfare. This also implies limits of financial technology - with the knowledge we have today, it appears clear that diversification is useful only on a single portfolio and not on a systemic level. Excesses such as "bond insurance" to generate cheap borrowing will not be attractive if insurance is sold at attractive premium. Rating agencies should be disenfranchised, or given some liability connected to ratings they give.
Implications to be noted:
Cheap liquidity caused the financial crisis. Private banks had such easy access to Central Bank liquidity that everybody with a business card could get "leverage" on their "diversified" investment products. This distorted risk premia, and basically rewarded short sightedness and led to the entire economy resembling a pyramid scheme. Should my suggestions be implemented, risk premia would no longer be distorted by excessively cheap liquidity, which in my eyes was the main factor contributing to the current malinvestment crisis.
This will make monetary policy less effective. This is a good thing, as recent history has shown that Central Bankers do not possess the foresight necessary to wield a tool as powerful pas determining financial system liquidity for any particular currency. This is an area where the market should be given more space, so that risk premia once again reflect risks taken.
What should be done right now:
Bankers want their firms to remain private so that they can continue to benefit from their privileged position in the financial system to syphon off public wealth for themselves. This is unacceptable.
The financial system is bust. For recapitalization to be durable, the financial system should once again reflect true values, and prices should not be determined in a political process (lest the financial sector mutate into an industry with soviet incentives with corruption, inefficiency and waste on an even higher scale than today). To achieve this, the entire system should be put into administration, and all liabilities laid bare to the regulator. Bankrupt firms should be identified, their equity and debt holders wiped out.
In the short term, operations could be consolidated into a mega bank which would then start organizing itself into free and regulated operations. Free operations would be sold off in small tranches to ensure competition and some upside for the taxpayer. Regulated operations organized as elaborated previously. Financial institutions which are not bust should generally be left alone, subject to the constraint that they would be required to remain smaller than "too large to fail". Certain deposit holding entities may elect to consolidate in the regulated sector.
That's about it for a short summary. I welcome debate on these issues, and look forward to any feedback anybody may have.
Monday, February 9, 2009
The case for war
We have come a long way in the past century. Despite many conflicts and the use gruesome technologies of mass destruction, the world is now more integrated than ever. The cold war was won by the west, defusing the main source of potential international conflict. Anyway, Globalization has caused economies to become more integrated, making world wars all but impossible.
Or is it really so?
During the pre- 1914 belle époque, the world was arguably even more economically integrated than today, with international trade as a percentage of gdp at all time highs in many nations. Given the horrors of WWI, and the resolution that the world had experienced the "war to end all wars" leading to the establishment of the league of nations to guarantee international security few would have thought that WWII was a mere two decades away.
There is a consensus among economic historians that WWII was to some extent caused by widespread poverty in the wake of the great depression, with national populations seeking strong men to solve their problems. It is also given that economic nationalism and protectionist policies exacerbated the global economic slowdown.
Today we are again confronted with economic difficulties of epic proportions. Again, politicians are seeking to solve their domestic issues by proponing measures designed to foster local economic growth over the most efficient method of production, leading to lower efficiency and increased costs. Again, these measures are sowing the seeds of international conflict. Although the magnitude as to what extent protectionist policies contributed to the great depression remains a topic of debate, the symbolic importance should not be neglected.
After all, we can learn certain things from the twentieth century. One of these lessons is that trade wars can lead to real wars.
Or is it really so?
During the pre- 1914 belle époque, the world was arguably even more economically integrated than today, with international trade as a percentage of gdp at all time highs in many nations. Given the horrors of WWI, and the resolution that the world had experienced the "war to end all wars" leading to the establishment of the league of nations to guarantee international security few would have thought that WWII was a mere two decades away.
There is a consensus among economic historians that WWII was to some extent caused by widespread poverty in the wake of the great depression, with national populations seeking strong men to solve their problems. It is also given that economic nationalism and protectionist policies exacerbated the global economic slowdown.
Today we are again confronted with economic difficulties of epic proportions. Again, politicians are seeking to solve their domestic issues by proponing measures designed to foster local economic growth over the most efficient method of production, leading to lower efficiency and increased costs. Again, these measures are sowing the seeds of international conflict. Although the magnitude as to what extent protectionist policies contributed to the great depression remains a topic of debate, the symbolic importance should not be neglected.
After all, we can learn certain things from the twentieth century. One of these lessons is that trade wars can lead to real wars.
Tuesday, January 6, 2009
What to do about financial crisis
Although markets started the year with a cheer, the dire economic reality is currently taking precedent over wishful thinking that "the worst is over".
Deleveraging is ongoing. Sales are declining, contributing to an increase of deflationary pressures.
Credit remains tight, with banks reticent to lend despite unprecedented guarantees and liquidity facilities.
With interest rates approaching zero, certain renowned economists are calling a liquidity trap, the situation whereby credit remains tight despite liquidity being nominally cheap and available. The explanation for this phenomenon can be simplified substantially: Banks expects the economy to get worse, and are tightening credit conversely. By doing this, banks are reinforcing, indeed to some extent causing this trend.
Whereas Neoclassical economics suggests exiting this situation by giving money away, enhancing demand for goods, thereby supporting economic activity, Keynesian economics suggests government infrastructure projects to achieve the same aim.
Both these approaches have the potential to help us out of the current slump. Infrastructure projects would be more likely to produce long lasting benefits, whereas giving money away may
bring less value for money due to the fact that some of the stimulus would be saved.
The current issue with both these approaches remains not their theoretical soundness, but their political feasibility. Many politicians are still unaware of how dire the situation the economy is currently in really is, and remain skeptical towards stimulus operations which are nominally enormous such as the 800bn US$ pro0grma proposed by Barack Obama. Given the persistence of failed economic ideology, there is potential for this stimulus program to be downsized or stalled to the extent that it become insufficient and fails. In Europe, the situation is even more complicated, given the decentralized political process and perceived beggar-thy-neighbour effects of localized economic stimulus. This discussion is further complicated by the fact that governments are already in severe fiscal stress, arguably due to the competitive international pressure to reduce taxes below the level of comparable nations, to improve the attractivity of the economy for the productive factor capital. This in many cases worked as planned, with capital moving to the states where the least limits and costs were imposed on its use. Unfortunately, the expected fiscal benefit often remained scant, and major governments have been compelled to borrow from future generations to fund their operations. Even today, when any neutral analyst worthy of the label should be aware of the fact that unfunded tax decreases in large, open economies are most likely to result in state funding strains, and a corresponding decrease of the capability of the state to fund their operations than in economic growth, many are still calling for tax cuts, despite their realization that bailouts are necessary.
To summarize:
The economy is in trouble.
We should better fix it.
We will then have to pay for it.
Deleveraging is ongoing. Sales are declining, contributing to an increase of deflationary pressures.
Credit remains tight, with banks reticent to lend despite unprecedented guarantees and liquidity facilities.
With interest rates approaching zero, certain renowned economists are calling a liquidity trap, the situation whereby credit remains tight despite liquidity being nominally cheap and available. The explanation for this phenomenon can be simplified substantially: Banks expects the economy to get worse, and are tightening credit conversely. By doing this, banks are reinforcing, indeed to some extent causing this trend.
Whereas Neoclassical economics suggests exiting this situation by giving money away, enhancing demand for goods, thereby supporting economic activity, Keynesian economics suggests government infrastructure projects to achieve the same aim.
Both these approaches have the potential to help us out of the current slump. Infrastructure projects would be more likely to produce long lasting benefits, whereas giving money away may
bring less value for money due to the fact that some of the stimulus would be saved.
The current issue with both these approaches remains not their theoretical soundness, but their political feasibility. Many politicians are still unaware of how dire the situation the economy is currently in really is, and remain skeptical towards stimulus operations which are nominally enormous such as the 800bn US$ pro0grma proposed by Barack Obama. Given the persistence of failed economic ideology, there is potential for this stimulus program to be downsized or stalled to the extent that it become insufficient and fails. In Europe, the situation is even more complicated, given the decentralized political process and perceived beggar-thy-neighbour effects of localized economic stimulus. This discussion is further complicated by the fact that governments are already in severe fiscal stress, arguably due to the competitive international pressure to reduce taxes below the level of comparable nations, to improve the attractivity of the economy for the productive factor capital. This in many cases worked as planned, with capital moving to the states where the least limits and costs were imposed on its use. Unfortunately, the expected fiscal benefit often remained scant, and major governments have been compelled to borrow from future generations to fund their operations. Even today, when any neutral analyst worthy of the label should be aware of the fact that unfunded tax decreases in large, open economies are most likely to result in state funding strains, and a corresponding decrease of the capability of the state to fund their operations than in economic growth, many are still calling for tax cuts, despite their realization that bailouts are necessary.
To summarize:
The economy is in trouble.
We should better fix it.
We will then have to pay for it.
Monday, January 5, 2009
Monday, December 15, 2008
Is there no safe haven?
Hedge Fund ponzi schemes.
Where they are not fraudulent, they are just not very good at what they do. Alpha, in the case of the industry, if not in the case of certain managers, is apparently a myth.
Private Equity buyers strike.
Private Equity relies on committed capital which may be invested over significant time periods before they make money. As many investors are currently becoming reticent to throw good money after potentially bad money, this makes private equity problems a self-fulfilling prophecy, as young firms will not be getting the necessary cash to grow in to viable ones.
That mutual funds are crap is a well known fact.
Deflationary trends across the board. The credit crisis appears to be winning the battle with monetary authorities in the short term. If this goes on, we might end up in a rather unfortunate situation. Well, it's not as if recent history does not have a good example of what deflation looks like .
So, INflation or DEflation. Which will prevail?
In the long term, cheap money will lead to hyperinflation and a probable reflating of the credit bubble. The reason for this is that central bankers like inflation. Indeed, inflation is the only scenario they can deal with so they will always aim for it. In fact, so desperate are they to produce inflation that their efforts will likely lead to hyperinflation somewhere along the way.
Investing in an inflationary environment is quite easy. As prices will tend to go up, most investments are likely to yield positive returns relative to cash, the value of which is constantly eroded. Indeed, in an expected hyperinflationary environment it may be advisable to get a lot of debt and invest it, by for example buying real estate on margin (standard mortgage deal).
Deflation, on the other hand, is another beast altogether. Deflation of course means prices across asset classes trend down. Therefore, a wise investment is generally perceived to be cash "cash is king". Why buy a house today if I can live in this cardboard box for a bit longer and then get a nicer, bigger (not more expensive!) house tomorrow for what I would pay for an inferior property today?
Unfortunately, macroeconomic conditions are eroding substantially. Unwise policy decisions by central bankers and short sighted political systems have led to a credit bubble. This credit bubble is being brought on to the balance sheets of Central banks and governments due to short sighted bailout mentality. Some currencies are indeed starting to resemble Ponzi schemes themselves. Yes, I am talking about currencies backed by toxic credit. We used to be able to go to cash and let those private risk takers go poor. Nowadays, our immensely wise monetary authorities have decided to bail out the private risk takers, with potentially drastic effects for the economy as a whole (an interesting writeup from the inflationist camp here).
Therefore, in the short term, it may be advisable to hold a diversified basket of currencies, as it is not feasible that they will all fail simultaneously due to the fact that currency values are always relative to each other. When you feel that monetary authorities are winning the battle against deflation, go leveraged long.
After all, hyperinflation makes some investments appear fantastic (and they are relative to currency holders!).
Due to the negative value usually generated by stock picking, and the excessive fees paid for it, a broad based etf is probably a good option.
Where they are not fraudulent, they are just not very good at what they do. Alpha, in the case of the industry, if not in the case of certain managers, is apparently a myth.
Private Equity buyers strike.
Private Equity relies on committed capital which may be invested over significant time periods before they make money. As many investors are currently becoming reticent to throw good money after potentially bad money, this makes private equity problems a self-fulfilling prophecy, as young firms will not be getting the necessary cash to grow in to viable ones.
That mutual funds are crap is a well known fact.
Deflationary trends across the board. The credit crisis appears to be winning the battle with monetary authorities in the short term. If this goes on, we might end up in a rather unfortunate situation. Well, it's not as if recent history does not have a good example of what deflation looks like .
So, INflation or DEflation. Which will prevail?
In the long term, cheap money will lead to hyperinflation and a probable reflating of the credit bubble. The reason for this is that central bankers like inflation. Indeed, inflation is the only scenario they can deal with so they will always aim for it. In fact, so desperate are they to produce inflation that their efforts will likely lead to hyperinflation somewhere along the way.
Investing in an inflationary environment is quite easy. As prices will tend to go up, most investments are likely to yield positive returns relative to cash, the value of which is constantly eroded. Indeed, in an expected hyperinflationary environment it may be advisable to get a lot of debt and invest it, by for example buying real estate on margin (standard mortgage deal).
Deflation, on the other hand, is another beast altogether. Deflation of course means prices across asset classes trend down. Therefore, a wise investment is generally perceived to be cash "cash is king". Why buy a house today if I can live in this cardboard box for a bit longer and then get a nicer, bigger (not more expensive!) house tomorrow for what I would pay for an inferior property today?
Unfortunately, macroeconomic conditions are eroding substantially. Unwise policy decisions by central bankers and short sighted political systems have led to a credit bubble. This credit bubble is being brought on to the balance sheets of Central banks and governments due to short sighted bailout mentality. Some currencies are indeed starting to resemble Ponzi schemes themselves. Yes, I am talking about currencies backed by toxic credit. We used to be able to go to cash and let those private risk takers go poor. Nowadays, our immensely wise monetary authorities have decided to bail out the private risk takers, with potentially drastic effects for the economy as a whole (an interesting writeup from the inflationist camp here).
Therefore, in the short term, it may be advisable to hold a diversified basket of currencies, as it is not feasible that they will all fail simultaneously due to the fact that currency values are always relative to each other. When you feel that monetary authorities are winning the battle against deflation, go leveraged long.
After all, hyperinflation makes some investments appear fantastic (and they are relative to currency holders!).
Due to the negative value usually generated by stock picking, and the excessive fees paid for it, a broad based etf is probably a good option.
Friday, December 5, 2008
Sources of financial system Leverage
This will be a post in work. I am looking to list all sources of financial system leverage and hope your comments will contribute to the oeuvre!
- fractional reserve banking:
- national fiat currencies
- insurance system leverage
- leverage in the shadow financial system
- off-balance sheet accounting
- double gearing
- derivatives clearing houses
- unfunded government obligations: Medicare, pension liabilities.
- special drawing rights?
- uncollateralized interbank lending
[insert 2008 12 15:
- fraudulent leverage in Ponzi schemes (apparently substantial as witnessed in the Madoff case)]
[insert 2009 04 03:
- Mark to Optimism leverage due to FAS 157 amendment]
- GSE leverage, trust funds for S.S. and Medicare, for example (thanks to JP):
Can anyone think of more, or, more importantly, direct me to sources where this leverage is quantified? Or would anyone argue that certain concepts should not be in the list, or are counted more than once under different names?
- fractional reserve banking:
- national fiat currencies
- insurance system leverage
- leverage in the shadow financial system
- off-balance sheet accounting
- double gearing
- derivatives clearing houses
- unfunded government obligations: Medicare, pension liabilities.
- special drawing rights?
- uncollateralized interbank lending
[insert 2008 12 15:
- fraudulent leverage in Ponzi schemes (apparently substantial as witnessed in the Madoff case)]
[insert 2009 04 03:
- Mark to Optimism leverage due to FAS 157 amendment]
- GSE leverage, trust funds for S.S. and Medicare, for example (thanks to JP):
Can anyone think of more, or, more importantly, direct me to sources where this leverage is quantified? Or would anyone argue that certain concepts should not be in the list, or are counted more than once under different names?
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