Saturday, October 3, 2009
A very good analysis
Hop down to zerohedge regularly to get high quality regular analysis - this particular piece is in my mind very much to the point.
Sunday, May 31, 2009
Thursday, May 7, 2009
The Inflation myth
Markets have rallied substantially of their previous lows. It appears that many market participants are rationalizing this with inflation expectations, which in the most extreme form turns out something like this:
The rationalization appears to be as follows: The FED has pumped Trillions into the financial system, so they must eventually pop up somewhere and produce inflation. Monetary expansion always fuels inflation does it not?
Well, basically, no.
The Fed has pumped trillions into the financial system. However, this is not effective monetary expansion but merely bank credit lines to pay for previous losses that have occurred due to last years repricing of risk in the credit markets. This pumping does not expand the money supply in the real economy, but merely buffers the shrinking of the money supply which is occurring due to financial system deleverage and writeoffs.
More precisely, the expansion of the FED balance sheet is largely due to the provision of "short term" liquidity to distressed financial institutions. Despite the concerted effort of the US government, the financial system remains severely stressed.
US consumers have been living off debt. Now it has been noted that this is unsustainable, credit lines are being cut: deflation, unless the FED effectively nationalizes the banking system by the backdoor to increase credit, which would be insane - not to mention illegal. The FED is stuck between a rock and a hard place, and is desperate to produce confidence so that defaults will not rise even more.
However, they appear to have forgotten that there is a relation between confidence and the real economy. The real economy remains unfixed. When the financial system delevers (which it must! - even Ben would have to agree on that), this is what you get:
Indeed, I agree that the current irrational exuberance is partly due to inflation expectations, and partly due to manipulation. Inflation expectations do to some extent drive effective inflation. However, in this case the inflation expectations are fighting an extreme crisis in the financial system, and a growing crisis in the real economy.
While layoffs continue, and people feel poorer whilst their credit lines are being cut, there is no driver for house prices to stabilize. Indeed, the premature confidence building is likely to cause greater difficulties down the road as people get poorer for being whiplashed twice in the stock exchange. I gather however that the treasury and the fed have decided that it is first necessary to recapitalize the financial system on the back of the sheeple (expect plenty of short prop trading in the summer or early autumn just as some "catalyst" causes markets to plummet again (this will be orchestrated via earnings, expensive oil, swine flu...).
Real inflation is impossible to produce whilst private and corporate credit lines are cut, especially in a consumption driven economy. The only driver for inflation will be the drop in the value of the dollar, however this will not bode well for indices as companies will suffer more in the aggregate given the bloated retail/consumption sector.
In case you need another example for what happens in a debt-deflation scenario:
The only real difference being that this time the problem is global, and there is no external growth area to export to.
In my analysis this is going to be brutal. So lots of Japan before we get anything close to Zimbabwe.
The rationalization appears to be as follows: The FED has pumped Trillions into the financial system, so they must eventually pop up somewhere and produce inflation. Monetary expansion always fuels inflation does it not?Well, basically, no.
The Fed has pumped trillions into the financial system. However, this is not effective monetary expansion but merely bank credit lines to pay for previous losses that have occurred due to last years repricing of risk in the credit markets. This pumping does not expand the money supply in the real economy, but merely buffers the shrinking of the money supply which is occurring due to financial system deleverage and writeoffs.
More precisely, the expansion of the FED balance sheet is largely due to the provision of "short term" liquidity to distressed financial institutions. Despite the concerted effort of the US government, the financial system remains severely stressed.
US consumers have been living off debt. Now it has been noted that this is unsustainable, credit lines are being cut: deflation, unless the FED effectively nationalizes the banking system by the backdoor to increase credit, which would be insane - not to mention illegal. The FED is stuck between a rock and a hard place, and is desperate to produce confidence so that defaults will not rise even more.
However, they appear to have forgotten that there is a relation between confidence and the real economy. The real economy remains unfixed. When the financial system delevers (which it must! - even Ben would have to agree on that), this is what you get:
Indeed, I agree that the current irrational exuberance is partly due to inflation expectations, and partly due to manipulation. Inflation expectations do to some extent drive effective inflation. However, in this case the inflation expectations are fighting an extreme crisis in the financial system, and a growing crisis in the real economy.While layoffs continue, and people feel poorer whilst their credit lines are being cut, there is no driver for house prices to stabilize. Indeed, the premature confidence building is likely to cause greater difficulties down the road as people get poorer for being whiplashed twice in the stock exchange. I gather however that the treasury and the fed have decided that it is first necessary to recapitalize the financial system on the back of the sheeple (expect plenty of short prop trading in the summer or early autumn just as some "catalyst" causes markets to plummet again (this will be orchestrated via earnings, expensive oil, swine flu...).
Real inflation is impossible to produce whilst private and corporate credit lines are cut, especially in a consumption driven economy. The only driver for inflation will be the drop in the value of the dollar, however this will not bode well for indices as companies will suffer more in the aggregate given the bloated retail/consumption sector.
In case you need another example for what happens in a debt-deflation scenario:
The only real difference being that this time the problem is global, and there is no external growth area to export to.
In my analysis this is going to be brutal. So lots of Japan before we get anything close to Zimbabwe.
Saturday, May 2, 2009
Government Lies
Governments lie.
Well maybe not every government all the time. But certain governments lie sometimes.
In case you need reminding/convincing, please look here, here and here (this list could of course be expanded on substantially).
Some lies may be good. Maybe it is best to downplay swine flu if its spread is inevitable. Personally, I do not adhere to the school of thought which appears to think that the people are too stupid, emotional or short sighted for the truth but I understand the argument. However, I can by no means bring myself to believe that the amount of lies and propaganda being produced regarding the current situation in the global economy will result in a beneficial outcome.
But first some lies:
'No one should be confused about what a bankruptcy process means. This is not a sign of weakness but rather one more step on a clearly charted path to Chrysler's revival.'
— President Obama (MW)
No real need to comment on this one it must be apparent that it is total nonsense.
"I remain confident that the economy will start to grow before the end of the year."
- Alistair Darling (Reuters)
The UK budget, and Darling's comment has been almost universally derided so I will merely provide a link.
This list could also go on and on, but I gather most people would get bored and may commence smoking some good ol' green shoots. So - enough propaganda nonsense. Let's look at a truism: "A depression is a self fulfilling prophecy".
Confidence is key in economics. If people think they are wealthy, they consume more, leading to more aggregate demand, leading to more aggregate supply, leading to economic growth, making people feel more wealthy...
This mantra has been repeated for many years now. Central Bankers have used this as the rationale for allowing ever more debt and leverage to dominate the economy, in turn bloating the financial sector and attracting ever more of the best and brightest to the global game of musical chairs with structured credit derivatives. This game has gone on and on, leading to where we are today with an amazingly intransparent derivatives bubble of nominal value of many times the size of the global economy.
Now that we have experienced a blip in this ponzi-esque system of ever increasing cross-leverage and debt bubbles, we should take a step back to reflect on what would be the best way to operate moving forward.
Currently, the approach being chosen to fix the bursting of the bubble is to reflate the global bubble. This was the path chosen when the Tech bubble burst - easy money then led to the real estate bubble. Maybe the next bubble will be in green technology equities? In order to maintain "con-fidence" in the system we are led to believe that everything is alright.
Everything is not alright. The financial system remains largely insolvent even though taxpayers have already bought trillions worth of inflated credit at significant premiums to what any rational investor is willing to pay and despite bankers taking bonuses of sizes that appear ludicrous to anybody who is not used to burning trillions worth of value that does not belong to them.
Despite the fact that the financial sector is too big for its own good, Governments have gone far beyond covering insured deposits and ensuring the flow of debt to important, producing firms. No, they have decided to take on the inflated debt of so-called risk takers in the economy so that other "risk takers" are not impaired on their "investments".
This although much of this exposure was only taken on in light of an expected government bailout, and some of the largest recipients of government bailouts claim to have been "fully hedged", in the knowledge that they had bought a nonsensical financial product in an unsustainable game of ever increasing debt.
We may be in a difficult time of chaos, but cushioning supposed "risk takers" from the consequences of their own actions makes no sense. The only rationale for bailing out institutions which do not hold private deposits and do not engage in direct lending activity could be that they are indeed too intensively linked to systemically fundamental financial institutions via derivative exposure that they are too large to fail.
Should this indeed be the case, the solution is not to pump trillions of taxpayer monies into exactly these entities, further increasing moral hazard and apparently encouraging the largest, and correspondingly most dangerous risk taking in the financial history of mankind.
Here I would like to mention Goldman Sachs, the systemically important "bank holding company" which is essentially a hedge fund with preferential access to federal reserve liquidity, which undertakes no direct real economy lending nor holds retail accounts and just got over 20 billion USD in TARP money due to apparently being insolvent, is now the no. 1 proprietary trader on the NYSE, larger than the next 14 institutions put together.
Conspiracy theorists claim this is a concerted effort by GS and the US government to prop up the market to retain confidence. I gather that this is more likely a desperate attempt to make back losses in the credit markets to avoid insolvency. Whether it is one or the other, what is clear is this is being done by a firm that took government money, despite GS employees averaging more than 360'000$ of compensation (including janitorial staff!) in 2009.
Propping up markets with taxpayer money is maybe not illegal, but highly questionable. Bailing out private financial institutions and their equity and bondholders who made bad debts is ludicrous, and makes no sense whatsoever if you believe that markets are the best way to allocate resources, which is what these guys have been telling us at least for the last 20 years. The distributional consequences of these actions are horrendous, and show a complete disparity between government elites and people who actually have to do honest work for a living. Socialism for the rich is inexcusable, and makes no economic sense.
However, governments are taking the riskiest and most likely to fail approach possible: Whilst they preach confidence and green shoots, they are subsidizing reckless risk taking by those who need it least, truly destroying the last bit of equity or market control in the financial sector. The banks will not provide credit to companies given the macroeconomic outlook of deflation that they created themselves. Indeed, they will attempt to exploit the last days of the game to the absolute maximum whilst paying out as much compensation as they can get away with. This is going on with very little government control or oversight, especially in the United States.
Given this outlook, it the systematic creation of confidence in an already failed system on its last legs, which will inevitably sucker some fools into the financial markets is not just cynical and dangerous, but downright criminal. Not only will they fail to save the financial system, which, given it's current form, is actually a good thing, but it will also inflict long term damage on the prestige of the political system, making the rise of radical solutions all the more likely.
We must reform the financial system, and we must do it according to certain basic principles previously laid out here. Merely perpetuating the current inefficient, fundamentally unfair and wide open to abuse system is not an option.
The best way to fix the crisis would be to immediately separate the deposit-insured banking sector form the highly risky, speculative investment banking activity. The withdrawal of the Glass-Steagal acts was indeed a short sighted act.
Keep small business loans running, keep deposits insured, put aside some extra cash for large firms needing short term liquidity and THEN:
Let the market run it's course. Let the Investment banks who made bad, leveraged bets fail. The good guys can then start/get hired by hedge funds who CAN fail and who get capital in the market not from the FED or some other taxpayer funded corrupt gravy train. The other guys who don't get hired can then go to activities which actually bring a benefit to society unlike parasitical and useless overpaid musical chairs playing with structured credit derivatives.
This should have been done right from the beginning. Insuring GS speculative trades and bonuses with FED, TARP and FDIC cash is a scandal, and tantamount to daylight robbery. Eventually the moral hazard and failed incentives will lead to a greater crisis down the road. The bill to the taxpayer increases with every day the corrupt Geithner crew neglects true reform.
Too large to fail is too large to exist. We need smaller banks and more competition not enormous intransparent and immensely powerful state sponsored dinosaur banking behemoths.
Well maybe not every government all the time. But certain governments lie sometimes.
In case you need reminding/convincing, please look here, here and here (this list could of course be expanded on substantially).
Some lies may be good. Maybe it is best to downplay swine flu if its spread is inevitable. Personally, I do not adhere to the school of thought which appears to think that the people are too stupid, emotional or short sighted for the truth but I understand the argument. However, I can by no means bring myself to believe that the amount of lies and propaganda being produced regarding the current situation in the global economy will result in a beneficial outcome.
But first some lies:
'No one should be confused about what a bankruptcy process means. This is not a sign of weakness but rather one more step on a clearly charted path to Chrysler's revival.'
— President Obama (MW)
No real need to comment on this one it must be apparent that it is total nonsense.
"I remain confident that the economy will start to grow before the end of the year."
- Alistair Darling (Reuters)
The UK budget, and Darling's comment has been almost universally derided so I will merely provide a link.
This list could also go on and on, but I gather most people would get bored and may commence smoking some good ol' green shoots. So - enough propaganda nonsense. Let's look at a truism: "A depression is a self fulfilling prophecy".
Confidence is key in economics. If people think they are wealthy, they consume more, leading to more aggregate demand, leading to more aggregate supply, leading to economic growth, making people feel more wealthy...
This mantra has been repeated for many years now. Central Bankers have used this as the rationale for allowing ever more debt and leverage to dominate the economy, in turn bloating the financial sector and attracting ever more of the best and brightest to the global game of musical chairs with structured credit derivatives. This game has gone on and on, leading to where we are today with an amazingly intransparent derivatives bubble of nominal value of many times the size of the global economy.
Now that we have experienced a blip in this ponzi-esque system of ever increasing cross-leverage and debt bubbles, we should take a step back to reflect on what would be the best way to operate moving forward.
Currently, the approach being chosen to fix the bursting of the bubble is to reflate the global bubble. This was the path chosen when the Tech bubble burst - easy money then led to the real estate bubble. Maybe the next bubble will be in green technology equities? In order to maintain "con-fidence" in the system we are led to believe that everything is alright.
Everything is not alright. The financial system remains largely insolvent even though taxpayers have already bought trillions worth of inflated credit at significant premiums to what any rational investor is willing to pay and despite bankers taking bonuses of sizes that appear ludicrous to anybody who is not used to burning trillions worth of value that does not belong to them.
Despite the fact that the financial sector is too big for its own good, Governments have gone far beyond covering insured deposits and ensuring the flow of debt to important, producing firms. No, they have decided to take on the inflated debt of so-called risk takers in the economy so that other "risk takers" are not impaired on their "investments".
This although much of this exposure was only taken on in light of an expected government bailout, and some of the largest recipients of government bailouts claim to have been "fully hedged", in the knowledge that they had bought a nonsensical financial product in an unsustainable game of ever increasing debt.
We may be in a difficult time of chaos, but cushioning supposed "risk takers" from the consequences of their own actions makes no sense. The only rationale for bailing out institutions which do not hold private deposits and do not engage in direct lending activity could be that they are indeed too intensively linked to systemically fundamental financial institutions via derivative exposure that they are too large to fail.
Should this indeed be the case, the solution is not to pump trillions of taxpayer monies into exactly these entities, further increasing moral hazard and apparently encouraging the largest, and correspondingly most dangerous risk taking in the financial history of mankind.
Here I would like to mention Goldman Sachs, the systemically important "bank holding company" which is essentially a hedge fund with preferential access to federal reserve liquidity, which undertakes no direct real economy lending nor holds retail accounts and just got over 20 billion USD in TARP money due to apparently being insolvent, is now the no. 1 proprietary trader on the NYSE, larger than the next 14 institutions put together.Conspiracy theorists claim this is a concerted effort by GS and the US government to prop up the market to retain confidence. I gather that this is more likely a desperate attempt to make back losses in the credit markets to avoid insolvency. Whether it is one or the other, what is clear is this is being done by a firm that took government money, despite GS employees averaging more than 360'000$ of compensation (including janitorial staff!) in 2009.
Propping up markets with taxpayer money is maybe not illegal, but highly questionable. Bailing out private financial institutions and their equity and bondholders who made bad debts is ludicrous, and makes no sense whatsoever if you believe that markets are the best way to allocate resources, which is what these guys have been telling us at least for the last 20 years. The distributional consequences of these actions are horrendous, and show a complete disparity between government elites and people who actually have to do honest work for a living. Socialism for the rich is inexcusable, and makes no economic sense.
However, governments are taking the riskiest and most likely to fail approach possible: Whilst they preach confidence and green shoots, they are subsidizing reckless risk taking by those who need it least, truly destroying the last bit of equity or market control in the financial sector. The banks will not provide credit to companies given the macroeconomic outlook of deflation that they created themselves. Indeed, they will attempt to exploit the last days of the game to the absolute maximum whilst paying out as much compensation as they can get away with. This is going on with very little government control or oversight, especially in the United States.
Given this outlook, it the systematic creation of confidence in an already failed system on its last legs, which will inevitably sucker some fools into the financial markets is not just cynical and dangerous, but downright criminal. Not only will they fail to save the financial system, which, given it's current form, is actually a good thing, but it will also inflict long term damage on the prestige of the political system, making the rise of radical solutions all the more likely.
We must reform the financial system, and we must do it according to certain basic principles previously laid out here. Merely perpetuating the current inefficient, fundamentally unfair and wide open to abuse system is not an option.
The best way to fix the crisis would be to immediately separate the deposit-insured banking sector form the highly risky, speculative investment banking activity. The withdrawal of the Glass-Steagal acts was indeed a short sighted act.
Keep small business loans running, keep deposits insured, put aside some extra cash for large firms needing short term liquidity and THEN:
Let the market run it's course. Let the Investment banks who made bad, leveraged bets fail. The good guys can then start/get hired by hedge funds who CAN fail and who get capital in the market not from the FED or some other taxpayer funded corrupt gravy train. The other guys who don't get hired can then go to activities which actually bring a benefit to society unlike parasitical and useless overpaid musical chairs playing with structured credit derivatives.
This should have been done right from the beginning. Insuring GS speculative trades and bonuses with FED, TARP and FDIC cash is a scandal, and tantamount to daylight robbery. Eventually the moral hazard and failed incentives will lead to a greater crisis down the road. The bill to the taxpayer increases with every day the corrupt Geithner crew neglects true reform.
Too large to fail is too large to exist. We need smaller banks and more competition not enormous intransparent and immensely powerful state sponsored dinosaur banking behemoths.
Thursday, April 2, 2009
Peace in our time
"We have today therefore pledged to do whatever is necessary to:
· restore confidence, growth, and jobs;
· repair the financial system to restore lending;
· strengthen financial regulation to rebuild trust;
· fund and reform our international financial institutions to overcome this crisis and prevent future ones;
· promote global trade and investment and reject protectionism, to underpin prosperity; and
· build an inclusive, green, and sustainable recovery. " (full text here)
> Wow those guys certainly know how to build confidence! A new era of financial regulation and sustainable economics is born!
This is great! Or - it only it were true.
Indeed today showed some very worrying news for the sustainability of the financial system:
"The Financial Accounting Standards Board revised the rules to allow companies to use the judgment to a greater extent in determining the "fair value" of their assets. The board also made it easier for companies to avoid having to take impairment charges against earnings when they suffer losses on their investments." (WSJ)
Yes.
The guys who brought this mess upon us through incompetence or fraud are now allowed to value their "assets" themselves!
This will merely have the effect of decreasing transparency in the financial system, leading to more uncertainty and room for fraud, most likely prolonging the crisis and certainly not contributing to a sustainable solution.
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.
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