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.

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.

Bankruptcies are good!

US car companies are currently lining up for crisis cash. Whether they get it or not is largely up to the political process. Whether or not doling out cash to failed enterprises is a good thing for the economy is within the scope of this blog.

I will attempt to make it simple:
-The big three failing means massive layoffs and an immense cost to society.
-The big three not failing means keeping employees employed in structures which, despite having had ample warning and time to adapt, were unable to meet the challenges of the market. We should also not forget that bailing out these enormous cash burners would come at an immense ongoing cost to society. Note that GM is currently rumored to be burning about 2bn US$ every month.

So whatever way we choose to go, there will be an immense cost to society. Given that consumers have already voted down the product range, the question remains: Do we, as a society, want these companies? Do they produce positive externalities for society?

The answer, for me, is no. Car manufacturers exist to produce cars. If they fail, they can no longer produce cars. Equity and to a large extent debt holders get punished for investing in a bad company. End of story?

Not quite. Many proponents of bailouts or not letting companies fail argue with the employees. That companies should be maintained due to the fact that their highly specialized workforce would encounter difficulties in finding new jobs and therefore their jobs should be maintained, subsidized with public wealth.

Nothing could be more far from the truth. Indeed, society has already taken these peoples jobs away by not buying the cars. To keep people in jobs to NOT build cars would not only be a waste of money, but also a waste of talent. Auto engineers with time freed up from keeping their seats warm in Detroit could go out and start designing the kind of car / electro-mobile / apparatus that people actually want to buy and use, thus becoming efficient participants in the economy. I for one am certainly unwilling to believe that all US auto engineers were designing the products they actually wanted to.

Of course, many auto workers will not be able to find work in their industry of choice, and will have to adapt. This is also a good thing. After all, laid off auto workers could become teachers, laborers, financial institution liquidators or a multitude of other things that the economy of today requires.

In general terms, the same logic applies to financial institutions. Let's take the example of Citigroup.

Citigroup is about to fail. Maybe, probably. The stock market appears to be reacting to the announcement that they would be firing up to 75'000 employees, or a quarter of their workforce. I must admit this comes as little surprise to me, as I gather that they have been effectively bankrupt for quite some time now. After all-even CITI must be hard pressed to liquidate non-core assets to the tune of half a trillion in this market.

What strikes me is that although they have been obviously extremely distressed for quite some time now, they have been kept on a lifeline by 25bn of TARP funding via sales of preferred stock. Now that the Tarp is no longer buying up distressed assets (which could have relieved the CITI balance sheet to the tune of 79bn$, according to some analysts) the company is being forced to recognize its dire straits.

Well - good that the mess is now being cleaned up, pity about the 25bn investment which may now be largely worthless?

The US treasury can invest in financial institutions, allowing for more savvy investors to exit their positions at more attractive prices, but it appears that this time they cannot compensate for the immense value destruction which is the bursting of the credit bubble without putting themselves at risk. Furthermore, there are gaping moral hazard and socialization of losses issues. After all, the bailout money does not come from nowhere, it comes from the state. This is money which, rather than bailing out investors who made poor decisions, could go to repairing the pisspoor US infrastructure, or to education, or to medicare...

There are similar examples everywhere. As I am based in Switzerland, I will go into the example of UBS. With UBS stock going down the drain (now trading around CHF 11 down from over 80 just over a year ago) it appears that they may be challenged to shore up confidence, despite the Swiss taxpayer committing to buy up "assets" to the tune of around 60 billion CHF alongside an equity investment of about 6bn. Despite guarantees and subsidies by the Swiss taxpayer equating to almost 9000 CHF (~7500 US$) per PERSON IN SWITZERLAND the markets, and particularly UBS board members appear to have little confidence in the firm.
From my perspective as a taxpayer in Switzerland, I feel ripped off , and would prefer to have not had my currency backed with debt bought from US credit Ponzi schemes, thank you very much (and I hold UBS restricted stock in an amount which used to have quite significant value)!

But what about the systemic implications?
Admittedly, systemic issues are critical. The uncontrolled failure of Lehman Brothers wrought havoc in Financial Markets, with banks unwilling to lend to each other. This is due to the fact that other banks know what kind of assets their peers hold. Assets which were bought and priced at values which were based on assumptions of inflation which are now turning out to be false.

So the banks are bankrupt. Well not all, but a lot of them.

The solution adopted so far is to recapitalize the banks (for more detail see Wednesdays post). This would be an ok approach if we were merely experiencing a temporary glitch which can be compensated by short term liquidity provisions. This is not the case. The banks are not insolvent but bankrupt. It appears very unlikely that credit markets will recover to a point where most leveraged banks who participated in US credit musical chairs will be able to recover their investments.

Given these constraints, the questions beckons regarding financial institution recapitalizations is: Will it be enough? Where will we draw the line? From the point of view of somebody who has worked for many a financial institution, let me just note that honesty is not a virtue they are known for.

From a macroeconomic perspective, the issue is becoming is it already too late? Do countries, and especially the US, even have the cash necessary to undertake such immensely deficitary exercises just as their tax base is shrinking?

Some thoughts on the financial crisis

This being the first post in my new blog, I would like to outline what in my mind is the fundamental issue with efforts currently being undertaken as a response to the current financial crisis, and conclude with an outline of what a more attractive solution might entail.


Financial Crisis
The financial crisis has been going on for quite some time now, despite repeated claims to the contrary by the Paulson - Bernanke fire brigade, and several other bureaucrats in the initial stages of the crisis.

Given that the US administration is soon to to change, it is interesting to note the differing agenda of the current administration, who remain focused on "shoring up confidence" while implementing incoherent and hastily stitched together programs to stop the crisis from worsening, from that of the incoming administration, who appear to be talking up the crisis. Paul Volker's speech at Lombard Street research certainly does little to foster confidence: "What this crisis reveals is a broken financial system like no other in my lifetime". It should be noted that Paul Volcker was alive and kicking during the Great Depression. Whether this is a warning by Volcker to go out and buy canned food or whether this is merely an attempt to pre-empt partisan attacks when the Obama administration proves incapable of solving the mess left by the current incumbents is unclear to me at this time.

However, I do generally appreciate a bit of straight talking regarding this crisis as I tend to get rather worried when I see Central Bank Board members, Professors with substantial reputations, turn in to cheerleaders for the financial system, as experienced at this event. The point being of course that the crisis must be really bad if a member of the Governing Board of the SNB is unwilling to tell you that it is, in fact, really bad.

It appears clear to me as it has for some time now that the current financial crisis is indeed going to be the major historical economic crisis of our time. Deflation appears to be increasing, causing enormous wealth destruction across the globe. The extremely expensive programs to buy up toxic assets and recapitalize the degenerate financial system appear to be largely futile, as banks remain unwilling to provide capital to the real economy. Therefore, it appears inevitable that the situation will get worse before it gets better.

What to do about it?
Problem: The highly overleveraged financial system has produced paper liabilities (to itself) that are so enormous that they can no longer be borne by the financial system.
So far, two main paths have been chosen to solve this problem:

Solution 1: Liabilities will be transferred to the public (Switzerland mostly, initial TARP) so the financial institutions can continue as if the crisis never happened, in the knowledge that the state will always bail them out.

Solution 2: The public invests in financial institutions via equity participation, thus recapitalizing banks and subjecting banks to increased oversight and control by the state. Once the banking system works again, state equity participation will be sold.

To me, solution 1 is certainly the most irresponsible, short term solution imaginable, and signals excessive coziness between Central Banks and the Private Financial system. Indeed, without severe penalties to the financial institutions who seek public capital to operate, the moral hazard involved in this operation is extreme. Solution 2 is far more attractive, as it goes some way to align interests and also control between the investor (the public, i.e. you) and the entity invested in. Banks do not want to be controlled by the state so they will endeavor to become self-sufficient once again as soon as it is feasible, and then try and make sure that they remain independent from state interference.

However, the main problem with both of these approaches is that they do not address the main problem, namely, unsustainable levels of risk taking in the financial system. Both approaches have the aim of financial institution recapitalization, and do so by injecting public capital into supposedly private enterprises, with the implicit goal of reflating the credit bubble so that we can all continue as we have so far. It is widely accepted that levels of leverage prevalent in the system were excessive prior to the crisis. For this reason, attempts to maintain previous levels of credit such as directives to financial institutions in the UK and US to maintain or even expand levels of mortgage lending will not only be extremely expensive, but largely futile. Indeed, such measures will merely postpone the inevitable.

The long term solution will have to focus on maintaining the economy in a state of relative balance by eliminating the excesses which led to the current crisis. It will have to address issues such as the role of state in the markets, moral hazard, government sponsored entities or the problem of being "too large to fail" and most fundamentally, public vs. private risk raking.

I realize that this is quite an undertaking, However, if you decide to follow this blog then maybe I may find the time to attempt an outline of a real, sustainable solution to the problem, one that will hopefully minimize the exposure of the public to financial system excesses.