Sunday, December 21, 2008

Robert Paterson's Boyd 2008 Summary - Hope!

From Robert Paterson's blog on Boyd 2008:

* The goal for us all to work to is clear - that we have to build back into the system Resiliency. This means that each region has to work to become largely energy, food and financially self sustaining and that each region needs to network into the others. In effect we shift from an efficient machine to a resilient network

* That the leadership model is no longer the dominant hero but the ego-less servant

* That we cannot wait to be saved. We have to all do our part to make our place "Home"

Many are desperate that somehow President Obama save us and importantly turn the clock back. Take us back to consumer heaven of 2006. Even if he could, would this be the right thing to do? To take us back to a world that is a fantasy?

What got us to this place?

The Dark Side of a Mindset. The Machine/Institutional/Newtonian/Engineering Mindset that created most of the wealth of the 19th and 20th century tipped over into the dark side. Where not only did we give up all our power to institutions but gave the few that ran them the license to use these institutions for their own benefit.

So we spend nearly a trillion on defense but not on what the troops really need. We spend billions of health and America is on a par with Cuba. We spend billions on education and more than 50% of Americans are functionally illiterate. We spend billions on food and we eat crap. We see that the leadership of these institutions live in a bubble. The gap between the rich and poor has never been greater. The middle class is being squeezed. We don't make anything anymore. We make no progress toward energy independence.

Friday, December 12, 2008

Deflation has become inevitable

For a while now I have been on the fence on the inflation/deflation issue – whether the massive monetisation of bad debts by central banks and governments will lead to rapidly escalating inflation as currencies are debased or, alternatively, lead to deflation as bad debts and illiquidity undermine all commercial and financial activity in the economy. I’m now coming down on the side of deflation for a very simple reason: there is no longer any incentive to save or invest, and so debt and investment cannot increase much beyond current bloated levels.

In Lombard Street, Bagehot’s seminal tome on fractional reserve central banking, Bagehot advises any central bank facing a simultaneous credit crisis and currency crisis to raise interest rates. By raising rates they will ensure that foreign creditors remain incentivised to maintain the general level of credit available while the central bank resolves the local liquidity crisis through liquidation of failed banks and temporary liquidity support of stressed banks.

The very opposite policies have been pursued by central banks in the US, Europe and UK since the beginning of the sub-prime crisis in August 2007. They have cut policy rates drastically, and as the crisis escalated and spread, the yield on government debt has dropped to negative territory. Meanwhile they have shielded those responsible for the creation of record levels of bad debt from any regulatory accountability, relaxed transparency of accounts, and provided massive taxpayer-funded financial infusions to prevent failure and liquidation.

While in the short term these policies have expediency and the maintenance of market “confidence” on their side, in the longer term these policies must undermine any confidence a rational and objective saver or investor might have that savings or investment in the US, EU or UK will be fairly remunerated at an above-inflation rate, or that savings and investments will be protected by effective oversight and regulation from the sorts of executive debasement and outright misappropriation and fraud that are beginning to colour our perceptions of the past decade.

Anyone sitting on a pile of cash now is unlikely to want to either (a) place it in a bank, or (b) invest it in the stock market. As a result, the implosion of the financial and real economy must continue no matter how big the central bank’s aspirations for its balance sheet or the treasury’s aspirations for its deficit.

If US, EU and UK had substantial domestic savings to fund their banks (as in Japan in 1990), then perhaps the consequences would not be so imminently disastrous. Lacking sufficient domestic savings, however, their actions will likely make foreign creditors in Japan, China, the Gulf and elsewhere question whether it is worthwhile to keep pumping scarce savings into such flawed and reckless economies.

During the reckless boom years, savings collapsed in bubble economies as retail and commercial and financial actors alike chased speculative yields with greater and greater leverage. During the reckless bust years, savings will collapse further as retail and commercial and financial actors chase safety by hoarding their meagre remaining assets from further erosion by refusing to lend at negative returns and refusing to finance failed corporate and investment models that only enrich poltically-connected management and intermediaries.

The determination to avoid any accountability for failed banks, failed business models, failed regulatory systems and failed academic rationales for all the above invites anyone with spare cash – an increasingly select crowd – to withhold it from further depredations. It is this instinct, more than confidence in the government, which is driving so many to seek the temporary safety of short-dated government securities.

The result of discouraging domestic and foreign creditors and investors must be inevitable deflation as debt levels become increasingly hard to finance and ultimately contract. Irresponsible central banks and governments can try to bail out the failed banks, businesses and municipalities at the centre of every popped bubble, but the bubble economies are ever more certain to deflate with each bailout. Each bailout further undermines the market discipline which is bedrock to a saver or investor’s decision to part with hard-earned cash by trusting it to the intermediation of the management of a bank or business.

It’s this simple: I won’t invest in a country that bails out failure and punishes savers. I won’t invest in the US or UK until they change course and protect savers and investors, ensuring a reasonably predictable positive return. In the EU, I will be very selective, preferring those conservative states like Germany that never embraced the worst excesses, although sadly still have fall out from individual banks' stupidity in buying into foreign excess. I will know when it is safe to reinvest when policy interest rates, bank/intermediary oversight and accounting standards give me confidence I am better protected than the corporate or financial elite.

While it may take the Asian and the Gulf State investors longer to embrace my analysis, I have no doubt that they too will eventually conclude that parting with their savings under the terms now on offer will only deepen their losses. They would be better off keeping the money at home, investing locally under local laws and vigilance, and letting the US and UK implode.

The argument against this has always been that with trillions already invested in the US during the deficit years, the Chinese and Gulf States would suffer even more horrible losses from a collapse of the western economies. This is accurate, but not complete, as it ignores the relative value of cash investment at the top and bottom of a bursting bubble. Once the collapse has bottomed out, so long as a globalised economy survives, there will be even better opportunities for those with savings to invest selectively in businesses with clearer prospects and more certain profitability under regulatory frameworks which have been restored to a proper balance of investor protection and intermediary oversight.

Right now survival of businesses in the West depends largely on political pull and access to regulatory forbearance and central bank or treasury finance. The market has failed, and officialdom is collaborating in perpetuating that failure.

Should the western economies implode in deflation, however, there will be new opportunities to return to market-based policies that reward effective, efficient management and punish corrupt, debased management. Until that happens, those that invest will continue to lose money. Once deflation is exhausted, then those that invest can expect to make and retain profits again.

I think it took me so long to feel confident about predicting deflation because the floating currency system under dollar hegemony and Bretton Woods II distorts the workings of both inflation and deflation. Despite the US being the epicentre of all the failed debts, failed securitisations, failed credit derivatives, failed rating agencies, failed banking businesses, failed corporate governance, failed accounting standards, failed capital adequacy models, and failed regulatory forbearance, the US dollar has recently strengthened as deflation globalised. The US exported inflation in the boom years, and now exports deflation in the bust years.

Since spring 2008, as US investment banks sold off assets, imposed margin calls, and used access to unsegregated wholesale assets in custody in the rest of the world to upstream liquidity to their US-based parents and affiliates, the dollar has strengthened relative to other currencies. The media reports this as a “flight to quality”, but it is more like a last looting of the surrounding countryside before dangerous brigands hole up in their hilltop fortress. The brigands appear temporarily wealthy compared to the peons left stripped and penniless and facing winter. When the brigands have eaten all the stolen grain and livestock, however, they will have no means to replenish except to use force to raid the countryside again. The peons can always hunt, forage, farm and carefully husband a surplus to gradually increase their wealth. If the brigands raid too thoroughly or too regularly, the peons have no incentive to grow crops or keep herds (negative savings returns) and everyone starves (deflation).

In the meanwhile, the peons just might wise up, hide any surplus more securely and organise mutual defense against further attacks to ensure that their peon children prosper and the brigands die off. That would be the end of Bretton Woods II, and the rise of China, India, the Gulf and other productive and/or resource rich states which invest surplus in domestic productivity and regional growth.

I reread my piece on Fisher’s Theory of Debt Deflation in Great Depressions the other day. One of the more confusing aspects is his assertion that the dollar “swells” as debt deflation takes hold. What he meant, of course, is that deflation increases the quantity of assets and the likely investment return each dollar purchases as deflation wrings debt and misallocation of capital out of the economy.

It is now clear to me that policy makers in the West are determined to apply every available resource to underpinning failure, misallocation and executive excess. As this discourages the honest saver from parting with cash, policy makers are ensuring that deflation will wreak its havoc on the financial and real economies of the world. Only when that deflation has played out and rational policies that reward market-based management and returns are restored will it be worthwhile to invest again. In the meanwhile, any wealth saved securely from state seizure will "swell" to buy more assets in future - a key aspect of deflation and a key means of restoring the control of the economy into the hands of more farsighted savers and investors.

I have quoted Mr John Mill before, but it bears repeating: ““Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.” The extent to which capital has been betrayed in the past quarter century under Bretton Woods II, bank deregulation and the Basle Capital Adequacy Accords is unrivalled in the history of fiat banking. The bankers, lawmakers, regulators and academics who collaborated in the betrayal still hold power, like the well-armed brigands in the fortress, and their continued collaboration to prevent accountability must inevitably discourage honest savers from risking further loss. Even so, it is the savers/peons who hold the ultimate power as they can starve the brigands.

Some day soon savers will revolt at financing further depredations. They will refuse to buy even government securities, gagging at the quantities of issue forced upon them under terms of only negative return. When that final massive bubble bursts, deflation will follow its harsh corrective course and clean out deficit-financed “unproductive works”.

When that happens, if reason is restored in markets with effective oversight, I might consider investing again, very selectively, in whatever productive works might then be on offer and only when secure in realising - and retaining - a positive yield.


Apologies for not posting last Friday.

Writing for this blog has been a great experience, forcing me to refine my views about current events and the principles which should underpin financial market interactions and supervision. In parallel, I have been forced to re-evaluate whether I should commit to sorting out some of the practical aspects of the future of banking in the global economy. Writing takes a lot of time and passion, and these are limited commodities for any of us.

I have accepted a full time executive position which will take all of my time and passion going forward in 2009, so the blogging has to be suspended at year end. The job will enable me to put into practice the principles I’ve illuminated here, hopefully mitigating some of the impacts of financial instability. I’ll still lurk, and maybe comment on Professor Roubini’s thread from time to time.

Wish me luck!

Friday, November 28, 2008

What We Value Is What We Save In a Crisis

“When a woman thinks that her house is on fire, her instinct is at once to rush to the thing which she values most. It is a perfectly overpowering impulse, and I have more than once taken advantage of it. . . . A married woman grabs at her baby; an unmarried one reaches for her jewel-box.”

-- Sherlock Holmes from A Scandal in Bohemia, by Arthur Conan Doyle

When a central bank thinks its house is on fire, it too will rush to save the thing valued most. In the United States, the central bank has rushed to save the bonuses and dividends of its Wall Street clientele by hiding away the bad assets that can no longer be foisted on gullible investors. In Europe too the response of central banks has been to save the wholesale banking and securities industry rather than the consumers and businesses underlying the real economy’s longer term productive strength.

For a comparative of what is valued elsewhere, it is worthwhile to look at what is being saved. I received in my inbox yesterday documents outlining the efforts being taken by the Hong Kong and Chinese authorities to address the liquidity crisis in their respective jurisdictions. They are available online here (Hong Kong) and here (PRC). The contrasts with the West are striking, and humbling.

Hong Kong is swiftly introducing a scheme to guarantee credit to SMEs (small and medium enterprises) and exporters. China is introducing controls to limit bank credit to over-extended speculative sectors, accelerate rebuilding in the regions affected by the earthquake earlier this year, and promote improvements in local infrastructure, education and economic adjustment.

Holmes would have been disgusted by a married woman who grabbed her jewel-box in preference to her baby. In the same way, I am disgusted by the central banks preserving the privileges of the financial elite in preference to the jobs, incomes and businesses powering the real economy. The US and UK authorities may criticise the banks for their inaction in freeing up lending to commercial businesses constrained by the credit crunch. The Hong Kong and Chinese authorities are implementing guarantee schemes and innovating initiatives to rapidly address the problem.

As Holmes would have considered a child’s life worth more than jewels, I consider the workers and businesses in the real economy as meriting greater protection than the financial elite. It is not merely that I think the financial elite little better than criminals for their irresponsible excesses of recent years, but that I fear long term harm and political instability will come from neglecting the needs of the real economy.

Shortsightedness is a peculiar affliction of the Western economies. We cannot seem to project the consequences of our actions beyond the next quarterly report, fiscal year or - at most - election cycle. Eastern policy makers have a capacity for longer vision – and longer memory – which makes them appreciate sooner the potential consequences of bad policy. Perhaps this is a consequence of the longer term dedication required to gain political ascendancy in their less cyclical heirarchy.

That China's leadership is concerned with the implications for the real economy – and political stability – was confirmed this morning in an unusually blunt public statement by the chairman of the National Development and Reform Commission. From the Financial Times:

The downturn in the Chinese economy accelerated over the past month and could lead to high unemployment and social unrest, the country’s top economic planner warned on Thursday.

Zhang Ping, chairman of the National Development and Reform Commission, said the government needed to take “forceful” measures to limit the slowdown in the economy, which included Wednesday’s large cut in interest rates and a sharp increase in fiscal spending. The rate cut was the fourth since September.

“The global financial crisis has not bottomed out yet. The impact is spreading globally and deepening in China. Some domestic economic indicators point to an accelerated slowdown in November,” Mr Zhang said on Thursday at a rare news conference.

Mr Zhang’s warning about the potential for social unrest as a result of factory closures underlined the mounting concern in Beijing about the fallout from the global financial crisis.

“Excessive production cuts and closures of businesses will cause massive unemployment, which will lead to instability,” Mr Zhang said.

As Jim Rohm observed, “Failure is not a single, cataclysmic event. You don't fail overnight. Instead, failure is a few errors in judgement, repeated every day.”

The crisis in debt markets has been rolling since the sub-prime collapse of August 2007. The increasing illiquidity of commercial paper, trade credit, municipal finance and other debt markets was foreseeable and inevitable. And yet the central banks and treasury authorities of the Western nations have done nothing to shield these essential sectors from the ill effects of the financial sector implosion while giving virtually unlimited funds to the banks authoring the collapse.

Any discussion of China always invites criticism of its anti-democratic governance. It is worth remembering that the philisophical defense of democracy lies in the proposition that it is more likely over time to serve the interests of the electorate than a system which disenfranchises the people from the determination of their leadership. If the democratically elected governments - through their appointed executives and central bankers - are free over an extended timespan to ignore the interests of the people, then how is a Western democracy superior to a Chinese bureaucracy? From looking at the policies and practices of the past year, the merits of Western democracy are not immediately apparent in ensuring that policy responses to the financial crisis are aligned with the interests of the people. Even over the past decade, it is not clear that the policies of the democratic Western governments have aimed to strengthen and broaden the economy to benefit of the electorate rather than a narrow, self-serving elite.

According to Brad Setser, the World Bank is projecting increases to China’s trade surplus in 2009 as falling commodity prices lower production costs. Those unelected bureaucrats are doing something right.

If China and Hong Kong recover sooner, prosper more, and gain global political and economic authority in consequence, it will be because they made fewer mistakes and made them less persistently than their Western counterparts. If the promoters of democracy want to strengthen their case, they might best do so by ensuring that their leadership adheres to policies which promote the longer term health and well being of the economy as a whole rather than the short term enrichment of an undemocratic elite.

Friday, November 21, 2008

Dollar Strength Sustainability

Coincident with the passage of the Paulson Plan in early October, the top prime brokers (MS, GS, JPM) issued margin calls on hedge funds which raised the average margin required from about 15 percent to about 35 percent. At a time of fragility in global markets and global confidence, this was equivalent to the sudden contraction of global market liquidity by a trillion dollars or so. A huge sell off in quality assets followed as hedge fund managers struggled to meet the margin calls.

Because hedge funds are unregulated, and prime brokerage credit isn’t well reported for aggregation, there is no obvious way to compile exact data. Nonetheless, it would be rational to assume that simultaneous global margin calls on a vast cross-section of hedge funds would have a dramatic effect on global markets. Hedge funds accounted for well over half of all market transactions in 2007, so are a huge driver of maket trading and liquidity.

Trillions of dollars of value were wiped off the balance sheets of the world’s investors over the next few weeks as forced selling forced prices lower and lower. Adding to the selling pressure, many hedge funds were simultaneously raising cash for redemption demands of investors also squeezed by margin calls by their creditors.

I’m sure none of this was intentional (wink, wink). I’m sure there was no coordination among the prime brokers (nudge, nudge). I’m sure it would never occur to anyone in the Wall Street prime brokerage banks that manipulation of leverage could create profitable trading opportunities (cough, cough).

The result was a collapse in global prices for equities, debt and commodities. FIRE SALE! Everything must go!

As the margin calls got met, the dollar strengthened. It strengthened hugely against the pound. From $2 to the pound earlier this year, Sterling has slid to below $1.50. This is likely because there are such a lot of hedge funds and private equity funds here in London, all struggling to meet their margin calls in New York.

At the same time, we observed a huge expansion in the monetary base as the Fed doubled its balance sheet and Paulson doled out taxpayer largesse to Wall Street. The banks began to accumulate massive reserves and Treasury yields crashed lower, especially at the short end. Treasuries gained value as the prime brokers parked the incoming margin cash in the safest, most liquid asset - the primary collateral for all interbank obligations too. These reserves and Treasuries are just sitting in the Fed and not contributing one iota to the stimulation of the economy.

All of this is interesting recent history. Now what happens when some of these trends reverse?

What happens to the global markets when the deleveraging stops? What happens when there are no more global margin calls on the surviving hedge funds? Will anyone want to buy dollars when they don’t need them to repay dollar debt?

Will there still be inflows to US Treasuries when few need a place to park cash for short term liquidity? What will prop up demand for the Treasuries then?

What happens when banks begin to use reserves to lend or speculate in the now crashed assets available globally at fire sale prices?

With most of the growth still projected to occur outside the USA, will some of those Treasuries be sold to take advantage of the many equity investment deals on offer? How will that affect the dollar?

We are observing huge swings in asset markets. We are observing huge swings in foreign exchange markets.

I’m not going to make any recommendations, but I predict we haven’t seen the end of volatility. The rapid rise of the dollar, the massive demand for Treasuries, are hugely convenient for the US Treasury as it finances the expansion of the Fed balance sheet and the giveaways to the corporate welfare queens on Wall Street and elsewhere in the last days of the Bush administration. It seems unlikely, however, that the conditions can be long sustained.

When they reverse, we may see a fair sized bounce in global equity markets, a loosening of credit conditions in global debt markets, a revaluation of commodities, and a revaluation of the mighty dollar. Many will call the bottom and pile back in.

I wonder how long that will last . . .

Hat tip to FTAlphaVille where the team gives me much to think about every day and the analysis of trends is superb. Picks for this week include:

M3, where are thou?

Fill your boots!

Dollar *danger* ahead

Friday, November 7, 2008

The Fed doubles its balance sheet - above $2 trillion in just 5 weeks

Think about that. If any commercial or investment bank had been seen to do that, it would become an instant leper in the credit markets. It is a truism that banks go bust by writing business that wiser banks rejected, and so grow their balance sheets faster. As a young bank supervisor I was told that the surest way to spot a potential bank failure was to look for outliers in asset growth.

Had anyone at the Fed or FSA been brought up in the old school, they would have seen Countrywide and Northern Rock coming a mile off. Perhaps they did, but in the new Friedmanite culture of forbearance and free markets, and Basle II risk models, they decided to let capitalism run its disastrous course rather than take unpopular decisions about constraining the prerogatives of over-compensated executives and shareholders.

And now we have the Fed doubling its balance sheet in just five weeks. It is exactly by taking on the assets of the banking sector that are otherwise unmarketable that the Fed has grown its balance sheet. And it is by doing this while indulging the banks in continued oversized dividends and executive bonuses that leads me to believe the policy must ultimately fail to either correct the problems in the US banking sector or sustain the credibility of the Federal Reseve as a prudential supervisor and lender of last resort.

Dallas Fed President Richard W. Fisher has speculated that the balance sheet could expand to $3 trillion by January:

“You can see the size and breadth of the Fed’s efforts to counter the collapse of the credit mechanism in our balance sheet. At the beginning of this year, the assets on the books of the Fed totaled $960 billion. Today, our assets exceed $1.9 trillion. I would not be surprised to see them aggregate to $3 trillion—roughly 20 percent of GDP—by the time we ring in the New Year.”

At the same time the Fed has equalised the interest it pays on reserves deposited in the Fed and the Fed Funds target rate. That undermines any incentive to interbank lending, virtually ensuring that banks will prefer to hold their cash as reserves at the Fed rather than as lending exposures to one another. On the other hand, according to a Fed research note from August, it allows the Fed to supply greater liquidity for market needs without the risk of pushing lending rates below target rates.
In contemplating the anomalies of this policy, it occurred to me that it might be aimed at reinforcing the dollar by drawing reserve balances to the Fed in preference to other central banks as they follow the Fed by cutting rates this week. Perhaps the Fed is pre-emptively combating dollar capital flight, or perhaps it is a further extension of the "ring fence" tactic of drawing assets to the US in contemplation of future insolvencies to secure advantage for US creditors over global peers.

As Sam Jones at FTAlphaVille commented yesterday:

There’s a big danger here for the Fed: that it is trying to catch a falling knife. The Fed is risking things it’s never risked before. That’s not to say we’re in apocalyptic territory at all; consider the firepower the Fed has behind it. It is though, to use a hackneyed, but apt phrase, paradigm shifting.

In Japan, where quantitative easing failed, the central bank’s balance sheet swelled to a size equivalent to 30 per cent of GDP. The Fed’s balance sheet is currently equivalent to 12 per cent of GDP.

This is uncharted territory for a central bank of a reserve currency. I suspect, however, that these moves play into the strategy of the Paulson Plan survivor bias. As someone reminded me recently, Mr Paulson's primary objective at Goldman Sachs was to outperform peers in both good times and bad times. If profits were to be made, he wanted Goldman to have more of them. If losses must be booked, he wanted Goldman to have less of them. He seems to have taken the peer outperformance strategy global with the Paulson Plan.

Hat tip to FTAlphaVille for posting relevant Fed insights yesterday and today:

The mother of all balance sheets

Fed capitulates: the central bank is broken

Change I can't quite believe in

I wanted Obama to win. I really, really, really wanted Obama to win. McCain/Palin gave me nightmares. Just about the whole world held it’s collective breath willing Obama to win on Tuesday.

Obama’s election is powerful confirmation that America remains a land of opportunity, a democracy where power is allocated at the ballot box. It reassured the world that despite the lawlessness and arrogance of the past eight years, Americans are capable of enlightened, rational self-determination. It restores hope in much of the world that America can reorient itself toward tolerance and dialogue.

For all of that, I haven’t been happy since watching Obama’s acceptance speech live Wednesday morning on the BBC.

I have a bad feeling that America has just elected its Tony Blair. The package of Change the voters ordered isn’t what is being delivered to the White House.

The appointment of Rahm Emanuel as White House chief of staff didn’t ease my mind. Like Mr Blair’s close advisors Lord Goldsmith and Baron Levy, Mr Emanuel may inflame the suspicions in the Middle East that the agenda for the region under Obama will be no different than under Bush. The credibility of the United States as an honest broker and agent for peace will be further eroded if Obama’s gatekeeper is viewed as pre-disposed to more of the same policies which have fuelled hostilities. I hope it is not anti-Semitic to make the point that objectivity and fair dealing will be suspect with a chief of staff who is the son of an militant Israeli, who served as a civilian volunteer for the Israeli Army, and who has used his public positions in American politics – except for a brief stint at Dresdner Kleinwort Wasserstein – to promote Israel’s interests.

Those who know Mr Emanuel suggest that because his devotion to Israel is unquestionable, he will be able to push Israelis toward moderation. Perhaps the combination of a Kenyan goat herder's son with an Irgun terrorist's son will be a winning combination for crafting a durable peace. But many in Israel, the Middle East and Washington will expect that future acts of aggression by Israel against Iran or other neighbours will be defended – if not promoted – by the man at Obama’s elbow.

It is now emerging that Mr Emanuel was also a director of Freddie Mac when it stands accused of misreporting profits and ignoring red flags.

The rumours that either Larry Summers or Tim Geithner will be made Treasury Secretary made me even queasier. The appointment of either of these architects of the current global financial disaster, these arch-deregulators and serial-forbearance artists, would be a great middle-finger to America’s foreign creditors and the global investors suffering asset deflation. Both men have been instrumental in, first, the Fed’s exported inflation via massive monetary bubble-blowing and, now, the Fed/FDIC/SIPC exported deflation through Chapter 11 and margin call orchestrations ensuring more pain abroad than at home.

Summers would be particularly egregious. Not only did Summers promote the Friedmanite export of toxic debt to the rest of the world at the Clinton Treasury, at the World Bank he promoted the export of toxic pollution to underdeveloped nations to add poison to poverty. To quote from his 1991 memo, "I think the economic logic behind dumping a load of toxic waste in the lowest wage country is impeccable and we should face up to that."

The much bandied idea that Robert Gates, former deputy director of the CIA under President G.H.W. Bush, architect and financier of Saddam’s military machine and Bin Laden’s Al Qaida, might be kept as Secretary of Defense under Obama “for continuity’s sake” after six years of failed and callous military adventurism in Iraq and Afghanistan, with occasional illegal forays into Pakistan, Georgia, Syria and Iran, makes me frankly nauseous. If America is ever to restore its fiscal balance, cuts in the bloated military/security/intelligence apparatus will have to be implemented. A career insider central to the creation and export of the bloat is the wrong man for the job.

Maybe the problem in America is not a struggle between rich and poor. Overtaxed and undertaxed. Empowered and disenfranchised. Educated and illiterate. Insured and uninsured. Law abiding and lawless. Godless and God-fearing. Republican and Democrat. Red and Blue.

Maybe the problem in America is there is no struggle about the fundamental mechanisms of American oppression and aggression: debt and threat.

American policies promote debt and force as the hammer and anvil for shaping the economy and the political dialogue. What cannot be financed into penury must be crushed into submission. The bulk of the economy is designed to prosper either the bankers or the police/prison/military/intelligence industries at everyone else’s expense. Propped up on these twin pillars of debt and threat, America remains staunchly and irrevocably American whoever wins the elections.

The restoration of fiscal prudence has been swiftly repudiated post-election in favour of more debt-financed “stimulus” and “stabilisation”.

The restoration of the rule of law and holding those who committed crimes accountable – both within America and internationally – has received no post-election endorsement from Obama.

I asked the asylum Iraqis at the local kebab shop last night what they made of the American election. They follow the news, and I’ve always found them knowledgeable and articulate. The kebab chef (a former civil engineer from northern Iraq) looked glum. “It makes no difference. They are all the same.” I fear his well-informed cynicism is sound.

Our unglamorous and unelected British prime minister, Gordon Brown, called for more international cooperation “with American leadership central to its success” – as he toured the Arab Gulf with his begging bowl. He was physically following American “leadership” as he trailed Deputy Secretary of the Treasury Robert Kimmet’s pilgrimage to the Gulf last week. American leadership got us successfully into this debt crisis, and Brown appears determined to follow it even deeper.

The central banks in the UK, EU and Switzerland obliged yesterday by following the Fed toward negative real interest rates, discouraging savers and lenders alike by cutting 150bps, 50bps and 50bps respectively. Jean-Claude Trichet spoke of the cooperation of the central banks as a “brotherhood”. He made me think of the mafia or the Freemasons. Perhaps he meant to.

Obama’s election still inspires me. I still hope for change.

Obama demonstrated good judgement throughout the campaign, and good management of the people working for him. That in itself will bring major change to the White House.

Better managed American debt and threat policies under Obama will be an improvement over the horribly managed debt and threat policies under Bush. Some hope.

Friday, October 31, 2008

Byways and Tribal Capitalism

I have been indulging in leisure again. For nine days I backpacked along the ancient Ridgeway, the superhighway of Neolithic Britain and a trade route into the modern era. Starting about 6,000 years ago, (roughly the time Sarah Palin imagines Adam and Eve holding hands in a newly wrought Eden) the Britons occupying the plains either side of the Ridgeway were settling the river valleys to raise crops and herd animals. As the crops and herds increased, and the Iron Age and Bronze Age opened trading opportunities in new technologies, these Britons took strides that set them and their heirs on the road to market capitalism.

The road they followed is the road I walked – the Ridgeway Trail.

The Ridgeway is a geographic feature of Jurassic and Corallian limestone, an 87 mile long spine of rocky downs running through Southern England from Ivinghoe Beacon in Buckinghamshire to Overton Hill, near Avebury in Wiltshire. It was linked by other routes to ports in the South and on the Channel. The Ridgeway was admirably suited as a commercial highway in early times because the limestone was porous, draining rain away from the high pathway to the plains below. When the tracks below were impassable mires of mud for man and beast, the Ridgeway remained a quick and easy road from one region to another. Being high, with excellent views down the slopes and over the plains, it was also possible to detect and defend against brigands who might beset unwary travellers, with ring forts provided to secure travellers and goods along the route.

Neolithic Britons were secure enough to form large agrarian tribes, planting and harvesting grains and herding sheep. They were prosperous enough to have excess grain and sheep to trade for iron and bronze tools and gold jewellery and other valuable trade goods. They were economically advanced enough to have specialisation, with certain tribes and regions known for their skill in producing iron or bronze or pottery. They were politically advanced enough to have organised militias, with a ‘warrior aristocracy’. They were wise enough to promote collective security and agree byways for safe passage with neighbouring tribes to enable commerce along the Ridgeway.

The Ridgeway reminded me every day we walked along that it is infrastructure, transparency and mutually-enforced rules which secure and grow markets for productive capitalism. Infrastructure provides a common framework for trade to take place. Transparency allows those trading in markets to evaluate each other’s wares and defend against brigands who might wish to ambush the unwary. Rules of safe conduct and fair dealing promote the confidence which encourages those with excess production to bring it to market to trade for their present and future needs. Mutual enforcement ensures that the temptation of any tribe to loot its neighbours is curbed by the risk of finding itself precluded from the trade routes and from access to markets.

I imagine that like many small, agrarian, tribal states, England of the pre-Roman period was organised into settlements relying on militias with only small dedicated military elites. This arrangement, as exists in modern Switzerland, allows the civilian militia to contribute most of its energies under secure conditions to increasing production, growing the surplus which sustains collective prosperity. Although a professional military or ‘warrior aristocracy’ can be useful in providing skilled leadership, if that military gets too large, or the aristocrats too greedy, the incentive to produce a surplus is removed and tribes tend to weaken, grow poor and fail. Prosperity and security require a delicate balance in the social contract.

The Ridgeway also reminded me that prosperity invites looting by aggressors. By the Roman era, England was producing a large enough surplus to be exporting across the Channel, with trade goods from as far afield as the Mediterranean. This has been substantiated by findings of pottery, jewellery, coins and other goods in early Celtic settlements.

It was the prosperity of England as a grain exporter that led Julius Ceasar to covet it for the Roman Empire.

A professional military demands a large production surplus from the civilian population to sustain it. The state expropriates the surplus production and provides it to the military. If the military can secure more resources and more production to the state, the expropriation can increase prosperity of its tribe – or at least the elite that commands it. But if the military fails to secure more resources, then the expropriation from those producing a surplus will gradually erode the incentive to produce a surplus – leading to decline and increasing poverty and political strife.

Ceasar understood that securing the large agricultural surplus of England to finance and feed his armies would help underpin the military strength of the Roman Empire. Naturally, the Romans secured and settled the most prosperous agricultural regions. As a result, there are Roman traces along the Ridgeway – improvements to the roads, the forts, and the commercial links to market towns and ports on the coasts. We walked Roman roads last week too - straight, raised and solid even 2,000 years later.

Following the Romans, the Danes, the Angles, the Saxons and the Normans invaded and occupied the same lands. Throughout the changing political and ethnic mix of tribes and elites, the Ridgeway continued to function as a trade route through prosperous middle England.

Modern markets could usefully reflect on the durable Ridgeway model of market infrastructure. Transparency of assets – whether sheep or shares or CDOs – is critical to the effective function of markets for price discovery and investment. Those who have secured a surplus are unlikely to risk taking their wealth to a market where assets are not open to inspection and proper valuation. Security of trade routes and market towns for merchants and traders is essential to encourage those with a surplus to bring it forward, promoting effective allocation of assets and underpinning growth in production. Mutually-enforced rules of conduct, fair dealing and safe passage are key to building a reputation that attracts both buyers and sellers and ensures a sustained market prosperity.

The modern ‘warrior aristocracy’ could usefully reflect on the fate of societies that deplete the incentives to surplus production and fail to secure commensurate returns from a costly military. Whether a Neolithic tribe, a Celtic settlement, the mighty Roman Empire or the Soviet Union, history proves that a tendency to excess expropriation by the state undermines any incentive to investment and surplus production. Excess expropriation will ultimately weaken the economy supporting the elites and the professional military that secures their privileges and interests.

As the global elites meet in the coming weeks to address the current economic crisis, they could do worse than contemplate the lessons I gleaned from the Ridgeway. Those who provided poor transparency, promoted dishonest market practices, looked the other way or collaborated in the robbing of passing merchants and investors, and otherwise violated the precepts embodied in the Ridgeway model should be held accountable for their failings. The global model going forward must return to the principles embodied in the ancient stone backbone of English commerce.


The Ridgeway (Wikipedia)

The Ridgeway National Trail

Neolithic, Iron Age and Bronze Age Britain (BBC)


Congratulations to Rich H (Miss America) who was to cover for me last Friday and instead secured his own position in the RGE blogroll.

Friday, October 17, 2008

We had to burn the village to save it

The title of this diary is a quote from the Vietnam era that sums up for many the arrogance and pointlessness of American aggression in Asia two generations ago. It keeps coming to mind each time I read President Bush’s (paraphrased) statement this week: We had to nationalise the banks “to preserve the free market.”

There is no free market when the government owns the actors and sets the terms of transactions. There is no village once it has been burned to the ground.

The collapse of the financial sector is unacceptable. It is unacceptable to bankers who have vested careers, status and equity wealth in the disproportionate expansion of the financial sector. It is unacceptable to politicians who have risen to high office doing the bidding of the financial sector in ceding progressively more generous taxpayer subsidy and regulatory forbearance to its chieftains.

And so in the US, UK and EU we have politicians appropriating more petrol to hand to the arsonists who started the conflagration which is consuming our economic and political fabric. The regulators whose forbearance is a root cause of the current conflagration are handing the arsonists fresh zippo lighters. The policies adopted in these debtor nations will fail, must fail, because they destroy what remained of market economies. In the meanwhile, however, the bankers and the politicians and the regulators cannot conceive of failure and so insist on more of the same – ordering hundreds of billions in more incendiaries to fuel the blaze. The same tax breaks. The same housing subsidies. The same regulatory forbearance. The same ill-transparent, off balance sheet, accounting sleight of hand. The same eradication of market incentives to productive, disciplined saving, investment and labour.

Those who would prudently save will be punished with negative real interest rates and asset deflation. Those who would prudently invest in productive industry will be starved of scarce capital and forced into liquidation. Those who would prudently labour for a decent wage will be slowly robbed by inflation and kept docile by the threat of unemployment.

There can be no more iniquitous alliance than to have the politicians at the service of the bankers, unless perhaps it is to have the military at the service of the bankers too. The US seems to have committed itself to this worst of all possible combinations, with Congressmen threatened by the imposition of martial law if they failed to acquiesce to the Paulson Plan. Thankfully the British and EU militaries are too small and ineffective to be leveraged into a similar threat to global or domestic peace and security.

Subsidised banking seems a faster method of going bust than military adventurism, but the two together will see the US bust even more certainly. The $700 billion appropriated for the Paulson Plan and the $840 billion extended in parallel by the Federal Reserve last month are together more than three times the expenditure on US wars for the past five years. The federal borrowing requirement for 2008 is now in excess of $1.02 trillion, and for 2009 is now estimated between $1.5 and $2 trillion.

Such hyperbolic growth in the fiscal deficit and debt is unsustainable, even with such very tolerant creditors as the Japanese, Gulf Arabs, Russians and Chinese. They can see that each dollar added to the Fed’s balance sheet is tinder for burning those already held or denominated in their reserves. They can project the curve forward. At some point, they must react and restrain further debasement of their reserves and investments, either by collectively raising the prices charged for the resources and products they export, the interest charged on existing and future debt, or the forced exchange of debt for equity ownership of real economic assets.

Or all three.

The cycle of debt deflation is just getting rolling. The banks were only the first bailout and already the federal deficits are ballooning unsustainably. What will be the recourse when municipalities and states face default through catastrophic tax and revenue shortfalls? What will be the recourse when large commercial employers, industries and infrastructure confront failure from collapsing consumption expenditure? What will be the consequence when unemployment, homelessness, political disaffection and crime are resurgent and threaten the political fabric?

We are at the end of the beginning. Hank Paulson has played a clever game for the past decade of exporting dodgy paper to the US creditors abroad while forcing a middle class subsidy of the tax exempt corporatists at home. Now he plays a clever game of devaluing all currency and paper assets, exporting the pain to foreign taxpayers and investors. But this is not a game that America can win without the debasement of everything America once represented as holding value in its formerly prosperous market economy.

In my experience, there is nothing so permanent as a temporary expedient. It is hard to see how partially nationlised banks will ever be more than the means of political redistribution of wealth and power, and so corrupt both the economy and political system.

We had to burn the village to save it.

Perhaps someday we will hear a remorseful Mr Paulson or Mr Brown echo Robert McNamara, early architect and aggressive propagator of the Vietnam War: “We were wrong, terribly wrong.”


I will be out of touch for most of the next nine days, but will check in as and when I can. There may be a guest blogger here next Friday who I'm confident will be enthusiastically received, if he accepts.

Monday, September 29, 2008


I had the following quote ready to publish when the bill passed. The vote against the bailout bill was a pleasant surprise, but the House still has until Thursday to be bought off or to cave to pressure. Or maybe democracy is still alive in America?

"The bank was saved, but the people were ruined."
- Henry M. Gouge, circa 1830

Friday, September 26, 2008

Learning from Rudi Bogni: The Thin Space of Financial Activity

Every good morality tale needs heroes as well as villains. In the past few weeks all we’ve seen are the villains raping and pillaging and despoiling all that we hold dear – rather like the first hour of the original and uncensored Mad Max.

I’ve made it pretty clear what I think about the villains that have got us into the current meltdown mess. Even I need a break from cynicism every now and then, however, to remind myself that better is truly possible. I thought I would take the opportunity of my post this week to reflect on a personal hero who epitomises what banking once was and whose philosophical writings can point us toward what banking should be again when the dust settles and we contemplate rebuilding our collapsed financial house of cards.

No one is perfect, and I’m sure he’s not either, but he’s shown consistently good judgement, intellectual curiosity and resistance to orthodoxy over the years. If we had a hundred bankers in the world like him, we wouldn’t have today’s crisis.

The bravest decision he took was in 1995, following the collapse of Barings Bank, as he explained in The Prospect:

I am a 47-year-old banker - chief executive of Swiss Bank Corporation in London, to be precise - and I have just decided that I need to go back to university for two years to study mathematics. Some of my friends think I am mad, and perhaps they are right. But perhaps something strange has happened to banking too.

It is hard to imagine that there is anything really new in banking. The tools of the trade have been around and in use, pretty much unchanged, for hundreds of years. Yet within the span of my own career, the world of international finance has enjoyed a renaissance-a spurt of creativity in the 1970s and 1980s, when new techniques emerged which have transformed the conduct of many banks and bankers. These techniques-collectively known as derivatives-have spawned a new jargon (would you know what to do with a Jellyroll, or an Alligator Spread?), huge new sources of profit, and mystifying new types of risk.

Imagine devoting yourself to the study of advanced mathematics in your mid-40s from the lofty heights of CEO of a Swiss bank! I wouldn’t be so noble, from more modest altitudes.

SBC had acquired O’Connor Associates, a Chicago derivatives trading partnership. The O’Connor partners were soon installed as senior executives throughout SBC, and changed it from a sleepy private bank to a powerhouse of aggressive power trading in the newly emergent global derivatives markets. Rudi needed to go back to school to know the business he was managing. He stepped down from the top job and got a degree in advanced mathematics at Imperial College, London.

That made Rudi an instant legend in the City and was the first I heard of him. He returned to finance as the Chief Executive of UBS Private Bank and Member of the UBS Group Executive Board. Since then I have followed his writings. For some years past I have enjoyed his friendship.

One year into the course, he emphasised again the importance of executives confronting the changing requirements of banking:

IC Reporter (10 February 1997)

Despite holding a degree in economics and business administration, Mr Bogni really did go back to basics under the tutelage of the Centre, sitting mock GCSEs and A levels in maths and statistics. Probability theory, calculus, algebra and stochastical modelling are also on the programme. “It’s a course not really designed towards a degree,” said Mr Bogni, “but towards the specific mathematics required for my type of business.”

Not all of those who share Mr Bogni’s business of derivatives are convinced of the benefits to be gained from the study of modern applied mathematics. However Mr Bogni believes that those who do not recognise its importance are avoiding the changing nature of financial markets. “Among the people that I respect there is a genuine understanding of what the issues are. It’s not a question of derivatives being a part of the financial markets, they are the financial market now.”

Rudi Bogni wasn’t afraid to admit that his bank had become unmanageable within the limits of his traditional banking background and understanding, and to take a hard look at his own qualifications to wager the bank’s capital on derivatives. If more CEOs had done that, then the proprietary dealing desks would never have gained the leverage that leaves the banking system so woefully undercapitalised today. If more CEOs pondered the philosophical basis for creating and allocating wealth, and the political means of asserting or coercing state power in the cause of more wealth accretion, then perhaps the destruction of jobs, savings and security would be less threatening to the investors, pensioners and taxpayers facing systemic financial failure this week.

In June of this year, Rudi published a piece in Wilmott Magazine (subscription only – the most expensive monthly on either side of the Atlantic, according to Forbes). At the risk of stretching fair use, and with the author’s consent, I’m going to quote it extensively here as it gets to the heart of the crisis we now face:

The Thin Space of Financial Activity

Those of you who may have read Bill Bryson’s A Short History of NearlyEverything will certainly recall his thesis that life on earth as we know it is an exceptional event and a possibility that materialized only within very small boundaries.

I wish you to consider how much smaller those boundaries are for the existence of financial activity.

First of all, you need a thinking species that lives and prospers in a cooperative environment. Second, you need a reasonably developed economy. Third, you need the ability to save and do more than survive only hand-to-mouth on a daily basis. Finally, you need reciprocal trust and a framework of law, as well as accepted customs and rules.

. . .

We have just witnessed last year—and we are still witnessing this year—how a relatively minor breakdown in trust and information has brought two markets, the interbank money market and the CDO market, to either display strong anomalies or freeze. Worse could come if we do not all learn to respect the boundaries within which financial activity can exist and thrive.

Investment bankers have to learn that if you have ambitions to act as an agent for an issue of a financial product, you should also have the means to make a market in that very same product in good and bad times—and investors should hold you to that. Regulatory walls between origination and trading have solved some problems, but they have also become an easy alibi for not standing behind one’s responsibilities.

Furthermore, they must understand that a revaluation of financial assets because the cost of capital has sharply decreased is not due to their genius. It is a physical law as much as conservation of energy, and therefore they do not deserve bonus payments for that. They should also realize that when they push bonus expectations beyond the moral threshold of 50/55 percent of net revenue, they are forcing their employers to take unacceptable risks to meet such expectations and that such a course of action can only end in tears.

Rating agencies have to learn about financial history and free thinking, not only about ticking boxes. Furthermore, they have to learn that the theory of overcollateralization differs from the historical experience, if you dig long enough into the past.

Regulators must learn that any new rule is a starting point for regulatory arbitrage and the mother of unintended consequences. Hence, there should be a few good rules, not thousands aimed at covering each potential circumstance. Most governments seem to have understood the lesson that the pursuit of inflation as an easy solution will bring them down in due course and for a long period. They seem to be deaf, however, to the fact that corporate taxation above 30 percent and personal direct taxation

over 40 percent, as well as an overall tax take including indirect taxation of over 50 percent, will either cripple both financial and economic activity, force people to take excessive risks, or push them elsewhere.

Retailers of financial products and solutions must realize that they are dealing with people’s lives and families’ futures. They cannot behave as street peddlers. Clear ethical boundaries must be the first line of defense, even before any legal framework is considered, because the law is unlikely to be as clear-cut as morality.

Finally, investors must be realistic about expectations. The best you can hope through financial activity is to preserve your wealth. If you want to create it, become an entrepreneur. If you want to gamble, stop whining when you lose.

If we do not all learn to be guided by such simple principles, financial activity as we know and need it will be put at risk. Trust will be eroded, impossible expectations will be created, and we will look back to the past 60 years as a golden age of economic development and financial maturity that may not be replicated any longer.

. . .

Politicians and regulators must stop hectoring and accept responsibility for having unintentionally pushed financial activity beyond sound boundaries by meddling without really understanding. Basel 2 in particular requires a very critical new look, if not a recall, as you would do for a line of cars when you realize that the brakes do not work as expected.

. . .

An excess of CO2 may be a major threat to civilized life as we know it, but the malfunctioning or freezing of the financial system could happen much faster, and we would have no control over it, as it depends on the psychology of literally billions of individuals. The consequences of such a malfunctioning do not bear thinking: breakdown in trade and investments, freezing of savings and pensions, advent of totalitarian regimes, war, and so on.

The financial system is a delicate mechanism and an essential one. Let us all treat it with some respect.

The thin space of financial activity requires a carefully calibrated commitment to balance by all parties participating in defining the sphere and scope and framework for financial interaction. In trying to deliver ever-increasing profits all around by growing the pie with inflationary monetary policies, executive excess, heightened investor expectations, regulatory and rating agency forbearance and other unrealistic and unsustainable policies, we have each and every one of us contributed to the current collapse.

Soon we will be doing a forensic analysis of what went wrong, and then look to craft new policies as a basis for rebuilding. We could do worse than look to Rudi Bogni’s analysis of the thin space of financial activity as providing the template.


More excerpts from Rudi’s writing over the years:

Re: Excessive Liquidity, Self-Indulgence and Self-Deceit (1 March 2007)

I read Dr Malmgren’s submission to ATCA with great interest. As in the Middle Ages and early Renaissance, there is an increasing risk in our less and less enlightened and less and less educated societies for the financial operators to be blamed for all economic evils, the same way that unfortunately the Jewish and Lombard bankers used to be blamed for the disasters caused by the excessive indebtedness of the European monarchies of the time.

Reality is much simpler. Take a bathtub and fill it to 1/3, then throw a stone into it. It may cause waves, but it might not flow over. Take the same bathtub and fill it to the brim, then throw a stone into it. It is most likely to flow over.

What we are experiencing is an unusually long period of extreme liquidity. Whatever the motivations for it, they are essentially political motivations, driven by political intents. Whether it is to finance wars without increasing taxation, whether it is to make people feel good about the inflated value of their assets so that they are going to spend more and promote GDP growth, whether it is to buffer one country’s voters from the natural effects that working less should entitle them to a lesser share of global goods and services, there are political intents behind the excessive liquidity.

Politicians are shying away from telling the truth to their voters and a vicious circle of self-indulgence and self-deceit is being buttressed by excessive liquidity.

Blaming incorrectly the equivalents of the Jews and Lombards of today, ie hedge funds and private equity investors, is the modern version of the French kings locking up the bankers in order to avoid taking the due blame and repaying the debts.

Long term it is a strategy which can ultimately lead only to decline.

Turning difficult issues which require courage, like global warming or global competition, into a religion of fear is the novel way by which politicians aim and unfortunately short-term succeed in keeping the masses, and often even the intelligentsia, in the dark and unable to confront policy-makers on the rightful field of rationality.

Rudi Bogni

The Left and Right defined the 20th century. What’s Next? Prospect (March 2007):

Left vs Right was and is purely a nominal distinction between two strands of the same totalitarian posture. The real problem of the 20th century was that the demographic and economic pressures that fractured the empires gave rise to national states with leaderships ill equipped to face the nihilist challenge. The vacuum was filled by totalitarian regimes, whose ideologies set fire to Europe and the world. Remember that Hitler was a failed architected, Staline had studied for the priesthood an Mussolini was a schoolteacher. The heirs of the 19th and 20th century nihilists are today’s faith-based terrorists. If today’s democracies fail to win against the new nihilists on the intellectual and communication level, they will have no chance to win in the security space and will create another dangerous vacuum, ready to be filled. Nation states have proven a disastrous political experiment in the 19th and 20th century; they may well prove catastrophic in the 21st century, due to nuclear proliferation. Nevertheless, I hope that the 21st century will see a substantial reduction of political infrastructures. If a conglomerate is bad or indifferent at most of what it does, shareholders force it back to its core competences. Everything else has got to go. Why should it be different for governments? This is neither left nor right; it is common sense. Large countries’ politicians love to deride small countries’ direct democracies. Why? Because they fear their example and their nimbleness. The political systems inherited from the 20th century, whether democratic or totalitarian, are neo-feudal, incompatible with a 21st century when electors vote every so many years, but consumers vote and bloggers blog 24/7.

The Stars and Gripes (12 July 2002):

Curing hatred of America is not easy. The European intelligentsia, because of the value its educational system places on knowledge for its own sake, tends to develop a highly critical sense and a healthy scepticism. US elites, despite being trained to think for themselves, tend to be less self-critical, perhaps too focused on getting rich. This creates a big communication gap. I concentrate on Europe versus America because if there is anybody who can help America to shed its self-satisfied myths and treat the rest of the world as equals with whom it is OK to disagree, it is us Europeans. US and European interests often converge, even when our hearts and minds do not meet.

What is certain is that half-educated people, with puerile, dogmatic, self-centred half-knowledge, are the salt of tyranny. The greatest tyrants of the century we have just survived, Hitler and Stalin, were half-educated men of hatred. Only knowledge accompanied by self-deprecating critical spirit can dispose of hatred, whether of America or of the rest of the world.

But I must admit - and this is why this book created a sense of emotional release - that until now I have never seriously confronted my close American friends with what I did not like about their country. I used the same polite diplomacy to avoid taking to task my Jewish and Arab friends over Palestine. This is wrong. Discourse is the stuff of civilised life; complacency is the crystallisation of ignorance and the begetter of lost lives.

Raised by the Yankee Game (3 May 2002)

When I hear the debate as to whether capitalism won over communism, triggering perhaps the end of history, I get very annoyed. Capitalism did not win a thing. Thatcher and Reagan may have pushed down communism’s crumbling walls, but the revolution was elsewhere. It was in places such as the City of London, beacons of freedom, where young men and women of any nationality could go to work every day reporting to a person of different background and culture, working for shareholders perhaps of a different country, free to choose their career, employer, lifestyle, perhaps even work attire. Free to speak their mind and to pay the price for it if necessary. But what a small price in comparison to that of living in an autocratic society such as the Soviet Union.

Brad Setser: Extraordinary Times

Brad Setser has a fascinating insight to offer in his newest post, Extraordinary Times:

In the last two weeks — if I am reading the Federal Reserves’ balance sheet data correctly — the Fed has:

Increased “other loans” to the financial system by around $230 billion (from $23.56b to $262.34b);

Increased its “other assets” by about $80b (from $98.67b to $183.89b);

Increased the securities it lends out to dealers by $60b (from $117.3b to $190.5b);

That works out to the provision of something like $370b of credit to the financial system in a two week period. And that is just what I saw on a cursory glance.

The most that the IMF ever lent out to cash strapped emerging economies in a year?

$30b, in the four quarters through September 1998 (i.e. the peak of the 97-98 crisis).

The most the IMF ever lend out over two years?

$40b, in the eight quarters through June 2003 (this covered crises in Argentina, Brazil, Uruguay and Turkey)

This is a very real crisis. The Fed’s balance tells a story of extraordinary stress. I never would have expected to see the Fed lent out these kinds of sums over such a short-period.

My response:

Excellent and timely, Brad. I’ve been speculating all week that the pressure being used on the Congress to pass the Paulson Plan is the threat of Fed illiquidity. As of two weeks ago, the Fed had lent out more than $600 billion of its $800 billion balance sheet Treasuries against crap MBS collateral.

The Paulson Plan would have allowed the banks to unwind the repos putting the Treasuries back in the Fed, get cash for the crap MBS, and get more Treasuries from the issues financing the $700+ billion funding of the Plan. As a bonus, the Paulson mark-to-maturity price becomes the implicit Level 3 price for capitalisation of all the firms and banks in the system, giving them some breathing room to stay in business. Everyone wins except the poor American taxpayer.

The Fed is very close to being illiquid. That is the fear factor we are seeing at work, and the reason no one will discuss why the bailout is needed - only emphasise the urgency.

Wednesday, September 24, 2008

Did Buffett Just Give Us A Coded Warning?

Warren Buffett, new stakeholder in the megalithic survivor-biased Goldman Sachs, has referred to recent upheavals in the financial markets as "an economic Pearl Harbour". He is a very smart man who knows his history, having lived it and seen it up close. He will know better than most that Pearl Harbour is now understood in well informed circles to not only have been foreseen by FDR, but provoked by FDR in an orchestrated campaign to engineer a war with Japan dating from a plan adopted in 1940.

As yoyomo reminds us in an earlier thread, the book Day of Deceit: The Truth About FDR and Pearl Harbour provides dispositive documentary evidence.

Historians have long debated whether President Roosevelt had advance knowledge of Japan's December 7, 1941, attack on Pearl Harbor. Using documents pried loose through the Freedom of Information Act during 17 years of research, Stinnett provides overwhelming evidence that FDR and his top advisers knew that Japanese warships were heading toward Hawaii. The heart of his argument is even more inflammatory: Stinnett argues that FDR, who desired to sway public opinion in support of U.S. entry into WWII, instigated a policy intended to provoke a Japanese attack. The plan was outlined in a U.S. Naval Intelligence secret strategy memo of October 1940; Roosevelt immediately began implementing its eight steps (which included deploying U.S. warships in Japanese territorial waters and imposing a total embargo intended to strangle Japan's economy), all of which, according to Stinnett, climaxed in the Japanese attack.

Warren Buffet knows better than most just how dirty and mean this Bush administration plays. The politically motivated prosecutions of AIG after he endorsed Kerry in 2004 will have left scars, and his advising Obama puts him at huge risk if Rove succeeds with another GOP victory.

He is in the insurance business, isn't he? So think of his acquisition of a huge stake in Goldman Sachs and his endorsement of the Paulson Plan as insurance. Meanwhile, he may just be patriot enough to have provided a coded clue as to what he really believes you can expect.

Tuesday, September 23, 2008

Marcy Kaptur (D-OH): "Real reform now or nothing!"

Must see.

She rips Wall Street a new one.

Quotable: On Bank Balance Sheets

"The problem with financial institution balance sheets is that on the left hand side nothing is right and on the right hand side nothing is left."

Monday, September 22, 2008

Rep McDermott (D-WA): Paulson "able to catch a pass he threw to himself"

Rep McDermott gets it:

Mr Speaker,

The people in Washington State are very troubled by the fact that King George has been disposed of by King Henry.

We picked up Newsweek magazine today and we have a new King... King Henry?

We're supposed to give him 700 billion dollars of our money. He doesn't want any review. He wants to be able to do whatever he wants with it. He doesn't want any Congressional oversight. And worst of all, the new king is just like the old king: He doesn't want any sacrifice.

He says, "Oh we can't threaten the salares of the investment bankers who drove us into a ditch. We can't get anyone to pay for this."

This is the third time we've done it with this bunch. First the war, that didn't get paid for. Then the tax cuts, that didn't get paid for, and now King Henry takes over to distribute 700 billion dollars. He's going to be there for four months. And in four months he will make deals and then he'll go out and he'll be able to catch a pass he threw to himself.

Saturday, September 20, 2008

"Non-Reviewable" - Sometimes there really ARE conspiracies

The text of the proposed emergency markets legislation is now available. Just as expected, it will contain a provision to provide immunity from any review by any court or executive agency. Either get with the collaborationists or get with the insurgents. There is no other choice. The USA doesn’t exist as we once knew it.

The relevant text from the legislation:

Sec. 8. Review.

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

Good luck, everyone. We’re in uncharted waters now. There is no rule of law if this passes - there are no markets. We’ve all been had, and the worst is yet to come.

Friday, September 19, 2008

The Unitary Federal Reserve - Crisis Choreography

Along with much of the world, I have watched with increasing disquiet as the United States of America morphed under President Bush into a lawless soft dictatorship more like the USSR than the USA.  Under his theory of the "unitary executive" the laws that Congress enacted were disapplied by signing statements and secret legal opinions.  The protections of the Constitution were eroded and marginalized by police powers and warrantless surveillance.  International treaties governing the protection of sovereignty, rules of war and the universal rights of man were distorted by unilateral interpretation and willfully hidden misconduct.  Court rulings and judicial review were avoided, and where forced, were ignored or overridden or negated by executive pardon.  Transparency and audit became a joke with refusals to cooperate with tribunals or to comply with supeonas or produce evidence.  This lawlessness has not made the world or the United States or its allies safer in the age of terrorism as it has degraded and confused what we might have hoped to defend.

Just as we here in the rest of the world hoped we might breathe easy with the end of the Bush administration in sight, and several creditable candidates for president coming forward, the lawless unitary executive has expanded to embrace the Treasury and the Federal Reserve, debasing and contaminating the financial markets globally with its spread to our own central banks and market authorities and destabilizing our banks and investment markets.  Once again in the name of crisis and expediency the laws are ignored, decisions are taken in secret, extra-judicial reapportionment of property and contract is mandated by executive fiat, and legislative review and judicial intervention are impossible. Over the past year every financial crisis has been met with lawless and Enron-esque innovation by the Federal Reserve and Treasury, and this week was arguably more extreme.

After this week's secret and unaccountable and extra-legal moves by the US financial authorities, I will not be holding any assets in the United States.  I do not understand the rules.  I doubt any rules will be applied fairly to all the players.  I cannot be sure who the umpire works for, or what principles the umpire thinks they should uphold.  I will not play the game.*

Let's look at a timeline of some of the decisions I would class as extra-legal or Enron-esque:

The (Selectively Leaked) Discount Rate Cut (August 2008)

Super SIV (October 2007)

Term Auction Facility (December 2007)

Bear Stearns/JP Morgan bailout and subsidy (March 2008)

Primary Dealer Credit Facility (March 2008)

Reverse MBS Swaps (April 2008)

Equity investment and collateral (September 2008)

Administrative Repeal of 23A (September 2008)

AIG nationalisation (September 2008)

Expansion of the Fed Balance Sheet through unprecedented Treasury refinance without appropriation by Congress (September 2008)

Central bank dollar liquidity draws (September 2008)

Resolution Trust Company/Super SIV Redux (next)

And that's just the list of actions we know about.  Much may have been orchestrated and influenced behind the scenes in  credit markets and traded equities and commodities.

At no stage have any of these significant enhancements to the prerogatives of the Federal Reserve, these derogations of explicit statutory limits, these stark departures from past authority and conduct, been the subject of democratic legislative proposal or review, or even public consultation and comment.  In the name of exigency, they have all been sprung as fait accompli on a shocked financial community, and since been treated as unquestionable and unreviewable.  Every initiative introduced as a temporary measure has become a permanent fixture.

The unitary executive of the Bush presidency eroded and disregarded the civil rights of Americans and others.  The unitary Federal Reserve disregards the property and contract rights of Americans and others.  Arguably the actions of the Federal Reserve over the past year represent the largest state confiscation of wealth in the history of man, dispossessing currency investors, equity investors, bond investors and taxpayers of literally trillions of dollars of current and future wealth by executive fiat.

The hypocrisy of the Bush administration criticizing Chavez while defending Paulson and Bernanke should be the stuff of late night stand up comedy.

And the answer to the crisis so created, according to those in authority in Washington and Wall Street, is to give more concentrated power with less review and less oversight to the Federal Reserve.  The reforms now being discussed in Washington are aimed at (1) gutting the SEC so that it can no longer challenge the Fed's primacy in investment bank and financial conglomerate prudential supervision, oversight of clearing and settlement systems, market integrity and stability and introducing “principles based” regulation so that no one well connected need ever worry about prosecution or conviction ever again; (2) gutting the FDIC so that it can no longer challenge the Fed's determination of capital adequacy or prudential supervision at insured banks or restrain cross-affiliate financing or excessively risky activity within bank holding company groups; (3) gutting the CFTC so that the Fed has primacy to oversee risk management in all OTC and exchange-traded derivatives clearing and margin; and (4) providing explicit powers to the Federal Reserve to promote "market stability" by means which shall be secret, unreviewable, and above challenge in the courts; and (5) making the Federal Reserve the prime global regulator for review of the regulatory and prudential supervision arrangements everywhere else in the world through mandated “harmonization” of global standards as a quid pro quo for foreign market recognition and access.

Stalin couldn’t have drafted a better plan for central control of the global economy after wreaking such havoc and devastation.

Up until this week I thought the gold bugs a bit mad.  I couldn't see the sense of holding something that couldn't be spent but could be seized (as gold was seized in the 1940s).  I still think they are a bit mad, but I am actively looking for any alternative to currency and market investments as a medium of exchange and store of value.  Given the very public concerns now being expressed in China and Russia, I am keeping company I would have once thought very surprising indeed.

For now the ECB, Bank of England and others are content to cooperate with the Fed, but as the chaos deepens and it becomes clear that the losses are to be allocated principally outside the US borders to those foolish enough to hold assets the Fed’s policies degrade and debase, they will begin to question and to look to each other for common interest and alignment.

The loss of 1200 lives on the Lusitania was deliberately allowed to justify US entry into World War I.  The attacks on Pearl Harbour were known in the White House three days before the bombs fell, but were ignored to justify entry into World War II.  Tonkin Gulf was a fraud.  WTC hijackers were financed by US allies and WTC 7 was . . . whatever.  Saddam’s weapons of mass destruction were fabricated in the forgery shop of Ahmad Chalabi’s Iraqi National Congress.  You get the idea.

Not all catastrophic events were willful or anticipated, but all were used to force through an agenda that was pre-agreed by a powerful elite that stood to profit from a preferred course of policies that could only be pursued in the undemocratic atmosphere of crisis.  Crisis prevents objective determination of the public interest.  Crisis undermines both markets and democracy.

I no longer believe that every financial collapse is unanticipated or without behind the scenes orchestration of effects.  I no longer trust the authorities to act fairly, honestly, in the public interest.

In the past year and just this past week, trillions of dollars of wealth have been allocated or misallocated, preserved, appropriated or destroyed by central bank fiat.  If we really have nations of laws and not men, capitalist markets and not command economies, then it’s essential we peek behind the curtain to ask by whom and why and hold them accountable.

Lawlessness has not enhanced our security as citizens, and lawlessness will not enhance our security as investors or depositors either. Banks and markets require regulation in the public interest, and determination of the public interest requires transparency, accountability and the rule of law.


* For those cynics out there, let me remind you I gave up trading in January this year. I had a small amount of cash in a US dollar account. That account is now closed.

Hat tip to Joe Mason, for expressing similar views here on RGE Finance and Banking yesterday: Crisis Policy is Redrawing the Boundaries of our Financial System - and not necessarily in productive ways

And, as ever, thanks to the courageous Professor Roubini for providing a forum for views challenging the orthodoxy.

Thursday, September 18, 2008

Denninger warns of US political failure

Every now and then I have enjoyed reading Karl Denninger's Market Ticker on current events. His most recent video, which he warns may be his last, warns that the line crossed by the Treasury and Federal Reserve in creating new money to bail out Wall Street will - if unchallenged - lead to the political failure of the United States and its constitutional government as a representative democracy. He makes some very good points.

Unlike most people, I knew in 2002 and early 2003 that the United States was determined to attack and occupy Iraq because I have a long memory for bank failures. I knew that Ahmad Chalabi was the same forger, embezzler and fraudster who had looted Bank Petra of $300 million before fleeing Jordan, almost causing the collapse of the Jordanian economy. Since all the intelligence fabricated for the war emanated from Chalabi's Iraqi National Congress, I knew the whole thing was being orchestrated by authorities.

I get the same queasy feeling today about events on Wall Street, and like Denninger, I wonder what the plan really is for the nation as more and more lines are crossed with extra-legal executive authority. I did not expect in 2002 and 2003 that war for oil in Iraq would lead to black sites, renditions, torture, Blackwater deployed in New Orleans, and other proximate results of a lawlessness and unaccountability that remained unchallenged and unchecked. I do not know what to expect of the USA in the years to come. That worries me deeply.

Friday, September 12, 2008

Ring Fences, Rustlers and a global bank insolvency

In this week which has seen so much speculation on the fate of Lehman Brothers, it seems only sensible to review how an international insolvency of a major bank works and what it might mean for international creditors. The insolvency treatment of international banks has remained one of the stubbornly difficult areas of law to harmonise and huge uncertainty and complexity remains. For excellent background, see Cross-border bank insolvency by Rosa Maria Lastra of Queen Mary, University of London.

Although markets are global, and Lehman Brothers operations span the globe, all insolvency is local. The basic premise is that each jurisdiction buries its own dead and keeps whatever treasure or garbage it finds with the corpse. Local creditors get to recover their claims out of the locally available assets. If, and only if, there are any assets left over will international creditors be invited to make a claim for the rest. Europe has managed to harmonise cross-border insolvency for banks under directives and local law to embody principles of universality and unity within the EU, but that only works equitably if enough assets are in the EU when the bank fails, and local insolvency law still applies in all its divergent complexity.

Claims against a bank are deemed located wherever the contract creating the claim is undertaken. If it is under US law then the claimant must look to the liquidator in the United States and assets under his control for recovery. If the claim is in Hong Kong, then the claimant looks to the Hong Kong receiver and assets.

The key to having a happy insolvency, if such a thing exists, lies in ensuring that when a globalised bank goes bust, all the best assets are inside your borders and subject to seizure by your liquidators on behalf of your creditors. Everyone else outside your borders is on their own. As the US dollar is the reserve currency of banking and US Treasuries, Agencies and other assets are the highest preferred asset class, the US is almost always in a good position in an international bank failure.

The principle of using local assets for local recovery is known as the “ring fence” – the idea being that insolvency drops an invisible “ring fence” around any valuable assets at the borders to meet claims arising within the borders. No country is more assiduous in weaving the ring fence than the United States of America. It is a very successful strategy for US creditors. US creditors of failed international banks tend to recover disproportionately relative to creditors anywhere else. The ring fence contains all these choicest assets for US creditors, and all the international creditors are forced to pick among the dross of foreign assets to eke out a recovery, only receiving any residual US assets remaining after US creditors get 100 percent recovery.

Lehman has been deeply troubled and subject to speculation since the early spring. That was just about the time that we started to see a marked sell off in foreign markets where Lehman has long been a major player. Recently, along with intensification of that sell off, we have seen a strengthening of the US dollar and US asset markets.

If one were cynical, and one believed that Lehman was going to be allowed to fail pour encouragement les autres one might wonder if Lehman was quietly bidden – or even explicitly ordered – to sell off its foreign holdings and repatriate the proceeds to asset classes within the US ring fence. This would ensure that US creditors of Lehman received a satisfactory recovery at the expense of foreign creditors. It would also contribute to a nice pre-election illusion of a “flight to quality” as US dollar and assets strengthened on the direction of flow.

If one were really cynical, one might even think that a wily bank supervisor might arrange to ensure 100 percent recovery for its creditors with a bit of creative misappropriation thrown in the mix. Broker dealers normally hold securities and other assets in nominee name on behalf of their investor clients. Under modern market regulation, these nominee assets are supposed to be held separately from a firm’s own assets so that they can be protected in an insolvency and restored to the clients with minimal loss and inconvenience. Liberalisations and financial innovations have undermined the segregation principle by promoting much more intensive use of client assets for leverage (prime brokerage and margin lending) and alternative income streams (securities lending). As a result, it is often very difficult to discern in a failed broker who has the better claim to assets which were held to a client account but reused for finance and/or trading purposes. The main source of evidence is the books of the failed broker.

On the wholesale side, margin and collateralisation in connection with derivatives and securities finance arrangements mean that creditors under these arrangements should have good delivery and secure legal claims to assets provided under market standard agreements. As a result, preferred wholesale creditors could have been streamed the choicest assets under arrangements that will look above suspicion on review as being consistent with market best practice.

If Lehman were to go into insolvency, I will be interested to discover whether US creditors achieve a much higher proportion of recovery than their global peers in other locations where Lehman did business. If so, it will likely be because of the US ring fence and the months of repatriation of assets and funds back into the confines of the ring fence before the failure was finally orchestrated. It will also be because the choicest assets were preferentially delivered to preferred US creditors under market standard margin and collateral arrangements.

Unfortunately, the pace of an international insolvency means that any retrospective evaluation will be so far down the road that I will likely be almost alone in looking backwards to see what the final distribution effects are and what they mean for equitable principles of international banking practice.

Friday, September 5, 2008

Weaning the banks off the Old Lady's teat

There is a warm sense of security that comes from suckling liquidity from the teat of the central bank rather than foraging for capital and earnings in a harsh world full of threats and predators. Nonetheless, there comes a time when a good mother pushes away her importunate young and forces them to fend for themselves subject to her stern guidance and supervision.

Central banks have been suckling their broods of commercial banks since the credit crunch first exploded on the scene in August 2007. Now there are signs that the Bank of England and European Central Bank, at least, are keen to push their broods toward self-sufficiency, even at the risk that not all survive independently.

The Old Lady of Threadneedle Street has announced that she really, really means it when she says that the Special Liquidity Scheme introduced to enable banks to draw her gilts against mortgage-backed collateral will be closed down 20th October. The SLS was opened as a “one-off operation with a finite life” and was never intended to do more than bridge the liquidity gap created by the collapse of the mortgage-back securities market while banks adjusted their business models to changed market conditions.

The banks, led by UBS, are throwing temper tantrums, stamping their little feet, screaming in the financial press, but so far the Old Lady is holding firm. Mervyn King said last month:

"The SLS was introduced as a measure to deal with a legacy problem of liquidity of the stock of assets which banks owned last year when the crisis hit. So that window will close in October. The longer-term issue of tightening of credit conditions is much wider. That is to do with the health of the capital position of the banking system, and it's very important not to confuse the two".

Mr King’s determination to husband what remains of the Old Lady’s resources may have something to do with profligate abuse of them when opened to her brood. What started out as a scheme to extend up to £50 billion (a bit less than $100 million) in liquidity to shore up the UK credit markets during a surprise credit dislocation may have been drawn for as much as £200 billion in total as crunch turned to constriction. The Bank will only publish the true scale in October after the SLS closes. The SLS has been hungrily drained by banks keen to swap whatever unmarketable dross remained on their books for good central bank gilts.

The abuse has been made plain in numbers reported by the BIS.

Banks issued a record £45bn in mortgage-backed bonds in the three months to the end of June - more even than at the very height of the housing boom in 2006 - according to figures from the Bank for International Settlements. . . . . The Quarterly Review added: "Most of the UK issuance followed the Bank of England's announcement in April 2008 of a Special Liquidity Scheme (SLS) that enables UK banks to swap illiquid assets such as mortgage-backed securities against UK Treasury bills."

This record mortgage-backed issuance comes at a time when new mortgage lending in the UK has contracted very sharply, down 71 percent year on year for the month of July. That indicates a cynical abuse of the Old Lady’s generosity. Rather than be left with dry dugs dangling to her waist, the Old Lady would prefer to wean the banks while she retains ample bosom and sufficient other assets to shore up her public stature.

Over at the European Central Bank, a rule change this week will increase haircuts (discounts to stated market value) for collateral provided under that liquidity scheme from next February. The ECB has made available over EUR 367 billion (a bit less than $700 billion) under very liberal terms.

According the Financial Times:

The changes, which take effect from February 1, include increases in the average “haircuts” applied to asset-backed securities. A haircut is the amount deducted from the market value of a product when judging its value as collateral. In future, a blanket 12 per cent haircut will apply, replacing a previous sliding scale of between 2 per cent and 18 per cent. There will be penalties for asset-backed securities valued using models and for unsecured bank bonds.

Restrictions already in place on banks using assets they themselves had formed were extended to stop banks using assets from issues to which they had offered currency hedges or liquidity support above a certain level.

Analysts at Barclays Capital said the extra haircuts would mean banks might have to post an additional €25bn-€45bn of securities for collateral purposes. “That could cost €375m to €450m annually to banks ... Not in­significant, but probably bearable,” said Laurent Fransolet, analyst at Barcap.

The normally politic Yves Mersch made explicit reference in his remarks to "dangers of gaming the system".

Nonetheless, with house purchases falling to new lows and credit getting progressively tighter, the Labour government and the Council of Mortgage Lenders are wild to have another source of cheap liquidity if the Old Lady denies them. A new scheme for taxpayer-subsidised mortgage finance is in the offing. It is clearly bad public policy to have the government subsidise further borrowing for the housing sector after such a destructive bubble, but the scale of vested interest and the unpopularity of the Labour incumbents as the house prices fall make a new scheme a certainty all the same.

Rather like a mother who loves her young no matter how ill-bred, destructive and abusive they are to their peers or the community, the Old Lady of Threadneedle Street is unlikely to mind very much if British banks prosper by depredations on the politicians, taxpayers, market counterparties, corporate treasurers, hedge funds and others so long as they are out of the house. Having proved they have no sense of gratitude or duty to the Old Lady that preserved them in time of need, the others who will become their new targets can expect even less consideration.