The perils of a state run banking system
An near endless number of loons are insisting that we must have greater State direction of bank lending in this country. We've even loons light in the current Government insisting that this should be so: to say nothing of the true loons further left whose mantra seems to be "Forward to Five Year Planning!".
One little story from a place where they really do have state directed banking:
Banks prefer to lend to state-owned enterprises, sometimes because they are urged to do so but also because it is safer: if it runs into problems, the debt will be restructured and they will not be penalised.
Not that that is going to surprise anyone: one group of bureaucrats is always going to be ready to lend to another group of bureaucrats. But then what happens?
"Fundraising" from private lenders is illegal in China, but also commonplace........Official interest rates for savers are so low – negative in real terms – that lending illicitly is much more attractive than putting your money in the bank.
OK, markets will out, there's a demand for investment opportunities, a demand for financing, outside what those state owned banks are willing to do.
So, what happens next?
Now 31, Wu's fortunes have changed dramatically. She is on death row, facing execution for fraud and raising money outside the banking system.
They shoot you.
It's certainly a fairly severe reaction to market competition, isn't it? But in the end that is what has to happen. Not the shooting, but the punishment. For if a functioning free market outperforms the inevitably incompetent state bureaucrat run banks the the state will inevitably take action against that market that is showing them up to be the incompetents they are.
It's an extention of PJ O'Rourke's point, that we should never allow the people with all the money to also be the people with all the guns. And given that government has all the guns we really shouldn't be allowing them to control the money as well.
Weekend notes
Detlev Schlichter is on typically forceful (and, yes, depressing) form over at Paper Money Collapse.
We should accept that deleveraging is ultimately unavoidable. If it comes with a period of deflation – so be it. But we will get neither. The system will be sustained at this stage of arrested collapse for as long as policymakers can get away with it. My outlook is that we will get even bigger central bank balance sheets (forget exit strategies! There is no exit!), we will get no sustained growth but inflation will creep higher.
The noisy advocates of easy money and of government stimulus always pretend to care for Europe’s unemployed youth. It is today’s youth that would have most to gain from a cleansing correction now, and it is those who already made their money and who sit on inflated assets and overstretched balance sheets that have most to gain from the central bank’s policy of extend and pretend. That is, until the whole thing goes pop anyway. Which won’t take too long.
In the meantime, the debasement of paper money continues.
Have you read his book yet? If not, get your copy here.
***
Charles Murray's new book 'Coming Apart: The State of White America, 1960-2010' seems to be stirring up a lot of debate. His thesis, as I understand it, is that the gap between a new upper class and new lower class of Americans is growing, but that it has far more to do with diverging values, cultures and behaviours than economics. I haven't read it yet, but David Brooks says he'll be "shocked if there’s another book this year as important". For now, I just like Murray's comment to the FT on the race for the Republican nomination:
I am really unhappy with Obama. I really think he's terrible, but Romney and Santorum as the alternatives? Don't even think about Newt… I'm in despair. I mean, I'm a libertarian. I will take Romney over Santorum. And both of them over Newt. That's not a ringing endorsement, I know, but what can you say about such a field?
***
On the other hand, for all his flaws (and they are many) Mitt Romney has at least said something exciting about tax - he plans to cut marginal rates by 20 percent across the board. As Fraser Nelson wrote in the Telegraph last week, Britain's Conservatives should take note. They won't win the next election by chasing opinion polls and running scared from the Left's renewed class warfare. They need to craft an aspirational agenda that is worth getting out of bed to vote for. As it is, all the Tory leadership is talking about is which taxes to raise to provide cover for scrapping the 50p tax rate (which isn't actually raising money anyway). They blame the Liberal Democrats, of course, but the real problem is that they are themselves completely unprincipled.
***
In happier news, I was delighted to see the Wall Street Journal's Mary Anastasia O'Grady endorse the legalisation of cannabis on Fox News. Ever so gradually, the tide of opinion is turning against America's deadly, destructive, disastrous war on drugs. There is even talk that Colorado voters will approve a ballot initiative to legalise and regulate the production, sale and consumption of cannabis this November. Now there's something I could bring myself to vote for.
On the Greek CDS market
To return to Felix Salmon (just because he's the one writing interestingly about a currently interesting subject) on the Greek bailout. I find it very difficult to understand the concerns he has. A CDS, a credit default swap, is a form of insurance against someone you have lent money to by purchasing a bond, defaulting on what they owe you. Greece has defaulted, this has been declared to be a credit event, the CDS will pay out and it would appear that all is well with the world.
Going forwards, then, I can’t imagine that investors will have much if any confidence that CDS will really perform the hedging function they’re designed for. My feeling is that if you look at the numbers for total single-name CDS outstanding, they’ll decline steadily from here on in. Because you ultimately can’t trust them when you really need them.
I really don't see that. The contracts have shadowed the bonds all the way down, they have been triggered and they will pay out.
But still, the whole CDS saga in Greece and elsewhere does rather feel as though ISDA is making it up as it goes along.
As I've mentioned before, I like this in a decision making system. In a legal system, as I've said. Far too many of the world's problems are caused by people trying to write rules to deal with any and every possible and impossible eventuality. I would much prefer a few basic ground rules, the accretion of precedents and then on top, the ability to look to both of those when those unthought of impossible things happen.
But it's this that really puzzles me:
The word that jumps out at me here is Restructuring. In Europe, restructuring counts as a credit event; in north America, by contrast, it doesn’t. Which means that the derivatives market was pretty lucky here. If the standard Greek CDS documentation had looked like the standard US CDS documentation, there wouldn’t have been a credit event,
I cannot see how the market was "lucky" simply because everyone has agreed to abide by the terms of the contracts they signed.
Oh, and just one more note, not about Felix. Now that the CDS have been triggered, now that we're going to see a settling of them all as a result of this "event". And given that we're not going to see the banking system of Europe fall over as a result, please, could we have a little less wittering about the evils and dangers of derivatives please?
Economics is fun, part 12: Banking
He's back, and you might notice one big improvement — from this video onwards, the sound should be a lot better. In this video, Madsen talks about banking. Banking isn't about money stored in vaults, he says, but people acting as middlemen between savers and borrowers. In lubricating the lines of savings and credit, bankers are indispensible to a well-functioning economy. But there's a dark side, too: politically-driven bailouts for banks that go wrong.
You can watch the rest of this series here, and buy Madsen's book, which these videos are based on, here.
The sovereign CDS market is broken
Or so some will tell you these days. The reason given is that ISDA (the committee that decides such things) has just decided that Greece has not in fact defaulted on its bonds and therefore the CDS protection that was bought on those bonds does not need to pay out.
Cue consternation among those who don't quite understand what is going on. Look, we can see that Greece is defaulting, CDS was intended to pay out on default, no payout, that's the end of the CDS market, right? Well, umm, no, as two very different people have independently pointed out.
It is true that we expect Greece to default any time now. Indeed, it's entirely possible to argue that Greece is planning to default. That that swap of bonds, where the ECB gets to have new bonds, everyone else has to take a 70% haircut on their old bonds, that this is a default because of the subordination and the different treatment of two holders of the same bonds.
But, here's the thing. This all hasn't happened yet. The prices of a CDS on Greek soverign debt has been closely tracking the value of the bonds, tracking that price all the way down in fact. So that part of the market has been working just fine. But what about that final trigger, the declaration of default so that not just collateral moves but that money gets signed, not just handed, over?
Well, yes, we all think that Greece is about to default, yes, we all think that the deal announced and about to get underway meets the definition of a default. But that's the point: it's all just about to get underway. This is all still in the future. So the default hasn't happened yet meaning that the CDS does not pay out yet. When the default does happen then they almost certainly will. And the Greek events won't be the end of the sovereign CDS market, they'll be a vindication of it. Those who bought the insurance will get paid out. Those who didn't won't.
Likely to encourage a few more people to buy the insurance, isn't it?
Reforming the financial sector
Banking is a tricky topic for liberals. The lines between state and private sector are blurred: if a private bank knows it will be bailed out by the government, it won't act with the prudence it should. Banks, trading in state-monopolized money, act as intermediaries between the state and the private sector, and can be the direct beneficiaries of monetary expansions by the Bank of England, like QE. Government interventions in the banking sector create bad incentives. Banks themselves aren't to blame for responding, rationally, to those bad incentives, but those responses can cause serious problems in the rest of the economy, as we saw in 2008.
Today, Steve Baker MP is proposing a ten-minute rule bill, to try to fix some of these bad incentives. The bill, says Baker, will:
- Enforce strict liability on directors of financial institutions
- Enforce unlimited personal liability on directors of financial institutions
- Require directors of financial institutions to post personal bonds as additional bank capital
- Require personal bonds and bonuses to be treated as additional bank capital
- Make provision for the insolvency of financial institutions
- Establish a financial crimes investigation unit
In a perfect world, I would object to special rules to increase bankers' personal liability — fixing the principal-agent problem should be a private matter between banks' shareholders, directors and managers. But we don't live in a perfect world. It's virtually certain that the government would bail out any major bank that collapsed. That means that second-best provisions may have to be made to reduce the bad incentives facing bankers. Increasing their liability is a tough way to realign bankers' incentives along those of the bank itself.
The real key, though, is the fifth point. Making provision for bank insolvencies is the key to weaning banks off the government's teat. Governments will bail banks out whenever it's politically expedient. So, how do we make provisions for bank collapses without granny losing her savings? Sweden dealt with its financial crisis quite successfully in the early 1990s by taking a "bail-in" approach, where bank creditors are required to foot the bill instead of taxpayers, and debt-to-equity swaps are made, imposing haircuts on bank bondholders. If Baker's bill can start the ball rolling on this sort of reform, we'll all owe him a debt of gratitude.
Read more on Steve Baker's site: Financial Institutions (Reform) Bill – Liability of bankers and treatment of bonuses; Use of personal bonds and bonus pool to make good bank losses; Other measures
Ros Altman is (almost) right on Quantitative Easing
Ros Altman, Director General of Saga Group, upbraided the Times for praising QE in a letter yesterday. As Altman rightly argues, QE diminishes the incomes of pensioners and the savings of future pensioners: 'QE has permanently impoverished more than a million pensioners, and thousands more purchasers will recieve reduced pensions each week'. Altman also points out that QE has a more subtle impact on the economy: 'pension liabilities and deficits rise when gilt yields fall, forcing companies to divert resources into their pension funds, rather than growing their businesses.'
She states that, as a result, 'QE transfers money from middle-class pensions to banks and borrowers, which will reduce long-term [economic] growth in our ageing population'. Altman is quite correct, even if QE is not also adding to more latently to inflation - which may well be the case, further adding to its redistributive effects. Of course, many borrowers are also 'middle class' pension savers. For instance, many people saving via pensions are simultaneously borrowing via mortgages who are being simultaneously punished and rewarded. Either way, class is not a relevant issue here, the issue is whether borrowers - including the government - should be given preferential treatment over savers.
There is a broader point, moreover, that the state is arbitrarily reallocating resources between different groups without the groups themselves, in many cases, and perhaps even the government being aware that it is doing so. Whilst explicit redistribution is problematical, this sort of redistribution is far more pernicious. The impoverishment of pensioners and creation of further disincentives to save throws them even further into reliance on the largesse of current and future taxpayers as well as being destructive of capital formation.
One might quite fairly observe, contra Altman, that pensioners have been unfairly benefitting for taxpayer-funded government borrowing in the form of interest and capital growth in gilts. Two wrongs, however, do not make a right. Further, pension funds are hardly to be blamed for investing in gilts as they present an artificially lower risk than other investments (although clearly not, in the case of some sovereign debt!), not to mention that pension funds are mandated into doing so. As well all are aware, or should be, government fiscal intervention diverts resources from productive areas of the economy and more efficient uses of scarce resources and thus crowds out economic growth. Hence we observe the stagnant, heavily indebted economies of Europe, the USA and Japan not to mention heavily-indebted developing nations with large fiscal burdens funded by inflationary monetary policies.
Unfortunately, Altman rather blots her copybook by arguing that 'the authorities should find ways to lend to small firms directly'. Picking of 'winners' by governments is notoriously unsuccessful and no way to grow an economy. It also carries the risk of incurring further liabilities on the taxpayer if such firms are unviable. Further, Altman argues that government should 'harness pension fund assets to underwrite infrastructure projects.' This dangerous idea, which has recently been floated by the Chancellor, seems to present carte blanche to governments to 'invest' assets in their favoured white elephant schemes as no doubt HS2 will turn out to be. Pension funds should be left to decide which assets will bring returns, not have the state decide for them. If this latter idea takes root, we're all better off storing our savings as gold bars under the bed. In the final analysis, the state simply should not be in the business of interfering in how much credit is available in the economy; this has been tried and tested to destruction, or pretty near it. The real solution is to prevent government manipulation of supply and demand for savings, borrowing and credit-creation via the mechanisms of central banking and fiat currency.
Nazis v the Bank of England
BBC News reported today that newly de-classified files from 1945 reveal that MI5 concluded that a Nazi counterfeit currency programme which increased the amount of British Pound notes in circulation by 10% during World War II had achieved the Nazi’s goal of “destroying confidence abroad in Bank of England notes”.
By contrast, during the 3.5 years since September 2008, the Bank of England has increased the amount of British Pound notes in circulation by 28% and increased the total UK money supply by a factor of 3.34 times! Has this also had the effect of “destroying confidence abroad in Bank of England notes”? Well, the fact that the British Pound has lost almost 60% of its value relative to the price of gold since September 2008 might be a clue.
The fallacy of Project Merlin
Project Merlin – the idea that the UK Treasury can centrally plan the amount of credit needed in the real economy – was a predestined failure.
Recent data released by the Bank of England was disappointing for the UK SMEs. The lending target fell short by £1bn, even though total lending did rise to overshoot its target by £25bn. The banks claim they did their job as required, while accusing the sluggish economic recovery and poor demand for credit from small businesses as the reason behind lower SME loans. On the other hand, SMEs blame high credit costs and unfavourable loan terms, calling for more competition between the banks to offer better products and lending models.
The reaction from both sides, the banks and the businesses, was as expected, proving once again the short-sightedness of politicians. Banks don’t want to loan to risky borrowers fearing new potential losses they are unwilling to accept. Businesses realize this and want more competition as the only possible way to lower the costs of credit.
However, with ideas such as credit targets the government is doing the opposite – it is undermining any possibility for more competition. When you set an artificial target applying to only the 5 largest banks, those banks will strive to meet the targets by increasing their dominance and taking a larger share of the market than usual. The result is that 5 biggest banks accounted for 90% of all SME lending last year.
The end result of the target was political pressure on banks to increase lending, no matter how and to whom, meaning that the banks channelled funds not guided by commercial incentives or market signals, but by the bulk of funds needed to be deployed to satisfy the central authority. This resulted in a huge misappropriation of resources where money, instead of flowing to projects where it might generate new value and growth for the economy, is artificially drawn to various projects simply to fulfil the given target.
Besides, how is the government supposed to determine the threshold of credit big enough to start up the recovery? Even if such a threshold existed, a target to reach it means the government can only influence the supply of credit, not its demand, which is what the results have showed. In addition, having credit targets, whether achieved through bank lending or by the Treasury itself (via credit easing) the ultimate effect will be dependency on government transfers and credit flowing only to politically selected companies, instead of those who could actually use the funds to create value.
Targeting a mandatory level of spending, savings or credit always reminds me of the misguided EU policy on mandatory expenditures on R&D in the IT industry to 3% of the GDP for every EU member (this was a goal of the 2000 Lisbon Treaty for 2010). Not surprisingly many of the countries fell short of the 3% target, and have tried to artificially move closer to it, by dumping huge amounts of money into R&D only to satisfy the target. Needless to say this yielded poor results and almost no substantial technological innovation or progress (these results were evident before the crisis even started). R&D is proven to have positive effects on technological advancement and economic growth, but when it’s promoted by subsidies and investment interventions, the market gets distorted by receiving wrong signals of what is a good investment and what innovation is most likely to deliver growth.
One can go a step further and compare this sort of reasoning to the Soviet Union planned targets for its heavy industry. Both are based on the same principal; that politicians and bureaucrats believe they are better qualified than individual businesses to make decisions on how much money should be invested in a particular industry. Just as the Soviet Union and the EU planning failed to create a competitive and a dynamic economy, so has the Merlin Project in the UK. And this wasn’t a policy enforced by the EU – it was a product of domestic thinking.
You don’t solve a problem in the economy by pumping taxpayers’ money into banks, technology or manufacturing, you do it by enabling a fair and competitive environment where successful firms triumph, while unsuccessful and those unable to adapt are forced to closed down. There is nothing more fair than the system of meritocracy. In a market economy it is a travesty to have private sector decisions and strategies be guided by politics.
Thankfully, Merlin won’t be repeated this year, but Mr Osborne is instead negotiating a new £20bn loan guarantee scheme with the banks in order to support his credit easing policy. What he doesn’t realize is that although this may provide a temporary short-term relief, it will have deeper consequences by creating dependency of the businesses on government transfers. In addition, it is very difficult to make a temporary policy work effectively, particularly when future expectations may undermine its temporary desired effects. The problem is always what happens when the government ceases its lending scheme.
A decrease of regulatory constraints and taxes will level the playing field for all businesses, making sure that competition gives rise to successful and adaptable companies. A much better way than a stimulus in any form of ‘easing’, is to lower costs for the SMEs.
Finally, can someone tell me what type of economic policy requires huge spending and stimuli from the government to the real economy in times of crisis? Is it called austerity?
Is this the monetary system we deserve?
We had our coursework assignment for Macroeconomics 1. I could have some fun with this...
Individual Assignment Task:
In 2011, Bank of England chose to maintain the Bank rate at its historic low even when the prevailing inflation rate was significantly higher than the targeted level. You are required to critically evaluate this particular policy decision of Bank of England.
Using available information on the UK economy from 2000-2010:
i. Outline the pattern of economic growth, inflation, and interest rate over the past 10 years.
(This task requires that you find annual data on these economic variables over the whole period. You must present the data in a table and you must also present it in a graphical way so that you detect any significant changes in growth, inflation and interest rate over this period. You should then comment on these changes.)
and,
ii. Explain and critically evaluate the policy of Bank of England in relation to inflation for the last one year.
(You should explicitly link the discussion to relevant economic concepts. You should keep in mind the interrelated nature of fiscal and monetary policies and use it to expand on the discussion)
Should I be good, and answer as no doubt they would like us to answer, or be honest and tell the truth about the failure of central banking, the curse of state manufactured inflation and the fiat money system?
It's a tough one. I'm sure Jock decided to put head over heart and gave the answers they were looking for. (All the better to change the questions when he's a professor himself.) But what a pity the world's pure fiat monetary regime, barely forty years old, is accepted so unquestioningly by nearly all academic economists. Perhaps they think "the science is settled", though lots of people who have claimed that in the past have turned out to be wrong.
What's doubly depressing is that economists, who are generally free market folk, don't see a problem with half of every transaction that takes place in the economy being based on the product of a state monopoly. A good way of judging something's efficacy is to ask, "If we were starting from scratch, is this what we would design?" Nothing as complex as a market economy can really be designed, so maybe of our fiat monetary system we should ask a slightly different question: "Absent state coercion, is this what would spontaneously emerge?"