George Soros says it's all the regulators' fault

That's the upcoming collapse of the European banking system that is. George Soros says that the main cause of the current and coming problems is the very odd decision that the regulators made about capital weights on sovereign debts.

When the euro was introduced the regulators allowed banks to buy unlimited amounts of government bonds without setting aside any equity capital; and the central bank accepted all government bonds at its discount window on equal terms. Commercial banks found it advantageous to accumulate the bonds of the weaker euro members in order to earn a few extra basis points. That is what caused interest rates to converge which in turn caused competitiveness to diverge.

I do take Soros to be a very bright man and a very knowledgeable financier. I don't take him to be quite the great economic guru that some seem to think he is.

But this does explain so much. I think it was Basel II which brought tis rule in: that soverign bonds needed no capital assigned to them and there was no haircut in repoing them with the ECB. And that does indeed explain why so many banks lent so much money at such low interest rates to countries that clearly were not as creditworthy as some others under the same rules.

It also explains why it all fell apart so quickly: as soon as the ECB was applying credit based haircuts to such bonds then the flood into the southern nations became a flood out again.

It also leaves us with a very important question. If it was indeed the regulators that caused this then what is the argument behind giving the regulators greater powers?

Does devaluation help?

A pamphlet by John Mills arguing for currency devaluation was recently sent to the "3,000 most influential Britons" (whoever they are). Thankfully, Prof Kevin Dowd and Gordon Kerr of Cobden Partners (Helping Nations Solve Banking Crises) and author of our paper The Law of Opposites have penned a short response rebutting the points made in the pamphlet:

"Devaluation (or at least unexpected devaluation) does produce one-off boosts to exporters (whilst also penalising importers: what about them?), but any 'benefits' it produces are only temporary, and cannot form the basis of a sustained policy without disaster. Moreover (contrary to Mills' assertions) there is no credible evidence - in the 1930s, post Bretton Woods, or any over any other period, anywhere - where a policy of sustained or repeated devaluation actually produced the benefits claimed for it. If it did, Argentina would be a role model.

"In essence, Mills fails to appreciate that any benefits it produces are only temporary, and if engaged in repeatedly will obviously rapidly debase the currency. I would argue that in the UK over the last 18 or so years the steady reductions in interest rates, followed by QE has indeed been exactly what Mills sets out as a policy of competitive devaluation.  Repeatedly the authorities have claimed (on every brief GDP or balance of payments uptick) that this policy has been working, yet we are clearly in dire economic circumstances.  For how many more years should this failed experiment continue?

"Devaluation is only the external manifestation of a currency losing its value, the internal manifestation being the old enemy, inflation. Devaluation and inflation are two sides of the same coin.

"Look at it another way: it is a basic fallacy to believe that simply tinkering with money (i.e., printing more of it) can possibly solve underlying real economic problems that require underling structural changes.

"In the 1970s the UK enjoyed the Barber Boom experiment - which worked too until we ended up with stagflation, the economy on the brink of collapse, the legitimate government brought down by Arthur Scargill and the Hard Left ready to institute a siege economy. But thankfully, the Goverment was forced into rehab and the policy was abandoned temporarily.

"Debasing the currency is never a long term answer and never works long term. It has produced disaster after disaster, and has been condemned by historians for thousands of years. Yes, concerns over unemployment, costs, etc are very real, but these have other (free market) solutions. As per William J. McKinley, the former US President and a firm advocate of the gold standard: "Good money never made times hard".  I would also refer Mr Mills to the attached brief WSJ piece on the high price of a cheap pound by my Cobden Partners colleague Jamie Whyte."

The financial crisis: finger pointing at last

Four years on, Mervyn King has finally admitted to some of his culpability for the banking crisis.  At the same time, he rpoints to the Treasury, FSA and Bank of England “Tripartite” for its combined responsibility.  He is right about that. Incredibly, during the ten years leading up to the crisis, i.e. as it was slowly developing, the Tripartite met only once.  King notes the mea culpa from the FSA, again only partial, but also notes the absence of penitence from Gordon Brown and Ed Balls.

He also failed to mention Sir John “Teflon” Gieve.  As a senior Treasury official he helped draw up the Tripartite agreement that almost guaranteed its failure.  He was then Permanent Secretary of the Home Office during the years the auditors refused to sign off the accounts.  His financial sagacity was further confirmed when, as link man between the FSA and the Bank of England during the lead up to the crisis, he effectively neutered them both.

King has had some hard words for the banks who, notably Barclays, have failed to admit responsibility, pay mega-bonuses based on profits from mis-selling and resolutely obstruct attempts to increase capital ratios to prevent a recurrence.  I have some sympathy with the banks on that last point.  Regulation was not, and is not, the solution.  We are unlikely to have another such crisis until the memory of this one is fully expunged, i.e. half a century.  We can already see the effects of higher capital ratios damaging our ability to escape recession.  To increase capital ratios, banks have to lend less to SMEs and increase their margins to everyone.  Look at LIBOR and mortgage interest rates increasing while the Bank of England rate has been stable at 0.5%.

At this particular time we need less capital ratios and more lending at keener prices.  When recovery comes, then by all means think again.

We are still in the doldrums of the banking crisis and are likely to continue to be for some time.  Yes, Sir Mervyn, we do need a proper independent enquiry and we need it now that the pressure is off but memories are, or could be, clear.

It is extraordinary, when you think of it, that we are mesmerised by the peccadillos of the Murdochs which have had a marginal, if any, effect on our way of living but ignore the far more grievous failures of the banks and the Tripartite which have brought the country to its knees.  We have a years long judicial review of the former and no review at all of the latter.

No wonder we have bank bailouts: regulators will always be captured by the firms they're meant to oversee

One important free market argument against government regulation of the economy is that regulators tend to become captured by corporate interests. When faced with a brief they know little about, politicians turn to the experts to devise policy and advise them on the ins-and-outs of the different industries they’re expected to regulate.

Who are those experts? Business leaders who’ve made their money by mastering their industry. The very people who stand to gain the most from some insider political power to protect themselves from competition. Firms are constantly looking for a way to exclude new entrants from the marketplace –  when governments have a lot of power over the market, the incentive for firms to try to bend that power to their will is overwhelming.

This is an unavoidable aspect of the fact that government officials – politicians, civil servants, and even “independent experts” the government loves to put in charge of its policy commissions – are human. They are no more or less greedy or easily swayed than anybody else.

This concept of “regulatory capture” is one reason I tend to prefer rules to individual discretion when thinking about regulation. There’s no way to ensure that only the angels get into power, and I’d prefer to avoid much discretionary power being invested in the hands of individuals, in case they misuse it.

All of this is important in understanding where we are and where we’re going. One of the most remarkable phenomena of recent years has been the revolving-door relationship between Goldman Sachs and the US government. Goldman Sachs is not a morally bad company, but its success has led to its executives being tapped up for senior roles in the Clinton, Bush and Obama administrations – notably Hank Paulson, a former Goldman CEO who presided over the Troubled Asset Relief Program (TARP), the first major bailout for US banks during the financial crisis.

There is no need for conspiracy theories here. It is sufficient to presume that Paulson’s ties to the financial world made him sympathetic to calls for bailouts and to the idea that established firms in the financial sector could not be allowed to go bust in an orderly fashion.

Paulson is not, personally, the one to blame: the system that gave anybody the power to pervert the market with bailouts is. If Paulson had not been in that position, someone else had – and if not someone tied up with Goldman Sachs, then with JP Morgan, CitiBank, or one of the other large banks. The mindset that these established firms have to be protected at any cost would be there, wherever the Treasury Secretary had come from.

All this came to mind yesterday when reading that Goldman Sachs’ Jim O’Neill is rumoured to be in the running to succeed Mervyn King as Director of the Bank of England. No doubt O’Neill has a lot of valuable experience – although I find his much-celebrated categorization of the “BRICs” (Brazil, Russia, India and China) as must-invest powerhouses slightly underwhelming. But, like all ex-financiers who enter the political-regulatory nexus, he would be beholden to the established firms that made him who he is today.

For different reasons, an academic may be little better, unless he was a truly radical visionary. But, if O’Neill or someone like him gets the job, I know what response my money will be on when the next financial crisis rolls around.

How Apple and Amazon show that stock market investors really do think long term

I know, I know, we're told that stock markets are short termist in outlook, obsessed only with the next quarter's results. This is an appalling indictement of neoliberal capitalism and must be stopped immediately by putting politicians who only look to the next election result in charge.

I realise that this next little point is not proof of anything, nor an entirely solid refutation of the above, but I do think it indicative:

The situation for Amazon now resembled "what we saw back in the 2004 to 2006 time frame when the company was making a lot of investments and margins got squeezed. Then in the years following, margins expanded and revenue accelerated. It looks like the company is in that position right now."

Shares in the company leapt to $225 in extended trading, further swelling the company's already lofty valuation of more than 70 times earnings.

In comparison, the 12-month forward price-earnings ratio for the S&P 500 stands at about 12, while Apple is trading at 13 times forward earnings.

Amazon is, famously, a company that is willing to sacrifice the short term in order to create a long term exploitable profit opportunity. Apple makes great products, oh yes they do, it's also had a blinding run recently. But they're not, in anything like the same way, building a structure as Amazon is doing. They're retailing their products and their continued success in doing so depends upon continuing to develop new products rather than exploiting an ecosystem as Amazon is doing.

Apple makes vastly more in profits than Amazon does, this is true: yet each $1 of profit that Amazon makes is more highly valued than each $ that Apple does. Another way of saying the same thing is that investors believe that Amazon's business model will produce greater profits in the long term.

Now I agree, this doesn't answer all the other indictements of appalling neoliberal capitalism: but it's most certainly not evidence that investors are short term in their outlook, is it?

A positive agenda for financial reform

Detlev Schlichter is on excellent form today, outlining a way out of the crisis and towards monetary sanity:

Step 1: Privatize the central bank.

Do not even introduce a gold standard. Just transfer ownership of the central bank officially to the banks that have an account with the central bank. This is the first step for the state to exit the sphere of money. The central bank is no longer a public institution run by bureaucrats and politicians but an entirely private undertaking. It is owned and operated by the banks.

The central bank administers bank reserves and provides certain clearing functions. The banks need this, for now at least. Shutting the central bank down is not that easy. But its most pernicious aspect is that it is a policy tool. This would end abruptly with its privatization.

Step 2: The state revokes with immediate effect ALL laws and policies that relate specifically to banking and money.

From this moment on, banks are capitalist enterprises just like any other normal business. There is no lender of last resort (at least not one run by the state), there is no inflation target or other official monetary policy for which the banks function as conduits, which under the present system puts them in the strange position of being profit-seeking enterprises and policy-transmission mechanisms simultaneously. But equally, there is no backstop for the banks from the state any longer. No guarantees, no deposit insurance or taxpayer bailouts. If a deposit insurance institution exists, it is handed over to the banks, similar to the central bank. Again, the state has exited the business of regulating, supervising, licensing, subsidizing and backstopping the banking industry.

Entry into the field of banking is now free. You do not need a license. You do not need an account with the now privately owned central bank (although without such an account clearing with other banks might be difficult). There are no legal tender laws anymore, so if anybody has any bright new ideas about money (Liberty Dollars, bitcoin) they are most welcome to try them. The consumer alone will decide over success and failure.

Monetary policy has ended. Bernanke testimonies on TV will be replaced with reruns of old Simpson episodes. Senators and congressmen will have to find new soapboxes from which to propound their personal economic theories.

Step 3: The state’s gold hoard is handed over to the banks.

What? A gift to the bankers? – I do not consider this a gift to the banks but more a return of property to the bank depositors. The bank depositors are the ones that should benefit from this transfer most.

The present monetary system could only have come about because it was once based on gold. Deposit banking spread at a time when banks still promised to repay deposits or banknotes in specie, and when all banks were thus required to hold (some) gold reserves – reserves that no political entity could create at will. Only slowly and gradually was the gold backing removed and replaced with various implicit or explicit state guarantees, all of which are now practically failing.

This is all sensible, practical stuff. As Detlev notes, this would stabilize the banking system by imposing the discipline of the market onto it, and go a good way towards ending the cycle of boom and bust that money and credit expansions drive. And, by removing the printing press from the government's arsenal, it would raise the cost of government borrowing. This is a feature, not a bug: a government forced to borrow at higher rates will have no choice but to live within its means, as private firms and households do.

The return of the recession

So it’s official: Britain has double-dipped. Is anyone really surprised?

Of course, today’s number are relatively insignificant in statistical terms, and there is every chance that the Office of National Statistics will revise them a few months down the line. So we shouldn’t put too much faith in the details of today’s announcement or try to draw lessons that aren’t there to be drawn.

But it has been obvious right from the start that this was not your average, run-of-the-mill, cyclical downturn. The financial crisis and the recession that followed it was and is the result of severe, deep-seated structural problems in Western economies. And Britain has bigger structural problems than most.

Put simply, we are addicted to debt and constant monetary expansion. This has eroded our capital base and undermined our productive capacity, and has skewed the economy disastrously towards those sectors that thrive on credit and easy money: namely housing, finance, and big government. The boom years inflated huge bubbles in these sectors; the bust years have revealed how much of that growth was unsustainable, or even illusory.  

The situation we are in now can be summarized as follows. The economy remains heavily distorted: the prices of houses and financial assets are artificially inflated by government policy; banks which would have failed in the market have been kept on life support; gigantic, hugely inefficient public sectors are being sustained by money-printing and growth-sapping taxation. The savings needed to support investment aren’t there, and we’re weighed down with one of the highest levels of public-private debt in the industrialized world.

The astonishing thing is that every single one of those distortions is consciously, willfully being pursued by the government as a matter of policy. Quite frankly, it is surprising we aren’t doing worse than we are.

Not that there is all that much governments can do to create growth in situations like this. Yes, tax cuts and deregulation would give the private sector a sorely needed boost. And yes, reforming / privatizing / abolishing the public sector (as appropriate) would do wonders for Britain’s productivity. But what really matters is what governments don’t do. They have to allow the mistakes of the boom years to be unwound. They have to let markets adjust. They have to let new patterns of sustainable specialization and trade develop spontaneously, without bureaucratic interference.

That is a process – and it takes time. But unless we go through it, we won’t be returning to robust, real growth any time soon. The road we are on leads to a zombie economy. It’s time we took a different one.

We need a visionary at the Bank of England, and there's only one man for the job

Daniel Hannan notes that Adam Posen, Bank of England Monetary Policy Committee (MPC) member and noted inflation “dove”, promised last year to resign his post if inflation didn’t fall to meet the MPC’s inflation target. With inflation at around 3.5%, it looks like he will have to stick to his promise. There is only one person fit to replace him: monetary economist Professor Kevin Dowd.

Compared with more well-known economists like David Blanchflower, Dowd is not well known outside of economics circles. But his work on money and banking is ground-breaking. As one of the fathers of the “free banking” school (along with American economists George Selgin and Lawrence White), Dowd has laid the foundations for modern theories of private monetary and free banking systems.

We have a system of monetary socialism: the government has a virtual monopoly on the money supply, and dominates the banking system through its protection for favoured, entrenched banks. On inflation, Dowd is neither a “hawk” nor a “dove”: applying such a distinction to him would be like saying Ludwig von Mises thought the Soviet Union should build more or fewer cars, instead of thinking that the state shouldn’t have any role in the car-making business at all.

His book Private Money is a modern classic, outlining the practical realities of moving to a system of market-based money, without state involvement. (It's not online, but this review gives a good outline.) I have just read an excellent preview of a forthcoming paper of his on different private moneys like the Liberty Dollar and Bitcoin.

Dowd’s work since the crisis has been superb, reminding free marketeers of the dubiousness of knee-jerk defences of banks, and outlining a plan to restore market mechanisms to the banking system – most notably, plans to ensure executive, depositor and shareholder liability in failing banks. His book (co-authored with Martin Hutchinson) on the 2008 crisis, The Alchemists of Loss, is a masterpiece. His lecture to the Adam Smith Institute last year, The Decapitalization of the West (video), was a tour de force, detailing the grim state of the world’s governments and financial institutions. Read his Cato Institute publications here.

Dowd is that rarest of things: a visionary who is willing to roll up his sleeves and offer workable, gradual steps towards a better world. And nobody in Britain understands the great challenge of our age better than he does. As we teeter over the brink of perpetual financial crisis, we need someone with the wisdom to pull us back. Forget about hawks and doves: the Monetary Policy Committee's next member should be an owl.

The case for gold

City AM asked me to make the case for gold in 140-words, for yesterday's comment pages. Here's what I came up with:

Gold isn’t a traditional investment good: it is an alternative to paper money. From that perspective, its allure is all too clear. The purchasing power of gold is as good now as it was in 1900. The pound lost 99 per cent of its value over the same period. As a store of value, gold wins hands down because its supply is inelastic: you can’t create more of it every time you need to bail out a bust financial sector or bankroll a profligate government. Of course, I don’t know whether the gold price will be higher next week, next month, or even next year. But I do know that the things which have driven gold’s surge – uncertainty, money-printing, and fiscal incontinence – are here to stay. Monetary debasement is the whole point of a fiat currency. Make of that what you will.

Wolfson revisited

In December 2011, the Adam Smith Institute asked one of its Senior Fellows, Miles Saltiel, to form a team to compete for the Wolfson Prize for an essay on the best course for the Eurozone if members decide to drop out. He assembled a crew of City professionals and economists, who pored through the law-books, worked up the sums and took the counsel of an international group of seasoned veterans.

It turns out that our entry took a different approach from the shortlisted five, with a pronounced focus on making existing institutions work. One of the finalists has been generous enough to express his surprise not to find himself up against it.

Please click here to see the entry, setting out our analysis and proposals in full. It is offered as a contribution to the debate promoted by the prize, which we see as playing a positive part in adding to public understanding and the formation of professional opinion. Below the fold, we reproduce the one thousand word non-technical summary:

If Member States leave the Economic and Monetary Union, what is the best way for the economic process to be managed to provide the soundest foundation for the future growth and prosperity of the current membership?

We may not have reached a Berlin Wall moment but, if a Eurozone member secedes, policy-makers will be imprudent to continue to rely on theories of “optimal currency areas”; likewise the econometrics supporting them. Neither would withstand the evidence of policy failure. We take it that there are no magic bullets: Germany will not ride to the rescue, as much for lack of means as lack of will. Future Eurozone membership will be the result of a tussle between leaders’ political will (and capacity) and market judgment (if not sentiment).

To answer the Wolfson questions squarely, we offer serviceable proposals to manage adjustment and minimise turmoil. We take a piecemeal approach, going with the grain unless doing so threatens systemic risk. Our approach to economic welfare is similarly piecemeal: we decline an overarching attempt to theorise or forecast on a continental, let alone global, scale. Rather, we put forth proposals to deal with situations as they might arise, together with illustrative calculations.

We have analysed the legal position, the ambiguity of which presents a seceding State with the opportunity to take a strong line in negotiations. Here also our proposals go with the grain. We adhere to legal precedents wherever possible; we enlist the IMF as lead facilitator, making use of their long- standing expertise in the field and subscribing to their well-established processes; we also enlist the ECB as local facilitator, as the body best qualified to lead the EFSF or its successor, assemble other EU institutions, and act as an interlocutor with members. We invoke a standstill at the moment of redenomination to stabilise the immediate situation. We propose a treaty process as best meeting the need for comprehensive resolution. We suggest the use of proven templates for exchange instruments and introduce specific monetary, fiscal, and regulatory forbearance policies to ease adjustment.

Our proposals break new ground where they decline the Paris Club process, so as to cater for EU decision- making institutions. We envisage the ECB waiving claims for official creditor status, to the extent of a haircut and willingness to accept a lower coupon for exchange instruments. Failing leadership and adequate fiscal and monetary easing by the ECB, we propose the formation of “Resolution Funds”. These intergovernmental groups of European and other states would function as ad hoc bank-like bodies, supporting fiscal and monetary easing, facilitating microeconomic reform, and if economics permit, acting as agent to issue exchange instruments supported by defeasance or collateral. We also envisage regulatory forbearance: from the BIS on recognising exchange instruments at par for tier 1 capital for Basel III requirements; from the IASB on the ECB’s treatment of delinquent assets, should haircuts fail fully to reflect impairment; and from jurisdictions governing bond agreements to suppress premature litigation threatening good order.

Our proposals contemplate arrangements to place assets from a seceding State in trust for collateralising exchange instruments, if third-party underwriting or defeasement fails; to alter IMF quotas to incentivise the participation of global capital-surplus States; and to invoke the seniority of treaty law to legitimate secession and the ensuing settlements, as well as to address obstacles posed by capital market instruments to an orderly resolution.

We do not shirk the calculations which lie at the heart of any solution, while mindful of the defects in our own. In particular, macroeconomic modelling is imperfect, with output only as good as the assumptions going in; and specific defects by way of the risk of roseate outcomes stemming from self-righting algorithms and inattention to the banking sector. In our essay we present:

• Estimates for bank contagion;
• Estimates for fiscal and monetary easing, as well as for burden-sharing for different classes of obligors, together with facilitating microeconomic reform for weak seceding states;
• Illustrative budgets for recovery for weak seceding states and balance sheets for the recovery institutions we propose; and
• Model runs for five economic scenarios: an example of a weak seceding State, Greece; and an example of a strong seceding State, the Netherlands. We then address the Eurozone as a whole, where we consider policy continuation, EMU dissolution, and fiscal union; notably, our runs suggest that the first of these is the worst case.

Our piecemeal solution adds up to a comprehensive answer to the Wolfson Prize questions and a pragmatic solution to secession from the Eurozone. We offer it in a spirit of contributing to a debate between contestants for the Wolfson Prize, which we see as playing a positive part in adding to public understanding and the formation of professional opinion.

Summary

In December 2011, the Adam Smith Institute asked one of its Senior Fellows, Miles Saltiel, to form a team to compete for the Wolfson Prize for an essay on the best course for the Eurozone if members decide to drop out. He assembled a crew of City professionals and economists, who pored through the law-books, worked up the sums and took the counsel of an international group of seasoned veterans.

It turns out that our entry took a different approach from the shortlisted five, with a pronounced focus on making existing institutions work. One of the finalists has been generous enough to express his surprise not to find himself up against it.

Please click here to see the entry, setting out our analysis and proposals in full. It is offered as a contribution to the debate promoted by the prize, which we see as playing a positive part in adding to public understanding and the formation of professional opinion. Below the fold, we reproduce the one thousand word non-technical summary.