The following article is (after very light editing) something your author wrote early in October of 2008, when the padlocks on the Lehman office building doors were still swinging. The reader will, he hopes, find that most of the presentiments expressed and the analysis submitted sadly turned out to be more accurate than otherwise.
It is to our collective detriment that, eight long, painful, underemployed, increasingly indebted, more societally divisive years on, few if any of these lessons seem to have been drawn by the Powers-that-Be.
…The general confusion, and the introduction of paper money, infused in the minds of people vague ideas respecting government and credit. We expected too much from the return of peace, and of course we have been disappointed. Our governments have been new and unsettled; and several legislatures, by making tender, suspension, and paper money laws, have given just cause of uneasiness to creditors.
By these and other causes, several orders of men in the community have been prepared, by degrees, for a change of government; and this very abuse of power in the legislatures, which, in some cases, has been charged upon the democratic part of the community, has furnished aristocratical men with those very weapons, and those very means, with which, in great measure, they are rapidly effecting their favourite object.
And should an oppressive government be the consequence of the proposed change, posterity may reproach not only a few overbearing unprincipled men, but those parties in the states which have misused their powers.
Letter from the Federal Farmer to the Republican, Oct 8th 1787
After a blizzard of unco-ordinated initiatives and the usual spate of grossly unintended consequences, state intervention in the banking system seems to have reached a near apotheosis this week as the authorities finally seek a comprehensive solution to the extraordinary bank-on-bank run which has so roiled world markets in recent months.
As a result, we are now confronted with the spectacle of governments around the world variously guaranteeing deposits and new bank security issuance, subscribing (forcibly) to significant equity stakes, offering to buy up bad assets, and, of course, offering ‘unlimited’ access to repo facilities, discount windows, and FX swap lines to all manner of institutions and against all manner of heretofore unthinkable collateral.
Thus, the attempt to stop the rot and to restore a modicum of trust to what has become a thoroughly psychotic system has, at last, begun to address more than just liquidity issues – all of the prior attempts at which have proved merely to be pouring water into a gapingly cracked pot. At last – as was long foreseeable by all except those holding the reins – an attack has been launched upon the solvency issue and this has even essayed not to make matters worse by totally expropriating existing shareholders in the target banks and hence scaring the wits out of those with equity in all of the rest.
Barely have the announcements hit the newswires, however, and the next potential downside has begun to emerge in terms of the politicisation of lending to be imposed upon these new hybrids in future. As Chancellor Merkel put it, state money was contingent upon the banks ‘following certain rules’ – including the demand that her ministers should ‘exercise influence’ over management decisions and make stipulations on lending to the Mittelstand.
And why not?
If Fannie Mae and Freddie Mac – taken into government ‘conservatorship’ for the sin of backstopping too many low quality mortgages, you will recall – have been ordered by their new controllers to write $40 billion in – well, err – additional low quality mortgages each month, should we be surprised to hear that the UK regime, too, has made it a tacit condition of its rescue package that aid recipients must reduce borrowing costs for householders and ‘small’ businesses and maintain loan volumes at 2007 levels – irrespective of whether such borrowers actually want it or not!?
After all, hasn’t every bank in the world effectively become a kind of super-Fannie Mae overnight– a private-public chimera with skewed incentives and uncertain objectives – and doesn’t this mean that the all we have done is to swap one kind of agency problem, one brand of moral hazard, for another?
True, we may have less to fear from megalomaniac CEOs and testosterone-charged head traders piling up unimaginable levels of risk and capitalising decades’ worth of contingent, model-based basis gains into one, juicy, bonus and stock-option enhancing fiction of anticipation, but, will it be any better when we have to contend instead with equally self-aggrandising and no less short-termist politicians grubbing for votes, pandering to lobbyists, and imposing their narrow prejudices upon the market to the detriment of consumer sovereignty and entrepreneurial endeavour?
Goodbye to all that
What a sorry denouement this is to an era in which banking (very broadly defined) came to be regarded as THE business to be in – even to the detriment of the very same productive activities to which it is the industry’s primary purpose to furnish the means with which to carry on their delivery.
As this quarter century-long trend gathered pace and quickened to its Icarian end, ever more grotesque levels of leverage, ever less prudent practice had to be indulged in if the ostensibly high levels of return on capital were to be conjured up each time the quarterly results were filed.
This global increase in gearing was pursued at first largely off the balance sheet, via special-purpose vehicles, derivatives trades, and the whole prime broker-hedge fund circus, but – at length – sheer greed on the proprietary trading desks and a wholesale seduction by their own sales patter led these same banks to pollute their own visible balance sheets with toxic CDO tranches, LBO bridging loans, and all manner of other enormities.
Incidentally, did no-one ever stop to wonder why it was that so-called ‘negative basis trades’ (the business of buying a less-rated credit and insuring it for a lower all-in cost than the credit spread pick-up offered) could persist for so long? One surely did not have to believe in the myth of ‘efficient markets’ to wonder how such an anomaly could persist for so long in the face of such massive arbitrage activity. Did no-one stop to wonder whether someone, somewhere was cruelly underpricing the associated risks and thus leaving everyone exposed to an unwinding?
Aside from these mistakes – ones by and large that they did not make in the Enron-WorldCom dress rehearsal when the banks actually did ‘unbundle’ risk (i.e., pass it on to some other poor sucker) – a very crucial point seems to have been lost amid all the unjustified braggadocio which then the fashion and which was equally indulged in by exactly the same clique of politicians now stooping to coarse populism in their invective against their erstwhile cocktail party guests, campaign donors, and task force special advisors at the banks.
This point was the very simple one that if banks could only offer suitably high returns on their wafer thin slivers of equity by leveraging up throughout the whole hierarchy of inverted pyramids towering above it, did this not mean, at root, that we had far too many banks in relation to the basic need for institutions by which credit could best be intermediated to keep the wheels of industry turning and through which savers could have their abstinence today turned into plenty tomorrow by transforming their funds into productive, entrepreneurial capital?
If so, then setting aside the immediate, vexed issue of how to prevent today’s inevitable business cycle contraction from crumbling the whole flawed edifice of fractional reserve banking into dust – with the attendant grave consequences for the whole economy, not just the malinvested surplus whose necessary demise constitutes the downleg of that cycle – this observation makes it rather ironic that, in order to address an endemic overcapacity in such a dangerously destabilising business as banking, the main thrust of the current bail-out is unreservedly aimed at preventing any reduction in the number of participants in it.
Indeed, as Italy’s ECB board member, Lorenzo Bini Smaghi, put it, in reference to the G7 vow not to let any ‘systemically important financial institution’ go to the wall: “’Systemically important’ banks in Europe means ALL banks!”
Were this any other, common-or-garden overgrown industry, swollen into a bloated dinosaur behind a wall of state protection and unjustified legal privilege, the final revelation that it had all been simply a waste of scarce capital would at least prompt a widespread debate about the merits of saving it on an indiscriminate basis.
Alas! Our modern commercial world – not to mention the parasitic welfare state which so infests it – has become so irretrievably entwined with the fate of its bankers that such a coolly rational process of triage has become well-nigh unthinkable.
Arguably, the vacillation and counterproductive dithering of the US authorities has served to put even further beyond the pale any who would dare to suggest that to unleash a little overdue ‘creative destruction’ in the field of banking might be to free up the greatest number of evolutionary niches since the K-T boundary event.
In essence, Ben & Hank first managed to instil – via an hysterical barrage of unorthodox actions and soothing prevarications – an unwarranted sense of confidence in the market, all the way up to the Bear, Stearns take-over. Then, by then unleashing a torrent of mutual distrust with their glaringly inconsistent treatment of the liability holders of Lehman, AIG, and WaMu, they greatly added to the panic until it became so heightened and the wave of cross-selling and forced liquidation reached such fevered proportions that it was no longer possible to suggest that a prompt recognition of impaired assets – and either a private recapitalization, or a rapid disposal of any salvageable holdings on the part of those thus revealed as insolvent – has been what the world has been crying out for since the music stopped last August.
Compounding this catalogue of cock-ups, they and their peers have only served to delay the financial crisis until the real economy has had time to catch up with it, so that the woes of finance are now feeding on and feeding into those increasingly being felt across the whole world of making, moving, and merchandising. Had all assets been properly marked down a year ago, when the problems first emerged, banking would surely have been better placed now to weather the economic rallentando, and could even have been in a position to contribute to its solution, rather than, as at present, acting to magnify its impact.
It was hard enough to argue for a market solution to a non-market problem like banking – banking being a mongrel offspring of Quattrocento sharp practice and Baroque political centralisation, godfathered by a well-intended Victorian legal misunderstanding of what constitutes money – but to call now for a wholesale transfer of assets from less to more competent entrepreneurs when a functioning capital market on which to effect this has entirely ceased to exist has become a problem of an entirely different magnitude.
Breaking the Banks in Monte Carlo
But, supposing it could be done, would a major free-market retrenchment of banking, as presently constituted, not represent a deflationary catastrophe, as the orthodoxy insists must be the case?
Well, yes, the prices of a whole range of entities (tangible or otherwise) which had only risen so far because of the banks’ willingness to lend against their purchase would, inevitably, decline were that particular tap turned off. However, in the admittedly Utopian case that such a withdrawal were matched by a return to a genuine hard money system – so that confidence in the basic medium of exchange were restored along the way – perhaps the balance of consequences might end up in the plus column, once the initial pain of dispelled illusion and miscast expectations had passed.
Though we would agree with the deflationary pessimists that the late burst of increase in ‘high-powered’ money and its lower aggregates represents nothing more than a shift in preferences from less to more liquid credit measures and, hence, that it has done little more to date than to shore up the tottering superstructure, we are also not totally convinced that a ‘deleveraging’ which led to a return to a more normal relationship between M2/M3-type credit and transactional money (properly defined) – and hence between deferred and discharged exhaustive consumption – would somehow mark the final end of the division of labour, the specialisation of function, and the steady flow of savings into judicious investment which is the font of all our modern material well-being.
As a rough proxy, total expenditures in a developed economy come in at roughly 2 ½ times the sum of final personal consumption estimates. Schematically, this suggests we need a comparable ratio between money and credit, first to move goods along the productive structure and then to make final payment for them.
In the Eurozone, for example, the ratio between M1 and non-M1 M3 is typically the 1.7:1 we might expect. In Japan – now a paragon of prudentiality – it currently sits at 1.2:1, far removed from the dizzy heights of over 6:1 which prevailed at the height of the Zaitech Bubble. It is to be remarked that such an outlier is worryingly reminiscent of the current ratio of over 5:1 to be found between similar aggregates in the US.
If this leads us to suspect that far too much credit has been created in relation to real economy activity, we can further support our contention by noting the fact that while the BIS estimates of the stock of international debt securities has been multiplied 2 ½ times in the five (mostly Boom) years to the end of this year’s first quarter (a heady CAR of 20%), financial debt made up 84% of that increment whereas non-financial corporate obligations clocked up a mere 6.8% contribution.
In terms of the much larger stock of domestic debt securities, the 11% CAR evidenced in that same period is still nothing to be sneezed at, but again, corporate debt only comprised 8.6% of the increase. Even in traditional lending, BIS banks increased exposure to other banks, hedge funds and governments between two and three times as rapidly as they did to non-banks. Since those latter include not just the non-financial businesses with whom we are primarily concerned, but other non-bank financial institutions and individuals, too, the overall ratio of productive to both non-productive and speculative-’incestuous’ credit is likely to be even lower.
Furthermore, in the OTC derivatives markets, of the 30% annualized rate of increase (excluding credit derivatives) seen over the half-decade to December ’07, less than one-seventh of the increase involved deals written with a non-financial institution. Indeed, the OCC report for derivatives on the books of US commercial banks (which represent just over one quarter of the global total) shows that less than 2% of all outstandings are booked with a (non-financial) ‘end-user’ as a counterparty, while the BIS reckons that barely 1% of mushrooming profusion of credit derivative contracts involve a non-financial firm.
It may appear far too simplistic to suggest that the world could get by very nicely, thank you, if Bank A limited its activities to taking a deposit from Saver B and lending it at matched term to Goods & Service provider C; or to arranging the occasional debt or equity issue for C and placing it with B for a small consideration; or to ensuring that foreign currencies might be bought and sold to cover the needs of international trade (a task made incomparably easier were they all to be firmly linked to gold, of course).
Nonetheless, it can hardly be denied that the disproportionate ‘casino’ element of finance is there for all to see in the overwhelming preponderance of F2F (finance:finance) positions cited above – something which would be even more greatly magnified, of course, were we to look at the notional turnover of financial claims, rather than at the stock of them. For example, the $9 trillion a day churn which takes place on futures exchanges, or the $1.1 trillion daily average of equities (as well as corporate and municipal bonds) cleared across the DTCC in the US are patently not all being conducted for the purpose of allocating scarce capital means to their best esteemed ends.
Thus the suspicion remains that, however difficult it is in practice to disentangle the two elements and however painful the transition to a world of sober financial intermediation and the sternly realistic reckoning of the true scarcity of tangible capital – as opposed to the ready availability of insubstantial credit – this would inculcate in economic actors, a certain evaporation of the worst of the excesses might ultimately lead to a far more rational basis on which to conduct our affairs thereafter.
Note that none of this requires more ‘regulation’ in any positive sense – much less fatuous, top-down pipe-dreams of a newly-imposed ‘financial architecture’ signed by the plenipotentiaries of the Great Powers at some latter-day Congress of Vienna. All it would really require would be for a repeal of all exceptions to the rule of contract and a removal of all government support for banks. Ideally, this new nakedness would encourage a voluntary re-adoption of a hard money system, but the State could always atone for some of its past sins by accelerating the process, were it so minded.
How Green is my (Tennessee) Valley?
All in all, some reduction in the higher order monetary aggregates – so long as the quantity of ‘money’ proper does not fall too precipitously with them, but merely ceases henceforth to grow at more than a snail’s pace – would entail a thoroughgoing and largely therapeutic cull of many of our more wasteful activities, whether overt or disguised.
Not only would this greatly curtail the chronic overspending indulged in by Anglo-Iberians, in particular, but it would also derail all manner of overly optimistic, higher-order business undertakings. Current account deficits would shrink dramatically, an adjustment which would catalyse itself by removing the aggravating workings of Jacques Rueff’s ‘childish game of marbles’ by which one nation’s monetary laxity currently fuels another’s.
More importantly, it would also dispel the dangerous self-delusion by which mostly Western spendthrifts gorge unrestrainedly on their seed corn today, yet continue to expect a good harvest tomorrow, at the same time that the equally gullible Asian and Teutonic squirrels deny themselves a full sack of acorns in the here and now, in the vain hope that they will one day be able to feast sumptuously at the base of the mighty forests of oak miraculously sprung up out of the midst of those same over-indulgent Westerners’ mountainous heaps of midden.
That all of this could not fail to entail both material suffering and a major psychic disruption is not to be avoided, in much the same way that the man is horribly surprised who finds that the supposedly winning lottery ticket he holds is actually a worthless forgery and that he has made matters worse by having already begun to spend the proceeds, long before he has ever attempted to cash in the counterfeit.
But, just as it is better for our dupe to be apprised of his error at the soonest possible opportunity, before he has added further to the list of his angry creditors and importunate relatives, so would it do no good to attempt to avoid the realisation of entrepreneurial and individual error, by helping people find ways to continue to live beyond their means at the personal level, or to persist in building capacity beyond the possibility of either a timely and on-budget completion – or absent any realistic prospect of a profitable market for its output – at the company one.
But, of course, this is exactly where we are heading today – headlong down the path of clumsy intervention along which we have stumbled before.
For what else do you suppose the State is doing when it chooses to override private judgements as to credit worthiness by providing copious amounts of cheap finance to those who cannot otherwise access loans on these terms?
What do you suppose it will achieve when it replaces the fictional capital of ephemeral bank credit for the equally ethereal one of ‘taxpayer’s money’ (i.e., for what will rapidly become no more than a closely-related species of monetized debt)?
How do you suppose it will help to clear the housing market of its imbalances, if it starts strong-arming banks to desist from foreclosures or adds further tax distortions to discriminate against renters? What next? Will it arm the bailiffs with food parcels and bunches of flowers instead of repossession orders when electors fall behind on their loan payments?
What do you suppose will be the objective when Leviathan offers support packages for what it sees as ‘strategic’ industries, or when it starts pouring concrete where none before was needed? Or – as is a racing certainty to happen – it uses Gaian Doublethink to dress up the crude economic chauvinism of an Alexander Hamilton… and embarks upon an expensive ‘Manhattan Project’ in the sphere of ‘alternative energy’, encouraging all manner of other T. Boondoggle Pickens, Khosla Nostra, Gore-mandizing at the public trough, at the same time that it seeks to shelter such sub-economic wastefulness behind the protectionist measures it will impose by invoking the sacred cause of ‘saving the planet’?…
The Wreck of the Medusa
What [those proposing this all miss], of course, is that by propping up those firms which have been revealed as not profitably satisfying their customers’ needs; by promoting the fetish of end consumption at all means – even when practised by people who have already spent themselves into near-penury – and by substituting their dirigiste will for the emergent ordering of wants which should spontaneously be made manifest on a truly unhampered market, they will be doing incalculable harm in three overlapping ways.
Firstly, they will be preventing the Bust from cleaning out the stables in one quick, Herculean swoop and thereby they will clutter up the landscape with zombie firms, recruiting an army of the progressively demoralized to reinforce already failed generals and so blocking the path of efficient, private reconstruction.
Next, they will delay the necessary process of rebuilding the capital we have already lost by hewing to the Keynesian canard that this can somehow be brought about by accelerating the destruction of its own replacement faster than we can ever create it (for exhaustive consumption entails nothing less than the using up of what could otherwise be deployed as newly productive means – i.e., as capital).
Lastly, by competing for goods, services, and labour – usually on the most inequitable of terms, thanks to their coercive ability to rig the game – they will be layering the economic pie with a stodgy ballast of cost-plus, vote-buying busy-ness, leaving little room for the low-fat, high-nutritional filling of genuine business which is the true sustenance of prosperity.
Given that all of this will greatly impair the ability to create wealth, at the same time that it raises the Masses’ already elevated sense of entitlement, the only mechanism by which the widening gap between the populist rhetoric and productive reality can be disguised will be through the subtle theft of monetary debasement, backed up by raw redistributionism and all accompanied by an intensification of the demagoguery directed at the remaining ‘economic royalists’ – i.e., at those few, resolute business leaders still not fully bought and paid for by the Tammany bosses holding political office.
Add to this the fact that – as the sorry track record of both post-Bubble Japan and the post-Tech Boom West amply demonstrates – the central banks will be far too reluctant to remove their unparalleled degree of accommodation for fear of provoking a new crisis, as fears of 1931-3 are essential replaced by those of 1937-8 – supposing, that is, that with balance sheets now so horrendously compromised, they would feel able even to make the attempt.
Since, the longer this process lasts, the sicklier and more stimulus-addicted the economy will become, the more dependent on a continuation of the cheap money policy, there will soon remain all too few effective barriers between the elective kleptocracy and the access to the printing press it so covets.
In the meanwhile, the ‘free market’ has once again been blamed for a catastrophe which could only have been visited upon us because such a thing has never been allowed to operate.
The hard truth is that the failure we have today is not of something which could in anyway be described as ‘capitalism’, but by a treacherous imposture of that system; by an intertwined fraud made up of the perverse incentives of interventionism, by crony, revolving-door corporatism, and by a barely-disguised mercantilism.
All of these evils have been underwritten and paid for by means of the scam of fractional reserve banking and this, in turn, has been made worse both because of the state-backing implicit in its contemporary central banking nucleus and thanks to the additional, cross-border confusions of trying to base international settlements on an Escherian nightmare of one fiat batch of protested instruments being asked to function as the support for another.
Government is not, as Britain’s hapless First Minister would have us believe, the ‘Rock of Stability’, but the (Northern) Rock on which our ship of prosperity has torn out its bottom and nearly foundered.
Notwithstanding this, the remedy, as ever, is yet more interventionism, to be paid for with the issue of reams of yet moreassignats and to be conducted to a chorus of condemnation which, in truth, should be aimed at the same quack practices which are being promised as a cure, but which is instead conveniently misdirected to shower abuse on the straw man of the practice of a degree of ‘laissez faire’ which has never yet seen the light of day.
As the inevitable result of intervention is only disappointment, disillusion, and dissent turning to disaffection, the only possible response is seen to be one of yet more, desperately self-defeating intervention, with each successive cycle becoming more arbitrary and more vindictive in its application – and correspondingly more short-lived in its apparent efficacy – until the whole order of the society which has been practising such a voodoo of self-mutilation upon itself finally succumbs to its injuries, shortly preceded into the abyss by the value of its currency.
To the anticipated charge that this all comprises a verdict of almost unrelieved pessimism, the author can only plead that he feels it is not a wholly unjustified one for not only are the history books, but also the current affairs journals, littered with the wrecks of such would-be Sovereigns of the Seas.