Why do bankers earn so much money?

I was asked recently why it is that market forces do not push down the wages of the top earners in financial services.  The answer, it would seem to me, is that the profitability of the financial services sector is based on privilege, rather than normal economic activity, and it is this that drives hiring behaviour.

In a normal industry, where there is a profitable project, a number of different entrepreneurs have the ability to invest in this area.  The act of investing produces a good that a consumer buys.   The more of these goods produced, the lower the price that consumers will pay such that the profit making opportunity diminishes and the ability to pay higher wages/expand the business diminishes.  This process is good for society since it provides more goods demanded by the public at lower prices.  The entrepreneurs are motivated to hire additional people in order to invest in these areas increases profits to themselves.  A beautiful system, I’m sure you’ll agree.

However, the profits of the financial service industry are far in excess of where they would be in a true market economy without fractional reserve banking/fiat currency/central banks. Profits within the industry are essentially a product of the net interest margin (difference between interest rates at the short and long end of the curve) and the outstanding liabilities (more credit lent means more profit).

The central bank’s action keeps the net interest margin wide since it buys government debt at the short end of the curve and has an inflationary bias.  In addition, the ability of the central bank to continue to bail out the industry should it get into “liquidity” trouble encourages more risky behaviour – both in taking on additional leverage and taking additional duration risk. Hence the product of net interest margin and liabilities is artificially kept high by central bank action.  These excess profits are paid for by the rest of society through higher inflation.

Given that the vast majority of the banking sector’s profitability is dependent on privilege, it makes no sense for a firm to hire additional people in order to exploit profit making opportunities – there are no opportunities.  The rational response is to hire no one at all, except in the case where hiring defends and extends this privilege.  This explains the army of remuneration consultants, the bank-funded pro-central bank economists, the lobbyists, the symbiotic relationship between government and banks particularly evident in the higher echelons of the US government where officials seem to pass between top positions in government and on Wall Street so easily.

Some hiring of people of course is inevitable in order that administrative work is done, and this is also beneficial in defending privilege since the industry can argue to the government, from whence its privilege comes, that it is an importnant provider of jobs.  However, the insiders with the top positions are very reluctant to hire additional people since this would not increase their wealth though providing additional goods with demand, but rather dilute their privilege through more heads.


Europe on the brink

I came across this excellent report by Boone and Johnson from the Peterson Institute for International Economics on the mechanics of how the Eurozone sovereign debt crisis built up (hat-tip James Aitken of Aitken Advisors).

The report helpfully runs through the various policy options that the Eurozone leaders have, and runs through the likely consequences of default – interesting reading given the growing probability of some portion of this option being taken with respect to Greece at least.  The writer at least believes that default and ‘an end to the moral hazard regime’ has now become the most likely option.

Cobden centre readers will enjoy the description of how it was the ECB’s repurchase operations that entrenched moral hazard throughout the Eurozone through the treatment of all sovereign paper as collateral from banks equally regardless of its creditworthiness.

There is also an up-to-date summary of the current net claims of all countries against each other, all guaranteed and monitored through the ECB, imbalances that are still building.  Germany as of July was the largest creditor to the scheme at over Eur335bn.  In gamblers’ parlance Germany’s decision over whether to throw good money after bad will determine the route the crisis will take next.


Chinese money creation: why the Chinese central bank’s reserve position is no defence.

I have heard it said many times that China’s economy is likely to be resilient as it is sitting on huge foreign exchange reserves. The argument goes that should the Chinese banking sector run into trouble, the government will simply bail it out through sales of its trillions of dollars of US treasuries, accumulated over the last couple of decades.

Nothing could be further from the truth.

In order to examine the ability of the government to utilise these foreign exchange reserves, it is worth examining the mechanism though which they were accumulated. It goes something like this:

Chinese exporters sell goods to the rest of the world – particularly to the US. In order to pay for this, the US consumers use dollars, many of them freshly minted by the US central bank.

Chinese exporters now have dollars which they exchange for Renminbi at the commercial banks. The commercial banks then exchange the dollars for freshly printed Renminbi at the Chinese central bank. These dollars are then warehoused at the central bank and not spent. The purpose of the Chinese government in doing this is to keep its currency weak against the dollar.

However, the point of this is that expansion of the domestic Renminbi money supply is dependent upon additional dollar flows. It was this constant increase in new dollars that for many years resulted in the domestic monetary inflation within China.

More recently however, the flow of dollars has not been nearly so strong. When adjusted for overseas debts, the accumulation of new dollars since the financial crisis has been fairly lacklustre. In order to maintain the rate of increase of money in China since the crisis, the government has, therefore, commanded its domestic banks to increase lending through the normal fractional reserve trickery we have seen globally, thus leading to the credit boom we have witnessed in the domestic economy in China.

The point of all this is that any reduction in foreign exchange reserves in China necessarily results in a reversal of the process above – i.e. a reduction in the outstanding number of Renminbi in the system; the dollar reserves are the reserve base of the Chinese central bank and all domestic money is pyramided on this monetary base. Given that the Chinese economy is precariously dependent on overvalued real estate, induced by a credit bubble, this policy option is – therefore – effectively closed for the Chinese government.

Conceivably the Chinese government could diversify out of US treasuries into another currency. There has been some talk of it buying European sovereign debt in order to support the European governments in their increasingly desperate attempts to preserve the Euro in its current format. They can’t – however – afford to lose these reserves on an ill-conceived gamble as this would undermine their own domestic money supply, so Eurocrats hoping for Chinese peripheral debt-purchases may be disappointed; China would need some hefty guarantees.

The most likely course for China remains –therefore- that its domestic bubble will run its course and end like all bubbles: with a crash.


The Real Housewives of Wall Street

If you’re an American, this shouldn’t make you angry, it should make you incandescent with rage. As the Federal Reserve, for the first time in its history is forced to open its books following an act of Congress, some very dirty laundry is being uncovered. What did happen to all that bailout money?

Of course, if trillions of dollars of new money are created and handed out arbitrarily, it is likely that a few million will go astray. The beneficiaries are being made known to the US public, and not before time! Rolling Stone does a good job in explaining just how it easy it was to make millions of dollars, risk free, doing no work at all.


High Tax Britain

Have you ever wondered how much tax you truly pay? In order to do the calculation, VAT, national insurance contributions from both employees and employers, property taxes, various goods duties, council taxes, motor taxes, fuel taxes, cigarette taxes, environmental levies and a host of others need to be added to the more widely known income tax.

Fortunately the Adam Smith institute calculates this for the average Briton, and presents it as “tax freedom day”, which can be found here:

Currently the answer for the average Briton is that he spends just over 40% of his time working for the government and 60% for himself.

However, imagine you’re an industry that the government doesn’t like too much. As a tobacco, alcohol, energy or energy-related enterprise, the government sees you (or at least can paint you) as being responsible for a wide variety of social ills – cancer/alcoholism/global warming. But how far would it really go in raising taxes from you as a justified measure for all the pain it believes you cause?

In its latest earnings announcement, the UK pub operator JD Wetherspoon stated the following:

In the period under review, Wetherspoon made profit after tax of £22.1 million, but total taxes paid to the government were over £220 million, including VAT of £95.1 million, excise duty of £57.5 million, PAYE and National Insurance of £32.9 million, property taxes of £20.6 million and corporation tax of £11.1 million. This and the previous government have zealously increased taxes and regulation for pubs to levels which are, we believe, unsustainable. This has greatly increased the price of drinks in pubs and has widened the price gap between pubs and supermarkets, with a predictably huge increase in sales volumes for supermarkets, combined with a decrease in sales for pubs. The situation in Britain is in marked contrast to the approach in France, for example, where excise duties are far lower and where VAT, in respect of food in bars and restaurants, has been reduced to 5.5%. This has produced an increase in taxes and jobs for the French economy, through a reduction in the black economy and greater PAYE and corporation tax receipts. In contrast to previous decades, Britain has now become a high tax and regulation environment for business, with the effects of this being seen in many thousands of closed pubs and other small businesses across Britain, as well as a marked increase in unemployment.

Of course the government can get away with this extreme taxation because in addition to its implicit claim that pubs are responsible for alcoholism, the nature of their business means that pub groups cannot take their business offshore. They are fixed to the UK and therefore sitting ducks. The government can squeeze the life out of this industry and there is nothing the owners of these businesses can do about it.

The lessons to the businessman wanting to escape government persecution are:

  1. don’t be unpopular with the government; and
  2. don’t engage in any activity that you cannot threaten to take elsewhere.

Meanwhile, those of us who enjoy a quiet afternoon in our local country boozer are forced to pay for it through higher prices and less choice as lovely old pubs with hundreds of years of history close each year.


Building White Elephants in China

Loose US monetary policy has had its echoes all around the world.  The US dollar, once thought to be “as good as gold”, has now been shown be nothing of the kind. Gold bugs the world over have been proven right.  Countries scattered all over the world have either dollarised, or run very tight pegs.  In either case, this has meant largely adopting US monetary policy in countries as far flung as humble Ecuador (dollarised in 2002 following its own runaway inflationary disaster, which resulted in the emigration of 10% of the population) to the collection of Asian nations, China, Hong Kong, Malaysia, Taiwan, Indonesia, all of whom adopt some sort of peg to the US dollar.  Without exception, each of these countries has experienced extreme property appreciation these last two years.

This documentary explores the Chinese experience.

The mechanism through which expansionary policies are communicated through China appear to follow the following pattern:

  1. Central government requires GDP growth/employment creation and so instructs the state-owned banks to lend.
  2. State-owned banks lend principally to state-owned companies as these are good credit-risks, backed – as they are – by the state.
  3. State-owned companies buy land from local governments for property development in accordance with a master plan for development of a new business district.
  4. Local governments spend the proceeds on who-knows-what…here the trail goes cold.  However, land sales actually account for the vast majority of local governments’ income so one can be sure that they put plenty of pressure back on the central government to keep the cash coming!  Once the local government has it, this cash leaks out into the real economy somehow.  Some of it presumably gets recycled into new deposits on property.
  5. Individuals buy units using mortgages from private and state-owned banks, often using equity released from the appreciation of property bought in previous transactions.  Ultra-low interest rates, fixed by the central bank, help them keep up with their repayments.

In short, this process is little different in essence from the credit-fuel property booms that have occurred the world over and it will have at its heart cronyism, corruption and waste.

The stories of the booms and busts of each country carry a different twist as the setup of institutions in each country is different, with the common flavour being that of credit growth aided by monetary expansion.

To the requisite ingredients of loose money and credit growth, China has added the explosive ingredient of it being a command economy, which has served to amplify the misallocation of capital.  The results are spectacular.  The most populous nation on earth does most things on an epic scale, and property boom and bust is seemingly no exception.  Enjoy.

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I’m sure I had another tenner here somewhere

It’s the injustice of the current system that feels so appallingly wrong.  If you do not work in the financial services industry or for the government, then you should feel angry at the political shenanigans of last few years, for it is you who have paid for their mismanagement and extravagance and both you and your children who will continue to pay for years to come.  Not content with the shameful plunder of these last 30 years, the vested interests seek to maintain the same structures in place to allow it to persist, enriching themselves at the expense of the rest.

The common man has an inkling of who is to blame.  A straw poll of grievances of the bloke down the pub will often finger ‘bankers’ and ‘politicians’ as the rogues in our society, but he is unable to identify just how they pulled off this trick of empoverishing him.  He doubts himself as he does when he looks in his wallet leaving the pub after one beer too many thinking “I’m sure I had another tenner here somewhere”.

The free market is a fair system through which an entrepreneur can only become rich through serving the needs of his customers better than any other provider.  This should therefore result in beneficial systemic effects that all can enjoy.  As Von Mises wrote

‘A “chocolate king” has no power over the consumers, his patrons. He provides them with chocolate of the best possible quality and at the cheapest price. He does not rule the consumers, he serves them. The consumers are not tied to him. They are free to stop patronizing his shops. He loses his “kingdom” if the consumers prefer to spend their pennies elsewhere’.

So how did the bankers manage to pickpocket our pub-goer without him realising?  How did he cheat the free market system?

At its most basic, banking should be a management function whereby transactions are facilitated and savings passed efficiently to investment opportunities with the best prospects.  It is the success of these projects that provides the goods for all to consume in the future, and they are only successful if – like the chocolate king’s chocolate – consumers are willing to buy them.  Financial services are an indispensable part of the economy, created for and ultimately demanded by consumers.

But, we ask ourselves, how did there get to be so many of these financial managers, and why are they paid so much money?  Ordinarily the right number in any industry and remuneration will also be decided by market processes.  Too many financial managers will mean that any profits from the financial firm are eaten away, such that the industry is forced to shrink.  Surely it cannot be an efficient allocation of resources to see their numbers growing faster each year relative to the size of the economy.  And yet this is what we have.

OECD world factbook 2009

In the chart above the term “value added” does not seem apposite.  However, it is be indicative of the size of the industry relative to the overall national economies.

As banks create new credit, all these new loans earn interest, making the banks more profitable, allowing the hiring of new people so that their businesses can expand.  Banks have been able to expand their loan books without fear of these loans being called in, only because of they have a direct credit line from the central bank, which was has the ability to print new money.

The creation of new credit has pushed down the interest rate available below its sustainable long-term rate, and has allowed consumers pay more for assets, and so bid up their prices.  All those therefore working in areas of the economy who charge a fee on assets have also therefore benefited (fund managers, estate agents etc.).  This is captured in the numbers above.

Is it reasonable that more than 30% of the UK economy is now engaged in providing financial paper shuffling of one kind or another? This is not just due to the UK selling financial products overseas.  The trend of financial services becoming a greater proportion of overall economies is global, ubiquitous and is entirely down to over-cheap money.

Credit created today has the effect of driving up asset prices as mentioned.  It causes inflation down the line but this does not hit wages for the non-banks’ employees until much later.  The credit created tends to be deployed in the loans market first (the central banks’s favourite way to inject money into the system is to buy government debt).  This in turn has forced up the value of other financial assets, equities and houses.  However, the price inflation does not hit the average wage earner’s pocket until all the other prices have gone up beforehand.  Although his wages do not decline in pounds sterling, his purchasing power is taken from him, just the same, expropriated by the banks.

The other group that has ‘benefited’ from the policies pursued over the past 20 years is government.  Increases in asset prices caused by the credit expansion allowed the government to take ever increasing amounts of tax.  In addition, the low interest rates set by the central bank allowed the government also to borrow to unacceptable levels to fund its continued spending.  The central bank funds the government directly through buying its newly issued debt.

OECD world factbook 2009

This situation is only possible as a result of the existence of the central bank.  Without it, the commercial banks would be checked in their efforts to create more credit and the government would have no funding instrument and would have to reduce its spending.  Back in the days before central banks, governments themselves went bust.  Alas no longer.

So where does this leave our bloke down the pub?  He should be livid! He is squeezed between a hungry bank and a bloated government.  He can do little about it other than attempt to join these two favoured groups, which of course explains their expansion.

Annual survey of hours and earnings (ASHE) 2009

Note that the chart above tracks nominal wages.  When adjusted for inflation, we see that the median man has made little progress at all, if any, over the last 10 years.

The average man works hard in order that he might share in the gains that result from our society becoming more productive, is robbed every single day that he picks up his wage packet, the gains that would normally be seen as a result of falling prices spirited away out of his wallet without his knowledge.

It would be easy to blame individual bankers, or even the whole industry for this sordid con-trick.  However, each of the participants within the banking industry is only acting in his best interests.  The individual banker that did not take advantage of the subsidy granted to the entire industry in the form of central bank printing would be at a severe disadvantage relative to his competitors and may go out of business as a result.

As Austrian economists know, the only way to prevent this behaviour, and re-align the interests of the banks with the interests of their customers, is the abolition of the central bank.


Let universities choose their entrance criteria

A simple tweak to the funding of school exam boards would lead to better standards and more appropriate examinations at lower cost

The grade inflation of the UK A-level exams is well-documented, such that a need to introduce a new A* grade has occurred, following the introduction of an A* grade in GCSEs many years ago.  This is another case of treating the symptoms of a problem rather than the causes.  The most elegant solution is much easier and cheaper: simply let the universities set the exams.

The current peculiar system requires that schools are the bodies that pay the exam boards, which results in a horrible conflict of interests.  Exam boards compete with each other for schools’ custom. Given that schools are rated by parents by the grades that the students each of school achieves, it is natural that firstly that examination standards gradually weaken and secondly that the marking of said exams becomes more lenient over time.

This has two obvious effects:  Firstly, the universities are less able to distinguish between the best students due to the more lenient grading.  Secondly, the students are educated to a lower standard than their predecessors.  For this reason, degree courses now frequently have to extend over four years instead of the traditional three.  This is particularly the case with science degrees where I am told by physics lecturers that much of the first year is now spent covering material that 30 years ago would have been covered at A-level.

The simple reform whereby either universities be required to pay the exam boards or else set their own exams would result in the exams being set for the benefit of the universities.  Since it is the universities that receive the product of these examinations (the students), rather than the schools, who wave them goodbye at the age of 18, surely this structure would make more sense.  Given that exam content would be tailored for subsequent use at universities, this would also make the national curriculum redundant and so remove a large unnecessary cost.

I am confused as to how we were saddled with the current dysfunctional structure.  Certainly years ago, universities did set their own exams.  For example, in the North of England, the JMB was set up as a de-merged entity responsible for the setting of exams for Manchester, Liverpool and Leeds Universities.  This board later took in more universities’ exam-setting capabilities (presumably to reduce costs) and merged with the NEA to form probably the largest board, the NEAB.  This does not answer the question though as to how this resulted in the schools being responsible for the payment of the boards.  I wonder, does anyone know why this occurred?

This Telegraph article neatly illustrates the issue.


Don’t worry! The Bank of England has it all under control

I was amused to read the recent UK inflation reports. The ONS said that in July it “fell” from 3.2% from 3.1% in June.

The measurement of inflation in itself is absurd given its dependence on entirely subjective decisions about what should be included in the basket and in what proportions. In addition, a good today is often not strictly comparable with an equivalent good measured a year ago – this is particularly the case with respect to items subject to significant investment such as technology. I wonder how my marvellous new HTC smart phone is considered in the basket for example – such a product did not even exist 2 years ago.

How, therefore, can a reduction to inflation of 0.1% in a single month be regarded as anything other than an insignificant change?

More important I would say is that CPI is running at 3.1%, which is well above the Bank of England’s target of 2%. RPI (yet another measure of
inflation) is measured at 4.8%.

Meryvn King’s response to inflation running above target was most illuminating. When this happens, he is required to write a letter to explain the issues to the Chancellor of the Exchequer. Amongst the usual bilge (food went up by x, rail fares held steady at y), he gave us an insight into his likely future response to the inflation that cannot be hidden even by understated government statistics*. He stated that he would “write more letters to the Treasury over the coming months”.

And there we have it. Our irresponsible central bank’s role as a committed inflationist is confirmed.

* For an illustration of how governments have manipulated inflation statistics to suit their own purposes, take a look at the Shadowstats site, where John Williams has removed the government adjustments to maintain a consistent view of price inflation over the years. He thinks that as inflation used to be measured, it is running at somewhere close to 8% in the US and has been doing so for years.


Government spending to decrease? You’re having a laugh!

Beneath, I explain that, under the condition that the current financial system is not restructured, the proportion of the economy run by government, rather than reduce (as is currently proposed by the coalition) is instead much more likely to increase. This would certainly result in a reduction in rate of improvement of the standard of living at the very least and potentially could cause standards of living to drop. The situation is eerily reminiscent of Japan some 20 years ago. The fact that the current system can lead to such a consequence implies that a wholesale restructuring of the banking system should be considered.

In order to maintain monetary inflation, the central bank is bound to print money and give it to someone.

In the UK, we have a situation where the private sector is paying down its debts. It is doing this due to the following three reasons:

  1. the private sector is over-indebted. This applies particularly to the banking sector.
  2. individuals remain worried about job losses and high unemployment.
  3. individuals are worried about future tax increases from the government due to the high and increasing debt levels in the public sector (the economic phenomenon known as Ricardian Equivalence).

Private sector debt-paydown results in money instruments being destroyed. This will tend to have a negative effect on prices.

The UK coalition government has expressed a wish to reduce government spending [1]. If this is the, case, this would also have a deflationary effect since at the very least, the rate of increase of creation of new debt instruments would reduce.

However, the central bank has a mandate to “maintain low inflation”, i.e. not negative, but low and positive. Prices are broadly affected by the amount of money in the system, allied to the willingness of individuals/government to spend it.

Now the private sector’s actions are resulting in prices reducing somewhat, and the public sector’s likewise. In times gone by, additional credit created by the banks would be lent into the private sector directly, which would help the private sector growth to at least keep pace with that of the government.

The private sector is no longer creating additional credit. However, the central bank still needs to fulfil its inflation mandate. Its typical method of doing this is to print new money to buy government bonds. This gives the government money which it spends in the economy, which achieves the central bank’s objective of raising prices over time.

The central bank’s action of buying government bonds has the effect of vastly lowering the interest rate on government bonds compared with that on private sector debt. The implications of this are that the government is incentivised to spend more relative to the private sector. This is classic government “crowding out” of the private sector. It also fits neatly with the Austrian concept that states that the beneficiary of inflation is the entity that receives the new money first. In this case, the government receives the money first.

Hence, on the assumption that the central bank acts to cause inflation and does this through the purchase of government bonds, it is almost guaranteed that the government will be the entity that engages in the additional spending. Of course, this can result in a vicious circle as the more the government spends, the more that the private sector saves to fund it, which results in deflation of prices and compels the central bank (under its idiotic inflation mandate) to print even more.

I predict that UK government spending, far from falling from its current level, will rise beyond all expectations over the next five years. Unfortunately, due to the government being an appalling investor of other people’s money, most of this spending will inevitably be wasted, which results in fewer goods produced by our nation and declining living standards for all.

Much as the creation of credit by private banks creates distortions, the new money created by banks at least gets lent by private institutions in order to make a profit. Hence, the return on these projects is likely to be greater than on those sponsored by governments. By this measure at least, credit-creation by banks is preferable to money-printing by governments (though neither is desirable).

This is not idle theory. We have seen this precise situation played out in Japan over the last 20 years following its debt crisis. The graph beneath shows what has happened to government debt in Japan since its banking crisis in 1990.

There is a way out. This is to allow businesses to go bust, to allow the loans in the system to go bad, allow interest rates to rise and to cut the size of the government. Unfortunately, this was not allowed to happen in Japan and there is absolutely no evidence that this is happening in the UK.

The current consensus is that the system is too fragile to allow this to happen. If this is the case, then there is clearly a problem with the system. The proposal put forward by Toby Baxendale is by far the best of any to reform the banking system that I have seen. It should be given more consideration than it currently has been.

[1] Or at least not increase spending — the Tax Payers’ Alliance recently examined HM Treasury’s numbers and concluded that government spending under our chancellor’s current forecasts would fall by a mighty 4% in real terms over this parliament; hardly austerity.