Great diagnosis of credit bubble, not so sure about the cure

Yet another book bemoaning the credit binge – and wondering what to do about it – has hit my desk. Richard Duncan’s effort, The New Depression: The Breakdown of the Paper Money Economy, is a book that contains a fascinating and powerful diagnosis of how we got to our current pass. But in his understandable enthusiasm to show how to head off disaster, he makes an astonishing proposal at the end that made my jaw drop.

This 179-page book, published by John Wiley & Sons, lays out statistics so eye-wateringly shocking that make the book worthwhile on those grounds alone. There are lots of tables and charts which ram home just how leveraged the Western economy has become. Take this item as early as page 2:

It is immediately apparent that credit expanded dramatically both in absolute terms and relative to gold in the banking system and to the money supply. In 1968, the ratio of credit to gold was 128 times and the ratio of credit to the money supply was 2.4 times. By 2007, those ratios had expanded to more than 4,000 times and 6.6 times, respectively. Notice, also, the extraordinary expansion of the ratio of credit to GDP.  In 1968, credit exceeded GDP by 1.5 times. In 2007, the amount of credit in the economy had grown to 3.4 times total economic output.

Duncan blames a number of factors for the West’s credit hangover: central bank hubris (foreign as well as domestic), fractional reserve banking and reduced reserve ratios; the severance of a link between money and gold (a theme I have written about before); high public spending, and some – not all – financial deregulation. While I might quibble with some of the finer details, Duncan is undoubtedly effective in putting across the facts. I like his chapter (4) where he says monetarists such as the late Milton Friedman made the mistake of not taking sufficient account of credit when they sought to explain the impact of money supply growth in an economy. For as Duncan says, under modern fractional banking, and the disintermediation of banks from financial transactions, there is little difference these days between credit and money.

For example (page 57):

Meanwhile, because of financial innovation, credit has become more like money. Most credit instruments have long met the three criteria that define money. They can serve as a medium of exchange, they are a store of value, and they are a unit of account. In the past, however, they were not liquid. Now they are.

Anyway, as the book proceeds to the various ghastly scenarios (depression, stagnation, high inflation), Duncan states (page 133): “the economic process itself is no longer driven by saving and investment. Instead, it is driven by borrowing and consumption”. It is hard to argue with that, given the foregoing.

But then he recites the argument, which has also been stated by the likes of Paul Krugman, that events such as the Second World War and the enormous expansion of state power and spending associated with them, helped end the Great Depression of the 1930s. (This ignores the fact that in 1920-21, in the aftermath of the First World War, there was a brief, sharp recession and equally sharp recovery with no state-led stimulus.) In other words, Duncan is sceptical about the idea that, as suggested by the late “Austrian” economist Murray Rothbard, we could have resolved the credit bubble of the 1920s and subsequent crash by letting prices find their own level without state intervention. And so we get to this idea of Duncan’s: a massive US government programme to invest in solar power on the same sort of scale of ambition as the old space programme of the 1960s. Oh boy.


The government could cap its spending on current programmes and spend more, instead, on investment programmes that could be made to quickly to pay for themselves.

First of all, it would surely require far more than a cap on current spending to make room for investment on whatever “investments” Duncan has in mind. We would need serious cuts, including a willingness to touch the controversial areas of Social Security and Medicare (and their non-US versions). In the US, the country has already had a “stimulus” programme of almost $900 billion, and controversial energy projects such as the failed Solyndra project, to show for it. Government-led “investments”, as even the least cynical observer of such things could show, often deliver poor rates of return. If an investment is worthwhile, then why not let private entrepreneurs and investors engage in it with their own money? The 1960s space programme, for example, certainly achieved great things, but it is questionable whether it helped re-boot the US economy. It may even have derailed it from more useful long-term projects.

Nevertheless, despite my concerns that Duncan is groping for a statist, big-government solution to our deranged economic world, he is to be congratulated for laying out the challenges so starkly. The days of living in a fool’s paradise of easy credit must surely be over.

This article was previously published at  It is reproduced here with the author’s permission.


Nowhere to run

James Tyler’s recent comments about the negative Swiss interbank rates reminded me of a discussion I had with a private-client lawyer in London yesterday.

She told me of how wealthy clients are being told they have nowhere to run with assets: property is hideously expensive; stocks are risky; many commodities are seriously overbought (gold at $1,750 an ounce); sovereign debt from Western governments is full of default risk and local currency emerging market debt is no longer great value.

A sign of how desperate some are for any “real assets” of value: every day I get press releases about wine funds, gold, antiques, and timber. (Actually, timber is probably not a bad idea if you want steady, low volatility growth, and timber comes with nice tax breaks in the UK). But for the mainstream investor, there are hardly any places to run.

On the Swiss front, the rise in the value of the Swiss franc (up roughly 30 per cent) in the past two years has hammered the earnings of banks such as UBS, Credit Suisse, Julius Baer and EFG.

No wonder the gnomes of Zurich are getting restless.


Never Mind Keynes, Wealth Managers Should Read Kipling

This article appears courtesy of WealthBriefing, where it was first published.

Whenever there is a crisis in financial markets such as that we have lived through, of one thing you can be sure: there will be lots of books written on the subject, frequently with weird or racy titles such as “The Big Short”, “How I Caused The Credit Crunch,” or “Fool’s Gold”, just to name three. But as I explain later, it makes more sense to read Rudyard Kipling instead.

Some of these books are quite insightful; some are just rattling good yarns and a chance for bruised investors to indulge in schadenfreude. The quality is highly variable: clichés about “greedy bankers”, for example, get wearying after a while. (Earth to media and politicians: greed was not invented by Milton Friedman or credit derivatives).

As far as wealth management is concerned, the value of any study of the recent disasters must be in ideas on how banks and other institutions can be better managed in future to avoid heavy losses and above all, to restore client trust and confidence. That is the ultimate point of spending a few hours ploughing through such tomes.

There are a few works out there that are worth your time, and I recently came across what I consider to be one of the very finest: “Alchemists of Loss: How Modern Finance and Government Crashed the Financial System,” written by Kevin Dowd and Martin Hutchinson. Dowd is, among his other positions, emeritus professor at Nottingham University Business School and since 2002, he has also been director of research at Black Swan Risk Advisors in Berkeley, California. Hutchinson is a veteran of the financial markets with 25 years’ experience under his belt. Both men are able, through their business and academic learning, to get their minds around the eye-wateringly complex fields of what they call Modern Financial Theory – a term embracing all the various innovations in risk management, asset allocation, options pricing, derivatives, accounting standards and credit analysis. They argue that while there are some aspects of MFT worth retaining, much of it, they say, is “rubbish”. They don’t mince their words!

The book makes a number of broad points about how we got into our current predicament and usefully, what sort of institutional and policy changes are needed to improve the situation. Here are the main points:

A return to honest money

Central banks, as issuers of fiat money and led astray by the hubris of trying to manage an economy by manipulating interest rates, have created a huge credit/asset bubble by maintaining dangerously low interest rates in recent years. A reprise of economic history, such as that of the US and UK housing bubbles, is used by the authors to ram this point home. The writers are supporters of market liberalism, arguing for a return to “hard money” – such as some kind of commodity-based currency. They oppose bank bailouts, saying that dud banks should be folded up under controlled bankruptcy processes like any other business. The authors are harsh about many aspects of what they call “crony capitalism” in Wall Street and London, and often say rude things about so-called tax havens, not to mention well-connected bankers at Goldman Sachs and other firms. However, make no mistake – the authors warn of a regulatory backlash that can be just as damaging as the original crisis. For example, they argue that many regulations, such as the Sarbanes-Oxley accounting laws in the US, are damaging.

Ownership liability

Another crucial reform area, the authors say, relates to limited liability laws and other regulatory changes. This is all about how firms are owned and the alignment of incentives. They say that limited liability, and its twin, bankruptcy protection rules, have fostered a climate of short-termism and risk-taking in banks and finance. This is one of the most controversial parts of the book. Dowd and Hutchinson want a return to unlimited liability partnership structures of the sort still used by many Swiss private banks such as Pictet or Lombard Odier. Short of such a move, shareholders in banks should have extended liability, such as by the practice of making bank shareholders liable for twice their shareholder investments. Another idea is to create, in the Articles of Incorporation, various protections against owners selling out, or at least encouraging them to look after long-term interests. One way is that Articles could require a relatively high dividend payout.

A more prudent approach to risk

The authors argue that a more partnership-friendly form of banking, harking back to the more cautious model seen in London before the post-1986 “Big Bang” reforms, would clear out many of the allegedly reckless trading practices that are associated with the crisis. For instance, owners of such banks would no longer tolerate heavy use of leverage. Credit derivatives would be used far less; securitisation of debt would decline and off-balance sheet techniques would be frowned upon. Clarity is supreme. Banks would be less likely to risk their own and client capital in highly leveraged hedge funds, private equity and other vehicles. And with banking less prone to encourage leverage, so the authors argue, the “con-trick” of hedge fund mangers being paid to deliver market Beta-plus-leverage would disappear as the price of money was based on supply and demand of real savings, not funny money. To earn a genuine crust, active management would be a more sober affair.

Many investment models don’t work

The authors point out, in convincing detail, that MFT has grossly underestimated risk at the “tail” of any bell-curve distribution of likely outcomes.This leaves investors dangerously exposed. A lot of value-at-risk models, for instance, seem to assume that a 2008-type event happens only once a century, the authors say. Well, consider the crises of recent times: the UK stock market bubble and crash of the early to mid-1970s; the 1979 oil shock; the 1987 stock market crash; the Japanese stock market crash of the early 1990s; the 1997-98 Asian crisis and Russian debt default saga; the 2000-01 implosion of the dotcom boom; September 11, 2001; the housing bubble and of course, the bankruptcies and mass failures of 2008. That is a pretty high level of frequency. And a lot of assets, such as those that were supposedly lowly correlated in normal times, have proven to be very highly correlated at precisely the point when investors need these theories to work.


I found much of the argument that the authors present to be compelling, although I think the limited liability issue perhaps has not been developed sufficiently (a follow-up study would be good to see). One criticism I do have is that they sometimes try a bit too hard, I think, to go for the populist vote by bashing the likes of “non-doms”, “tax havens” and the like. (In fairness, they want flat, lower taxes across the board, which would put some international financial centres out of business). But in general, there is a verve, and sense of drama, in this book that makes for compelling reading. One of the most demanding parts of the book for me was its chapter on modern risk management ideas. But they managed to make their discussion of the risks in VaR models, or Gaussian distributions, remarkably vivid. They showed how so much of the modern banking industry has, by a mixture of hubris, bad thinking and cheap money, been led into such dangerous territory. And the experience of 2008, which has seen so much turmoil, gives their argument a lot of credibility.

I am not so sure whether Modern Financial Theory will die out soon. A lot of time, money and intellectual capital has been invested in such ideas over the years and it will take a lot of reform, maybe through a new generation of young financiers, for better ideas to gain ground. There will also need to be change in the institutional ownership structure of banks and less leverage in the economy overall. And it is folly, I think, for anyone to imagine that speculative activity will go away, nor should it. Even in a world of “hard money”, some of these ideas will linger on. After all, in the kind of free market Dowd and Hutchinson want to see, there will, I assume, still be a need for large, liquid financial markets in derivatives to enable firms to hedge price risk. To do that, you need speculators willing to make prices in markets and shoulder the risks that others are not willing to bear. The much-maligned speculator has been around since the dawn of human market exchange – even the ancient Greeks speculated on olive oil.

It is fascinating, by the way, to compare this book with a work produced back in 2003 by Raghuram G. Rajan and Luigi Zingales, “Saving Capitalism from the Capitalists”. These authors, unlike Dowd and Hutchinson, are far more positive about certain government rules and structures such as limited liability. They see limited liability, which in the UK and US developed in modern form in the mid-19th Century, as a great engine of capitalism, not a moral hazard, and they argue that much supposedly toxic trading activity creates choice and liquidity. For instance, they argue that the more conservative banking model that Dowd and Hutchinson applaud often was a very clubby, unimaginative one that did no favours for entrepreneurs. For example, whereas Dowd/Hutchinson defend old US state restrictions on bank mergers, the other authors say that bans on cross-state border banking hurt business growth. I guess that the authors of Alchemists might argue that yes, a lot of old regulations were harmful, but the modern financial models are often slow at providing start-ups with capital and anyway, with much speculative froth removed, bankers could and would focus more on channelling savings to business, not dangerous finangling.

Alchemists of Loss is a book that urges us to heed the message of Rudyard Kipling’s magnificent poem, “The Gods of the Copybook Headings”. Here it is:

Then the Gods of the Market Tumbled, and their smooth-tongued wizards withdrew

And the hearts of the meanest were humbled and began to believe it was true

That All is not Gold that Glitters and Two and Two make Four

And the Gods of the Copybook Headings limped to explain it once more.

Or to put it another way – we need a return to honest money. While not everyone will be convinced of all the authors’ points, this is a book that deserves to be taken seriously by the wealth management sector

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Bloomberg: Fed May Hesitate on More Easing After Critics Question Mandate

It was with a certain wry amusement that I read on Bloomberg about how Republicans in Congress are attempting to stop Federal Reserve chairman Ben Bernanke from debauching the dollar further via a second bout of quantitative easing (i.e., creation of new credit out of thin air). The tone of the piece is not that hostile to the Republicans making this attempt.

Given the dramatic reverse for the ruling Democrats in early November, there could be a decent chance that even if the Fed is able to go on down the path to monetary lunacy, that at least it will no longer have political cover from those men and women on the hill. If the Republicans can make “honest money” a serious campaign slogan for the race for the White House, it should hopefully create a good environment for our ideas.


Cobden Centre Annual Lecture 2010 – honest money and the national debt

Last night, yours truly, along with a number of other Cobden Centre supporters and assorted free marketeers, listened to Toby Baxendale talk about a radical proposal to sort out the UK national debt. He talked about a good many other things, but the centrepiece of his talk was how, as part of a key reform, we could slash the debt burden and save future generations from the crippling expense of the current debt.

What interested me, beyond the core of Toby’s talk, was the reaction from the audience. A number of people I spoke to – their conversations are off-the-record so I will not name them – told me they were skeptical about Toby’s reasoning on the national debt point, although they accepted that, at face value, there may be a vital point they were missing. I must say that I am not entirely convinced myself but that may because I have not understood the point and need to do a bit more thinking and reading. In particular, there is a worry that the Cobden Centre might appear, unless we thrash these issues out clearly, to be pitching some sort of “magic bullet” solution. And I am sure that Toby does not regard there being anything magical about honest money.

One simple issue that arises from any plan to wipe out a lot of debt is the law. In debt restructurings, for example, one point that bankers have to deal with is the seniority of debt holders. The UK’s national debt is held by a variety of different people, foreign and domestic; it is held by a variety of institutions. Any plan to adjust debt, or cut it, has to take into account the kind of people who hold it and any contractural issues that may arise. It may sound nick-picky but it is the sort of detail that is actually very important in resolving debt issues at the corporate level, for example.

I was mightily impressed by the few words of Steven Baker in reference to his maiden speech on the issue in the House of Commons. It almost seems too good to be true that we have a sitting MP who actually understands, and wants to spread understanding of, these issues. (The fact that Steven has actually had a serious job as an engineer is also a refreshing change). For far too long, the free market position has suffered from a lack of articulate defenders in parliament (there have been honourable exceptions, such as the late Nicholas Budgen or Jock Bruce-Gardyne). Simply conveying the message that states make a mess of money is a key argument to make. It would be good for other MPs and commentators in the mainstream media to be more acquainted with the Austrian school. There are already signs that this might be stirring: consider this article on banking by Dominic Lawson, who seems to have inherited his father’s grasp of good economics.

Economics – Traders make $8bn bet against euro

Euro coinsThe Financial Times has an item up about the weight of investor pressure to sell the euro, taking the view, no doubt, that the financial crisis affecting debt-laden Greece could raise the chances of a breakdown in the single currency bloc:

Traders and hedge funds have bet nearly $8bn (€5.9bn) against the euro, amassing the biggest ever short position in the single currency on fears of a eurozone debt crisis.

What interests me about this saga are not the specifics of the Greek financial debacle – which is, in my view, a particularly egregious example of fiscal incontinence by that country’s government – but rather what the FT story tells us about the benefits of short-selling.

The practice of shorting, which describes the process of temporarily borrowing a financial instrument such as a currency, selling it and repurchasing it at a cheaper price to pocket a profit, has sometimes been politically attacked. About two years ago, the UK government decided that those wicked investors who had been shorting the securities of banks such as HBOS needed to be warned off. It was if the very idea of seeking to profit by taking a negative view of a stock or bond was “unpatriotic”. In their defence, policymakers might argue that they were trying to prevent frenzied attacks on a company or country, but all too often, attacks on shorting turn out to be a classic case of “kill the messenger”. I hold no great admiration for George Soros, given his political views, but he certainly did the UK a favour, in my view, in shorting the pound in 1992, a process that eventually helped drive the UK out of the European fixed exchange rate system at the time.

Likewise, in the latest example of foreign exchange drama, traders who are shorting the euro are sending out a powerful message: this currency has a great big flaw in it. Can, for example, the relatively big economies of Germany and France be expected to bail out Greece in the way that say, the Federal US government might have to bail out California, a state that has been teetering on the brink of collapse for months? Such a bailout would only raise the question of whether countries doing the bailing out were entitled to have a more direct say about the fiscal policies of a member state.

Healthy Shorting, in any event, is part of a healthy, liquid financial market. Without those who are willing to sell, buyers cannot operate (a point so obvious that I feel a bit embarrassed to have to even mention this on this site). If we want efficient price discovery to work in markets, then it should be possible for operators to profit not just from when a price rises, but when it falls. Shorting can enable financial players to hedge risks.

Of course, part of the issue for those monitoring the markets is that the routes by which an investor can short a stock have multiplied. You don’t have to be a big hedge fund with access to a powerful prime broker such as Morgan Stanley or Deutsche Bank. You can, for example, short a security through derivative-type products such as contracts for difference (CFDs) and spread-betting, both of which are instruments open to the retail investor, given certain constraints. These processes can be accessed online via firms such as IG Index, for example.

So armed with such instruments, traders can express a bearish, as well as bullish, opinion. And the FT story is striking about what the euro bears think. For example, the report says that traders and hedge funds have bet nearly $8bn (€5.9bn) against the euro, “amassing the biggest ever short position in the single currency on fears of a eurozone debt crisis”.

Figures from the Chicago Mercantile Exchange, which are often used as a proxy of hedge fund activity, showed investors had increased their positions against the euro to record levels in the week to February 2.

It has been one of the ironies of the financial turmoil that when problems first arose, it was easy for the European nations such as Germany and France to hint that their systems were so much more robust than the approach taken by those cowboy Anglo Saxons. But in truth, EU countries, many of which now have levels of debt that are alarming investors, have big problems. Short-sellers are simply expressing the wider worries that investors have about the viability of the euro and the willingness of euro zone states to operate a sound currency.