FT columnist Martin Wolf considers narrow banking and 100% reserves.
The FT has a new series on the future of investment. But what, I wonder, is the future of finance itself? Who is confident that the financial system now emerging from the crisis is safer, or better at servicing the public’s needs, than the one that went into it? The answer has to be: few people. The question is how to remedy this dire situation.
What entered the crisis was, we now know, an ill-managed, irresponsible, highly concentrated and undercapitalised financial sector, riddled with conflicts of interest and benefiting from implicit state guarantees. What is emerging is a slightly better capitalised financial sector, but one even more concentrated and benefiting from explicit state guarantees. This is not progress: it has to mean still more and bigger crises in the years ahead.
By kind permission of Sean Corrigan, we make available the September edition of his Resource Ruminations “Superhighway to Serfdom”:
“The danger of modern liberty is that, absorbed in the enjoyment of our private independence, and in the pursuit of our particular interests, we should surrender our right to share in political power too easily. The holders of authority are only too anxious to encourage us to do so. They are so ready to spare us all sort of troubles, except those of obeying and paying! They will say to us: what, in the end, is the aim of your efforts, the motive of your labours, the object of all your hopes? Is it not happiness? Well, leave this happiness to us and we shall give it to you. No, Sirs, we must not leave it to them. No matter how touching such a tender commitment may be, let us ask the authorities to keep within their limits. Let them confine themselves to being just. We shall assume the responsibility of being happy for ourselves”
Benjamin Constant, ‘The Liberty of Ancients Compared with that of Moderns’, 1816
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Imagine, if you will, that we stand today at a cross-roads and that we see to our right a minor road which branches away to climb rapidly upward in an ultra- (even a hyper-) inflationary surge to ruin. On our left, we find a trackway which twists downward, descending rapidly into a Slough of Despond after threading its way past the rusting ironwork, boarded windows, and unfinished building work of a renewed financial crisis and after jolting its users horribly about in the ruts and potholes of further, poor political decision-making as they motor to their doom.
In all likelihood, however, our state-employed bus driver will avoid these two offshoots and will rather stick steadfastly to the busy highway along which we are currently speeding, a broad Road of Good Intentions along whose dreary verges we see an army of labourers sweating over the construction of an ever more ramshackle confusion of governmental props, buttresses, and scaffolding as they try manfully to shore up the crumbling Babel of bad debt and faltering businesses to be found there, at least beyond the next election date.
Responding to an article in The Times, Steven Baker indicates the origins of our views on the economic situation and its causes, of our prospects and of the best route to sustainable prosperity.
For the Times, Jim O’Neill, Chief Economist at Goldman Sachs, writes:
Based on the evidence I have seen this month, it looks as though the world moved out of recession in the second quarter. When we see the evidence for this, in the third-quarter data, it is likely that many areas will have returned to close to trend growth.
He goes on to explain the emotional and subjective criticism he has received in response to previous articles, the evidence and his optimistic outlook for the world economy, concluding:
Since March, close to the time that developed stock markets bottomed, our GLI has shown a vigorous bounce and, indeed, for the past two months the monthly increases have been the sharpest we can find. The chart of the monthly changes, as you can see, looks pretty much like a V, not a W. Right now, it suggests a much stronger bounce in the world in the next six months than consensus and, along with other data, is why in our latest forecasts we predict that world GDP will recover by 4 per cent in 2010. This will include the UK because, despite all its challenges, it is an economy small and open enough to be greatly influenced by the rest of the world.
Mr O’Neil is a senior economist and Goldman Sachs makes a great deal of money. So why do we disagree?
There are three important schools of economic thought: Keynesian, Monetarist and Austrian1. We follow the Austrian School. In contrast to the others, it has a robust capital theory and an understanding of the interest rate as the price which coordinates the economy across time. Unfortunately, Mr O’Neill’s economic thinking causes him to look at the immediate empirical evidence and make pronouncements which, while superficially justified, lack a deep theoretical understanding of the situation, that is, the distortions in the capital structure of production.
Of course, this is not to assert that money cannot be made by bankers in the short term under the present system. The question is whether that system of thinking can explain our predicament and the best route out.
Gordon Kerr, a banker with expertise in derivatives and foreign exchange, explores the evidence of moral hazard in the bank bail outs.
By rescuing the banks with taxpayers funds the Government won the approval of many who were horrified at the prospect of repeats of the TV footage of depositors queuing to try and take their money out of the first failure, Northern Rock.
Whilst the protection of depositors is to be welcomed, that protection could have been achieved by the adoption into the UK banking business model of the ‘honest money’ policies familiar to frequent visitors to this site.
What commentators dwelt less on at the time of the UK bailouts were the distortive effects on the market of continuing taxpayer support. The market’s cries for the emergence of new brands, perhaps even the revival of the genuinely mutual template, remain stifled. Why would depositors choose such new brands when the old mismanaged failures enjoy a government guarantee, albeit in some cases implicit rather than explicit?
If the frightening consequences of the new era of zombie banking were not plain enough, the report in today’s Daily Telegraph by Philip Aldrick removes any iota of doubt:
Northern Rock should not be allowed to complete a planned restructuring without paying financial penalties, Britain’s building societies have told European competition regulators, on the grounds that the nationalised mortgage lender will otherwise have an unfair advantage.
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Northern Rock is planning to split into a “good bank”, BankCo, which will continue to lend, and a “bad bank”, AssetCo, which will house and run down the bad loans. The BSA, which represents Britain’s mutual lenders including Nationwide, said the break-up will allow BankCo “to lend freely, without having to absorb losses from non-performing loans, unlike all of its competitors”.
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Northern Rock has one of the worst lending records of all UK banks. Some 39pc of its £62bn of mortgages are in negative equity, and it made a £724m loss in the first half on the back of £602m of bad debts. Without hiving off the loss-making mortgages, Northern Rock would only be able to lend profitably by charging uncompetitively high rates.
The lender has stressed, however that the restructuring is in taxpayer’s best interests as it will allow the bank to operate without further capital injections.
In Scandinavia, in the early 1990s, mass bank failures were resolved by the ringfencing and liquidation of ‘bad’ assets in ‘bad banks’ to enable the brands to continue with the performing loans or ‘good’ assets.
The difference between Scandinavia then and the UK now is twofold: firstly the scale of the failures was small – the banks were restored by the excision of a relatively modest amount of nonperforming property loans; secondly the miscreant senior managers were pursued in the courts for personal restitution. It is worth noting that in today’s money the average annual compensation of very senior bankers in Northern Europe at that time would have been around the £100,000 mark. Whatever restitution funds were actually extracted were clearly therefore meaningless when measured against the taxpayer cost of the bailouts.
However the pursuit of those deemed responsible dealt with the worst possible consequence of the bailout, moral hazard. This pursuit removed any temptation that the next generation of bankers might otherwise have sensed to overleverage their banks in reliance on the state on the basis that they personally would have nothing to lose.
The Northern Rock ‘good bank’ will continue with the state guarantee. Rather than emphasise the importance of ending this or paying for it, Northern Rock believe that the continuance of the guarantee is in the taxpayer’s best interests since it “will allow the bank to continue to operate without further capital injections.” The failure of the spokesman to make any reference to the source of such future “capital injections” (you and me), or to imply any doubt that such ‘further capital’ would be available if required, is staggering. The most worrying aspect of the quotation is the apparent absence of irony.
All UK big banks are now explicitly, not just implicitly, state guaranteed. That is why sterling has fallen, entrepreneurialism hindered, and bank shares have risen. Certain Parliamentarians have invoked the term “casino banking” to summarise the banking malpractice that has created the failure (nobody really believes the ‘global crisis’ explanation beloved of the PM).
The UK holy trinity of treasury, regulator and central bank have not only failed to deal with the moral hazard point, their actions have sadly exacerbated it. Senior bankers are enjoying the highest levels of compensation with even less personal risk than before.
Unfortunately for the trinity however, market forces remain at work. The authorities’ failure to even recognise, let alone address, the moral hazard issue regrettably enhances the probability of a new wave of ‘casino banking’ failures.
An afterthought — moral hazard defined
Moral hazard refers to the idea that certain types of insurance systems might cause individuals to act in a more dangerous way than normal, causing a difference between the private marginal cost and the marginal social cost of the same action.
– S Ross, ‘The Economic Theory of Agency: the Principal’s Problem’, American Economic Review, vol. LXIII (1973), 134-39
Entering the Greatest Depression in History by Andrew Gavin Marshall
While there is much talk of a recovery on the horizon, commentators are forgetting some crucial aspects of the financial crisis. The crisis is not simply composed of one bubble, the housing real estate bubble, which has already burst. The crisis has many bubbles, all of which dwarf the housing bubble burst of 2008. Indicators show that the next possible burst is the commercial real estate bubble. However, the main event on the horizon is the “bailout bubble” and the general world debt bubble, which will plunge the world into a Great Depression the likes of which have never before been seen.
Lloyds Banking Group on Wednesday said that the deteriorating state of its loan portfolio had caused it to recognise £13.4bn of impairment charges in the first half of 2009.
The bad and doubtful loan charges caused the partly state-owned bank to post a £4bn interim pre-tax loss on a pro-forma basis, compared with a £2.8bn profit in the first half of 2008.
Prompted by an FT article on banks’ excess profits arising from quantitative easing, entrepreneur and economist Toby Baxendale explains how QE widens wealth inequality and damages the economy.
Wall Street banks are reaping outsized profits by trading with the Federal Reserve, raising questions about whether the central bank is driving hard enough bargains in its dealings with private sector counterparties, officials and industry executives say.
The Fed has emerged as one of Wall Street’s biggest customers during the financial crisis, buying massive amounts of securities to help stabilise the markets. In some cases, such as the market for mortgage-backed securities, the Fed buys more bonds than any other party.
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“You can make big money trading with the government,” said an executive at one leading investment management firm. “The government is a huge buyer and seller and Wall Street has all the pricing power.”
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Larry Fink, chief executive of money manager BlackRock, has described Wall Street’s trading profits as “luxurious”, reflecting the banks’ ability to take advantage of diminished competition.
So said the FT yesterday, on the front page: the article is available here.
The essential thrust of the article is that the United States Government — via the Federal Reserve — has intervened in the securities market to buy various bonds in great quantity and with a level of transparency which enables sellers to “game the system”. Sellers charge excessive prices to which the Fed does not object, because the policy objective is to inject new money. In turn, Wall Street bankers are enjoying a bumper recovery in their profits through charging a clip on all transactions brokered.
Thus, not only have these banks been bailed out by the American taxpayer but, for a large part of their profits, they are on the Welfare State. Indeed the whole apparatus of Wall Street is looking like a giant department of the Welfare State. The bankers are prospering on the Welfare State of Credit.
This should come as no surprise to economists in the tradition of Hayek and Mises. The article makes no reference to the very destructive effects on the economy caused by creating money out of thin air to buy government bonds; it just highlights the fact that the governments’ agents in placing the money into the economy are the banks and bankers themselves. This must always be done at the expense of the general population and in favour of the first recipients of the money, i.e. those on whom the government spends the money and the bankers themselves.
Even if Congress backs the Paulson bail-out, the $700 billion blast cannot save the US, Britain or the world from the deepest economic slump since the Thirties. If Congress balks, God help us. The credit system is suffering a heart attack. Inter-bank lending is paralysed. Funds are accepting zero interest on US Treasury notes for the first time since Pearl Harbour, because no bank account is safe.
Prompted by an FT article on banks’ excess profits arising from quantitative easing, entrepreneur and economist Toby Baxendale explains how QE widens wealth inequality and damages the economy.