We are indebted to Ewen Stewart of Arden Partners for permission to publish his report: A Game of Two Halves – Equities to Win. Please see that report for full detail.
2009 was a remarkable year for the global economy and a remarkable year for equities. In this note we try to explain why 2009 turned out as it did and examine the prospects for 2010 and beyond.
We have called this note ‘A Game of Two Halves – Equities to Win’ because we believe that although the short-term trends for the UK economy are improving the longer-term forecast looks troubled indeed. Despite this, we believe the outlook for UK equities remains positive.
The first few months of 2010 may well surprise on the upside in terms of employment, house prices, consumer-spend and even, ultimately, GDP. But this is no ‘V’ shaped recovery.
We argue that trend growth, longer term, is likely to significantly disappoint. We argue that the UK’s superior growth, relative to many other developed nations, in the noughties was largely an illusion and we struggle to find the dynamo for growth over the next few years. We believe that the unwinding of the extraordinary fiscal and monetary stimulus, is a necessity, but will also be very difficult to achieve painlessly.
We believe the markets are still underestimating the structural problems with the public sector deficit and that politicians of all colours will be forced to deal with it. The consequences of not doing so would result in rising interest rates and a collapse in international confidence. The deficit remains the key issue for the UK and it may well bring substantial political challenges in itself. Indeed perhaps we should not have called this ‘A Game of Two Halves’ but a ‘Back to the Future – Welcome Mr Heath and the 1970s’?
Despite this, we are not bears of equities. It is true that current valuations are not particularly cheap by historic standards but the UK stock market is fairly defensive and internationally diverse. We believe equities look attractive against cash, bonds and, ultimately, real estate. We are concerned about a potential rise in inflation and again equities are a good hedge.
We have set a year end target of 5750 for the FTSE 100. Sector valuations do not follow a clear pattern and we believe this offers a number of anomalies. We have outlined our suggested sector weights below. As a generalisation, we seek overseas earnings – especially the US$, moderate leverage and strong cash flow as the place to be in 2010 with a return to M&A being more pronounced than perhaps expected.
The extreme cannot become the norm?
It may be a blessing that Ben Bernanke made the study of the 1930s great depression his speciality. We say may because, while the unprecedented global response undoubtedly has alleviated economic implosion, it does remain to be seen if the ‘nationalisation’ of deficits, the eclipse of moral hazard and the unique policy of both near-zero global interest rates and, in many parts of the globe, with quantitative easing (QE), has succeeded in sending growth back on an inflation-free growth projectory or whether the underlying malaise has been merely kicked into the medium grass. These issues are global, with substantial government deficits, trade and growth imbalances impacting upon different regions.
Source: Bank of England Stability Report, December 2009.
The economic policy reaction in the UK has been greater and more prolonged than any G20 nation, which is partially demonstrated by the chart above. The Bank of England cut interest rates to 0.5% (the lowest since the foundation of the Bank in 1694); 2009 saw a programme of QE to the tune of £200bn (equivalent to 25% of all outstanding gilt stock) and government spending was accelerated, despite plummeting tax receipts. The fiscal deficit is forecast by the Treasury to peak at 12.6% of GDP – a figure roughly twice as large as the UK’s 1975-1977 IMF crisis, and on a par with Greece.
Read on: A Game of Two Halves – Equities to Win
By way of nakedcapitalism.com this excellent article from washingtonsblog.com on “Fictional Reserve Banking”:
But whatever you think about fractional reserve banking, whether or not you agree with its critics, the truth is that we no longer have it.
As the above-linked NY Fed article notes:
In practice, the connection between reserve requirements and money creation is not nearly as strong as the exercise above would suggest. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels.
And as Steve Keen notes – citing Table 10 in Yueh-Yun C. OBrien, 2007. “Reserve Requirement Systems in OECD Countries”, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, 2007-54, Washington, D.C:
The US Federal Reserve sets a Required Reserve Ratio of 10%, but applies this only to deposits by individuals; banks have no reserve requirement at all for deposits by companies.
So huge swaths of loans are not subject to any reserve requirements.
Welcome to the new financial landscape…
We are grateful to Robert Arbon for pointing out this article on Greg Mankiw’s Blog:
I just returned from the spring meeting of the Brookings Papers on Economic Activity, where I was a discussant for Alan Greenspan’s new paper on “The Crisis,” which has gotten a bit of media attention. I thought blog readers might enjoy reading my comments on the paper. Here they are:
This is a great paper. It presents one of the best comprehensive narratives about what went wrong over the past several years that I have read. If you want to assign your students only one paper to read about the recent financial crisis, this would be a good choice.
There are, however, particular pieces of the analysis about which I am skeptical. But before I get to that, let me begin by emphasizing several important points of agreement.
To begin with, Alan refers to recent events in the housing market as a “classic euphoric bubble.” He is certainly right that asset markets can depart from apparent fundamentals in ways that are often hard to understand. This has happened before, and it will happen again. When the bubble bursts, the aftershocks are never pleasant.
This post is excerpted from Mises’ “The Causes of the Economic Crisis and Other Essays Before and After the Great Depression” which is available to buy here and download here. Both Andreas Acavalos and Toby Baxendale supported the production of this book.
On covering government deficits by creating new money (pp 2-3):
If the practice persists of covering government deficits with the issue of notes, then the day will come without fail, sooner or later, when the monetary systems of those nations pursuing this course will break down completely. The purchasing power of the monetary unit will decline more and more, until finally it disappears completely. To be sure, one could conceive of the possibility that the process of monetary depreciation could go on forever. The purchasing power of the monetary unit could become increasingly smaller without ever disappearing entirely. Prices would then rise more and more. It would still continue to be possible to exchange notes for commodities. Finally, the situation would reach such a state that people would be operating with billions and trillions and then even higher sums for small transactions. The monetary system would still continue to function. However, this prospect scarcely resembles reality.
On credit expansion by banks, its effects on the economy and the ensuing crisis (pp 113-115):
The crisis breaks out only when the banks alter their conduct to the extent that they discontinue issuing any more new fiduciary media and stop undercutting the “natural interest rate.” They may even take steps to restrict circulation credit. When they actually do this, and why, is still to be examined. First of all, however, we must ask ourselves whether it is possible for the banks to stay on the course upon which they have embarked, permitting new quantities of fiduciary media to flow into circulation continuously and proceeding always to make loans below the rate of interest which would prevail on the market in the absence of their interference with newly created fiduciary media.
If the banks could proceed in this manner, with businesses improving continually, could they then provide for lasting good times? Would they then be able to make the boom eternal?
They cannot do this. The reason they cannot is that inflationism carried on ad infinitum is not a workable policy. If the issue of fiduciary media is expanded continuously, prices rise ever higher and at the same time the positive price premium also rises. (We shall disregard the fact that consideration for (1) the continually declining monetary reserves relative to fiduciary media and (2) the banks’ operating costs must sooner or later compel them to discontinue the further expansion of circulation credit.) It is precisely because, and only because, no end to the prolonged “flood” of expanding fiduciary media is foreseen, that it leads to still sharper price increases and, finally, to a panic in which prices and the loan rate move erratically upward.
Suppose the banks still did not want to give up the race? Suppose, in order to depress the loan rate, they wanted to satisfy the continuously expanding desire for credit by issuing still more circulation credit? Then they would only hasten the end, the collapse of the entire system of fiduciary media. The inflation can continue only so long as the conviction persists that it will one day cease. Once people are persuaded that the inflation will not stop, they turn from the use of this money. They flee then to “real values,” foreign money, the precious metals, and barter.
Sooner or later, the crisis must inevitably break out as the result of a change in the conduct of the banks. The later the crack-up comes, the longer the period in which the calculation of the entrepreneurs is misguided by the issue of additional fiduciary media. The greater this additional quantity of fiduciary money, the more factors of production have been firmly committed in the form of investments which appeared profitable only because of the artificially reduced interest rate and which prove to be unprofitable now that the interest rate has again been raised.
Great losses are sustained as a result of misdirected capital investments. Many new structures remain unfinished. Others, already completed, close down operations. Still others are carried on because, after writing off losses which represent a waste of capital, operation of the existing structure pays at least something.
The crisis, with its unique characteristics, is followed by stagnation. The misguided enterprises and businesses of the boom period are already liquidated. Bankruptcy and adjustment have cleared up the situation. The banks have become cautious. They fight shy of expanding circulation credit. They are not inclined to give an ear to credit applications from schemers and promoters. Not only is the artificial stimulus to business, through the expansion of circulation credit, lacking, but even businesses which would be feasible, considering the capital goods available, are not attempted because the general feeling of discouragement makes every innovation appear doubtful. Prevailing “money interest rates” fall below the “natural interest rates.”
When the crisis breaks out, loan rates bound sharply upward because threatened enterprises offer extremely high interest rates for the funds to acquire the resources, with the help of which they hope to save themselves. Later, as the panic subsides, a situation develops, as a result of the restriction of circulation credit and attempts to dispose of large inventories, causing prices [and the “money interest rate”] to fall steadily and leading to the appearance of a negative price premium. This reduced rate of loan interest is adhered to for some time, even after the decline in prices comes to a standstill, when a negative price premium no longer corresponds to conditions. Thus, it comes about that the “money interest rate” is lower than the “natural rate.” Yet, because the unfortunate experiences of the recent crisis have made everyone uneasy, the incentive to business activity is not as strong as circumstances would otherwise warrant. Quite a time passes before capital funds, increased once again by savings accumulated in the meantime, exert sufficient pressure on the loan interest rate for an expansion of entrepreneurial activity to resume. With this development, the low point is passed and the new boom begins.
Via James Tyler and zero hedge, The Fastest Growing Export of the Western Banking Industry is Fraud:
Politicians and bankers would do well to head the more than 200-year old words of Patrick Henry in his infamous “Give me liberty of give me death” speech:
“Mr. President, it is natural to man to indulge in the illusions of hope. We are apt to shut our eyes against a painful truth, and listen to the song of that siren till she transforms us into beasts. Is this the part of wise men, engaged in a great and arduous struggle for liberty? Are we disposed to be of the number of those who, having eyes, see not, and, having ears, hear not, the things which so nearly concern their temporal salvation? For my part, whatever anguish of spirit it may cost, I am willing to know the whole truth; to know the worst, and to provide for it.”
Today, if politicians and bankers merely channeled the same amount of energy that they expend in deceiving the people into fixing the monetary system, then perhaps they would have already come up with a viable solution by now. To have the slightest fighting chance of resolving this crisis with a solution that benefits the people, politicians and bankers must be courageous enough to tell the public the worst of the truth and to provide for it. But fraud, and perpetuation of an illusion seems to be their only concern today. And with good reason. After all, as illustrated by a recent Center on Budget and Policy Priorities study, they are the only ones benefiting from this fraud. From 2002 to 2007, the top 1% of Americans captured nearly 70% of the income gains in America. Today, in my opinion, today, the number one reason why the vast majority of people still cannot except the possibility that we will soon enter into a second phase of this global economic crisis that will prove to be far worse than the financial disruptions we experienced in 2008 is the following: Most people alive today have no memory of the Great Depression. For those that do, certainly they are able to identify with much greater clarity, the similarities in the patterns of fraud back then and the patterns of fraud occurring today.
A bank , building society that uses factional reserves, lends long and pays out short is only going to exist should confidence be kept in it. The “Run on the Rock” in the summer of 2007 saw people queuing to get their cash out of the Northern Rock which resulted in the first systematic run on a bank since the 1866 run on the Overend, Gurney & Company bank in the UK.
Readers of this site will know that a bank can only exist with the legal and accounting privilege that allows them to use current creditors – i.e. the depositors of the Presbyterian Mutual Society (PMS) – to lend out a multiple number of times to property loans and other entrepreneurial loans. Readers will also know that when they deposit money they in effect lend it to the bank and become a creditor to the bank. A deposit of cash into a bank/Mutual means you as the depositee lend money to the bank/Mutual That is, to be very clear, when you deposit, you cease to own the money – the bank does. This was established by law in 1811 in Carr V Carr and reaffirmed in Foley V Hill 1846.
The Society’s audited accounts for the year ended 31st March 2008 showed £305m of loans and £5m of liquid assets to pay up to £310m on demand deposits. So one can deduce that there was only £5m of cash supporting £310m IOUs to its creditors, the depositors. This means that the PMS multiplied its credit creation to the tune of 62 times! This is nearly twice the average of all the banks licensed by the Bank of England. In fairness to the Society, they did pay out £21m before they were left with only £5m of cash, so £26m of cash was in their vaults when the run happened. Thus a more conservative 12 x credit was created out of thin air or a leverage ratio of 1 part cash to 12 parts credit existed in this Society.
A quick refresher on how the banking system allows this creation of credit out of thin air can be found here http://www.cobdencentre.org/2010/02/a-day-of-reckoning/ where I say, “ It is often forgotten but when you place £1m in a savings account (in cash) in say the Royal Bank of Scotland, which has no legal reserve requirement, they then lend £970k (in credit) , keeping on average 3% of cash back in reserves, to an entrepreneur in say HSBC, who then deposits that money in HSBC. We now have one claim to the original £1m and one claim to the £970k. The money supply has moved from £1m to £1.97m – just like magic! This is credit expansion.
The reality is that across all the banks in the United Kingdom licensed by the Bank of England, we have for every £1 of money (in cash), £34 in claims to money (credit)!”
The Administrators’ report tells the sorry story of events in summary which I list underneath, but one glaring fact is omitted. This is that the very Government of the UK actually triggered the loss of confidence in this Bank. When our Prime Minister in his own words was “saving the world” he ordered a full guarantee , government backed, on all deposits. The PMS, which had 10,000 members, went into administration following a rush by savers to withdraw their money at the height of the banking crisis in October 2008. People withdrew their money as they learned the Society was not covered by the government’s bank deposit guarantee scheme. Previously they were content to leave their money in the Society. For the purposes of this article, it is not needed to debate the point: was it or was it not a bank that should have been supported by this guarantee? The salient point being that not being guaranteed scared people into making withdrawals where little existed before.
From the Administrators’ report of the12th January 2009 that can be down loaded here http://www.presbyterianmutualsociety.co.uk/files/Administrator’s%20Proposals%2012.1.09.pdf the Society was placed into Administration by the Directors on 17th November 2008. The following are selected quotes from this report which speak for themselves:
“the demand for withdrawals by members of their investments exceeded its cash reserves;”
“the members’ investments were historically withdrawable on demand but the cash was invested by the Society in longer term investments such as property and loans.”
“For the Society to allow members to withdraw their investments on demand and invest members’ money in longer term investments, the Society required a high degree of confidence among its members that their investments were secure. However this confidence has been severely tested by the current economic climate and eventually the demand by members for withdrawals exceeded the Society’s cash reserves. …I believe it will be difficult for the Society in its current form to continue as a going concern.”
“loan capital will be treated as creditors and will therefore be paid in preference to members’ shares.”
As you will be aware the Society does not benefit from the deposit guarantee scheme.
During the month of October 2008 the Society experienced an unprecedented increase in the number of requests for repayment of members’ investments. It was common practice for the Society to repay investments on receipt of a request, and payments of £21 million were made up to Friday 24th October 2008, leaving £4 million in the Society’s bank account.
An emergency meeting of the Society’s Board of Directors was convened on 25th October 2008 and it was resolved that:
…the 21 day notice period for the repayment of members’ investments be invoked in respect of requests received from members as at that date and any new requests received from members.
On 6th November 2008 the Society’s Board of Directors met again and it was reported that the demand among the Society’s members to withdraw their investments had increased which further exacerbated the Society’s liquidity. It was also reported at this meeting that legal proceedings had been commenced by three members seeking repayment of their investments. It was resolved by the Society’s Board of Directors on 6th November 2008 that the Society should be placed into Administration so that its assets could be protected, subject to enabling legislation being passed to permit the Society to go into administration.
During the period 27th October 2008 to 17th November 2008, the Society had received requests for withdrawals in excess of £50 million but the Society had cash reserves of only £4 million to meet such requests.”
Now this would have been the story of every bank in the UK if the government had not acted as it did as we were ‘panicking’ as a nation. We should also note that all banks are in the same precarious situation as the PMS was with regard to lending long and paying out short still, to this day. Do we need to live like this?
The Future Safe Way to Run Banks and Provide Interest for Savers and Lending to the needs of Trade.
If banks were mandated to hold 100% reserves of cash in their vaults, they could issue their bank statements saying what they owe you each month and you would know that you actually had cash in the vault to support your deposit that is represented by your bank statement. The bank statement after all is only a thing that would more accurately be called a “bank IOU statement.” Should you want interest you could ask for the cash you have deposited to be placed in a highly liquid government bond that could be converted into cash when you need it, paying you a rate of interest. Should you want a higher rate of interest, you can lend your money i.e. cease ownership and place in a bond that has in turn been lent to an entrepreneur for 6 months, 1 year, 2 years, 3 years, 5 years etc with the highest rate of interest being given for the longer term locked away and lent to somebody.
The Solution for Paying Out 100% of the PMS Depositors’ Lost Money- £310m – Now, Today
Following the work of 5 Nobel Prize winners and the founder of the American Chicago School, I would suggest the following written about in the Day of Reckoning article;
The Bank of England immediately issues notes to cover all the deposits i.e. redeem all the depositors for 100% cash notes and coins to be placed in their accounts. Please note, this costs the Bank of England the price of paper and the ink and nothing else and IS NOT INFLATIONARY and generates no liability to the UK taxpayer – see next point.
At the same time, get the administrator of the PMS to delete all current creditors (the depositors) as these have now been redeemed from the bank’s books by the Bank of England. The deleting of these bank obligations means that the money the depositors did lend on deposit to the PSM no longer exists, so for the sake of argument, if there was £310m of deposits, these have been redeemed in cash by the Bank of England and the equivalent amount of deposits have been removed from the money supply. Cost to the Bank of England = zero and cost to the UK tax payer = zero. Money supply stays the same.
The PMS in administration now has only assets i.e. loans from entrepreneurs /people who are repaying the loans or mortgages. These can now continue to get repaid, but instead of paying the creditors of the PMS, there are now none, so these loans can go into paying off the National Debt.
This way all parties win.
A courageous politician in Northern Ireland or in mainland GB could well put forward a Private Members’ bill which could be the first legislative move to establishing Honest Money.
The Day of Reckoning article linked to above provides the start of the legislative solution to the whole UK wide banking system whose model is sadly no different to that of the little PMS.
I went to this event today.
“22/02/2010 – Ideas Space
Quantitative Easing: Friend or Future Foe?
The Bank of England entered unchartered territory in January last year when the Treasury authorised it to begin a radical monetary policy experiment that we now know as “Quantitative Easing”. Given the unprecedented monetary conditions resulting from the liquidity crisis, the Asset Purchase Facility has been welcomed with open arms, and now stands at almost £200bn invested in UK gilts and corporate debt. But has QE had an economic impact to match its political use? Will the cure prove as dangerous as the disease? How and when should the Bank close the lid on this potential Pandora’s Box?”
Several leading economic figures including Roger Bootle, Tim Congdon and Allister Heath, chaired by Policy Exchange’s Chief Economist, Andrew Lilico, will debate and discuss the merits of quantitative easing, the exit strategies for the Bank of England, the main challenges the UK’s economy will face as a result of the program in 2010 and beyond, and how policymakers should face them.”
These are my notes:
Tim Congdon spoke first , this basic message was that unless money supply, primarily bank deposits, is kept very tight and only moderately growing, there will be trouble ahead with boom or bust. QE has kept the economy on the road and the money supply has not fallen. He acknowledges that there were some problems in measuring this.
Roger Bootle second, he opened by accusing one of our columnist, Liam Halligan of being intellectually devoid of any understanding of economics as he viewed Liam’s world to be predicated on massive inflation and a bond strike and this would never happen. He also said that QE could happen an infinitum. I tell no lie, this is what he said. In fact he was of the view that this should go on and on for whatever amount of time until we were out of trouble. People needed to believe that this policy was going to be the policy that would sort out the economy and indeed he agreed with Krugman, that crude of all the crude Keynesians, that Japan had actually done too little to stop the ongoing deflation. The UK’s risk was never going to be inflation but deflation.
Allister Heath opened with saying he reluctantly supported QE as the key thing was to stop a monetary deflation but questioned why we were having a debate in the first place about the merits of QE and should we do more etc when we should be questioning why do we inflation targeting ? As this has given us the biggest boom and bust in living memory should we not dispense with this independent Bank of England , FSA and other so called control bodies and centralise further into one overall controlling body that controls the broad money supply?
I was utterly bemused by all this tosh spoken in the name of economics with glimmers of hope only coming from Allister Heath.
The chairman asked three questions and the audience were asked three questions with one follow up.
I asked “in business I create wealth by making my factors of production work more efficiently to produce more goods and services. I invariably have to lengthen the structure of my production by saving and investing this money in new and more efficient kit to produce more of my goods and services for better prices and service level for my customers. With those goods I can exchange them with other entrepreneurs, shop keepers etc for my basic food, rent for my roof over my head etc via the medium of money. Money is bits of paper in this country and an electronic bank deposit, so having more of the bits of paper and banks deposits to exchange for the same goods and services would only mean my purchasing power had been debased, so no wealth would have been created. I thought this question go to the heart of the matter.
The second was about bond yields – had they or had they not moved up or down.
The third as about what the panel thought about the questioner’s view that we could only get out of this mess via and export related recovery.
Peter Bottomley asked a question that I cannot remember.
The Chairman then had another round of questions.
Mine was relegated to the bottom by the Chairman. Roger Bootle thought it should be answered by Tim Congdon and in the end Allister Heath did give an answer which acknowledged that no wealth could be created by paper alone and that there was a large body of work in Mises and Hayek showing that the creation of credit causes boom and bust . He was reluctant to support QE as it at least kept money supply near static as opposed to imploding, but saw no ability for it to create wealth . I was not allowed time to debate this with Allister , but did mention afterwards that as he said to me, the Austrian School was divided between those who would support a printing of money to offset a fall in V and those who would just advocate a deflation to allow the market to clear at new lower prices. Having to go I should have added, there is a third camp based around the Cobden Centre who would advocate 100% reserves as this would fix the money supply and you can never have a run on the bank with 100% reserves in place. This is explained here http://www.cobdencentre.org/2010/02/a-day-of-reckoning/ .
Allister framed his discussion in the mainstream language of the Quantity Theory of Money, more I suspect to engage with his fellow economists rather than he having any belief in it being more than a tautology. For a refutation of the Quantity Theory see here http://www.cobdencentre.org/2009/09/qe-errors/ . I did point out at the end after the event had finished that if V went down, how could me selling a house to someone, real bricks and mortar exchanging for money and having it sold back to me for the same 10 times create any wealth? Yes we can increase the velocity of the circulation of money by doing daft things like I describe, but Allister accepted nothing like wealth creation will come of it.
The medium of exchange will not create wealth on its own. It is not wealth. If you hold these bits of paper you hold claims to wealth. The retained goods and the savings we have are wealth. The whole capital infrastructure of our companies and private balance sheets are wealth . This infrastructure drives wealth creation via the dynamic entrepreneurial spirit of men of action who mix the factors of production into the most efficient combinations to satisfy the most amounts of needs. No small matter of printing paper that facilitates exchange or adding electronic reserves to banks will make that wealth creation process any easier. The second part of this article explains how wealth is created http://www.cobdencentre.org/2009/09/can-the-manipulation-of-interest-rates-create-wealth/ .
A poor day for economics!
Via Darius Guppy: our world balances on a sea of debt
What is needed is a root and branch re-evaluation of that most curious of cultural inventions – money, argues Darius Guppy.
See the enclosed article above, it could be written for this site.
I am delighted by the comments that show more and more people are questioning the madness of fractional reserve banking.
Soddy was our first Nobel price winner to suggest 100% reserves as a solution and I am delighted that Guppy is aware of this academic and his work.
BJ’s excellent article today rightly draws comparison between the bailout of Greece and the bailout of Northern Rock.
He makes the excellent point that we should be grateful that the myth of monetary union without federalism is now starkly exposed.
His own shortcoming is that he does not quite understand the seriousness of the banking crisis and therefore his article ends at the crisis point with no solution apparent to the UK’s Greeklike problem, other than the implied debauching of the currency.
Without reform along the simple lines advocated by the Cobden Centre I fear that, even outside the Euro, the banking system may crash again.
Dowd, Alchemists of Loss
We are delighted to announce a forthcoming book by Cobden Centre Senior Fellow Professor Kevin Dowd and US-based journalist and former investment banker Martin Hutchinson: The Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System. The book contains some delightfully simple insights into a complex subject. For example:
The credit default swap sneaked up on everybody, becoming a $62 trillion market, without anyone outside the business knowing much about it. As the Bear Stearns, Lehman and AIG debacles revealed, these instruments also involved highly non-transparent credit risks of their own. As a holder of a CDS you don’t know whether your counterparty has issued only a few of your CDS, in which case you’ll probably get paid in a bankruptcy, or whether he has issued fifty times the outstanding debt you’re trying to hedge, in which case you’re unlikely to get paid.
Financial engineering’s benefit to the global economy is highly questionable and the proliferation of financially-engineered products of recent years has brought few benefits and led to huge losses for society at large. As we have seen, one quarter’s bad losses in late 2008 wiped out all the accumulated financial engineering profits of the last quarter century and saddled taxpayers with a bill for hundreds of billions, if not more.
Prof. Dowd has kindly agreed to pre-release two chapters through The Cobden Centre:
From Chapter 16:
Alert readers will have already picked up some of the advice we would give investors and clients of financial institutions:
- take a longer-term perspective and return to investment rather than speculation;
- do not seek to ‘enhance’ yields, because this always exposes investors to hidden costs and risks, whilst firms seeking finance should resist cutting corners on their financing costs, for the same reason; thus, both parties should be realistic in their expectations;
- avoid frequent trading, focus on static over dynamic strategies, buy and hold over activist portfolio management;
- pay more attention to costs and hidden charges, and work on the assumption that higher charges are usually a good signal of a bad deal;
- distrust commission-based salespeople;
- if you use derivatives, be clear why and use them only for risk management and not speculation;
- avoid complicated opaque products; and
- do not take liquidity for granted and ensure that your liquidity is protected in a crisis.
Besides this motherhood and apple pie stuff, investors should also be careful of correlation-based investment and risk management strategies, which work well when not needed but are apt to break down when they are. This is not to suggest that they should give up on diversification. People understood diversification long before Modern Portfolio Theory, but they tended to practice it differently and more wisely. Diversification was assessed by committees of experienced practitioners, who took a long-term view and relied on their judgment rather than unreliable correlation estimates – a far cry from modern practices of modern fund management, with its obsession with short-term performance assessment
Investors should demand transparency. Perhaps the most sobering lesson we have learned since the subprime crisis broke is the benefit of transparency in business dealings. Time after time, when a fiasco has occurred, a key contributing factors has lack of transparency. Subprime mortgages, CDOs and credit default swaps were all financial innovations that relied crucially on nobody asking too many questions. So too with the vast Madoff Ponzi scheme, involving some of the most sophisticated investors in the world, which rested on the same fatal human omission.
Download Chapter 16 to read on.
From Chapter 17:
The restoration of a rational and stable financial system inevitably requires major reform on a number of fronts. History gives much guidance here and also a role model: the period we should seek to emulate is the nineteenth century. Then money was sound, the dominant currency of the time, the pound, was literally as good as gold, while financial institutions were conservative and generally stable, and an altogether healthier financial ethos reigned.
It is very common these days to sneer at the gold standard: after all, it was Keynes who once dismissed it as “a relic from a barbarous age”. We would suggest, on the contrary, that a gold standard or some suitably 21st Century commodity equivalent would be highly desirable, and put an end to the disastrous century-long experiment with fiat money and its attendant miseries of inflation and monetary instability. The fact that Keynes opposed the gold standard is a further reason to support it.
The nineteenth century model would also entail major reforms to financial institutions and the regulatory system: greater liability and greater responsibility, the repeal of deposit insurance and investor protection legislation and the abolition of the big financial regulatory bodies such as the SEC and FSA. And by nineteenth century standards, we really mean early nineteenth century standards, those that pertained to the period before the Bank Charter Act of 1844 and the Companies Act of 1862, when liability was very real.
As for the banking system, we would suggest that the role model is Scotland pre-1845, when the Scottish banking system was virtually free of state control, unhindered by a central bank, and equally admired and envied across the world – and copied by countries such as Canada and Australia. In all three countries, free banking systems operated highly successful for very long periods of time. Indeed, the Canadian system was widely admired in the United States – and many US reformers in the late nineteenth century saw it as their ideal. The Canadian system was highly stable – apart from the failures of two small Alberta banks in 1985, its last notable bank failure was that of the Home Bank of Canada back in 1923. There were no Canadian bank failures in the 1930s and, even after the establishment of the Bank of Canada in 1934, many still regard the Canadian banking system as the best in the world.
Our first choice environment would be one with a commodity standard, free banking (no central bank) and financial laissez-faire, restrictions on the use of the “limited liability” corporate form and the most limited government. Even if we don’t return all the way to these early nineteenth century standards (and we can imagine the opposition!), we should still move as much as possible in that direction, though we would not advocate the reintroduction of the notorious debtors’ prisons immortalized in the fiction of Charles Dickens! However, our proposed reforms herein are adapted to the “second best world” (if it’s actually that; it may be about thousandth best of all the ‘parallel universe’ possibilities) in which we live, with relatively large government, a fiat currency and a central bank.
The most important institutional policy that must be solved is that of an excessively expansionary monetary policy. Simply making the monetary authority “independent” does not achieve this if the monetary authority retains its interactions with politicians and the financial community, both of which want loose money. The ideal to aim at is a hard money Fed, a Paul Volcker Fed.
Download Chapter 17 to read on.
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- Huerta de Soto, Money, Bank Credit and Economic Cycles
- Baxendale, A day of reckoning: how to end the banking crisis now
- What is wrong with banking, part 1: the legal nature of banking contracts
- Frank Whitson Fetter, Development of British Monetary Orthodoxy 1797 – 1875
- F. A. Hayek, Denationalisation of Money: The Argument Refined
- Gordon Kerr, How To Destroy the British Banking System and Bailing out the Banks – Glaring Evidence of Moral Hazard
- James Tyler, My Journey to Austrianism via the City, Money is not working and How to avoid future encounters with financial meltdown
- Irving Fisher, 100% Money, 1935