Lehman Brothers’ collapse in 2008 was intended to intended to teach financial markets that they could not rely on an implicit government guarantee for too-big-to-fail (TBTF) banks. What bondholders learned was the opposite: never again would an institution of that size be allowed to collapse because of the de-stabilizing effect on the entire financial system.
Rescue of Dexia by French, Belgium and Luxembourg governments is the latest example. Bond-holders received 100 cents in the dollar/euro. Markets are just too fragile to consider giving bondholders a haircut. Denmark earlier had to back down from forcing haircuts on bondholders when Danish banks found themselves shut out of funding markets. [WSJ]
Frequent calls for TBTF institutions to be broken up have proved ineffective. Instead the problem has grown even larger with post 2008 rescue/take-overs of Countrywide and Merrill Lynch (BofA), Bear Stearns and WaMu (JPM), Lehman (Barclays), and Wachovia (Wells Fargo) reinforcing Willem Buiters’ survival of the fattest observation.
Proposals to reduce systemic risk through adoption of the Volcker Rule, which would prevent banks form trading for their own account, are proving difficult to implement. The 298-page first draft offers few clear definitions of restricted activities, instead calling for suggestions or feedback.[Bloomberg] Drafters should consider turning the rule around, offering a list of approved activities that banks can pursue, rather than attempting to define what they cannot. I have great respect for banks’ ability to find loopholes in any restrictive list.
The Rule on its own, however, cannot protect taxpayers from future bailouts. It does not prevent banks from over-lending if there is another bubble. There is only one solution: increase capital ratios — and apply similar ratios to securitized assets. Increases would have to be gradual, as some banks could respond by shrinking assets rather than raising capital — which would have a deflationary effect on the economy. Changes would also have to be sensitive to the economic cycle. The easiest way may be to set a long-term target (e.g. 20% Tier 1 + 2 capital by 2030) and leave implementation to the central bank as part of its monetary policy.
Together with the Volcker Rule, increased capital ratios are our best defense against a recurrence of the GFC.
At the end of the day someone is going to have to take the haircut. Shuffling the debt around is akin to playing musical chairs with a hot potato. And when the music stops, as it surely will, we all know the buck will stop with the humble tax payer (again)!
Have you ever considered the possibility of the nationalization of the banking sector? I think that money in private hands always will be a risk.
A banking sector run by government is even worse than one run by the private sector. The best is private sector banks but with strict government regulation.
**Free Market Instability and the Correct System of Stabilization**
Before we can examine the correct system of stabilization for a free market economy we first need to observe exactly what a free market economy is and the reason behind the current market instability.
**The free market system of economic government**
For a quick recap, a free market economy is one where every market participant is completely free to buy or sell whatever they want for any price they can agree on, without any influence or control by the government. It is essentially millions of people trying to gain the best deal for themselves they possibly can by trading goods and services.
The theory behind it is that if every individual attempts to gain the best deal for them self then the market will self regulate as buyers will not accept a price that is too high and sellers will not offer a price that is to low, thus keeping the prices in a stable range and pushing demand away from scarce goods (as they will become too expensive) in favor of more plentiful ones (which are cheaper), thus promoting extra production of goods with higher demand (as the profits become more attractive) and less production of goods with lower demand (as the profits decline), etc etc…
That is the free market system of economic government in a nut shell.
One of the main benefits promised by the free market system is that their is no central control (and no opportunity for corrupt governments to profit at the expense of ordinary citizens).
One of the main selling points for the free market theory was economic stability.
The alternatives to a free market approach are differing levels of ‘fixed price’ markets, where the government decides what people buy and sell and how much they pay for them. This system is wide open to dishonest conduct by those who set the prices, decide what is on sale etc… and is therefore less desirable than a free market system of government.
The theoretical benefits from a free market system of government are huge and individual freedom ordinary citizens enjoy today is largely dependent on it, but it does have one major weakness:
**The weakness of the free market system of government**
The weakness of the free market system of economic government is this: Individual free market participants can be deceived, or mislead, (by the government, or big corporations, through the mass media) into acting directly ‘against’ their own best interests.
As the free market is dependent on people acting ‘in’ their own best interests for stability we can see that their is a major problem here. This problem of public deception we are currently living under is what I call a deceived market.
**The Deceived Market**
Examples of a free market participant being deceived into acting against their own best interests:
a. Toxic sub-prime mortgage debt being cut up and sold as AAA securities to the government of Iceland. No explanation needed here.
b. Inflation figures being manipulated by the world governments to suit their desired monetary policies. This inflation figure means one thing one day and another the next dependent on what the government wants the country to do.
Food for thought: The invisible hand of the market (as Adam Smith famously put it) is defeated by the invisible tax of inflation.
This kind of deception is how all free market instability is created.
I would say that the stability the classical theory of free market enterprise promises is entirely dependent on every market participant successfully acting in their own best interests, all the time.
With the current levels of public deception right now I think this point deserves an extra moments consideration!
If a person buys when it is in their best interests they should be selling then the market will be pushed in the wrong direction. If an enormous majority buys when everybody’s best interests is to sell then we are setting up for a major catastrophe.
**The correct government of a free market economy:**
As we know, in order for a market to be a free market their must be no direct government intervention.
Therefore: the only method of regulation available for the government to use is what I would call ‘Information Based Regulation’ (Info-reg).
Info-reg is simple really: inform ordinary people of what is going on in such a way that they are able to make good decisions about what is in their own best interests.
This market sanity can be achieved through the use of “Free Market Economic Indicators”.
**Free market economic indicators**
If we want to call an economic indicator a free market economic indicator it must make easy sense to all market participants. Or in other words it must be possible for a straight-d maths student who left school at 15 to be able to figure out what is going on in the economy.
Inflation as an economic indicator fails in this respect as it doesn’t tell people what is happening to the value of their savings accounts, instead it just explains what is happening with the money supply for the whole country, and its method of calculation is always being altered to suit the policy decisions of the day.
Because of this level of complexity inflation is a controlled market economic indicator.
This is just one example of complex economic indicators that deceive the market into becoming unstable. But just as instability is caused by deception, stability is created by honest, understandable information.
**Construction of a Free market Economic Indicator:**
If an economic indicator is going to make sense to everybody in society it must be easy to understand, and it must also be relevant to everybody.
Therefore we need to begin by creating an index about something that everybody has to pay: the most basic cost of living.
**The Poverty Line Index**
This index measures the changing cost of life on the poverty line for a standardized family of 4.
Take the average cost of the cheapest 2 bedroom flat, enough food needed for the average 4 person family to stay healthy, power for heating and cooking, etc.. but nothing in the way of common luxuries.
If one week costs $200 at the start of the year and $300 at the end of the year we can all see exactly how much closer to the poverty line we are now at the end of the year compared to the start of the year.
Motivational information indeed.
**The dollar value index**
This index tells people how long a certain amount of money (say $1000) will pay for life on the poverty line.
Using the cost of our standardized family of 4 living on the poverty line, measure the changing amount of money need to pay for this over time to make an index.
If $1000 buys 2 weeks on the poverty line for our family of 4 at the start of the year and at the end of the year it buys 1 week of life on the poverty line then we can all see that our money (in the bank or being paid as wages) has lost half its value over that time due to government money printing.
[As opposed to deceiving people into thinking their wages are just as good as before but the cost of living has mysteriously risen]
**Consumer Power Index**
This measures the changing ability of individual consumers to buy goods and services.
Take the amount of money the average wage earns in 40 hrs and subtract the cost of one week on the poverty line, for our standardized family of 4, and what is left is the consumer power value.
Make an index of the changing power of the consumer so that people can see whether they should be spending more or less on luxuries.
**Stabilization of the housing market using Info-reg**
Create an ‘average wage vs the average house price’ index.
Like with the dollar value index this will tell how affordable housing is for the average wage earners in a country and show how home affordability is changing over time.
If the entire house buying population can see that the average wage can only afford a house in the cheapest 25% of houses on the market today then massive speculation on further increases in house prices will look like a bad idea to everyone, and even tho people are feeling irrational exuberance from any recent house price rises the market will not scream higher on hot air.
In an environment of perfect economic clarity (sanity), where every individual house buying member of society can see exactly what a house is really worth, a Housing Price Bubble could never form.
**The Alternative**
The world has been stuck in a tussle between free market capitalism and dictatorial socialism for the last 250 years and if the free market fails again (like it did in the 1920’s) then we will surely fall back into a destructive cycle of socialism once again. If history is any guide to go on then a ‘Third-World’ war could quite possibly ensue if another crazy dictator gets control of a major world power.
Without economic sanity (through honest economic information) the free markets of the world will continue to run wild and cause havoc…. and the control freaks will most likely take over once again.
**The goal of Socialism delivered by a free market economy**
In my humble opinion: The only way everybody in society can live in freedom and prosperity, at the same time, is through the use of ‘Free Market Economic Indicators’.
Tell all the citizens what is really happening to their money and the Free Market will allocate resources to those who need them in the most efficient way possible. In this way the main goal of Socialism can be achieved without any central control (or the loss of an individuals freedom to determine their own financial destiny).
People too often confuse a free market with an efficient market. They are two different animals entirely. Not all free markets are efficient and not all efficient markets are free. Some degree of regulation tends to improve market efficiency.
Yes you are right. Like rules of the road. Financial risk limits and no-lending zones etc….
A good example of Information Based Regulation is the disclosure requirements for financial planners and investment advisors in Australia. Nice idea but it doesn’t work. Disclosure documents can run to 40 pages or more. How can the man-in-the-street make sense of that? A system that works is the health warning on cigarette packaging: a simple graphic image is far more effective than a 40-page document.
Essentials Index
The average cost of life’s essentials rose by 34% in July..
Dollar Power Index
The amount of essential goods one dollar buys fell by 22% in may..
House Affordability Index
The cost of the average house rose to 248% above what the average wage can afford..
Good stuff Colin! Maybe it’s just a case of ‘TOO BIG TO FAIL….TOO BIG TO BAIL”. Well, at least it rhymes! However, continuing the rhyming theme….are they too big to NAIL?? Yes, probably, as it’s always back to the ruthless, greedy and unscrupulous end of human nature. This occurs, equally, at either end of the natural distribution (bell) curve. White collar criminals at one end and blue collar criminals at the other.
BOTH cost society, and hence the taxpayer, a fortune because of the need to constantly bring out legislation and regulation to combat their misdemeanours and excesses. This then instigates the need for institutions like the police force and specialist government departments, like the Financial Services Authority (FSA) in Britain, in order to monitor and control them.
Probably, white collar greed and ruthlessness is the MOST dangerous end as it threatens and endangers ‘good capitalism’. Sadly, these types can’t think ahead and just don’t care.
It’s not just bankers either; it’s also corporate industries. Somehow their CEOs have managed to persuade themselves and others that they are worth up to 100+ times!!! what average people are worth. These irresponsible, selfish idiots should also be under the media microscope. Unlike entrepreneurs (who deserve any wealth they make) they have no great talent and take no personal financial risk….they just play act their role in the Corporations. I have often thought about this and I always fail, miserably, to work out how they can value themselves as they do on any normal decent basis of hours worked, intelligence, knowledge, company size etc. These parameters are a not, for some mysterious reason, applied to the income of those at lower levels in the same company! 🙂 The very best figure I arrive at is between 2-10 times the average person.
Even the CEOs of charities often have £1m+ salaries too!!!…..I could go on…… 🙂
Apologies for the ‘soap box’ moment. 🙂
Thanks Colin, for the open discussion forum about money, western style. Irrespective of what the goodies and baddies do, money shall be valued at whatever the respective countries GDP is. Notice the the word ‘is’ holds to the state of present tense, which is crucially important.
Nobody talks about the value of money in present tense, but it has exactly the value of whatever a country is producing now. Imagine that Australia stopped all production, because we felt like doing it. We produced absolutely nothing for 1 month. What would the value of our dollar be during this time period? I expect it would be valued around 2 to 3 cents in the dollar, tops.
If you are not negociating a higher value to the Aussie dollar in the above extreme conditions, consider my point. The point is that all of our super, savings and property values are dependent on what producers do now. This is so for the banks, government and service people.
I’m saying that the people and businesses involved in actual production of physically solid products, substanciate the value of the Australian dollar. The fears of government people, market traders, bankers and various parasites in the production of physical substances, may ‘bugger up’ our production procedures? But I can garantee that we will do what we understand and trade for what we make, no matter what our dependents do. Fix your monetry stupidities, if you can. Australian production businesses are going to make money, no matter what.
You are right that exchange rates are determined by supply and demand, but that is not just trade-generated (import/export) demand. There is also speculative demand and long-term capital flows.
The only solution is NO BAILOUT BY TAPAYERS, the GOLD standard (a la Utah) and govt. stop interfering with the market.
Could not agree more. The TBTF banks have become essentially socialists… if they make screw up the taxpayer bails them out…if they are wildly profitable they are then capitalists. The CEO of BA essentially said as much when he defended the much maligned debit card fee saying, “We have a right to make a profit.” Actually they have a right to compete for profits and if they are unsuccessful they should not be able to hold the taxpayer hostage as an entitlement.
Better capitalization ratios would help prevent that.
You are right on the money, Colin.
Thanks for doing a great job with your technicals newsletter.
Enjoy your rare but insightful comments on the fundamentals too.
Capital ratios are only relevant to the gearing ratios.
Regulating risk profiles for banks and their exposure to naked or semi funded derivatives may help minimise future solvency issues.
European banks were geared 50 times prior to 2007.
Specific asset class deflation smashed them.
Regulation will probably never get up in my view especially while the likes of Tim Gietman hop from the regulated to the Fed ..
Lobbiests and greed make the sandwich we all eat and insisting on more bread won’t stop the choking.
In my view.
See Causes of the Crisis: Basel II
What I would like to know is who are holding the other side of all the debt in the planetary financial system. All money is borrowed from the banks , a system started around three hundred years ago.There are only two ways forward from here that can improve thing for the 99%. Either some of the money created from thin air is written of and re loaned, or .the 1% stop investing and start spending in a way that will employ all those who want to work.
All money is created by banks out of thin air. The debt burden is no longer sustainable in shrinking ( western) economies. The lenders must write of some of the debt , or start spending some of the trillions they are sitting on. If not the fractional reserve system that has worked relatively well for the last three hundred years will seize up and no one will be big enough to bail it out.
Alternatively, raise bank reserve ratios and limit new debt creation. The risk is deflation which would cause a total collapse of the banking sector, so we have to apply this gradually. Writing off debt will also wipe out the banking sector — which would bring down Main Street.
Hi Colin
The point I was trying to make was that the main problem with the system is that the 1% ( to use a phrase) have cornered most of the worlds productive capacity and cash assets. What you suggest will help, but will do nothing for the base flaw in the fractional banking system which is concentration of wealth. History ( including today ) is full of examples where the dis possesd rise up to redress the balance of ownership.This is not good for anyone.
I agree, joint us world wide today, we can change the world http://15october.net/
Strange idea ‘all money created by banks out of thin air’, This is simply not so, banks in Australia are tightly regulated and the amount they can loan must be in a reasonable proportion to the amount deposited. Banks don’t create money, governments do. They control the mint and the money supply.
You are correct that the government control the mint and money supply , but they don’t create money , they borrow it from the central bank The fractional reserve system that is used by the worlds banking system is about three hundred years old and started at the creation of the bank of England. Governments do not create money they borrow it from their respective central bank who create it out of thin air. There is not one country in the world who’s currency is backed by any thing tangible other than their respective right to extract money (tax) from the citizens , So where do you think the computer based credit that is over and above the deposit comes from other than thin air?
While governments continue to bail the banks out with few, if any, strings attached, there is no encouragement for them to change their greedy ways. Colin, if I may, I would just like to move to your prediction that every oil spike has been followed by a recesssion and, therefore, it’s just a matter of time before another one hits us. I think it already has but the market seems not to have understood this fact just yet. Prices are certtainly down but the collapse seems to be in a holding pattern presently. What is your current view on this seeming historic absolute?
It irritates me when people talk about ‘greedy banks’, If you look at the financial figures, the return on capital, profit margins, EPS, DPS or any other financial measure for all our banks it is no greater than for any other company or a reasonable norm. Banks are simply businesses and must show a reasonable profit per share or per dollar invested or else shareholders will dump them. The only thing greedy about our banks is the payments to directors. They are simply out of court and it’s high time the govt took action to limit payments to directors of public companies.
Solution: no shareholders, public banks, direct control to the wage of directors, bonus, ban fiscal paradises etc
The issue is not just the greed of the billions in bonuses after the tax payer stopped them becoming bankrupt because of their incompetence. It is also the unethical practice of selling something as “AAA” knowing they are worth less , then betting against their own customers at the casino called derivatives.It is also the revolving door that connects the politicians to the bank executives.
Exactly, politicians and bank executives are the both sides of the same coin. And with no shareholders they wouldn’t need to do those corrupt practices like selling “AAA” stuff when they knew didn’t worth nothing.Banks have to be a tool, a service public, not an aim in its own.