Wednesday, December 31, 2008

The Crisis of 2009 - the Fault of Markets or Governments?

This post started out as an attempt to address the many interesting and often enlightening comments that have been made against the posts. However, in attempting to address two comments in particular I found that the responses led me onto a completely different track. This is one of the benefits of having having so many intelligent and incisive commentators on the blog. They spur new ideas and considerations.

In this case, I found that my rather meandering answers to their questions somehow morphed into something entirely new, a defence of free market economics. There are ever more calls for interventions in every market, more regulation, more controls, and all this adds up to is ever more government interventions. However, as I wrote my answers, it seems that everything that has gone wrong in the world economy can be directly, or indirectly, traced to government interventions. Despite this, the blame for this crisis is being laid at the door of the free market?

A good place to start is actually to look at the root cause of the problems, which I have detailed throughout this blog (e.g. here). This is the massive input of labour into the world economy, which has happened as a result of both India and China entering into world markets. This has led to the effective doubling of the available global labour force in a period of about ten years. It can not be emphasised enough here, that the massive dumping of labour into the market is not the fault of free markets, but is the result of a correction of government intervention in China and India. Both of these countries were artificially holding their labour back from the market until recent times. It is the sudden reversal of a government managed market distortion that has caused the shock to the world system. Governments in countries like China held back their labour force in a way analogous to a dam, only to let the dam open as a flood. Thus we have a massive imbalance in the available labour as a sudden shock to the global economy.

The real surprise in this distortion is that the free market system has managed to integrate such a massive input of labour as effectively as it has. However, the free market system is quite simply incapable of adjusting quickly enough to absorb this level of input flooding in. Whilst the system is flexible, it is simply not able to adapt quickly enough.

Another element at the root of the curren crisis is also the result of government intervention. In conjunction with dropping a massive labour supply into the world market, there has been an ongoing distortion in the world market.

As is pointed out by Lord Keynes (a commentator - not the original Keynes), we do not live in the perfect world of free trade, of genuine open competition. Lord Keynes points to the myriad ways in which competition is distorted, and quotes the quasi-mercantilist approach of China as detailed by Clyde Prestowitz:

Today, China is already the largest market in the world for steel, mobile phones, cement, aluminum, and electronic components. Within 20 years, it will likely be the largest market in the world for just about everything. If you are a manufacturer, you will pretty much have to succeed in the China market to have a chance of surviving anywhere else. In theory, you can serve the China market by exporting, but there are some good reasons why you might not. Because Chinese labor is inexpensive, production processes that are capital-intensive in the advanced countries can be “dumbed down” and made much less capital-intensive in China. As a manufacturer, you cut both your wage and your investment costs. On top of that, the Chinese government at local, provincial, and national levels will offer substantial investment incentives -- such as long tax holidays, capital grants, free land, low utility rates, worker training, and other beneļ¬ts -- to companies willing to put plants and research-and-development facilities in China.

These investment incentives confound free-trade theory. They are, in fact, distortions of the market, and therefore of questionable legitimacy under the rules of the World Trade Organization. This has never been challenged because other countries have investment subsidies, too. (American states offer tax deals to induce companies to invest.) China, however, subsidizes investment strategically to capture new industries at higher levels than anyone else.

Prestowitz goes on to say the following:
Nor are there government policies to maintain U.S. advantage; it is assumed that American genius and free markets will automatically result in U.S. leadership.
Prestowitz is making a perfectly valid argument that China is following a beggar-thy-neighbour approach, and that the approach is nothing to do with free and fair trade. However, he also makes the point that the West has used its own variants of such policies, just with less aggressive mercantilist intentions. As Pretowitz points out, there is a belief that US brilliance will suffice.

I have long argued that China has been using unfair trade to gain unfair advantage, and that the US should have long ago confronted this problem. The posts can be found here and here, and I detail many of the unfair trade practices, as well as a threat by the Chinese government to destroy the $US.

However, the picture painted by Prestowitz, whilst perfectly valid, does not emphasise enough one of the real keys to the success of China. That key is the drive and determination to succeed at every level of Chinese society. I have lived in China for several years, and I was trying to think of an illustration of that drive. I then remembered a little street food restaurant that I used to use for my breakfast. It was open seven days a week from six in the morning until 11 at night, and every day, every hour, it was manned by the married couple who owned the business, with their daughter occasionally helping out.

Not all Chinese people are so hard working, but it is hard to see many cases of such complete single minded dedication to work in the Western world. The business was small, not very well run, but they were going to succeed, whatever it took from them. Knowing Chinese culture, their motivation was almost certainly to secure their daughter's future. Can anyone in the Western world deny that people such as these deserve their place in the sun, deserve the opportunity to secure the future of their daughter? We hear so much about the poor wages of Chinese workers, but we do not hear of these hard working people working to secure the future of their family.

There is generally considerable talk of 'slave wages' making the difference in China. However, low wages are only one part of the equation. I have seen a side by side comparison for an identical product made in a French factory and in a Chinese factory. The wage differential made the difference of a few percent, but it was in all of the other elements of the cost that the real differential lay. It is for this reason that I have emphasised that the solution is about restructuring of the Western economies. Whilst, for high labour input goods, labour cost will be a significant factor in competitive advantage, it is not the case for many products.

So where does this leave China in the world trade system?

On the one hand, they have an economic structure that is highly supportive of a competitive position, and where there is a strong argument for their success being deserved. On the other hand we have aggressive mercantilist policy, such as the control and fixing of the currency, no enforcement of intellectual property, and so forth. I have long argued that the US in particular should confront China over the latter problems, but have also recognised that the US is in no position to confront China, as China has the ability to destroy the $US (read the posts I linked to earlier for details of this). However, the lack of action, under the Chinese threat to the $US is just allowing China to build ever more leverage and exacerbates the problem. Better to face the pain for the $US now than later, when there is even less left of the manufacturing base.

What we are seeing is a world trade system that is anything but free, open and fair, and where the strong advantages of China are being rammed home with unfair trade practices. However, as has been pointed out, the problem is that to different degrees other countries are using unfair practices. It is the fact that these practices are entrenched to different degrees that makes it so difficult to deal with the particularly effective form of quasi-mercantilism practiced by China. For example, during the Asian financial crisis, there was universal acclaim for China for not devaluing its currency in line with the fall of other Asian currencies. It was apparently right to fix their currency at that time, when it suited Western interests, but not now that it no longer suits Western interests.

What you have here is a situation of 'pick 'n' mix' on the question of free and fair trade. Everyone can agree with everything, as long as it protects their own interests. This pick n mix approach offers legitimacy to Chinese unfair trade practice, and leaves complaints struggling to reach the moral high ground.

So where has this led us?

At its most basic, when a Western manufacturer tries to sell into the Chinese market they will often struggle to sell their product, as the Chinese government has held their currency at an artificially low level, and provided subsidy and incentives for manufacturers within their borders. In fact the Western company has trouble selling into any market in which they compete with any China based company. The Chinese government in following this policy has developed what can only be described as a powerful form of investment. In holding down the currency, the Chinese government makes every individual in China poorer in the short term (the investment - foregone income), as they do not have access to the same amount of goods as if they had a stronger currency, but the upside is that this relative poverty now is an investment that destroys the competitors who are unable to compete on these unfair terms (the return). It is a policy for long term success at the cost of short term wealth. It is a very effective investment, but one which is completely unfair in an open trading system and a system that creates imbalances in the world economy.

In the traditional definition of mercantilism the aim is the accumulation of bullion but, in this modern form, it is the accumulation of foreign exchange reserves. As has already been pointed out, the accumulation of such reserves has seen a transfer of power into China, which now has the power to run a steam-roller over currency markets. With that threat, they are in a position where they can face down demands for fair trade, and all the while their supply of foreign currency grows strengthening their ability to destroy currencies at whim.

In the picture painted by Prestowitz, the implication is that China has won through following this policy. It is now increasingly evident that they may have actually set in motion their own catastrophe.

The simple truth is that, as countries like China use unfair trade measures to gain advantage, imbalances build up as a result, and the world system goes out of kilter, requiring ever more government interventions to stave off disaster, but creating the foundations of the next round of disaster. China has built up a massive trade imbalance, but in doing so has sowed the seeds of their own downfall, because they have quite literally destroyed the wealth of the market on which their own growth in wealth was dependent.

Instead of allowing their currency to float, they hold it down, and hope to support their own economy by exporting into the west, thereby pushing the West further into the ground. All the time, they are destroying their customers, and doing so at the cost of holding their own people in relative poverty. As a simple example, allowing the RMB to float freely and rise would dramatically pull down the cost of Western medical equipment, and allow for cheaper and better health care. One of the key reasons for Chinese people saving so much is the cost of health care as this is largely provided on a cash payment basis. That very high savings rate holds back the growth of their internal consumption of their own production, as well as the products from other countries. The result of the RMB rate is an artificially high cost of medical equipment and medicine. This in turn feeds into the cost of medical care, and this feeds into higher savings rates, and this feeds into less domestic consumption. In other words we can find just one small impact of the artificial currency level and see that it is just one of the many small distortions that ripple through markets as the result of government interventions, leading to its own problems, its own imbalances.

The implication of writers like Prestowitz is that China is winning in this great game of beggar-thy-neighbour. However, as we view the slide of the Chinese economy, it does not look much like a winner. It will not be long before the trade barriers start to go up in retaliation, or the collapse of their export markets sucks them down. In either case, they can not win in the long term, and the cost for China may be very high indeed. It might be that they see the kind of instability that leads to bloody war and revolution. Returning to the little ripple caused by health care costs, the switch to internal consumption in the Chinese market is, in part, held up by the very distortions that have led to the rapid economic expansion. As their exports collapse, they need that switch to the internal market, but one of the reasons for consumers keeping their wallets closed is the cost of health care, and that is partly the result of the mercantilist policy on currency.

I have just chosen one example of the problems that the Chinese government intervention in the exchange rate creates, the cost of health care. However, it is if we imagine a full float of their currency that we see the extent of their difficulties. If they float the RMB, China will likely collapse. With so much accumulation of foreign reserves, such a strong balance of trade they are in a position where any float would see the RMB soar to astronomic levels. The result of such a change would be to wreak destruction on their export machine, and create a massive inrush of imports. Whilst they might retain a strong balance of payments position, they would see large sectors of their export industry wiped out overnight, as well as seeing foreign companies suddenly emerging as effective competitors within their own markets. Quite simply, the artificial exchange rate has insulated their business from tough competition.

In short, they have accumulated this massive reserve of power and wealth, the massive accumulation of foreign reserves, at the cost of trapping themselves. They must keep exporting as a large part of their economy is structured towards this goal but, in doing so, they are impoverishing and destroying their customers. The only way they can save their customers is through a move to fair trade, but the destruction to their economy of such a move would see their country likely collapse into chaos. If they keep going as they are, their customers will go bust, and they will eventually collapse with them, and if they abandon the policy that is destroying their customers, they will also collapse. If their customers call time on their unfair trade, they threaten to sink the $US, but in doing so China will destroy the massive reserves they have accumulated, along with their customers. They could try to manage the rise in their currency, but they would still need to make the rise in the RMB fast enough to prevent a trade war, and to prevent the destruction of their customer base. The shock would still be too great.

In other words, their quasi-mercantilist policy allowed them to grow at a rapid rate, but the rate of growth has turned out to be an illusion. One way or another, they sink or swim with those upon whom they directed their mercantilist policy. A balanced and fair trade policy might not have offered such astounding rates of growth, but the rate of growth might have been sustainable and solid.

In one of the posts on China that I linked to, I suggested that China was balanced on a knife edge, that as the Western economies crumbled, maybe China had the capability to soak up the losses with growth in internal consumption. However, their mercantilist export policy meant that this was never going to be possible. They could have allowed their reserves, for example, to be used to pay for the building of a system of health insurance, or a basic social security net. Such a move would have allowed for their people to have the confidence to spend some of their huge reserve of savings. They need not have followed the expensive and overly complex state models of the West, but come up with at least some form of security for their people. Now it is too late. They can not change the savings culture of their people overnight, and can not therefore stimulate internal demand. They can not overnight structure their economy from their reliance on exports to the West.

Had their currency been free floating, they might not now have their reserves, but there might also have been a better balance of growth between export and internal growth. The massive growth in their industry might have still been export oriented, but not so fatally so. Furthermore, with a free floating exchange rate, their rise would have been more measured, and not led to the destruction of the customers that provided for that growth.

As it is they now own the massive reserves of currency, but the question arises as to how those reserves might be deployed without destroying the value of those reserves. In order to utilise those reserves, they need to start buying things from the US, with most of their reserves held in $US. However, their mercantilist policy has left the US in a position where they have less and less to sell to the East. What does China want from the US, that is does not now manufacture at home? Yes, there will be some things, but they will be relatively expensive because they have trapped themselves in their own currency game. The only way that China will be able to use those reserves will be to sell large amounts of the reserves and, in doing so, destroy the value of those reserves. Their massive reserves are, in other words, valueless paper.

I hope that this is becoming clear. Whatever China does now, the imbalances that it created have left it with no options for riding out this crisis. If they float their currency they fall into chaos. If they fix the rate at which they maintain their exports, they will suffer retaliation, or simply proceed to economically destroy their customers. Yes, they will accumulate yet more reserves of yet more useless paper...but to what end?

Their mercantilist policy once looked to be a very clever road to success, and has given them economic power. The trouble is that the economic power they have gained as a result is as illusory as the apparent economic success in the West over the last ten years. It is the economic power, to borrow a phrase from the cold war, of Mutually Assured Destruction. They can not escape the fact that their economic fate is entwined with the West, and they are now locked into a morbid lover's embrace with the West, even as the west plunges over the cliff edge.

Is this a case of free market failure? I think that it would be hard to pin the blame on the free market under such circumstances. One of the great balances of trade, the rate of exchange of currency, was allowed to be manipulated. This manipulation caused imbalances that a floating currency would long ago resolved.

However, there is another guilty party in all of this, and that is the US. In this respect, I agree with the analysis of Prestowitz. The US has issued useless paper on a scale that is quite simply astounding. As Prestwitz says, the attitude has been:
If the Chinese are foolish enough to exchange low-priced consumer goods for cheap U.S. paper, let the party continue.
So the Chinese exchanged their hard earned currency for what is now evidently useless paper. And the exchange was one in which the Chinese exchanged their hard earned labour by lending to the consumers who would then buy their goods, and would repay that debt with ever more paper with ever less value.

The US has used its position in the world currency system, has abused its position, to pour ever more paper into the world markets to fund their own boom in consumption. The same argument, to a lesser degree, can be made of many other Western countries, such as the UK. However, whilst they followed a similar route, none could manage the scale of the US, where the strength of their status as a reserve currency gives them so much more potential to get away with it over such a long period of time. I have said it before, and will say it again, the $US is the biggest bubble that the world has ever known.

However, the issuance of the useless paper is not a great money for nothing scheme that will hurt the Chinese. The US may have got huge amount of product in exchange for useless paper, but it will eventually hurt the US too, as it will eventually bounce back to the US as a horrendous devaluation of the currency which will destroy the wealth of the American people.

Once again, the bubble is not the result of a free market failure, but is the result of government central banks being able to issue fiat currency. If they were constrained by ensuring that the money had some underlying contractual value, such issuance of money would never have been possible.

Once again, this is not the failure of markets, but the manipulation of markets, of debasing the value of the very thing upon which markets are built - money. In one sense, yes, there has been a market failure. The US should have been punished for the irresponsibility of its actions a long time ago. However, once again, the markets have been distorted, with governments around the world, again with China as a good example, following mercantilist approach such that they have followed policy of actively seeking to accumulate $US reserves. This is not demand to support trade between countries, but a modern misguided attempt at the accumulation of 'bullion'. The market did not create demand for this bullion, but government policy. If there were just the purchase of $US for trade between countries, then the bubble would never have grown as it has done. If it were trade alone that determined the value of the $US, it would have sunk long ago, as the $US just does not produce enough that others want to buy. Quite simply, there is relatively very little demand for the $US to allow trading with the US.

So we have a debased $US.....

.....and if you thought that the manipulation of money already detailed were not enought, Jeremy, a commentor, posted a link to a Youtube clip in which experts on gold discuss the interventions of central banks in the gold markets. One of the most important points of the discussion (I believe) was the consideration that gold is a competitor to fiat currency. In particular, there has been a significant move of individuals into private holdings of gold. I have discussed at some length that fiat currency is built entirely on confidence, and the move into gold is indicative of the erosion of that confidence. Again, I recomend this clip, as it is very illuminating. One of the points that is raised is that central banks have been shown to be regularly intervening in the gold markets. The interviewees debate why on earth central banks, issuing fiat currency, might have any interest in the gold market. As is identified at the start, gold is still a competitor to fiat money, so the only explanation for the interventions that makes sense is to hold the value of gold down, to make it unattractive in relation to the fiat money. Again, there is government intervention in markets, and in this case in support of their own increasingly debased fiat currencies.

Then we come to the other market distortions that have allowed the US to continue to borrow and issue useless money. One of the greatest distortions can be found in the Basel accords, in particular Basel I. As I have detailed in my previous post on the banking system, the accords actively encouraged banks to buy up issuances of government debt. OECD sovereign debt is a key constituent of the capital adequacy ratios of banks. It is quite extraordinary that banks have been actively encouraged to lend to governments. The idea that governments should borrow at all is in any case quite absurd, but that rules for the financial system should be implemented to actively encourage lending into governments just heightens the absurdity. As I pointed out a long, long time ago, such lending pulls money away from the private sector and only serves to increase the cost of capital for the private sector, which has to compete with the ever growing government deficits by attracting higher interest rates.

For the sake of convenience, I will quote my post on Government borrowing:
Another reason why government borrowing is influential is best illustrated by a simplification. I am an individual investor and wish (for whatever reason) to make an investment in £GB. I will be faced with a range of choices for where I might to wish to put my money. For example, I may wish to lend into the consumer markets (e.g. putting my money into a building society account where it will be used to provide mortgages), or invest in companies (e.g. stock market), or I can lend to the government (e.g. bonds) and so forth. In each case I must make an assessment of risk and reward. If we take the example of lending of money to the government through the purchase of bonds, these kinds of bonds are considered to be 'no-risk' (a misnomer - as they do have risk) and therefore are highly competitive in the respect that they are relatively very safe investments (in some cases they even allow for inflation). By comparison non-government lending looks pretty risky.

In this situation, my investment decision would, if all investments were offering the same yield, be to go for the government bonds. Why take a risk on putting my money into unsafe instruments such as consumer lending. As such, non-government competitors must offer me a premium over lending to the government in order to give me an incentive to invest my money in their asset. As such the government becomes a formidable competitor in the market for where I invest my money, and set a benchmark on the minimum yield I will accept. In doing so, they are distorting the markets, and setting an effective minimum interest rate in the market.
And this is just the start of the negative effects of government borrowing. For more detail, you may wish to visit the original post. Once again, we have a massive distortion in the market, a distortion in which governments can set the baseline on the accepted level of return on investments, can draw money away from investment into productive private business, and all on the basis that they have a legal entitlement to extract cash from their populations at some point in the future to pay for their borrowing.

I do not intend to reproduce my post on the banking system here, but the encouragement of lending into governments is not the only distortion that has been caused by banking regulation and the interference of governments into the banking market. What I will do is answer another of the comments that I have received. Chas H offers this point on my proposed reform of banking, which I will quote in full:
Thankyou for another well argued post. I would welcome the kind of explicit presentation of risk that you propose, but I see two obstacles to making it work.

1) We live in a culture which does not understand risk. Thus many people buy lottery tickets with a real belief that that they stand a good chance of winning the jackpot. At the same time many people become neurotically anxious about the miniscule risks to health presented by eating certain types of food.

2) We live in a risk-averse society which is burdened down by absurd legislation and precautions to remove risk.
It is for this reason that there must be bank failures on an ongoing basis, and the regulation of banks to make them 'safe' need to be abolished. There needs to be a regular reminder that risk in investment is real, and this will create caution. Such failures will help prevent systemic risk of the kind that we are witnessing. Yes, individuals will be hurt in such bank failures, but it is a discipline on the business of banking, and reminds us all that risk is real and exists. As for point 2, this is exactly the problem. Individuals are currently in a position where they can take huge risks with their money, and then, if that risk goes bad, they suffer no consequence, as the loss is absorbed by everyone else. That is the nature of the previously implicit/explicit (and now just explicit) government guarantee of the banking system. If we remove the consequences of risk, greater risk can be taken with a sense of impunity, encouraging systemic risk taking.

This leads me to a question from a regular commentator, Lemming, who asks whether capitalism and Fractional Reserve Banking can only survive in a situation of growth. The answer to this is that FRB is a matter of risk. In times of growth, the risk is on the upside, and in times of contraction it is on the downside. Even during these bad times, some investments will continue to make money. The trouble is that people just don't like losing their money or accepting that they are risking their money. It all comes down to explicit acceptance of risk. During contractions, there will be more bank runs and bank failures. As some institutions find that they have utilised their depositors funds unwisely, they will find that depositors will lose confidence in their ability to manage their money and secure returns on their investment. In all such cases they will then be subject to the risk of a bank run, in which their available cash reserves are insufficient to meet depositor demand for cash. This will just serve to ensure that people scrutinise their decisions more carefully.

It can best be summarised this way. If we think of the average person opening a deposit account in a bank, how much care do they ever take over that process? They simply look for the highest rate of interest....without any acknowledgement that their higher rate might come with a greater risk to the capital. Such is the government regulated and implicitly and increasingly explicitly backed banking system.

This is not capitalism. This is a dream of a one way bet. Risk free investment.....It is the heart of the problem that I identified in my banking reform post.

Once again, we are very far from failures caused by the free market, and can see that the root of the problems is in the regulation of markets. I give an example in my post on the banking system that directly links developments in the financial crisis to responses to the Basel Accords, and the example that is given by no less than the Bank of England. They spotlight how growth in securities was directly encouraged as a result of Basel I. Again, this is detailed in the banking post. If you read the post in full, it is evident that market failure was not the cause of the financial crisis, but rather it is the endless interventions of government.

I have given some examples here of some of the root causes of the current financial crisis, and none of them are the result of market failure, and all of them are the direct result of government interference and manipulation in markets. As hard as I look, whenever I look to the roots of the problem, I find not market failure, but rather problems that are the direct or indirect result of government interference, manipulations, and regulation of markets.

A long time ago, I listened to a recorded lecture from the von Mises Institute. I can not reference it here, as I forget the details of where I found it or who the speaker was (apologies). One of the key elements of the lecture was that Marx got it fundamentally wrong when he said that he was describing the capitalist system. He was, in fact, describing a mercantilist system, and the reason why Marx's analysis was so wrong was that he thought he was analysing something that was in fact something else.

As I have written this post, this observation came to mind. People are readily describing the economic crisis of today as a failure of free markets. It is nothing of the kind, but represents the distorting effects of governments on markets. There has been no free market, but rather a series of market interventions. What we are seeing are ripples of chaos that emerge from the many distortions in the markets created from those interventions.

One distortion is the withholding of labour from the market, followed by the sudden release of that labour into the market. Another distortion that followed is the artificial currency exhchange rates that allowed the accumulation of worthless paper, issued because government has been allowed and encouraged to borrow, and allowed to run a policy of endless expansion of money. Meanwhile, the banking system has been regulated into ever more distorted activity, and the regulation offered guarantees of the system, encouraging horrendous risk taking through a promise of an unlimited guarantee of the system.

Mercantilism, government intervention, regulation and distortion of markets. If we wish to find a culprit for all that has happened, it is not the fault of free markets, but it is the fault of the endless interventions in the markets. Quite simply, blame for the mess we are in is being put in the wrong places.

Note 1: My apologies for not answering the many comments but, as you can see, I became somewhat distracted.

Note 2: Mercantilist is not a very good term, but it does appear in the dictionary, and seems more convenient than discussing the subject as an 'ism'.

Sunday, December 28, 2008

2009 - The Year of the Fall of the West

As 2008 comes to a close and we head into a new year, I thought that (for once) I would follow convention with a brief review and predictions. For new visitors to this blog, I should mention that much of what I write is referenced to reputable sources, but for today I will only reference in a limited way, relying on my previous posts for my analysis. If you are new to the site, you may want to browse through some of the previous posts (see links to the left).

In November of 2007 year I wrote the essay that was the precursor to this blog, 'A Funny View of Wealth', and that has been the bedrock of the thinking of this blog. In the essay, I presented an argument which completely diverged from the thinking of mainstream economists. I pointed out that, in the UK (and the same could be said of the US), there had been no real growth in what I considered to be wealth creating assets over the last ten years which could explain GDP growth; manufacturing, commodity extraction, export of services, and tourism (no net growth).

Instead I pointed to the growth in debt, and asset inflation (real estate) as the source of all of the GDP growth of the last ten years. This debt, in conjunction with the multiplier effect, along with upwards levers such as immigration, created an illusion of growth in wealth. It led to the 'post industrial', 'service economy'. My argument was that this was completely unsustainable, and that a collapse in asset prices would signal a self-reinforcing downward spiral in the economy, driven by a collapse in consumer sentiment (a massive belt tightening) leading to the collapse of the service economy, higher unemployment, more belt tightening and so forth into a downward spiral. I concluded that essay with the following:
'The situation overall will be a massive contraction in the UK economy, a contraction that will see the UK step back in time in terms of economic development. The contraction will need to be deep and severe enough to reverse the illusory gains of the previous ten years (or even longer), and will require that the UK restructures its economy from top to bottom. It will, in effect, be the most significant crisis to hit the UK since the World War II. The only way out of the crisis will be to alter the fundamentals of the UK economy back to producing more goods and services for export led growth, and away from debt based growth in services. It will be a long, and very painful adjustment that will see the UK lose its place as one of the worlds’ leading economies, and recovery from the crisis will take many years.'
Perhaps the most important prediction within this paragraph is that I suggested the UK economy would contract back at least ten years. Since I made the predictions for the economy, mainstream economics has slowly been catching up. I watched as week by week the Economist magazine's weekly poll of forecasters ticked down GDP growth predictions by 0.1 % increments, all the while still predicting growth in the economy - at least until the full savagery of the current crisis was staring at them square in the face. The reality of the scale of the crisis is now sinking in. This sub-head from the Telegraph a few days ago:

The 2009 recession could be so severe it sets Britain's economy back five years, according to the most chilling warning yet on the scale of the looming slump.

In other words, they are catching up with my prediction, but not there yet. They will finally accept the reality of the scale of the contraction only when it is right before them. My prediction was that UK economy would one of the worst hit in the world, if not the worst. One of the key transmission mechanisms of the collapse of the UK economy that I identified would be a collapse in the value of the £GB. We have this from the Times:

This year, however, Britain – with a GDP per head of $43,859 (the pound buys fewer dollars) – has been o v e r h a u l e d b y t h e U S ($46,993), France ($45,088) and Germany ($44,245). Only Italy, ($39,641) and Japan ($38,692) remain behind.

Worse is to come, according to the Oxford Economics projections, because of the recession and the sliding pound. “UK GDP per capita in 2009 will be 24% lower than in America and will be over 15% lower than in Japan, Germany and France,” said Adrian Cooper, managing director of Oxford Economics.

“It will even be 7% lower than GDP per capita in Italy, where economic performance has been very poor over the past decade.

It had become fashionable amongst many commentators to discuss currency strength in disparaging terms, talking about it being a matter of 'virility', rather than being a substantive issue. If I remember correctly, the example I gave to illustrate the nonsense of this view was a person with a preference for Belgian beer. If the £GB weakens, then that beer will cost the individual more, and that individual is therefore poorer. If the individual's income does not buy as much beer today as it did yesterday, how can anyone argue that the individual has not become poorer?

The simple reality is that, as each day goes by, as the £GB slides further, every single individual holding and earning in £GB becomes a little poorer. The £GB has a long way to fall yet....

In order to understand why the £GB has so far to fall, it is first necessary to explain why it continued to ride high for so long. One element is the irrational element of confidence. However, underlying this confidence is good old fashioned supply and demand. The key question here is; why was there so much demand?

The answer is rather scary. First of all, we have run consistently large trade balance deficits for many, many years. There is therefore minimal demand for the £GB to buy our products and services. Tourism sees a negative balance, with more spent overseas by British tourists than others spend in the UK. For commodities, our major source of commodity wealth, North Sea Oil, peaked a few years ago and is in decline. The real source of demand for the £GB is very scary indeed.

We are now all aware of the massive expansion in debt in the UK over the last 10+ years. Much of that debt has been financed from overseas. In order to lend to UK consumers, business and government, overseas investors had to buy £GB in order to then loan that money. This is a huge source of demand. In other words, a large part of the demand for the £GB was demand that was driving the UK into ever deeper debt....Our creditors, such as China and Saudi Arabia, are now turning off the supplies of credit, and are no longer buying the £GB to lend to us. Demand from this source will continue to evaporate...

A second area of demand was for inward investment, with much of that investment going into inflating assets, and the one area of growth - the service sector. With the downward spiral of the UK economy, only the clinically insane will invest in the UK, excepting the vultures who will pounce upon distressed assets at knock down prices.

As such, there is very little genuine demand for the £GB. To add to the woes of the £GB, we can add the latest in the insanity of government economic policy. The government is borrowing ever larger sums of money, and pouring it into the black hole of a bankrupt banking system. I predicted that when the government bailed out the banks, it was just the start. The banks had lent too much into an economy built on debt, in an upwards spiral of debt driven growth. It was self-reinforcing. The more the banks lent, the more the economy grew, and then the more the banks lent. I predicted that, as the spiral went into reverse, the losses of the banks would just increase. This from the Telegraph:

Britain's banks face up to £70bn of losses on commercial property loans, enough to force some of them into a further round of taxpayer bail-outs.

Investment bank Close Brothers forecasts massive writedowns in light of its forecast 50pc-60pc slump in commercial property values by the end of 2009 compared to the market’s 2007 peak. Most property experts believe such values have already dropped 30pc this year.

Such writedowns could again imperil banks’ capital ratios, potentially forcing them once more to go cap in hand to the Government.

This is just one sector of lending. Consumer debt is going to sour ever more quickly. Commercial lending is already falling off a cliff with, for example, prediction of carnage in the retail sector. The retail sector is just the most visible part of the bust. All of this just means bad news for the banking sector, who will continue to make huge losses.

In amongst all of this, the government is using its stake in the banks, and the fact that they are one of the only remaining sources of capital to bully the banks to keep lending into this mess, rather than making provisions for the next stages of debt delinquency carnage. It is a recipe for ongoing catastrophe. More bad lending into a collapsing economy.

Then we come to the real horror for the £GB, and for the UK economy overall. Everything suggests that the Bank of England and the government are planning to print money as a solution to the deep problems in the UK economy. In a post here, I have detailed how the government is seeking to hide the fact that this is their plan. If you are new to the blog, take a moment to read the post, as it is all referenced, including to Bank of England resources.

A long time ago, I predicted that the UK would default on its sovereign debt, and that default would happen at about this time (we are about a month overdue on my original prediction). As the predicted time for the default approached, there were more and more signals that the markets were less and less willing to fund UK government borrowing, and the debt default became ever more inevitable. I became more and more certain that I was right, and the default was a certainty.

It was at this point that the discussion of money printing suddenly appeared from left-field, with the Bank of England openly discussing the possibility. I was puzzled that such a dangerous policy was being considered, and gnawed at the question of why the Bank of England and government might be considering this. It was at that point that is occurred to me why this was being done. If the bank prints money, and then lends that money into the banking system, the banking system can then use the money to buy up government bond issues, thereby financing government debt. Under the Basel rules, lending into OECD governments creates tier 1 capital, and therefore means that the banks are seen as meeting capital adequacy rules. In other words, the banks return to (apparent) solvency, and the government manages to continue borrowing, and does not default on the loans. In the meantime an Act of 1844 that required the Bank of England to publish the amount of currency issued is abolished, such that the Ponzi scheme can be hidden.

All the while, the excuse for printing money is given as the avoidance of deflation. Whilst this excuse might stack up in the US, where their currency has not (yet) devalued, in the UK the devaluation of the £GB means that we are importing inflation. Whilst there may be deflationary impacts from the contraction of the economy, the imported inflation from the collapse of the £GB makes the idea of deflation very unlikely.

I have explained what money printing actually really means over several posts. The first point is that it does not create value, but transfers value from the existing supply of money. You can not create value out of thin air. If there are 100 units of currency, and you just print 10 more, all you are doing is spreading the value of the 100 units into 110, such that all of the currency is devalued. This is, of itself, highly inflationary. It is also a form of taxation. In transferring some of the value from the currency in supply into the newly printed currency, there is a movement of value to the printer of the money - the Bank of England, and eventually the government. Therefore, whilst the government makes its rather sad and pathetic VAT tax cut, they are quietly taxing ever more money to pay for their borrowing. It is the ultimate stealth tax.

What we have here is a 'double whammy'. As the demand for the £GB is in decline, the government is increasing supply. In so doing, the only possible outcome is inflation, and capital flight. The UK is now on course for hyper-inflation.

What does hyper-inflation mean? The first problem is that it will see the destruction of savings, and investments. The massive destruction of debt that comes with hyper-inflation may seem to be a good thing in a nation sinking under mountains of debt. However, when no one any longer trusts to lend, there is no investment, there is no prospect of return to growth. All of those who have been responsible and have saved are punished, and the feckless are rewarded. It is a recipe for long term pain. Meanwhile, the £GB becomes worthless, and every single holder of the currency just becomes that much poorer. As capital flees the country, there is no money left in the economy, nothing left to rebuild the economy.

The real truth is that, when the printing presses turn, we are witnessing one of the greatest debt defaults in history. In printing currency, yes, it is possible to pay the debts, but paying back debt with a debased currency is just another form of default.

How is this all going to unwind for the UK?

It is a very big question. I am not really sure that I know the answer. I am not sure how bad things may yet become. Many months ago, a commentator on a post asked whether I thought that there would be food shortages in the UK in the future. I suggested that this would not be the case, and still think that it will not become that severe. However, I do think that the UK is heading towards that kind of severity, though will never reach that point. There are still enough companies in the UK that can create genuine wealth, that are competitive in the world, but they are too few in comparison to the needs of the country. This has been evident for many years in the ongoing balance of trade deficits.

So what has caused all of this mayhem? Why is the world economy, and the UK economy in particular, in such deep difficulties?

As I progressed my commentary in this blog, I started to unravel the real causes of the problems in the economy. In one of my early posts, 'The Cigarette Lighter Problem', I was grasping my way to the nature of the problem. The problem I was trying to answer was why it was that an identical cigarette lighter costs nine times as much in a Western economy as it does in China. The same distribution, the same manufacturing costs, the same shop service. Everything is the same. How can this additional cost be justified? The only answer that made any sense was to identify massive value adding industries in the West, such that they could disburse this wealth into the wider economy, and that these industries were not to be found in China. It was hard to find any examples that could explain such a differential. In a later post, I identified the differential, and it was that the lighter was being funded by the appearance of wealth, the appearance of value added, that was rooted in debt. In other words, although we might not have directly borrowed money to buy the lighter, if we trace back the sources of economic growth, and the real source of the money, it could be found in debt.

It is here that the problems arise. It returns me to 'A Funny View of Wealth', the essay at the start of this blog. We have had the appearance of wealth, as borrowed money flooded into the economy from real wealth producing countries. We spent that money, created massive amounts of activity in the economy through the multiplier effect, and all the time we were just spending our future wealth. It is this borrowed money, that paid so much of our income, that was being used to support the difference in the price of the lighter between China and the OECD country. In other words, when we purchased the lighter, through the massive input of credit in the economy, we could pay such a high price for the lighter. The sick part of this is that one country lending us the money to pay for the overinflated price of the lighter was China, the manufacturer of the lighter.

What this really means is that the wealth producing countries, the big exporters, have been lending us the money with which to buy their goods. They did so in good faith, in the belief that we were good for our debt. We are not. I have often used the example of an 18th century aristocrat to illustrate the problem. His family has always been rich, and his creditors believe that this is the natural condition. However, the lavish lifestyle led by the aristocrat has, for a long time been supported by credit. His estate no longer produces enough wealth to cover his costs. The creditors will keep lending, but only to the point where they finally realise that they are lending to him to pay back his previous borrowing.....

I have said that the creditors lent in good faith. However, all is not well in this regard. In particular the artificial value of the RMB in particular has been an aggressive and damaging factor in the mix. It is, and has been, a massive export subsidy for companies operating out of China. It has meant that China has enjoyed an export led growth boom, but at the cost of destruction of large swathes of manufacturing in the Western world. Quite simply, it is unfair trade practice, and has contributed to large imbalances in world trade, and sucked foreign currency into China, which has then been lent back to the West.

This is not to say that the only problem has been the problem with the RMB. One of the themes throughout this blog has been the question of labour supply in relation to commodity supply. I first detailed the problem in 'Why do Economists Get it so Wrong?' The argument is quite simple.

In the past ten or so years, the labour force of the world has doubled. There were always the huge numbers of workers available in countries like China and India, but they were previously under-utilised. What changed was that these workers have been given access to capital, to technology, and access to world markets. As this happened, they became a part of the world labour force.

When we look at the entry of the emerging economies in this way, it becomes apparent that we have had a massive supply shock into one of the key inputs of production. At the same time, whilst we have this massive oversupply in this one input into production, there has not been a commensurate increase in supply of another vital input into production - commodities. We saw this shock in the eventual spiking in oil prices. This spike was what finally motivated the pushing over the edge of the Western economies, which were already balancing on a precipice of debt fuelled consumption.

At its most simple, we have a situation in which, about ten years ago, commodities were supplied at a rate of 1.2 units per worker. As the emerging economies seriously entered the world economy, the supply of commodities increased, but not at a fast enough rate to match the numbers of new workers. Eventually, demand outstripped supply, and the commodity prices spiked upwards. In effect we hit the point where there were only 0.8 or 0.9 units of commodity per worker. Whilst the numbers here are made up, I hope that this illustrates the basic principle.

The result of that commodity spike was to expose the impossibility of the ongoing imbalances. The output of the world was being consumed in the West, but increasingly the production was in the East. The East was lending the money for the West to continue to consume a disproportionate amount of world resource, at the cost of the wealth of their own more productive populations. Something had to give.

What gave was the Western economie, and they have taken with them the emerging economies - who built their structures to support Western consumption. Having geared their economies to the West, they now no longer have markets for their goods. The imbalance is correcting in a very painful way.

As world trade collapsed, so did the demand for commodities. I make an analogy here of a man running towards a brick wall of commodities. The wall is moving forwards, but not as fast as the runner. Eventually, the runner hits the wall and bounces back, only to later start to run towards the wall later. We have just bounced back. The running will resume later....

Today, economists are finally starting to 'get it'. However, I think that it may be economic historians who finally grasp what has happened. The simple truth is that the world moved out of balance with the massive input of labour many years ago. The massive boom in debt simply hid the imbalances. It was not complex financial instruments that created the problems, but rather they were the reaction to the wall of credit that flowed into the Western economies from the ever more productive East.

As more and more credit flowed in, there were few opportunities to invest that money into wealth creating assets. The Western economies were bloated in comparison to those of the East, and in many sectors were unable to compete. If you wanted to invest in manufacturing, you looked to the East. As such, there was a wall of money entering the economies of the West, with limited opportunity for investment into productive assets. Instead, the money was lent into consumption, and into asset price inflation. If you have a limited supply of assets, and an increasing supply of money chasing those assets, you will have asset price inflation. When you have a huge supply of money, and limited investment opportunities, the quality of the investment will suffer. The first tranches of money will go into low risk, high return investment but, as the money keeps flowing in, these good investments will disappear, leaving the investor only the option of pouring money into ever more risky investments. This is the source of sub-prime, and the financial instruments that were developed were just a method of hiding the poor quality of those investments. The financial crisis was caused by the imbalance, not the other way around.

In other words, the catastrophic failure of the banking system was simply a result of too much capital with no good place to go. All the while that the money was pouring into black holes of investment, economists, bankers and governments could point to GDP growth to show that their economies were miraculously growing. However, GDP is a measure of economic activity, not a measure of wealth creation. Where that activity is generated through growth in debt, it is not economic growth, but the destruction of future wealth. The delusion was that activity meant wealth creation.

What we therefore had was a massive imbalance in the world economy. The East was increasingly producing goods for the West to consume. Meanwhile, the East lent money into the West so that the West could continue to enjoy a lifestyle of comfort. The East, in other words, worked hard to support the lifestyle of the West....

It was always impossible that such a situation might be sustained. At some point, at some time, the massive imbalance had to be corrected. This is the process that we are witnessing now. The only element still missing is the collapse of the mighty $US.

In this matter I have been wrong. I long predicted a collapse in the $US. It has not happened.


However, if we look at what has driven events, what has caused this crisis, it is apparent that the $US must finally collapse. The US is just one huge deficit, and has long since ceased to pay its way. When I made the analogy of the aristocrat, we can extend this analogy to the US, but in the case of the US, the US is the King. How much more difficult to imagine that the King is broke. After all, the King's head appears on money.

At this moment in time, the $US is the biggest bubble in history. In my previous post I discussed money and the banking system. The important point about fiat money is that there is absolutely no support for its value excepting confidence. At present, as the reserve currency of the world, the $US is holding onto its value, despite ever more issuance of the currency - they are printing money too. With the US as the 'King' it is hard to imagine that it is bust, that the US is in as bad a state as the 'aristocrat' that is the UK. However, the two countries are running paralell, and there is only a difference of scale. If we compare the two economies, they are very similar in all of they key points that I have discussed so far.

As such, the $US will collapse. It is just a question of when.....

When I first started writing on economics, I wrote with the optimism that, once the nature of the problem was recognised, we would take action to reform our economies to meet the challenge, the hyper-competition of the East. The one thing I have not seen since is any single policy or initiative with this purpose. All I have seen is policy that seeks to replace the lost consumer borrowing with ever more borrowing, and an attempt to recreate wealth through the use of the printing press.

There has been a collective burying of heads in the sand. The only possible outcome for this is that, what would always have been a painful adjustment, is going to be agonising.

I am very sorry to say this, but the situation can only get worse. The next stage of the crisis is hyper-inflation, and that can mean only one thing.

What we will witness in 2009 is the fall of the West.

Friday, December 26, 2008

Banking Regulation - Buyer Beware

This post on bank and financial regulation has been under consideration for a long time. The reason why it has taken so long is that I was allowing myself to become confused, in much the same way most people become confused over these issues. The cause of this confusion is that we all seem to forget what the financial and banking system is, and what it does.

The reason I am now able to write this post is that I have had a very good comment posted on 'Financial Crisis - A Brief Review', in which the author offers an argument that deregulation caused the current financial crisis. The argument that was presented helped me to focus in on what matters, which is to ask what banks are for, and how the financial system operates. In particular, the argument that the Financial Services Modernization Act of 199, in conjunction with a fiat money system, was fingered as the guilty party (I am simplifying, so I suggest reading the original comment). The comment also pointed me to the Ludwig von Mises Institute for an article in support of the argument. The reason why the comment and this article allowed me to finally write this post was that I was preparing all kinds of complex counter arguments, including a long discussion on the Basel Accords, when I realised that I too was missing the point. Whilst I cover these issues, I am now not so concerned with these details, but more concerned with basic principles.

I was forgetting what the banking system was for, and what money is for. It is only if we remember this that we can start to think of how the system can operate effectively. If we keep these basics in mind, it will become apparent that much of the banking regulation is trying to achieve the impossible, the removal of risk. It also becomes apparent that the system of money is built on foundations of sand.

The logical starting point for reform would be the issue of what money actually is. It is not some magic substance that has a picture of a famous dead person on it, or the picture of the queen, but something which has a purpose in the exchange of goods. Lets imagine, for example, that a sofa shop owner is in need of milk for his family, and that the milk requirement is one cows worth of milk production per day. He believes that one cow's worth of milk production for the lifespan of the cow is worth one sofa in his shop.

Now, in the real world, it may be the case that I do not have a cow to provide the milk to the sofa shop owner, or a farm, or anything else which the sofa shop owner wants. However, for the sake of ease, we will say that I am in the business of providing consultancy to farmers, advising them on best practice in milking. As such, I can sell my advice for milk. My own milk requirements are very small, so I do not need all of the milk that the farmer provides in return for my advice. When I want to buy the sofa, I could therefore write a contract that, instead of providing one cow lifespan worth of milk to me in return for my services, the farmer instead directs that same milk to the sofa shop owner. As such, I am now in the position to make an exchange for the sofa, and can take it home.

As such, money is an intermediary, which allows us to not have to go through this complex process to make an exchange for a sofa. In order for money to operate in this role, so that I do not have to set up lots of contracts, the person in the shop must believe that the intermediary that I provide (money) = one cow's worth of milk over the lifespan of the cow. In other words, the shop owner would expect that the money I provide will be able to purchase milk in the quantity of one cow's production (a) over the number of days the cow will live (b). When I enter the shop without a cow or a cast iron milk supply contract, I must provide the shop owner with something which guarantees that I will provide the shop owner with a x b worth of milk, over a period of several years. In effect, that is what I am exchanging for the sofa.

In other words, money is a contract for the provision of x amounts of goods and/or services. It allows us not to have to go through life making lots of impossibly complex contracts, between all of the specialisms in which we participate, which would be quite impossible and inefficient to manage. Quite simply, it is better that we use an intermediary that offers the same contractual commitment. In order for this to work, the contract implicitly must have the same value tomorrow as it does today. When I hand over money for in exchange for the sofa, the sofa shop owner is going to get a bad deal if, in three years time, he finds that he is only able to purchase three quarters of a cow's milk production. It is for this reason that inflation is bad. It is, in effect, a breach of a contract. Whenever inflation occurs, we lose some element of our belief in money to honour the contracts between one another. I have chosen the milk production example to illustrate this point, as it is very important in the consideration of money.

To illustrate this point, I recently had a comment on a post regarding hyper-inflation and whether it is a good time to buy a house at such a time. My answer was as follows:
I have read about hyper-inflation in principle, but here is a good question of the process in practice. The first thing is that, during hyper inflation, the value of cash is destroyed. At the same time the cash price of assets rise, although their real value may not change. At its most basic, what I am trying to say is that, if a pint of milk has the same value as a loaf of bread, whilst the cash value of these may change, the relationship of the value, one to another, does not necessarily change. So it is with housing. If a house is worth 100,000 pints of milk today, all other things being equal, it will be worth 100,000 bottles of milk tomorrow. However, the value of housing was over-inflated, such that all things are not equal. As such, whilst the cash price of a house may rise, the value of that asset will presumably continue to decline relative to other assets.
Within this reply, we have a problem when we think about money. Within this scenario we have a situation where the value of one thing versus another is unstable. In the case of of the house, today it might be worth 1oo,ooo pints of milk but the next day it may only be worth 99,000. Alternatively, if there is a sudden expansion in the dairy industry, it may be that the house will be worth 110,000 the next day, as there is an oversupply of milk into the market, thereby reducing the value of milk relative to other items. This can happen to any particular product, commodity or service - and that includes gold.

If we take the value of gold, it might be that the demand for gold drops, due to a change in society where gold becomes associated with 'bling', thereby reducing the demand for gold for personal decorative use. In such a situation, there will be an oversupply of gold relative to the demand for gold, and the value in exchange of gold will drop relative to other items. The problem that I am illustrating is that nothing has a fixed and enduring value in exchange relative to other things.

Now we come to the situation of money today. As many readers will be aware, the gold standard was abandoned many years ago. The gold standard was a situation in which each unit of currency could, in principle, be exchanged for a fixed amount of gold. Today, there is no such backing, such that money has no contractual guarantee. I would therefore like to return to my milk and sofa example.

When I enter the sofa shop, bearing a fistful of bank notes, I am offering the sofa shop owner something that he believes to be a contract, but which actually is not a contract at all. If we say that there is a situation of high inflation, or hyper inflation, then there is no recourse for our sofa shop owner. I might give him £2000 which today looks like it will pay for a cow's lifetime supply of milk, but which will in three years time not be able to be used to purchase even one day's supply of milk. There is no contractual commitment in what I had handed him. None whatsoever.

How does the situation differ under the gold standard? I have already pointed out that the value in exchange of gold varies relative to other goods and services. As such, I could go into the shop and purchase the £2000 sofa in exchange for money which can be converted into x amount of gold. If there is a massive expansion in gold production, or gold was less desirable for the 'bling' factor, then it may also be the case that the gold in three years time would be insufficient to buy the milk that was required by the sofa shop owner.

In such a situation, it becomes apparent that money, in all forms, is a fundamentally flawed concept. I will commit the sin here of quoting Wikipedia, but they offer an excellent summary of what money is supposed to be:
"Money is a matter of functions four, a medium, a measure, a standard, a store."
In all cases it is very easy to achieve the first three, but the last point is the one that causes the problem. In all cases it is impossible to guarantee the last item, even with gold. If it is a store, it must be accepted that it is potentially a leaky one. In other words, whatever is used as the standard unit of exchange, it carries with it risk that the value in exchange today and tomorrow might not be the same.

We are therefore in the tricky position of having to make some choices. On the one hand, we could abandon the concept of money altogether, which would mean endless complexity in arranging reciprocal contracts between endless numbers of individuals. On the other hand we have to use something as an intermediary in exchange whose value is subject to change. The former option is simply impractical, and the latter is unsatisfactory. However, the options are just these.

From this perspective, it is apparent that there is a necessity for money, but that money needs to still retain a contractual value. Under the present system of fiat money, there is quite literally no contract whatsoever, and the value of money in exchange rests in its entirety on the delusion that there is an underlying contract. Such a system has huge risk, because if ever there comes a point where individuals demand that the contract they believe to be there is fulfilled, they will find that there is nothing there at all. It is the current situation in the Western world that there is a huge amount of money issued, that this money has been used to purchase goods and services from other countries, but there is very little that the money can actually be exchanged for. This is seen in the imbalance in trade between the East and the West (ignoring cases like Germany).

In other words, if the countries that have provided the goods and services try to exchange the money issued in the West for goods and services, they will find insufficient goods and services available for the money to purchase. We have, for example, used the money issued to buy plasma TVs from China and can not offer any good or service in return for those purchases. We have used an item in the exchange which is not actually backed up with any contractual commitment to reciprocate with anything. We are in a situation where, if the perception of the underlying contract is tested, it will be found that it does not exist. At that point, the belief in the value of money will quite literally disappear. This is the risk that has been taken.

It is at this point that we return to the very imperfect gold standard. If all currency issued is backed by gold, then there is an explicit contract. If you do not wish to use the money in exchange for any goods or services, then you have the option of exchanging the currency for a fixed amount of a commodity. Whilst there is a risk that the value of that commodity might fall in relation to its value in exchange with other commodities, goods or services, it will always have some value in exchange. It guarantees that money will always have some value. Gold is used because it has, throughout history, has a relatively high value in relation to many other commodities. However, any commodity has the same function and the question of which commodity just becomes a question of relative historical value stability, and practical questions of how it can be stored/used/transferred etc.

In short, money must have an underlying contractual commitment, or it becomes subject to losing its meaning. Whether that contract is an exchange for gold, or any other commodity, the important point is that the contract is fixed. In this way our sofa shop owner knows that, whatever happens, he will always be able to buy at least some milk with his money, even if he is unable to buy as much milk as he originally expected. It is very imperfect, but it is better than the option of being able to buy no milk at all, which is possible under a system of fiat money.

It is at this point we now need to turn to the broader issue of banking and financial regulation. Although I have not expressed any preference for which commodity might be used as a backing for money, I will stick with the gold standard as being the method of contractual commitment.

The first question that is raised is who might issue money. My answer is very simple. Anyone at all. That means you, or I, or the person next door can issue money. It is, in any case, what we do all the time. If we remember that money is an intermediary in exchange, we start to see that, for example, when we offer to do something for another person in exchange for something else, we are effectively issuing money, in some cases the unit of currency is a verbal promise, in others a contract written to say that we will do something. In both the case of the contract and the promise, they are both units of exchange.

For the purposes of the wider economy, in ensuring that exchange is efficient and effective, it is important that there are monetary units that are widely accepted. It is only in ensuring that this objective is achieved that there should be any regulation of money. Whilst anyone can issue money (though I suspect few would accept notes backed by nothing where there is a gold standard alternative), there is a regulatory role in ensuring that there is available a particular form of money that is contractually tied to gold. As such there is a regulatory role in the issuing of this money. That role is to fix the rate of exchange, ensure that it is never changed, and to ensure that money that is so fixed can be identified as such.

As such, any individual, or institution, can issue gold backed money, provided that they can demonstrate that they have the gold available to meet the standard, and that the gold is secured against sale. The role of government in such a system is to monitor the institutions that are issuing the money to ensure that they have sufficient gold, and the printing of the money in a consistent format with the issuing institution's name printed on the money. The government might also issue currency, but only if it is also backed with sufficient gold to meet the standard. The institutions that can issue money according to the gold standard would have a special designation as deposit banks. All money within these banks would be contractually guaranteed to be able to be converted into gold (or at least nearly all of it, as an allowance would be needed to allow the banks to acquire the gold as deposits rise). As these banks would not be investing money, they would need to charge a fee for the deposits.

In addition to deposit banks, there would also be an alternative, and relatively unregulated banking system, where the banks would be designated as 'speculative' banks. It is here that we come to the difficult subject of regulation. Before we continue, it is worth reviewing the two basic purposes of banks.

The first purpose of banks is as a place to store money in a relatively safe place. The deposit banks serve this purpose, and therefore there must always be deposit banks available to individuals and businesses, even if the government must step in and offer this service (the least preferable option). The second role of banks is as a conduit for investment. This is best explained by thinking of an individual who has £10,000 saved from their salary. They have several options of what to do with this money. On the one hand, they might put it into a deposit bank, which will only guarantee that, at any time in the future, that money will be able to be exchanged for a fixed amount of gold. Alternatively, they may wish to use that money for speculative investment.

The investor has several choices on how to invest that money. On the one hand, the investor has a sister who is planning to open a restaurant. She is looking within the family for investment capital. Being her brother, he knows her well, she has explained her plans, and he must therefore make a judgement on whether this is a good investment. On the other hand, he might invest the money in the company which he works for, as the company is offering shares in the company to employees in order to raise money for the development of a new product. He knows the company well, he knows the details of the plans for the new product, and can therefore reasonably judge whether it is a good investment. His final option is to outsource the investment decision to an institution specialising in investments - a speculative bank.

In all three cases there is a common factor. In all three cases he must risk some, or all, of the value of his money. In all cases, the money will be invested in projects where, if he wants the money to be returned, there is no guarantee that it will be immediately available, or whether it will ever be returned at all. All three cases are identical in this respect, and no amount of regulation will ever change this basic reality. It is here that we come to the fundamental problem of modern regulation. It is aimed at removing the risk from investment, the risk that money will not be returned to investors. It is really very simple, as soon as a person/institution wishes to gain interest on their capital, they take a risk with that capital. The only way for interest to be accrued is through investment, and all investment is speculative and inherently risky. To try to regulate risk away is therefore an impossibility, but this is the purpose behind much of the regulation.

Regulation of risk is not possible, but regulation of provision of information about risk can be regulated. If we take a look at the Basel banking accords, they do not seek to regulate information but are seeking to regulate risk. A very good discussion of the Basel accords can be found here at the Bank of England website, and I will use it as the basis of discussion. In particular, the date of the paper is 2001, and the paper therefore details the thinking of regulatory institutions pre-credit crisis. The introduction to the piece starts as follows:
The 1988 Basel Accord was a major milestone in the history of bank regulation, setting capital standards for most significant banks worldwide—it has now been adopted by more than 100 countries. After two years of deliberation, the Basel Committee on Banking Supervision has set out far-reaching proposals for revising the original Accord to align the minimum capital requirements more closely with the actual risks faced by banks.
The important point in this paragraph comes in the last sentence. This is the problem that is inherent in all regulation, that there is an objective standard of assessment of risk that can be discovered and codified. The thinking behind regulation is best summarised again in the BoE paper:
One issue when deciding on the capital requirements for
each probability-of-default band is the appropriate
solvency standard that regulators should be targeting for
minimum capital.(5) This needs to balance prudence
with efficiency. Banks are regulated to protect
depositors (because of information asymmetries and the
social consequences of loss of savings) but just as
importantly to protect the financial system. This reflects
their central role in the economy. Because of their
position in the payments system and lending to small
and medium-sized businesses and retail customers, the
cost of banking crises can be very high. Bank of
England research,(6) which examines 43 crises worldwide
over the last 25 years, indicates that economic activity
forgone during the length of a banking crisis can
amount to between 15% and 20% of annual GDP.
So here we have expressed very clearly. Bank regulation is to protect depositors. What the statement does not do is explicitly state is protect them from what. What they mean when they say protect depositors is that the intention is to protect depositors from losing their money. Such an objective is impossible, as all investment carries risk, including complete loss of all capital. The only way to protect depositors is through the provision of a deposit bank (as detailed before) and even that carries the risk that the value of gold might be subject to change. The other problem highlighted is information asymmetry between depositors and the banks. Rather than address this problem, regulation seeks to address the impossible - the elimination of risk for depositors.

The answer to this perceived problem, was Basel I. This is described in the BoE paper as follows:
The 1988 Accord represented a revolutionary approach
to setting bank capital—an agreement among the
Basel Committee member countries that their
internationally active banks would at a minimum carry
capital equivalent to 8% of risk-weighted assets (with
the Committee setting broad classes of risk weights).
The agreement was made against a background of
concerns about a decline in capital held by banks,
exacerbated by the expansion of off balance sheet
activity, and worries that banks from some jurisdictions
were seeking a short-term competitive advantage in
some markets by maintaining too low a level of
The introduction of the Accord seems to have led to
some rebuilding of capital by the banks in the G10, but
over time the broad nature of the risk categories created
strains.(2) The Accord differentiates between exposures
using general categories based on the type of loan—
exposures to sovereigns (split into OECD and
non-OECD), exposures to banks (split into OECD and
non-OECD, with the latter split into less than one year
and more than one year), retail mortgages, and other
private sector exposures. Little allowance is made for
collateral beyond cash, government securities and bank
So here we have a determination of risk which assumes that, for example, OECD based banks are safe. We now see that this is not the case, and many of the banks in the OECD would, without government support, now be bankrupt. We also see that lending into government securities is also 'safe' but, as I have argued elsewhere in this blog, countries such as the UK are extremely unsafe at present.

So here we have the essential problem. A bunch of very smart people got together and said that they were able to determine levels of risk. Their conclusions have been shown to be wrong. In particular, OECD banks have demonstrably been shown to be, in a very large number of cases, unsound. I will reiterate this point once again - they were wrong.

Another point in the Basel I accord was that it creates a perverse incentive to lend to governments. Investing in government debt means that money is not being invested into potentially wealth creating investments in the private sector. It also virtually guarantees that government will have access to credit, regardless of whether the governments are acting responsibly or irresponsibly. Such guaranteed provision will almost certainly have been a factor in the growth in Western government / OECD debt. However, it would be impossible to prove one way or another.

So now we come to the Basel II accord. Once again, I will quote from the BoE paper. It makes interesting reading.
The broad categories reflected the state
of systems in banks at that time. But during the
1990s, banks started to develop more sophisticated
systems to differentiate between the riskiness of various
parts of the portfolio to improve pricing and the
allocation of economic capital. These systems
highlighted the discrepancy between required capital
and economic capital for some exposures, creating an
incentive to sell some loans. The chart below sets out a
risk measure, the value at risk (VaR) over a one-year period,(1)
for portfolios of exposures in each rating
category, and shows that for loans to all borrowers down
to BBB the Basel minimum requirements of 8% capital
(of which 4% is equity) would probably be higher than
the equity capital that a bank would chose to hold.

This disincentive for banks to hold prime-quality loans
was probably one of the factors behind the securitisation
boom in the United States. By March 1998, outstanding
non-mortgage securitisations by the ten largest US bank
holding companies amounted to around $200 billion
(more than 25% of these banks’ loans).(2) Banks outside
the United States were also increasingly turning to
securitisation to adjust their portfolios. The ability of
banks to choose how much risk they wished to carry
against a particular quantum of regulatory capital
threatened to undermine the objective of an
international capital floor. Another concern about the
Accord was that the limited recognition of risk reduction
through collateral or credit derivatives would discourage
banks from taking advantage of these techniques and
more generally impair the development of markets.
I have highlighted two sections with italics, which stand as two examples which will illustrate contradictory points. In the first section, the securitisation boom is seen to be as a result of Basel I. This was to lead to many of the problems we have seen today. The second point was actually a positive point for Basel 1, which was that it was limiting the growth of credit derivatives, which are creating ongoing problems for the banking system today, but this was seen as a negative by the BoE. Basel II sought to rectify this 'failing'. In both cases, the regulation had distorting effects on the structure of markets, and in one case a positive outcome is seen as a negative. The regulators simply can not make accurate assesment of risk.

Another interesting feature of Basel II is that the accord put the credit rating agencies centre stage in the assessment of risk:
Under the standardised approach banks will slot
assets into weighting bands according to ratings from
eligible rating agencies (ie recognised by national
supervisors in accordance with specified criteria).
The BoE paper acknowledges that the rating agencies may be no better than the banks at assessing risk, but fails to acknowledge that there is a central conflict of interest - that the ratings agencies are paid for conducting the rating by the banks themselves. The importance of the poor preformance of these ratings in the current financial crisis can not be overstated. However, they were critical to the entire Basel II system:
Exposures to borrowers without a credit rating will be
placed in an unrated band that will carry a 100%
weight (ie 8% capital charge), but regulators are
requested to review the default experience of the
particular market (and individual bank) to decide
whether this is sufficient. Undrawn facilities to
corporates of less than one year, which currently
carry a zero weight, will be weighted at 20%.
At the heart of all of this regulation is an unfounded belief that, somehow, there are a bunch of people with sufficient wisdom to determine risk, and therefore create a system in which risk of failure is abolished. Such a point view can only do one thing - create complacency. It creates a situation where, provided you meet the rules, you must be sound. However, the institutions then game the rules, and seek ways to best exploit the rules. The only solution to this is ever more rules, and ever more complexity, and within that complexity the institutions will just find new ways to subvert the rules. Above all else, however, is the simple fact that it is not possible to remove risk from investments, and that risk must be an accepted part of any system, including risk of bankruptcy.

I started the post mentioning a commentator's very good and interesting argument that deregulation caused the problems. It is a good basis to discuss the idea that deregulation was the problem. One of the points made was as follows:
But, at any rate, since Basel II was not even published until June 2004, and not implemented in the US until the years after 2005 (well after the housing bubble began), how could it be a major cause of the current crisis?
Of course, Basel I (which was published in 1988 and implemented in most Western countries in 1992) could have played a role. But in the absence of the three factors discussed above (the Financial Services Modernization Act, the Commodity Futures Modernization Act of 2000, and the real estate bubble), how could Basel I have caused this on its own?
I would not suggest that Basel 1 caused the problem by itself, but rather was a contributory factor, and this can be seen in the BoE paper. The reason for the housing bubble was actually the result of a flood of capital into western markets (resultant from the shift in the world economy) with insufficient good investment opportunities to soak up the capital. Once the sound investments were gone, then there was little choice but to invest in ever more risky investments. This was compounded by the state entities of Freddie Mac and Fannie Mae having an unfair advantage in the provision of lending into prime mortgages, leaving less investment opportunities for the genuinely commercial banks. As for Basel II, it may not have caused the problems, but it certainly exacerbated the problems. In particular, putting the ratings agencies centre stage was problematic, as well as the structure for internal risk assessment.

The author of the comment, in a second comment, quotes the following:
Paulson convinced the SEC Commissioners to exempt the investment banks from maintaining reserves to cover losses on investments. The exemption granted by the SEC allowed the investment banks to leverage financial instruments beyond any bounds of prudence. In place of time-proven standards of prudence, computer models engineered by hot shots determined acceptable risk. As one result Bear Stearns, for example, pushed its leverage ratio to 33 to 1. For every one dollar in equity, the investment bank had $33 of debt!”
I would argue that this is just an example of the problem of regulation. The SEC legitimised all of this. Without such legitimacy, without the approval of a regulatory body, would this kind of practice have been so readily accepted? It is at the very heart of my argument - regulation and regulators encourage complacency. The commentator also mentioned the role of regulatory arbitrage, with the UK offering a laxer regulatory regime as a way of attracting more banking business to the UK. It is yet another example of how regulation can create distortions in the market place. The UK claimed that its 'soft touch' regulation was both sound and more efficient but, as with the US system, it was neither sound or efficient. It is possible to therefore suggest that every regulatory regime should meet the same standards of regulation, but we then encounter the Basel approach, where the risk assessment regime of both of the accords have now been shown to be wrong.

They were wrong, but conferred a false sense of security/legitimacy in the activities of the banks, much as the SEC did in the example given above.

What of the Financial Services Modernization Act, the Commodity Futures Modernization Act of 2000? These are fingered as the guilty in the cause of the financial crisis. However, I would suggest that, for example, the legal structure of financial institutions is not an issue of concern. The structure of financial instruments is not an issue of concern. As you may be gathering, the real issue of concern is the nature of the oversight of the activities of the institutions.

As the BoE suggests, there is an asymmetry of information. When I gave the example of the person investing the £10,000 I pointed to two examples in which the investor had good knowledge about the potential investments (his sister and his company). In these cases information was not a problem, but even with good information the risk remained. The problem of information arose with the speculative bank. How can an investor make an assessment of an institution as complex as a bank in the assessment of risk. How can he know what an SIV or CDO actually are. It is here that we have the assymetry of information.

Before continuing, a quick question. Should the investment of our investor's money in his sister's restaurant be subject to regulation? Just as putting money in a speculative bank risks the life savings of our investor, so does investment in his sister's new business. Regulation is there to protect the investments of depositors, but why would that protection not apply to investment in his sister's new business. In both cases, if the investment of that money goes wrong, then he loses his savings. For some reason, when the word 'bank' is mentioned, confusion arises. We MUST protect the savings of individuals invested in banks, but not if an individual invests in other ways. Why? In both cases the individual might lose all their money, so investing in his sister's business should be regulated, if regulation is to be meaningful and consistent.

For example, if the government guarantees money invested through a bank, why would it not do the same if the business of the sister of our investor goes bankrupt. In both cases the money was used for investment, in both cases our investor lost his savings. Where is the difference? As I said, mention of the word 'bank' seems to change everything, but I can see no rational explanation of why this should be the case. An investment is an investment, whatever the conduit.

The classic picture conjured up in defence of the regulation is that of a little old lady losing her life savings. My answer to this is the deposit banks. If, however, the little old lady wishes to venture outside the relative safety of a deposit bank, then she must accept that she moves into risk, including risk to all of her capital. However, the problem is just the same for all investors, and conjuring up images of little old ladies is just an emotive argument. A 30 year old man with a family to support will also be hurt badly if he loses all of his savings.

So how can this problem be overcome, the problem that when we invest money, we are subject to great risks? The answer is that the problem can never be overcome, but can be mitigated with information. In particular, the nature and source of the information needs to be regulated.

As such, the most important piece of regulation would be to actually make it illegal for banks, or any other financial institution, to pay for any kind of rating on their overall financial status, or the status of any of their products. It is obvious really, but the users of the ratings need to pay for the ratings if their interests are to be represented. As long as the banks pay for their own ratings, their is a fundamental conflict of interest.

The other regulation is even more straightforward. All of the speculative banks need to call themselves by this title, as a constant reminder of their nature. Whenever an account is opened, a standard form will state that they make no guarantee of the return of any cash deposited in their care, and that the person opening the account must declare that they accept the conditions. In addition, on a daily basis, they would be regulated to publish their daily (gold standard) cash reserves available for immediate withdrawl as % of deposits, as well as a monthly rolling statement of % change upwards and downwards. These would be audited on a random basis, with massive fines for any attempt to massage/distort the figures. The figures would be published on their websites and, where a bank has branches, published in the all of the branches in a predetermined format.

The aim of such a measure is to remove the complacent belief that any investment is safe. It is to remind individuals and business that they should take care over where they place their money. It is a climate of fear, and one which will encourage people to pay for services which critically scrutinise the state of the banks. A climate of fear sounds unpleasant, but it is the only discipline that will ensure that investors and depositors have a care for the use of their money. In addition, there is the security of the deposit banks, which will always be an option if the fear of the unregulated sector is too great for any individual. The deposit banks offer greater security than the existing banking system. In addition, other banks will take intermediate risk positions, maintaining relatively high cash reserves, but at the cost of smaller returns on money invested. This is the nature of all investment - the trade off between risks and returns. In a deposit bank, almost no risk and no returns.

At the heart of this argument, I keep on returning to risk, and the impossibility of the removal of risk. Even a deposit bank, backed by gold has risk. Any regulation that suggests that it removes risk is a delusion, and this has been demonstrated in this financial crisis. What was safe is now unsafe, and the regulators have been found to be wrong.

As such, my proposed reform does nothing to remove risk, or to attempt to mitigate risk. The aim of the system is simply to make the nature of the risk more transparent. Despite this, little old ladies, and 30 year old family men, will lose their savings. However, if that little old lady were to lose her money through investing in her grand daughter's business, no one would call for regulation of the granddaughter's business or ask that she not be allowed to ask her grandmother for investment.

As I said at the start, banks just serve two purposes. A relatively safe place to leave your money, or as a conduit for the risky business of investment. I have proposed a return to the gold standard, not because I believe that it is risk free, but because it provides for an alternative that offers people a certain contractual guarantee, albeit a guarantee with a limitation that the value of that guarantee is variable. It allows for deposit banks to offer a fairly low risk, but nevertheless a risk. It also supports the value of money, through offering an explicit contract. The value of that contract may vary, but the contract remains regardless of any change of circumstance.

I am not sure that I have done this subject full justice, but hope that, at least, it presents a challenge to the belief that banks must be regulated. There is a lot more detail that I would like to discuss, but time is (as ever) too short and I have other comitments that I need to attend to. I am also sure that there will be faults in my thinking, so I look forward to the astute readers of this blog pointing out the problems.

Note 1: I have not responded to the many posts over the last few days, as this has been a bit of a long and demanding post. As ever, I will try to catch up, though the backlog seems to get bigger by the day.

Note 2: I have reread the post, and apologies that it is a bit clunky in places. I hope that it is clear enough.