Bleeding the 'Real' Economy to Support the Financial System

I am in the highly unusual position of agreeing with Krugman (or at least in part), the Nobel winning economist who writes in the New York Times. He has just recently written an op-ed on the subject of the huge profits being achieved by Goldman Sachs ($US 3.4 billion), and says the following:

The huge bonuses Goldman will soon hand out show that financial-industry highfliers are still operating under a system of heads they win, tails other people lose. If you’re a banker, and you generate big short-term profits, you get lavishly rewarded — and you don’t have to give the money back if and when those profits turn out to have been a mirage. You have every reason, then, to steer investors into taking risks they don’t understand.

And the events of the past year have skewed those incentives even more, by putting taxpayers as well as investors on the hook if things go wrong.

Inevitably, the massive bonuses that Goldman are about to distribute are a major point of the controversy. However, whilst this is all good populist material, the focus should be on a system in which the banks were bailed out in the first place. As Krugman identifies, it is a case of 'heads they win, tails other people lose'. Krugman, I recall, was in favour of 'saving' the financial system, as were many others. What we are now seeing is the result of the 'salvation' of the system. The banks that took huge bad bets are now appearing to make large profits.

Regarding Goldman Sachs as the evil in the machine, the populist mantra of the day, I will not criticise them. Provided that they act in the law, their duty is to do the best possible for their shareholders, and also their employees. Goldman Sachs are simply doing a very effective job within a framework that allows them so much leeway. They are no different from GM in holding out their hand for government support, but are simply more effective at doing so. Goldman Sachs are just a symptom, and are certainly not the cause of the problem. It is not their role that should be subject to criticism, but the government and the Federal Reserve - it is the state that is the problem. It is the state that is at the root of the appearance of the bumper profits and bonuses at Goldman Sachs.

I say 'appearing', as there are real question marks over how 'real' these profits actually are. The bailout of AIG has been linked to an indirect bailout of Goldman Sachs, for example by the bane of Goldman Matt Taibbi of Rolling Stone magazine. On top of AIG, it is not clear how much Goldman has been bailed out by the various programs that have been enacted to remove toxic assets from the balance sheets of banks, as the recipients of such bailouts is shrouded in secrecy. There are also the changes in accounting rules have allowed banks to do some extraordinary accounting tricks:

During the financial crisis, the market prices of many securities, particularly those backed by subprime home mortgages, have plunged to fractions of their original prices. That has forced banks to report hundreds of billions of dollars in losses over the last year, because some of those securities must be reported at market value each three months, with the bank showing a profit or loss based on the change.

Bankers bitterly complained that the current market prices were the result of distressed sales and that they should be allowed to ignore those prices and value the securities instead at their value in a normal market. At first FASB, pronounced FAS-bee, resisted making changes, but that changed within a few days of a Congressional hearing at which legislators from both parties demanded the board act.

This is just one example. In other words, as a result of the bailouts and the changes to the accounting rules, it is nigh on impossible to work out exactly where any real profits might lie. Quite simply, nobody but the banks themselves and the Federal Reserve, and perhaps other arms of the government, can untangle the real state of the banking system. However, it is almost certain that the sudden profitability of the banks is rooted in the various bailouts and accounting tricks. Whilst it is quite plausible that many parts of the Goldman operations are profitable, the overall genuine profitability is buried in the accounting and the bailouts. Krugman identifies the complete opacity of the situation as follows:

I won’t try to parse the competing claims about how much direct benefit Goldman received from recent financial bailouts, especially the government’s assumption of A.I.G.’s liabilities. What’s clear is that Wall Street in general, Goldman very much included, benefited hugely from the government’s provision of a financial backstop — an assurance that it will rescue major financial players whenever things go wrong.

Under such conditions, it is no wonder that so many commentators are calling 'foul' over the massive bonuses that are going to be paid out by Goldman Sachs to their employees. However, the underlying problem remains as to why all of this has taken place. Why have the changes to the accounting rules taken place, and why are toxic assets being taken off the hands of the banks, thereby transferring risk from the private sector to the state sector?

The argument has been that certain financial institutions are 'too big to fail', but the reality is that the various government measures to support the situation is entrenching the system in which the large financial institutions threaten the financial system. With each bailout, with each measure, they undermine the market forces which might discipline the banks, creating ever more public exposure to private risk taking. In doing so, they simply embolden the banks to take further risks.

As was identified at the start of the process of the bailouts, there is an inherent moral hazard in bailing out banks, in that they cannot lose. They become a one way bet, and that will, however much oversight is applied, eventually lead to complacency, and excessive risk taking. It is now apparent that, under the current system, profit is guaranteed by public institutions. The worst case scenario for the major banks is that they might have a few quarters of poor or no profits, but there is an implicit guarantee that the government will do whatever is necessary to engineer a return to profitability. There will be no more Lehmans in the future, as the new regulatory regime will never allow another major bank failure for fear of a repeat of this crisis. One way or another, the 'too big to fail' banks will be immune from any major losses.

The solution given by many, like Krugman, is more supervision and regulation. However, if a bank is 'too big to fail', with proposals for special levels of supervision as a result, it will become to be seen as the 'safest' kind of bank. If a bank is seen as 'safe', it will offset any measures such as stronger capital adequacy requirements through being able to raise finance more cheaply, and through the state guarantee will win more business, and the result will be to just get bigger, and consolidate ever more risk into a small number of institutions. The crisis has already seen a consolidation in the number of major banks, and this process is likely to continue.

The problem is that the same regulators who failed to see the risks in the current system will be responsible for regulation under any new system. Whilst they might (possibly) be able to spot the kind of risks that caused the current financial meltdown, what is to say that they will be able to spot the risks that arise in the next particular set of economic circumstances? The difference is that, next time around, it is more likely that there will be even more concentration of risk in a few major institutions, and therefore even greater system-wide risk.

If you doubt what I am saying, take a look at one of the key policy makers discussing the state of housing and the financial system pre-crisis. I found this video of pre-crisis statements by Bernanke on Reddit recently. For the many out there calling for more regulation, you will need to think about how the regulators might be able to identify risk, when the record of policymakers is so abysmal. Quite simply, the policymakers who will formulate the regulation are clowns dressed up in important titles, armed with mechanistic formulae and jargon.

Whilst all of the shenanigans continue in the financial sector, the 'real' economy in the US continues to bleed. At some point in time, it is the real economy that will have to pay the price of the salvation of the 'financial system'. Again, I find myself agreeing with Krugman:

The bottom line is that Goldman’s blowout quarter is good news for Goldman and the people who work there. It’s good news for financial superstars in general, whose paychecks are rapidly climbing back to precrisis levels. But it’s bad news for almost everyone else.

The fact is that, one way or another, the 'real' economy will eventually be paying for the profits at Goldman and the massive bonuses, and that 'real' economy is already suffering extreme pain. In the meantime, it is not apparent that the 'salvation' of the financial system has translated into salvation of the economy. For all the talk of 'green shoots', the US economy continues on a steady descent, with all the pain that means for those working in the 'real' economy.

The panic engendered when the financial crisis hit is now over. I argued against the bailouts at the time that they were taking place, at that moment of panic. I argued that the resource being poured into the banks would be needed whilst the economy restructured. I argued that the bailouts would continue on from those that were proposed at the start, and that is what has taken place. And.....every single $US that has been poured into the rescue of the financial system will one day be repaid in taxation from the 'real' economy. I argued against the bailouts on this principle.

All of this, hidden in opacity, has led to a point at which insolvent banks are now able to make a 'profit'. Exactly why has this massive bleeding of resources into insolvent banks been allowed to take place? Where exactly is the salvation of the real economy, the pot of gold at the end of the rainbow of the financial system? Like the pot of gold and the rainbow, if we just go a bit further.....we might just find the pot of gold.

In this terrible mess, the point that is forgotten is what a financial system is actually really for. It only exists to allocate accumulated capital and provision of insurances; the financial system should be a support to the real economy, by efficiently allocating capital. It is entirely unclear how pouring trillions of dollars into insolvent institutions, capital which will eventually be taken out of the 'real' economy, might facilitate this. The 'real' economy is now expensively supporting the financial system, rather than the financial system supporting the real economy. It seems that this is the exact opposite of what a financial system actually should be doing. It is simply beyond any reasonable explanation.

It is the same policymakers who are supporting the financial system at the cost of the economy who will be formulating the new regulatory framework. It is the same policymakers who failed to see the risks inherent in the financial system that will be overseeing and regulating the future risks in the financial system. It is the same policymakers who have overseen the consolidation of the banking system into fewer hands, who are engineering a system in which banks will be ever more concentrated. It is the same clowns who were responsible for the current mess in the financial system, who have engineered that insolvent institutions make profits, that will suddenly have the wisdom to create a 'safe' financial system in which major risk is banished.

It is not an encouraging prospect.

Note: The use of the term 'real' economy is a convenience, as the financial system is actually part of the real economy. As such it is used simply as a way of saying that I am referring to the provision and exchange of services and goods outside of the financial sector.

Fractional Reserve Banking - More Explanation....

This post is a follow on from many comments on my last post on fractional reserve banking. If this is your first visit to the blog, you may want to look at some of the posts linked to on the left before this post, as this post is a little narrow and more than a little abstract, and attempts to clarify the previous post. If you do want to read on, in order to understand this post, you will need to read my previous post, which is here and may find the comments made by readers helpful in understanding the questions I am trying to address.

Before going on, I will re-emphasise something that some people missed. I am very clear that the central banks do indeed create money (but more of that in a future post). However, this should not be mixed up with the principle of whether Fractional Reserve Banking FRB creates money. My post on FRB seems to very contentious, with one commentator on a forum being very complimentary about the blog overall, but also suggesting that I do not understand FRB. I think the problem prompting such comments is very basic, and is the subject of argument amongst the different schools of economics - the question of what money is.

Returning to the definition of money, in my original post I went to some effort to make clear my definition of money. The argument about whether FRB creates money depends on how you might define money. Perhaps I never made the relationship between FRB and money clear as one person asked why I added this discussion of what money is.

I specifically gave the case of the IOU to make the point of my definition. The IOU is only money in the narrowest sense because it has a limited use in exchange, as it is only meaningful to a very limited number of people who are able to assess the value of the IOU. I would quote the section of the original post here but it is quite long. As such you may wish to return to the post, and you will find it about a third of the way down (using the scrollbar).

As another aside, it might be noted that a fiat currency can be viewed as an IOU, as in a fiat system we just collectively (most of the time) believe in the value of the fiat money. There is no underlying contract that gives value to the money, but simply a belief that is has vale. This is a difficult point to summarise, so you may wish to read my post here as this discusses money in some depth.

The question at the heart of the debate is whether FRB allows the creation of money from nothing. If we go back to how the money creation argument let us look at another example which is as follows:

Depositor A deposits 100 gold coins into Bank A.
Bank A loans 80 gold coins to borrower A for the purchase of a house.
Borrower A writes an IOU for 80 gold coins made out to Bank A.
At this stage we still have a total of 100 gold coins.
The house Seller A accepts the 80 gold coins in exchange for the house.
Seller A then deposits the 80 gold coins into Bank A.
At this point in time, we still have only 100 gold coins in total.
Bank A again has in hand the 80 gold coins.
Bank A lends out 64 of the gold coins to borrower B to purchase a house.
Borrower B writes an IOU for the 64 gold coins.
And so the process might continue....

....But you will notice that on each occasion, the total number of gold coins never changes, and the amount that the bank can lend diminishes on each occasion. Furthermore, there is never an increase in the number of gold coins, just an increase in the IOUs. I have left out interest on this occasion for simplicity and also because (at some point) I would like to deal with this on a post about inflation and deflation. In the end, in the above scenario, the bank will only ever be able to lend a total of 80 gold coins.

The key question in all of this is how money is defined, and this is why I went to some effort to make clear what my definition of money actually is. Under my definition, money only exists in the collective minds of all of us. Whilst some might imagine that the IOUs are money, they are not money, they are IOUs whose value requires specialist knowledge, is highly speculative and they are therefore of limited use as money.

The whole point of a bank run is that, when push comes to shove, these IOUs can not be used as money, because the depositors will not accept a note from the bank that says 'at some point in the future, subject to all kinds of circumstances, we will be able to give you x number of gold coins' - the simple reality is that in a case where gold coins are the universally accepted currency, that is all that counts as money in real terms.

As the situation stands, when people lined up outside Northern Rock, they wanted and accepted £5, £10, £20 and £50 notes, not IOUs. By their definition this is the only money there is, and they collectively are the only people that matter, as they finally determine what money actually is. In other words, the banking system creates what they believe is money on their balance sheets, but the people that really matter (all of us) do not accept the 'money' on their balance sheets as 'money'. It is an entry in a book, and can not be used as a unit of exchange that is accepted by us all.

In the example I have given above, lots of IOUs are created but there are never more than 100 gold coins, and therefore no money has been created. When someone wants their money back, they will not accept the IOUs, but they will accept the gold coins.

I used gold coins on the basis that in everyone's minds eye, it could be seen that no more money is created in the system. In my discussion of the subject I make very clear that the 100 pieces of gold creates a total of 80 pieces of gold lending in a 20% reserve system. Even Ben Bernanke's discussion of FRB agrees with this saying the following regarding a 20% reserve system:

'At this final stage the ratio of reserves to deposits equals the ratio desired by the banks (20%). No further expnasion of loans and deposits can occur after this point because the ratio of reserves to deposits is at its minimum acceptable level.' - Macroeconomics, 4th Edition, Ben Bernanke and Andrew Abel, p525.

In other words, at the end of the system, no more than 80% of the reserves can be lent. However the money shuffles around, the total money 'out in the world' will never be more than 80% of the total deposits. In the case of inter-bank lending, as I pointed out, the amount of those reserves 'out in the world' actually diminishes each time a bank lends to another bank.

At its most basic, an IOU on a bank balance sheet does not constitute money. It does not constitute money because it is not accepted as a unit of exchange. This is why we have bank runs.

I can quite understand why people become so confused about this, as many people would like to imagine that the IOUs do constitute money, in particular many economists. However, the reality is that, when push comes to shove, this does not constitute money, which is why banks hold reserves. However everyone might try to pretend that an IOU is money, the truth that it is not money is revealed when a depositor asks for their money back.

The problem that we have here is made even greater by the fact that fiat money is of itself a form of money based upon nothing more than belief that it is money. However, it is the only medium of exchange that is universally accepted. The idea that IOUs on a bank balance sheet are money is occasionally tested, and whenever the test happens, it is found that it is NOT money. Once again, we can see this in the case of Northern Rock.

As before, comments are welcome. I hope that I can leave this subject and start to look at central banks, but will come back to the subject if anyone can do the following:

1. Show me how the IOUs held by Northern Rock, the numbers in their books, constituted money.
2. How, using gold coins, with no central bank input, a fractional reserve banking system might create more gold coins than depositors have put in (excluding interest payments). For the sake of ease, please try to use 20% reserves.
3. How a bank lending to another bank does not lead to diminishing credit outside of the banking system (again in a flat 20% reserve system)

As I have said, comments welcomed and I hope that I have clarified my point. Like many commentators on my last post, I am occasionally seduced by the idea that money is 'created' when I have read the clever arguments, but keep pulling myself back to the reality of what a depositor accepts as money, and also what I would accept as money. What would you accept as money if you went to get your money from the bank, and they refused to return your £10 as a bank note when you ask for it to be returned as such?