EZ money – you can Bank on it!

It is just like a circus act – spinning plates as the audience waits for one to fall. When one falls, the act is over and they all fall. The plates – the Eurozone and banks – are spinning still – just – but the spinner is tiring, there is less time to go and the plates are shaking wildly.

 

Both the European banking system and its impact on the Eurozone are in critical mode. The illnesses are not being treated – we are merely ameliorating the symptoms. The new package of measures announced on 29^th June provide some breathing space but the banks are the same banks as they were before and the Eurozone has exactly the same problems as it did on the 28^th June.

 

Twin Devils: EZ and Banking

 

Banking is a devilish concoction – see my earlier posting: https://jeffkaye.wordpress.com/2012/02/05/banks-and-time-travel/

which focuses on the Mephistophelean trade that banking makes with us – the bringing forward of tomorrow’s wealth into today (with our soul in return). No government since money was invented has properly understood banking or had the ability to control it and democracies are ill-suited to manage the banks, the bankers or their products (although that is not a case made for ending democracy!).

 

On the same day that the EZ nations announced their new answers to the EZ crisis, UK banks were being vilified for their LIBOR manipulations and for wrongly selling interest rate insurance to small businesses (many of which collapsed under the strain of the repayments when interest rates collapsed under the banking-induced downturn in 2008). It couldn’t be made up!

 

The EZ nations horse-trade over more loans to the banks which bypass the sovereign debt obligations of Italy and Spain, amongst others. Banks will get loans directly from the ECB (for example) – which means that Germany will guarantee 50% of the loans, but France, Italy and Spain will also carry a burden.

 

The twin devils are fighting for their existence and the markets applaud every move – but, the problems persist.

 

Twin headache

 

Banks have existed far longer than the EZ and will outlive it. The likelihood is that the EZ nations, fighting for the survival of the Euro, will continue to miss the point. Banks are not, in the main, national entities, they form part of a world-wide consortium. Banks are a supra-economy and their product – money – can be created easily and changes time – lending and borrowing transform today’s problems into tomorrow’s – in a way that nothing else in economics can do.

 

Banks’ ability to transform time (the magical transformation that lending and, to some extent, insurance provides) is exactly what has provided the EZ with its problems – and the issue that wrecked Lehmans and nearly wrecked the US banking system. The banks’ inability to control themselves within reasonable and rational limits of lending has now been transferred to the countries where they are based. Sovereign debt has been amassed to cover the time travelling antics of the banks. Twin problems.

 

Paying it Back

 

Most economists are unclear about the problems that banks provide when unregulated on a macro-economic scale – all governments suffer the same lack of understanding, Money is not just easily created and employed, it effects transfers between time that equilibrium-based traditional economics does not understand. A loan provided to a company at an interest rate with payments spread over many years represents the ability of that company to achieve something now rather than later. The debt is paid off through interest (the economist’s price of money) and over time. Discounted cash flow techniques (based on interest rates) debase the future – eventually, it completely discounts it as though it was worthless.

 

But, the price of money is not just the interest rate. Price is repaid from tomorrow’s debt mountain when the debts pile up beyond the ability of payers to pay. The devastation of the Greek economy and young people’s work prospects in Spain testify ingloriously to this. The price is a heavy burden when the macro-economic effects of out of control banks are misunderstood. Supply and demand curves for money are meaningless when money is more or less free and money becomes free very often in society – which assumes a zero risk. It happened in the 1990’s and it happened just prior to 2007/8 – money was free because it was being created from nothing – by new forms of leveraging in secondary and tertiary markets that no-one understood. Interest rates were of no use as bankers and financiers scoured the market for easy bets (for that is what they were).

 

Now, we face many years of deleveraging – where yesterday’s over-leveraging is paid back – where time travel gets reversed. It must be that the discounted cash flow calculations were wrong – the assumptions were riddled with errors.

 

3D Chess played with blindfolds in different time zones

 

Economic management of banks and of sovereign debt makes assumptions based on projections that are misunderstood. Fund flows and interest rates that are meant to cover the supply and demand parameters miss the critical build-up of debts at a national level and at an international level. It is the mass of debt and the difficulty of managing that debt pile against a continuously changing assembly of poorer and poorer borrowers that constantly defeats bank management. The constant desire to bring forward projects from tomorrow into today – whether by an individual or a company or a government – feeds that process. It is the drive to consume now, the size, complexity and continuous shifts that make the problem so much greater than it was in the 19^th Century.

 

3D Chess played with blindfolds and over different time zones looks easy in comparison and the answers are not easy to come by. The answers being implemented are micro-economic in the way that individual banks are required to increase capital ratios, for example.

 

The complexity in a period of deleveraging allied to a need for growth is enormous. Governments cannot (over time) have it both ways. Most developed nations are over-leveraged having borrowed far too much out of tomorrow’s wealth. At the same time, we are being told that we need more growth to help repay the debts. There is a limited intelligence involved here – or just maybe that the limited intelligence of politics is competing with economic reality. We should all be aware that for those countries in a downward spiral there are but three ways out of this: to deleverage (i.e. pay back debts); to reflate and debase a currency; to default – or a mix of the three. In the US and UK, reflation and currency debasement has been attempted; in Greece, there has been a default; elsewhere in Europe, the can keeps getting kicked but it looks more and more likely that German taxpayers will pay out for Italian and Spanish profligacy without the huge institutional and cultural changes that would make the investment worthwhile.

 

What’s the answer?

 

Governments have been trying to control banks for hundreds of years and failed. In the 21^st Century, complexity has risen as has the ability of major banks and their staff to manipulate markets and manipulate customers.

 

This is not just a banking or EZ crisis – we have now to question our economic judgement and whether capitalism as we have practiced it for the last fifty years works. Just like corruption, banks and bankers will swarm into any gap that the market allows. It is not much use to anyone to swing the pendulum back and forth on regulation as economies grow or splutter.

 

After all, the problems in banking and in the EZ are problems of economies and problems that are due to a laissez faire relationship with growth as measured by….money (GDP). The only targets that we (not just the UK but world-wide) measure our success in is in money. The only targets are GDP targets – growth targets are GDP.

 

What is the answer? The answer lies in our ability to bring quality (and ethics) into our economic affairs.

 

Quality vs Quantity

 

As the Chinese and other developing nations rise up the GDP scale and as the world continues to use up its natural resources, we have not assessed why we continue to follow 19^th Century economic principles that propose that we spend our way to happiness. GDP growth is important as societies develop – as hunger is eradicated, shelter is found, clothing is ensured and jobs provided. How important it is when we are “grown” is the debate that is now needed. Growth in what?

 

The rush for money (what seems to be the mainstay of society) is what has rushed the banks and EZ into the mire. We don’t understand the impact we are having on the next generation and beyond in terms of debts built-up and resources squandered.

 

We now have a quality vs quantity argument that underlies all the short-term “solutions” that we read about. The right answers require the right questions and the right questions may include something like: “do we need to use up tomorrow?” – that is what banking is, a discounted cash flow estimate of the future where everything is translated into numbers and where quality is completely overcome by the quantitative.

 

Numbers are in charge – and therefore banks (based solely on numbers) are at the forefront of such an economy. EZ crises are based on money and the addiction to numbers – GDP and growth. While this continues, so will our willingness to allow banks to seek out new methods of extracting tomorrow’s benefits to today.

 

To untangle societies from the rush for loans and products that banks supply (and EZ countries end up securing – and paying back through taxation) we should address the root cause – our predilection to the amassing of tomorrow’s money or its equivalent at the expense of tomorrow’s quality of life. Our kids and their kids deserve better – ask young Greeks or Spaniards.

 

 

Banks and Time Travel

So, Mr Stephen Hestor of Royal Bank of Scotland was pressured into giving up his bonus by a Parliament that threatened to vote against it.

So, Mr Fred Goodwin gets be-knighted by a committee advising the Queen.

Ancient institutions – the royal family and the House of Commons – are playing that old game (which the politicians invariably lose) about who is in charge – government (be they democratically elected or through birth) or the banks? Governments (at least the democratically elected bits) change with the whims of the electorate – banks and banking survive because money is the root of all our economic prosperity – banking is the provider of dreams.

It is a very old game. Since well before Nathan Rothschild strode above the travails of mid-19th Century politicians who were desperate for his bank’s money to fund their economies and wars, banks and bankers have formed their own super-economy – one that economists and politicians have progressively failed to explain or manage.

While the Royal Bank of Scotland saga focuses on bankers’ pay and the balance of reward between employees and shareholders (i.e. who should gain most from banks’ profitability), this misses the crucial issue completely.

What is it that makes banks and banking so critical to world economies in a way that no other industry is so that we are willing to allow them monopolistic rewards – the rewards akin to a totalitarian regime? More than this, how is the overall financial services industry – of which banks are just part – changing and how does it need to change to best serve people and real wealth producing companies, people and our governments in the 21st Century?

What are banks for?

At a simple level, banks are there to provide the alchemy to the economic system – they are asset transformers (David Llewellyn – the New Economics of Banking – 1999). Banks and financial institutions transform money received into money loaned. They transform short-term into long-term. They make tomorrow’s needs available today by making money work hard.

This transformation process (the essence of monetisation ever since the ending of barter economies) has been a crucial bedrock on which economic growth is based. The wealth effect of the asset transformers has been to bring forward tomorrow’s growth into today or next year’s into this or the next generations into this one. This time travel – the bringing forward of the future – is seen whether it is Governments spending trillions today to pay back in future generations, companies bringing forward projects on the basis of payback in three to five years all the way to purchases made on credit cards to pay back (or not) in a month or six. Banks and financial institutions have developed ever-more sophisticated ways to drive the transformation.

Sub-prime problems in 2008 showed, like most banking crises, the fault line in the world’s financial system – the cracks that often appear in that bedrock.

Pressure builds up just like the earth’s crust before an earthquake as financial institutions offer more and more high risk promises to transform the future to the present. In this case, promises to those who could never repay to buy properties they could never afford. It could have been corporate over-stretching. It could have been government over-spending – as it has now become: a massive sovereign debt crisis in the western economies.

The short-term bonus culture of the banks was and remains a symptom not the problem. The battle between senior bank employees and their shareholders is not the problem. The essential risk nature of banking (and there never has been a safe period when bankers were just bank managers who would not give loans – this is a myth circulated while banks were providing high risk loans throughout the corporate and national world) is that the asset transformation process (this time travelling capacity to bring forward tomorrow into today) is deemed to be so critical to the world’s economic system that banks (and many other financial institutions) are deemed to be vital and their survival guaranteed by governments. This has led inexorably to the current sovereign debt crisis in Europe and the ability of senior banking staff to act as monopolistic winners over both the banks’ shareholders and the rest of the economy. As David Kynaston wrote about the reasons for more recent banking excesses : “the most important is the arrival of the insidiously tempting one-way bet.”(David Kynaston – City of London – 2011)

So what (if anything) can be done to change this?

The Threat to the Time Travellers

As Llewellyn’s paper in 1999 suggested (and this was before the banking mayhem of 2008), banks are undergoing major changes that technology (for example) is forcing. Banking (for so long run by insider networks who knew each other and government ministers intimately, went to the same schools and spoke the same language) is now more open to other institutions (whether supermarkets or Virgin) and trading companies are better equipped to tackle the markets directly (corporate bond issues being the main way of doing this).

Yet, traditional banking methods and the banks’ place in the economy (especially in London) feels similar to what it has done for 200 years even if the competition is growing from other institutions and from overseas (Chinese banks – owned and dependent on the Chinese State – especially). Defence of our banks by our government against the newly developing nations financial institutions is one impediment to progress.

This could be a tipping point, though. Money and monetary systems will remain the kratogenic blocks on which economies slide and which cause massive earthquakes from time to time, but the banks’ position within these systems will change. Digitisation and the spread of wealth into the developing nations of China, Brazil and elsewhere will fracture the monopoly position of western banks and the West’s financial institutions. This may well be a good thing as monopolies are inherently massive impediments to improvement and sustainable growth.

A problem is that western economies that are dependent (or believe they are) on their banking system (London and New York especially but Paris and Frankfurt and elsewhere hate the prospect of losing their monopolies) will fight tooth and nail to prevent or at least slow the pace of change.

The other impediment to change is that those who are in charge of the change process – governments – don’t really understand the nature of banking. Tinkering at the edges (whether bonuses or knighthoods) is a waste of effort. Enlarging capital bases and splitting the casino elements of banking (which would be allowed to fail) from the more traditional lending elements of banks is moving to the right lines if (and this is the critical issue) there is an understanding of how this addresses the massive risks that banks are engaged in (and always have been). Many have argued that this splitting (providing only banks which are less susceptible to macroeconomic shocks should be given last resort assistance) is a cornerstone requirement.(Rochet, J-C Macroeconomic Shocks and Banking Supervision – 2008)

The enlarged capital bases and splitting of key activities into Chinese wall separated entities are hints of the crucial risk factors but not the answer in themselves. For risk and uncertainty are two entirely different features. Risk can be assessed, uncertainty cannot – a set of unknown unknowns. Individual bank risk at the micro-economic level may be manageable through higher capital ratios but take all the banks together and does an amalgam of micro-economic management techniques bulk up to a macro-economic solution?

As digitisation and competition (from other corporations and from newly developing countries) grow, it will lead to more opportunities to time travel. Yuan-based promises are no different from $ or € or £. The risks just get higher.

The critical issue is to manage the degree of tomorrow’s future wealth that we are willing to risk having now. Just like burning oil and gas today has a direct impact on our future generations, so monetary time travel can suck in tomorrow’s wealth. Just ask the Greeks (and Portuguese and the 50% of young Spanish without jobs) whether they agree with monetary time travelling – taking too much of the future for consumption now.

This is a hard call. Growth (at least that measured in the altogether faulty way that we measure GDP – quantity not quality) is at the core of our being. Banking has fuelled that core essence. Reducing the scope of banks and other financial institutions to bring tomorrow into today is a huge macro-economic decision that national banks (like the Bank of England) have to take on responsibility for.

National Banks – their role in macro-economic management of the Banking System

This is not just about bank regulation – it is about the how (at a macro-economic level) the risks and uncertainties are managed on a national and on a world-wide basis. Systemic and earth-shattering breaks in the system can only be better managed when international macro-economic indicators are understood and somehow controlled.

Transaction taxes, capital ratios, splitting bank operations are, I repeat, micro-economic devices. Macro-economic devices now need to be devised and international mechanisms established that regularly evaluate the banks’ individual exposure to macroeconomic factors. (Buch, Eickmeier, Prieto – Macroeconomic Factors and Micro-level Bank Risk – 2010). Building a model of this exposure using 21st Century macro-economic modeling techniques and used within an international banking framework, could be the starting point to better management of extreme banking risk.

But, it will take a transformation of international mindsets and international agreements to take 19th Century economic and political models into the 21st Century. Technology has moved on and presented individual banks and financial institutions with the ability to further manipulate economies and left governments in their wake. This needs some rebalancing and governmental management institutions need to be set up to oversee the critical part banks play in our world and to establish the macro-economic monitoring systems that are needed to avoid economic collapse.