If you are new to this blog, you are invited to read first “The Largest Heist in History” which was accepted as evidence and published by the British Parliament, House of Commons, Treasury Committee.

"It is typically characterised by strong, compelling, logic. I loosely use the term 'pyramid selling' to describe the activities of the City but you explain in crystal clear terms why this is so." commented Dr Vincent Cable MP to the author.

This blog demonstrates that:

- the financial system was turned into a pyramid scheme in a technical, legal sense (not just proverbial);

- the current crisis was easily predictable (without any benefit of hindsight) by any competent financier, i.e. with rudimentary knowledge of mathematics, hence avoidable.

It is up to readers to draw their own conclusions. Whether this crisis is a result of a conspiracy to defraud taxpayers, or a massive negligence, or it is just a misfortune, or maybe a Swedish count, Axel Oxenstierna, was right when he said to his son in the 17th century: "Do you not know, my son, with how little wisdom the world is governed?".

Monday, 27 April 2009

A matter of confidence

Long standing confidence of some can be irrationally based. Confidence of all may be irrational but will only last briefly. As Abraham Lincoln observed: “You can fool some of the people all of the time, and all of the people some of the time, but you can not fool all of the people all of the time.”

Politicians, experts and commentators talk frequently about consumers’ confidence. They refer to it giving impression as somehow this is a panacea for the economic crisis: when consumers’ confidence returns we will all be saved. They do not explain however what consumers’ confidence depends upon and why it disappeared.

Consumers’ economic universe operates between three worlds:
- the world of goods, products, services, etc that consumers buy;
- the world of money, convertible to cash on demand, that consumers earn, save or spend to buy goods, products, services, etc.
- the world of banks balance sheets: consumers borrow, save or invest their money in the financial system with expectations to be able to convert it to cash or spend it at some point.

The balance between these three worlds is critical for economy to function efficiently. It does not mean that there is one-to-one relationship between them in terms of value. For example if every consumer wanted to buy a certain model of a car, or indeed almost any good, product or service, there would not be enough of them on the market. However there is a consumers’ confidence, that should they decide to do it, there will be a product for them.

In a balanced economy, if a demand of certain products or services grows, it becomes more expensive, therefore it is more profitable to produce or provide it, and therefore producers or providers step in balancing a demand with supply. And vice versa: if a demand falls suppliers limit their production.

In a normally functioning healthy economy consumers do not stock products (even those vital for survival grain, water, fuel etc) or get services in advance. They have confidence that it will be always available for them on demand. However in some unusual circumstances, when consumers lose confidence they can make a run on a product. This usually happens at the outset of wars or social unrests. For example, during a war time a loaf of bread can cost a fortune, but even in less extreme situations, in Britain during fuel protests in September 2000, some consumers lost confidence to a level that a lot of them started stocking up gasoline. Similarly there was a run on bottled water in the beginning of the Iraq War in 2003 sparked by rumours of possible poisoning of water supplies in Britain. These are examples when an event breaks consumers’ confidence resulting in panic buying. In this case, restoring confidence is a cure.

However the confidence also can be broken on supply end: if there is a too frequent shortage of certain goods or services, consumers are not confident that they will get them on demand. Therefore they tend to stockpile them exacerbating the shortage. This is typical of countries with high inflation. However in such a case no matter how persuasive, for example, Zimbabwean government would be in asking the consumers not to stockpile goods, this would not restore a balance. There is too much money on the market chasing too few goods.

Confidence is a key for an efficient market of goods and products so consumers do not make run trying to stockpile them. But market cannot be based on confidence only as it is not an irrational belief but an effect of a very rational experience that, for everyone, there are enough goods and services going around on the market.

The same rational foundations of confidence apply to our money that we earn, borrow, save, invest and sometimes spend. Not much of it is kept outside the banking system as cash. To a great extent money ends up in banks as deposits: directly (e.g. savings, investments) or indirectly (e.g. spent and paid in by a retailer). Banks, in turn, lend this money which again ends up back in banks and is lent out again. This is called a multiple deposit creation process. As long as banks were lending with a loan to deposit ratio less than 100%, they were creating a finite amount of money, for every £1 cash, reflected on their balance sheets. For example, at loan to deposit (L/D) ratio 86.5%, for £7.41 on banks balance sheets there was £1 cash in banks reserves, at L/D ratio 90% for every £10 on banks balance sheets there was £1 cash in banks reserves and, at L/D 95%, for every £20 on banks balance sheets there was £1 cash in banks reserves.

Therefore banks worked as a confidence trick. Not everyone needed cash at the same time. Everyone believed that when they needed cash they would get it from the bank. This is the same type of confidence as on the consumers’ products and services market. It was borne out of experience. Any serious dent in that confidence could have ended up in run on the banks, when depositors try to get all their money out and keep it at home as cash. This would inevitably lead to a collapse of the system.

In the last 10 years or so, the banks turned such a healthy system on its head. They started lending more money than they were taking in deposits, i.e. with loan to deposit ratios above 100%. It meant that the ratio of banks balance sheets to cash circulation started growing at exponential (i.e. incredibly fast and compounding) rate, going to infinity if it was not stopped. It meant that for every £1 on the banks balance sheets there was no reserve created in a cycle. In fact the existing cash reserves were depleted and banks balance sheets kept on ballooning. This is a classic financial pyramid creation process. The fact is that with every cycle of multiple deposit creation process, with L/D ratio above 100%, the banks balance sheets were becoming more and more bogus. However, based on erstwhile experience, depositors, individuals and institutions, had confidence and continued to believe in the value of banks balance sheets.

The collapse of the pyramid happens when depositors realise that there is no cash for them when they need it. When a ratio of banks balance sheets to cash on the market is too huge. This is followed by a massive collapse of confidence. This in turn accelerates the pyramid collapse.

This mechanism is described in The Largest Heist in History, the founding article of this blog.

At present many politicians, analysts and journalists are calling for public confidence in the financial system. However confidence is borne out of experience and reality: basic rational facts. And the reality is that in December 2007 the value of outstanding derivatives, which epitomises the global pyramid, was $1.144 quadrillion (now it is very likely to be much higher, possibly in $5 - $6 quadrillion region). This was more than 21 than the world’s GDP (of $53 trillion). The currently committed global stimulus package is 1/572 of that (around $2 trillion). The size of the pyramid, i.e. a value of bogus banks balance sheets, is too huge to be even remotely confident that it is sustainable by the market liquidity. Governments’ rescue packages, miniscule to the notional value of the pyramid, are simply throwing good money after bad. There is also no chance that an economic growth could catch up with it.

Unless this huge financial pyramid is liquidated the difference between its notional value (running into quadrillions of dollars) and cash on the market (trillions of dollars) is so insanely colossal that calling for consumers’ confidence is a futile exercise. Bare figures (as above) show that such calls are not credible.

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