Currency risk: a China's advantage

Every now and then we read or listen in the mainstream media that Chinese companies are overpaying for assets. Or that they are undercharging for contracts - like building infrastructure - they are entering into in many parts of the world . Every so often we hear the same arguments from the western companies that lost in competition to their Chinese counterparts. Quite often companies that lost to the Chinese protest and make accusations about Chinese state subsidies, unfair competition, undercutting, etc. All in all, the prevailing media image of the Chinese investors is that their decisions are not commercially sound (because they are overpaying) and politically driven (by overpaying they are trying to build a political influence). Nothing can be further from the truth. Anyone who dealt with the Chinese knows that they are commercially very shrewd indeed. What is the answer? How Chinese can overpay and still be shrewd. The recent negotiations between China and Russia or Turkmenistan regarding natural gas supplies are good examples.

China is sitting on a mountain of foreign reserves, some 3 trillion of the US dollars in value. Around half of that is in the US dollars. It is impossible to spend or invest such massive reserves, or a meaningful portion of it, without undermining their value. In the current economic conditions there is also a very high risk that these reserves will lose value. On top of that Chinese reserves keep on growing, and if Chinese stopped this process, i.e. stopped buying the US securities, the dollar would have collapsed, so their reserves would have lost very significantly. A solution that China pursues is spending a significant portion of their dollar (and generally foreign) reserves on buying assets representing long term tangible value such as natural resources, or making investments that would allow to derive a long term value, e.g. in infrastructure.

In the process of making an investment decision Chinese investors have to take into account that the money they spend carries a significant risk of losing value. Something around 30% - 50%. So if a seller (or a contractor) asks a Chinese company for $1, it represents a risked value of between $0.50 to $0.70 to the Chinese. This is the fiscal arithmetic of Chinese investors that takes into account their currency reserves risk.

On the other side, western companies, especially US' operate in a different fiscal environment, albeit under the same commercial principles. Even if they make investments with their own money, and more often than not it is borrowed money, they have to account for its costs. For example with an effective interest rate of 5%, $1 investment carries costs for an investor of 5 cents a year. So $1 investment represents a risked value of $1 plus interest.

Therefore facing a competition with Chinese investors, western companies, especially US', cannot compete on price. An investment of $1 represent a spending of 50 to 70 cents to Chinese whilst it represents $1 plus interest to a US or western companies. Assuming all other factors are the same (and usually they are quite close) a Chinese company can pay 1.42 to twice the price that a western company can pay acting on the same level of commercial rationality and soundness.

Such issues fly well above the heads of mainstream media pundits, politicians and even western companies' executives. These issues are very important however. They show how western governments' fiscal policy (especially the US') heavily undermined competitiveness of the western companies in the global economy. It all also shows how China is winning commercial game with the west. Crying about and protesting Chinese uncompetitive "commercial irrationality" will not help as it is... commercially irrational.

The chickens are coming home to roost

Mr Robin Griffiths, technical strategist at Cazenove Capital, told CNBC: "If the (dollar index) takes out the low that was made roughly a year ago I really think that will not only encourage more sales, it will cause a little bit of minor panic. A year ago it was deemed too cheap, if it goes any lower than that it's actually become toxic waste."

The blog readers are invited to read (again) an article published on this blog a year and a half ago: "A US way out?" The pundits are slowly getting the message: the chickens are coming home to roost and the US are doing some form of Chapter 11 to the rest of the world. This is the way the US are trying to recover from "The largest heist in history". It does not look too promising to be successful since it appears that the financial pyramid is too large and its mechanisms too powerful. The relationship between the financial industry and the taxpayer was turned into one akin to loan sharks and their victims. Any new spare financial balance or economic capacity will be eaten by the financial industry.

"To the Simple Man"

In the wake of the Wall Street crash in October 1929 as Great Depression erupted Julian Tuwim wrote the following poem. Ten years later the world was engulfed by the World War Two.

To the simple man

When every wall is hid by many
new posters freshly pasted up,
when ‘to the people’, ‘to the Army’,
in black print stare appeals alarming,
and any dolt, and any pup
will take for gospel each old lie
that one should go and shoot off guns
and murder, poison, rob, at once;
start drumming into all our noggins
the ‘Fatherland’; the mob incite,
bamboozle with bright-coloured slogans,
egg on with ‘Our historic right’,
‘every inch’, ‘glory’, ‘sacred borders’,
with ‘our forebears’, ‘pay the price’,
with ‘heroes’, ‘flag’ and ‘sacrifice’;
when bishop, pastor, rabbi come
to say a blessing on each gun,
for God has told them, that His will
is that for Country – you should kill;
when gutter tabloid screams and rages
in letters huge on its front pages,
and herds of females lose their voice
throwing bouquets at ‘our brave boys’,
– O, my untutored simple friend,
mate from this land, or other land!
Know that the bells for these alarums
kings strike, with girls with ample charms,
Know it’s all hogwash, lies perverted,
And when these call out: ‘Shoulder arms!’
That somewhere from the ground oil spurted,
With dollars soiling the bright colours;
That in their banks there’s something rotten,
They smelled some moneybags, it looks,
Or cooked some scheme, the oily crooks,
For higher import tax for cotton.
Drum on the pavement with your gun!
Ours the blood, the oil is theirs!
And through each capital and town
Scream out, to guard your cash blood-won:
‘Tell us another, noble sirs!’.

(translated from Polish by Marcel Weyland)

The real end of the Empire

It has been said on today's BBC "Question time" that for 200 years Britain had greater budget deficit than now. Even after the World War 2 it was able to build an amazing social system with NHS and social housing. "So what's the bother now?" the host, Mr David Dimbleby, asked.

It appears the there is a significant difference. For 200 hundred years at the time Britain was an empire, a real superpower that controlled its destiny. The financial markets and other lenders to the government at that time had really had to rely on what British government had been prepared to pay. And they had to lend if they wanted to exist. In a way it was a synergy but with Britain, as a state, had an upper hand over the financial industry. Now it is the other way round: Britain is at the mercy of the financial markets. It does not act like a sovereign state but like a minion being bullied by a loan shark. This is a reason why we see savage budget cuts now, and despite that, times are very uncertain indeed.

Globalisation is not a new phenomenon. The British Empire was truly global: "the Empire on which the sun never sets". What changed is who is in charge.

On a slippery slope

This week announced spending cuts on defence in the UK indicate the scale of the current financial crisis. Even, as a result of the previous Labour regime brought about economic disaster, at the end of 1970's the UK did not have to cut its forces that deep. In 1982 it was still able to mount a successful Falklands campaign. In the height of Conservative induced recession of the early 1990's it was able to provide a significant contribution to the First Gulf War. After the defence budget cuts just announced the British conventional military capability will be reduced to symbolic. Only nuclear deterrent will keep British position on the UN Security Council not reduced to a rather indefensible remains of a period when Britain was still a power.

Cuts of public spending in general on a similar scale will happen in other areas. They are also happening other countries like France where a very generous pension age is to be extended from the age of 60 to 65. So be it one might say. Maybe it all makes sense. Maybe it is not in British national interest to remain a significant military power. Maybe rising pension age is good for society. After all people who work longer (in good conditions, of course) are healthier and live longer. Besides industries and businesses propelled by the public sector are usually not the best examples of efficiency and productivity. The point is however not whether such saving and cuts make sense but why they are a financial necessity. Why such public spending cuts are not diverted through tax cuts or other spending to education, research, better pensions, health service, etc.

All the public spending is necessary because of the depth and spread of the financial crisis. This financial crisis is reshaping our social lives. It is done under propaganda of necessity and impunity for all those responsible. There is not much public debate. Having organised a pyramid scheme that pumped the cash out of the economy (and a lot of it is sitting in shadow banking and offshore financial centres), as described in "The largest heist in history", governments have kept taking money out of taxpayers pockets by making cuts and raising taxes, to sustain a pyramid of liabilities created by the financial industry (that incidentally has been funding a pretty good lifestyles of its administrators, i.e. the bankers).

In the UK the Prime Minister, Mr David Cameron, naively believes that this is "taking the Britain out of the danger zone". Nothing can be further from the truth. In fact the bankers achieved what the author of this blog warned about well over a year ago: they control, through mechanisms of the financial markets, the taxpayers in the same way as loan sharks control their victims with bullies with baseball bats. It is not more sophisticated in practice. It is not a socialist view but a laissez-faire perspective. The bankers are running a creeping October Revolution of our times: killing free market-based capitalism and replacing it with a communism for the filthy rich. As the recent Irish experience indicates, they are preparing to come for more. The present improvements of the UK standing on the financial markets after making cuts promises is an encouragement to make further cuts. Once the "markets" judge them deep enough, i.e. maximising a room in the budget to transfer more money to the banks, the "markets" will go the other way. The most obvious mechanism will be through downgrading British rating giving completely free cash to the financial industry. Due to the scale of the financial pyramid the end to this is not in sight. We are on a slippery slope and any talk about a better future is fooling people. Unless it is a better future for the bankers. On the face of it, leaving political wranglings aside, whilst the last Labour administration allowed (or even colluded) the financial pyramid to grow, the current Conservative one appears to sustain it. There is a solution however. But it requires guts, competence and wisdom.

Liquidity v money supply/demand

On 7 October 2010 The Economist published an article "The costs of repair". Its author wrote:

"So far the current recovery is following this post-crisis script. Output is sluggish and credit is growing weakly or shrinking across much of the rich world. But is this because over-leveraged households and firms have become less willing to borrow or because banks have become less willing to lend? In other words, is the credit problem one of demand or supply?"

Then the author concluded: "Both supply and demand probably play a role."

The question is wrong and the answer is wrong too. The problem is neither of supply nor demand but of liquidity: i.e. too high money multiplier makes it too risky to lend and to borrow. Banks do not have money to lend without fear of losing liquidity and money is too hard to come by to repay loans which is putting off prospective borrowers. In terms of statistical analysis (correlation) such situation will show up on both: supply and demand as causes, as both are causally subsequent to an underlying (and overriding) cause which is too high money multiplier (i.e. liquidity shortage). Here you can read more on liquidity shortage caused by high money multiplier.

Hopefully such money multiplier based analysis of the current financial crisis finds its way into the mainstream.

Incidentally it appears that the mainstream economists put too much weight, without understanding, on statistics and real analysis (in mathematics) and too little (practically nothing) on other branches of maths such as topology (that allow to determine relationships between phenomena which are the subject of an analysis). And The Economist and the mainstream media and the politicians are just confused. Little wonder, over 2 years after the Lehman Bros collapse the financial world remains in a mess and the taxpayers keep paying for it: after stimuli, spending cuts. What's next since the end is not in sight?

PS. Interestingly, it was The Economist that wrote the post script to this article. On 22 October 2010 they wrote in Benoit Mandelbrot obituary: "That markets are not Gaussian has now been accepted. Dr Mandelbrot’s interpretation, however, has not. Even if it had been, the bankers might not have noticed. They preferred algorithms to geometry." It is a good step forward. However if The Economist understood what they were writing about they would refer to topology rather than geometry.

The financial system, as we know it, is dead

Politicians, economists, bankers and mainstream media financial pundits fail to acknowledge the obvious: the financial system as we have known it for a hundred years or so is dead. Literally.

Until 2008 in the financial system a central bank was at its heart in every country (or a currency region like eurozone). It was regulating the money creation process by creating a lending base upon which commercial banks created credit. In a nutshell if economy had been getting overheated, i.e. there was an oversupply of money, sometimes called a "cheap credit", and inflation increased above what was regarded as an acceptable target (usually pretty low, in single percentage figures), the central bank would have raised the interest rate making borrowing more expensive. On the other side if inflation was too low, or growth too stagnant, the central bank would have lowered the interest rate thereby lowering the costs of borrowing. The interest rate had to be above an inflation rate as otherwise lending would not have made commercial sense. This is an obvious wisdom. What is somewhat less obvious is why it was so? Why if a central bank had raised or slashed interest rate, until the outbreak of the current financial crisis, all commercial banks would have had to follow? By no means this was regulated by any directives or government pressure. These were open market operations that worked until September 2008.

A central bank has a sole prerogative of printing money (whether as banknotes or through electronic credit, but this is the same). When a central bank set its interest rate it meant that it was prepared to lend to the financial markets at that rate. It would have also borrowed from the commercial markets below that rate. This was done using financial instruments bought and sold on the financial markets and priced by the financial markets. I.e. the price was real as other commercial institutions were selling and buying the same instruments at the same price. It is called open markets operations. A central bank was buying the financial instruments if they were giving more yield than its interest rate and selling them otherwise. This was producing the balance of money supply with inflation and growth as the commercial banks were lending at the rate that followed very closely the central bank’s own rate. For any commercial bank the central bank was, in practice, unlimited source of credit supply at the cost of its rate. The difference between a commercial interest rate and a central bank’s interest rate represented operating costs of a commercial bank and a customer risk (i.e. were insurance against bad loans).The existence of a number of commercial banks created competition market so their interest rates followed very closely central bank’s rate. The government did not have to tell the banks to lend money. After all it was their core business. Instead a central bank was raising or lowering its interest rate, did open market operations and the financial markets did the rest. All recessions as we knew them until 2008 were in fact market readjustments, balancing acts, between inflation, growth and money supply.

This does not work anymore. The central banks’ interest rates in the countries that suffered from the financial meltdown of 2008 (US, UK, Eurozone) are at the rock bottom. Below the inflation rates. The commercial banks are scarcely offering credit, well above the central banks’ interest rates. In fact they do not want to offer it at all and the governments are pathetically calling for the banks to start lending. (Well, they would if they could. It is their core business after all.) What’s happened? Why, as before and for a hundred years, central banks cannot intervene through open markets operations and let the financial markets sort that out?

The current financial crisis was caused by the financial institutions, with help from the regulators and the governments, setting up the giant global pyramid scheme by lending with loan to deposit ratio greater than 100%. The banks’ cash reserves were depleted and the money multiplier reached stratospheric levels. In fact no one knows it if risks of contingent and possible liabilities parked in OTC contracts and the shadow banking system are taken into account: the lowest estimates are around 50. Therefore a huge number of financial instruments on the financial markets do not represent much commercial value but the scale and depth of the pyramid scheme. Commercial buyers do not want to buy them. These instruments are worthless. Hence central banks cannot buy them either for newly printed money. Almost any additional liquidity is produced through quantitative easing. This is a centrally controlled process of spending newly printed (or electronically transferred) money on financial instruments for which there are no commercial buyers. This is in sharp contrast to how it used to be: the process of money supply was controlled by central banks and dynamically executed by the financial markets.

This crisis shows that financial system, with all its mechanisms like mark-to-market, worked till 2008. But it was simply killed when it was turned into a giant pyramid scheme. Little surprise there. The current governments’ actions of pouring taxpayers money (through quantitative easing, financial stimuli and spending cuts) are nothing more than pathetic attempts to revive rotting and smelly corpse of the pyramid scheme. Instead this pyramid must be liquidated and the system must be started afresh. There will be losers of course. The current political and financial establishments are trying to push the costs on the taxpayers. Taxpayers sometimes protest that they do not want to pay for the damage caused by the political and financial establishment (who still reward themselves very handsomely for the mess that they caused). It is still not clear who, in practice, will win this argument as the problem simply appears to be too big to be quietly absorbed by the taxpayers in an ordinary course of politics (taxes, spending cuts and government and businesses propaganda). Or, as the signs are, we might end up in an even bigger mess.

Does Bob Diamond (new CEO of Barclays) understand banking?

The first answer that comes to mind is emphatic: yes. His position proves that. Hence it is worthwhile to reflect on his opinions in the recent Telegraph. As it was reported: "Bob Diamond, the new chief executive of Barclays Bank, has turned on critics of "casino banking" saying that the use of the term "has no basis in reality. [...] [Investment banks] aren't casino businesses. These are real, client-driven businesses. We are providing services to corporate clients, to fund managers, to retail clients through branch banking and high net-worth banking."

Over a year ago the author of this blog observed in his article "Investment banking perverse casino model": "[...] the modern investment banking business is operated like a casino whose owner lends tokens to punters at a very high interest rate. However the punters’ loans and interest become only payable to a casino owner out of their winnings.

No sane casino owner would have ever accepted such a self defeating business model. Yet the banks are such casinos. Banks’ stakeholders (shareholders and depositors) are such casino owners. And bankers are the punters."

Casinos are also "client-driven businesses" providing services. Albanian pyramids as well as a Madoff's pyramid were also such businesses. In fact similarly to Albanian pyramids' and a Madoff pyramid's clients many direct (and indirect, like the whole economy) clients of investment banks went bust. As shown in the "The largest heist in history" the entire financial system was turned into a giant global pyramid.

The crux of the matter is that casinos and pyramids do not create any tangible value but are mechanisms of wealth redistribution heavily biased (i.e. giving the disproportionally large proceeds) to those who control them. That is why gambling, which additionally due to its addictive character is considered by many as vice, although legally accepted in many countries is generally heavily regulated. Financial pyramids, which proved lethal to economies on very many occasions throughout history, are banned altogether in the civilised parts of the world.

An unbelievably professionally shallow character of Bob Diamond's comments (e.g. "[Investment banks] aren't casino businesses. These are real, client-driven businesses.") seems to suggest that he does not really understand the fundamentals of banking (in particular the mechanism of money multiplication). And as a PR exercise these comments were insulting to any half-intelligent taxpayer who has to pay, by higher taxes and cuts in public spending, through his (or her) nose for the costs of the crisis caused by the banks' engineered crude financial pyramid. However it is reasonable to assume that Mr Diamond is representative (or rather above the average) of top financial executives. No wonder then we are in such a massive financial and economic mess now, listening to unreasonable and actually irrational excuses type-"it is global, no one could have predicted that". However, thanks to no more competent politicians, thus far the financial establishment is successful preserving the perverted nature of the financial industry.

James K. Galbraith: "Fraud at the root of the financial crisis"

James K Galbraith, along with Bill Black and a few others, have been making similar arguments to the author of this blog for a long time. Hopefully the work on this blog contributes to the technical and legal arguments that prove that the current financial crisis is a result of fraud (whose mechanism is a classic pyramid scheme). The title given by this blog author.

Statement by James K. Galbraith, Lloyd M. Bentsen, jr. Chair in Government/BusinessRelations, Lyndon B. Johnson School of Public Affairs, The University of Texas at Austin, before the Subcommittee on Crime, Senate Judiciary Committee, May 4, 2010.

"Chairman Specter, Ranking Member Graham, Members of the Subcommittee, as a former member of the congressional staff it is a pleasure to submit this statement for your record.

I write to you from a disgraced profession. Economic theory, as widely taught since the 1980s, failed miserably to understand the forces behind the financial crisis. Concepts including “rational expectations,” “market discipline,” and the “efficient markets hypothesis” led economists to argue that speculation would stabilize prices, that sellers would act to protect their reputations, that caveat emptor could be relied on, and that widespread fraud therefore could not occur. Not all economists believed this – but most did.

Thus the study of financial fraud received little attention. Practically no research institute sexist; collaboration between economists and criminologists is rare; in the leading departments there are few specialists and very few students. Economists have soft-pedaled the role of fraudin every crisis they examined, including the Savings & Loan debacle, the Russian transition, the Asian meltdown and the dot.com bubble. They continue to do so now. At a conferencesponsored by the Levy Economics Institute in New York on April 17, the closest a formerUnder Secretary of the Treasury, Peter Fisher, got to this question was to use the word “naughtiness.” This was on the day that the SEC charged Goldman Sachs with fraud.

There are exceptions. A famous 1993 article entitled “Looting: Bankruptcy for Profit,” by George Akerlof and Paul Romer, drew exceptionally on the experience of regulators who understood fraud. The criminologist-economist William K. Black of the University of Missouri-Kansas City is our leading systematic analyst of the relationship between financialcrime and financial crisis. Black points out that accounting fraud is a sure thing when you can control the institution engaging in it: “the best way to rob a bank is to own one.” The experience of the Savings and Loan crisis was of businesses taken over for the explicit purpose of stripping them, of bleeding them dry. This was established in court: there were over one thousand felony convictions in the wake of that debacle. Other useful chronicles of modern financial fraud include James Stewart’s Den of Thieves on the Boesky-Milken era and Kurt Eichenwald’s Conspiracy of Fools, on the Enron scandal. Yet a large gap between this historyand formal analysis remains.

Formal analysis tells us that control frauds follow certain patterns. They grow rapidly, reporting high profitability, certified by top accounting firms. They pay exceedingly well. At the sametime, they radically lower standards, building new businesses in markets previously considered too risky for honest business. In the financial sector, this takes the form of relaxed – no, gutted – underwriting, combined with the capacity to pass the bad penny to the greater fool. In California in the 1980s, Charles Keating realized that an S&L charter was a “license to steal.” In the 2000s, sub-prime mortgage origination was much the same thing. Given a license to steal, thieves get busy. And because their performance seems so good, they quickly come to dominate their markets; the bad players driving out the good.

The complexity of the mortgage finance sector before the crisis highlights another characteristic marker of fraud. In the system that developed, the original mortgage documentslay buried – where they remain – in the records of the loan originators, many of them since defunct or taken over. Those records, if examined, would reveal the extent of missingdocumentation, of abusive practices, and of fraud. So far, we have only very limited evidenceon this, notably a 2007 Fitch Ratings study of a very small sample of highly-rated RMBS, which found “fraud, abuse or missing documentation in virtually every file.” An efforts a year ago byRepresentative Doggett to persuade Secretary Geithner to examine and report thoroughly onthe extent of fraud in the underlying mortgage records received an epic run-around.

When sub-prime mortgages were bundled and securitized, the ratings agencies failed to examine the underlying loan quality. Instead they substituted statistical models, in order to generate ratings that would make the resulting RMBS acceptable to investors. When one assumes that prices will always rise, it follows that a loan secured by the asset can always be refinanced; therefore the actual condition of the borrower does not matter. That projection is,of course, only as good as the underlying assumption, but in this perversely-designed marketplace those who paid for ratings had no reason to care about the quality of assumptions. Meanwhile, mortgage originators now had a formula for extending loans to the worst borrowers they could find, secure that in this reverse Lake Wobegon no child would be deemed below average even though they all were. Credit quality collapsed because the system was designed forit to collapse.

A third element in the toxic brew was a simulacrum of “insurance,” provided by the market incredit default swaps. These are doomsday instruments in a precise sense: they generate cash-flow for the issuer until the credit event occurs. If the event is large enough, the issuer thenfails, at which point the government faces blackmail: it must either step in or the system willcollapse. CDS spread the consequences of a housing-price downturn through the entire financial sector, across the globe. They also provided the means to short the market in residential mortgage-backed securities, so that the largest players could turn tail and bet against the instruments they had previously been selling, just before the house of cards crashed.

Latter-day financial economics is blind to all of this. It necessarily treats stocks, bonds, options, derivatives and so forth as securities whose properties can be accepted largely at face value, and quantified in terms of return and risk. That quantification permits the calculation of price, using standard formulae. But everything in the formulae depends on the instruments being as they are represented to be. For if they are not, then what formula could possibly apply?

An older strand of institutional economics understood that a security is a contract in law. It canonly be as good as the legal system that stands behind it. Some fraud is inevitable, but in afunctioning system it must be rare. It must be considered – and rightly – a minor problem. Iffraud – or even the perception of fraud – comes to dominate the system, then there is no foundation for a market in the securities. They become trash. And more deeply, so do the institutions responsible for creating, rating and selling them. Including, so long as it fails torespond with appropriate force, the legal system itself.

Control frauds always fail in the end. But the failure of the firm does not mean the fraud fails: the perpetrators often walk away rich. At some point, this requires subverting, suborning ordefeating the law. This is where crime and politics intersect. At its heart, therefore, thefinancial crisis was a breakdown in the rule of lawin America.

Ask yourselves: is it possible for mortgage originators, ratings agencies, underwriters, insurers and supervising agencies NOT to have known that the system of housing finance had becomeinfested with fraud? Every statistical indicator of fraudulent practice – growth and profitability– suggests otherwise. Every examination of the record so far suggests otherwise. The verylanguage in use: “liars’ loans,” “ninja loans,” “neutron loans,” and “toxic waste,” tells you that people knew. I have also heard the expression, “IBG, YBG;” the meaning of that bit of code was:“I’ll be gone, you’ll be gone.”

If doubt remains, investigation into the internal communications of the firms and agencies inquestion can clear it up. Emails are revealing. The government already possesses critical documentary trails -- those of AIG, Fannie Mae and Freddie Mac, the Treasury Department andthe Federal Reserve. Those documents should be investigated, in full, by competent authorityand also released, as appropriate, to the public. For instance, did AIG knowingly issue CDS against instruments that Goldman had designed on behalf of Mr. John Paulson to fail? If so,why? Or again: Did Fannie Mae and Freddie Mac appreciate the poor quality of the RMBS theywere acquiring? Did they do so under pressure from Mr. Henry Paulson? If so, did SecretaryPaulson know? And if he did, why did he act as he did? In a recent paper, Thomas Ferguson and Robert Johnson argue that the “Paulson Put” was intended to delay an inevitable crisis past theelection. Does the internal record support this view?

Let us suppose that the investigation that you are about to begin confirms the existence of pervasive fraud, involving millions of mortgages, thousands of appraisers, underwriters, analysts, and the executives of the companies in which they worked, as well as public officials who assisted by turning a Nelson’s Eye. What is the appropriate response?

Some appear to believe that “confidence in the banks” can be rebuilt by a new round of goodeconomic news, by rising stock prices, by the reassurances of high officials – and by notlooking too closely at the underlying evidence of fraud, abuse, deception and deceit. As youpursue your investigations, you will undermine, and I believe you may destroy, that illusion.

But you have to act. The true alternative is a failure extending over time from the economic tothe political system. Just as too few predicted the financial crisis, it may be that too few are today speaking frankly about where a failure to deal with the aftermath may lead.

In this situation, let me suggest, the country faces an existential threat. Either the legal systemmust do its work. Or the market system cannot be restored. There must be a thorough, transparent, effective, radical cleaning of the financial sector and also of those public officials who failed the public trust. The financiers must be made to feel, in their bones, the power ofthe law. And the public, which lives by the law, must see very clearly and unambiguously that this is the case. Thank you."

Irish lesson - post scriptum

In an article "Irish lesson" published on this blog on 14 August 2010, the author argued that the UK credit rating will be cut by the rating agencies, despite (or rather because) of the government savings, public spending cuts and austerity measures.

Recently a credit rating agency, Moody's, has confirmed such an intention.

The so-called "financial markets" have become so transparent, conspicuous and predictable in their rather crude ripping off strategy of the taxpayers that it defies belief. It adds insult to injury: this is exactly like a burglar sending an advance notice to his victims and then robbing their homes in front of their eyes.

We are getting poorer

Let us look at the current economic figures as reported tonight by the BBC (interest rates given are per annum):

On the "costs" side: the Consumer Price Index is currently running at 3.1%. The Retail Price Index, which reflects the real increase in costs of living, is currently running at 4.8%.

On the "income" side: the wage rise is currently running at 2%. The Bank of England interest rate is currently 0.5% and it is difficult get anything above that on the savings.

Our savings are eroded by a staggering 4.3% a year. Shockingly it is more than Halifax standard variable rate which is at 3.5% a year. However those with mortgages are not that lucky since, typically, they have to earn their living. Their wage is shrinking by 2.8% a year. This is offset to some degree by depreciation of the loan value if an interest of the mortgage is below the rate of inflation (using Halifax rate it is 1.3%). These figures are striking: we are all ripped off, savers or mortgage payers alike. The economy remains in a morbid state.

What does the above tell us? We, the taxpayers, are getting poorer. With trillions of pounds circulating in the economy the difference between "costs" and "income" is substantial. And growing (in an exponential way, i.e. very fast indeed). So on the whole we are getting much poorer. It is clear that this is a process, executed in a rather clandestine way, of inflating out the current liquidity crisis since the effective interest rate (interest rate minus inflation) is negative. This is the way we are paying for the largest heist in history. It begs a question why neither politicians nor mainstream media discuss this aspect of the current economic situation.

Irish lesson

The UK government was warned in the article “Prime Minister, sort out this mess, please” about the risk that by making all the savings and cuts, without taking adequate protective steps, it is is “inviting” the “financial markets” to downgrade the UK rating. I.e. the saving and cuts are very likely to be perceived by the “markets” as the government's increased capacity to borrow short term by the amount of those cuts and savings. Hence it will be able to pay more in interests to the “financial markets”. There seems to be a little doubt that the “financial markets” are not going to miss such opportunity to get even more money from the taxpayers. “Financial markets” have a very short term strategies. Practically it is all about to the next bonus, a Madame Pompadour view of the world: “aprés nous le déluge”. As it seems the credit rating agencies do not play a role of objective judge of credit worthiness but are merely tools for making money by the “financial markets” players.

After the article “Prime Minister, sort out this mess, please” was published this is precisely what happened to Ireland. On 19 July 2010 The Irish Times announced having made massive spending savings, cuts and implemented austerity measures, Ireland rating was downgraded. The same strategy of the “financial markets” can reasonably be expected towards Britain. This is how the "financial markets" work these days. Indeed they are already half way there, i.e. the government announced saving and cuts without taking adequate protective measures. And the reasons for the UK downgrade will not be important: they will always be found.

Heading towards global Zimbabwe?

On 9 August 2010, BBC Newsnight reported that $1 trillion stimulus package was not sufficient v, "the recovery is losing momentum" and that quantitative easing (QE) is now expected to follow, to stimulate the economy.

In her report, a BBC Newsnight journalist, Ms Naga Munchetty, gave an explanation what QE was. Her account was absolutely consistent with the foundation premise of this blog, and the analysis based on it. The current crisis was caused by the financial institutions that constructed a giant pyramid scheme (by lending with loan to deposit ratio greater than 100%, thereby generating in a run away manner a massive and uncontrollable money multiplier).

Ms Munchetty said: "Quantitative easing is likened by some economists to pouring liquid down the black hole in the dark." This black hole is nothing mysterious. In fact it is the amount of money needed to reduce the current massive level of money multiplier to an acceptable level. Smaller money multiplier means higher financial liquidity as one dollar of real cash has a smaller number of dollars of liabilities to serve. Historically, when economy functioned properly, it used to be in 5 - 8 region. In simpler terms, this is printing money to support the financial pyramid so it does not run out of cash. Had Albanian gangesters been allowed to do the same in 1997, their pyramids would not have collapsed either. However they did not have a clout of the modern days' financiers to convince Albanian government that this was the "right" way forward.

Ms Munchetty continued: "It's hard to tell how deep the hole is, or when you are close to filling it up." This precisely refers to the fact that we do not know the current level of money multiplier. (As it has been proved on this blog this is a direct result of a lending with loan to deposit ratio greater 100%: it is its characteristics. It is a loss of control of money multiplier resulting from lending with loan to deposit ratio greater than 100%.)

The filling in"holes of confidence", i.e. restoring confidence between banks, companies in the commercial world, mentioned by Ms Munchetty is simply a reduction of money multiplier to an acceptable level. It is also clear why banks are not lending: they hold off to QE money as it reduces the money multiplier, which any lending whatsoever would have increased (even with a minimal loan to deposit ratio).

However, contrary to what Ms Munchetty's suggested, "what happens next" once the black hole of liquidity is filled up is completely predictable. Once money multiplier reaches acceptable level, the banks will start lending again. It is their business and in fact they are urged to do so by politicians and business people. At that point the QE money, trillions of dollars will find its way to the market and will get multiplied. Even if the banks lend with a very low loan to deposit ratio of 50%, this money will be doubled. If they use a conservative 80%, a much more realistic scenario, the money will be multiplied by 5. I.e. every trillion of dollars in circulation will very quickly create a demand for 5 trillion worth of products and services in the current low inflation economy. To economists who "do not know": this means, surprise, surprise raise in inflation at an instant. Now you have been warned.

Any suggestion - supposedly by some economists - that printing money will result in economic growth, as Ms Munchetty also mentioned, defies belief and rational thinking. If that was possible any country would grow its economy by printing money. We all would be rich without doing much work (apart from running the printing presses). Presently Zimbabwe would have led the world as the most successful economy. It is simply amazing what some bewildered or dishonest economic pundits come up with trying to avoid the central issue of this crisis: the financial system has been a massive pyramid scheme with all its fraudulent characteristics.

"Hier liegt der Hund begraben"

In Britain, the politicians are putting pressure on the banks to start lending. The public pressure and the media are also adding to it. It has been going like that, on and off, for some months, well over a year. Yet the banks whose primary business is to generate income by lending money are not doing so. Why something that was banks "raison d'être" and "modus operandi" for hundreds of years until the outbreak of the current financial crisis in September 2008, became so problematic. Is it not bizarre?

The public perception of the banks is that they are nasty. That it is all down to greedy irresponsible bankers that act against the national interest. Whilst it looks like a reasonable assessment of the state of the banking, it does not explain the root cause. If the banks had had money they would have lent it: this is the business they know very well for centuries and it is very profitable.

The crux of the matter is that by creating a massive pyramid scheme the banks pumped out the massive amounts of cash from mainstream banking to shadow financial institutions, hedge funds, offshore, SIV, etc. The money multiplier (in a simplified way called the leverage) is far too big to allow for further meaningful lending. The money put by taxpayers rescued the system but it was not enough to fill the liquidity hole sufficiently enough so as to reduce money multiplier to manageable level. In fact the government does not know what the size of liquidity hole is. In fact, due to the nature of the OTC market and off balance sheet practices, it appears that it is impossible to assess it but strong indications are (e.g. figures by the Banks of International Settlements in basel) it is massive: globally hundreds of trillions or even quadrillions of dollars. Many times over the world's GDP. Any lending, even very conservative, increases money multiplier still further.

The banks are caught in a "damn if you do, damn if you don't" situation. If they start lending as politicians and the public expect, they will deteriorate still very fragile liquidity situation, with a high risk of another massive credit crunch. If they don't, the economy recovery is very seriously impeded which also has a very serious impact upon the financial markets liquidity. "Hier liegt der Hund begraben."

No politicians' appeals are going to change any of that. They are, in fact, quite populist and rather incompetent. Or maybe bankers are expected impossible, to create a pretext to get them by the throat and sort them out? Politicians becoming more clever than bankers? "Exitus acta probat." Banks do not lend because they cannot. The solution is a reduction of money multiplier: "Prime Minister, sort out this mess, please".

The Economist on weed

In the last issue of The Economist an article "The banks on methadone" was published.

Its author wrote:

"All these banks are trying to lower the ratio of loans to customer deposits; sounder banks will be rewarded when a new banking levy comes into force next year. Lloyds Banking Group, for example, has a loans-to-deposit ratio of 169%, according to research by Nomura Securities. Barclays and RBS are at 130% and 134%, respectively."

It looks that, at long last, the banks acknowledged that lending with loan to deposit ratio greater than 100% was the cause of the crisis (or at very least that it is a huge problem). This was made clear in "The largest heist in history" written at the end of 2008, immediately after the crisis erupted. However the banks are not going to publicly acknowledged that but are trying quietly do the right thing: reduce this ratio. The snag is that it was not the ratio itself that hit with liquidity crunch but the ridiculously high money multiplier that directly resulted from lending with loan to deposit ratio greater than 100%. High money multiplier means that $1 (or £1, €1, i.e. cash, the legal tender, only real liquidity mean of settling liabilities) has to serve in the system a massive number of dollars (euros, pounds) of banks liabilities ($40, $100, $1,500, anyone's guess could be good as the control was lost by losing control over derivatives and shadow banking markets). This results in banks' assets turing to toxic waste as there is not enough cash in the system going around (due to high money multiplier) to settle the transactions.

Here is a banks' quagmire: continued any lending by banks even with a very low loan to deposit ratio (like 5% or 10%) still increases money multiplier (albeit at much slower rate), therefore exacerbating banks' liquidity position further. So the banks should not really lend at all. But if they do not lend at all the entire system would grind to a halt and the economy would collapse (most likely banks would not get any more of repayment of the loans). So we have a classic: "damn if you do, damn if you don't". So there is little wonder that the banks took all the money from the government but did not start lending again. If the politicians had a bit of intelligence (and basic knowledge of finance) they would have known it. They could not have expected banks to "repair" their balance sheets and lend money at the same time. These two things are contradictory. The point is that there are only two ways of reducing high money multiplier: inflate your way out (print money) or write off banks liabilities (or their combination). Both are not socially and politically acceptable (but a gradual inflating out is already happening).

The writer in The Economist continued:

"But the banks may be wrong to think that squeezing loans will improve these ratios; the Bank of England warned in June that growth in lending is usually the main driver of higher deposits."

It is a mathematical fact that if you stop lending and your loans come back as deposits (which are not re-lent), the ratios would be improved from above 100% to below 100%. However, on practical level the economy, as we know it, would be killed in this process as the money stopped circulating. If you lend less out of your deposits, your loan to deposit ratio will go down (however you may still struggle with high money multiplier). Higher lending indeed drives higher deposits, as the writer in The Economist said, but in absolute terms. This is false in terms for ratios: higher lending drives the loan to deposit ratio higher. This is a mathematical fact. The Economist writer does not understand the basics and confuses a relative figure of loan to deposit ratio with absolute figure of deposits. It is quite amusing to watch the banks doing the right things quietly (so they are not accused of not doing so in the first instance) whilst being lambasted by The Economist for doing these right things.

The paragraph cited in two bits above from The Economist epitomises what went wrong with the banking system (lending with too high loan to deposit ratios) and that mainstream commentators do not have a basic understanding of the mechanism how it works. Even nearly two years later. Although banks got round to it eventually: but it looks that it will be too little and too late and, of course, they will not acknowledge that they were effectively peddling and Albanian-type pyramid scam.

The world has gone bonkers

The Sunday Telegraph has reported today: "JP Morgan has raised serious concerns about its commitment to its new £1.5bn European headquarters at Canary Wharf because of anger within the bank at the lack of support for the financial sector in the UK."

Has £850 billion subsidy pumped by the UK taxpayers to the financial sector not been enough? The sooner these guys like JP Morgan go, the better. Compared to JP Morgan, Arthur Scargill is a true standard bearer of laissez faire capitalism.

Or, perhaps, it is worse: the bankers want to ensure that "The largest heist in history" continues. That the government supplies the financial sector with massive subsidies, to the tune of hundreds of billions of pounds a year, in perpetuity, fleecing the taxpayers in the same way as loan sharks do their victims.

What a strange world…

Back in September 2008 the financial system came to a halt and nearly collapsed because the financiers were unable to manage it properly. With all the financial tools at their disposal (spreads, CDS', ratings, etc) they led the system into a catastrophic failure. This was unprecedented event, not a situation that may happen. Therefore the financiers proved conclusively that for one reason, gross incompetence, or another, downright fraud, or both, they are not a suitable profession to judge the credit risk or any aspect of the financial probity and good management.

To prevent the financial meltdown governments stepped in and rescued the banks. Now the same financiers, the same people, are judging the credit risk of the governments, quite often on the debt incurred to avert the banks from going under. They undermine their saviours by speculating with the very same money that governments pumped in. Never mind that these financiers proved in 2007 and 2008 in the most spectacular way that they were incapable of assessing financial risks properly, governments are following the financiers "suggestions", saying that they react to the financial markets' behaviour. The recent cuts in public spending by the British government is a good example of such perversion. Yet neither mainstream media nor politicians pointed to such truly bizarre arrangement: incompetents or fraudsters are effectively telling governments, who rescued them, what to do.

Who on Earth with a sound mind, in any profession, would have followed someone who discredited himself (or, not to be sexist, herself) in the most spectacular possible way (i.e. catastrophic failure) by demonstrating to have been incompetent or a downright fraud? However this is a norm for governments in dealings with the financial world. On one side politicians complain about greedy and irresponsible bankers but on the other they just dance to their music.

It is clear that the politicians are grossly incompetent or corrupt. They either mistake the rules of free markets economy and capitalism in general with the gross incompetence and fraud of the financial world (in which case they are themselves incompetent) or they deliberately conspire with the financial world in fleecing the taxpayers. The revolving doors between the financial world and governments make the latter supposition very plausible indeed. This is not an emotive statement as one might think. This is a reasonable professional assessment reached by any competent fraud investigator.

However the fact that we elect these politicians democratically makes it all damning on us. In democracy we have to acknowledge: "we got what we deserve".

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PS. For the British taxpayers: this article is not arguing that the British government should not have cut its public spending. This is a more complex subject dealt with in "Prime Minister, sort out this mess, please". It simply demonstrates that the politicians' justification that they had to do so in response to "financial market pressures", to preserve the ratings, etc, is devoid of any logic or honest rationale.

Don't jump over yet. It will get worse.

"An nescis, mi fili, quantilla prudentia mundus regatur?" - Axel Oxenstierna
("Do you not know, my son, with how little wisdom the world is governed?")

Watching Newsnight report on European banks last night was a truly shocking experience. Neither Mr Paul Mason, who prepared the report, nor Mr Gavin Esler who hosted the discussion, nor the invited pundits Mr Raghuram Rajan and Ms Gillian Tett, went beyond a shallow analysis that described how really bad it was (using some rather vacuous parallels, e.g. "a sticking plaster"). But we know all that: this has been blatantly obvious since the financial crisis erupted towards the end of 2008.

The only sound words of advice from the experts were that we should find out more precisely how bad the banking situation was (implying the size of liquidity hole, i.e. the level of money multiplier). Mr Raghuram Rajan added that there should also be a programme to deal with the banks that are found to be in a bad shape. But this is all trivial and blatantly obvious since 2008. You do not employ experts to find out these. It must have insulted intelligence of any half sober viewer. (But who is actually sober at the time of Newsnight?) This has been described in the "The largest heist in history" immediately after the crisis erupted.

If it takes experts and pundits well over a year to work out such basics, that are not even a start of understanding the causes and mechanism of this crisis, little wonder why got into such mess in the first place and even less hope that the crisis will be resolved peacefully. It provides disturbing reassurance that we are heading for quite a disruptive end to it. The Great Depression that started in 1929 ended with World War Two ten years later. It seems increasingly likely that an event of a similar scale will sort out the current mess since neither the politicians nor the expert have even a basic understanding what they are dealing with.

And the causes are actually trivial. They are huge and of a criminal nature: using a pyramid scheme mechanism the money multiplier (leverage) was ballooned massively. To solve it, it is necessary to reduce it: either by engineering high inflation (printing money solves the liquidity shortage) or liability write downs (less banks liabilities solves the liquidity shortage), or, of course, some combination of the two. The entire process for the UK, including how to protect the taxpayers' interests, has been described in "Prime Minister, sort out this mess, please" but it applies to eurozone (and the US) too. But with clueless (or corrupt) politicians and experts there is very little, if any, hope for an orderly solution of this crisis. "Do you not know, my son, with how little wisdom the world is governed?"

It is time to face reality over global liquidity black hole

In his article in the FT, "It is time to face reality over Greece's debt", Nouriel Roubini makes a right diagnosis but it is simply too narrow and has been blatantly obvious since "the largest heist in history” came to light at the end of 2008. The global financial system has a massive liquidity black hole: hundreds of trillions or even quadrillions of dollars that resulted from a classic pyramid scheme, that the financial system was turned to, and organised by the financiers and regulators with a blessing of some politicians.

Roubini diagnosis that Greece cannot escape a default applies equally to the UK, US and the entire eurozone. It is only a matter of timing: first Greece then the US. The UK is bust already: yet no one is prepared to admit it: it is an open secret. So as the eurozone.

Roubini recommendations have a deep sinister aspect. If implemented they will mean that having saved the banks, the taxpayers will keep on paying to these banks practically forever. And as before the money will be taken out of them by private "investors" who will pay the bankers handsomely for running such a scam. This "investors'" and bankers’ dream is taxpayers (and their children and grandchildren and grandgrandchildren and …) nightmare. It is a classic relationship of a loan shark and his victim.

Nevertheless there is a solution. World best option is an orderly default. It should take a form of global orderly write downs akin to the US Chapter 11 approach in the private business. This was elaborated in "Prime Minister, sort out this mess, please". It applies equally to the UK as the rest of the financial world that suffers from the liquidity hole. And a new ways of recouping taxpayers money should be considered (and eventually introduced). For example, taxing all money transfers, say 80% - 90%, to and from offshore financial centres (and of course to and from any country that does not sign up to such an arrangement). Such a deal would have to apportion the proceeds from such tax (so no country can be privileged as an offshore banking gateway) and could be used to plug the global liquidity hole.

The world is in the midst of an unprecedented crisis which is moving from country to country. The sheer scale of it, just numbers, makes it completely unsolvable using standard approach: i.e. let’s make taxpayers pick up the bill. It is simply too big for that. This is beyond any moral issues of massive wealth transfer (i.e. theft) from the middle classes to the very rich. Communism for the rich has triumphed. But let's hope that it will be defeated like its more sophisticated Soviet predecessor.

A nightmare round the corner?

With the current budget the Chancellor paved a way to the UK rating being downgraded soon. Do not be misled by the reaction of the guild market today. Before it the UK was so much in debt that it could not have been downgraded (as should have if ratings were honest measures of the market) as it would simply not pay (and the whole rating system would have been undermined). Now as the Chancellor made a lot of savings thereby creating a capacity for the government to borrow and spend more, the so called financial markets (i.e. bankers) will come back and ask the taxpayers to share it. To get it the UK rating looks likely to be reduced. It will not happen instantly and some pretext will be used.

The taxpayers must watch how much of their hard saved and paid money to the Exchequer, thanks to the Chancellor current budget, will result in the UK debt reduction and how much will be siphoned off to the banks to keep funding on-going salaries and bonus bonanza there and to keep on supporting the financial pyramid that the financial system has become. This is the way the relationship between banks and taxpayers has become akin to loan sharks and their victims.

Prime Minister, sort out this mess, please

Over the last week in Britain there has been a parliamentary festival "what to do with the public debt". The government is arguing that it must cut the public debt very quickly, and harshly, or otherwise the UK will lose its credibility to the markets, its rating will go down and costs of servicing the debt will eventually skyrocket. The opposition is putting their point across that if the public spending is cut then the economy will not get a necessary investment in order to guarantee future tax receipts that will eventually bring the public debt down. It is an argument between "cut and save" now and "spend, invest and earn more". There are merits to both arguments: but they are both missing the point how to solve the existing financial mess that the last Labour government financially engineered for the UK.

Let us deal with credit rating, and its possible downgrade, for the UK. Originally when credit ratings were invented some years ago they were meant to be an objective tool of assessing the risk of default of a debtor. As long as they were done by creditors, at no conflict of interest situation, they played their objective role.

In the last decade or so, the sense of credit rating has changed. The financial institutions that were selling the financial products (thereby getting into debt themselves) started commissioning the ratings for their own products. The higher the rating the lower the costs of the debt. Ultimately many products that were clearly of no value whatsoever were sold with the highest possible credit rating. Credit rating does not mean any more what it used to mean. Now it is a crude tool used by the financial players to make money and very frequently it has nothing to do with the underlying credit worthiness.

The current public debt has to be seen against this backdrop and the fact that the banks are still full of the financial instruments which they cannot cash on the open market. The massive UK debt means that the government is unable to borrow any more money and pump into the banks. If the banks executive turned up now on the Number 10 doorstep and requested yet another cash injection into the financial system, like they did in September 2008, for example in order to prop up massive bonus schemes for the bankers, they would have had to be turned down. The government simply would not be able to hand over more money. But the bankers need it so they are not going to give up easily.

Now the credit rating is used. The UK is threatened by the financial institutions that unless it cuts its pubic debt its rating would go down and the costs of debt servicing would increase thereby increasing the annul spending by the government. There is nothing far more from the truth. If the rating were cut and the debt could not be serviced, then the government would have to take emergency steps and the banks would not get any more money. The whole Greece saga only happened because the banks assessed that there would be a bailout. If there had not they would not have done anything as they would not gain anything by putting a pressure on Greece. This is a rational economic behaviour. Now they try the same basic crude method with Spain and are testing the ground with the UK.

However the game with the UK is a bit different. The financiers know they cannot risk bringing UK economy down. In fact they are unable to do so as the government would have introduced emergency measures to prevent it, and many financial institutions would have come out as losers from it. So using a crude tool of "credit rating" (which has nothing to do with real credit rating) they are trying to force the UK government to cut the debt, thereby increasing the government capacity to borrow more – at the taxpayers’ costs – in the future. Once the government makes all the big savings, of hundreds of billions of pounds or more, cutting many public services and making everyone feel it, the bankers are very likely to turn up again at Number 10 doorstep with begs of toxic waste that remains in the system and will demand another bailout (or else the banking system will collapse). At that point it will be too late. Like Gordon Brown, David Cameron will have little choice but to cough up another few hundreds of billions to the bankers. All those money saved by savage public spending cuts.

However as there is more than one way to skin a cat (sorry, taxpayers), the process of the bankers skinning (again) the taxpayers may actually be not that conspicuous as asking for another multi billion rescue package. It may also take a form of continuous dripping of money from the Exchequer into the banks (by, for example, so called market operations). In which case we will never see any savings made and the pundits who tend to protect the bankers are likely to comment that even the savings were not sufficient to reduce the public debt. They are also likely to peddle a nonsense how much worse it would be if the cuts were not done.

These scenarios and their mechanisms were presented in the first article of this blog, "The largest heist in history" over a year ago. It is astounding that neither the government nor the opposition, then and now, can foresee such glaringly obvious very high risk scenario.

What could and should the government do to bring to order the financial system that became a vampire squid on the face of taxpayers? How can the government remove a risk of taxpayers being treated by the financial industry in the same way as loan sharks treat their victims? It is not a rocket science. There is a basic five point action plan that deals holistically with the current crisis: resolves the current mess and prevents it from happening in the future.

1. Banks must be broken up so none of them is "too big to fail".

As explained before on this blog a "too big to fail" bank enjoys free insurance against failure. This is anti-competitive and is also a continuous burden on public finances by carrying risked costs of the potential failure, hence this is a free public subsidy. For both reasons such behaviour is completely unacceptable under free market rules and should be, if it is not already, made illegal.


2. Separation of high street consumer banking from investment banking.

In the process of breaking up the banks into businesses each of which is not "too big to fail" consumers banking, typical high street deposit and lending activities must be separated from the high risk investment banking. Under Glass-Steagall Act there has been such a rule and it worked for over half a century. It did not take even a decade after it was repelled and we ended up in the current crisis. Therefore whilst theoretically it may not be necessary, the experience strongly indicates that it is a good practice to separate high street consumer banking from investment banking.


3. Deleveraging of the financial system and write downs of toxic waste (i.e. liquidation of the financial pyramid).

As Mr Will Hutton observed on the Dispatches programme last Monday, the banks leverage is around 50. I.e. around £50 of banks liabilities are covered by £1 real cash. Such leverage is unsustainable. A typical sustainable leverage is 5 – 10, 10 only in times of good market confidence. Therefore between 80% - 90% of so called assets are simply toxic waste. The financial assets must be ring-fenced and the proper orderly process of write downs must be done. The aim of this process is to reduce the leverage to a sustainable level between 5 – 10.

The crux of solving the current crisis is the reduction of unsustainable leverage (50 or more) to a sustainable level (5 - 10) and who are going to be losers of this process.

As there will be losers: i.e. people and companies whose assets will be destined to be written down, the government must find a way to deal with it in form of providing a limited security. The ultimate test of the government guarantees and how they are discharged should be of a public interest. For example if a pension fund goes bust as a result of such assets write downs and ultimately the pensioners are the losers, the government must consider taking over a liability for these pensions (at a level, e.g. 50% or 80%, that it can afford or with a possible cap). Another example is if a bank goes bust. Then the government, through one of the nationalised banks would take over accounts and operations and guarantees individuals and businesses their interest. This will no doubt require some government spending but it is likely to be far cheaper than propping up the entire system with no limits as is happening now. Any new government stimulus package that may be necessary will not end up in the financial institutions black hole of toxic waste but in a newly healed banking system, as described in this point and two proceeding points. The banks will not have a problem to start lending again as they will not have an issue of dealing with massively excessive historical leverage. The losers of such operations whose assets were ring-fenced to be written down will be able to resort to private litigation against all those individuals (bankers, regulators) who brought such misery on them.

There is nothing unusual in this step: write downs are typical actions in corporate restructuring and recovery. However in case of the financial industry it is the sheer unprecedented global scale that is daunting. In that respect banks that hang on to bogus assets, which are in fact toxic waste that should have been written down or significantly valued down, and present them as genuine assets on their books, are no different in their accounting practices from Enron. Whilst Enron was using such "creative" approach to extort money from the banks and private investors, banks are extorting money from the taxpayers. Hence banks must be dealt with as decisively as Enron was: it is far better to pick up the pieces now than to allow such a scam to keep on growing.


4. Setting up an effective deterrant against a future crisis happening (i.e. prosecuting the fraudsters).

This crisis is a result of a massive pyramid scheme whose fraudulent mechanism has been lending with loan to deposit ratio greater than 100%. As it has been argued already on this blog, the financiers, bankers, regulators and some politicians that engineered or are responsible in any other way for this financial crisis must be prosecuted. They must end up in jail and their wealth (or any wealth that was "generated" by them as a result of this crisis) must be confiscated. This is not only a basics fairness, the scammers and fraudsters are not allowed to get away with their crimes and spoils of their crimes, but it will help to fund any compensation resulting from the assets write downs as described in point 3 above. Ultimately there is no better way of preventing the next crisis than prosecuting perpetrators of the current one. Enforcing the law is the best regulator.


5. Reducing the public debt.

The last point will be reconciling the public debt against what is recovered from the scammers, as described in point 4 immediately above, and also against any liabilities of the institutions to the government that resulted from orderly dealing with assets ring fencing and write downs as described in point 3 above. For example if the government owes debt to an investor (e.g. bank, financial institution) but at the same time due to a write down (as described in step 3) such an investor ends up owning money to the government (directly or indirectly, e.g. pensioners, individuals, businesses who lost in such write down and were taken care of by the government), then the government subtracts such write down from its debt to the investor. This is likely to reduce the government debt, possibly quite significantly: it seems that a good portion of a near trillion pounds rescue package can be offset against the government debt. And only then if it is not enough the government must do necessary cuts in public spending to balance the books and bring public finances into black.


Desperate times call for well-thought through measures.

Disappointment or hope?

Future of Banking Commission produced the report with very sound and thought-through recommendations: the banks cannot be too big fail and separation of risky investment structures from safe deposit banking. There are other sound recommendations. However, what striking is, that is all so obvious. It begs a question why such basic and trivial rules were not observed in the first instance.

Importantly the report does not recommend prosecuting of all those who engineered the current financial crisis. Bankers, regulators and some politicians. This crisis is a result of a giant global pyramid scheme, the same in its structure and mechanism as in Albania in 1996 – 1997.

The circumstances of producing the Future of Banking Commission report reminds a situation of a neighbourhood where houses were notoriously robbed. Its association established a commission and came to a conclusion that houses needed to have a secure lock fitted. Well, done. However such report did not conclude that the Police should be informed and the thieves must be pursued, caught and prosecuted. Languish years in jail and their wealth confiscated to compensate their victims.

This blog has long argued that enforcing law is the best regulator. The Future of Banking Commission report shows three points. Firstly the politicians, and official authorities, are clearly way out of their depth in dealing with the current financial crisis: present the glaring obvious as some kind of achievement. Secondly the establishment has realised, as Mr David Davis put it on today's Andrew Marr Show, that "if we don't do something, next time [a crisis] happens it will break the country - it will go bankrupt". He confirmed the obvious that the scale of the ongoing financial crisis is enormous. Thirdly, by not recommending pursuing and prosecuting all those who caused the current crisis, the establishment is trying to protect them (as they are part of it).

Or maybe our democratically elected representatives will come to the last point later. Albanian government was prepared to prosecute the scammers. Let's hope that our government will live up to the same standards of probity and integrity.

Comment to: To the Chancellor: UK ain't Canada

For all those who know my blog the comments below should not come as novelty, but it is worth repeating:

1. The banks should be broken up into business units of a size that NONE of them is too big to fail. Any business entity that is or is allowed to become too big to fail enjoys a free survival insurance at the costs to the taxpayers. Not only is this unfair on taxpayers (it is in fact extortion of money through the back door) but it is discriminatory to entities which are not too big to fail. I.e. under the EU rules it a monopolistic and uncompetitive practice which is banned. Hence it begs a question why the authorities allow such illegal practices to exist in the financial sector? Stupidity? Corruption?

For clarity, the current crisis is not a failure of free market rules. It is a result of breaking them and substituting them with communist-like ideology (communism for the rich that is). It is an absolute scandal that the financial sector is run by people who implemented the worst of the communist practices straight from ailing Brezhnev era. The banking communists are the new working class of the 21st century: they successfully executed a revolution of robbing mid-income people and redistributed the spoils to the fabulously rich, making them even richer. Even Soviet communism in its heyday was not that economically perverse.

2. We do not know (and indeed HM Treasury does not know) whether the bailout support the banks got, £850 billion, plugged the liquidity whole. At present it is clear that not more than £70 billion is possible to be recovered by the Treasury and the costs of bailout money is accumulating. Strong signs are that the liquidity hole still exists and may be absolutely massive (possibly even going into quadrillions of dollars globally, and the UK share of it may be huge). Therefore it is likely, above moderate, that the financial institutions in the UK will come to the government for hundreds of billions pounds of more money. (Please note that Greece bailout is in fact a bailout of private banks that lent Greece money.)

3. The basic, intuitive, risk analysis points that the chances of banks asking for hundreds of billions of pounds in form of a new bailout (again) is currently moderate but likely, 3+ (on a classic 1 (min) - 5 (max) scale) but the severity of it is massive, 5 (on the same scale). Hence the overall risk profile - on 1 to 5 scale - is 4+: this is a lot! This means high alert. Just below: imminent. This analysis is intuitive and not mathematically strict. But it is not an argument to ignore it but to prompt the Chancellor to instigate a detailed risk examination.

For the reasons above, whilst the government savings which look reasonable now may turn out to be foolish and for the benefit of the financial sector shafting the taxpayers big time again. How about that?

To the Chancellor: UK ain't Canada

On 6 June 2010 The Daily Telegraph reported that the British Chancellor of the Exchequer planned spending cuts that would be similar to Canadian ones in mid-1990's. These were the very savage cuts of public spending: 20% a year for three years.

Below is a word of caution that the Chancellor is unlikely to get either from the mainstream media or his political friends (and foes).

Canada had to cut its budget deficit because its government overspent on typical public services. The country lived, for some time, beyond its means. Hence its debt had to be repaid and adjusted to an affordable level one way or another.

British budget deficit, in its vast bulk, is of completely different nature. It resulted from the government actions to save the financial institutions at the end of 2008. Although the British government has been spending too much for quite some years on the public services, it were the banks' rescue packages, stimulus packages that were used to plug the financial sector liquidity hole that make up for a vast bulk of the current budget deficit. We are not in debt because we spent too much on schools and hospitals but because we spent absolutely unbelievably extortionate amounts of monies on financial institutions (or, as Gordon Brown said, to "save the world").

As the author of this blog was officially informed (in writing) by HM Treasury, the government does not know the size of the liquidity hole in the financial system. Therefore it does not know how much (if any) more money (billions, trillions?, of pounds) it is still likely to pump into the financial system to assure the liquidity.

Therefore it is reasonably likely that, having completed a serious of savage cut, Canadian-style, the government will save, say, a couple of hundred billions of pounds. Possibly more. At that time, once the financial industry realises that the government liquidity ratio has improved, another liquidity crisis will crop up in the banking industry. And all the monies that government saved, putting a lot of ordinary folk in hardship, will be used to "save the world" again.

The government, hence the taxpayers, will end up back in square one, with the same massive budget deficit as now (or more), but living under massive austerity spending measures. It is quite clear that this is exactly the same mechanism as loan sharks operate, whose victims are squeezed for every penny. In this case the loan sharks is the financial industry who use the government to squeeze the taxpayers for every penny.

The British Chancellor of the Exchequer should be well advised that before he contemplates any cuts, he has to ensure that the financial industry's liabilities (current, potential or future) are completely isolated from the taxpayers. I.e. that, by legal and other arrangements, the government is prohibited from bailing out any financial institution. Otherwise all the savings, done at the huge costs to the taxpayers, destroying lives of many of them, are likely to become savings that, once again, will be pumped into the financial industry like at the end of 2008.

A short tale about a Bailiff and a Good Man (or a brief history of the current financial crisis)

Once upon a time, in a village, a Bailiff lived. He was irresponsible, greedy and whilst he was good in collecting other people's money he was not that that good in managing his business. So the Bailiff himself ended up in a deep, deep debt.

In the same village, at the time, a Good Man also lived. The Bailiff pleaded with the Good Man:

- please lend me some money, a lot of money or otherwise I will go bust. And if I go bust then the whole village will go bust as the debtors will be able not to pay their debt. You have to save me, you have to "save the world".

The Good Man was a… good man. Just that. Not necessarily wise. He turned to Bailiff's friends in the village for advice. They all told him:

- you must help the Bailiff or otherwise our village will collapse. You must "save the world".

The Good Man was not wise. That's why he was not rich either. A simple hardworking man. He did not have his money to lend. So he went to a local Bank. He put all his possessions, all what he earned and inherited, as security. He pleaded all his future income. He borrowed as much as he could. He invested them in the Bailiff's business. That was just enough for a short time as the Bailiff's debt was so huge. The Good Man was even proud and bragged that he "saved the world". But only just and for a short time.

In the meantime the Bailiff was paying himself a handsome salary. The Good Man, being under pressure from his family, inquired whether he could get more in repayments. He also suggested that it was rather unreasonable for the Bailiff to pay himself so much whilst he was in debt.

The Bailiff said to the Good Man:

- you are paying for my great talent as a bailiff. This talent is worth all that and more. If I have to stop paying myself that much I would leave the village and will find a job somewhere else. And the village will collapse.

Being not that wise, rather too optimistic about his income and having underestimated his financial commitments, the Good Man overborrowed. The Bank realised that he would not be able to pay back his debt. The Bank eventually got very anxious and decided to sell the Good Man's debt to a local Loan Shark. The Loan Shark, who knew all the tricks of the trade, decided to make a mint out of the Good Man. That's a loan sharks’ business after all. He started sending demands to the Good Man, making him pay as much as he could. And more. The Good Man was starving. His family was starving. And paying. But his debt kept on increasing with penalties for late payments, additional sky-high interest, administrative charges, etc.

To enforce his "rights" and collect as much money as possible from the Good Man the Loan Shark hired… the Bailiff. And the Bailiff was thriving proving to be a man of many talents indeed.

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For those who still not get it:

1. The Bailiff are the financiers and bankers (especially investment bankers).

2. The Good Man are taxpayers (represented by our democratically elected governments).

3. Friends of the Bailiff are all kind of consultants and advisors that work for governments.

4. The Bank are the financial markets.

5. The Loan Shark are the hedge funds, offshore funds and many shadow banking institutions.

6. The Good Man investment in a Bailiff's business is called "stimulus package".

7. The Good Man costs cutting and saving to repay the loan to the Loan Shark is called "austerity package".

… and so on.

Kill your saviour: currencies' crisis is looming

In February this year [2010] the author of this blog wrote a report which was commissioned by an organisation of sovereign wealth funds, "Money Multiplier effect on currency risk" ^*. The conclusion was inescapable at that time, which was well before the Greek crisis. The currencies of countries which are heavily in debt are facing realistic to high risk of collapse. This was true especially with respect to eurozone which was (and still is) facing a break-up or major realignment. The US dollar is not much on the radar but does not look much better. Since then German Chancellor, Angela Merkel, confirmed "The euro is in danger".

The global pyramid scheme which was engineered by bankers and financiers (with help and blessing of regulators and some politicians: how are you Mr Gordon Brown?) resulted in a very high Money Multiplier. I.e. $1 (£1, €1) real cash has to service to many dollars (pounds, euros) of liabilities on banks balance sheets. This resulted in ongoing liquidity crisis. Governments "rescued" the banks by pumping cash (and cash guarantees) into them thereby putting economies heavily in debt to a tune, globally, of trillions of dollars. However this has been only a temporary reprieve since it covered only a very tiny portion of banks liabilities (especially toxic papers on their books). Although Money Multiplier was reduced (i.e. improved) as described in "The largest heist in history" the improvement was insignificant and, very likely, it has grown since then. This put the economies into a deep financial trouble. Now chickens are coming home to roost: as predicted at the time (end of 2008) rather than curing the problem in the private financial sector, governments decided to buy their time by spreading it and making it much worse dragging taxpayers (and future generations of taxpayers) into it.

To repeat the advice from the end of 2008: "If governments do not liquidate the global pyramid scheme [as explained in this article what it was but primarily write offs of many financial instruments and liabilities of so-called "casino" banking], the money they injected will be, in time, converted into toxic instruments (e.g. securities) and cashed in by organisers and privileged customers of these schemes (or in the case of Albania, gangsters and their customer friends). As the amount injected is around 200 times less than the notional value of toxic instruments, the economy will not even see a difference. It will be a step back to September 2008, only now with trillions of dollars of taxpayers' money spent to sustain the pyramid scheme. It will be merely throwing good money after bad. But can governments afford to come up again with the same amount money and do it 200 times over or more? This is based on a very optimistic assumption that the notional value of toxic instruments is not increasing. If governments take the route of continuing to inject money, they will make taxpayers dependant on the financial system in the same way that criminal loan sharks control their customers — their debt is ever increasing and customers keep on paying forever as much as it is possible to extract from them."

The ongoing liquidity (banking) crisis and the sovereign debt crisis, that just blew up, are two sides of the same coin: much too high Money Multiplier, or in simpler terms the global financial pyramid is simply too huge and keeps collapsing.

There is a perverse, sinister side of this process: the very same bankers and financiers whose institutions (i.e. the vehicles of their actions and source of rather exuberant income; this must not be confused with proper ownership, shareholding) were saved from spectacular collapse with "stimulus packages" are now using their institutions, saved by taxpayers' money, and taxpayers' money to attack the budgets of governments (i.e. taxpayers). Kill your saviour if you have an opportunity to do so and it brings you benefits: it is a free market version of an old rule "dog-eat-dog". In fact a prediction made on this blog over a year ago that the financial system – society relationship would turn into a relationship akin to loan sharks and their victims has materialised. As it is taxpayers, and their children, have to keep on paying ever more, as much as they possibly can, with no hope of any recovery. This is called "austerity packages". Loan sharks developed such ideas for their victims in the past and now the mainstream financial industry has learnt such methods and is scaling it up to encompass entire economies. This was a predicted result of "stimulus packages" exposing governments as weak, incompetent and corrupt.

The next step on this path is very likely to be a currency crisis. We already see its beginning with euro. The US dollar will also not escape a reality check. But as pointed out in April 2009 in an article "A US way out?" this make take some time and end up in a somewhat unorthodox solution.

There is only one way out: a combination to a greater or lesser degree of the two processes:

- Zimbabwe way: inflating this crisis out (printing money will reduce Money Multiplier by increasing the volume of cash available to satisfy liabilities on banks balance sheets);

- Chapter 11 way: write offs of liabilities on banks and countries balance sheets (removing liabilities on banks and countries balance sheets will reduce Money Multiplier by reducing the size of liabilities that cash available has to satisfy): an extreme form of such scenario, which is quite likely, was presented over a year ago in a short article mentioned above "A US way out?".

(And of course banks must be banned from recreating the same problem again, for example by lending with loan to deposit ratio above 100%. This is all on this blog: a bit complicated for a paragraph of explanations here.)

From banks liquidity crisis and banking collapse to sovereign debt crisis to currency crisis. These are the stops on the same path: a collapse of the global financial pyramid scheme engineered by the financial world (or technically a result of much too high Money Multiplier). The Great Depression that started in October 1929 reached its grand finale in 1939 with the World War Two. Whether the end of the current crisis will be as dramatic and "spectacular" time will tell. But there is very little to feel optimistic since politicians live in a state of denial and do not tackle the root cause of the current situation. Well, they are unlikely to have a clue about it.

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^* If you would like to obtain a complete copy of this report published by Arab Financial Forum titled ”Sovereign Wealth Funds – Where Are They Going?”, please send a request to Arab Financial Forum Secretariat: info@meconsult.co.uk