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?"