Greece: there is a method in this madness

Every person with rudimentary understanding of finance knows that preventing Greece from defaulting on their debt by giving it yet more loans (at very high interest rate, by the way) only delays the default and makes it bigger. Everyone knows it is a sheer madness: it is like borrowing even more money on one credit card to pay off the debt on another. A classic financial fools' trap. So why the governments agree to it if it is so idiotic. Well, there is a method in this madness. If Greece defaulted now this would have affected to a great degree private banks. By lending Greece even more money, this time by the countries, Greece is getting into even more difficult financial situation, but it is shifting the debt from private banks onto taxpayers. So when inevitable happens and Greece will eventually go bust it will be mainly taxpayers that will end up with unpaid debt rather than private banks.

This is so trivial: people in power are not that stupid. So why do they do it? Why are taxpayers in business of saving private business such as banks? (Incidentally it is against the EU rules about state subsidies.) The largest heist in history continues and indeed the financial industry loan shark strategy against the taxpayers is meticulously implemented (with the help of the politicians).

S&P: downgrade of US debt outlook

A rating agency S&P kept America’s credit rating at AAA. However for the first time in its 70 years rating history of the US debt, the agency cut its outlook from “stable” to “negative”. A negative outlook means there is a one-third chance of a downgrade below AAA in the next two years. It is yet another sign that the financial crisis is progressing as expected. This can hardly be called a blow for US debt. It is simply a well predicted result. One can also reasonably expect a US grand finale in some form predicted in an article "A US way out?" two years ago.

The lower the US, and indeed any other country's, debt rating the higher the interest rate that has to be paid on it. Hence the beneficiaries are the banks that, incidentally, caused such massive sovereign debt mounting in the first instance by engineering the pyramid scheme that collapsed causing the credit crunch in September 2008. As predicted two and half years ago "The largest heist in history" continues and there seems to be no end to it in sight.

China is buying up the world

(making the US a debtor of the whole world)

The US is hooked on China produced consumer products. The US buys massive volumes of goods from China and pays for them with the US treasury papers (the US debt). Can the US stop it? No. That would require moving production from China to the US which would take years (possibly decades) as it took decades to large scale of production of consumers goods to China. Never mind the fact that it could cause the US economy to collapse or at least massive hardships and internal implosion of home budgets as the US produced goods would be far more expensive that China's for the US consumers.

China is getting this massive volume of the US debt papers. These papers on the markets are AAA-rated and markets have to consider them as good as cash in international transactions. Otherwise the US dollar would have collapsed. So the 2/3 of world reserves that are held in the US dollars. No country can afford this to happen as this would have been a financial Armageddon. So China is buying access to the world natural resources, funding development of key infrastructure in many countries, investing in companies paying for it all with the US debt papers. The same logic will apply if China decides to use its massive stockpile of the US treasury papers to buy the European debt or help to finance the ailing European banks. Effectively China is using its cheap labour force to get as much as possible US debt papers which it uses to "buy" the world.

However this way China makes the US a massive debtor to the entire world (wherever China invests). It is impossible to rollover debt to infinity. So at some point, difficult to tell when, the US debt spread all over the world will become too big to roll it over once more. (Technically the growth of the US debt from trade imbalance with China is a pyramid.) In the same way as liquidity crisis happened in 2008 making banks debtors to the taxpayers, the collapse of the US debt and dollar will make the US insolvent to the rest of the world. All the countries and companies that China effectively paid with the US debt whilst "buying" up the world). Also all business entities that sit on the US debt, a huge part of the financial system, will also end up with a mountain of worthless US papers. No one will be able to come to the US rescue. However China will be left "owning" the world. (There is an element of exaggeration in using the words "buying" and "owning". This is to make this risk scenario clear.)

Furthermore China also buys debt of other countries using the US debt papers thereby making the US even a bigger debtor to the rest of the world.

Even if it does not end in such an extreme way (and there is no reason why it should not), China is slowly but heavily undermining the US world position using the trade imbalance between the two countries: by taking over key assets all over the world and buying influence with funding infrastructure project and by making the US a debtor to many countries and significant business interests.

In the same way as countries used to use and sacrifice health and life of soldiers to build their greatness (as we know it from history), China treats its cheap labour force in the same way: it is their real frontline that lets China acquire massive volumes of the US debt, at the same time keeps the US locked in such arrangement.

It does not look too good at all. The US is likely to react at some point (at the end it is a military hyperpower). It is anybody's guess how it will look like.

NB. for those who like historical perspective: Germany started World War 2 in 1939 because Hitler came to conclusion that it was cheaper to kill the creditors than to pay them off. One may start wondering whether the US may, at some point, start thinking in the same way.

Bankers having a free lunch

Robert Peston published an interesting piece on his blog "Can banks dodge the break-up?". He wrote: "the Bank of England estimated this [state] implicit subsidy [of being protected by taxpayers against failure] as being worth around £100bn per annum at the peak of anxiety about the fragility of banks in 2008-9, and perhaps half that figure subsequently."

The state, taxpayers, are part of economy. Their subsidies, of whatever nature, come at the costs: they are paid for one way or another. If subsidies cost hundred of billions of pounds, these hundreds of billions of pounds must come from somewhere. For example taxpayers pay them by additional costs of government bonds or through some other transactions with the financial markets. "There ain't no such thing as a free lunch."

The City of the 2010's is strikingly similar to the British heavy industry of the 1970's. It provides no financial value to the economy and can only survive with taxpayers subsidies. Any tax receipts from the financial industry are dwarfed by the subsidies, bailouts and stimulus packages. Even City luminaries, top financiers and bankers, bear a striking resemblance in their attitude and characters to their trade union counterparts, so called "barons", of the 1970's. Will the City share the same fate as British heavy industries of the 1970's? The signs are not particularly optimistic.

(Sadly) the financial crisis proceeds as expected

Robert Peston published on his BBC blog, "Person's Picks"" an article "The unbelievable truth about Ireland and its banks". It is somewhat disconcerting that major media business commentators are surprised with the obvious. (At least to anyone who was bothered to read "The largest heist in history" published over two years ago.)

Indeed the current hit is no end to the Irish predicaments. The same fate is awaiting other countries that have been a part of the global pyramid scheme. UK and the US will not be immune so let us not be surprised with yet another liquidity crunch when it is sparked off by the financial instituions in the UK in order to extract yet more money from the taxpayers. In fact the British government has effectively invited the financial institutions to come for more money by making spending cuts thereby creating a room to borrow more to "help" the banks when they "need" it.

The very first and most spectacular victim of the pyramid collapse in 2008, Iceland, handled the crisis in the best way: took the loses, defaulted on their financial obligations, now negotiates with the creditors in a pretty tough way and pursues on criminal charges all those who engineered the crisis in the first instance. The governments of Ireland and the rest of Europe should take this as an example as otherwise the taxpayers will keep being exposed to the loan sharks' tactics currently pursued by the financial industry.

Regulating financial risks

Governments of countries affected by the financial crisis are preoccupied with designing a set of regulations that would prevent the future banking crisis (called "liquidity shortage" or "credit crunch") from happening. The actions are taken on the local level, introducing new regulations, and international level, e.g. Basel III. At the same time nothing is done to break up banks so they are not "too big to fail" or to separate investment banking from high street banking that would prevent using depositors cash for, often very risky, financial speculation.

But is it possible to regulate financial risks? To get to the bottom of it, it is necessary to understand what the major factor of liquidity shortage risk is. Ever since the full reserve banking was abandoned, i.e. the situation when banks were acting as safe storage business and depositors had to pay to keep their money there, when bankers realised some hundreds years ago that at any one time they only get a withdrawal call on a small proportion of the deposits held, banks started circulating money. Circulation is in fact money multiplication, i.e. for every £100 paid in as deposits banks lend out a portion of it. Typically it was between £80 - £90. This made the banking system work as statistical machine whereby for every £100 liability, the bank held only £10 - £20 cash.

The risks of running a banking system in such a way is rather obvious. The first one is psychological: if depositors demanded a large proportion of their deposits, for whatever reason, a bank would not have money to satisfy them. This is called a bank run. The second one is the actual level of cash reserves that banks have to hold to ensure liquidity. Banks were insured for such contingencies in two ways.

The first one was banks lending to one another. In case one bank was short of liquidity another bank was lending it to satisfy the demand. As the interbank interest rate of lending was lower than what banks were offering their customers, all banks were still making money, it was a profit sharing scheme, and the whole system worked like an integrated statistical machine.

The second way of insuring against liquidity shortage was keeping the actual liquidity reserves at the appropriate level. For example, at every one time, for every £100 possible immediate withdrawal call, a bank has say £15. And this is a hard one. Banks create money out of nothing: they are statistical risk machines. Therefore the basic question is : where are the borders between reasonable commercial risk taken by the bank and reckless risk that leads to failure (or even much too high risk which amounts to a downright fraud)?

Sometimes it is possible to identify a straightforward case of fraudulent actions. For example in the run up to the current financial crisis that started in 2007/2008 many banks, including major well known banks, were lending with loan to deposit ratio greater than 100%. This was a classic fraud, known for hundreds of years as a pyramid scheme. (That is why people who were responsible for the banking system in the run up to the financial crisis financiers, regulators and politicians were classic fraudsters or grossly incompetent/negligent. However their sheer number and massive collective influence guarantees their immunity from prosecution.)

However finding a line separating taking commercial risk and reckless risk by banks is impossible. It is changing on day to day basis and it is impossible to cater by regulations or laws for every major economic eventuality. (All those who are old enough may remember that the communist system was an attempt of such a holistic approach to economy that spectacularly failed.) For hundreds of years it was tough justice and self regulation, in a free market setting, that ensured that banking system worked. Later central banks came onto the scene like Bank of England. They ensured that problems were picked up early before they got out of hand and also acted as lenders of the last resort.

Firstly banks owners put their capital and their freedom or even life at stake. Dealing with some else's money is a serious business. If a bank failed bankers were losing a lot: quite often all their and their family wealth, their freedom or even their lives (and even lives of their families). For some centuries of banking such harsh penalties were watered down and concept of limited liability was introduced. However it is not unknown that only a few decades ago Bank of Englad was taking very tough actions on banks and bankers that failed and were rescued. It was not widely publicised in order not to raise panic. Therefore, whilst not advocating returning to exactly ancient methods, financiers and all those who are responsible for handling someone else's money must face a very harsh personal justice in case of failure. This is the first level of deterrent. The current practice of rewarding financiers for recking the financial system is not only a travesty of natural justice but, on a practical level, also ensures more problems in the future.

Secondly banks were only lending to each other, to help in case of liquidity shortage, if they trusted each other. Therefore they were monitoring each other whether they were taking justified commercial risk and the liquidity shortage was statistical event, or a bank in trouble took a reckless risk in which case it was denied a short term credit to cater for liquidity crunch. In such case the bank was allowed to fail with all the consequences for the bankers described above. This was self regulation. In the UK, Bank of England sometimes stepped in (not in the recent case of BCCI thou) to rescue such bank. Nevertheless this also involved harsh penalties for the failing bankers. Sometimes other banks stepped in and took over the failing bank.

The public must realise that depositing money in a bank carries a risk. However such risk can be insured. This means that it has to be backed by additional insurance capital, so the return on deposits would be lower than otherwise would have been. Whether it is a government backed and compulsory insurance or voluntary arrangement, is a policy decision.

In fact a bank going bankrupt every so often, like in any other business, is a necessary part of the free market economy. It weeds out the weak businesses, reckless risk takers, unlucky and fraudsters. It is a proper free market pruning process and banks must not be immune to it as they are at present.

Thirdly, and above all, banks cannot be "too big to fail". For hundreds of years this was precisely the case. If banks are "too big to fail", then the free market is dead. Self regulation does not work. Instead it is a system akin to communist central planning that so spectacularly failed over two decades ago.

In a nutshell, in order to put the financial system back into shape governments must not regulate more but less as it is impossible to regulate dynamic financial risks. It is exactly the same problem as a challenge of centrally planned economies: predicting people's micro-behaviour. Governments must reintroduce free market into the financial industry. Banks must be small enough to fail. Banks must regulate themselves, apart from general law and basic, bottom line regulations (which should be a role of central banks and general justice system). And in case of a banks' failure all those carrying responsibility for managing such bank must be held personally responsible expecting very harsh penalties.

Inflation trap

There has been a common wisdom - which was put to practice - that when inflation was going up above the set target, Bank of England (or a relevant central bank in other countries) responded by increasing interest rate. The reasoning behind was that there was too much money in circulation (called broad money supply). This was according to the following mechanism: people were borrowing a lot, they typically spent this money, this money returned again to banks and was re-lent again. The increased interest rate made money more expensive to borrow, hence people could borrow less and usually existing borrowers had to pay more interest on the existing loans. This was suppressing inflation as people had simply less money to spend but the actual mechanism worked through suppressing the volume of money on the market: broad money supply.

The current wave of inflation in Britain is a result of the pyramid scheme engineered by the financial industry. Once the financiers - using a crude pyramid scheme mechanism which was lending with loan to deposit ratio greater than 100% - raided the banks cash reserves the government stepped in and pumped hundreds of billions of pounds into the banking system by directly rescuing the banks and by quantitative easing. The former put the government into heavy debt. In the latter case money is finding its way to the consumer markets causing inflation. All these resulted in pound stirling losing credibility. The situation of other major currencies, US dollar, euro, yen are the same or worse. Hence investors, globally, started moving to a safe heaven of commodities. They started to convert their currency based investments into investment linked to commodities. This causes inflation which in turn undermine currencies even more and the process continues.

The current figures show that the growth of broad money supply in the UK is very low and is lower than the growth of narrow money supply (see graphs below). This means that money multiplier is going down (as money multiplier can be expressed as a ratio of broad money to narrow money). The financial market keeps balancing itself but in the meantime the currencies have little credibility and investors want to minimise a risk of holding them by moving to commodities. Therefore Bank of England faces unprecedented situation: the inflation is going up but raising interest rate would not stop it as the inflation is not a result of high growth of broad money supply. In fact raising interest rate can further damage economy and make things worse by slowing the growth thereby ability to repay the public debt.

Raising interest rate is not a solution and Bank of Englad knows it. Its Governor acts wisely but does not say everything. The problem is, however, that the money multiplier is so high that inflation caused by it is likely to be going up for quite a while. We are getting poorer thanks to the pyramid scheme engineered by the financial industry. The Bank of England Governor Mervyn King observed that "inflation could cause serious problems for families over the next three years". You can say it again, Mr King. And in the meantime the captains of the financial industry keep rewarding themselves handsomely with the money raided from the middle classes since this is what high taxes, spending cuts and inflation are all about. "Prime Minister, sort out this mess, please"

Source: Bank of England

How banks' role changed

Traditionally the banks' role was to be a risk agent between a depositors and lenders. Banks were talking deposits and were lending them making money on the interests rate difference between the two. This process was underwritten by banks capital which was risked by banks' owners in case they ended up with too many bad loans and the bank failed. In this case banks owners lost money and possibly some depositors. So on one side there was a pressure on the banks to be careful (as owners did not want to lose their capital) but on the other as there was a large number of banks (in the past) there was competition pushing the cost down and innovation up.

For the last couple of decades the number of banks decreased and they became too big to fail. As a result they were rescued by the government. Banks are no longer risk agents (underwritten by private capital). They became public utilities, huge oligopolies, whose business is underwritten by the state. And they behave as such.

The only way to restore a proper banks' role in the economy is to do what, quite likely, Margaret Thatcher would have done. In line with principles of free market, the banks should be broken up into much smaller enterprises so no bank is too big to fail and capitalise them by selling additional share if necessary. And these banks, indeed a large number of them, should be forced to compete against one another. Depositors will be able to buy an insurance policy against failure or a state may charge a levy on banks as such insurance. And like any other business, sometimes, one of those banks will fail. This will be a proper free market cleansing of weak business which is necessary for free markets to operate. Other banks will pick up the pieces to take over a customer book - a major value of any bank - of a failed bank and if this did not cover deposits of the failed bank the insurance would cover the rest.

The government has to understand such basics: if banking system is regulated properly, there are no banks which are too big to fail, it is not different than any other business.

"Financial markets" loan-shark mechanism at works

On 11 January 2011, The Financial Times published the following graphic:


The graph of 10-year government bond yields show that they grew considerably, manyfold, in the last 12 months. Yet nothing has happened in the last 12 months that was not predicted 12 months (or even longer) ago. For at least last 18 months the world financial situation (e.g. economic growth, banks liquidity, sovereign debt, etc) is going very well according to predictions. (It is a matter of judgement but one might say that things are going worse according to "plan".) Therefore 10-years government bond yields should be the same (or within a very narrow margin) now as they were a year ago. But they are not. In a nutshell the system works as follows:

1. In the past year governments were pressurised to cut public spending. Making such cuts creates a financial room for governments to spend more money on servicing the debt (i.e. pay more taxpayers money to the banks).

2. Then the so-called "financial markets" increase bond yields, which results in paying more taxpayers money to the banks. This was facilitated by public spending cuts.

3. Hence, in practice, what governments saved by making these cuts, is transferred to the banks by increased bond yields mechanism. In fact it is more: as the FT graph shows the government debt keeps growing which creates yet more pressure for further public spending cuts. Littles doubt, once they are made the bond yield will be increased further. And the process will be repeated.

It is not a sophisticated financial mechanism. It is not innovative at all. It does not require a "successful" (as the British Prime Minister Cameron called it) financial industry. No need of well qualified bankers to implement it. It is the most classic loan sharks' strategy: primitive no-brainer.

Incidentally it was predicted in "The largest heist in history", an article written over two years ago, that this was the direction the financial industry would go unless governments took a decisive action.

Euro is dead

A single currency is not simply about having the same notes and coins in circulation. A key part of a single currency is having the same interest rate on all sovereign debt, in the same way as there is a single central bank's interest rate. Quite often this argument was used to sell the single currency project, Euro, to the public in some countries of somewhat lower credibility than Germany or France. At present, there is no more single sovereign debt interest rate in Euro-zone: for example, German debt attracts much lower rate than Greece's.

The governments must face the fact that the sovereign debt markets decided and Euro-zone governments confirmed it by not introducing a single Euro-zone bonds (i.e. underwritten by all Euro-zone governments collectively): the Euro is not a fully fledged currency any more. It is dead. Now we are dealing with Euro which is a fudge of a single currency. Whether the next step would be to become a single currency again or the Euro-fudge keeps disintegrating is the question for 2011. The inklings are that the latter is very likely to be the case as Germany are unlikely to guarantee debt of other Euro-zone countries such as Greece, Ireland, Spain, Portugal, Belgium, Italy. The list is quite long indeed.

However it is highly likely that European politicians will keep repeating that the Euro is safe and it is business as usual. For an experienced psychiatrist-counsellor this will not come as a surprise. It is called a denial syndrome. For example, some close relatives of a dead refuse to accept this fact for a long time. Indeed this was how the French Finance Minister, Ms Christine Lagarde, came across on the last week's BBC Newsnight.

Happy New Year 2011, Prime Minister (and sort out this mess, please)

It is somewhat nauseating to listen again and again about forthcoming massive bankers' bonuses, like in today's Prime Minister's interview on the Andrew Marr Show. The public is entertained continually with bankers' bashing exercises and anti-financial industry "hate campaign". It is all PR stunt to divert public attention from the grim financial reality of the 2011.

The current situation is bad it will get worse this year. Greece and Ireland were "rescued" last year. Portugal and Spain are next in line for such financial markets "benevolence". The UK time will eventually come too. And then the US'. Indeed as last week it was reported on BBC Newsnight Ben Bernanke started seriously hinting possible insolvency of the US. Well done, Mr Bernanke but this is nothing new and you may well wish to read (again?) a nearly two years old piece, "A US way out?", to realise that it may produce rather stunning outcome.

All western countries are waiting to be "rescued" (read: "fleeced") by the "successful", as today David Cameron has called it, financial industry. Indeed the Prime Minister showed today a mind-boggling art of squaring a circle: on one side he believed that the financial industry was lending irresponsibly (to a point that it brought about the financial crisis) but at the same he believed that it was a successful industry.

The reason for all these banks "rescue" campaigns is that the money multiplier remains huge and there is no way out of this mess without massive inflation or debt write offs (defaults), or both. The question is who is going to get hit: the banks are shifting direct loss consequences from themselves upon taxpayers. This is what the rescues are all about. Yet no mainstream media or pundits, politicians or experts dare to answer two questions: "what are the money multipliers of major western currencies, US dollar, Euro, Pound Sterling, etc?" and "what should the money multiplier be in order for the financial system to be solvent"? The answers to these questions may produce some uncomfortable truth: the western world is bust and is simply rolling over its problems. The banks are part of it. They are "rescuing" countries in order to help their insolvent balance sheets (i.e. they are rescuing themselves) shifting direct liabilities upon taxpayers (mainly hardworking middle classes)

In reality massive bankers' bonuses, whilst morally repugnant and even a rather dishonest way of funnelling taxpayers money to financiers' coffers, are a smokescreen, a PR stunt that suits the government and banks, designed to cover that the financial system is bust. It is buying time but this cannot keep going on forever. When your house is on fire you are not going to complain that someone is stealing small items from it. Therefore rather than talking, again and again, about the bankers' bonuses "Prime Minister, sort out this mess, please".

UK's 21st century democracy

Today we could read in London's Metro that a gym fan was tried for 2p (two pence) fraud. He used his friend's pass to gain access to the gym and do some exercises.

Only several days ago we could have read that the inquiry into the former Royal Bank of Scotland CEO, Sir Fred Goodwin's behaviour who was ones of those who caused the current financial crisis was dropped by the Financial Services Authority. Little surprise, as expected, since the FSA was at best effectively complicit to the bankers' behaviour.

The ongoing financial crisis is a result of primitive and conspicuous fraudulent practices of the financial industry, regulators and some politicians either by direct involvement or by allowing such a primitive and conspicuous fraud to run for years. The type of this fraud has been well-known for centuries. It is a pyramid scheme. How the pyramid method was implemented by the financial industry in the context of this crisis was described in detail in the first article on this blog: "The largest heist in history". It is nevertheless ironic that for years the crudest of financial crimes has been described by the pundits and the mainstream media as "sophistication of the modern financial industry". This has been public deception on a par with 17th century Dutch tulip mania. This is how historians will judge it in the future.

Thus far the crisis resulted in massive global economic downturn and economic near-collapse of some countries. In Britain it led to massive public spending cuts, increase of taxes and payment obligations by the public (such as the current tripling of the university tuition fees), demolition of traditional pensions schemes and, in fact, savings. And much more is still to come. Don't jump over yet, it will get worse.

Coming back to 2p gym fan's fraud story: if we contrast it with the financiers, regulators and some politicians multi-trillion pound fraud, we have to ask a question: is this what the 21st century British rule of law and democracy is all about? (Ask your local MP.)

Joseph Stiglitz: "We Have To Throw Bankers In Jail Or The Economy Won't Recover"

Nobel prize winning economist Joseph Stiglitz told AOL Daily Finance on October 20th, 2010: "This is a really important point to understand from the point of view of our society. The legal system is supposed to be the codification of our norms and beliefs, things that we need to make our system work. If the legal system is seen as exploitative, then confidence in our whole system starts eroding. And that’s really the problem that’s going on. [...] I think we ought to go do what we did in the S&L [crisis] and actually put many of these guys in prison. Absolutely. These are not just white-collar crimes or little accidents. There were victims. That’s the point."

The author of this blog presented such view in an article that started this blog: "The largest heist in history" which Professor Stiglitz has known since January 2009. In fact this blog was only started since experts, politicians and mainstream media pundits ignored such obvious view two years ago. And great majority of them keeps ignoring it. Welcome to the club, Professor Stiglitz.

"I would recommend you panic" *

The world is going crazy. Americans are printing dollars Treasury papers (and keep getting into deep debt) to sustain whatever is left of their once top lifestyle. Chinese are buying them in order not to let the dollar fail (at least for now). Chinese are pushing whatever they can of this money mountain out acquiring whatever they can in terms of influence, assets, commodities (and rights to them). This mountain overall keeps on growing. In terms of mechanism we are really dealing with the world money circulation system being turned into a global mega version of Lehmans.

At one point, in the same way as commercial banks refused to roll over Lehmans debt in September 2008, China will refuse to roll over US debt. And the whole system will collapse. This will leave China with still a massive real wealth of assets and possibly notionally even bigger mountain of the US T-papers worth as much as Lehmans shares, ie nothing. I think China already accounted this notional loss as clearly this is the way to finish off the US financially and acquire real wealth globally (influence, assets, commodities and rights to them). This is a war in all but name. The US is defenceless unless it uses real weapons. Quite scary.

The US, for political reasons, cannot stop this process itself. The question is what will happen in the US (or how is the US going to react) if China stops this process or it is simply stopped as such a mechanism cannot run to infinity. (If anything the computer power is limited and ultimately such process is bound to collapse for strictly technical reasons, e.g. lack of sufficient memory or processing power for financial transactions.)

This is crazy: on one side financial institutions' executives caught the national budgets by their throats. The queue of countries waiting to be 'rescued' is long (and includes the UK). Today Portugal seems to have got into a 'rescue' mode (following Greece and Ireland). On the other side China got by the throat the US financial system which is an ultimate foundation of the global financial system.

What will happen when China does not buy another tranche of the US T-papers (because it will refuse or... the financial computer system will collapse)? How is the US going to react? I think, the sheer scale of money involved and the past history teaches us that it will be a very sad, if not dramatic, end.

It is clear that the politicians do not understand the scale of what is going on and that it is getting worse. Thus far every 'significant' government decision (like the recent public spending cuts in the UK) for the last 2 years has always been heralded the beginning of the recovery. And as expected, it always got worse. The reason is that the fundamental cause behind this crisis, too great money multiplier, is not getting any smaller. This crisis is NOT a debt crisis. Debt is only a manifestation of the real cause of this crisis: too high money multiplier, that looks on the outside like a debt crisis. It is like pneumonia of an AIDS sufferer. Indeed it is pneumonia but the AIDS is an underlying problem. Why politicians, the mainstream media and pundits still do not get it seems rather impossible to tell.

^* - a quote from Hugh Hendry interview

Irish crisis: why British government cut public spending

The ongoing financial farce in Ireland shows with crystal clarity why Britain was "persuaded" by the, so-called, "financial markets", pundits and all sorts of experts to cut the public spending. If British kept on spending as much as they used to it would not have enough money to rescue Ireland. The UK would have been on the financial edge itself. According to the Bank of International Settlements in Basel the UK banks' exposure to the Irish debt is 222.4 billion euros (page 16 of the report). If Ireland is bailed out, in fact, it will be British financial insitutions that will be bailed out too. Without having made the spending cuts a few months ago Britain would not simply have money to do so. Hence the UK banks would have ended up in a very deep trouble (if not bankruptcy). To summarise the whole saga (which shows the, so-called, "financial markets" modus operandi):

- first Irish banks were run out of money, thanks to a pyramid scheme that was operated, and ended up in a deep financial trouble; Ireland was "persuaded" to make deep cuts to rescue them; i.e. banks' debt was propagated as the country's debt;

- after everything was squeezed out of Ireland itself its rating was downgraded in order to generate even greater liabilities of Ireland towards the, so-called, "financial markets";

- then countries like the UK, Germany were persuaded by the, so-called, "financial markets" to make cuts in order to create a budgetary room to pay more to the, so-called' "financial markets";

- now Ireland has been "attacked" by the, so-called, "financial markets"; Ireland is simply a conduit to squeeze other countries (like Britain, Germany) that are tied to the Irish debt and make them keep paying to the, so-called, "financial markets".

- after Ireland is "rescued" the, so-called, "financial markets" will continue operating according to this modus operandi; there are more countries in a queue waiting to be "rescued"; the, so-called, "financial markets" will decide the timing.

Is this a conspiracy? No, it is not. This is how, so-called, "financial markets" work. This what the City and Wall Street are really all about. (The rest is simply a pretty transparent smokescreen creating a pretence of legitimate business. Like some Greek restaurants operating, in fact, as illegal cassinos.)

The author of this blog described this mechanism well over a year ago. It is well known to governments, policy and decision makers. The, so-called, "financial markets" are so primitive in executing it that any half intelligent and quarter competent financial observer picks it up immediately. This is, in fact, the very same mechanism that typical loan sharks use to extort money from their victims: tie them up to debt, then set the rules that the debt is ever increasing, persuade them to save on everything, borrow from others and work harder in order to increase payments to loan sharks (these days called: "the financial markets"). Simple and primitive, inni't?

If the British government believe that by making cuts, in the way they do them, they will lead the country to recovery and prosperity, they either do not understand the causes behind the current crisis or are actually working for the interest of the, so-called, "financial markets" (for example, hoping to get a job in the City and get spolis of their actions). Or both. The obviousness of that behaviour defies belief. Or maybe one of blog readers can offer a better explanation? There is a way out however: "Prime Minister, sort out this mess, please". It is not that difficult but it requires really tough decisions (including prosecuting the financial fraudsters and liquidating the pyramid scheme).

US-Sino Currency Rap Battle

(by Next Media)

Currency wars: where will it end?

The current financial crisis put a huge question mark on the credibility of the major currencies. The rounds of massive quantitative easing - printing of trillions of dollars - of unpredictable consequences, major banks balance sheets crisis, sovereign debt crisis and so on. In the midst of it the economic prospects of the US and the EU still look gloom as there is no apparent revival trend that would lead to a sustainable growth. All the governments are doing looks like life support of the dead corpse of the financial system rather trying to stimulate the economy. No wonder, as the financial system was turned into a giant pyramid scheme it keeps on collapsing. And it will keep on collapsing until the pyramid is liquidated. The currencies such as the US dollar, Euro, the British Pound are in fact such a pyramid scheme vouchers.

The recently proclaimed currency wars underpinned by the current US initiative of quantitative easing, kind of a major fiscal offence, are likely to result in further undermining of the major currencies. In fact it is likely to further undermine the world financial system as we know it which is based on fiat money where currencies represent the credibility and financial worthiness of economies they represent. As currencies are used so crudely as financial weapons their credibility as a value store will soon be gone. So what next?

There are economies and businesses in the world that generate profit. They need to store value in a credible way. If the major currencies lose such a role the natural way will be a come back to a barter-type economy. Buying commodities, land, etc. and trading it. It looks likely it will go in this direction but the system will be managed in far more refined manner rather than a typical barter of a gone by age. The obvious candidates would be virtual currencies. Each of which would represent a basket of commodities agreed by parties to a transaction. The obligation to pay a bearer would not be in any currency but in a basket of commodities. However, one can expect, that typically a payment would be accepted by a receiving party in some currency - or currencies - equivalent at the time when it is settled. Technically there is no limit to a number of such currencies: a new one may be created for the purpose of a new transaction. However one can reasonably expect a good degree of standardisation, i.e. a major 3 - 5 virtual currencies, commodity baskets. This would facilitate trading between them and trading between the contracts based on them. In fact China's massive multibillion dollars commodities-for-cash deals are good early examples that such a system is already emerging.

Virtual currencies would be inflation immune within the commodities they represent. They would be durable and non-perishable as they will not be actual commodities but rights to get them on demand when a contract representing a particular currency is settled (i.e. value is exchanged). Such model should be quite appealing to countries like China and India whose development depends to a large degree on the access to commodities. It should also be appealing to commodities producing and trading countries as they would not be dependant on a very uncertain fate of the US dollar (a major, by far, current commodity trading currency). And as a value store, virtual currencies would always store a real value despite the fact that there would always be a risk of a commodity going up or down against the others. After all, this might not be such a big revolution: ultimately it may lead to re-basing the national currencies, turing a full circle from abandoning de-based and worthless paper money and going through a modern form of bartering. This time round not strictly currency based on gold but on various commodities baskets. However there could be a lot of bumps, or worse, along the way.

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.