Economy: "What a beautiful Catastrophe!"

Can you imagine you are a civil engineer trying to design a building whilst one of the most fundamental laws of nature keeps changing the way it is working? For example, if gravitational force were to become much stronger when acting on some of the construction materials? You are likely to end up constructing a building that will not behave as you expected when you designed it.

It is a bit of a loose parallel but economists face the same problem when dealing with the current financial crisis. Macroeconomics theories assume that the financial system works properly even during the financial crisis performing what is known as money multiplication function, multiplying currency to broad money. All the growth expectations, inflation predictions have this mechanism built in. The Keynesian approach of economic stimulus through public investment and many other anti-crisis measures are also based on it. All modern economy exists thanks to the existence of the money multiplier function: otherwise it would a bartering or quasi-bartering system and banks would be simply secure stores of money.

The financial crisis that started in 2008 and continues to the present day is not the first economic downturn in human history. It is also not the first time the banks have collapsed, or have been on the verge of collapse. But it is the very first time that the entire modern financial system is on the verge of collapse or indeed keeps on collapsing. This has happened as a result of turning the financial system from a manageable money multiplication and risk management/optimisation machine into a classic example of a pyramid scheme.

As a result, money multiplication does not function in the economy. Banks are not lending. Whatever money comes into the financial system, for example by a government borrowing or QE, sinks into a pyramid and is used to cash toxic assets. This is a way of preventing the financial pyramid from collapsing: just having enough liquidity to keep the system going. The current raids on the Euro zone are a classic example of banks scraping around wherever possible for more liquidity to be added into a corrupt system.

When money multiplication function does not work in the economy, the entire modern economic theory does not work. This is one of many reasons why so many “plans for growth” devised by the biggest economic brains have not worked in the last 3 years. The solution is actually technically quite simple: it does not require much economic "wisdom", just a lot of political guts. Forensic accountants, receivers and prosecutors are needed rather than economists. This is all about liquidity shortage and the fact the banks are not lending (i.e. performing their money multiplying function in the economy).

What can we expect ahead in 2012/2013? As other currencies and the International Monetary Fund are pulled into rescuing the Euro zone, it is very likely that other currencies and indeed the IMF will come under the threat of collapse, or they will collapse actually.

What should really puzzle everyone is that nothing has changed in the way the financial system has been run for the last five years or so. Even the same people are still in charge. And as more and more money has been pumped into it, the financial crisis has kept on spreading from small banks to larger banks to the entire financial system to sovereign debt to currency systems. Albert Einstein once famously defined insanity as "doing the same thing over and over again and expecting different results". Do the politicians, top economic experts and mainstream media pundits not show strong signs of insanity because they believe that by doing the same thing yet again, i.e. pumping even more money and pulling even more countries and the IMF into it, they will stop the crisis from spreading? It seems rather obvious that, as before, it will spread even further pulling into it more countries and the IMF unless the contagious aspect of it, i.e. a pyramid structure of the financial system, is eliminated. And because the modern economy cannot function without a healthy financial system the crisis will ultimately ruin the western economies altogether. This is the current direction.

As explained in "The largest heist in history": there is no way of winning with a pyramid scheme. The only way out is to liquidate it. Poland learnt it in the early 1990's, Albania learnt it half a decade later. It is obvious that the western world is learning this in a hard way now. Hopefully it will heave learnt before it is too late. The later it is done the more damage will be inflicted. And if it is not done the pyramid will collapse eventually with spectacular effects. No doubt Zorba the Greek’s applause: "What a beautiful Catastrophe!" will serve amply to describe it.

PS. Since this article was written the European Central Bank announced that it was pumping nearly a half trillion new Euros into the European financial system. This confirms the main argument of the blog: the pyramid keeps on collapsing and the politicians and the decision makers keep on trying to prevent it from a collapse. Just one more time: things are getting from worse to even worse.

Debt magic: a story from Devon

On a grim rainy autumn afternoon a tourist comes to a small seaside town in Devon. He plans to stay for a week. He finds a hotel and decides to stay there. At this time of the year, which happens to be during the low season, the hotel is empty and the tourist gets a great deal: an entire week for £100 provided he pays upfront in cash.

As soon as the hotel owner gets £100 he calls the hotel cook. He owes him £100 in unpaid wages as the business has not been good recently. The cook gets his £100 and goes to a local grocer, his childhood friend, who was helping with weekly shopping by providing a small credit line. The cook gives the grocer £100. The grocer then goes to his local wholesaler whom he owes £100. The grocer settles his debt. Quite often the wholesaler spends evenings in the hotel bar drinking whisky. He owes the hotelier £100 for drinks. Now he has money and the hotel owner gets it.

At that point the tourist discovers that the hotel is not really up to standard. Without going into detail (so as not to discourage anyone from visiting Devon which is beautiful and this story is a fiction) the tourist goes to the reception asks for £100 refund for his room and leaves. But he also leaves some residents in this small seaside town happy on this grim day: thanks to him they have cleared their debt.

There is a serious point to the story. The reciprocity of debt is not uncommon. Many people have mortgages and loans on a liability side and savings, endowments and pensions on an asset side. A customer has debts towards a bank and a bank has debts towards a customer. In reality these debts offset each other. However in the world of banking they add up: banks make money by servicing debt in whichever direction, especially those who are intermediaries. France owes the UK €227 billion, the UK owes France €209 billion. Germany owes France €206 billion, France owes Germany €123 billion. This BBC interactive map shows the euro debt structure. Banks make money on all debt.

This is one of many reasons why the global debt must be audited and all reciprocal debt should be offset. This was recommended in "Prime Minister, sort out this mess, please" a year and a half ago. Of course, not all debt would be nullified like in this small seaside town in Devon. But there is no doubt that a huge mountain of debt would be greatly reduced. But such an approach has been ignored thus far because if it were not, banks would lose huge income streams (for acting as debt arrangers/managers) from the taxpayers. No doubt they are unlikely to allow this to happen.

Has Cameron killed the City?

The Germany's strategy of solving the euro crisis is still not completely clear: but it starts looking rational. Unlike other world leaders Angela Merkel understands what behind the financial crisis is. Rather than throwing good money after bad and adding and allowing more bailouts (for example by allowing European Central Bank to print more money), as she was pressured by Obama, Sarkozy and Cameron, in true German style, she called the financial markets bluff and started methodically reforming the financial system first. She also ensures that the execution and control of the reform will be under German control so it is not hijacked again by scammers and many politician who are happy-clappy about the the financial markets. But the jury is still out how it goes as no doubt it will be a bumpy process.

David Cameron decided to opt out from Merkel's reform. He justified it by defending the British national interest or, more precisely, by the City's. Leaving aside a rather dubious point that City interest is congruent with the British national interest, which in the midst of the financial crisis sounds - to put it mildly - irrational, was Cameron's action helping the City in the long term?

The financial industry is heavily subsidised in the UK by the taxpayers (i.e. the costs to the UK economy of having this industry exceed the tax receipts by far). The City does not exist as the UK financial centre but as the main European one competing with likes of New York, Tokyo, Shanghai and Hong Kong. Without ability to do business in Europe freely the City will be a "surplus to requirements" on the world's markets. There is no doubt that very rational financiers in Frankfurt and politicians in Berlin would like to take over the City's position. And the fuming Sarkozy and the French will be happy to help, just finishing off the City. Now Cameron created the best opportunity: the openly expressed desire of vengeance by Sarkozy and much less, but in practice far more lethal, by Merkel will ensure that France and Germany will do all their best to cut the City out of European deals and financial markets. And, with the support of practically the rest of Europe, it will be easy: unlike the war with Iraq a real "cakewalk". This is very likely to result, in a decade or so, in Frankfurt getting the pole position in finance in Europe with some spillover and subordinate business conducted in Paris. When Thatcher went to Brussels to negotiate she brought back the rebate. When Cameron went there he put the financial industry on the gallows.

It was not just Cameron's idea to "defend" the City's interest. He was under pressure from the British financiers. (Having said that Cameron and his team are unlikely to understand such considerations. The mainstream media do not seem to fare any better. There seems to be a complete strategic void in the establishment.) It is clear that they lack a basic survival instinct. The City financiers et consortes give preference to a short term personal gains, like this or next year bonus, over the long term interest of the industry and the country. "Greed is good", who said that?

However, sadly, it seems so British and so unsurprising. In the 1970's the British heavy industries refused to adopt to a changing world: first signs of globalisation. They put a pressure on the British government to subsidise them with taxpayers money and keep them going. As a result within a couple of decades the industry that had led the world into the 20th century was confined into history. The very same process is happening now. The City financiers demand state subsidies (i.e. bailout, quantitive easing, tax exemptions, etc) and want to carry on as before. They disregard the fact that the world is changing. They look after their short term interest and it looks like that the financial industry that led the world to the 21st century will be history in the UK not before long. It is the same approach as militant trade unionists of the 1970's although they most likely were acting unwittingly and were not wise enough to understand that. However considering the current degenerated and pathological state of the financial industry in the UK, which appears to be beyond help, finishing it off, unlike the collapse of the manufacturing, may actually be the best option for the British future. Countries can be successful without overblown financial services: Sweden, Denmark, the Netherlands or Germany. Now it is clear they cannot be successful without healthy manufacturing. These are not emotional arguments but purely pragmatic economic and social considerations.

Last but not least: unlike the UK, Germany went through the 1970's and 1980's managing their manufacturing base excellently. They strengthened it and now are the world manufacturing powerhouse. It looks very likely that in a decade or more - possibly after some unpleasant events like wars - the Germany will have a blooming financial sector, whilst in the UK the City will be seen as British Leyland or British Coal is seen now. And no doubt some will argue that the City collapsed because... it did not get enough support from the taxpayers.

Why don't they sort out this mess?

This is the question to the world leaders, Barak Obama and Angela Merkel. Of course they will have to do it together with other leaders, from China, the EU, the UK. What has to be done was written long time ago. These are quite simple steps described in "Prime Minister, sort out this mess, please" but executed globally. It has to be done in a coordinated manner. As the financial markets degenerated into activities which do not carry any economic value but, at the same time, affect the nominal debt and liabilities between countries and institutions, the world financial markets have to be suspended. On a Friday afternoon, after the closure of the last financial market, the world leaders should announce such an action and start an immediate process of restructuring of debt and financial markets described in "Prime Minister, sort out this mess, please". Part of this process should also be agreeing new rules (like abolishing credit rating agencies in the current form) according to which the financial markets can reopen and function. The capital flows in and out currency zones, like a euro zone, should be suspended for that period (and only allowed by a relevant central bank under extraordinary circumstances).

In practice such process is not dangerous at all. It is simply a long global weekend of the financial markets. No one losses anything by such action as everyone will have what they have had at the time of closure. Of course the outcome of the negotiations will change that but it would be agreed write-offs rather than a messy degeneration of the value resulting from financial gambling. And if it is not done like this, it will happen anyway, one way or another, but quite likely after a global bust up: basically a massive war or a series of wars.

Incidentally the problems that the governments currently experience with the financial markets are not new in history at all. At the end of the 19th and the beginning of the 20th centuries, after the Second Industrial Revolution, the US experienced massive powers of huge trusts and monopolies like Rockefeller's Standard Oil. And the US government managed to deal with it successfully for the benefit of the US and the world economy. Broke it apart. The Sherman Antitrust Act was enacted. Despite two world wars disasters, this was the foundation for the western world economic success of the 20th century.

Looking ahead 200 - 300 years, the future generations will judge the current period in history not too favourably. At best the current financial crisis, caused by quite primitive, easy to understand and predict its consequences the massive global pyramid scheme, will be laughed at and compared to Tulip mania in the Netherlands in the 17th century (e.g. toxic waste financial instruments compared to Tulip bulbs), but more realistically, with an element of distance that the time will give, it is very likely that the current political and financial elite will be looked at as a bunch fraudsters (manipulators) and idiots (who were manipulated). This is not actually the view of the author of this blog but an analytical judgment, i.e. a probable scenario, that the current world leaders should also take into account: how they are likely to be seen by the future generations. But they might not even be able to do that.

Andrew Neil (BBC) is "scared": better late than never

Last Wednesday on "Daily politics" (BBC 2) whilst commenting George Osborne's statement, Andrew Neil said that he was "scared" by the current economic situation. It was a really worrying statement. Firstly if a journalist of such off-the-record knowledge, known for a rather moderate language, said that he was "scared" the situation must be really ghastly, i.e. the economy is on the verge of a systemic collapse. Secondly, the time to be scared was three years ago when the financial system collapsed and when it was more than obvious that unless the fundamental overhaul to the system was done it could only get worse. Basically what's happening now was easily predictable three years ago. In fact the current crisis is very mild indeed as it could have been considering the real state of the banking system.

Incidentally back in May 2010 Hugh Hendry gave a sensible advice: "I recommend you panic". At that time many people took this as an eccentric comment of a financier, although it was obvious that it well thought through advice.

George Osborne should also not be too smug because the UK keeps AAA credit rating and has a very cheap borrowing rate, cheaper than Germany. Currently the financial markets are preoccupied with taking as much money as possible, squeezing Germany to the maximum. Once they finish this process, and in the meantime the UK makes a lot of cuts thereby creating a lot of room for additional borrowing in the future, there is little doubt that the financial markets will turn their attention to the UK and squeeze it for more cash. Hence all the money that the Chancellor is saving now are really destined to the bankers coffers. This is how financial system works these days. It is all about extracting as much money as possible from the middle class taxpayers. Another obvious fact that seems to be completely missed.

The largest heist in history continues (as predicted)

It is enough to read a couple of yesterday's newspapers' headlines "It's official: credit crunch is back" (The Daily Telegraph) and "Day the world's banks wobbled" (The Daily Mail) to realise what mess we are in, that the situation is dire.

The credit crunch is not back. It has actually never gone away for the last three years. The global pyramid scheme is still run by the financial institutions. It keeps on collapsing like any pyramid has to. And the taxpayers - through governments and central banks - are the last pyramid "customers" that were forced to join this criminal scheme and finance it through the tax system. An utter scam.

This process was described and predicted three years ago in the submission to House of Commons Treasury Committee. It was a warning that was ignored and "the largest heist in history" continues. It will lead to absolute ruin: it will be a ruin of middle classes in the West.

To quote the report to the House of Commons Treasury Committee published in April 2009 (!!!):

"(...)

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

(...)"

Despite this governments have allowed "the largest heist in history" to continue for years. However now it looks like that Germany may have had enough of this ongoing financial scam and, by the end of the next week, will pull a plug on it, as far as they are concerned.

Strategic thinking void

When the incoming UK government announced severe cuts and tax rises all group were affected, including the police. Yet with such cuts and tax hikes it is rather obvious - no benefit of hindsight needed - to realise that strikes and public unrest are very likely. When Margaret Thatcher decided to take carry out deep reforms over 30 years she excluded from cuts the police. In fact she improved the police terms and conditions of their employment. Incidentally a few weeks ago the Poland's government showed the same approach to reforms: giving a rather raw deal to almost everybody but improving the police's.

So there was little surprise that when the looting erupted in London and other towns last summer, the police was quite apathetic to react. It looked almost ostentatious as if they were taking their time. As a result the scale of disorder might even surprised the police but it proved a vital point to the government. The point was that the police was important and they better thought twice before they made any further cuts. It is unlikely that it was the police officers conspiracy. It looked it was a manifestation of self-defence, that may got out of hand a bit.

Now the government is making yet another mistake. It is going into confrontation with trade unions. Historically strike were very unpopular in Britain and the public tend to blame the striking folk more than the government for the inconvenience. But this approach was a result of a judgement on the situation that to many in the society seemed fair. In the past the strikers had a good deal and generally were living on the state subsidies, like heavy industry workers over 30 years ago. This stereotype was later transferred onto all public sector workers.

But times changed. No the group that is now being subsidised heavily and most is the financial industry. All taxpayers have to chip in to subsidise the City to much higher degree than heavy industry 3 - 4 decades ago. And the remuneration of financiers is much higher than of the heavy industry workers. The public sector finances are in such a huge mess because the government has to over borrow in order keep the banks afloat. This all is a source of protest amongst all those who are affected by the government spending cuts and tax rises. "We are all in it together" apart from the financial industry who can only carry on their old ways doing business due to the fact that "we are all in it together" keep subsidising them.

Therefore now the public is likely to have a lot of sympathy for the workers going on strike. And it is an irony that trade union are actually fighting for more free market, i.e. cutting subsidies to the financial sector. The striking workers do not want anything more. They want to keep what they have got which, compared to heavily subsidised financial industry, is not that much. The government is likely to make a misjudgement: ordinary taxpayers are likely to accept the strikes as a protest against them subsiding the financial industry. And this can only fuel even more unrest and make other groups join in.

With disaffected unemployed youth that have little prospects as even they find the job they will have to start paying taxes to subsidise the financial industry, not exactly happy police, radicalised trade unionists and public sector workers and the general public who frankly have enough to keep subsidising the banks, the government should think of contingencies for a long period of discontent. Cynics say that some already are ready for it: resign and join the City (i.e. continue to live at taxpayers expense).

"Credit easing": another good money thrown after bad

When politicians start doing something right you can be sure that the situation is serious. This cynical comment - sometimes quite unfair - seems to be true this time. The British Finance Minister (the Chancellor of the Exchequer), George Osborne, plans for a "credit easing" programme for small companies worth £20 bn (possibly up to £40 bn). The previous money expansion programmes, i.e. banks' recapitalisation and rounds of quantitative easing, failed to jump start the economy. The reason was simple and obvious before these actions: no benefit of hindsight. Having depleted the banks reserves by running a giant pyramid scheme (effectively banks defrauded the reserves), the banks were holding on to new money to keep them afloat. In 2008 it was already obvious that if the government wanted to jump start the economy, it must have set up an altarnative system of putting new money into economy AND circulating them outside the mainstream financial system.

After over three years the government seems to have understood the first part. Hence the decision to start "credit easing" for small companies. It is an introduction of new money into economy effectively bypassing the banks. The amount mentioned is not staggering. It is £20 bn, but it can be very effective. Typically in a healthy functioning economy, with a healthy financial system, would have multiplied this narrow money in circulation into £140 - £200 bn broad money. This could have jump-started the economy.

However contrary to a recommendation given to the House of Commons Treasury Committee, the government does not provide any mechanism to circulate these £20 bn in the economy safely, generating new credits from the initial injection, "easing". Once businesses start getting credit through "credit easing" these money will end up in the financial system, it will be cashed for all sorts of toxic waste that the financial system has generated for years and keeps generating them or in the reserves. It will not be relent. It will be another way of subsidising the banks. As a result £20 bn will be expanded in a minimal way, if at all. No doubt it will help some struggling small businesses. But there is a very high risk that from the economic perspective it will be a good money, with the best of intentions, thrown after bad money.

Sometimes a half of good solution is a bad solution: "credit easing" seems to be falling into this category. It is likely that in six months time or so the government will be wondering why the programme failed. But is it not obvious now?

Budget. What budget?

It is not that long ago when the Chancellor of the Exchequer (the British Finance Minister), Gordon Brown, was preaching the virtues of a balanced budget. In fact this was a commonly accepted wisdom: in a period covering up and down ("boom and bust") of economic cycles governments should balance their budgets. They should have neither surplus nor be in debt. There was a debate how it can be achieved. One approach was that a surplus produced during good times is saved and then used in bad times. The government is never in debt and any surplus is kept as a reserve for bad times. The opposite approach is that during bad times the government gets into debt which is then paid back during good times. The practical solution would be somewhere in between. Precisely where, can be the subject of pragmatic arguments and philosophical debates. What had never been put into question was the entire concept as it clearly makes sense.

After the outbreak of the current financial crisis when governments had spent massive amounts of monies to subsidise the collapsing financial industry, the concept of the balanced budget remains forgotten. Now the real issue is the maximum level of debt governments can sustain in servicing it. In practice it means that governments would remain in maximum permanent debt paying maximum amounts in interest and service payments to the financial industry. And whenever the capacity of repayment appears the debt will be increased, rather than repaid, so the maximum level of permanent interest and service payments to the banks is maintained. Such increase of debt can be achieved through various mechanisms like additional bank's bailout or a downgrade in the credit rating. This is a classic strategy that loan sharks use against their victims: this is how the financial industry - with politicians as conduits - treats the taxpayers now.

This current level of governments debt is a direct result of banks' bailouts. These bailouts broke the traditional economic cycle of "boom and bust". Indeed Gordon Brown's claim that "boom and bust" in the UK was abolished seems correct. But not in a way that Mr Brown would have hoped: the UK ended up in a state of permanent, or at least very long term, "bust" state. When the British government rescued banks to the tune of £65 billion (of direct costs) in 2008 it was not just about £65 billion, a massive amount of cash as it was. These £65 billion ended up in banks coffers filling up the liquidity hole which was created by the banks running a giant pyramid scheme. Banks did not start lending and it was obvious that they could not have started doing so. So £65 billion did not end up in real economy but in the banking system securing interbanking transactions against toxic waste which were generated by the pyramid process. Needless to say these £65 billion generously helped to fund the financiers remuneration.

This £65 billion debt is not just a normal government debt as it would have been if this money had been spent in the economy through tax cuts or public spending. If the banking system was relatively healthy (i.e. did not require rescuing and was not such a pyramid as it is) and the government borrowed additional £65 billion, to fund tax cuts or to spend on public investment programme to stimulate the economy, then through the healthy banking system credit creation cycle this £65 billion would have been multiplied seven to ten fold. Therefore the debt directly generated to rescue the banks in the UK in real economic terms cannot be considered as additional £65 billions on the government balance sheet but as £455 billion to £650 billion lost opportunity costs of the real economy.

Bailouts, such as one in the UK, happened in the US and the entire eurozone. It is economic value is not in hundreds of billions of euros or dollars, but in serious trillions. And it keeps growing. The financial system which was turned into a classic case of a pyramid scheme (in legal and technical terms) and which the governments decided to support, is killing off the real economy. The idea of a balanced budget is unlikely to come back soon.

Debt Dynamics

Debt, in itself, generates more debt by attracting interest. At present it appears that the current level of debt, in Eurozone - and in almost all western economies including the US' - attracts more interest than the repayments generated through economic growth (collected as taxes). There is no doubt that recovering from the current crisis will require debt write offs. But how much would it be on a global scale? It makes a significant difference if, for example, 20% of debt on the banks' books (globally) has to be written off for the economy to recover, or 99%. And it is actually likely to be far closer to 99% than 20%. And then there is a question who will be on a receiving end of such write offs: basically who is going to lose loads of money. As the history shows the answer to this question may make the difference between peace and war.

But debt write off is not such a simple process. If it happens it will be a default. Even if voluntary the courts are likely to rule that it is a credit event. This, in turn, will trigger CDS' payouts (sometimes referred to wrongly as insurance against a default; in fact these are the bets put that default would happen). Due to the nature of CDS' these payouts may actually be greater than the underlying debt, value of default (since it is possible to buy CDS' on a particular default event exceeding the value of the debt). So from financial system perspective, debt write offs may trigger liabilities much greater than debt itself: i.e. the cumulative value of CDS' payouts may exceed, by far, the value of written off debt (some estimates go into hundreds of trillions or even quadrillions of dollars). And who is going to pay it? The guarantee will come back again on the taxpayers doorstep.

The current credit creation mechanism in the banking system (lending with loan to deposit ratio greater than 100%) is also unsustainable. Such mechanism needs financial innovations, like collateralising and rolling over of debt, to be operated. The unsustainability of this mechanism is such - it is basically a pyramid scheme mechanism - that even if a sufficient global debt reduction is done (even a total 100% write off), and somehow CDS' liabilities are written off too, the debt write off strategy will not work anyway: the world will be back in debt and soon.

The new debt generated by credit creation with loan to deposit ratio greater than 100% will very quickly (at exponential, intractable, pace to be mathematically precise) return to pre write-off level. But a credit creation process cannot be stopped totally without killing the economy altogether. This is actually what is happening to a large extent now: banks lend very little to genuine businesses. The solution to such quagmire is given by basic mathematics (this is what the work on this blog has been all about): after making sufficient write-offs, lending with loan to deposit ratio (system-wise) greater than 100% should be banned explicitly. Thus far it is banned implicitly as pyramid schemes are banned, but financial institutions ignore it. In practice ledning with loan to deposit ratio greater than 86.5% (or even less) should be banned. This is not a guarantee of a solution to all economic and financial system problems giving a speedy recovery, but without it no solution is possible. The world will keep getting into debt deeper and deeper.

The quagmire of the current situation is that, from technical and legal perspective, for some years (at least a decade but most likely much longer) the financial institutions have been running a massive global pyramid scheme. What we have been observing for the last 3 years is a typical ongoing collapse of the pyramid. It looks exactly the same as Albanian pyramids of 1996 - 1997. The fact is that the financial system - with the support of politicians - is determined to maintain such a massive pyramid scheme. In practice it means more collapses and bailouts and never ending debt for the taxpayers to keep such a loan shark business going.

Lord Lawson: Greeks should vote "no" in the referendum

Today at lunchtime, Lord Lawson (a UK Chancellor of the Exchequer between 1983 and 1989) has given a lecture at the National Liberal Club in London. The title, put in form of a question was: "Is the Eurozone crisis a threat to global stability?" It was an excellent review of many aspects of the causes and mechanics of the ongoing financial crisis from macroeconomics perspective.

After the lecture, during a question session Lord Lawson was asked how he would have advised the Greeks to vote in the referendum (if there is one) on accepting the last week's financial bailout deal. His answer was unequivocal "no". Lord Lawson did not answer a question whether he expected colonels back in power in Athens by this Christmas.

Greek recovery: Greece doing Iceland?

It is impossible to say whether Greece will (or will not) leave the euro. Let's leave it to fortunetellers. However the rest of Eurozone seems mortified to the point that they decided to parade and grotesquely admonish Greek Prime Minister Papandreou in front of G20 leaders. Cannes, the European film capital, was indeed the fitting location for this tragic farce.

It may well be the case that Germany might not be able to leave euro themselves orderly before the whole thing starts crumbling. So the Greeks get bullied by their European friends. They are told that they will be better off by accepting a massive austerity programme than by defaulting and basically starting from scratch as a bankrupt country. Public spending control and cuts is a good idea. But the Greeks are not the Germans. And even the last time round when Germany went through economic hardship, in the 1920's and 1930's, it produced the leader whose idea about European integration was rather unorthodox.

Greece is told that if they get half of their debt written off, accept a massive economic hardship for a decade, by the 2020 they will still be... 120% in debt to their GDP. It is unsustainable. By comparison the current Italy's debt to GDP is, surprise, surprise, 120% and is considered as unsustainable, And Greeks are meant to approach this level from the other side. Therefore, frankly, Greeks are on a receiving end of a lunatic proposition. The fact that the European leaders do not see this unreal side of their actions does not say much about them. It is actually very worrying.

The concept of bankruptcy was invented and defined in law for a reason. It is possible to reach a point when nothing works better for a debtor than accepting the insolvency and starting with a clean sheet.

Greeks can also take Iceland as an example: it was really the first and the only country that went bust in this crisis. They admitted the game was up. Iceland started negotiated hard with creditors. They have had their national interest in mind: first come Icelanders and then they can pay others. And quite rightly so: this is what sovereign nations, and their governments, are all about and creditors to sovereign nations know exactly that when they lend money.

Not surprisingly although Iceland is still heavily criticised for their actions, it is reviving pretty well. And less than three years ago it reduced its financial and state institutions to a basket case. However the common sense and survival instinct prevailed and Iceland is now where it is. Actually not bad. Greece can recover fast too: if Greece default on all of their debt, by next year, they will be running on the budget surplus, such is the current burden of interest. Take example from Iceland is no-brainer. Besides country bankruptcies are quite common in history so really the fuss, the opposition about the Greeks going bankrupt is about effectively enslaving them, to make them keep paying as much money as they can be squeezed for till the end of the world, and possibly one day longer. A classic loan shark strategy.

There is a side show to the prospect of Greece defaulting that no politician or commentator is taking about. Typically the most important and interesting things are those which are not talked about. Greek debt is supposed to have been "insured" by CDS'. So there should be no problem with Greek default, should it? It does not appear so. Despite the fact that CDS' are sometimes described as insurance against defaults, they are not. (As clearly they cannot bear the costs of Greece defaulting.) They are simply tools of market speculation with heavily misleading financial information about them: financial "weapon of mass destruction" as Warren Buffett called them. They epitomise the pathology of the financial system. Greece has many clever people in finance and wealthy individuals. Therefore it seems quite reasonable to assume that many of them, having common sense and possibly some inside inklings, bought a lot of CDS' betting that Greece would eventually default. They had plenty of money: apart from their own, thus far European bailouts were generous. Technically their CDS' value may actually exceed the Greek debt itself. Many time over. Therefore it is not inconceivable that, even if Greece do not benefit itself financially from the default, the default may actually produce a number of Greek millionaires or even billionaires. Greeks have an upper hand? This is what modern innovative finance is all about. Only if you know how to play it right.

Germany v "Financial Markets": the only game in town

This morning Herman van Rompuy said in his speech in Strasbourg that he expected Greece to achieve a level of debt of 120% to its GDP by 2020. This is what is considered by eurocrats and the "financial markets" as sustainable. If this figure is anything to go by then we can easily unravel what the "financial markets" game towards Germany is all about. Ultimately the banks love debtors provided they are credible and pay. And none is better than Germany in that respect.

Currently the Germany public debt is on the level of 85% of its GDP. Therefore it would be beneficial for the "financial markets" if Germany "borrowed" additional 35% (to reach a level of 120%). The best way of borrowing would not really be borrowing in a traditional sense of this word (for example to invest) but generating liabilities out of thin air to the financial institutions (e.g. bailouts, rescuing Greece, Italy, etc.). Additional 35% of German GDP would give the "financial markets" around 1 trillion euro.

So by hook or by crook, expect a lot of maneuverings on the "financial markets" to force Germany to part with their money. Another crisis, another "market uncertainty", another threat of bankrupting:... Greece, Italy, Spain, Portugal (take your pick, it does not matter which one). This is what the game is all about, Euro is a very handy tool for the "financial markets" to conduct a process of trying to extort money from Germany for the "financial markets". Printing presses in the US and the UK have a limited speed after all. That is why Germany leaving Euro is quite a plausible proposition. Angela Merkel does not look like a mug and is rather unlikely to be sucked into this game.

Germany Euro Abfahrt?

For some time there has been a discussion going on Greece possibly leaving the Euro. Greece's current sovereign debt is unsustainable. It can only be propped up with Germany's help. In fact this process to some degree suits Germany as long as it does not cost it too much. Greece's financial problems make Euro weaker. This helps German economy which is based to a great degree on export. So Angela Merkel has to play a balancing game of spending as little as possible on saving the Euro from collapse still keeping the Euro weak, whilst at the same time making sure that Germany, and especially their exports, keep growing. But this process cannot go on forever. Now there is a talk of Italy's joining Greece as the financially failed state of Eurozone. This will elevate the crisis onto a stratospheric level. Italy's debt is, circa, six times greater than Greece's (assuming there are no hidden financial arrangements of some sort of creative accounting) and the business of propping up Italians will be a game of completely different magnitude.

Germany is well known for meticulous planning and forward thinking. They must realise that it would only be a matter of time that if Greece's debt is written off to a large degree, others, Italy, Spain, Portugal, will pick up a begging bowl and join the queue. Germany can hardly afford to pay for Greece's debt. Forget about the rest. German policy and decision makers must understand that. They cannot feed the rest of Eurozone and, through them, the entire failed financial industry (which engineered this entire mess in the first instance). Therefore it appears increasingly likely that Germany end-game of bailout delays and never ending discussions is delaying a real market event: Germany leaving Eurozone. The discussions, and agreements even if made, have very little short and medium term market credibility in any event, let alone long term credibility. The discussions and negotiations time is used by Germany to prepare properly for their exit, gearing up their financial system, and in the meantime keep benefiting from a weaker Euro. If Germany leaves it is likely to take with them a couple of financially prudent and trustworthy countries such as the Netherlands, Luxemburg, Austria and Finland. And the rest of the Eurozone led by Sarkozy and Berlusconi will be left to their own devices. No doubt they will hold interesting summits. If the new German currency gets too strong (for example to impede its exports) there are many ways to weaken a currency in a way far more beneficial to Germany than subsidising failed Eurozone with some of its dysfunctional economies (Greece and Italy) and lining up bankers pockets with massive bailout tranches.

If Germany thinks and plans its future in line with its long term national interest, which is a credible assumption, it seems it makes more sense to start considering Eurozone without Germany (and possibly the Netherlands, Luxemburg, Austria and Finland) rather than Eurozone without Greece. Of course before this happens and Germany walks away with pride of the financial bull untarnished, it will have to show all their good will of trying to do impossible: credibly save the Euro. Hence such an impassioned Angela Merkel's speech in Bundenstag today. And what is the alternative: becoming a dairy cow of the rest of Europe and the entire financial industry? Not really an appealing one.


PS. If some in the mainstream media wonder about the logic and rationale of the risk scenario above (as they are likely to) they are actually quite trivial: whenever you see a failing business or enterprise you actually see the strongest leaving first. Unlike the weakest they have options.

PS2. The recent events seem to make a hypothesis of Germany leaving euro even more credible. The Eurozone masters are going to China to ask for help with euro bailout. Until recently Germany was the largest world exporter and only a couple of years ago lost the pole position to China. If China invests in euro bailout it will start wielding considerable influence over the single currency and is also quite likely to gain better export terms to the EU. This would become a mechanism that is likely to weaken the German position as an exporter on the international markets. It is rather inconceivable that Germany do not realise that. The alternative is to leave euro (with China interest in it) and manage own affairs separately (or possibly with other strong nations: the Netherlands, Luxemburg, Finland or Austria).

Financial Apocalypse Now

"no one could buy or sell" - Revelation, 13:17

In autumn 2008 the banks lost liquidity as a result of running a massive global pyramid scheme. The governments stepped in and pumped trillions of euros into the system. This saved the banks from collapse. Yet the governments did not liquidate the global pyramid scheme. The money given to the banks only prolonged the existence of the pyramid and increased it in size. At the same time the governments ended up in heavy debt.

This rescue operation worked at the time as the sovereign debt then was not that high and the governments had enough credibility to repay the debt incurred. (Such repayment was to come from the future tax receipts.) Now, on the back of Greece looming default, a new liquidity crunch in the banking system appears inevitable. Basically if Greece defaults many banks will lose the capital adequacy and will require bail outs. As the European governments have the experience of the autumn of 2008 they want to prevent it by setting up a bail out fund to the tune of 2 trillion euros. In fact the Greek debt crisis is supposed to be saved by taking even more debt. Is such situation sustainable? Solving Greek sovereign debt by even more sovereign debt and spreading it

In 2008 when the governments took on massive debts to bail out banks the governments had credibility that they would be able to repay the debt (of course, with taxpayers' money). However with the debt even growing, with hundreds of billions euros added to it since, and very little economic growth it does not look credible at all that the governments will be able to repay the debt after additional 2 trillion euros are added. 2 trillion euros is more than 2.5 times of an unsustainable annual public deficit for 2010 of the entire EU: a deficit that heavily impedes growth and hence the chance to repay the debt itself. In such situation the sovereign debt will be heavily downgraded. This will result in banks ending up in further liquidity crisis as banks reserves will lose in value. As the sovereign ratings will be downgraded, pumping more money into the banks by the government will not even be a theoretical option.

This is a scenario of banks going bust spectacularly and the currencies (as apart from euro other currencies including the dollar) are likely to lose credibility. The only way out - a technical one - will be fast running printing presses: i.e. a hyperinflation. And, in practice, western economic system will be reduced to some form of a barter. And if the EU or the governments try to keep a tight control over it, well, "no one could buy or sell". Angela Merkel seems to realise that there are such risks.

This scenario is not inevitable. There are ways out. But to implement them, the governments must understand the nature of the current crisis first and then be prepared to make difficult political decisions. And the things can keep going, actually getting worse, for some time with taking half measures: you can only imagine what the ministerial discussions in Brussels are all about.

State investment bank and the European banks meltdown (in slow motion)

As reported on tonight BBC Newsnight, currently politicians and business leaders in the UK propose setting up a structure that would amount to a state investment bank. Originally it was called by the Chancellor of the Exchequer a "credit easing". This means that the government would be lending money directly to businesses bypassing the commercial banking system. Nearly three years ago the author of this blog wrote in the first article "The largest heist in history":

"Deposit accounts records, along with mortgage and genuine business accounts, would be moved to a specially created agency of the Bank of England which would honour them with government help. If a pension fund collapsed due to a bank collapse, individual pensioners would continue receiving their unchanged pensions from the social security system. This would guarantee social stability and a normal flow of cash into the economy."

Finally, years too late some politicians and experts have started realising the obvious: the 2008 crisis exposed the financial system as dysfunctional and that it did not serve the real economy anymore. Therefore any economic stimulus must not have gone through the banks, as it would never reach the business but instead would be consumed by the financial pyramid. A government help for businesses must be provided directly.

In the meantime the European banking system is facing a collapse. There is a talk in Eurozone of setting up a multi trillion euro rescue fund for the banks. But where is this money going to come from? The European countries are in debt to the extent that it prevents them being a source. (Otherwise any more debt will trigger credit rating downgrades and the confidence will collapse. This in turn will trigger another debt meltdown chain reaction.) And there is no other source. However Eurozone countries may still try. This would only prolong the agony and make inevitable collapse even more spectacular.

"If governments do not liquidate the global pyramid scheme, the money they injected will be, in time, converted into toxic instruments (e.g. securities) and cashed in by organisers and privileged customers of these schemes (or in the case of Albania, gangsters and their customer friends). As the amount injected is around 200 times less than the notional value of toxic instruments, the economy will not even see a difference. It will be a step back to September 2008, only now with trillions of dollars of taxpayers’ money spent to sustain the pyramid scheme. It will be merely throwing good money after bad. But can governments afford to come up again with the same amount money and do it 200 times over or more?"

was also stated in "The largest heist in history".

It is of no particular satisfaction to the author of this blog, in fact it is a rather sad reflection, that the process of the financial collapse that he predicted nearly three years ago is happening now. This process was easily avoidable if the decision-makers followed the recommendations described in "The largest heist in history" and refined in "Prime Minister, sort out this mess, please". Of course the particular events and their timing could not have been predicted. But the logic of the process or rather its result, the financial meltdown that is happening now, was trivial to anticipate and prevent. A multi trillion euro question is why the decision-makers did not act accordingly.

It's a pyramid indeed

The analysis on this blog was written as an intellectual exercise deliberately outside the mainstream academic research, so it was not influenced by the conventional thinking. But the work, especially its technical aspect, was meant to be serious and correct. In August last year the work on this blog was reviewed and used by Ms Marina Stoop of Swiss Federal Institute of Technology in Zurich (one of the world leading universities, alma mater of Albert Einstein and no less than 30 Nobel Prize winners). Under the supervision of Professor Didier Sornette, she wrote her Master Thesis "Credit Creation and its Contribution to the Financial Crisis".

The thesis acknowledges the taxonomy of credit creation process introduced in an article on this blog "Computational complexity analysis of Credit Creation": Full reserve banking, Fractional reserve banking, No reserve banking and Depleting reserve banking (page 29 of the thesis). It concurs that as a result of practice of Depleting reserve banking (or Depletion banking system as it was called in the thesis) "the money multiplier tends to infinity and the liquidity risk is 100% in a finite time." (page 30 of the thesis)

The thesis also cites financial perpetuum mobile example from the blog article showing how Depleting reserve banking works and then concludes:

"This describes well how the bubble economy worked that led to the current financial crisis. In the years preceding the crisis, the money (“wealth”) created in the system was not tied to the real growth rate of the economy. It therefore created the illusion of a perpetual money machine where wealth would grow at an accelerated pace." (page 31 of the thesis).

Having acknowledged that a "Ponzi scheme is a fraudulent investment operation", with respect to Depleting reserve banking, the thesis confirms that it "is a classic example of a Ponzi (pyramid) scheme". (page 92 of the thesis) This is exactly what the author of this blog asserted since the end of 2008: the financial system had been been turned into a pyramid scheme and its collapse was inevitable (and indeed easily predictable).

As this conclusion comes from a leading university in the world, are politicians and, more importantly, prosecutors going to do anything about it?. The ball is in their court.

The graph below shows exactly an exponential growth of Money Multiplier (this time it is expressed as a ratio of broad money to currency supplies in the United States), the direct effect of Depleting Reserve Banking: (source: US Federal Reserve)


Looking at the diverging trend of M3 (broad money) to currency on this graph, it is simply too terrifying to discuss what happened after 2006, when the reporting was ceased. The graph HERE shows even faster increase till 2008, then a decrease of growth, deleveraging between 2009 and mid 2011 and back to the old pyramid pattern. So the current collapse should not come as a surprise.

This is precisely what is achieved by lending with loan to deposit ratio greater than 100%. It is a classic representation of a pyramid scheme. (Both top and bottom graphs: top one showing broad money exponentially diverging from currency and the bottom one - as near linear on a logarithmic scale - showing a pretty steady pace of exponential growth.) This is what is called a Depleting Reserve Banking (not Fractional Reserve Banking any more). This is what the model presented in "The largest heist in history" captures (as said: "the proof of the pudding is in the eating").

Money multiplier v loan to deposit ratio

I have noted that in discussions going about my blog on some fora - including financial and bankers' ones - many confuse a concept of money multiplier with a concept of loan to deposit ratio. For example:

"Comment:

Re Rosie's excellent questions and the subsequent discussion, it's well worth looking at http://gregpytel.blogspot.com/

The author looks at what happens if the Reserve Ratio is allowed to go negative -- i.e. the banks loan out £101 (or more!) for every £100 deposited. Couldn't happen, right? Read for yourself...

RGB

Response:

That would actually be a very prudent reserve ratio...the banks traditionally would lend £900 for every £100 reserve.and that was in the good old days of Capt Mainwaring,in some cases recently that was stretched to a £100 deposit turning into £4900 in loans!(stupid boys)

The Comment clearly refers to loan to deposit ratio whilst the Response is about money multiplier.

Just as example, loan to deposit ratio of 90% - i.e. lending £90 out of every £100 - gives money multiplier 10, whilst loan to deposit ratio of 101% - i.e. lending £101 out of every £100 - gives unbounded money multiplier (i.e. the money multiplier tends to infinity at exponential pace).

Still confused? Then please read: "Computational complexity analysis of Credit Creation".

Credit ratings: wealth transfer mechanism from taxpayers to private corporations

London riots provide a perfect attention diversion, or rather a smokescreen, of financial looting of the taxpayers currently implemented by the financial industry that goes largely unnoticed. As the first article on this blog, "The largest heist in history", showed the financial system was turned into a giant global pyramid scheme. Nearly three years ago, in the fall of 2008, it was obvious that "Unless and until the governments identify, isolate and write off toxic instruments held by financial institutions every pound put into “rescue” is very likely to end up being good money thrown after bad."

The current financial system has been operated as a giant global pyramid scheme (where lending with loan to deposit ratio greater than 100% is a pyramid mechanism) for at least last 15 - 20 years. It assures that the liquidity shortage is a systemic feature of the financial system. The excessive debt is not at the heart of the current crisis. The politicians and the "eminent" financial pundits that repeat this constantly to justify the public spending cuts (which quite often can be a very good idea as living beyond the means is disastrous) show the lack of competence on a massive scale. In the current crisis the debt is a manifestation of something far more lethal: too high money multiplier. No wonder that with such leadership the financial situation of the western world is going from bad to worse and whilst politicians are talking about solving the problems they keep creating new ones. The exception in the West is the German Chancellor Ms Angela Merkel. She appears to understand what it is all about and is very skilfully navigating for the benefit of Germany amongst her peers who are clueless.

All the money pumped into the system by the governments, since September 2008, in form of bail-outs and quantitative easing was wasted (as predicted). Basically it was used to prop up the financial industry itself - paying massive amounts for lavish offices, salaries and bonuses - whilst the rest of the economy kept on struggling. But as it was obvious over two and half ago years the financial industry keeps returning for more of taxpayers money.

The first ongoing form of financial looting is the bailouts of countries like Greece. The private banks that took on the risk themselves when they lent money now expect the taxpayers to underwrite the risk that they took. It is a perversion, an absolute distortion of the principles of free market economy which made the western world so successful for most part of 20th century despite two disastrous world wars and indeed social tensions. It is a version of a communism for the rich where the profits go to private coffers whilst the losses are underwritten by the taxpayers. It is a mechanism of funnelling taxpayers money to private pockets.

The second ongoing form of financial looting that appears to be gathering pace now is the use of credit ratings. It is quite crude and primitive. But, boy, it works.

For many years credit rating agencies have been assigning ratings both to private corporations debt and state sovereign debt. If it was just a matter of opinion it would not matter. Anyone, including the author of this blog, is entitled to his/her opinion. However credit ratings are a part of the fabric of the financial system. They dynamically determine the costs of borrowing: what a debtor has to pay to the creditor. The higher the credit rating the lower the costs of debt and vice versa. It has been clear that for some years the credit ratings of sovereign debt was, using the same standards based on historical statistical review of default occurrence, too low compared to credit ratings to the private corporations debt. For example the world has seen no default of AAA rated countries whilst many AAA-rated financial products turned out to be lethally toxic (and it was manifestly clear they were toxic at the time they were assigned AAA). With the downgrade of the US sovereign debt from AAA and the prospects of downgrading other countries', also the prospects of downgrading cities and local governments, this trend of underrating countries' debt in comparison with the private debt looks more prevalent.

The fact that, based on the same methodology, countries are underrated in comparison to private corporations is not just a matter of opinion as President Obama seemed to naively suggest putting a brave face over a big problem. It means the states (countries, taxpayers) pay more money for servicing their debt than if they were private corporations in the same circumstances. In the financial markets of global capital allocation the effect is profound. This asymmetry of the costs of debt constitutes a global wealth transfer mechanism from states (countries, taxpayers) to the private corporations. It is not an ideological opinion or a matter of political ideology but a financial fact. This does not imply whether it is morally right or wrong which is for each reader to decide (or even not decide at all). It is the way the financial industry works.

This wealth transfer mechanism of underrating the sovereign debt in comparison to private corporation debt, is basically a bailout by stealth provided by the taxpayers to the financial industry. It is yet another method that the financial industry is implementing to extract money from the taxpayers. It is not a conspiracy: simply it makes good business sense for the financial industry, whilst making politicians' financial competence look rather questionable. However due to the pyramid nature of the financial system this will also not be enough. Sooner rather than later money will end up in private hands as a way of wealth transfer. It will prolong the crisis, make the pyramid bigger and impoverish the countries and the societies. More austerity. And it will make the final implosion of the financial system even more spectacular than what you can observe with the LHC in CERN.

City thieving reached Inner City

It is impossible not to reflect that the kind of social breakdown that made streets of Britain look like the streets of Bagdad immediately after 2003 fall of Saddam indicates that City greed and thieving practices reached the inner city.

Bankers are got away with their crimes of stealing money from the taxpayers by organising a massive global pyramid scheme. Moreover they were rewarded for they with hefty benefits and bonuses. To the rioting yobs it looks as if they were given handout bags with trainers and mobile phone by the police when they were leaving looted shops.

What compounded the effect is that a lot of MP's were helping themselves with expenses. They got away with it. "It was a muddle not a fiddle" for most of them to quote a classic phrase. For yobs the MP's are thieves who were allowed to get away with thieving. The mainstream press, the beacon of elite and status in the society, were generating stories (therefore big money) through illegal means (phone and e-mail hacking). The got away with it. The police, a very senior one, was helping themselves by taking bribes from journalists for breaking the law (disclosing confidential information). They got away with it. And so on.

A very few yobs are able to express these so clearly (but one or two suggested just that when questioned by the journalists). But they have perception that those in authority - captains of the financial world, politicians, social elite (like journalists), the police - are criminals. So what they are doing are simply joining them. As they are yobs they are not committing en masse white collar crimes through insider dealings or giving dodgy credit ratings, but, in line with their social station in much more unsightly way, looting and causing mayhem. As it seems this is less dangerous than white collar crimes: since it is immediately visible it is dealt with instantly. Whilst the white collar crimes have a very long term eroding effect. The effects of which we see on the streets of Britain now.

But the outcome is predictable. The yobs will be punished (quite rightly) with harsh sentences whilst financial criminals will be rewarded with even more bonuses. And the social breakdown and moral destruction will continue. You may ask yourself where it all ends.

PS. Nobody should be in any doubt that this article excuses the rioters and yobs. It does not. They are criminals. However it is a reflection that whilst the government is rightly very quick to condemn and fight unsightly physical violence and robbery of the inner cities, it is nurturing the financial thuggery of the City. Basically financial yobs hold the government by the throat.

The largest heist in history continues

Rather than writing a commentary upon the current events on the financial markets, why not re-read the analysis that is nearly three years old: "The largest heist in history". In particular:

"Governments became the ultimate customers of pyramid purveyors with the hope that when they offer their custom it would somehow stop the giant pyramid scheme from collapsing. This is extremely naive and very dangerous. The incredibly fast growth to infinity of pyramid schemes, which is only accelerating, will ensure that the government will not stand a chance to sustain it, unless this massive pyramid scheme is brought to a halt and liquidated. But there is no sign of governments contemplating doing that yet.

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

In a normal free market economy a business that fails should be allowed to collapse. If a business is a giant pyramid scheme, like the current financial system, it must be allowed to collapse and its executives and operators should face prosecution. After all running pyramid schemes is illegal. Letting the banks collapse would have been a far more commercially sound solution than the current approach, provided the governments would have secured and guaranteed socially vital interests directly. For example, individual deposits would be guaranteed if a bank collapsed. Deposit accounts records, along with mortgage and genuine business accounts, would be moved to a specially created agency of the Bank of England which would honour them with government help. If a pension fund collapsed due to a bank collapse, individual pensioners would continue receiving their unchanged pensions from the social security system. This would guarantee social stability and a normal flow of cash into the economy.

The hard part would be to liquidate financial institutions while sifting through their toxic waste and to distinguish genuine non-toxic instruments and the results of pyramid scheme operation. Deposits, mortgages and business accounts are clearly non-toxic in principle. However, in the modern banking they were mixed with potentially toxic assets. This would be a gargantuan task.

(...)

Unless and until the governments identify, isolate and write off toxic instruments held by financial institutions every pound put into "rescue" is very likely to end up being good money thrown after bad. (The governments, as ultimate customers of the global pyramid scheme, are supplying the pyramid purveyors and beneficiaries with tax payers' cash and the largest heist in history continues.) Alongside the liquidation process, but after the toxic waste has been isolated and fenced off in failed financial institutions, governments must launch a fiscal stimulus package and go after the pyramid purveyors and beneficiaries to recover any cash and assets from them and bring them to justice. As the financial pyramid scheme is global, any action—including the recovery cash and assets—must be global, too. It is intriguing that banks in traditional offshore financial centres like Belize, US Virgin Islands, Bermuda, do not appear to suffer from liquidity problems. They do not require rescue packages even though a lot of them are subsidiaries of much larger banks which are affected by the current crisis."

Hence what is happening now, considering the way governments and organisations such IMF acted, was obvious that it was going to happen: "The largest heist in history" was published by the House of Commons Treasury Committee. No benefit of hindsight whatsoever.

Irrational exuberance: two double whammies of the US debt limit increase

It is a rather unorthodox way of solving debt problems by taking on yet more debt. It is even more unorthodox if the servicing of the existing debts is impossible without taking such additional debt. This is a classic example of a downward debt spiral: sliding into bankruptcy. Yet this is exactly what the US, as well as Britain and many countries in the Eurozone are doing.

What the solution is for the US now, the debt limit increase of another $2.1 trillion on top of the existing $14.3 trillion, will come back later to haunt the world markets: the US will have to continue to borrow to meet their financial obligations. Unless and until the US produces a balanced budget, the problem will keep growing. And they better do it soon as such balance has to be sustained on average through ups and downs of the economic cycles in a long term. This, in fact, was a golden rule that Gordon Brown preached but was never able to put it in practice. US talk of a $2 trillion (or even $4 trillion) debt reduction over 10 years is farcical at best.

Rating agencies, by the nature of their business and, more importantly, their conduct create a lot of uncertainties in the markets. The credit rating is not just a figure that became popular recently. It is typically part of any creditor-debtor agreement on the financial markets. The lower the credit rating, the greater the interest rate that the debtor has to pay to cover the costs of the additional risk. Whilst it seems to make logical sense, such methodology is a source of instability.

If a debtor is less likely than before to satisfy the creditors then its credit rating has to be decreased. Consequently the interest payments on debt have to go up. But with the increased interest payments the debtor is even less likely to satisfy its obligations. Hence another rating downgrade is very likely. And so on.

The credit rating agencies would only have a stabilising effect on the markets if countries in debt had the scope to readjust their finances in order to prevent the downgrades. And they act as if they have such scope. The credit rating agencies methodology and practice is a typical recipe for a downward debt spiral.

Moreover the credit rating agencies credibility has not been enhanced by a rather inadequate (to put it mildly) assessment of many financial instruments in the run-up to the credit crunch of 2007 - 2008. The fact that the agencies did not come clean on what went wrong then should also be a point of reflection.

The US debt is a different kettle of fish to all other financial papers due to its value, and the fact that two-thirds of world reserves are held in US dollars. A downgrade of the US debt will have grave effects on the world markets. Moreover, as many American politicians ask "why we let these guys even be in business" the US may administratively deal with the credit rating agencies; effectively dismantling the financial markets as we know them.

Hence despite the US amassing a huge debt, the agencies seem to be determined to keep AAA rating. This, of course, makes a mockery of the rating system.

An AAA rating of the US debt allows the debt papers to be traded and considered by the financial markets as good as cash. But it is not cash. It is debt and it will have to be repaid at some point. As long as US debt papers function on the financial markets as cash they are effectively printed money that fuels high inflation. For that reason in the last couple of years, we observed high inflation in commodities and other durable assets, such as real estate.

Not unexpectedly the price of gold has been reaching record levels and Swiss Frank started behaving like a commodity rather than a currency. It is becoming clear that the investors use the time to convert as much as possible of the US debt to as much as possible "real wealth". It is clear that the AAA rating of the US debt does not reflect the confidence of sophisticated financial investors. And the world at large is artificially propped up on confidence. It is yet another bubble that is going to burst.

The real effect on consumer markets is that despite very low levels of lending to businesses, very low wage inflation, very low growth, the consumer inflation is accelerating. It is a state of stagflation.

The real effect on financial markets is that the financial bubble keeps on growing. The financial bubble is not an esoteric term describing imbalances. It is a simple formula, a ratio of the liabilities that the financial institutions have or may be demanded to settle, to the means of such settlements such as cash or financial instruments which are considered as good as cash. At present, with an artificial AAA rating, the US debt appears as a mean of settling financial obligations. This has the effect of making an already huge financial bubble look smaller. It is exactly as if an ordinary person mistook the figures on his credit cards statements for his savings.

However once the market returns to its senses, i.e. that the US debt is debt not cash and may not be repaid, its entire value will have to be subtracted from the means of debt settlement AND added to the liabilities of the bubble formula. The effect of subtracting the US debt from the bottom of the bubble ratio and adding it to the top will be the first part of the double whammy. The scale of the financial bubble will be seen instantly. This will have an immediate effect on any dollar denominated transactions and capital and is very likely to lead to a huge credit crunch.

But unlike the credit crunch that happened in 2008 which followed a period of very low inflation, the US debt induced credit crunch will have been preceded by a period of a very high inflation. This will leave the world, or at least a huge part of it, facing huge public debt, very high prices and very limited means to pay. This is the second part of the double whammy: a formula for sliding into poverty.

This article was first published in The Arab Financial Forum Newsletter August 2011, Issue 1

Greeks' upper hand

Greece is bust but no one formally admits that: i.e. there is no credit event as yet. There is an unusual resistance to face the obvious reality. On one argument why Greece should not go bust is that it would give a "bad" example to other countries that restructuring debt through default is the best for these countries at the costs of creditors. The other argument, not voiced that openly, is that currently a lot of debt is held by private banks (mainly in France, Germany and the UK) if Greece goes bankrupt, these private banks would face liquidity crunch, like or even bigger than at the end of 2008, and would require "rescue" packages from the taxpayers. This, in turn, would undermine the public trust in banks. It is impossible to predict the effect but a massive run on the banks is quite realistic then. Indeed justified. So the process of "rescuing" Greece is in fact an exercise of shifting their debt from private banks' books directly onto taxpayers books. And when Greece will go under private banks will be in safe positions and the taxpayers will get the hit directly. In other words it is a pathetic pantomime played to the public that banks are safe and prudent institutions to keep confidence in them.

However there is the third possibility. It is quite certain that behind many billions of euros lent to Greece there were many CDS' sold on the back of it. The Greek debt CDS market is vibrant.The European Central Bank should make it clear (down to at least 1 billion euro) how many billions of euros would have to be paid if Greece defaults on their debt. It is quite typical for CDS' that they were sold many times over exceeding the underlying debt. Hence if Greece defaulted, i.e. triggered the credit event, then the liabilities of some banks and financial institutions to the counterparties that bought CDS' may be many times (10, 20, 100 times or more: make your own guess) more than the Greek debt (going into trillions of euros). If that were the case then the financial system would go into the meltdown.

Greeks should ensure that they understand the CDS' position vis-a-vis their debt. If Greece is really such a store of toxic waste then they should use it to extract as much money as possible from the rest of the world that cannot allow them to go bust. Indeed some of these rescue loans they should use to insure many times over their own debt. So when the system collapses - as it eventually will happen - they would not be liable for their own debt but the counterparties that sold them CDS'. The financial system is so dysfunctional now, and the bankers are so greedy, that it should not be a problem to conduct such legitimate financial operations.

Incidentally there is nothing new in this analysis. This process, of toxic waste propagating through the financial system was predicted to follow the credit crunch of 2008 in the first article of this blog The largest heist in history written two and half years ago. It was clear already then that the financial system was at a state of utter dysfunctionality and stupidness.

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.