Too Big To Understand

One thing that has undergone hyperinflation in recent years is the length of financial regulations:

Too Big To Understand

The Dodd-Frank regulatory hyperinflation crowds out those who cannot afford teams of legal counsel, compliance officers, and expansive litigation. Dodd-Frank creates new overheads which are no challenge for large hedge funds and megabanks armed with Fed liquidity, but a massive challenge for startups and smaller players with more limited resources.

As BusinessWeek noted in October:

The law requires Hedge Funds to register with the Securities and Exchange Commission, supply reams of sensitive data on trading positions, carefully screen potential investors, and hire compliance officer after compliance officer.

So, is this expansion in volume likely to improve financial stability? No — the big banks are bigger and more interconnected than ever, which was precisely the problem before 2008, and they are still speculating and arbitraging with very fragile strategies that can incur massive losses as MF Global’s breakdown and more recently the London Whale episode proves.

Andy Haldane laid out the problem perfectly in his recent paper The Dog and the Frisbee:

Catching a frisbee is difficult. Doing so successfully requires the catcher to weigh a complex array of physical and atmospheric factors, among them wind speed and frisbee rotation. Were a physicist to write down frisbee-catching as an optimal control problem, they would need to understand and apply Newton’s Law of Gravity.

Yet despite this complexity, catching a frisbee is remarkably common. Casual empiricism reveals that it is not an activity only undertaken by those with a Doctorate in physics. It is a task that an average dog can master. Indeed some, such as border collies, are better at frisbee-catching than humans.

So what is the secret of the dog’s success? The answer, as in many other areas of complex decision-making, is simple. Or rather, it is to keep it simple. For studies have shown that the
frisbee-catching dog follows the simplest of rules of thumb: run at a speed so that the angle of gaze to the frisbee remains roughly constant. Humans follow an identical rule of thumb.

Catching a crisis, like catching a frisbee, is difficult. Doing so requires the regulator to weigh a complex array of financial and psychological factors, among them innovation and risk appetite. Were an economist to write down crisis-catching as an optimal control problem, they would probably have to ask a physicist for help.

Yet despite this complexity, efforts to catch the crisis frisbee have continued to escalate. Casual empiricism reveals an ever-growing number of regulators, some with a Doctorate in physics. Ever-larger litters have not, however, obviously improved watchdogs’ frisbee-catching abilities. No regulator had the foresight to predict the financial crisis, although some have since exhibited supernatural powers of hindsight.

So what is the secret of the watchdogs’ failure? The answer is simple. Or rather, it is complexity.

Big, messy legislation leaves legal loopholes that clever and highly-paid lawyers and (non-) compliance officers can cut through. Bigger and more extensive regulation can make a system less well-regulated. I propose that this is what the big banks will use Dodd-Frank to accomplish.

I predict that the regulatory hyperinflation will make the financial industry and the wider economy much more fragile.

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The Cantillon Effect

Expansionary monetary policy constitutes a transfer of purchasing power away from those who hold old money to whoever gets new money. This is known as the Cantillon Effect, after 18th Century economist Richard Cantillon who first proposed it. In the immediate term, as more dollars are created, each one translates to a smaller slice of all goods and services produced.

How we measure this phenomenon and its size depends how we define money. This is illustrated below.

Here’s GDP expressed in terms of the monetary base:

Here’s GDP expressed in terms of M2:

And here’s GDP expressed in terms of total debt:

What is clear is that the dramatic expansion of the monetary base that we saw after 2008 is merely catching up with the more gradual growth of debt that took place in the 90s and 00s.

While it is my hunch that overblown credit bubbles are better liquidated than reflated (not least because the reflation of a corrupt and dysfunctional financial sector entails huge moral hazard), it is true the Fed’s efforts to inflate the money supply have so far prevented a default cascade. We should expect that such initiatives will continue, not least because Bernanke has a deep intellectual investment in reflationism.

This focus on reflationary money supply expansion was fully expected by those familiar with Ben Bernanke’s academic record. What I find more surprising, though, is the Fed’s focus on banks and financial institutions rather than the wider population.

It’s not just the banks that are struggling to deleverage. The overwhelming majority of nongovernment debt is held by households and nonfinancials:

The nonfinancial sectors need debt relief much, much more than the financial sector. Yet the Fed shoots off new money solely into the financial system, to Wall Street and the TBTF banks. It is the financial institutions that have gained the most from these transfers of purchasing power, building up huge hoards of excess reserves:

There is a way to counteract the Cantillon Effect, and expand the money supply without transferring purchasing power to the financial sector (or any other sector). This is to directly distribute the new money uniformly to individuals for the purpose of debt relief; those with debt have to use the new money to pay it down (thus reducing the debt load), those without debt are free to invest it or spend it as they like.

Steve Keen notes:

While we delever, investment by American corporations will be timid, and economic growth will be faltering at best. The stimulus imparted by government deficits will attenuate the downturn — and the much larger scale of government spending now than in the 1930s explains why this far greater deleveraging process has not led to as severe a Depression — but deficits alone will not be enough. If America is to avoid two “lost decades”, the level of private debt has to be reduced by deliberate cancellation, as well as by the slow processes of deleveraging and bankruptcy.

In ancient times, this was done by a Jubilee, but the securitization of debt since the 1980s has complicated this enormously. Whereas only the moneylenders lost under an ancient Jubilee, debt cancellation today would bankrupt many pension funds, municipalities and the like who purchased securitized debt instruments from banks. I have therefore proposed that a “Modern Debt Jubilee” should take the form of “Quantitative Easing for the Public”: monetary injections by the Federal Reserve not into the reserve accounts of banks, but into the bank accounts of the public — but on condition that its first function must be to pay debts down. This would reduce debt directly, but not advantage debtors over savers, and would reduce the profitability of the financial sector while not affecting its solvency.

Without a policy of this nature, America is destined to spend up to two decades learning the truth of Michael Hudson’s simple aphorism that “Debts that can’t be repaid, won’t be repaid”.

The Fed’s singular focus on the financial sector is perplexing and frustrating, not least because growth remains stagnant, unemployment remains elevated, industrial production remains weak and America’s financial sector remains a seething cesspit of corruption and moral hazard, where segregated accounts are routinely raided by corrupt CEOs, and where government-backstopped TBTF banks still routinely speculate with the taxpayers’ money.

The corrupt and overblown financial sector is the last sector that deserves a boost in purchasing power. It’s time this ended.

Zombie Economics

Occupy Wall Street seem to oppose banker bailouts because bailouts are unfair. Bankers — by and large the most privileged class in society — got at the last count over $14 trillion of interest free money from central banks and governments to keep on doing the same thing — getting rich from speculation, on the backs of workers and the productive economy. The rest of society — teachers, nurses, factory workers, entrepreneurs, the unemployed, etc — have to “share the pain” of unemployment, austerity and a depressed economy.

This is particularly unfair, because it is the bankers and speculators who caused the crisis in the first place. But there is a much deeper economic reason to oppose bailouts than simple unfairness. Bailing out failed and failing financial institutions creates a zombie economy. Why?

In nature, ideas and schemes that work are rewarded — and ideas and schemes that don’t work are punished. Our ancestors who correctly judged the climate, soil and rainfall and planted crops that flourished were rewarded with a bumper harvest. Those who planted the wrong crops did not get a bailout — they got a lean harvest, and were forced to either learn from their mistakes, or perish.

These bailouts have tried to turn nature on its head — bailed out bankers have not been forced by failure to learn from their mistakes, because governments and regulators protected them from failure.

So it should be no surprise that financial institutions have continued making exactly the same mistakes that created the crisis in 2008. That crisis was caused by excessive financial debt. Wall Street banks do not just play with their own equity — they borrow huge sums of money, too. This debt is known as leverage — and many Wall Street banks in 2008 had forty or fifty times as much leverage as they had equity. The problem with leverage is that while successful bets can very quickly lead to massive profits, bad bets can very quickly lead to insolvency — a bank that leverages itself 50:1 only has to incur a 2% loss on its portfolio to have lost every penny they started with. Lehman Brothers was leveraged 30:1.

Following 2008, many on Wall Street promised they had learned their lesson, and that the days of excessive leverage and risk-taking with borrowed money were over. But, in October 2011, another Wall Street bank was taken down by bad bets financed by excessive leverage: MF Global. Their leverage ratio? 40:1.

So why was the banking system bailed out in the first place? Defenders of the bailouts have correctly pointed out that not bailing out certain banks would have caused the entire system to collapse. This is because the global financial system is an interconnected web of debt. Institutions owe huge sums of money to one another. If a particularly interconnected bank disappears from the system, and cannot repay its creditors, the creditors themselves become threatened with insolvency. If a bank is leveraged 10:1 on assets of $10 billion, then its creditors may incur losses of up to $90 billion. Without state intervention, a single massive bankruptcy can quickly snowball into systemic destruction.

Ultimately, the system is extremely fragile, and prone to collapse. Government life-support has given Wall Street failures the resources to continue their dangerous and risky business practices which caused the last crisis. Effectively, Wall Street and the international financial system has become a government-funded zombie — unable to sustain itself in times of crisis through its own means, and dependent on suckling the taxpayer’s teat.

The darkest side to this zombification is that it takes resources from the productive, the young, the creative, and the needy and channels them to the zombies. Vast sums spent on rescue packages to keep the zombie system alive might have been available to increase the intellectual capabilities of the youth, or to support basic research and development, or to build better physical infrastructure, or to create new and innovative companies and products.

Zombification kills competition, too: when companies fail, it leaves a gap in the market that has to be filled, either by an expanding competitor, or by a new business. With failures now being kept on life-support, gaps in the market are fewer.

The system needs to change.

As Professor George Selgin of the University of Georgia put it:

Our governments chose to keep bad banks going and that is why quantitative easing has proven a failure. Quantitative easing failed because almost all the new money the government created has gone to shore up the balance sheets of irresponsible bankers. Now those banks sit on piles of idle cash while other businesses starve or cannot get started for want of credit.

It’s the same scenario that Japan has experienced for twenty years. They experienced a housing and stock market crash in 1990, bailed out their banking system, and growth never really recovered:

Ever since then, unemployment has been elevated:

That is the fate that Britain, Europe and America face by going down the Japanese zombification route: weak growth and elevated unemployment over a prolonged period of time. They face having the life sucked out of them by the zombie banks and corporations, and the burden of an every-growing public debt to finance more and more bailouts:


Instead of bailouts, we need to allow failed banks and corporations to fail and liquidate so that new businesses can take their place. Nature works best through experimentation. Saving zombie banks and zombie corporations kills experimentation, by rewarding failure, and preventing bad ideas from failing. If bad ideas and schemes cannot fail, it is impossible for good ideas and schemes to truly succeed.

The role of the government should be to provide a level playing field for experimentalism (and enough of a safety net for when experiments go wrong) — not pick winners. If experiments go badly, that is no bad thing: it just means that another idea, or system, or structure needs to be tested. People should be free to go bankrupt and start all over again with a different mindset and a different idea.

Motherfucking Global

How times have changed for Jon Corzine.

Just a couple of months ago he looked like the prime candidate to take over Tim “No Chance of a Downgrade” Geithner’s poisoned chalice at the US Treasury.

Now he looks like he’s heading to jail for stealing money from clients.

Probably the most sage coverage of this saga comes from Roger Lowenstein writing for Bloomberg:

Thirteen years ago, when the hedge fund Long-Term Capital Management was desperately negotiating with Wall Street banks for a bailout, Jon Corzine, the chief executive officer of Goldman Sachs Group Inc. (GS), called John Meriwether, LTCM’s founder, and read him the riot act. Wall Street would invest, Corzine said, but “JM” would have to accept more controls, including strict supervision over his firm’s trading limits.

Corzine, I wrote soon after, “understood the flaws” at LTCM better than anyone. The firm had no controls over risk limits, no accountability to anyone who wasn’t a trader.

Essentially, Corzine forgot the lessons of LTCM‘s failed arbitrageurs, and went the hyper-leveraged Martingale path. The trouble is that unless you predict accurately, this kind of activity is a quick and easy road to bankruptcy. Leveraged 50:1, a 2% drop in asset prices can be a wipeout, and end in insolvency.

There are two key points, and one key question to take away from this:

  1. The American banking system is susceptible to a Euro-collapse — MF Global went down betting on a Euro-stabilisation. The web of derivatives extends across the global financial system, creating ever-growing fragility.
  2. None of the lessons of AIG and Lehman have been learned — the bailouts and stimuli saved a broken system, and allowed it to continue to be broken.

And the question:

  1. What effects will MF Global’s removal from the web of debt have on the financial system as a whole?

The first point is obvious (although Morgan Stanley will keep denying it, and focus instead on how Groupon is worth at least $100 a share). The second point has been obvious for a long time.

The question is much murkier. Is MF Global too big to fail without sending financial systems into freefall (a la Lehman)?

The answer seems to be “probably not”.

From TIME:

So far, the problems at MF Global appear to not be spreading to other banks. While MF Global has $40 billion in assets, it only owed about $2 billion outright to other banks. What’s more, more than half of that debt is owed to J.P. Morgan, which is one of the strongest banks around. There are other banks that are owed $6.3 billion from loans MF Global took out to make its Euro debt bets. But those debts are backed by the bonds that MF bought, and if they end up being good as Corzine claimed, then those banks should get their money back, as well as the profits Corzine hoped to pocket for his firm. MF Global does not appear to have the same type of derivatives exposure to other banks that led to the demise of Bear Stearns and Lehman Brothers.

Nonetheless, we will see what we will see when we see it.