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Bigwigs Debate 'Too Big to Fail'

It looks like the weight of "bigwig" opinion leans towards breaking up the too bigs. I agree. There is no validity to the "economies of scale" argument; in fact there are serious diseconomies of scale in large far-flung organizations. There is no validity to the "global reach" argument that Simon Johnson demolishes. The only good reason I can see supporting the too big case is that too big bonuses would not be possible in smaller scale institutions. So, all in favor of taxpayer funded $700k annual bonuses for the mathematical wizards who blew up the financial meth lab with us in it?

Is Too Much or Too Little Money Being Created?

Good point, Mr. McTeer, and one that should be repeated until it sinks in. Most commentators keep saying inflation "must" be on the horizon given the Fed's expansion of the monetary base and other monetary easing measures. But as you point out, these commentators are ignoring the far greater scale of the private sector credit contraction that is occurring. The Fed has applied an ounce of deflation prevention to a pound of deflationary pressure. There is no 'inflation' present in this equation.

Banks have found plenty of creative ways to lose billions over the past few years. So it may not be surprising, after past misadventures in Argentina and Russia, that Western banks poured more than $10B in loans into a little-known bank in Kazakhstan - most of which have gone bust, and may have been diverted by the bank's chairman.

When the world was seeking yield Wall St generated financial products to absorb the money and promise returns. When the world thinks Kazakhstan is the hot market why shouldn't some sharp local banker absorb the money and enrich himself? Wall St skimmed billions off of absurd sub-prime loans. "Due diligence" anyone?

How to Live with a Financially Illiterate Population

I agree that a CFPA is needed because everybody needs to use financial products and most people will never understand them, just like toaster and cars. We stridently require that toasters and cars be idiot-proofed, that they be made to behave completely predictably. It is not too much to ask the same of financial products.

In the revised introduction to "The Ascent of Money", Niall Ferguson lists as one of the 3 major insights he gained while writing the book, "equality and its absence".

A few people are financially literate. Everybody else is less so. Ferguson writes, "But finance also exaggerates the differences between us, enriching the lucky and smart, impoverishing the unlucky and not-so-smart. ...The rewards for 'getting it' have never been so immense. And the penalties for financial ignorance have never been so stiff."

If we can agree that what distinguishes developed countries from less developed is the presence of a flourishing middle class, then the widening income gap between the financially savvy and the rest of the population can be seen as a devolutionary force. The middle class is becoming poorer because the benefits of the economy flow disproportionately to the financially savvy and lucky at the top of the food chain.

People who know how to make things and build things are getting poorer. People who know how to finance things are getting richer. This trend leads to a rich financial aristocracy ruling a population of impoverished peasants. I am not speaking for Ferguson when I say that this state of affairs is the ultimate outcome of 'the ascent of money'.

I don't think this is a desirable outcome. It is economic prowess and innovation that creates wealth. Financial prowess and innovation merely redistributes ownership of that wealth. Conservatives and libertarians who bemoan government welfare state redistributionism are beguiled into celebrating financial welfare state redistributionism as "market outcomes". They are deceived. These are not "market" outcomes.

Since the 1982 Latin debt default big finance has been a client of the corporate welfare state. A recently publicized Fed missive from that era shows that 7 of the 8 largest US banks were rendered insolvent by their exposure to that bad bet. In Canada 4 of the big 5 banks were similarly affected by their exposure to the Latin default.

Western banks malinvested Arab petrobillions into Latin American resource plays, creating overcapacity. When all that new production came onstream commoditiy prices collapsed and the Latin governments had insufficient revenues to service their development loans, so they defaulted. Latin American resource development was the first of our recent debt bubbles to burst. The bust rendered insolvent all the overexposed banks. And each time since 1982 we have bailed them out.

So big finance is not big and profitable due to "markets". It only still exists due to "bailouts". Capitalism would have meant the bankruptcy and dissolution of those banks. Smaller players would have picked up their assets at bankruptcy sale prices. Smaller players would have become bigger, and probably lent into the next bubble, and they in turn would be bankrupted and their assets picked off by a new set of players.

Each cycle of malinvestment and bankruptcy redistributes wealth from the formerly wealthy to the newly wealthy. Everybody makes mistakes, and fails. As the Chinese say, "From shirtsleeves to shirtsleeves in 3 generations."

Nobody can become "too big to fail" if they are made to pay for their malinvestments in the normal capitalist way. But since 1982 big finance has been in the process of capturing its regulators. Laws are made to protect them from their mistakes. Laws are modified to let them 'earn' their way out of insolvency, like borrowing at 0% from the Fed and 'investing' in Treasuries paying 3.5%. This is a pure transfer of money from the taxpayers who ultimately fund Treasury interest to the failed banks who collect the interest payments.

Finance has become way too important a component of modern developed world economies. Insofar as it funds productive investment by intermediating between passive savers and active innovators, finance is the engine that drives wealth creation. But when finance ceases funding economic activity and only finances wealth redistributions by betting on various financial instruments, the business cycle has reached the "speculative" stage that is supposed to end in collapse of the malinvestments and a redistribution of financial and economic power to solvent players from insolvent. We have not let that happen.

Will Dubai's Standstill Spark a Reversal in the Dollar?

In answer to the question posed in the title of Cam's article I say, yes, the Dubai issue will spook the markets and initiate a short term pullback where the dollar will temporarily turn higher. This will lead to short covering on overleveraged US$ carry trade investments which will have a negative impact on whatever markets the carry trade is invested in. But the carry trade is not big enough to generate a systemic event. This will be a dip followed by a return to trend. The dip will overshoot to the downside which will induce sideliners who have been waiting for an opportunity to join the rally to jump in. I'm not saying any of this is rational, but it's becoming clearer that market behavior is about 3 parts emotion and 1 part reason.

Leverage to Move the World

John wrote,
"The above argument overstates the loss of value because many things of utility have been created during this century that did not exist at the beginning. But it is certainly true that a significant part of the inflation of the past hundred years represents no value. "

I think what happens in our fiat money system is that the quantity of money and monetary debt in the system becomes increasingly disconnected from the quantity of real productive capital. In a rising economy debt can be repaid by investing in new equipment that increases production of goods. After the debt is repaid the fixed capital remains even though the debt-money has been extinguished.

The credit-money began its existence as a loan and it ends its existence when the loan is repaid, so over the total life cycle of this credit creation no new permanent money has been created. But fixed capital and productive capacity HAS been added.

So now we have the situation where fixed capital is capable of producing abundant goods. But where will the new money come from to buy those goods? During a building phase like the US and world enjoyed after WWII there are always new profitable productive ventures to be financed with new loans and these add money into the economy. But as those loans are paid down money is removed from the economy and extinguished, so we have the situation where a whole bunch of fixed capital is capable of producing abundant goods, but where will the money come from to buy them?

Natural growth periods like population expansions, building up newly opened frontiers, and integrating new technological innovations, all offer opportunities to borrow and invest money and earn it back to repay your loans. But in a more "stationary state" economic environment where there are not many new growth opportunities, where will the money come from to buy all the output and keep the economy going?

The only source of new credit creation in such a state is "consumer" loans. Banks create new credit-money and people spend it into the economy, adding the needed fuel to keep the economic machine running. But every consumer loan is ultimately borrowing from your own future consumption. I can buy and enjoy the goods today, but for years into the future I must consume LESS than I earn in order to devote some of my income to repaying my loan.

This is not like a business loan invested in increasing production, where the loan can be repaid by increasing sales. Consumer deficit spending is a straightforward borrowing from your own future spending. When that future arrives and you have already committed all your income to previous spending, the consumer loans source for new money is exhausted and your fiat debt-money/credit-money monetary system arrives at its inevitable end state.

Fiat credit money is a true Ponzi scheme, where early borrowers can only repay their loans and make ongoing profits if later borrowers keep injecting new money into the system. When this ongoing money creation metric stalls we get a debt crisis and an economic recession. All of the fixed capital and labor is still there ready to go to work producing goods, but the system has run out of spending money.

Money is the fuel that drives the whole economic machine. Our system of creating money as bank loans runs into the problems I just laid out. It runs out of gas. It requires constant and accelerating "economic" growth, not just monetary growth, to keep new credit-money coming into the system. If the economy is not growing then productive enterprises will not be able to maintain production and sell it all at a profit in order to first repay the loans they used to build up their fixed capital and then to sell goods for ongoing profits. They will not be able to employ labor and pay incomes.

In a stagnant or declining economy nobody is a good credit risk. Banks who lend into such an environment risk their own solvency so they try to contract, recover monies they have already advanced rather than trying to grow their balance sheets. But in our system where all money is issued as debt, if there is no debt there is no money.

So we have an economic infrastructure of fixed capital and trained labor capable of producing abundance, but the monetary fuel production mechanism of repayable bank loans has reached its limits of exhaustion. Once you reach this point, in the absence of new frontiers to productively and profitably invest new money in, you either let your economy drop down into permanent Depression or you introduce a new source of money.

The new money cannot be issued as debt. You have reached your system's limit of debt so more new debt cannot fix it. You have already reached the state where the old debtors cannot repay their loans. The new debt will not be repayable even if you try to collect on it because the conditions for rapid economic growth (new frontiers, rising population, etc.) and profitable investment of borrowed money no longer exist. From here you need a flow of non-debt money into the system to keep the economy fueled, to maintain a steady state of production and consumption that doesn't depend on ongoing growth.

Towns and communities (and California) are experimenting with creating their own local money. Comox, British Columbia in Canada has created "Community Way Dollars", for e.g. Such measures work fine for a limited local economy. But for a national economy you need real dollars. So the government must create and distribute the non-debt money into the economy to keep it fueled when the bank-loan money fuel supply reaches peak debt.

'Fiscal conservatives' and others are aghast at this idea of the government creating and giving away free money. They say there are always new innovative growth opportunities to keep the credit cycle pumping new money into the economy. Okay guys, it's up to you. Show me these profitable opportunities that lead to jobs and incomes and buying power to keep the economy running and I will believe monetary innovation is not necessary.

Capital Requirements Are a Bad Thing, Says Morgan Stanley

The banks argue that without outsize bonuses they will lose the best talent. The best counter argument that I have seen is, Good. This kind of risk taking talent properly belongs in hedge funds, making bets with money that fund investors can afford to lose. If you want safety deposit your money in a bank. If you want risk of loss with the prospect of a higher return then put your money in a hedge fund. Wall St banks want it both ways, with taxpayers backstopping both the low risk aspects of adequately capitalized commercial banking and the high risk aspects of dubiously capitalized investment banking.

Deposit creating institutions like banks should function like monetary utilities, regulated to provide a stable supply of money to the economy at an affordable price with very low risk of blowouts. This utility function is the reason we guarantee bank deposits with taxpayers' money and it's why we bail out commercial banks during systemic insolvency events. The economy depends on commercial banks so we try to keep them safe and help them up when they need it. Taxpayers have no interest in guaranteeing casino bets where players get all the upside and taxpayers pay all the losses.

If Morgan Stanley doesn't like safe capital levels then it should voluntarily split its operations into commercial banking and investment banking. There are thousands of small and medium banks in the US who would like to pick up a larger share of the commercial banking market. Small banks are more nimble and efficient and can operate profitably even with higher capital requirements. The US doesn't need tottering multitasking monoliths that repeatedly fall over and require trillions of dollars of taxpayer support.

Why the Dollar is Continuing Lower

Savers/investors have boatloads of money and spenders have too much debt and diminishing employment prospects. The Fed's dual mandate is price stability and maximum employment. Reduced domestic spending puts deflationary pressure on CPI prices while a shrinking dollar adds inflationary pressures on imports like oil.

Monetary easing in the form of low interest rates is the standard policy to increase credit and spending and stabilize prices in a deflationary environment. Increased spending also increases employment. So both aspects of the Fed's mandate suggest continuation of the monetary easing policies.

China's yuan is tied to the dollar so inasmuch as consumer goods are imported from China, a lower dollar will not affect CPI prices. America's other major import, oil, would trend higher with a falling dollar. As oil is an input into virtually all prices, mainly due to the need to transport goods, higher oil will put inflationary pressure on CPI prices. Higher input costs and tight domestic spending will squeeze profit margins for US producers and retailers. But squeezed profits absorb some of the oil price inflation so CPI prices will not necessarily follow oil up point for point.

On balance I don't think the Fed has much choice but to continue its monetary easing policies, and quite possibly expand them, in the face of the secular deflationary trend. Interest rates are going nowhere "for an extended time".

Bank of Montreal: Putting Shareholders Ahead of Bonuses

It would have been impolitic of B of M to increase bonuses in this year when most of Main St is feeling the recession. The G20 is out for banker blood. Cdn banks don't need to further inflame public sentiment and political pressure to regulate excessively. Due to Canada's already prudent regulation and bankers, Canada may escape the worst of the regulatory excess. Reducing bonuses this year shows the bloodthirsty public that bankers 'care', and are sharing their suffering.

How Much Would You Spend to Buy a Recession?

chris coonan,
I have been a small business employer since 1978. I'm not rich. I can't afford to keep people employed unless they are making money for the business. It is never pleasant to let people go. It would be even worse to keep everyone on payroll until my money and credit is exhausted then lay everyone off, including myself, during my bankruptcy.

How Important Is Central Bank Independence?

I think you caught the gist of the issue. It is the character of the nation that institutes an independent central bank in the first place. And it is the character of the nation that either accepts or rejects the monetary discipline later. If a morally corrupt entitlement nation will not accept discipline then central bank independence will be revoked and bailouts will ensue, regardless of future currency and inflationary implications. A corrupt people cannot be governed by the rule of law. They just change the laws to suit whatever they want to do.

More Losses on the Way: Don't Drink the Kool-Aid

Ben and Tim will ride to the rescue with a big vat full of grape flavored QE Koolaid. They have not yet begun to print.

The real estate losses, realized and unrealized, have created a deflationary secular trend. All of the inflation generating money creation has already been exhausted buying those properties and creating the bubble. The bubble profits are now sloshing around the world as an ocean of liquidity inflating investable asset classes. The bubble debts are now becoming defaults which threaten banking solvency, and constraining consumer spending and shrinking the real economy.

A program of QE targeted at households would put spending money in people's hands to support GDP. It would put debt paydown money in people's hands to bail out household balance sheets and restore bank mortgages and other loans to performing status.

This would not be inflationary. It would be anti-deflationary. It would target the source of the deflation pressures, which is the household balance sheet whose ills are infecting bank balance sheets. QE money that is not spent on consumption or used to pay down debt would contribute to the savings glut and asset inflation, which keeps interest rates and returns on investments low--a fairly benign side effect of the monetary injection.

Everybody was supposed to get their swine flu shot to prevent a nonexistent flu pandemic. The real pandemic is household debt. The cure is grape flavored QE Koolaid injected into households.

Commodities are haunted by a possible "Sub-Prime II" crisis, Citigroup (C) says, where prices are undermined by a "nightmare scenario" of surging rates and a dip back into recession - which would "demonstrate that investors never learned anything from the shock waves that descended on global investment."

With an ocean of liquidity sloshing around the planet seeking returns from non-existent profitable investments I don't think commodities investors need to fear the "nightmare" interest rate spike in the near to medium term. Investment money is cheap because there is an oversupply of it relative to available investments. Neither Bernanke nor other Western central bankers are going to invite recovery suicide by raising rates to support their currencies. Money is in trouble. Commodities and real companies have value.

When Free Markets Fail

Edward Harrison posted a good article today about the appropriate size and function of government. He pointed out that "liberty" is an essential goal of the US constitution.

If a self-serving monopoly or oligopoly controls essential factors of the economy there can be no liberty for anyone else, so in the US it should be an essential function of government to restrain overconcentration of wealth and power. By the same token government itself must be limited in its wealth and power, and many would argue that government today has indeed become a fascist collusion of big business and big government preying on the citizenry and destroying the prospects for liberty.

I tend towards the libertarian view but I recognize that capitalism generates an extreme concentration of wealth in the hands of the skillful and ambitious, a reality that Ayn Rand celebrated in "Atlas Shrugged". Even I must admit that Ayn made no allowance for capitalist losers, and that economic Darwinism and its social destruction is more uneconomic than a limited welfare state that keeps the losers in the game, if only at the margins. I share Hobbes' view that in a truly free market state of nature life would be a "war of all against all". So there is a place for government and even for the welfare state.

This is why economics has historically been studied as political economy rather than as pure market economics. Adam Smith saw himself as a political economist studying the moral issue of how to get the most benefit for an economy's participants and concluded that economic specialization and trade, though driven by the pursuit of self interest, is both morally and economically superior to alternate economic systems. The fate of losers, and their response to losing, is a political problem that cannot simply be factored out of economic equations. To get a realistic understanding of how economies work they must be seen within this wider context of political economy.

Smith's market maximizes liberty. Everyone is free to prosper to the best of their ability. But concentrated power, whether in the private or public sector, subverts this virtuous outcome. In order to be free markets must be competitive, or else they should be regulated like utilities so they serve the cause of liberty rather than the narrow interests of their owners.

There will always be losers who cannot really contribute much to an economy. But it remains true that it is the competition of individual vs individual in the pursuit of money and glory that drives innovation and wealth creation. As far as possible I think it is the function of the state to maintain an environment in which this healthy competition and individual reward can be maximized.

Eastern Alliance: Energy Investment in the U.S. and China

Good article and good investing advice.