As stockmarkets continue their volatile passage downwards one seemingly safe haven investment would appear to be the printing rights to Das Kapital - global sales have been soaring of late, with the likes of Nicolas Sarkozy seen palming his way through the minutiae. The whole viability of Capitalism is being called into question within popular media, and to some extent in government policy response. What is certainly true and is self evident in the events of the past few weeks, is that poorly regulated capitalism is bankrupt and the the banking elite who ran the show were inept.
What is also true is that there is a human tendency to latch onto systems and processes and label them unwittingly as better than they actually are, or in the sudden case of their failure to totally discredit them. In other words it's part of the human condition to overreact. There are plenty of cases throughout history to demonstrate that what we think as societies makes us strongest is also likely to lead to our precipitous demise. Nothing is perfect, and thinking things are typically limits our ability to see the wood from the trees - or as Leonard Cohen put it more eloquently:
Ring the bells that still can ring
Forget your perfect offering
There is a crack in everything,
That's how the light gets in.
The laissez faire, free-market approach isn't perfect...what is surprising is that people are thinking that this is surprising. The alternatives are worse.
What is (with hindsight) easiest to pinpoint is the fact that people, governments, bankers, regulators etc. overestimated the ability of the Monetarist approach to economic management to lead us to the promised land. As the Keynesian dogma was ushered out, the Chicago school ushered in an era of central banks aggressively fighting inflation, led by Paul Volcker at the Fed through the early 80s. Once his credibility was achieved in this area, with considerable pain in the early years (interest rates of 18% in 1982, and similar in the late 80s in the UK) global interest rates stabilised at extremely low levels never previously seen. Credit creation flourished and business investment shot up rapidly, global growth started to move above long term trends and the ruling powers of the world convinced their populaces of how smart they were, as they advocated their "light touch" approach to regulating capital markets, trade and business investment.
Military historians should be a compulsory member of any powerful decision making body, as they can likely point to the cycles of history to forewarn of likely problems when things are plain sailing...there is so much evidence in their field. In an article called the "Victory Disease" by Major Tim Karchner of the US army he outlines a whole host of major battles lost throughout history where the consequence of past battles having been won, was the likelihood of losing the next one increasing. It paints a nice parallel to the hubris of wealth creation over the past 25 years leading to where we are heading today.
The British military experience during the Zulu wars of the late 19th century illustrates the symptoms of the "Victory Disease" as Karchner calls it. The native Zulu population of Southern Africa was just another indigenous people for the British Army to defeat in the British Empire's colonization of Africa. Before fighting the Zulus, the British Army had fought the Boers over areas in southeastern Africa, but most of the British army's experience had been in battles with various indigenous tribes - the Xosas, Pedis and Gcalkas.
The British defeat at the Battle of Isandlwana on 22 January 1879 illustrates the danger of military force using established patterns. When planning the campaign that led to the Isandlwana defeat, the British commanding officer Lord Chelmsford (a good Essex boy) planned to fight the Zulus in the same manner in which he had "fought a messy little war on the Cape frontier to a successful conclusion". Unfortunately those battles were fought in a guerilla warfare mode, and instead the Zulus just produced an enormous army. The dialogue taken from the 1964 film "Zulu" has a comic sadness to it:
Adendorff: The classical attack of the Zulus is in the shape of a fighting bull buffalo, like this (he uses a bayonet to draw a diagram in the dirt): the head, the horns, and the loins. First the head moves forward and the enemy naturally moves in to meet it - but it's only a feint. The warriors in the head then disperse to form the encircling horns, and the enemy is drawn in on the loins, and the horns close in on the back and sides. (He stabs the bayonet into the ground.) Finish.
Lt. Bromhead: It looks, uh, jolly simple, doesn't it?
Adendorff: Oh, it's jolly deadly, old boy.
Lt. Bromhead: Good show, Adendorff, we'll make an Englishman of you yet!
In both the cinema and reality the Zulu army attacked one of the unsuspecting British regiments while it was encamped and killed virtually every man.
This week saw perhaps the greatist advocate of the monetarist doctrine, Alan Greenspan, admit that in truth (and with the benefit of hindsight) that the system wasn't perfect, even though for long periods it appeared to be.
The congressional committee's Democratic chairman, Henry Waxman, pressed him: "You found that your view of the world, your ideology, was not right, it was not working?" Greenspan agreed: "That's precisely the reason I was shocked because I'd been going for 40 years or so with considerable evidence that it was working exceptionally well."
The great strength of Monetarist economics - it's success over a long period of time - runs the risk of now becoming its greatest weakness. The world collectively was so confident in it that now that it has been proven fallible, that fallibility will cause gigantic fall-out. The human overreaction condition will likely kick in on the same scale. We may now embark a grand reworking, or perhaps even a complete destruction of capitalism as we have seen it work for the past 30 odd years, and blame the current failure on the concepts themselves. The truth is that the system is still the best available, but its practitioners need some work. This same scenario repeats itself over and over in our history.
But then the great lesson of history is that we never learn the great lesson of history.
Monday 27 October 2008
Monday 20 October 2008
Regulating integrity
Adam Smith once said that "Virtue is to be more feared than vice, because its excesses are not subject to the regulation of conscience". Perhaps a slightly funny way to look at the world, but i think it's a pretty insightful way to think about how we go about regulating the important institutions in society.
As the world is in the process of looking to apportion blame for the current financial crisis it seems that the majority of blame is being position squarely at the door of the worlds banks. The truth is that it's not really as simple as that, but thinking like that will keep things simple as people try to understand the process that led to their home being reposessed. The worrying knock-on effect of simply blaming "the banks" for this mess is that what is likely to follow is a whole raft of very poor regulation, that fails to increase the trust that once existed between each of us as individuals and these important institutions. People who work for banks, quite simply cannot be trusted, so to protect individuals from their wily ways swaths of rules will be introduced. We will move further away from the 'old' notion that Adam Smith points to, which is "regulation by conscience". I don't think it's too much of a stretch to suggest that one of the major causes of the current banking crisis was not insufficient regulation, but just poor quality regulation. The best form of regulation i can think of is this regulation by conscience...if i do something, do i fundamentally believe that in the grand scheme of things that this is a good thing to do. Good regulation, would create an environment where that would be the first port of call when making decisions, not to go and check the rule book. This is understandable a tall-order, as it involves a big mental shift across the system.
One of the rule books by which banks have been told to manage their capital and consequently their risk is the Basel Accords. The most recent version of this rule book, which was being put in place in banks across the world was catchily called "Basel II". Effectively this is a set of recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of these recommendations is to create an international standard that banking regulators can use when creating their rules about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. In practice Basel II attempts to accomplish this by setting up complex risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to safeguard its solvency and overall economic stability. Interestingly (if you get your kicks out this sort of thing), the big shift between Basel I and Basel II, was to give the worlds big credit rating agencies a much greater role in the whole process (not exactly looking like a rock-star move that one)...in fact under certain forms of this rulebook capital requirements for banks to hold against particular loans was directly taken from the credit rating from Moody's or Standard and Poors. Very simply if either of this 2 said your asset was AAA rated, the capital you required against that asset was reduced to virtually nil.
In a very simple example, the basic capital requirement for a bank is 8% of it's asset portfolio. So if the bank has made £100 million worth of loans, then they would need to hold £8 million worth as minimum 'protection' against those loans turning sour.
Under the Basel Accords, If however you carved up your mortgage book (via securitisation for example) and retained only mortgage assets with AAA ratings then you would only need to keep a fraction of that £8 million worth of capital against your mortgage assets. This could be a brilliant way of boosting shareholder returns; say the £100mm worth of mortgages pay an income of £2million per annum then your return on capital (very simply) is £2mm/£8mm x 100% = 25%. If however you could reduce you capital by restructuring your mortgage book, such that your income dropped from £2 million to £1 million, but commensurately you dropped your capital requirement to £2mm, then you would have doubled your 'return on equity' - £1mm/£2mm x 100% = 50%. Magic. Your shareholders think you are a genius, and now on the same amount of capital as you started with (£8mm), under the same terms you could go out and lend 4 times as much. Your shareholders are going to love you magic CEO person.
One of the biggest money spinners for banks over the past few years has been more complex forms of that stated above. One of my main jobs at the investment banks i worked at involved discussing with clients how to structure investments in such a way as to make them compelling from a 'return on capital perspective'. The method of doing this involved looking into the Basel II rule book and restructuring investments for our bank clients so that they could legally reduce their capital requirement so as to increase their return on equity. The problem in reality is that you weren't actually doing anything to change materially the quality of the investments...it was a grand form of window-dressing, or in the more base terminology of a former colleague; 'polishing turds'.
A second, and similar trend that developed over the past few years was a change in international accounting standards for banks (this was the one that Lehman Brothers grabbed with both hands so successfully until it blew them up). Another catchily titled accounting rule, called IAS 39, made it favourable for banks to shift some of their loans off "banking books" and onto "trading books". The trade off was simple...if you put assets onto your trading book, then the capital requirement against those assets dropped (good) but in return for this little pick me up you had to 'mark to market' those assets on a daily basis and record the changes in value through your overall profit and loss account. This would likely have the effect of increasing the volatility of your earnings...but when the assets that you are holding increase in value you look great. The large scale transitioning of assets onto trading books, effectively meant banks needed less capital for the same size loan portfolio. Consequently Lehman Brothers (and others) were able to have assets to capital of astronomic proportions. When all of the assets on these books collectively started to fall in value the speed with which Lehman was taken from hero to insolvent was very rapid. This was another rule change that in principle was a good idea, but the agents who were living by it played by the rules, but didn't have incentives to grasp the goal of the rule change.
One question that i hope regulators who are looking at the world now will focus on is this - The Basel Accords in principle are an absolutely fine way of thinking about securing the safety of the worlds banking system, but in practice if the agents who are supposed to live up to these standards didn't care for the principle of what they were about in their 'regulation of conscience' then you won't get the outcome you are after. I think the results speak for themselves.
As the world is in the process of looking to apportion blame for the current financial crisis it seems that the majority of blame is being position squarely at the door of the worlds banks. The truth is that it's not really as simple as that, but thinking like that will keep things simple as people try to understand the process that led to their home being reposessed. The worrying knock-on effect of simply blaming "the banks" for this mess is that what is likely to follow is a whole raft of very poor regulation, that fails to increase the trust that once existed between each of us as individuals and these important institutions. People who work for banks, quite simply cannot be trusted, so to protect individuals from their wily ways swaths of rules will be introduced. We will move further away from the 'old' notion that Adam Smith points to, which is "regulation by conscience". I don't think it's too much of a stretch to suggest that one of the major causes of the current banking crisis was not insufficient regulation, but just poor quality regulation. The best form of regulation i can think of is this regulation by conscience...if i do something, do i fundamentally believe that in the grand scheme of things that this is a good thing to do. Good regulation, would create an environment where that would be the first port of call when making decisions, not to go and check the rule book. This is understandable a tall-order, as it involves a big mental shift across the system.
One of the rule books by which banks have been told to manage their capital and consequently their risk is the Basel Accords. The most recent version of this rule book, which was being put in place in banks across the world was catchily called "Basel II". Effectively this is a set of recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of these recommendations is to create an international standard that banking regulators can use when creating their rules about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. In practice Basel II attempts to accomplish this by setting up complex risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to safeguard its solvency and overall economic stability. Interestingly (if you get your kicks out this sort of thing), the big shift between Basel I and Basel II, was to give the worlds big credit rating agencies a much greater role in the whole process (not exactly looking like a rock-star move that one)...in fact under certain forms of this rulebook capital requirements for banks to hold against particular loans was directly taken from the credit rating from Moody's or Standard and Poors. Very simply if either of this 2 said your asset was AAA rated, the capital you required against that asset was reduced to virtually nil.
In a very simple example, the basic capital requirement for a bank is 8% of it's asset portfolio. So if the bank has made £100 million worth of loans, then they would need to hold £8 million worth as minimum 'protection' against those loans turning sour.
Under the Basel Accords, If however you carved up your mortgage book (via securitisation for example) and retained only mortgage assets with AAA ratings then you would only need to keep a fraction of that £8 million worth of capital against your mortgage assets. This could be a brilliant way of boosting shareholder returns; say the £100mm worth of mortgages pay an income of £2million per annum then your return on capital (very simply) is £2mm/£8mm x 100% = 25%. If however you could reduce you capital by restructuring your mortgage book, such that your income dropped from £2 million to £1 million, but commensurately you dropped your capital requirement to £2mm, then you would have doubled your 'return on equity' - £1mm/£2mm x 100% = 50%. Magic. Your shareholders think you are a genius, and now on the same amount of capital as you started with (£8mm), under the same terms you could go out and lend 4 times as much. Your shareholders are going to love you magic CEO person.
One of the biggest money spinners for banks over the past few years has been more complex forms of that stated above. One of my main jobs at the investment banks i worked at involved discussing with clients how to structure investments in such a way as to make them compelling from a 'return on capital perspective'. The method of doing this involved looking into the Basel II rule book and restructuring investments for our bank clients so that they could legally reduce their capital requirement so as to increase their return on equity. The problem in reality is that you weren't actually doing anything to change materially the quality of the investments...it was a grand form of window-dressing, or in the more base terminology of a former colleague; 'polishing turds'.
A second, and similar trend that developed over the past few years was a change in international accounting standards for banks (this was the one that Lehman Brothers grabbed with both hands so successfully until it blew them up). Another catchily titled accounting rule, called IAS 39, made it favourable for banks to shift some of their loans off "banking books" and onto "trading books". The trade off was simple...if you put assets onto your trading book, then the capital requirement against those assets dropped (good) but in return for this little pick me up you had to 'mark to market' those assets on a daily basis and record the changes in value through your overall profit and loss account. This would likely have the effect of increasing the volatility of your earnings...but when the assets that you are holding increase in value you look great. The large scale transitioning of assets onto trading books, effectively meant banks needed less capital for the same size loan portfolio. Consequently Lehman Brothers (and others) were able to have assets to capital of astronomic proportions. When all of the assets on these books collectively started to fall in value the speed with which Lehman was taken from hero to insolvent was very rapid. This was another rule change that in principle was a good idea, but the agents who were living by it played by the rules, but didn't have incentives to grasp the goal of the rule change.
One question that i hope regulators who are looking at the world now will focus on is this - The Basel Accords in principle are an absolutely fine way of thinking about securing the safety of the worlds banking system, but in practice if the agents who are supposed to live up to these standards didn't care for the principle of what they were about in their 'regulation of conscience' then you won't get the outcome you are after. I think the results speak for themselves.
Monday 13 October 2008
Jam today or jam tomorrow...
An important tenet of many organised religions is the concept of delayed gratification. This can be seen as a measure of self-control, self-discipline and self-organisation - all of which are in theory helpful to the leading of a happy and at the same time socially responsible existence. Many psychologists, perhaps most notably Freud, tested the concept of delayed gratification on children - and it's has been widely recognised to be an important guide to the probable future success as those children pass into adulthood.
Life throws up many opportunities where we have to make decisions of this nature - do we want to have some jam today, or more jam tomorrow...and how much jam tomorrow would compensate for not having any jam today. Some Christian approaches may even suggest that we would not need to have any more jam tomorrow to compensate for no jam today, because the very process of self-discipline would actually increase the satisfaction of the same amount of jam tomorrow. I think everybody has experienced this concept - a piece of chocolate that has been promised as a reward for finishing the housework, the pint of beer after a long days walking.
Delayed gratification has lost its appeal in many western societies over the past 20-30 years. Perhaps a decline in religious leadership of our societies, or the rapid development of 'on demand' services, from media to finance, to travel and so on. There are plenty of reasons why, but it is certainly the case that gratification has become more immediate. As a child i can certainly recall delayed gratification as being central to my parents approach to parenthood. As children our weekly pocket money was paid every saturday morning, and we were given 10p for every year of age we were. The pocket money was never, ever paid before the Saturday morning, no matter how much pleading took place. I recall on one occasion, when i was eight years old coming back from our local park after Saturday morning football, and going with my Dad to our local newsagent (The Grange Star, Rathfarnham); Dad was picking up the papers and handed me my 80p pocket money for the week. I headed into the shop with him and surreptiously bought eighty 1p sweets (a truly glutenous performance). On returning to the car my Dad saw the substantial bag i was carrying and asked knowingly what i had bought. I hesitantly answered truthfully and proceeded to get an ear bashing for my totally reckless, greedy spending.
These sorts of reactions did not stem from any particular religious inclination, but i think my parents understood, perhaps intuitively (more probably from their parents) that it is an important life skill. Stories of my maternal grandfather working for the Bank or Ireland through the 50s and 60s, and his client relationships with farmers, shopkeepers and small business owners in the west of ireland were full of indirect tales of delayed gratification. The 'on demand' world that we exist in would have been inexplicable to them.
The financial mire that we are heading into could be directly attributable to the fall of the importance of delayed gratification. The credit expansion that has taken place since the early 80s, driven by low interest rates has been a grand borrowing against future income taken to excess. In banking terms we would call this the 'discount rate' - the rate of interest that we would use to discount a future sum of money into a figure today. As world wide interest rates fell, the true discount rate fell too...the real value of holding money in savings accounts dropped preciptously. The opportunity cost of spending was reduced to virtually nothing in the US where real interest rates during the Greenspan years were negative.
In my time working in the world of investment banking, the system encouraged short-termism and the 'jam today' mentality. From compensation packages to accounting approaches money tomorrow was a distant relation to money today. The same sadly held true as it now seems through broad swaths of western economies...from individuals, banks and in some of the worst cases governments. In the US, the fact that it has historically had a savings rate that hovered near zero, and at times was negative suggests that delayed purchases were not on the agenda. Sadly this doesn't create happier lives in the long run. In our societies the concept of success is measured in immediate ways - a new car, a new house, the biggest TV, the most exotic holiday.
What is going to be tricky is reversing this process. The American novellist Thomas Perry once said that "Reading a novel in which all characters illustrate patience, hard work, chastity, and delayed gratification could be a pretty dull experience". As recessions grip in various parts of the world people are going to have to find a way to make these things interesting again.
Life throws up many opportunities where we have to make decisions of this nature - do we want to have some jam today, or more jam tomorrow...and how much jam tomorrow would compensate for not having any jam today. Some Christian approaches may even suggest that we would not need to have any more jam tomorrow to compensate for no jam today, because the very process of self-discipline would actually increase the satisfaction of the same amount of jam tomorrow. I think everybody has experienced this concept - a piece of chocolate that has been promised as a reward for finishing the housework, the pint of beer after a long days walking.
Delayed gratification has lost its appeal in many western societies over the past 20-30 years. Perhaps a decline in religious leadership of our societies, or the rapid development of 'on demand' services, from media to finance, to travel and so on. There are plenty of reasons why, but it is certainly the case that gratification has become more immediate. As a child i can certainly recall delayed gratification as being central to my parents approach to parenthood. As children our weekly pocket money was paid every saturday morning, and we were given 10p for every year of age we were. The pocket money was never, ever paid before the Saturday morning, no matter how much pleading took place. I recall on one occasion, when i was eight years old coming back from our local park after Saturday morning football, and going with my Dad to our local newsagent (The Grange Star, Rathfarnham); Dad was picking up the papers and handed me my 80p pocket money for the week. I headed into the shop with him and surreptiously bought eighty 1p sweets (a truly glutenous performance). On returning to the car my Dad saw the substantial bag i was carrying and asked knowingly what i had bought. I hesitantly answered truthfully and proceeded to get an ear bashing for my totally reckless, greedy spending.
These sorts of reactions did not stem from any particular religious inclination, but i think my parents understood, perhaps intuitively (more probably from their parents) that it is an important life skill. Stories of my maternal grandfather working for the Bank or Ireland through the 50s and 60s, and his client relationships with farmers, shopkeepers and small business owners in the west of ireland were full of indirect tales of delayed gratification. The 'on demand' world that we exist in would have been inexplicable to them.
The financial mire that we are heading into could be directly attributable to the fall of the importance of delayed gratification. The credit expansion that has taken place since the early 80s, driven by low interest rates has been a grand borrowing against future income taken to excess. In banking terms we would call this the 'discount rate' - the rate of interest that we would use to discount a future sum of money into a figure today. As world wide interest rates fell, the true discount rate fell too...the real value of holding money in savings accounts dropped preciptously. The opportunity cost of spending was reduced to virtually nothing in the US where real interest rates during the Greenspan years were negative.
In my time working in the world of investment banking, the system encouraged short-termism and the 'jam today' mentality. From compensation packages to accounting approaches money tomorrow was a distant relation to money today. The same sadly held true as it now seems through broad swaths of western economies...from individuals, banks and in some of the worst cases governments. In the US, the fact that it has historically had a savings rate that hovered near zero, and at times was negative suggests that delayed purchases were not on the agenda. Sadly this doesn't create happier lives in the long run. In our societies the concept of success is measured in immediate ways - a new car, a new house, the biggest TV, the most exotic holiday.
What is going to be tricky is reversing this process. The American novellist Thomas Perry once said that "Reading a novel in which all characters illustrate patience, hard work, chastity, and delayed gratification could be a pretty dull experience". As recessions grip in various parts of the world people are going to have to find a way to make these things interesting again.
Monday 6 October 2008
Value Added
The concept of what 'value added' means has always been confusing to me. It is assumed, i think, that the answer is straightforward...but I have never really found it so. Apparently it's the case that the sun emits enough energy that ,if appropriately captured, 2 days worth of sun would sufficiently cover the entire human energy consumption for a year. In one sense, value added, would be the creation of a technology that captures this energy and i would have to work less presumably because my energy bills would have fallen...perhaps the 4hours less that i would have worked a week could be filled playing golf; as could everybody else in humanity...which might make the local club a bit busy. Alternatively i could continue to work the same amount, but would be able to buy more 'stuff'...a new set of golf clubs for example. These apparently are the old style economics of 'trade-off', opportunity cost and value creation.
For generations of economists, 'wealth creation' implies capital formation in these terms - generating and developing income-creating tangible assets. I think i can grasp this concept...i build a technology that can capture the energy of the sun in a highly efficient way, and can use this technology to generate income in some form.
In the Autumn of last year the US Census Bureau published figures for median real incomes for US families between 2000-2007. CNN at the time commented on the statistics that “...This is the first business cycle ever in which the middle class had less income at the end than the beginning” – from around $58,500 to $56,000. At around this time, the FTSE had touched a high pushing 6750, and the Dow was well above 14000. Markets were booming, both in equity and credit markets.
So while GDP growth, and a variety of market indicators reflected an economy that was growing steadily, the real incomes of the majority of Americans had actually fallen.
Away from the income generation of the average American, the growth of home mortgages exploded from an annual rate of $368.3 billion in 2000 to an annual rate of $884.9 billion in 2004, compared with a simultaneous increase in residential building from $446.9 billion to $662.3 billion. Altogether, the United States experienced a credit expansion of close to $10 trillion during these four years. By 2007, the size of the US mortgage market had reached an estimated $12trillion, of which an estimated $1.3trillion had been pushed into the hands of the euphemistically entitled 'subprime'.
At the same time as credit was expanding, so too was GDP. During 2000-2004 GDP added $1.9trillion to the country's, so the ratio of credit expansion to GDP growth was just over 5 times. During the 4 year period after the end of the 2nd world war, this ratio was roughly equal.
While consumption, residential building and government spending soared, unprecedented imbalances developed in the economy - record-low saving; a record-high trade deficit; a vertical surge of household indebtedness; anemic employment and income growth from wages and salaries; outsized government deficits; and protracted, unusual weakness in business fixed investment.
The crux of all this is that all that really happened in the US economy over the past 8years, was asset price inflation fuelled by record low interest rates. The average American was borrowing against a 'guaranteed' increase in asset prices (between 2000-2007 the average annual price increase was around 15%, stock markets showed similar annual gains). In truth, they were actually borrowing more than the expected future increases in asset prices. This is i think is technically known as Ponzi scheme. Ponzi schemes can be quite effective, if a touch morally bankrupt, as long a the music is still playing.
Charles Prince (the last Citibank CEO) was quoted in the middle of last year as saying that...
"When the music stops, in terms of liquidity, things will be complicated. But as long as the music playing, you've got to get up and dance. We're still dancing." Charles Ponzi would have been proud.
So where are things at?
Some numbers: US Credit expansion 2000-2008 was around $23trillion. GDP growth was nominally estimated at $3.6bn over the same period. Since the highs of the housing markets in 2006 and stock markets in autumn 2007 the estimated falls in asset values that the credit expansion are financing is estimated at over $5trillion. So the US consumer is by any accounting standard insolvent. We're well past the Keynes situation: If you owe a bank a hundred pounds, you have a problem...if you owe them a $100million, it has one.
Banks, Financial institutions and increasingly Governments are largely bearing the responsibility for the outstanding debt that financed these assets. Capital ratios are falling, so banks are seeking new capital and deleveraging (trying to sell assets) to get back to appropriate capital adequacy ratios. Banks will be net sellers of assets until their capital ratios reach a 'reasonable' level, but are going to be in a vicious circle with falling asset prices...the more assets they sell, the further the prices of assets they hold will fall, forcing them to sell yet more assets to balance their capital positions.
The goal of the US bail-out currently is to try to stem the descending flow of asset prices that a forced deleveraging has created. $700bn is a lot of money, but may well be a bit like trying to fix a leak in the Hoover Dam with a tube of hand-held polyfiller.
As Milton Friedman put it: "We all agree that pessimism is a mark of superior intellect"
For generations of economists, 'wealth creation' implies capital formation in these terms - generating and developing income-creating tangible assets. I think i can grasp this concept...i build a technology that can capture the energy of the sun in a highly efficient way, and can use this technology to generate income in some form.
In the Autumn of last year the US Census Bureau published figures for median real incomes for US families between 2000-2007. CNN at the time commented on the statistics that “...This is the first business cycle ever in which the middle class had less income at the end than the beginning” – from around $58,500 to $56,000. At around this time, the FTSE had touched a high pushing 6750, and the Dow was well above 14000. Markets were booming, both in equity and credit markets.
So while GDP growth, and a variety of market indicators reflected an economy that was growing steadily, the real incomes of the majority of Americans had actually fallen.
Away from the income generation of the average American, the growth of home mortgages exploded from an annual rate of $368.3 billion in 2000 to an annual rate of $884.9 billion in 2004, compared with a simultaneous increase in residential building from $446.9 billion to $662.3 billion. Altogether, the United States experienced a credit expansion of close to $10 trillion during these four years. By 2007, the size of the US mortgage market had reached an estimated $12trillion, of which an estimated $1.3trillion had been pushed into the hands of the euphemistically entitled 'subprime'.
At the same time as credit was expanding, so too was GDP. During 2000-2004 GDP added $1.9trillion to the country's, so the ratio of credit expansion to GDP growth was just over 5 times. During the 4 year period after the end of the 2nd world war, this ratio was roughly equal.
While consumption, residential building and government spending soared, unprecedented imbalances developed in the economy - record-low saving; a record-high trade deficit; a vertical surge of household indebtedness; anemic employment and income growth from wages and salaries; outsized government deficits; and protracted, unusual weakness in business fixed investment.
The crux of all this is that all that really happened in the US economy over the past 8years, was asset price inflation fuelled by record low interest rates. The average American was borrowing against a 'guaranteed' increase in asset prices (between 2000-2007 the average annual price increase was around 15%, stock markets showed similar annual gains). In truth, they were actually borrowing more than the expected future increases in asset prices. This is i think is technically known as Ponzi scheme. Ponzi schemes can be quite effective, if a touch morally bankrupt, as long a the music is still playing.
Charles Prince (the last Citibank CEO) was quoted in the middle of last year as saying that...
"When the music stops, in terms of liquidity, things will be complicated. But as long as the music playing, you've got to get up and dance. We're still dancing." Charles Ponzi would have been proud.
So where are things at?
Some numbers: US Credit expansion 2000-2008 was around $23trillion. GDP growth was nominally estimated at $3.6bn over the same period. Since the highs of the housing markets in 2006 and stock markets in autumn 2007 the estimated falls in asset values that the credit expansion are financing is estimated at over $5trillion. So the US consumer is by any accounting standard insolvent. We're well past the Keynes situation: If you owe a bank a hundred pounds, you have a problem...if you owe them a $100million, it has one.
Banks, Financial institutions and increasingly Governments are largely bearing the responsibility for the outstanding debt that financed these assets. Capital ratios are falling, so banks are seeking new capital and deleveraging (trying to sell assets) to get back to appropriate capital adequacy ratios. Banks will be net sellers of assets until their capital ratios reach a 'reasonable' level, but are going to be in a vicious circle with falling asset prices...the more assets they sell, the further the prices of assets they hold will fall, forcing them to sell yet more assets to balance their capital positions.
The goal of the US bail-out currently is to try to stem the descending flow of asset prices that a forced deleveraging has created. $700bn is a lot of money, but may well be a bit like trying to fix a leak in the Hoover Dam with a tube of hand-held polyfiller.
As Milton Friedman put it: "We all agree that pessimism is a mark of superior intellect"
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