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Veteran
Posts: 214
| Probably began with the controlled demolition of Bear Stearns in March 2008, before phase 1 (which began in earnest in August 2007) even impinged on the minds of the general public. That set the tone for how TPTB (the powers that be) would deal with the probable end of this financial system.
It's shape firmed up through the Lehman collapse and response to that; began to loom in spring 2010 and quickened in spring 2011 when it became clear the almost inevitable systemic problems would probably be unravelling within a year or so.
I feel I should explain things in both their wider and narrower sweep, apologies to those who've sucked some of these eggs before. I started writing this over two weeks ago, it's a long-ish read. Hopefully I've explained things coherently and understandably, ask if you want to explore bits in more detail, want substantiating links or better explanation.
What brought us to here?
The basics, long term:
Humans' proclivity for 'a better life'.
Exploitation of resources, especially fossil energy resources.
Development of transportation technologies.
Liebig's law: productivity of (A + B) > the productivity of A + productivity of B; ultimately leading to the maxima of globalisation which is now probably passed.
Development of a fractional reserve fiat money system which has leveraged our progress.
Improvements in food production and disease control which have facilitated rapid population growth.
All of these are probably good things, particularly if handled wisely. They've enabled humankind to grow about fivefold over the last couple of centuries and improved the standard of life for a billion people or two, massively. But within them are the seeds...
More recently:
Rapid deployment of world changing technology (mostly communications: radio, TV, phones, mobile phones, computing, personal computing, internet).
Application of the above to financial markets.
Securitisation: the creation (and rapid expansion) of markets for things like currency and commodity futures, debts.
Derivatives: transactions which are not direct investments but are essentially bets, and their stratospheric growth over the last decade.
The inevitable short-termism of democratic governance and financial markets.
Foolish cleverness by the financial and political cadres believing they can defy gravity, and their 'this can go on forever' (within their short term context) mentality.
Reaching limits: for production of finite resources, utilisation of land and water.
Climate change almost certainly due to the amount of greenhouse gases we've been pumping into the atmosphere.
Several of these are not good things and some are direct causal factors in our present predicament. Most of their bad aspects need not have happened and / or could have been mitigated had the wisdom and will existed. However, once we got past about 1980 on our present trajectory something was going to bottleneck our species so, in the wider scheme of things, does it really matter what the specific trigger is?
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Veteran
Posts: 214
| Once upon a time there were logical and sound reasons for things like currency and commodity futures markets. They enabled organisations to 'hedge' = buy and sell futures in stuff they would need to transact later so they could predict more accurately future costs / revenues hence plan their businesses more reliably.
Back in the late 1970s I sometimes played bridge with the finance director of Wellcome (large multinational pharmaceutical company, since swallowed by Glaxo etc), who once said to me that his currency department - two people - had made more profit in the last year on currency futures than the company had made from its normal business activities - and we are talking tens of £millions. I think Wellcome employed about 20,000 people in approximately 60 countries at the time.
So, even 30+ years ago, alarm bells rang: it's insane that people can make so much just trading futures compared with actually doing productive work. Of course, financial organisations were playing the game back then, too. Over the last 40 years the financial sector has grown from about 10% to 30% of the economy (measured by GDP) in US and UK, the manufacturing and financial sectors have traded places.
I've recently read a paper about why we didn't see the 2008 crash coming. More accurately: why most didn't but some did. Those that did had models containing an explicit entity for the financial system (mostly as FIRE: finance, insurance and real estate) and had a 'flow of funds' approach, which the paper categorised as 'accounting models'. Those that failed were the macro economic models followed by all governments and central banks (and many others), none of which explicitly identify flows of funds in and out of the financial system as an entity.
The accounting models were saying that the financial system was sucking too much from the real economy and it would inevitably end in tears - the real economy couldn't survive much longer with this financial monkey on its back. The macro economic models were blithely unaware of any problem. Echoes of something I said in "Frodo's solution" about the financial sector being like a tax on the real economy.
Nowadays so much has been securitised - what started with currencies and commodities for companies which needed it to manage their business in the face of volatility has expanded to a casino that all with money can play in and has spread to mortgages, selling debt, insuring debt, betting on debt defaults, the list is almost endless. Some have calculated that securitisation has inflated the price of commodities like oil by as much as 30%.
Then there are derivatives, like bets on stock indexes going up or down. OK, could be useful as a risk control (hedge) if you hold a lot of stocks but the total value of derivatives was more than 10x total global annual GDP back in 2007 (conservative estimate by the Bank of International Settlement), surely something has gotten out of hand. It makes sense to insure the life of someone you depend on but folks would be suspicious if you insured the life of Joe Zog of Taunton with whom you had no connection. Yet many derivatives are used just like that.
J P Morgan Chase (a US bank) made $4.6 billion profit in 2011Q3 of which $1.9bn was made betting against itself by betting its own bonds' interest rates would increase implying it was more likely to go bust. As well as being somewhat absurd that one can make so much money just betting on interest rate changes for a single corporation it whiffs of insider trading to me.
Lots of financial transactions (over 70% in US) are done by computers now and often they are sold within a second of buying - making a small guaranteed margin on many fast transactions is a reliable way for those with the technology to make money. Indeed, at least one US major finance house has been under investigation for delaying client transactions by a few hundred milliseconds to get their own transactions in with the foreknowledge of their clients' transactions. Many US finance companies site their systems as close as possible and with extremely fast communication to the computerized exchanges just to give them a few milliseconds edge. When markets behave unexpectedly these automated trading systems can shut down and / or malfunction, removing massive amounts of liquidity which the markets have come to depend on, hence causing events like the 'flash crash' of May 2010.
'Dark pools' are ultra fast networks separate from the normal stock etc exchanges where the big boys play betting games with one another on stocks, currencies, derivatives, independent of the official exchanges. These should be treated like unregulated bookies and banned.
In the aftermath of the dotcom bust of 2000, compounded by 9/11, Alan Greenspan, then chairman of the US Federal Reserve (the Fed, the US central bank), pursued an ultra-liberal monetary policy keeping interest rates too low for too long fostering renewed stock, commodity and property bubbles.
Approximately all the growth in the US economy since 2001 can be seen as due to equity withdrawal by homeowners' remortgaging and spending the proceeds. This was facilitated by Greenspan's accommodative financial policies and lax regulation.
Throughout the financial system has adopted a 'party on' mentality - it is in the players' interests to keep the present unreal game going for as long as possible while they are making money. I think the only way it can end is in systemic failure of the financial system, it's now too big and too estranged from reality to fail controllably.
Enough ingredients above to mix a nice explosion but the trigger in phase 1 was the profligate selling of mortgages to people who couldn't conceivably pay them. How could this happen? The people who were selling the mortgages weren't responsible for collecting the payments - their objective was to sell mortgages, not ensure the buyer could pay. They collected their fee and passed the loan on, whereupon it was sold on as a CDO (collateralised debt obligation) to some other sucker.
These were sliced and diced with other derivatives (ostensibly to spread risk) and sold on again with high yields and AAA ratings. Wierd mathematical financial alchemy was used to convince buyers that these were wonderful investments. Yes, the risk was spread - to almost everywhere. Then the inevitable happened.
US accounting rules back in 2007 had 3 levels of balance sheet financial security asset:
1. mark to market
2. mark to similar
3. mark to model
Of these you knew the price of 1, had a very good idea of the price of 2, but the price of 3 - them not being regularly traded - was 'modeled'. These became known as 'mark to fantasy' and comprised stuff like CDOs. In autumn 2007 I began to see analyses of major US banks in which, if you treated their level 3 assets as worthless, they would be insolvent. It was quite shocking what proportion of the assets of some banks was level 3, Bear Stearns and Lehman Brothers looked particularly bad.
Once the mortgage fiasco started to unravel the markets for many of the CDOs etc completely froze up, became illiquid, probably worth near nothing. Oh dear, that made most of the US banking system and more insolvent. Bear Stearns was most exposed and was sacrificed (would have died anyway), J P Morgan Chase ate it but only with a $30billion safety net cum bribe from the Fed. Six months of relative quiet then the system puked again. This time no one would take the risk of Lehman's liabilities at a price the Fed would pay so it went down. The financial system freeze spread from CDOs to just about everything.
Both Bear Stearns and Lehman had rancourous history wih the Fed and their banking compatriots stemming from the LTCM crisis in the 1990s so there was some relish, perhaps, in their gutting. But while Bear Stearns was taken down in a controlled manner (draw your own analogies) Lehman was not. Almost no one comprehended the collateral damage that would occur, the unravelling complexities of their financial assets rippled through most of the developed world's financial system.
Meanwhile other dimensions of the US financial system were collapsing for similar reasons: insurance (AIG), mortgage (Fannie and Freddie), bond insurers (MBIA, Ambak). Europe had to bailout parts of their financial sector, too: Northern Rock, RBS, Fortis, the largest irish banks, the main icelandic bank. They were insolvent: assets worth less than liabilities, and they would bring the whole US and developed world's financial system down if they failed. Decision required: try to keep them afloat or let the system break? It was close, there were a couple of weekends around the end September 2008 when we really didn't know whether we would have a functioning financial system on Monday (think: ATMs, credit and debit cards, shop tills not working, anywhere; banks closed).
Their choice was to throw money to the banks etc, in the hope they could get it back later from banks or taxpayers. To kick the can down the road. With hindsight I would say they got it wrong and fell between two stools, they should either have bailed Lehman out then done the rest of the bailout or let the whole system go with Lehman.
What they have done is transfered liability from the banking system onto countries. Now we find some countries are incapable of servicing their own debts so will default. That will undermine the assets of some banks who own that debt so they will need more recapitalisation from countries. This is known as the 'sovereign debt problem'. Ultimately it will dawn (despite all the money printing) that there is insufficient money to keep this joke afloat.
Govt actions have NOT been designed to stimulate economies, they have been 90%+ to recapitalize banks and the financial system. Given the scale of liability transfer to countries it would probably have been more cost effective to nationalize the failed institutions (Sweden did similar about 20 years ago, and it worked well).
In phase 1 the financial system partly malfunctions and its insolvency is bailed out by countries.
In phase 2 some countries become insolvent, that causes a reduction in the assets of banks etc who hold those countries' bonds (loans) so those banks need further recapitalization from countries to stave off their insolvency. Then more countries will become insolvent etc, etc - and ultimately the whole financial system (banks and countries) is insolvent. This will likely play out over months, perhaps as long as 2 to 5 years, possibly as fast as a few days if/ when the rush happens.
About five years ago I expected peak oil to be the ultimate trigger for the collapse of this financial system. It has been a contributary factor but now it's looking probable that the financial system is capable of destroying itself without much help from such external factors. | |
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Veteran
Posts: 214
| Ireland was the first and it wasn't really their govt's fault. Irish banks had been especially silly in their investments: taking big risks with property loans, making risky investments to chase higher interest rates. When the majority of the irish banking sector became insolvent the irish govt made a foolish error: it guaranteed all deposits at irish banks. Despite draconian austerity measures quickly implemented to try to put the irish govt's finances back on a stable footing the task was beyond any rational govt's ability. Ireland needed bailing out by Euroland, IMF and UK with loans at cheaper rates than the markets (banks) would grant them.
The markets were demanding over 10% interest, the generous IMF / Euroland / UK charged Eire top side of 6% (despite being able to borrow at about 3%, nice business if you can get it). To UK's partial credit they did subsequently reduce he interest rate they charged Ireland but stiil made a healthy profit.
Interestingly, UK bond average term is 7 years - about double that of next longest country. This is good for UK, it means we have less short term debt to refinance.
Here we come to some cruxes of this problem. When markets perceive a loan is risky they charge a higher interest rate to compensate. A proportion of just about all govts' spending is loan interest, those loans have 'terms' whereupon they need to be repaid and the govt typically must re-borrow to pay off those maturing loans. Higher interest rates mean higher govt borrowing costs for new loans.
There are two main stages of potential sovereign insolvency. The first is when total govt spend is higher than revenue hence borrowing must increase, most developed countries are in this boat at present, most are from time to time, and the financial system hasn't ended as a result. Key at this stage is whether the increased borrowing is seen as sustainable, so govts whose borrowing is increasing need to have credible fiscal policies in place to reduce their borrowing and / or credible explanations as to why the increased borrowing is not a problem. The second stage is when the cost of financing their debt alone is greater than govt revenue, usually due to increasing interest rates and already excessive borrowing, sometimes compounded by reducing revenue. This is clearly an unsustainable situation and will, almost inevitably, result in debt default - a failure to pay debts on time / in full / at all.
So to Greece, which is well into stage two of insolvency. They used their Euroland status to borrow at lower rates than were logical for their economy to finance unsustainable growth in public sector jobs with absurdly generous retirement etc benefits. Once the banking system got around to doing the sums on the greek economy they panicked and hiked interest rates on greek govt debt well beyond the level that the greeks could pay to roll-over their debt. Both bailout and default were inevitable. The first stage was a 20% haircut (greek bond holders lost that proportion of their investment) and a serious round of austerity measures.
That was far from sufficient, we are now negotiating the second stage of greek default which will probably be a 50% to 60% debt haircut plus further austerity (increased taxes and reduced govt spending) measures. There are two key questions: will those bailing out pay the price (including recapitalizing at risk banks) and will the greek people and govt accept and implement the austerity. Realistically they have no choice - all alternatives look worse for all parties.
But if Greece gets away with a default surely others like Ireland, Italy, Spain, Portugal, will want similar concessions? That is hopefully being built into stage two of the Euroland rescue, we'll have to wait and see how it plays out.
Spain and Italy (apologies to Portugal - they are an insignificant problem in the scheme of things) are potentially big problems insofar as they would cost too much to bail out, but objectively they shouldn't be a problem at present. Their borrowing is not too excessive; they are having no real difficulties rolling their debt over. However, Italy's growth has been poor for a decade or more and their borrowing has been increasing; Spain has had a collapsed property bubble and disturbingly high levels of unemployment. Unless these are resolved positively (and it's hard to see how) they will have problems financing their debt at some time in the nearish future.
STRATFOR have done an interesting piece attempting to quantify the total cost of greek bailout, their answer is 1.9 trillion Euro:
http://www.financialsense.com/contributors/john-mauldin/2011/10/07/...
How is this going to be paid for?
Euroland has set up the EFSF (European Financial Stabilization Fund) of 440 billion euros. Germany is not happy, they will be stumping up much of it, but they have little choice - Euroland will fracture if they don't. This will be used as security to somehow borrow (the detail of how is what is taking time to decide) up to 2 trillion euros to finance an orderly greek default. A fair amount will be spent recapitalizing banks which would oherwise be forced into insolvency due to their greek debt haircut.
So, Euroland creates this fund and uses it to borrow more money from banks in order to give / loan money to banks which are insolvent because of greek debt haircut. This kind of magic only works while everyone keeps believing in it.
Another possibility which might be more credible if Germany hadn't vetoed it is the issue of Euroland bonds - loans to Euroland as an entity. Euroland could then borrow money at low interest rates to loan on to needy countries like Greece while imposing appropriate financial strictures on those loans. I expect this will come to pass before too long. However, there could come a time when Euroland as a whole is seen as risky causing increased interest rates for all its bonds. Where will the cheap money come from then?
Such things are only possible within the fractional reserve money system we presently inhabit, where money deposits are used to create more money to be loaned out. The supply of money and debt must keep increasing, if it doesn't the system breaks. When that happens, and Euroland seems a plausible trigger, the amount of money could contract by a huge amount (possibly up to near 10x) causing a global deflationary depression the like has never been seen.
Ultimately Euroland needs to move towards a more homogenous fiscal (taxing and spending) regime = greater fiscal union. This has been tacitly understood since the idea of the Euro first took shape. It will be a long and slow process - too long to happen within the lifetime of this financial system, though its impending demise might quicken the process.
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Veteran
Posts: 214
| There are fundamental differences between US and Euroland. US is much more fiscally integrated, with some taxes and spending being locally (at US State and municipality levels) determined but most determined centrally. Euroland will almost inevitably move towards that model but presently virtually all Euroland fiscal policy is determined locally by its component countries.
Secondly, the US central bank (US Federal Reserve) has much greater established powers to create, borrow and loan money than the Euroland equivalent has (ECB = European Central Bank).
Thirdly, the US$ is the de facto global reserve currency. This allows the US to get away with financial and fiscal policies which would otherwise be severely punished by financial markets.
Euroland's financial problems are, as a consequence, first manifesting at country level. It is likely that major US problems may initially appear at US State level.
For the last couple of years there has been a generous facility in the US to help states through this financial crisis. It ends in spring 2012 and is unlikely to be extended in its present generous form. It has kept otherwise insolvent states solvent. Rather like the Euroland bailouts but has happened much less noisily because the tools for doing it were already in place within the US system.
US states and municipalities partly finance their operations by selling bonds (borrowing money from the financial markets, known as the 'muni-bond market'). Quite a few have behaved rather like Greece. One particular problem is overgenerous state / municipality employee pensions, there are some municipalities whose retired employee pensions and benefits alone will exceed the total municipality revenue within a few years.
The US Federal Reserve has a powerful toolkit for managing financial policy, long established credibility and intimate relationships with the financial system, and the world's reserve currency to play with. Above all, it can print money until the dollar's status is destroyed. They've been using these tools to keep the US banking and financial system, States and municipalities, solvent.
US fiscal policy at State and Federal levels has been to kick the can down the road by promising future spending cuts and tax increases rather than start the pain now. Better to upset the voters after one's left office, after all.
European countries have generally been much more upfront in implementing credible fiscal tightening. This has begun to impact growth and employment in many european countries, as one would expect.
The US has gambled that by not tightening policy it will encourage sufficient growth to solve the problems and reduce the pain of tightening in future. Only the US can play this strategy because it has the world's largest economy and its reserve currency, no other country or economic entity would be allowed to get away with it. If the gamble fails it will take the US economy, dollar, and developed world's financial system down. Rather troubling that US economic growth and employment has responded so weakly thus far.
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Veteran
Posts: 214
| The publically stated way of getting out of this hole is growth combined with austerity measures to get govts' spending back under control. These are two conflicting directions, so the task is to balance policies for austerity and growth so that both occur sufficiently without causing too much damage to the other, the economy, the financial system and the voters.
The unstated way is through inflation. This reduces the real value of money and debts, and greases the rebalancing of different aspects of economies which have, perhaps, got out of kilter - for example, by reducing the real value of social benefits, squeezing public sector spending. But inflation is a blunt instrument, significant collateral damage will occur, and does have a nasty habit of getting out of hand...
Probably the best we can hope for is a protracted period of stagflation punctuated by bursts of growth and contraction as the optimal balance of policies is hopefully felt out. Like the late 1970s /early 1980s.
But, is even that anemic level of growth now plausible? The debt overhang may be too great, globalization may have withered the real productive parts of some developed economies too far. External constraints may intervene. The gulf between where we are now and a future with growth and stability may be too great to cross.
Employment data out in early October substantiates reality. UK unemployment is worst for 17 years - the reduction in public sector jobs is just beginning to bite. US NFP (non-farm payrolls) for September were marginally better than expected at about 100,000 increase but that is somewhat short of the 160,000 needed per month to absorb the US increase in working age population. Some shocking statistics: there are fewer adults employed in the US today than there were 10 years ago despite over 10 million more of employment age in that time and there are 9 million fewer employed than 4 years ago. The employment situation in Ireland, Greece, Spain is worse still.
2011 Growth estimates for most developed countries as late as spring 2011 were in the range 1.5% to 3.5%, in reality the best will struggle to exceed 1% and most will be teetering on contraction. I expect the US and UK economies will be contracting in early 2012; Ireland, Portugal, Greece, Spain are already contracting.
Less growth => more unemployment => less govt revenue and more govt spending => more borrowing => less growth... etc. Not positive for the growth plus austerity solution. If it works at all it will be a long and hard road.
Time to factor in external constraints.
Commodity prices have remained robustly high, since the lows of spring 2009 they have been in a strong, steady and mostly quiet uptrend. If, as I think, there are real limits to our ability to produce resources and food, commodity prices will continue to generally rise in real terms. This acts as a drag on economic growth and may soon be sufficient to end the possibility of growth for the foreseeable future.
Climate change compounds matters. Increasing abnormal weather events cause increased insurance and infrastructure costs. Adverse weather, especially droughts and floods, impact crop production. Changing climate affects crop productivity as the best places to grow crops change and their production needs to migrate, a slow and hard to optimise process.
Agricultural land is shrinking and has been for over a decade, we have already cultivated all the best and our agricultural methods have damaged some of that significantly. We have over-exploited our water resources, especially underground aquifers which are like 'fossil water' and may take thousands of years to replenish. Biofuel production competes with food production. We could be near or past 'peak food' unless we radically change our eating habits and agricultural practices.
Then there is population. And the social unrest likely as things worsen. And the probable unwinding, partial at least, of globalization.
We have a financial system kept alive on little more than blind faith, a serious party habit, and a prayer; facing external headwinds that threaten to tear it apart if it fails to do that for itself first.
You'll know by now that I don't think the 'official solution' has much chance. However, TPTB and this financial system know no other way, they are unable to think outside their present box. But that is a necessary pre-requisite for solving our present problems.
The present box is doomed, get over it and get on with something useful. | |
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Regular
Posts: 63
| Thanks Agric. I enjoyed reading this. I've two questions:
First, what is the global situation regarding loans to fund sovereign debt. Basically, could China bail out Europe and if so, would we all end up eating with chopsticks?
Second, you don't seem to question the 'rightness' of economic growth - just whether it will continue to be possible. What do you think about the the possibility of a steady state economy, as promoted by environmental economists such as Herman Daly and by the Centre for the Advancement of Steady State Economics (CASSE)? | |
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Veteran
Posts: 275
| It's quite difficult to take a rational view of all this stuff. On a number of fronts we seem to be moving into uncharted waters, which means that gut feel (i.e. relying on previous experience) is unreliable, and the complexities of any of the issues, together with their inter-connected nature, makes it virtually impossible to work it all out from scientific principles. (And a lot is going to depend on human behaviour, which itself won't be based on scientific rigour, so over-analysing the situation may be a waste of time anyway.)
There are a few factors which Agric has missed from his piece.
The banks are still taking a lot of criticism, including some from politicians, for cutting back on their lending. But the same politicians are over-seeing the re-capitalisation of the banks, meaning the banks have to hold more liquid funds, and that can only come either from lending less or making bigger profits. You'd have thought, given the poor economic conditions, that making bigger profits would be difficult, but as far as I can make out quantitative easing pretty much guarantees bigger profits for the banks (don't ask me how!). But even so the banks are having to lend a lower proportion of their deposits, so we're going to be stuck with less bank lending for some time. At a personal level, that will mean mortgages will continue to be in short supply.
The other important factor is China and other sovereign funds. These are the countries which have been accumulating wealth rather than increasing their borrowings. The Chinese economy has been growing at around 10% a year whilst we've all been wringing our hands, which seems surprising when their main export markets are in the doldrums. China is one of the main targets as a contributor to the fund needed to resolve the Euro problems. The assumption is that they will lend money at a low interest rate in order to pursue their ambitions to be recognised as a world power - so that will take a bit of pressure off the banks, and gives a real input into the merry-go-round of insolvent banks funding insolvent countries funding...
Some seem to hold out hope that China (and other rapidly developing countries, India and Brazil, for example) will be able to continue to grow its economy as it develops its own middle class as a market to replace the depressed OECD countries. I can't really figure that one out, it sounds like pulling yourself up by the bootstraps, but maybe there's something in it.
Who knows where that leaves us, the whole thing may, in 50 years time, turn out to have been a storm in a teacup, but just now it's looking like a mighty big storm in a puny teacup. | |
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Phase 2: threads