An Open Letter About Austerity, Debt, and Public Policy from Alex Tsipras

As we read this, let us keep in mind that the Banks were mired in bad debts that were created by their fraudulent activities and speculation, and that they were massively bailed out by the people, in the most gentle and accommodating of terms if not outright subsidies.

And now they would prey on those who have saved them, seeking to extend more debts, and harsher terms, not only to Greece but to the poor and middle class of their own countries, in order to make them like slaves to unresolvable burdens, stripped of freedom and assets by a corrupt judiciary and politicians.

Even now, QE is being extended to buy unpayable and overvalued debts from the Banks, to free their balance sheets, and to give them more power to financially oppress the public.

"Most of you, dear Handesblatt readers, will have formed a preconception of what this article is about before you actually read it. I am imploring you not to succumb to such preconceptions. Prejudice was never a good guide, especially during periods when an economic crisis reinforces stereotypes and breeds bigotry, nationalism, even violence.

In 2010, the Greek state ceased to be able to service its debt. Unfortunately, European officials decided to pretend that this problem could be overcome by means of the largest loan in history on condition of fiscal austerity that would, with mathematical precision, shrink the national income from which both new and old loans must be paid. An insolvency problem was thus dealt with as if it were a case of illiquidity.

In other words, Europe adopted the tactics of the least reputable bankers who refuse to acknowledge bad loans, preferring to grant new ones to the insolvent entity so as to pretend that the original loan is performing while extending the bankruptcy into the future. Nothing more than common sense was required to see that the application of the 'extend and pretend' tactic would lead my country to a tragic state. That instead of Greece's stabilization, Europe was creating the circumstances for a self-reinforcing crisis that undermines the foundations of Europe itself.

My party, and I personally, disagreed fiercely with the May 2010 loan agreement not because you, the citizens of Germany, did not give us enough money but because you gave us much, much more than you should have and our government accepted far, far more than it had a right to. Money that would, in any case, neither help the people of Greece (as it was being thrown into the black hole of an unsustainable debt) nor prevent the ballooning of Greek government debt, at great expense to the Greek and German taxpayer.

Indeed, even before a full year had gone by, from 2011 onwards, our predictions were confirmed. The combination of gigantic new loans and stringent government spending cuts that depressed incomes not only failed to rein the debt in but, also, punished the weakest of citizens turning people who had hitherto been living a measured, modest life into paupers and beggars, denying them above all else their dignity. The collapse of incomes pushed thousands of firms into bankruptcy boosting the oligopolistic power of surviving large firms. Thus, prices have been falling but more slowly than wages and salaries, pushing down overall demand for goods and services and crushing nominal incomes while debts continue their inexorable rise. In this setting, the deficit of hope accelerated uncontrollably and, before we knew it, the 'serpent's egg' hatched – the result being neo-Nazis patrolling our neighbourhoods, spreading their message of hatred.

Despite the evident failure of the 'extend and pretend' logic, it is still being implemented to this day. The second Greek 'bailout', enacted in the Spring of 2012, added another huge loan on the weakened shoulders of the Greek taxpayers, "haircut" our social security funds, and financed a ruthless new kleptocracy.

Respected commentators have been referring of recent to Greece's stabilization, even of signs of growth. Alas, 'Greek-covery' is but a mirage which we must put to rest as soon as possible. The recent modest rise of real GDP, to the tune of 0.7%, signals not the end of recession (as has been proclaimed) but, rather, its continuation. Think about it: The same official sources report, for the same quarter, an inflation rate of -1.80%, i.e. deflation. Which means that the 0.7% rise in real GDP was due to a negative growth rate of nominal GDP! In other words, all that happened is that prices declined faster than nominal national income. Not exactly a cause for proclaiming the end of six years of recession!

Allow me to submit to you that this sorry attempt to recruit a new version of 'Greek statistics', in order to declare the ongoing Greek crisis over, is an insult to all Europeans who, at long last, deserve the truth about Greece and about Europe. So, let me be frank: Greece's debt is currently unsustainable and will never be serviced, especially while Greece is being subjected to continuous fiscal waterboarding. The insistence in these dead-end policies, and in the denial of simple arithmetic, costs the German taxpayer dearly while, at once, condemning to a proud European nation to permanent indignity. What is even worse: In this manner, before long the Germans turn against the Greeks, the Greeks against the Germans and, unsurprisingly, the European Ideal suffers catastrophic losses.

Germany, and in particular the hard-working German workers, have nothing to fear from a SYRIZA victory. The opposite holds. Our task is not to confront our partners. It is not to secure larger loans or, equivalently, the right to higher deficits. Our target is, rather, the country's stabilization, balanced budgets and, of course, the end of the grand squeeze of the weaker Greek taxpayers in the context of a loan agreement that is simply unenforceable. We are committed to end 'extend and pretend' logic not against German citizens but with a view to the mutual advantages for all Europeans.

Dear readers, I understand that, behind your 'demand' that our government fulfills all of its 'contractual obligations' hides the fear that, if you let us Greeks some breathing space, we shall return to our bad, old ways. I acknowledge this anxiety. However, let me say that it was not SYRIZA that incubated the cleptocracy which today pretends to strive for 'reforms', as long as these 'reforms' do not affect their ill-gotten privileges. We are ready and willing to introduce major reforms for which we are now seeking a mandate to implement from the Greek electorate, naturally in collaboration with our European partners.

Our task is to bring about a European New Deal within which our people can breathe, create and live in dignity.

A great opportunity for Europe is about to be born in Greece on 25th January. An opportunity Europe can ill afford to miss.

Alex Tsipras, An Open Letter to the People of Germany About That Which You Were Never Told

 

Related: 
Greek PM Freezes Privatisations

Anti-Austerity Party Gathers Support in Spain

The Banking System and Money Creation - A Forecast of Sorts

Money in the modern fiat sense originates from a number of sources.  Among these is the conversion of credit potential into money by the expansion of debt.  For the sake of simplicity I simply refer to this process as 'credit.'

This does not mean that 'credit' is money, not in the least. Credit is a source of money, and amongst the most vital in a highly geared fractional reserve banking system, but is still not money itself.

In our modern world of financial innovation, 'money' is most often created through the leveraged expansion of credit by private banks, and its subsequent employment in supporting real economic activity in the form of savings, consumption, and investment.

Private banks have been licensed the privilege to increase the supply of money through the exercise of fractional reserve credit and receiving insured desposits in return for assuming the responsibility for assessing the risks,  adhering to regulations, conforming to inspections, and taking the full responsibility for any losses by their management, shareholders, and bondholders. Otherwise it would be a very exorbitant privilege, a thinly disguised racket, and a confidence game.

"Gentlemen! I too have been a close observer of the doings of the Bank of the United States. I have had men watching you for a long time, and am convinced that you have used the funds of the Bank to speculate in the breadstuffs of the country.  When you won, you divided the profits amongst you, and when you lost, you charged it to the Bank."

Andew Jackson

While some central bank, either officially or de facto, most often manages the private banking system, providing additional credit where needed, largely through the discount window as lender of last resort, the real economy is able to generate enough money through its own activity to support its natural growth, with allowance made for seasonal fluctuations. Natural growth is rarely linear, but given to advance and consolidation, ebbs and flows.

One measure of this activity is the velocity of money, that is, the amount of real economic activity relative to the existing money supply using some sort of measure.  The measure does not do anything of course, but it is merely a measure of what is happening in the interaction between money creation and real economic activity, rather like a speedometer.

There are a number of 'throttles' which a central bank, and banking management for that matter, can use to manage and regulate the creation of credit and thereby the supply of money. Among these are lending standards, reserve requirements and quality, bank leverage and investment guidelines, and short term interest rates.

I will not go into these individually now, but one can see that this is how the capitalisation and activity of a bank is shaped, either by sound private management or the force of some external regulatory body, ideally in some combination and mutual cooperation.

For whatever reason, be it some exogenous event, human or natural, or the result of a period of mismanagement, the credit creation process may fail and the banks become unable to generate credit sufficient to serve the needs of the real economy. I can give any number of examples of why this might happen.

An appropriate one might be bank insolvency, that is, a sudden deterioration of the assets upon which the bank's credit rating is based, impairing its ability to acquire money to fund its daily operations.  This funding is known as liquidity.   It might be a simple and yet not incorrect to think of solvency as net asset wealth marked to market, and liquidity as cash flow available to meet demands.

In a financial collapse as the result of a financial bubble, an entire banking system might be brought low by some natural disaster or the deterioration of assets based on some chronic mispricing of risk.  This is most likely to be systemically severe if the credit creation process is concentrated in a few big banks, and/or the banking system is highly interconnected by counterparty risk. 

As an aside, and admittedly off the top of my head, I seem to recall that the objection which some economic scholars like Ben Bernanke have had to the gold standard and the Great Depression is that it helped, in their analysis, to transmit and transfer the economic failure in some countries to many countries, in the manner of a contagion.  Thank God they eliminated that problem with their new banking model, right?

Concentration and interdependency are negative influences on portfolio diversification.

At the point of a credit creation failure, the central bank, and most likely the government, must step in to remedy the situation. The most effective approach seems to be the shutting down of the bank or banks, the cleansing of  balance sheets, prosecution for fraud as appropriate, and then the reopening of the banks as well-managed and functioning institutions again, as appropriate and practical.

Hopefully the unsuspecting depositors have been made whole, while serious losses are realized by management, the shareholders, and even the bondholders of the bank, who presumably have a significant interest and effect on how it had been managed.  This satisfies equability and justice.

This resolution of the banks' balance sheets and management is what is called a sine qua non. If this does not happen, then the situation will continue in some crippled manner until it is corrected.  Even in the case of a natural disaster or some completely exogenous event, a general banking failure is the sign of some systemic weakness and concentration in the system.

During a period of bank restructuring, the central bank will most likely be called upon to take a more active role in the supply of credit to the real economy. It does this through its own lending facilities with the banking system though an ability to inject credit by purchasing financial assets from the remaining sound banks. 

This is absolutely the function of the central bank. It has little other reason to exist in the form that it does as a bank, except to stand ready as lender of last resort. If it does not perform this function, it is merely another regulator.

If the damage to the real economy is deep enough, the central government may have to intervene beyond prosecuting fraud, restoring the funds of depositors and the granted of new licenses to restructured banks.

If the central bank's activity to sustain the money creation process is not sufficient because of a spiral of diminishing demand caused by a lack of confidence to spend and invest, it can increase its own spending thereby stimulating activity in the real economy.

This is often controversial because during a sustained economic downturn government finances should turn negative, since their income from taxes on real economic transactions fall off, and perhaps sharply, due to a decline in those transactions.

I know this is a bit of a simplification, but it does essentially represent what happens.

The collapse of the credit system can be called a 'deflationary event.' It is deflationary not so much because it destroys money per se,  but because it reduces the growth rate of money relative to the needs of the real economy, and sometimes significantly.

A money supply is rarely static. It grows as a population and an economy grows and expands, and seasonal demand fluctuates, and can still be called stable.

Try not to think of a money supply in purely nominal terms but in relation to something else, like the real economy. If the economy is growing at five percent per year, the money supply would also be growing at about five percent a year just to maintain its stability and to satisfy demand. 

If the real economy is growing at five percent, and the money supply has no growth, then it will begin to act as a constricting force on the economy unless investments can be obtained from some external source if that is possible.

If it has been growing rather quickly relative to the needs of the real economy for whatever reason, and then suddenly the money supply growth stops without regard to anything real changes, it will have an artificial dampening effect on the real economy, prices, interest rates, and so forth. 

So why are the developed economies in such trouble today?

Because for whatever reason, the central bank and the government have failed to take that most important first step in a sustainable recovery in the aftermath of a credit bubble:  reforming and restructuring the financial system.

It is really that simple.

The imbalance that gripped the banking system, the oversized growth of financialisation through innovations in fraudulent conveyances, is still in place.   The activity has just moved to other segments of the economy to feed a bloated and overpaid financial sector that largely unchanged, except that the names on their business cards may be different and fewer.

What we have now is an oversized financial bureaucracy that continues to suck the life out of the real economy which itself has decreased in size and is less able to carry on gracefully.

In those countries that have taken the necessary steps to cleanse the debt and corruption out of their banking systems and restore a balance that favors real growth rather than financial manipulation and speculation, there has been a recovery. Iceland is one recent example. The US in the 1930's is another very good example.

And almost every one of the protections that the people put in place in the 1930's, based on their sad experience in the financial collapse of the 1920's speculative bubble in fraudulent financial instruments, was struck down.

The approach of 'bailing out the banks' and then shifting the pain of economic adjustment from the bank management, shareholders, and bondholders to the public is not only unjust, it is also ineffective, because it merely perpetuates the problems and distortions that caused the banks to fail in the first place and makes them much worse.

The result of this is most likely to be a prolonged period of significant stagflation, if the country has a sovereign currency sound enough to continue on supporting it.  In Japan this presented itself as a prolonged period of economic stagnation but not private deprivation for some reasons peculiar to the structure of their real economy and the nature of their political system.

So here we are. What happens next will be a policy decision.

Although it is different for Greece, whose currency is controlled by an external, and some might say foreign, authority, for the US the limit of the ability of the Federal Reserve to create money is the amount of outstanding debt that it can buy for its balance sheet. 

When working in conjunction with the Treasury, which is the issuer of the sovereign debt, the effect limit of this money creation is the value of the dollar as a medium of exchange for real goods and services, most importantly to non-dollar economies. 

Therefore it is not simply something in the control of the Fed, but a more organic response from the political class.

On one hand we have a powerful set of monied interests who have been the primary beneficiaries of the distortions in monetary and fiscal policy for the past twenty years or so.  And on the other hand we have the bulk of the real economy and the public, including the somewhat fortunate to the newly destitute.

There is a quiet power struggle taking place behind the scenes today over the policy decisions that have been and will be made in response to the crisis by the political class.  The decision is not naturally for the greatest good, and so therefore the polarization has deepened.

Huge sums are being spent, and much talent and energy expended, to shape and influence and frame the attitude and context of the policy debates, including the outright buying of power and influence in the political process. And even more money is being spent on selling those outcomes to the public, and buying a determined and highly vocal minority.  This is nothing new in history.

The people are confused, and in their confusion often become angry, and even hysterically reactive.  These are periods often rich in demagogues, scapegoating, nativisim, and nationalism. 

So here we are.  Where we go next is substantially up to us.  It is not so much that the system has gone wrong, but that our priorities have changed, leading to distortions in the way the system functions.

"Capitalism does have a lot of strengths, including producing things that are very innovative. But what drives capitalism is the profit motive. You can profit not only by making good things, but also by exploiting people, by exploiting the environment, by doing things that are not so good. The narrative that you describe ignores the extent to which a lot of the inequalities in the United States are not the result of creative activity but of exploitive activity."
Joseph Stiglitz

Significant discussions need to occur, and someone or some group must stand up for the right, the greater good.  There should be no doubt that some groups will quickly stand up for the wrong, the narrowly beneficial and broadly destructive, with passionate intensity.

Europe is a much more difficult situation, because their euro is controlled by a fortunate few who are politically separate from those who are feeling the brunt of the pain in the short term. The entire system as it is now constructed is inherently unstable, and cannot stand the stress.

And the same can be said for the 'success stories' like China and the Asian tigers, whose centrally organized economies are based on an unstable global export growth and artificially structured currency regime.

The first reaction of most people,  besides those who just skip the tutorial about how things work and reflexively chime in with a slogan like 'government is the problem so we must eliminate it' and say 'first' is to understandably ask 'how can I protect myself and my family.' Complete self-sufficiency is not obtainable for most, so one must settle for self-sufficiency as is practical. Preserving one's wealth from a rapacious financial system is key. Providing some practical form of food, shelter and protection for one's family is obvious. How to do that depends on one's means and abilities.

I will caution though, that if things progress as I think they might, there will be no place of complete safety to hide. Obviously some local situations might deteriorate badly, and one would not want to be there. But all things being equal, I would rather be amongst friends and in familiar territory, than a stranger in a strange land.

As Walter Bagehot observed, "Life is a school of probabilities."   There is a difference, and often significantly so, between what is possible and what is probable.  One needs be aware of the possibilities, but plan and act based on the evolving probabilities.  A plan based on extreme outcomes is often an extremely impractical plan. 

We live in interesting times.   Changes are coming at us, and so flexibility is an important component of preparedness.  But the best outcome would be for a return to more normal economic growth and stability, and this is not possible without significant reform.

The Banks must be restrained, and the financial system reformed, with balance restored to the economy, before there can be any sustained growth and recovery.

European Money Aggregates - No Deflation Yet - Policy Responses to Deleveraging

A few asked me about the monetary situation in Europe, one person prefacing it with the statement that 'they are collapsing.'

Well, they are not, at least not yet. And there is nothing that says that they must. But since the person saying this has been desiring this outcome for more than ten years now, I should have known they were not. 

We are now in a global deleveraging after a massive credit bubble was allowed to form, or one could even say promoted, by the Anglo-American banking system.  So it is a tautology to say that there are strong deflationary forces in the economy.  Of course there are, and we know from where they have come, and who profited. 

And the management of this situation is why a central bank exists, for better or for worse.  The long term cure is not to allow them to have created this in the first place.  But that horse is out of the barn, and so one must deal with what they have now, and not what they might have had if they had done differently many years ago.

Ray Dalio has published an interesting historical study of policy responses to deleveraging, and although I obviously do not agree with everything he says I strongly recommend it.  An In Depth Look at Deleveragings.

I keep a general eye on most of the major money systems, but obviously the reserve currency in the Dollar is of keenest interest. My inquiries with the others confirm that in a fiat currency regime, in the absence of external constraints, inflation and deflation are the result of policy decisions.  So one may fairly deduce what their money supplies are doing based on the nature of their national economic policies, allowing for incompetency of course.

The prevailing incompetency, or erreur de politique du jour, is shoveling money into the major banks and financial corporations without engaging in serious systemic reforms, in some vain attempt to trickle down a recovery by saving those made wealthy through fraud and economic distortion, and making their victims pay for it.   Austerity is the policy of the oligarchs.  And the coup de grâce is delivered in supporting a global currency regime that distorts international trade and fosters instability.

Where one does not control their currency, they take the policies which they are given by the central authority, unless there is some political decision made to change the arrangement.

In the case of Europe, there is an odd situation.  It has the currency of a political union, but the policies of a much looser confederation. The Europeans always seem to gravitate towards these unstable hybrids and compromises.  They have a streak of the romantic, perhaps, or it could only be willful self-deception.

These are somewhat independent economies joined under a common currency, but without the sort of transfer payment system that marks a real political union.   The euro is founded on a faulty premise, and therefore on sand, Or on the sandy soil of Berlin, perhaps.

In the States, for example, the monetary policy is set largely by the Northeast, but the tax and spending system transfers wealth to the poorer member states, largely in the South and Southwest. This is the trade off when a region with a somewhat independent local economy surrenders its ability to manage its own monetary policy and the ability to devalue and revalue its currency in trade.

The ECB and the major political powers are choosing a fiscal deflationary course that seems to favor their own powerful national banks and industrial interests.  And yet they are faced with printing enormous amounts of money to smooth over their rescue of their banks and the continuance of their arrangement. 

Those who are sitting on their loot from the bubble dearly wish for deflation, and tight money policies, and austerity for 'the others.'   What better way to acquire even more income producing assets, and power, and to continue to widen the gap between the haves and the have nots. 

While I have a general preference towards a hard money supply and organic restraint, the time to impose this is not after a general looting of the public has occurred by the monied interests.  They promote easy money and profligacy when it suits them, and then cry out in alarm for sound money and austerity AFTER they have the cash.  They swing from one bad policy decision to another.  Their hypocrisy is almost as boundless as the economists, intellectuals, and politicians who serve them.

The most likely outcome is for a breakup of the European Union as it is constituted today, and a continuing union with fewer members. The key is obviously the relationship amongst the big Five. Whether a powerful group attempts to 'unite' the greater Europe under a more comprehensive rule remains to be seen.

Personally I think the former is more desirable, at least within my lifetime. The latter course most likely presumes an eventual bloodbath that will be historic even compared to the century of blood just passed.

Critical Mass: The Mispricing of Derivatives Risk And How the Financial World Ends

Jim Sinclair does a good job of explaining the difference between the notional and real value of derivatives, and how that real value comes to bear on the financial system in the event of a default. You can read this here for a review of the basic concept if you do not understand it.

Within my own view of money, uncollateralized financial instruments like derivatives are credits, or potential money. When an event triggers them so that they become real, with a significant presence on the balance sheet and the income statement, then they become money.

In the financial world we see the extraordinary growth of derivatives in notional value, to almost unbelievable proportions. This mass of derivatives facilitates the withdrawal of money from the real economy in the form of wealth transferal, such as bonuses and commissions for example. But they do not become actual money themselves until some trigger event. To perhaps stretch our analogy to the physical world, it could be described as the withdrawal of the ocean, as money is siphoned from the real economy by the financial world, in advance of the arrival of a tsunami as derivatives start hitting the balance sheets and are transformed into 'real money.'

This could be the cause of a hyperinflationary policy error which I have been alluding to for the past several years.  The policy error is not in the simple setting interest rates, but the Fed's failure to regulate the banking system and manage its risks.   In this the Fed, particularly under Greenspan, was an abysmal failure, and improvement has not been forthcoming.

The explosion of the realization of derivatives would create enormous fortunes and unpayable debts. Depending on how the monetary authorities deal with it, the potential for a Weimer experience is there. Nationalizing the banks and canceling the transactions is one way out. Attempting to sustain these mythical financial structures will take the existing currency system down. That is the limit of the Fed's power.

Most theories and models are tested at the extremes of their limits, and I suggest that the coming financial crisis will wash many of the current economic and monetary models away, scouring the detritus of years of conflicting interests and fanciful adornments down to their foundations.   But the responsible parties will all sit back and say, "We did not know."    But of course they did.  They just did not care, as long as it paid them handsomely.

Taking this discussion of derivatives an important step further, the most significant elements of concern in derivatives are the same as they are in all financial schemes: unsustainable leverage and the mispricing of risk.

In derivatives the unsustainable leverage arises from the fact that the impact or risk magnitude of the derivatives, which are often uncollateralized, are artificially reduced by the assumed effects of 'netting.' And the risk is mispriced, not only in the terms of the agreement itself, but in the failure to properly account for counterparty risk as the instrument plays out in a larger risk portfolio. There is individual contract risk, and then there is the cascading risk of a highly compacted financial system.

We see situations today in which a single bank may have a hundred or more trillion dollars of notional value in derivatives on their books, against much less than a trillion in assets.

But the risk in such a large position is allowed because the banks can show that they have supposedly 'netted out' the risk by making other derivative arrangements that offset their own risk, in the manner of a hedge. As the amounts of derivative netting grows larger and more intertwining, the secondary effects of counterparty risk become tightly compressed.

What if a counterparty fails? Then all its own agreements fail, many of which may be hedges that also fail, and a cascading failure of these financial instruments in a tightly compressed and overleveraged system becomes catastrophic.

In 2002 Warren Buffett famously referred to derivatives as 'financial weapons of mass destruction.' But beyond that headline, few in the media took the time to actually communicate what Buffett was really saying, and the risks that the unregulated derivatives markets posed to the banking system.

The collapse of Lehman Brothers threatened to trigger a financial meltdown. A panicked leadership of the country was able to stop it, but at the cost of many trillions of dollars, and a distortion in the real economy that still goes largely unmeasured. And this was by intent, because the leaders feared a loss of confidence in the system. And so while the meltdown was averted, a credibility trap was created that is the epitome of moral hazard.

The influence and knowledge, call it soft blackmail of mutually assured destruction if you will, that the 'Too Big To Fail' banks obtained in this coverup of the depths of the fraud and mispricing of risk in the financial system has given them enormous power over the political process. It would have been more effective to have nationalized the banks and cut the risk out at the source, but the new president Obama was badly advised to say the least, by advisors he himself appointed, who were in fact long time insiders in the creation of the risk situation itself.

The global financial system is like a nuclear bomb. At its center are at most ten banks whose financial posture is overleveraged and interdependent not only amongst themselves but also with their national economies. It is not a question of 'if' they fail, but 'when,' and what is done about it.

The bailouts become geometrically larger given the size and interwoven complexity of the bets. The only feasible solution is to nationalize the banks, keep the real parts of the economy whole, and restart the system in a more sustainable manner. This is essentially what Franklin Roosevelt did in 1933, and to a more limited extent what J.P. Morgan did with the NY banks in 1907. In both instances they dictated terms and made the banks sign to preserve the system.

In the case of the 2008-9 crisis, Bush-Obama failed to dictate terms, and essentially allowed the banks to do whatever they wished to keep going without reforming the system, taking huge sums of money and paying off their bets while maintaining their bonuses and most of their positions. And this was a monumental political failure indeed, and history will probably not be kind.

When the next crisis occurs, there are still a variety of responses. The monied interests will wish to promote another bailout, with harsh terms being dictated to the public, rather than to the banks. This is what is happening in Greece. The terms will be so draconian and unsustainable that state fascism is the most likely longer term outcome. Germany is struggling with that decision today, in light of  bad results in their last two experiences along those lines. 

I am not hopeful that the leaders of the political world will have the resolve to do what it takes to bring the banks back under control, given the power that big money has obtained over our worldly leaders.


Following are edited excerpts from the Berkshire Hathaway annual report for 2002.

I view derivatives as time bombs, both for the parties that deal in them and the economic system.

Basically these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, or currency values. For example, if you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction, with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration, running sometimes to 20 or more years, and their value is often tied to several variables.

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counter-parties to them.

But before a contract is settled, the counter-parties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands. Reported earnings on derivatives are often wildly overstated. That’s because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

The errors usually reflect the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid, in whole or part, on “earnings” calculated by mark-to-market accounting. But often there is no real market, and “mark-to-model” is utilized. This substitution can bring on large-scale mischief.

As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counter-parties to use fanciful assumptions. The two parties to the contract might well use differing models allowing both to show substantial profits for many years.

In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.

I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.

Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counter-parties. Imagine then that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company.

The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counter-parties tend to build up over time. A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. However under certain circumstances, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z.

In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. (Such as in the case of AIG for example - Jesse) In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain.

Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants.  (This is the Greenspan argument for example, but he and others went further in fighting any sort of regulation in this area. - Jesse)

On a micro level, what they say is often true. I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.

On top of that, these dealers are owed huge amounts by non-dealer counter-parties. Some of these counter-parties, are linked in ways that could cause them to run into a problem because of a single event, such as the implosion of the telecom industry. Linkage, when it suddenly surfaces, can trigger serious systemic problems.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so  far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

As an endnote, it appears that the money in derivatives was too good for even Mr. Warren Buffett to pass up. Berkshire Profit Falls 30% On Insurance, Derivatives.

Netting

Here is a fairly simple financial industry explanation of 'netting.'

"Rather than execute a disastrously complicated web of transactions, swap dealers, and ordinary banks, use clearing houses to do exactly what we just did above, but on a gigantic scale. Obviously, this is done by an algorithm, and not by hand. Banks, and swap dealers, prefer to strip down the number of transactions so that they only part with their cash when absolutely necessary. There are all kinds of things that can go wrong while your money spins around the globe, and banks and swap dealers would prefer, quite reasonably, to minimize those risks.  (Presumably by assuming them away, as in the case of Black-Scholes. Except the assumptions made in netting as compared to the risk handwave in Black-Scholes seem like planet killer class ordnance compared to conventional bunker busters. - Jesse)

An Engine Of Misunderstanding

As you can see from the transactions above, the total amount of outstanding debts is completely meaningless. That complex web of relationships between A, B, and C, reduced to 1 transaction worth $1. Yet, the media would have certainly reported a cataclysmic 2 + 3 + 4 + 5 + 2 + 6 = $22 in total debts.  (But borrowing from Sinclair's description, if a major counterparty in this daisy chain fails, the notional netting can become 'cataclysmic,' and enormous losses can be realized, especially if there are linkages to the commercial credit and banking systems. And this is where 'mark-to-myth' and bailouts come in. - Jesse)

Charles Davi, Netting Demystified

Here is a visual representation of what a Lehman size failure would look like in today's financial markets.

Guest Post: The Perils of Credit Money Systems Managed by Private Corporations

In this instance the 'paper money' system would be analagous to money created by private banks by means of expanding credit. The Second Bank of the United States is the predecessor to the Federal Reserve Bank System which was established in 1913.

"The paper system being founded on public confidence and having of itself no intrinsic value, is liable to great and sudden fluctuations, thereby rendering property insecure and the wages of labor unsteady and uncertain.

The corporations which create the paper money cannot be relied upon to keep the circulating medium uniform in amount. In times of prosperity, when confidence is high, they are tempted by the prospect of gain or by the influence of those who hope to profit by it to extend their issues of paper beyond the bounds of discretion and the reasonable demands of business.

And when these issues have been pushed on from day to day until the public confidence is at length shaken, then a reaction takes place, and they immediately withdraw the credits they have given; suddenly curtail their issues; and produce an unexpected and ruinous contraction of the circulating medium which is felt by the whole community.

The banks, by this means, save themselves, and the mischievous consequences of their imprudence or cupidity are visited upon the public. Nor does the evil stop here. These ebbs and flows in the currency and these indiscreet extensions of credit naturally engender a spirit of speculation injurious to the habits and character of the people. We have already seen its effects in the wild spirit of speculation in the public lands and various kinds of stock which, within the last year or two, seized upon such a multitude of our citizens and threatened to pervade all classes of society and to withdraw their attention from the sober pursuits of honest industry. It is not by encouraging this spirit that we shall best preserve public virtue and promote the true interests of our country.

But if your currency continues as exclusively paper as it now is, it will foster this eager desire to amass wealth without labor; it will multiply the number of dependents on bank accommodations and bank favors; the temptation to obtain money at any sacrifice will become stronger and stronger, and inevitably lead to corruption which will find its way into your public councils and destroy, at no distant day, the purity of your government. Some of the evils which arise from this system of paper press, with peculiar hardship, upon the class of society least able to bear it...

Recent events have proved that the paper money system of this country may be used as an engine to undermine your free institutions; and that those who desire to engross all power in the hands of the few and to govern by corruption or force are aware of its power and prepared to employ it. Your banks now furnish your only circulating medium, and money is plenty or scarce according to the quantity of notes issued by them. While they have capitals not greatly disproportioned to each other, they are competitors in business, and no one of them can exercise dominion over the rest. And although, in the present state of the currency, these banks may and do operate injuriously upon the habits of business, the pecuniary concerns, and the moral tone of society, yet, from their number and dispersed situation, they cannot combine for the purpose of political influence; and whatever may be the dispositions of some of them their power of mischief must necessarily be confined to a narrow space and felt only in their immediate neighborhoods.

But when the charter of the Bank of the United States was obtained from Congress, it perfected the schemes of the paper system and gave its advocates the position they have struggled to obtain from the commencement of the federal government down to the present hour. The immense capital and peculiar privileges bestowed upon it enabled it to exercise despotic sway over the other banks in every part of the country. From its superior strength it could seriously injure, if not destroy, the business of any one of them which might incur its resentment; and it openly claimed for itself the power of regulating the currency throughout the United States. In other words, it asserted (and it undoubtedly possessed) the power to make money plenty or scarce, at its pleasure, at any time, and in any quarter of the Union, by controlling the issues of other banks and permitting an expansion or compelling a general contraction of the circulating medium according to its own will.

The other banking institutions were sensible of its strength, and they soon generally became its obedient instruments, ready at all times to execute its mandates; and with the banks necessarily went, also, that numerous class of persons in our commercial cities who depend altogether on bank credits for their solvency and means of business; and who are, therefore, obliged for their own safety to propitiate the favor of the money power by distinguished zeal and devotion in its service.

The result of the ill-advised legislation which established this great monopoly was to concentrate the whole money power of the Union, with its boundless means of corruption and its numerous dependents, under the direction and command of one acknowledged head; thus organizing this particular interest as one body and securing to it unity and concert of action throughout the United States and enabling it to bring forward, upon any occasion, its entire and undivided strength to support or defeat any measure of the government. In the hands of this formidable power, thus perfectly organized, was also placed unlimited dominion over the amount of the circulating medium, giving it the power to regulate the value of property and the fruits of labor in every quarter of the Union and to bestow prosperity or bring ruin upon any city or section of the country as might best comport with its own interest or policy.

We are not left to conjecture how the moneyed power, thus organized and with such a weapon in its hands, would be likely to use it. The distress and alarm which pervaded and agitated the whole country when the Bank of the United States waged war upon the people in order to compel them to submit to its demands cannot yet be forgotten. The ruthless and unsparing temper with which whole cities and communities were oppressed, individuals impoverished and ruined, and a scene of cheerful prosperity suddenly changed into one of gloom and despondency ought to be indelibly impressed on the memory of the people of the United States.

If such was its power in a time of peace, what would it not have been in a season of war with an enemy at your doors? No nation but the freemen of the United States could have come out victorious from such a contest; yet, if you had not conquered, the government would have passed from the hands of the many to the hands of the few; and this organized money power, from its secret conclave, would have directed the choice of your highest officers and compelled you to make peace or war as best suited their own wishes. The forms of your government might, for a time, have remained; but its living spirit would have departed from it.

The distress and sufferings inflicted on the people by the Bank are some of the fruits of that system of policy which is continually striving to enlarge the authority of the federal government beyond the limits fixed by the Constitution. The powers enumerated in that instrument do not confer on Congress the right to establish such a corporation as the Bank of the United States; and the evil consequences which followed may warn us of the danger of departing from the true rule of construction and of permitting temporary circumstances or the hope of better promoting the public welfare to influence, in any degree, our decisions upon the extent of the authority of the general government. Let us abide by the Constitution as it is written or amend it in the constitutional mode if it is found defective.

The severe lessons of experience will, I doubt not, be sufficient to prevent Congress from again chartering such a monopoly, even if the Constitution did not present an insuperable objection to it. But you must remember, my fellow citizens, that eternal vigilance by the people is the price of liberty; and that you must pay the price if you wish to secure the blessing. It behooves you, therefore, to be watchful in your states as well as in the federal government.

The power which the moneyed interest can exercise, when concentrated under a single head, and with our present system of currency, was sufficiently demonstrated in the struggle made by the Bank of the United States. Defeated in the general government, the same class of intriguers and politicians will now resort to the states and endeavor to obtain there the same organization which they failed to perpetuate in the Union; and with specious and deceitful plans of public advantages and state interests and state pride they will endeavor to establish, in the different states, one moneyed institution with overgrown capital and exclusive privileges sufficient to enable it to control the operations of the other banks.

Such an institution will be pregnant with the same evils produced by the Bank of the United States, although its sphere of action is more confined; and in the state in which it is chartered the money power will be able to embody its whole strength and to move together with undivided force to accomplish any object it may wish to attain. You have already had abundant evidence of its power to inflict injury upon the agricultural, mechanical, and laboring classes of society, and over whose engagements in trade or speculation render them dependent on bank facilities, the dominion of the state monopoly will be absolute, and their obedience unlimited. With such a bank and a paper currency, the money power would, in a few years, govern the state and control its measures; and if a sufficient number of states can be induced to create such establishments, the time will soon come when it will again take the field against the United States and succeed in perfecting and perpetuating its organization by a charter from Congress.

It is one of the serious evils of our present system of banking that it enables one class of society, and that by no means a numerous one, by its control over the currency to act injuriously upon the interests of all the others and to exercise more than its just proportion of influence in political affairs. The agricultural, the mechanical, and the laboring classes have little or no share in the direction of the great moneyed corporations; and from their habits and the nature of their pursuits, they are incapable of forming extensive combinations to act together with united force. Such concert of action may sometimes be produced in a single city or in a small district of country by means of personal communications with each other; but they have no regular or active correspondence with those who are engaged in similar pursuits in distant places. They have but little patronage to give the press and exercise but a small share of influence over it; they have no crowd of dependents about them who hope to grow rich without labor by their countenance and favor and who are, therefore, always ready to exercise their wishes.

The planter, the farmer, the mechanic, and the laborer all know that their success depends upon their own industry and economy and that they must not expect to become suddenly rich by the fruits of their toil. Yet these classes of society form the great body of the people of the United States; they are the bone and sinew of the country; men who love liberty and desire nothing but equal rights and equal laws and who, moreover, hold the great mass of our national wealth, although it is distributed in moderate amounts among the millions of freemen who possess it. But, with overwhelming numbers and wealth on their side, they are in constant danger of losing their fair influence in the government, and with difficulty maintain their just rights against the incessant efforts daily made to encroach upon them.

The mischief springs from the power which the moneyed interest derives from a paper currency which they are able to control; from the multitude of corporations with exclusive privileges which they have succeeded in obtaining in the different states and which are employed altogether for their benefit; and unless you become more watchful in your states and check this spirit of monopoly and thirst for exclusive privileges, you will, in the end, find that the most important powers of government have been given or bartered away, and the control over your dearest interests has passed into the hands of these corporations.

The paper money system and its natural associates, monopoly and exclusive privileges, have already struck their roots deep in the soil; and it will require all your efforts to check its further growth and to eradicate the evil. The men who profit by the abuses and desire to perpetuate them will continue to besiege the halls of legislation in the general government as well as in the states and will seek, by every artifice, to mislead and deceive the public servants. It is to yourselves that you must look for safety and the means of guarding and perpetuating your free institutions. In your hands is rightfully placed the sovereignty of the country and to you everyone placed in authority is ultimately responsible. It is always in your power to see that the wishes of the people are carried into faithful execution, and their will, when once made known, must sooner or later be obeyed. And while the people remain, as I trust they ever will, uncorrupted and incorruptible and continue watchful and jealous of their rights, the government is safe, and the cause of freedom will continue to triumph over all its enemies.

But it will require steady and persevering exertions on your part to rid yourselves of the iniquities and mischiefs of the paper system and to check the spirit of monopoly and other abuses which have sprung up with it and of which it is the main support. So many interests are united to resist all reform on this subject that you must not hope the conflict will be a short one nor success easy. My humble efforts have not been spared during my administration of the government to restore the constitutional currency of gold and silver; and something, I trust, has been done toward the accomplishment of this most desirable object. But enough yet remains to require all your energy and perseverance. The power, however, is in your hands, and the remedy must and will be applied if you determine upon it."

Andrew Jackson, Farewell Address, March 4, 1837

Why Is the Fed Creating Excess Reserves in the Banking System and Paying Interest on Them?

There have been some interesting side discussions at various venues including Naked Capitalism about the recent essay which I had posted titled When At First You Don't Succeed, Bring in the Reserves.

Let me clarify some points.

Yes, banking reserves in the US are a function of the Fed's Balance Sheet, by definition, because they are in the narrowest sense merely an accounting function, an entry on the books of the Fed reflecting actions undertaken by the Fed.

With purpose, I put the formal definitions of Reserve Bank Credit and Reserve Balances at the bottom of each chart. I had hoped this would make that point clear.

The essence of the essay was to point out the enormous increase in bank reserves which the Fed has created through their "New Deal for Wall Street" style banking programs. Because of this, the Fed has created a new function by which it pays interest on banking reserves, which to my knowledge it has never done before.

It is a new function at the Fed, and it does serve a important purpose. The purpose is to place a 'floor' under interest rates, in the face of a surfeit of liquidity which the Fed has created, and which shows up in the Adjusted Monetary Base, the Reserve Bank Credit figures, and so forth.

Now, some people have taken issue with my bringing the notion of excess Reserves to your attention for a variety of reasons. Even the mighty NY Fed has written a paper which attempts to defuse the notion that the excess reserves are indicative of anything that might be impeding lending.

Let me be clear about this.

The excess reserves are absolutely indicative of the Fed's having added substantial amounts of liquidity to the financial system. If the Fed were not paying interest on reserves, this liquidity would crush their target interest rates, since the banks are loath to hold reserves that are not generating some return. This is what they do, generate a return on capital. Capital has a price, even if it is an opportunity cost.

By establishing a floor, the Fed is setting a more blatant artificial level for interest rates, moreso than merely tinkering with drains and adds to the system. They are offering a riskless rate of return, and crowding out other competing requests for capital. Not necessarily a bad thing, but a reality of what they are doing.

What would happen if the Fed raised the interest rate it pays on reserves to let's say, twenty percent?

Economic activity in the US would grind to a halt, as banks placed every available dollar idly with the Fed's program, eschewing all other deals, liquidating assets if necessary, to place capital where it would receive the highest risk adjusted return. In essence, the Fed would 'crowd out' all other transactions that offered a lower risk adjusted return.

What if the Fed subsequently lowered the interest rate from twenty percent to zero? It would then enable more lending from the banks, as they sought to deploy their capital at higher risk adjusted rates.

There are some by the way that claim the excess reserves are so high because there is no demand for loans. This is a point of view only supported by those who a) have no understanding of finance and b) are seeking to support an extremely odd and mistaken view of the economy which seeks to justify their bets on a serious deflation.

There is always a demand for loans as long as there is economic activity; what varies is the price! Money is not particularly inelastic; that is, there is a rather high threshold at which people say, "I have too much!" It is rather a question of price, relative to return. Make the opportunity cost high enough and they will come (or be fired).

I hereby assert that I will borrow ALL funds the Fed might loan to me with no collateral at zero interest, and gladly so, as long as the short term US Treasury bills are paying more than 25 basis points interest. I reserve the right to defer on this offer if the Fed should make the policy error of hyperinflation a reality.

I hate to make points like this in the extreme with distorted examples, but sometimes it is what it requires to pierce through obfuscation to common sense.

So to summarize, what is the Fed likely to do if economic activity falters?

They are likely to lower interest rates paid on excess reserves closer to zero. They could even charge a 'haircut' on excess reserves which would highly motivate the banks.

These are all things which have been discussed before, often in the context of consumers! In fact, it is well known among bankers that as the Fed lowers interest rates money flows out of lower paying instruments like bank deposits and money markets, and into higher paying instruments that might be deemed too risky at high rates of riskless return. Such higher paying instruments are known as "stocks" and "corporate bonds." As former central banker Wayne Angell gleefully chortled in 2004, the Fed can indeed drive the public out of their savings and money market funds and into the equity markets by manipulating interest rates.

Does the Fed always 'create' excess reserves? It may be more correct to ask, does the Fed always create money, since excess reserves are an accounting function.

No. Banking reserves normally lag the creation of money, which is accomplished by lending, either from banks or more recently by neo-banks like Fannie, Freddie, GMAC, GE and so forth.

But at a time when economic activity is contracting, and the credit markets were seizing, the Fed took the lead in money creation by "monetizing" various types of debt. And they are going to enormous pains to maintain 'confidence' in the system and in particular the US dollar and debt. But we may ask, at what point does the confidence game become a con game? I would submit that it is when the Fed and Treasury purposely intervene in markets, beyond their normal interest rate targeting, and statistics and spread disinformation to manage perception.

There are other ways in which the Fed might address the failure of the productive economy to 'pick up the ball and run with it.' But most, if not all, of them involve the monetization of something, which is what happens when the Fed (and US Treasury) are taking the lead in money creation and not the productive economy.

Deflationists do not want to hear this, and central bankers do not wish you to know this, but it is the major factor in a fiat currency that it can be created literally 'out of nothing.'

This is why we have said long ago, and repeated since, that the limiting factor on the Fed's ability to create money is the value of the US Dollar and the sovereign debt.

As long as there is debt which can be monetized, then the Fed can monetize it and create money 'out of nothing.' For now they are acting with some reestraint, and channeling that money primarily to their cronies in the banking system, still able to mask the effects of their monetary inflation. CFTC Moves to Rein In Small Investors From Commodity ETFs

But the time is coming when they will not. And as they did when they demanded $700 billion in bailout money, the financiers will once again make the Administration and the Congress an offer which they think that 'we' cannot refuse, if only because the Congress will not listen if we tell them what we wish them to do, again.

The banks must be restrained, and the financial system reformed, and the economy brought back into productive balance, before their can be a sustained recovery.