i apologize for the inconvenience. we will be up and running again in a couple days.

Never mind JP Morgan, one is tempted to think while reading John Mauldin’s latest letter. After all JPMs balance sheet looks pristine in comparison, it will certainly not be among the first to fall. European banks are in front of this queue!

John lays out the size of the problem Europe and its banks are facing. I can recommend John’s newsletter highly. I have been following John for a very long time, since his beginnings as an economic commentator. By now he is a superstar in investment circles, not least because he had always warned from what was to come. His long-time “muddle through” forecast has been a very accurate estimation. It could all have been so much worse… but it is hardly over!

John has as balanced a view that I know in the world of economics. He reads and distils tons of information and gives you the thoughts of some of the best minds around. So, if you don’t follow him, check it out (ps, i don’t get any commission).

Happy Week!
Stephan

Waving the White Flag

By John Mauldin, May 12, 2012

Article

A common mistake that people make when trying to design something completely foolproof is to underestimate the ingenuity of complete fools.
- Douglas Adams, The Hitchhiker’s Guide to the Galaxy

For quite some time in this letter I have been making the case that for the eurozone to survive, the European Central Bank would have to print more money than any of us can now imagine. That the sentiment among European leaders was that they were prepared for such a move was clear – except for Germany, which is haunted by fears of a return to the days of the Weimar Republic and hyperinflation.

When Germany agreed to a fixed monetary union and a European Central Bank, it was with the clear understanding that it would be run along the lines of the German central bank, the Bundesbank. The members of the Bundesbank and the German members of the ECB were most outspoken about the need for a conservative monetary policy that would keep a clamp on inflation.

Read on: http://www.johnmauldin.com/frontlinethoughts/waving-the-white-flag

“It just shows they can’t manage risk — and if JPMorgan can’t, no one can,”

Simon Johnson, former chief economist for the International Monetary Fund.

What happened?

In essence, a trader at JPMorgan, Iksil a.k.a. the London Whale, was caught out on a limb with a huge bet he made. The details of the bet and how it relates to the bank’s balance sheet are unclear but not essential. Iksil built a large stake in investment-grade corporate bonds that had been discussed for weeks in the markets due to its size.

Iksil essentially sold insurance, CDS (Credit Default Swaps) on an investment grade corporate bond index (CDX IG9) with the interesting feature that it is being recalculated every 6 months to fit the definition of investment grade.

In the current environment, the bet might make a lot of sense. But it grew so large, an exposure over USD 100 billion that it skewed prices for the CDS on this index up to 20 basis points (0.2%), enough for rival traders to set up positions against Iksil. Eventually, the size of his position started to work against him. On a 100 billion position a market move of 2 percent is USD 2 billion. When Iksil was down USD 2 billion, management pulled the plug.

If you are interested in a lot more detail, check this out..
http://www.marketplace.org/topics/business/easy-street/jp-morgans-loss-explainer

What does it mean ?

Is Iksil the “Tip of the ice-berg” or just a blip, normal static in a global financial circus?

If Simon Johnson is right, he is the Tip of the iceberg!    Is he right?

Yes he is but… the famous but, bankers will find it easy to talk it down, explain it away.
For one, the loss may be large but not in relation to the firm’s size. Management (I am assuming they knew) took a calculated bet and stopped it out fairly early. JP Morgan has total assets of roughly USD 2.3 trillion and a capital base of USD 175 billion, 7.5% of assets and one of the best capitalized banks. JPMs capital covers the loss 60 times and the company’s annual profit in 2011 was USD 20 billion.  So, the numbers are big, but JP Morgan is bigger.

This is just what our banks are doing today. Don’t worry! DON’T WORRY?

This was the tip of the iceberg, an iceberg that we will become to see when the water levels drop.

There are thousands of these trades on and off the books of banks and finance companies just like JPM, amounting to an exposure that has been estimated at between 600 and 1000 trillion, thousands of times larger than the trade at hand. For comparison, global GDP is at around USD 60 trillion.

At the core of this are banks that have become far too large and far too leveraged. In the case of JPMorgan, a total of USD 800 billion (more than a third of JPMs book and more than JPMs core commercial banking book) of trading assets and securities are directly exposed to markets.  A mere 20% correction would wipe out JPMs entire capital.

This is the main reason that everything is being done to keep asset prices up with liquidity injections and subsidies to the banks who hold these assets.

Bankers have yet to explain how they justify the greater leverage they run?

…while also exposing themselves to riskier assets?

…with decision makers that are asymmetrically incentivized to take large risks?

…which they neither understand nor own themselves?

It used to be that these kind of trades were made by bankers who were partners in a business they owned. They owned their decisions, they owned the capital and the consequences, both good and bad.

Today the risk is not anymore owned by the decision maker, who generally only owns and takes out the upside. As far as managing risk in banks is concerned, they are managing mostly their own risks, not that of their customers or clients. So perhaps we would like to hear from Mr. Dimon, the same who also sits on the board of the New York Fed.

Whose risk are you managing? And how?

I am doubling down with Dr. Jim, who delivers another of his useful insights.  Europe is in a pickle and Austerity is the new expression that is meant to lead to lower debts via reduced spending and higher taxes. But austerity threatens to choke an already weak economy and perhaps make matters even worse by creating a viciously contracting feedback loops. Dr. Jim has an important angle, will politicians catch on?

Austerity and growth – Mutual reinforcement

The UK’s double-dip recession proves that ‘austerity’ doesn’t work. Spain’s unemployment rate has hit 24.4%, further proof that ‘austerity’ doesn’t work. All across Europe, as governments fall at an increasingly rapid clip, the debate is now turning to ‘too much austerity, not enough growth’. But let’s hold on just one minute and challenge the increasingly accepted wisdom (as Robert Wenzel so bravely did at the New York Fed last week) that ‘austerity’ and ‘growth’ are somehow mutually exclusive economic conditions. In the current debate austerity is all about cutting back on fiscal deficits. And, as we know from the data, in places like France, Italy, Spain etc, government spending accounts for around 50% of GDP so when it retrenches the measured GDP numbers tend to go down. Especially if the private sector – the minority element in GDP in many of these countries – is not in rude health. The argument goes that, since the private sector shows no signs of offsetting the reduced fiscal spending, all that fiscal austerity will end up doing is reducing ‘growth’ and thus inducing recession. After all, the evidence is all around us, isn’t it? Well, no.

The first thing to realise is that governments do not add to growth, full stop. Growth is all about production – of goods and services – and what makes that production occur. Government spending is all about consumption, which cannot take place before the goods and services are produced, and an arbitrary redistribution of income to the sectors that government favours or wants to take care of (we are not arguing that this transfer should cease, all we are saying is that is what it is). Government takes money from the productive segments of the economy and transfers it to, for the most part, unproductive segments. It is when that burden of transfer, either in the form of current taxation or interest and principal payments on its borrowing (future taxation), becomes large that the productive sector begins to shut down. In the Austrian scheme of things the most important growth driver in the economy is clear: profits. Without the profit motive there is no incentive for private business to become established, produce and grow. And if there is no private business formation there is no wage generation, no employment growth and no income source to use to demand goods and services. In order for the economy to grow, not just in Europe but everywhere, it should be government’s prime focus to create an environment where profit can be maximised and encouraged. Lower taxes, fewer regulations, reduced bureaucratic costs, more flexible labour markets, decreased subsidies and correct price signals (including market-determined rather than central bank-determined interest and exchange rates) all enhance that environment. Austerity that focuses on reducing these costs, which includes reducing the disincentives to work that unemployment and other transfer benefits encourage, will be a growth enhancer, not reducer. The problem with Europe is that it is simply the wrong type of austerity eg, tax hikes on the rich, that is being imposed because that is the easy, populist option. And as for the calls to reverse the austerity? Productive, private sector growth would be undoubtedly the biggest victim of that approach

“Let’s have one good meal here. Let’s make it a feast. Then I ask you, I plead with you, I beg you all, walk out of here with me, never to come back. It’s the moral and ethical thing to do. Nothing good goes on in this place. Let’s lock the doors and leave the building to the spiders, moths and four-legged rats.”

What better day than Labour Day to deliver a rebellious speech?

Courtesy of good friend Dr. Jim Walker.

“Robert Wenzel, editor and publisher of the Economic Policy Journal, recently delivered a stunning speech at the New York Fed. Contemporary political, economic, and financial discourse has been corrupted over the years of serial asset bubbles by all kinds of candy coated half-truths and outright distortions. Plain speaking is long overdue, and no surprise that often comes from the mouths of Austrian School economists – but usually not from so far behind enemy lines. Below we reprint only the most potent passages, including closing recommendations that cut right to the chase. This was truly an act of courage, and maybe even a few people in the room got the message.”

Robert Wenzel,

“I simply do not understand most of the thinking that goes on here at the Fed and I do not understand how this thinking can go on when in my view it smacks up against reality.

“In the science of physics, we know that ice freezes at 32 degrees. We can predict with immense accuracy exactly how far a rocket ship will travel filled with 500 gallons of fuel. There is preciseness because there are constants, which do not change and upon which equations can be constructed.

“There are no such constants in the field of economics since the science of economics deals with human action, which can change at any time. If potato prices remain the same for 10 weeks, it does not mean they will be the same the following day. I defy anyone in this room to provide me with a constant in the field of economics that has the same unchanging constancy that exists in the fields of physics or chemistry.

“And yet, in paper after paper here at the Federal Reserve, I see equations built as though constants do exist…(People) create equations based on this belief an then attempt to trade on these equations…the result was the blow up of the fund Long Term Capital Management, a blow up that resulted in high level meetings in this very building.

“Austrian Business cycle theorists are regularly ignored by the Fed, yet they have the best records with regard to spotting overall downturns, and further they specifically recognized the developing housing bubble.

“The noose is tightening on your organization, vast amounts of money printing are now required to keep your manipulated economy afloat. It will ultimately result in huge price inflation, or, if you stop printing, another massive economic crash will occur. There is no other way out.

“I beg you all, walk out of here with me, never to come back. It’s the moral and ethical thing to do. Nothing good goes on in this place. Let’s lock the doors and leave the building to the spiders, moths, and four-legged rats.”

The full text of Robert’s Austrian School cri de coeur at the New York Fed may be found in the following link – may we suggest you consider reading it, then re-reading it, then distributing it widely and then disseminating it to your clients too:

http://www.economicpolicyjournal.com/2012/04/my-speech-delivered-at-new-york-federal.html

In the US, the healthcare bill has passed and general attention is shifting back to the economy and financial industry regulation. As in healthcare, the stakes are high, for both the general public and the financial industry. As in health-care business interests are fighting hard for every inch and as in healthcare they are defending the indefensible.

Only, the subject matter seems much more complex for outsiders and politicians. The public’s lack of knowledge on finance is being brutally abused to engender fear and control the outcome. Even if more and more politicians seem to resist the power of the lobbyists, we are all stunned by the President’s insistence that the old guard determines the agenda (Paul Volcker aside).

Often we hear that this old guard, including the bankers we bailed out are the only ones who understand the issues. Are we really that gullible? There are enough financial professionals outside banking who understand the issues, almost certainly a whole lot better than the overstretched  leaders of our  “too big to fail” banks.  What’s more is that they should have great interest in speaking their mind in opposition of universal banks that have crowded them out during the boom and made a mockery of market mechanisms, literally destroyed it.

The necessity of serious structural changes in the financial industry is blatantly obvious, it seems, to everyone I speak to, even the bankers among them. Yet, there is a sense that the focus in the debate continues to be biased towards hedge funds and a so-called shadow banking system. Fact is that it was our large “Blue Chip” commercial banks, each larger than the global hedge fund industry combined, who spiraled themselves and our system out of control. The global top 20 of them doubled their balance sheets from 2004 to 2007 to $40 trillion, close to global GDP. Even if painful for those involved, the $50 billion Madoff scheme seems trivial.  

How did the banks do it? Simply put, they started to use their triple A rated commercial banking balance sheet (which is generally a very low risk business) to underwrite more adventurous business units. Their triple A ratings allowed them to raise funds at the lowest possible rate and invest in every kind of arbitrage opportunity, anywhere. Little surprise, their expansions were breathtaking and as a “lucky” byproduct risk premiums in their models collapsed in “virtuos” reflexivity with their self-created and increasing leverage.

No independent business or hedge fund would be able to beat these banks’ muscle and capital costs. Banks took over leadership across finance and in the process crowded out a diverse and multifaceted financial industry. The crowding out and loosing market share may have not hurt so badly since the cake was grown so fast and so large, even a much smaller slice of it felt very gratifying.

However, universal banking and its success has eroded the market’s raison d’etre, the efficient allocation of risk and capital. How did our global commercial banks, now universal banks cum Super HedgeFunds convince us that they knew how to integrate and effectively manage a myriad of businesses and risk structures across finance? They never had to convince anyone, not a regulator or a client, they just did it and increasing profitability was their proof of ability.  

Now, they have walked us into a financial crisis and based on the facts their businesses and their risk models have failed. To call this crisis a black swan event is good marketing but disingenuous. This was not a surprise nor an outlier nor an accident. According to many esteemed observers it was inevitable. Banks used a stable and low risk business to leverage themselves into unknown territory with doubtable tools and insufficient understanding. It is clear and had been discussed along the way that risks exploded, quite the opposite what banks’ models portrayed.

We can observe from the debate about compensation packages, our universal banks had huge trouble aligning interests and risks of decision-makers.   Their size and diversity of functions are an important factor but, I would like to suggest that false application of risk models made it impossible.  By now almost everyone in the financial world has come to understand and simplify the complex world of risk with one simple concept: price volatility and relative price volatility. Price volatility is a more or less workable proxy for risk for short term risk evaluation.  Banks however ignored longer-term risks, implicitly assuming that every long-term investment will become a short-term investment at some point.

Price volatility as a concept and its formulaic application are one-dimensional and make it easy to dissociate oneself from the real economic risks present in any investment. Add to this the fact that decision-makers mostly did not own nor were they directly tied to the capital underwriting these risks. Further take into account that price volatility is negatively correlated with liquidity and credit expansion. While increasing leverage obviously increased risks, applied risk measures collapsed having everyone believe risks were well managed.

Equally it was impossible for banks to use and structure derivative instruments properly. However, instead of focusing reform on the inadequate institutional structures the regulatory discussion remains on the instruments themselves. Throughout history financial crises always produce the instruments deemed most damaging, in hindsight. However, their particular characteristic matters not. Once the market is granted latitude to expand liquidity too fast and by too much the legal contract to package the deals to make it happen will always be found.  Let us be fooled into punishing the tools that have improved our lives and possibilities in many ways. We neglected transparency and oversight and expanded too fast; the exact instrument used is hardly the culprit.

If we have the goal to maintain systemic stability and avoid future financial crisis, it seems much easier and more effective to avoid excessive expansion of money and/or concentration of risks than to curtail and control financial innovation. As such the FED has to be ultimately responsible for not reigning in the extraordinary credit expansion, as this is its main purpose. The FED’s structure, focus of responsibility and transparency need addressing. 

Let me summarize: commercial banks took over inherently entrepreneurial niches in finance with their large scale bureaucracies and propagated and built a consensus towards a risk model that over time degraded the market’s ability to recognize and neutralize risks in small and digestible doses. Risk and capital became to be concentrated in the least capable institutions and the market failed. Ironically, Banks’ reliance on the assumption that markets are efficient directly caused market efficiency to break down.

Maybe Mr. Krugman is right in that we don’t have to break up our universal banks, maybe a sensible regulatory framework will do the trick all by itself and disintegrate these “too big to fail” businesses. But, in order to achieve any form of satisfactory reform, the perspective of the discussion needs to change. As long as the old guard, the largest and most powerful bankers along with the Fed, determine the agenda, there is little hope of restoring an efficient and sustainable market mechanism.

The issues are complex and of global nature.  It is time to get the non-banking financial industry leaders involved at the highest level. Today they have an opportunity to level the playing field, restore the integrity of their industry and help make ‘too big to fail” a thing of the past.

Good Corporate Governance demands that our large universal banks be broken up!

Over the years we have come to accept corporate scandals as normal fare in our capitalistic system. Still, when they are uncovered, these cases are nowadays generally dealt with little tolerance.

In the ultimate conclusion the ongoing financial crisis was caused by a monumental failure of governance. The discussion on re-regulation is thus a case of implementing a sensible system of governance. So, how are we doing? Are we on the right track? If not, why?

We know all about the breakdown of checks and balances in property lending, the rating agencies with perverse incentives and lack of independence or insurance companies who crossed over into capital markets without capital and/or know-how.

Certainly, some sensible changes seem under way, yet we continue to pull a blind eye on the largest and most harmful failures of corporate governance: the Federal Reserve and Commercial Banking.

The Federal Reserve is the institution at the top of our global financial system that has not only failed to govern the system but is itself a case of bad governance. Yet, it is not even questioned, instead it is being hailed as the savior from the crisis and an expansion of its role is being discussed.

Commercial banks on the other hand are fighting Paul Volcker and a growing number of elder bankers such as John Reed ex Citi, Nicholas Brady ex Dillon Read and head of Treasury under Reagan or John Bogle ex Vanguard who are pushing aggressively for a new version of Glass Steagall.

The bankers’ main counter to a break-up is the threat of a depression.  I cannot support this argument. How could restoring rules in place before the crisis was built be any worse than what we have now?  But it is true that there has to be a basic global arrangement. Finance more than any other industry is enormously fungible and globally mobile. Any country’s solitary action would simply lead to migration. Thus, on top of all the local hurdles, we need to come together and agree on a minimum standard for corporate governance within our global system.

When Glass Steagall was abolished in 1999, commercial banks expanded into everything that promised to lift profitability, from proprietary trading and investment to investment banking, investment advice, asset management, insurance and financial engineering. At that time European banks were already happily at it. However, instead of the world following the US with a good idea, the US followed the world with a profitable idea.

If politicians were sold on a model of dispersing or diversifying risks, in actuality risk became more concentrated. The financial system is not like the car industry, it is more like the transportation industry. Imagine a company were to build trains, planes, cars, boats and bicycles. The difficulties of integrating a full range of financial businesses and risks into one balance sheet have been fully exposed by this crisis.

It is not money or the financial system per se that creates innovation, growth and an improvement in the quality of our lives. Finance is merely the means to an end, the tool to create the optimum condition for valuable production or services. If, as is the case today, the lubricant, the catalyst within a system accounts for 40% of a system’s value, something has gone horribly wrong. The numbers are staggering and they point squarely at the banks, the global top 20 of which managed a combined balance sheet of more than $40 trillion in 2007 with their core businesses shrunk to often less than 20%. Bernie Maddoff may be an attractive Media target but his $50 billion fraud looks rather unsubstantial.

Bankers made the argument that spreading their wings into different areas of finance would help them diversify their business risks, i.e. reduce the volatility of their cash flows. The assumption is correct but it does not result in proper risk management, often quite the opposite. The supposedly reduced risks, indicated by a reduction in cash-flow and market-price volatility justified banks to expand businesses and leverage further in a reflexive cycle fed by derivative structures and the Federal Reserve. The ultimate result of this madness is that the stability of the system has come to rely on the ability to expand liquidity instead of sound structures that rest on sensible governance structures.

One of the most clear-cut distinctions between business models and risk structures in finance can be made between businesses dealing primarily with deterministic services and those that deal with an array of (often uncollateralized) uncertainties and time-frames that are not deterministic by definition.

Commercial banking concerns itself with largely deterministic, low risk finance. Banks take deposits, offer transaction and payment services and lend money attached to low-risk collateral. Commercial banking is very local and relationship based. The process is simple, involved, yet factory-like, with pretty much one contract matching the next, administered and overseen by a well-run back office in a secure and organized process. With all the ancillary functions—trade finance, foreign exchange, capital market access, payment services—a large national or global bank is a layered and multifaceted bureaucratic organization. Technology and experience have matured commercial banking into a commoditized, fairly low margin business whose risk is defined principally by overall economic stability and the leverage it is allowed to take on.

As such commercial banks are not set up to analyze or take non-collateralized risks, i.e. to manage funds and advise on investment. The management of non-collateralized risks and longer time-frames is generally very specialized, independent and most successful in entrepreneurial set-ups.

Fortunately, commercial banking is quite easily definable and detachable from the rest, in particular as there doesn’t have to be a strong line of separation. I see no reason not to allow commercial banks to engage in trading, investment banking, insurance or any other financial services that a client of theirs might require, as long as they remain marginal and account for less than 20% of the business, compared to often up to 80% today.

There is no alternative to ultimately breaking up these behemoths and contrary to what bankers have us believe, it is not difficult and not nearly as dangerous as the course we are pursuing now. It is not primarily a matter of technicalities, or global economic Armageddon, it is a matter of political will… to be continued

At the State of the Union, last week the President again delivered an inspiring speech. Certainly, one feels compelled to follow the lead. His number one priority in 2010 is to revive the economy and to create jobs. Yet, as convincing as the President lays out his plan, it smacks of Sisyphus and contrary to his opening remarks avoids the tough but necessary choices.

Looking back one year, the President’s assessment is that an economic crisis of the scale of a (Great) Depression, was avoided. However, irrespective of stock-market prices and the few positive signs of economic revival he can point to, the fact remains that the US economy remains flat on its back. Worse, the fundamental causes of this developing crisis remain firmly in place. The architects of the “successful” rescue plan are showered with praise for providing the financial system with the equivalent of a huge adrenalin shot, which achieved no more than to stop the decline and send the liquid asset markets into a frenzy. One year on we are looking at the highest stock market valuation in a century of data (Dow Jones and S&P, based on four quarter trailing earnings). Wall Street said thank you with record bonuses and Time Magazine celebrated with the man of the year, Ben Bernanke.

Despite the “good news”, the President concedes, much has to be done. He lays out his plan in some detail, mentioning small businesses, tax breaks and credits, lending programs, infrastructure programs, clean energy investments and importantly, investment in education.  Most sensible observers – outside the silly right wing supply side clique – agree with the President on the necessity of these programs. Although, the devil will be in the details and there is more than just a whiff of government activism. The President’s plans are not simply an attempt to create jobs but are in my view essential to rebuild the country’s basic infrastructure that has been wholly neglected during the past decades. Despite dim-witted proclamations of still too many political leaders blindly misquoting Thatcherism or Reaganomics, there is a role to be played by government (besides waging war) such as the provision of basic infrastructure, basic education, fundamental research or a sensible regulatory frameworks. The notion that industries should regulate themselves is unjustifiable, self-serving non-sense.

As the President further points out, his measures have been (and will be) insufficient to make up for all the jobs lost and in bringing back the economy to a sustainable growth path. As many ideas that spring from his creative mind, disappointingly, the President’s carefully avoids addressing the country’s historic level of debt that has to be digested and reduced. He dares not mention the realities of this inevitability, its deflationary and destructive reality for asset prices as well as economic growth. The US alone has accumulated a debt close to 4 times its GDP, mostly carried by its financial institutions and its consumers. Put that into relation to 1.6 times GDP prior the Great Depression. And, as I have been pointing out time and again, this enormous liability was built on the backdrop of investment and risk management tools that have corrupted any semblance to efficient markets during the past couple of decades (you will find a more detailed analysis of this in the book) and have divorced finance from the real economy.  It is truly a monumental mess. Our leaders dare not mention it.

Any sensible strategy to heal our economy has to focus on the financial industry and its key agent, the Fed and how to reduce the exorbitant levels of debt they have accumulated. Yet, the subject was a paltry side-note in the President’s speech. Now, that might have been a political decision. Admittedly, more recently, the President has spoken with a new-found toughness in dealing with special interest groups and Wallstreet in particular, demanding a “fee” of more than 100 billion from the large banks as well as regulatory changes. A modern version of Glass-Steagall seems to be in discussion, finally! and Paul Volcker is given a stronger voice (he hits the nail on the head in the New York Times http://www.nytimes.com/2010/01/31/opinion/31volcker.html?).  Yet, shockingly, there is hardly any mention of the Fed and the fundamental reform that is needed to restore some semblance of sensible monetary management. In fact, Fed Chairman Bernanke has just been reappointed, which endorses the policies that have led us into this mess and assume that they have saved us from a further bigger mess. However, if that leaves us hopeful for any reform at all in our financial system, it will be half-hearted at best and while politics justifies half-heartedness as pragmatism, in this particular case, half-heartedness will most definitely make matters worse.

On the one hand, not splitting up our universal banks (into good banks and bad banks) means that the entire financial system that is visibly and predictably retrenching in deflationary mode will be forced into even greater cut-backs. On the other hand, the practices and risk models applied on Wallstreet will continue to distort our financial system’s processes, reinforce its detachment from the real economy and propagate the excesses of the past. All the while, the Fed will be allowed to continue to conduct its monetary policy of the most foolish sort, steering us straight into the abyss.

With absolute certainty the US (and much of the rest of the world) finds itself in the early stages of a deflationary de-leveraging process. There is no point in fooling ourselves, this will be painful for Wallstreet and Mainstreet. However, fighting inevitability with frantic activity, makes this much more painful for the real economy than is necessary. The President tells us about his conviction that he is absolutely sure to have done the right thing, the necessary thing even though it was “as popular as a root-canal” to everyone involved. Henry Paulson, one of the architects of these policies and former Chairman of Goldman Sachs admits today that they had “no idea what they had to do”. Listening to Larry Summers, giving interviews in Davos gives no indication that he knows any more, a year and a half on.

And so the big plan they came up was to save a number of large commercial banks, which had really become oversized hedge-funds. Although they had no idea what to do, they came to the conclusion they needed to “save” a few global financial superstores to save the world. But it was not the necessary thing to do, nor the right thing to do, it was the easy thing to do: there is no way back, hence full steam ahead, continuing in the tracks of the same policies that have arguably caused the crisis in the first place.

The necessary and courageous strategy fundamental to saving the financial system would have been and continues to be splitting off the commercial banking books from the mostly toxic and leveraged “asset plays”. This means removing the essential commercial banking businesses from the crushing weight of their often many times larger and more “profitable” hedge fund businesses. If we indeed want the economy to start creating jobs, it will not be without the help of a healthy commercial banking system. Saving the monstrous hedge funds that we have allowed to build achieves the opposite, as it inevitably paralyses lending further.  When we fight deflation, we have to fight the deflation of our commercial banking system and the subsequent deflation of our (still healthy) businesses and shield them as much as possible from the necessary and unavoidable deflation of the towers of debt we have built, mostly on non-cash flow generating bets. Most of these “too big to fail” bets are about as far removed from the real economy as we can imagine. We haven’t saved the system, we pumped air into it, jobless fluff.

Allowing our banks, i.e their hedge-fund books to be exposed to the market mechanism would certainly bring down asset prices in a hurry and would likely result in a bit of a shock to the system. Let us remember though, asset prices are a price tag of the economy, they don’t determine or create value, they price it. Who wants to argue the real economy would stop in its track and we would all go home and retire because assets are re-priced? Indeed, a continuance of current liquidity pumping and fiscal bail-outs is sure to paralyze the financial system, and over time deflate our (still) healthy businesses; then we can go home and retire.

Sisyphus is busy plugging the holes punched into the system over the past decades, frantically distributing “sand-bags” and “duct tape”. He is a well-meaning and hard-working fellow but we cannot close our eyes to the root problems of this crisis. Current policy lacks a clear strategy, it is an accumulation of tactical measures that is likely to create less jobs than are being destroyed by the lack of decisiveness and spine in dealing with the financial system. Job creation leads through the financial system!

Happy New Year!!!
Baron of Munchhausen {PDF}

And yet again this blogger was side-tracked by the intensity of starting up businesses. I sure hope to be able to write more in 2010. Although somewhat belated, I don’t want to miss wishing you and your loved ones great health, abundant wealth and happiness in the New Year ahead.

During this reflective season the words of a wise friend of mine came to mind, “our dreams and aspirations are the blueprints to our lives”, a good thought to start my year.

As much as I believe in the basic truth of these words, there are some things that remain (for now) impossible for us humans, like teleporting or turning lead into gold.

As we begin a new year, markets, media, pundits and officials are united in celebration of a crisis behind us. The Economist calls it the “Great Stabilisation”. Mainstreet, small businesses and the growing rank of unemployed are asked to be patient, after all employment is never the first statistic to turn around. Demand will eventually return, somehow, as it always has, irrespective of the fact that in recent years it was driven entirely by an unsustainable credit expansion.

And there it is, the word “unsustainable”. Ben Bernanke along with the ruling interests disagrees, believing it is all a matter of liquidity and confidence, as they have “proven” for decades now. If everyone just believes that there are no limits to credit, it will make it true.

Consensus economic and stock-market expectations are far too optimistic. They limit their expectations to past “crisis” that were all “solved” by injecting liquidity into the system. The difference today is that this liquidity doesn’t flow through to the real system anymore. It stops at the banks and reverses flow into the central bank. The only life-blood that reaches Main street comes in the form of silly consumption driven programs such as “Cash for Clunckers”. TARP money spent on investment is almost negligible.

While the economy has become too risky for the financial gatekeepers, Ben Bernanke rides to the rescue in making financial  “investment” (once more) a sure bet, even at zero interest rates.

It created the dollar carry: “investors” (banks, in one form or another) are taking credit at zero interest in a currency (the dollar) that is driven down by the FED’s degrading balance sheet and fiscal debt expansion as it trades its pristine assets with the rubbish the market has accumulated during the heydays of the subprime mania. In essence, any hedge fund trading the rebound is paid to leverage itself up with what is effectively a net negative interest rate. As Bernanke promised in his infamous “Helicopter Speech” the game doesn’t stop at zero interest rate…. at least not as long as it holds.

Markets are up, risk indicators down, bonuses large, economy? Not as bad as it used to be, conclusion: crisis averted, hail Time Magazine’s man of the year Ben Bernanke.

Given the enormous interventions and consumption promoting activities in the US (and elsewhere), I find the scale of the “rebound” is rather disappointing.

Retail sales are still a good 10% below last year’s, durable goods orders in the US have hardly recovered, down 23% from last year, construction spending is down 13 percent and still sliding, housing starts are at minus 30% and flat-lining.

Whether signs of recovery are large, small or in-existing, Credit, the main driving force behind the demand that defined almost a decade of economic growth is contracting and will continue to do so. Consumer credit is contracting the fastest, delinquencies have exploded to 9% and credit card limits are cut almost across the board. The only party that is expanding credit is the government. The FHA (Federal Homeloan Agency) is underwriting mortgages as if there is no tomorrow with down-payments of as little as 3.5% while 25% of their loans given out just 2 years ago are delinquent. Maxine Waters, California Congresswoman, rightly points out “Let’s be clear. Without FHA there would be no mortgage market today.”

Unfortunately, as inflationary as the government’s intention much of its actions are deflationary by definition as total money (money plus credit) in the system as a whole continues to contract.

Re-regulating the financial system, no matter how benign, is deflationary. Although I do applaud the increasing popularity of bringing Glass-Steagall back, any form of it will be deflationary.

Far from signaling the end of the recession, the story of the financial markets in 2009 brings to mind the great Baron of Munchhausen, who, in one of his famous fantasies pulls himself and his horse out of a swamp by his own hair.

Liquidity propelled stock-markets are supposed to pull the economy out of its deleveraging mode with the gracious help of the FED and yet another carry trade.

Whatever the economic benefit or efficiency of this new credit, according to the Fed chief, fresh leverage is supposed to fix the economy. A formula that has been working for a long, long time but unfortunately, not unlike drug addiction, the system screams for every larger dosis  with ever increasing leverage needed to create the same effect.  In the 1960ies a dollar of debt taken on resulted in more than 60 cents of real economic growth. In the past 10 years one dollar of new debt meant no more than 14 cents of real growth. Shall we guess the efficiency of the current government driven debt expansion? Our debt is already 3 times the size it was before the Great Depression. What has gotten into us?

At the center of this financial madness are the large universal banks that have even increased their size and dominance since the crisis started not by lending but by swallowing smaller, less important institutions. And our financial superstores are largely left to continue as they were, managing huge balance sheets with the same silly risk models that are to a large extent responsible for this crisis.

And as to our monetary leadership, it seems ironic that a band of modern day Keynesians with their utter disregard for a coherent theory of capital and risk has been left in charge of a financial system that has become all about capital and risk.

Existing risk models had been discredited long before the crisis and have yet to be addressed by any of the new financial regulations announced.  Not in any of Mr. Bernanke’s analysis of the Great Depression have I found reference to the effects of leverage, the size and quality of debt as a major factor in both economic and monetary management. Why is everybody assuming investment during the past 30 years on the wings of modern financial theories was so immensely efficient? In many professional experts’ view quite the opposite is actuality.

It is no secret that liquidity stabilizes markets. That is its inherent quality, no magic!  However, we should not confuse market stabilization with a reduction of risk. Unless we are experiencing an historic break, the productive underbelly of our economy is driven by investments and cash flows and not fictitious asset valuations conjured up with ever-increasing leverage.  Unless Baron Munchhausen’s tale has a happy ending stockmarkets will eventually reverse south, possibly quite viciously.

Quite often I am being asked where to put money when everything is so gloomy. Indeed it is a bit tricky, gone are the days of buy and hold and everything is going up. The way down will be a bumpy ride. As a stock-picker I have always relied on company specific investments and cared less about the general environment. And that is what I am doing, but say you have excess funds, in the long-run, I would buy a lot of gold, physical Gold. Although, short term, I believe we will see a sizeable correction in Gold during the next 6 months as financial deleveraging accelerates. In a deleveraging environment generally liquid markets move highly correlated. I see that monetary push that pulled the carry trade is exhausted. The Fed will stop the mortgage train in March. What happens to the carry trade and markets when the long expected relief rally in the dollar takes off is clear. All asset markets correct, US treasury bills will be the safe haven >> ergo buy US 10 year T bills. No stocks, no fringe securitized paper, no commodities.

During the course of this probably quite long bear market (low in 2012/2013 as a guess), one will have to be nimble and reassess the risks on an ongoing basis. It could get wild.

Next to all this gloominess, I can see many reasons to be optimistic for our future. One of them is technological change that is visibly accelerating and is transforming our lives in many positive ways. When I find time next to write, I will share some of my thoughts on the bright future I see ahead.

Until then, keep safe and enjoy the moment. HsO

Energy an Overview PDF

In 2007, world consumption in energy was equivalent to 90 billions of barrels of oil or expressed in electrical output, about 55,000 terawatt hours (1 terawatt is 1000 gigawatts, 1 gigawatt is 1000 megawatts, 1 megawatt is 1000 kilowatts). This is the equivalent of the yearly output of 30,000 normal-sized power plants (600 MW).

80% of world energy is created by fossil fuels: 32% by oil, 21% by gas, and 26% by coal. Hydroelectric and nuclear energy contribute a bit more than 5% each and the burning of biomass (mainly firewood) about 9% (0.46% of which biofuels), leaving 1.9% (2008 figure) from renewable energies such as solar, wind, marine and geothermal sources.

Roughly one-third of the 90 billion barrels of oil equivalent in primary energy consumption is in electricity, of which two thirds is generated by burning fossil fuels. Coal accounts for 42% of world electricity production. Nuclear energy and hydro energy account for roughly 15% each. Biomass accounts for 1.1% and renewable energy sources for 1.3% of world electricity production.

These numbers show that despite the efforts of many major governments since Kyoto 1997, the contribution of renewable energy sources to our energy supply is still negligible.

Many point to a lack of commitment, coordination and political will as the reason for this paltry progress. In energy, as much as elsewhere, decisions are habitually driven by vested interests, frequently based on incomplete or “tailored” information and all too often not in the best interest of the propagated goals.

However, the reasons why so-called renewable energy sources will hardly make a serious dent into carbon emissions for at least another 30 years are not political; there are large technological and economic hurdles.

Any assumptions of us slowing down our total consumption can safely be discarded. The energy needs of an awakening emerging world are a force much stronger than any potential reduction of emissions attempted by all energy saving programs combined. China alone is building 50 to 60 Gigawatts electricity generating power a year, 70% of it with coal. This is the entire production of a large country such as the United Kingdom.

At the same time, all renewable resources have important drawbacks. Hydro and geothermal are not expandable to significant degree.

Solar is technologically not ready and has enormous negative capital and energy balances, i.e. solar still consumes enormous resources to create. The expansion of polysilicon, its main supply has large lead-times, technological hurdles and high capital intensity.

Wind is commercially viable onshore, but the costs and landmass involved to make this a serious alternative are enormous. Additionally, wind – like solar and other renewables – cannot be used as a base-load provider. They suffer from intermittency, and therefore cannot guarantee a stable supply.

If, and admittedly that is quite a big if, the predictions and assumptions of Al Gore turn out to be true, the only real way to deal with carbon emissions is to focus on cleaning up fossil fuel energy, primarily Coal. There are solutions, they are not cheap, but they are ready, tested and in operation.

In addition, coalbed methane may be developed into a sizeable gas provider. The use of gas substituting for coal or oil reduces emissions significantly.

With respect to renewable energy, it looks as if wind-power could become significant fairly quickly (within 20 years) and deliver up to 5% of global primary energy as an auxiliary source. It is, however, important to note that the cost of creating this capacity would in current dollars and technology amount to approximately $500 billion.

Rik And Uncertainty (PDF)

Paul McCulley of Pimco very eloquently describes the mechanics (and contradictions) of the ongoing government orchestrated asset bubble from the Bond market’s perspective.

He also muses about the future of finance, declaring the efficient market hypothesis all but dead and describes the dawn of behavioral finance. Bond guys continue to be, so it seems, much more attuned to the risks we run in our system.

One big unanswered question remains: how do we best frame our financial system to most efficiently handle risk and uncertainty to optimize the stability of our capitalistic financial system?

Correctly, finally, the efficient market theory seems to become recognized as the poison it is. Toxic it is especially in the hands of universal financial superstores who, with the help of this dubious theory have crowded out an atomistic and entrepreneurial institutional landscape. Much of finance needs to be much nimbler, quick footed and the incentive of ownership to handle the all-important but somewhat elusive influence of uncertainty. Of course adequate and independent regulative oversight is important but that is an issue for another time.

Equally, and as repeatedly impressed upon us throughout history, the ability to “handle” uncertainty is strongly correlated with leverage. The higher the leverage, the more volatility and destructive reflexive potential is allowed to grow in the system. This is quite the opposite of what is being portrayed by the risk models inherent the efficient market theory. As Paul McCulley explains, this seeming paradox can be observed live in today’s bond and equity markets. Additional liquidity reduces volatility and the perception of risk in the system. Risk can be handled by government to behave as it likes it to (at least for a while and sometimes for a long while).

On this count both the Fed and our large commercial banks (and not so much the non-bank financials who are in governments’ cross-hairs) are responsible for building up unprecedented leverage in the system. Thereby they increased risks, those real and more long-term risks, and directly reduced the ability of the financial system to deal with the system’s inherent uncertainty.

Now, in 2009, governments around the world (led by the Fed) have decided that there is only one way out of it: push on, accelerate, “guns” blazing, i.e. pumping liquidity (leverage) even if it means putting the entire financial system and governments’ financial position at risk. Even when it means that the systemic maltreatment of risk is allowed to continue; even when it means to contradict the steady advice of history. The path taken is not to re-establish markets’ proper functioning but to broaden its unholy suspension.

Unfortunately, this irresponsible policy is not simply a domestic US problem. Global monetary policy is under the leadership of the Fed and a certain Ben Bernanke. Despite grave doubts and resistance, in particular from mainland Europe, there is not much they can do in the current system where the dollar is the reserve currency and most everyone has built a US export dependency. Willingly or not, they all are compelled to follow Big Ben’s lead, a man whose academic rigor and credentials as a central banker are more than just questionable. (Fred Sheehan, Marc Faber on Ben Bernanke. I am not sure whether this global liquidity experiment will be to the advantage of the more timid participants such as Europe; they may end up with the short end of the stick.

One thing is sure; we are not dealing with the origins and root causes of this crisis. Instead we are moving farther and farther away from being able to handle the risks and uncertainties in our system.

Buckle up!

Copenhagen 2009 PDF

In December 2009 Copenhagen will host the Climate Change Conference in what is hoped by many to be the single most important environmental event since Kyoto back in 1997.

Media and politics is dominated by a great deal of half-truths and erroneous beliefs about our global energy economy and its impact on our environment. Above all, the impact on our much revered GDP growth is generally being exaggerated. This is particularly apparent when held against the fall-out created by the irresponsible handling of other issues and industries such as the current hot beds, finance and health. A well-informed, well-coordinated plan to clean up our planet and invest in future energy generation has the potential to create millions of jobs globally and to substantially improve our quality of life.

Whether or not global warming is caused by carbon emissions, the fact is we are polluting our planet. Today’s global energy policies are ill coordinated and mostly ill conceived. An economic analysis of the energy industry—reveals some shocking shortfalls and surprising conclusions. In a series of short articles I will try to provide a basic background to facilitate a more informed discussion on the subject.

Although certain alternative energies hold great hopes for the future, most are unlikely to become a valid alternative to fossil fuels for the foreseeable future. As a group, excluding hydropower, they account for no more than 1.3% of current energy production, and it is unlikely they’ll reach the 5% mark by 2030. An acceleration beyond that point should not be ruled out, but a number of technological and economic constraints are inherent in all currently available alternative energies.

The alternative economy can under no feasible circumstances make a serious dent into fossil-fuel energy production in the next 30 years, nor can nuclear or hydro power. They will remain an alternative for a long, long time, for reasons as various as physical availability, supply channel complexities, technological constraints, intermittency, high capital costs, and high inherent energy intensity.

If we are truly serious about cleaning up our planet decisively and immediately, the only feasible short-term solution I can see is to reduce the polluting qualities of fossil fuels, coal in particular. The cleaning of coal (carbon capture and storage, or CCS) as well as an accelerated extraction of coal-bed methane have a potentially much larger impact on carbon emissions than any renewable energy resource (including wind) over the next few decades.

Coal accounts for one quarter of total global energy consumption and over 40% of electricity production. It is our largest polluter and, according to Westhall Capital, emits 30% more pollutants than oil and almost double the pollutants of gas. Roughly, coal is responsible for 40% of global emissions of carbons and other pollutants. Any realistic and serious attempt to engineer a significant reduction in carbon emissions in the next 30 years will have to include carbon capture and storage (CCS).

Total installed coal capacity on the planet equals approximately 2,500 GW (gigawatts). According to the most recent calculations, retrofitting half of all coal plants on earth, approximately 1250 GW capacity, would cost us somewhere between $1 trillion to $1.5 trillion, plus an additional yearly expenditure of $100 billion to fit each new plant. Within 10 years the world could reduce carbon emissions by 20% for a total cost of about 3% of global GDP and in future build clean coal plants for an annual (additional) cost of no more than 0.2% of global GDP. Both CCS as well as coal-bed methane have reached technological maturity. Coal-bed methane has the added benefit of shifting our energy balance away from oil and away from our most unstable sources of supply. The U.S. holds an estimated 29% of global coal reserves; Russia, China, India, Australia, and South Africa together account for 50%.

For all our great achievements, we have yet to summon the political will to admit and react to the fact that we are abusing the resources of our planet because the market doesn’t force us to pay for some of them. We refuse to reverse a historic tax break for fear of slowing down our GDP growth. So far the scale of political commitment to reduce polluting emissions of energy production has been extremely small: CYKE, an independent research outfit, estimates alternative energy subsidies amount to between $50billion and $100billionn per annum globally (0.1% – 0.2% of global GDP); the market for carbon trading is worth about $120billionn per annum; and carbon taxes, with a few exceptions such as France, don’t really exist yet.

Is it not time to finally and in earnest start to internalize the external costs of our energy production? It will cost the GDP economy, but it will benefit the GQP (gross quality product) economy.

In all of it, it is crucial for the USA to understand that the world needs it to reclaim its leadership role in energy. Who else but the largest, richest, strongest, and most-polluting economy can stand up and change the game, and then elevate it to the next level? A committed participation is likely to bring in other important polluters such as China and India. Energy policy must finally receive the top priority it deserves.

Strategically, we must come together as a global community and step beyond the special interests that dominate local politics. We must better coordinate our investment in the future energy economy and agree on a system (cap and trade and/or taxes) that puts a price on the resources we are squandering today.

Tactically, to reduce carbon emissions in the short-run the only realistic choice we have is to clean coal.

Mother of all Asset Bubbles (PDF)

On November 1, Nouriel Roubini published a must read article in the Financial times titled “The Mother of all Carry Trades”.

He describes excellently what is going on in the markets and how another globally synchronized asset bubble is created by the reckless policies of the US Fed. Roubini Mother of all Carry Trades PDF, Link.

In short, Mr. Roubini explains how the financial markets have figured out a way to orchestrate an asset boom that is even more divorced from the real economy than the prior bubbles. The Fed has held interest rates near zero since Dec 2008 and has stated on Nov 4, 2009 that it will only consider raising rates if it sees a pick-up in “inflation” (which to Fed is the core CPI) or “resource utilization” (presumably employment). It also pursues quantitative easing via asset purchases that expanded its balance sheet from $800 billion in 2008 to now $2’000 billion.

In essence the Fed has created a situation where one can borrow at hugely negative interest rates (zero nominal rates coupled with a dollar depreciation) in the comfort of contracting risk premia (contracting “risks” are a happy byproduct of liquidity pushes in the world of modern finance, irrespective of and detached from real risks). The Fed is thus successfully stemming a deflation of assets with a supercharged version of its policies that created the credit mountain and asset bubble pre 2007.

Many will think to themselves that this is folly, wrong, even reckless, on so many fronts but what is the alternative? All alternatives are painful. It is very naïve, even irresponsible to assume that current policies wont be painful merely because our leaders’ horizon doesn’t extend beyond their next election cycle.

The Fed, Wallstreet and political authorities continue to hope that eventually their liquidity pushing will result in renewed economic growth. But what evidence is there that their policies are working or have ever worked?

Since 1999, in the greatest expansion of credit in human history, total credit in the US economy alone more than doubled in size from $25 trillion to now more than $55 trillion. This is close to 4 times US GDP and in relative terms 2.5 times more than prior the Great Depression.

This huge expansion in liquidity was not recognized as hyper-inflationary, as the choice of measure for inflation was and continues to be the core CPI, which for the time being continues to be only marginally affected by the liquidity generated. It was primarily asset markets such as stocks and properties that expanded at breakneck speed, despite visible deterioration of economic strength.

In the credit mania up to 2007 the American consumer still participated, somewhat. But he is done, no more expansion for him. Although his real income had hardly expanded throughout the past decades, rising property and stock prices allowed him to expand his demand by increasing debt and push consumption relative to GDP to a record 73% (USA). That compares with global averages in the low 60ies.  However, as we can guess, the great leveraged boom was almost completely void of real economic substance.

In the period from 1999 to 2007, to create one dollar of real economic growth, more than seven dollars of credit was needed. Compare that to approximately 1.5 dollars of credit needed for every dollar of real growth generated back in the 1960ies.

John Mauldin shows that without mortgage equity withdrawals, the average annual growth in the US economy from 1999 to 2007 would have averaged a measly 0.5%.

Today, two years into the crisis, the Fed and politician are still trying to convince themselves that if they only push more and more credit, no matter in what form or shape, the economy will revive eventually. After 10 years of reckless monetary expansion, they simply up the ante, creating conditions for the mother of all asset bubbles without regard to history and foolishly convince themselves to know how to land this supernova of credit softly in the arms of the next economic expansion.

Is there any doubt that the US consumer has to reduce spending and leverage in the coming years and adjust his demand to levels in line with real income pattern? This will be doubled down by huge demographic effects that are starting to kick in just about now.

Is there any doubt about the real economic impact of these inevitabilities?

The American economy has been weakening to near exhaustion with ever larger liquidity infusions necessary to keep it alive. Last quarter’s positive real GDP growth of 3.5% is not the sign of recovery that is happily cheered on by a Fed and a market hell-bent to ignore the quite obvious internal weakness of this figure which is driven by an inventory cycle and silly fiscal schemes such as the “cash for clunkers” program which merely borrowed a little more consumption from the future.

Crucially, however, personal expenditures and income figures remain weak, as is employment. Investment continues to decrease as is lending, accelerating its contraction from 3.9% yoy in September to 6.8% in October. Who would expect rising  investments when capacity utilization is at record low levels? Equally weak were the internals of an overall positive, but largely meaningless ISM report.

Banks, commercial banks that is, are tuned into the economic realities and they have been forced to adjust their assessment of risks and outlooks for cash flow generation. History teaches us that they will only start to lend again when they can see the cash flows well on track to recovery. As the consumer has to scale back there is no reason to expect these cash flows to come even close to the levels of the height of the boom.

But if lending is not possible or profitable in the real economy banks, that is their “hedge fund” like divisions simple leverage themselves up in a hugely profitable carry trade and pay themselves handsome bonuses, completely ignorant (or defiant) of the risks they accumulate yet again. After all, they can safely assume that in the next crisis we, the government will be there to pick up the pieces yet again.

It is very clear where Ben Bernanke, the head and brains behind this operation is leading the US and the world economy. For him, debt doesn’t matter, even if it is deployed completely divorced from any economic reality whatsoever. As long as asset prices measured in dollars are keeping up all is well for him and those who derive their income from turning those assets for a fee.

Mark Faber, one of those countless marginalized professionals who have been right every step of the way puts it as follows, “Personally, I think the future will be a total disaster….massive government debt defaults, and the impoverishment of large segments of Western society. But what I don’t know is whether this final collapse, which is inevitable, will occur tomorrow, or in five or ten years, and whether it will occur with the Dow at 100,000 and gold at US$50,000 per ounce or even confiscated, or with the Dow at 3000 and gold at US$ 1000.”

Reforming Banks II, United Kingdom

UK authorities have announced that they will break up two of its banks, the ones it now controls, Royal Bank of Scotland (RBS) and Lloyds. Back in 2006, RBS was the world’s largest bank as measured by the size of its balance sheet, which then amounted to $3’700 billion. RBS was also by far the fastest growing large bank in the years up to the crisis. No wonder it is in trouble, again. RBS and Lloyds are to be supplied with a total of $88 billion in capital, almost $50 billion from government funds.

Rightfully, the government should start to influence how these banks are run. However, the direction this influence takes doesn’t follow sound logic but advice from these banks’ competitors and supposedly pressures from the European Union competition authorities.

According to the Financial Times, RBS is held to sell its insurance businesses (Direct Line, Churchill and Green Flag), its small business operations in England and Wales, and its Global Merchant Acquiring business and Sempra, a commodities trading business. Lloyds will be forced to sell some of its retail banking operations and its Intelligent Finance online business.

Most everyone agrees that our financial superstores will have to be reduced with the goal to eliminate the hazard of businesses that are too big to fail. It is however preposterous to sell this effort with arguments of competitive policies which are nowhere near the center of our issues we have with banking today. Simplistically reducing bank’s size doesn’t change the fact that these banks run business lines for which they lack competence and institutional structures. The issue is not that that we have had commercial banks dominating a particular area or of commercial banking or too much concentration in any area of finance.

The issue is that our largest financial businesses try to run every kind of banking and financial service there is and are, not surprisingly, in over their heads.
Of course and without any delay, compatriot Joe Ackerman, CEO of Deutsche bank and supposed spokesman for our financial superstores has taken a stand against the “totally misguided” downsizing, calling it “unacceptable”.

He is right in one thing, the problem of too big to fail will not be solved by asking a bank with a $3’700 billion balance sheet to sell some branches and fringe businesses in which competitive authorities find “too much” concentration. It will still resemble an over-sized hedge fund, itself larger than the global hedge fund industry combined. RBS will remain intertwined and interconnected in the globally fungible world of finance. It will still run businesses for which it is utterly unqualified. And it will continue to do so with risk management tools that are sophisticated only to a non-mathematician and wholly inadequate, to put it very mildly.

Even though Mr. Ackerman is right, UK authorities are “totally misguided” in their action, his outrage only counters the advice given by his colluding peers across the aisle in a farcical charade that diverts attention from the real solutions, which would arguably be much more drastic for Mr. Ackerman and his peers.

I for one do not want to hear from Mr. Ackerman again until he explains how he manages his bank and its risks and tells us how his sophisticated models have failed him and his peers so miserably. I want him to explain the more than controversial concept of Value at Risk (VAR) to the public and why he believes he can be everything to everyone: an Investment Banker, an Asset Manager, a Private Banker, an Insurer, a Commercial Banker, a Derivatives Trader, a Broker and an Adviser on most everything the world of finance has to offer today.

Unfortunately, as long as government is being advised by the very banks it ought to reform, I guess we are fools to expect any independent logic in policy decisions. Even heads (and former heads) of central banks, i.e Mervyn King and Paul Volcker do not seem to have the gravitas to redirect the fateful course we are on.

Reforming Banks PDF

If you are interested in more background here are two relevant chapters of  Eye Of The Storm, (16) Asset Management, (17) The UBS Story

First, let me apologize for my long silence on my blog. It wasn’t a leisurely summer as some of you will have enjoyed: rising markets, lots of “Green Shots” and a couple of weeks at the beach, what more can you wish for. Not for me though.
Some of you know that I am not primarily an author and commentator. My entrepreneurial spirit has the tendency to take over and keep me busier than I bargain for. I am involved in a very exciting multimedia project produced by my wife Sandra (Yndico), that also uses the prototype of a, I dare say revolutionary, E-commerce  engine Yndico Store,  produced by a venture in which we have also become involved (facilitating the dawn of the much anticipated social commerce, you can get a little glimpse here:  Magnet).

Certainly, I have been following news and events, the return of the bulls, the inventory cycle, by many mistaken as the end of the economic crisis, and the sad tales and tragedies that gloomed up the summer while the political debate in the US grew beyond silly. Before I start; I have a pdf version of this post attached for all of you who like to read in two columns (I found that I am a much more efficient reader this way as my field of vision does just not cover the full width of a page).
After such a long time, there is much to talk about. Unfortunately, as you might have guessed, I cannot join in the cheerleading of the bulls amid the more than 50% rebound in stock-markets across the planet and all the economic “green shots”. Personally, I expect the next leg down to start any time now as hope gives way to facts and the reality of what we are up against. In the coming weeks I will try to address the important issues we face in our global economy. I will address the misguided fear and expectations of inflation that is taking hold in finance and media and explain why continuing deflation is so much more likely.
I will address the state of the economy and the inventory cycle that is being mistaken as a new dawn announced by the equity-markets’ rebound.
I will talk about China and emerging markets and why most of them are in for an even worse 2010 than the US economy.
I will address the rotten political process (we still call democracy), in which vested interests prevail over logic and facts, in which people who obviously failed are not only being left in charge of their businesses or posts but allowed to define the rules of the future: definitely not the change many voted for and an outright corporate governance night-mare.
And, I will write to you about the dire prospects of current policy direction that further impoverishes Main Street at the expense of Wallstreet that is driven by a misguided fear to take on the rotten structures in banking.
Although this all sounds very gloomy, I am in fact very upbeat about our long-term future. Technological change is clearly accelerating and is opening up huge opportunities. I believe in the ingenuity of people; we have always emerged stronger from any crisis. Today, the $50 trillion question is: who will pay for the mistakes of the past? Current policy direction would have Mainstreet footing the bill. This is glaringly unfair and given the scale of things, the resulting inequalities have the potential to become highly explosive.   There is much to cover indeed.
But, rather than concentrating on the negative, let us start with solutions. Last week, Mervyn King, the governor of the Bank of England took up ex-Fed Chairman Paul Volcker’s demand (voiced back in June) to split up our financial superstores along institutional lines (finally, I dare say). Promptly, Gordon Brown and Alistair Darling rebuked Mr. King, with the argument that the problems in the banking sector are more complex than Mr. King suggests, which is amusing coming from those two. Not surprisingly these two are pinning their hopes on more regulation. More regulation? Well, yes, rather smarter regulation is indeed necessary. Yet, it is precisely the complexity of the system that calls for a good dose of more market orientated measures.
Yes, agreed our regulators and financial “experts” were asleep at the wheel and that has to be changed. But we should not mistake the past 30 years in finance as a period of free-wheeling markets. In fact, quite the opposite is true. With regulators looking the other way, the “big and beautiful” took control and made finance their own, controlling the entire span of financial services in a happy hugely profitable oligopoly, rigging the market to their advantage and in the process distorting some of the most important price signals such risk or interest rates.
The financial industry is characterized by a variety of business structures with different risk profiles and functional dynamics that demand specific organizational and institutional structures, human resources and incentive systems. Described in detail in “Eye of the Storm” (www.eyeofthestormbook.com).
A commercial bank doesn’t have the institutional structures nor the functional abilities to advise anyone on investments (even less to manage assets themselves). HSBC, undoubtedly one of the most prudent and the most successful commercial bank on or planet, thrives on its strategic imperative that its core business doesn’t have the resources or structures to be successful in investment banking.
Yet today, virtually all globally leading commercial banks offer the entire span of services and products our financial industry has to offer and generate the bulk of their earnings in asset management and investment banking.
This was primarily made possible by the abundant tool box of Modern Finance that became wholly accepted, then mis-applied by bankers and cheered on by regulators and central bankers during the past 30 years. With the fall of Glass Steagall in 1999 in the USA, the last bastion of restrictions was lifted, with devastating consequences.
In the three years up to the summer of 2007 alone the top 20 global commercial banks increased their balance sheets by $20 trillion, 150% of US GDP.
Take the case of UBS, a swiss bank. At the end of 2006, UBS was the world’s 7th largest bank with $2’000 billion in assets on its balance sheet (Royal Bank of Scotland was the largest bank with a balance sheet of $3’700 billion). Of these assets straight loans amounted to $260 billion. UBS’ non-core business therefore was (and continues to be) a multiple of its core business. UBS also advised a total of $2500 billion of client assets for a fee.  Thus, in total, this commercial bank exerted influence on $4’500 billion in assets, roughly 10 times its host country’s GDP, 17 times its own core business and 110 times its equity capital. UBS became a hedge fund much larger than the total estimated size of the global hedge fund industry (approximately $3’000 billion).
During the past two decades, UBS and its peers crowded out smaller and better suited firms to handle the risks they ended up taking with misguided inadequate management tools. Smaller, entrepreneurial firms had no chance in the face of the balance sheets and market power of our commercial banks.
In order to even justify being able to manage these astronomical sums, UBS and its peers rely on the mathematical risk models spawned by Modern Finance. These models allowed them to boil down complex and diverse fields of businesses, investments and risks into simple and “precise” formulas. The inadequacies and dangers of the wholesale application of these models had been proven long before 2007. The irresponsibility with which they were applied and condoned by auditors, boards, regulators and central bankers is not open to subjective interpretation. The dangers were clear to everyone yet the money train was simply too big and too strong for anyone to stop.
When it was finally brought to a halt by ever more ridiculous practices, we had amassed the largest pile of credit in human history. In relative terms the USA’s outstanding credit today is 3 times the size it was at the beginning of the Great Depression. Worse, this credit was accumulated to a very large extent by institutions that were as ill-qualified as they come, using tools as unsuitable as anyone could imagine.
Yet, it would be wrong to blame securitization or derivatives for this crisis. Modern Finance and its tools have brought much efficiency and progress to finance, yet in the wrong hands they are wreaking havoc.
Now, as the chickens have come home to roost, these same bankers who mismanaged and rigged the market on a grand scale ask the taxpayer for a bailout. They then turn around and pay themselves large bonuses (based on such ridiculous arguments as to retain top talent), instead of accumulating capital reserves. In addition, not only are they being left in charge of their businesses but also of their own industry’s restructuring. Even Mr. King says he would allow bankers to “write their own will”.  Don’t we all hate men without spine?
It is a corporate governance night-mare that no private business would ever get away with. Our representatives, our politicians need to finally wake up to the monumental risk that commercial bankers pose, a risk that has become even larger in the 2 years since the crisis broke. It is dishonest and shamefully irresponsible to point the finger at hedge funds and non-bank financial institutions, while the truly responsible are declared too big to fail, too delicate to touch and too powerful to replace.
Central bankers, auditors, boardrooms and politicians alike need to finally drop their irresponsible attitude towards the theories of Modern Finance and how they are applied within our banking system.
Restricting commercial banks to commercial banking doesn’t mean the end of Modern Finance or securitization. It means that we are able to nurture a more nimble, fragmented, specialized institutional landscape that functions within a framework of proper incentives, checks and balances and businesses able to properly take and manage risks. Our financial system is indeed too complex for any one institution to handle the entire array of products on offer, in particular commercial banks. Properly framed and managed no institution in our financial industry will be too big to fail.
In closing let me say it again: this crisis was not an unforeseeable “Black Swan” event. We were headed towards the abyss for years with warnings ignored at the levers of power the world over. It is shameful to now stand in front of cameras and say “no one saw this coming” and feed the media and the people half truths and confusing, ill-informed garbage on the workings of the financial system. If you don’t understand it, admit it and step aside! There are enough independent professionals who understand exactly what is going on. This crisis was glaringly obvious to a great many people who have been ignored by greed and arrogance at the expense of every decent hard-working taxpayer.
Whatever self-serving politicians proclaim Mervyn King and Paul Volcker ought to be taken serious. It is our duty to act decisively. It is certain that most bankers wont like it. But everyone else will.
Mervy King Speech
Reaction by Brown and Darling

Capital Requirements for Banks

On July 10, 2009, the Economist writes about the need for increased capital requirements for banks.
Interestingly, in all its writing about the financial crisis and its resolution the reputed weekly is shying away from tough questions. Ironically, it writes “politicians seem not to have the stomach for the fight” for more radical changes. Indeed political will is the main issue today with the tough love necessary for our financial businesses.
One of the main conclusions of my research is that a carving out and nationalization of commercial banking assets from our financial superstores is doable and necessary: never mind too big to fail, too big, period. Our large money-center commercial banks, cum hedge funds have to be broken up along institutional lines (Glass Steagall II). These banks are running different business models on one common platform, under one roof with distorted compensation structures, applying inadequate risk models, relying on meaningless internal risk management tools and are driven by enormous corporate and individual leverage.
Government has to reshape the structure of our financial system, it has to take over and restructure failed institutions, which does not mean that it needs to run these banks. It means government controls the board and drafts management and compensation contracts that are symmetric and measured. Ownership does not equal management. With new rules in place, these banks should be re-privatised almost immediately.
The Economist also bemoans that higher capital requirements will lead to higher interest rates. The point is completely off the mark. Why?
First, interest rates will rise eventually no matter what. By now it should have become clear to everyone that the interest rate environment of the past decade was the result of the extraordinary amount of liquidity provided to the system. A reversion to sustainable levels is not debatable, it is only a matter of time.
If borrowing rates are lower than the cost of equity capital, the higher the leverage, the lower interest rates will be in the system.  Part of the reason we enjoyed historically low interest rates was precisely the enormous leverage we built. Using it as an argument against reducing that leverage is quite silly, really.
Second, Banks’ assets have a very diverse risk structure. The conversion of interest rates amidst the collapse of risk differentiation was one of the main distortions in the system fuelled by its myopic treatment of risk. Commercial banking, by its very nature is low risk, direct relationship banking that thrives on scale and sound organizational structures (one reason why mortgage lending was assumed to be very low risk deep into the sub-prime mess). Ordinarily, these assets are the healthiest components of our banks’ balance sheets, even today. Commercial banking is the backbone of our financial system and, if managed prudently, has a much lower risk profile than the securitized investment businesses that are crushing our financial industry.
Commercial banking can be run at very low cost. There are great examples that have reached global scale while sticking to its knits. HSBC, without doubt one of the best run large commercial banks has for long followed the strategic maxim of not straying outside of its core business. The bank continues to thrive. HSBC is one of the few truly global commercial banks. Certainly, it is a saturated market, incurring low rates of growth and little opportunity for expansion. Get used to it!
By taking over failed commercial banks, cum hedge funds, the US taxpayer retains the crown jewels of the system and has a chance to re-establish sound structures and stability at the core of the financial system, all with a budget that is defensible. US commercial banking assets amount to approximately $6 trillion. Assuming government takes ownership of half of these assets, and assuming a 20% write-off (which may be on the high side), total costs amount to no more than $600 billion.
As described in “Eye of the Storm”, whichever way we look at the issue, $50 trillion of total debt, more than 3.5 times GDP, towers over any historical comparison. As an example, merely to shrink back to pre-Great Depression debt levels we would have to take out more than $25 trillion. With an estimated maximum discretionary budget of $5 trillion (excluding debt service payments and recessionary revenue shortfalls) over the next 10 years, the US taxpayer cannot afford anything but an orderly liquidation of these assets.
Given the practices with which this tower of debt was built, we have to assume that a significant portion of it will not survive the looming depression. So far, most of the money spent on this crisis has been taking up more debt, by the taxpayer, to unburden the banks from the worst of these assets. Authorities continue to operate on the assumption that we are in a crisis of confidence and liquidity, while in fact it is very clearly a crisis of over-leverage and mal-investment.
A split up of our banks is doable, it is necessary and it is indeed the only financially viable option. Apart from a reversion to the mean, it will not result in structurally higher interest rates but it will give us a chance to re-establish tested and trusted institutional structures in our financial system, from ground zero, preparing it for the economic pain of the inevitable deleveraging and large scale deflation of asset markets ahead of us. If political will for a tough and professional stance on bank regulation doesn’t materialize, the realities of this crisis will force much more drastic measures further down the line.
The lack of political spine should not be a reason for the Economist to chime in half-baked solutions. If we are to find the will to carry through necessary reforms, our media, in particular such industry heavyweights as the Economist (and others), need to start asking tougher questions. Otherwise we have to start asking some tough questions about their alignment of interests.

PDF

The economy shows signs that it has stopped from falling and markets are up sharply from their low earlier in the year.
Does this mean the crisis is over?
In my last blog “Is this Crisis Over?” you can read about a few reasons why that is highly, highly unlikely. And there is more…
Good friend and brilliant economist Jim Walker has just published an article that brings evidence to the dynamics I am describing in “Eye of the Storm”.
Dr. Jim (as he is lovingly called in the investment community) explains and shows that all that money created by the FED since this crisis started (approximately $2 trillion) has immense trouble finding its way into the real economy but instead sloshes around asset markets, pushing up asset prices.
Despite a more than doubling of base money since early 2008, the US economy has not found any traction and continues to contract. Jim shows that the transmission mechanism is broken. The creation of M1, which is the base of money influenced by central bank action is not even translating into growth in M2, which includes parts of the private sector’s decisions in uses of  money.

Thus, as expected, the Fed is creating a lot of liquidity that does not translate into economic activity.

Loan growth is (and will remain for some time) negative.

One of the key characteristics of this crisis is that it was built on credit. The levels of credit outstanding are unprecedented and unsustainable. The FED continues to believe that creating base money will eventually restart the credit mechanism. I agree, but the cost is very high, in particular for main street. The Fed will have to print a lot of money. Its balance sheet has been expanded to approximately $2.5 trillion. This compares to a total US debt outstanding of $50trillion. All the additional money has been doing was finding a way to become profitable, and no matter what the Fed would like it to do it is not finding its way into the real economy and thus needs to flow into asset markets.
This is evidence that the US economy is not nearly as sound as markets and media are portraying. Markets are celebrating the end of the crisis with taxpayer’s money while hardly any of it is flowing into the real economy. In the meantime still sound businesses and most of all smaller local banks will be watching their loan books deteriorate on falling commercial property and a generally worsening business environment.
These banks and businesses we thought safe and sound because they didn’t engage in all the fancy financial engineering are going to be hit hard in the next round of collapse.
Unfortunately, international dynamics are exacerbating the situation… but this is a subject for another letter.

Feel free to ask any question here.
I will post a weekly blog addressing most and hopefully all of them.

Is this Crisis over PDF
With a global perspective and much reason to doubt the quality of the past boom it appears very unlikely that this crisis has seen its bottom.
In a recent exchange with Nobel Prize Laureat Paul Krugman, Prof. Niall Ferguson of Harvard echoes an often heard opinion that Mr. Bernanke’s “knowledge about the early 1930s banking crisis is second to none” and reason to be confident for averting a second Great Depression. The way he chooses his words is very interesting. He doesn’t say  “Great Depression” he says “banking crisis”, as if they were two independent issues.  Indeed, when one reads Bernanke’s papers it does reveal deep knowledge of the mechanics and liquidity flows in the financial system.
However, I have never found him analyzing the quality of debt in the system or the size of it, or calculating debt and debt services in relation to the nation’s ability to generate cash flows. This seems an odd omission and fatal when the resulting policies implicitly assume that fundamentally all or most debt employed in the economy is sound.  Mr. Bernanke’s stance is in essence: if credit runs ahead of debt, i.e. if leverage increases to uncomfortable levels, all the FED needs to do is increase the monetary base (print money) and restore sensible levels of leverage.
Naturally, today it is impossible to estimate the quality of the $50 trillion built up in the US alone. Its collateral, the assets that backed this debt, were to a large extent driven by the very expansion of debt. Importantly, Mr. Bernanke’s detailed observation of the Great Depression doesn’t answer the question whether his policies would have saved the system. One might argue that the collapse would have merely taken a different path. One of Mr. Bernanke’s main observations was that as soon as liquidity was provided to the system, the economy started to grow and countries that were late in abandoning the gold standard emerged later from the Depression. What would have been the effects of a liquidity injection early on in the crisis? As we can observe today, since mid 2007, the FED has more than tripled its balance sheet and the government has taken on a couple trillion of bad assets. After two years of enormous efforts Bernanke has nothing to show for.
Is it really a surprise that after almost two years of such unprecedented action, the economy is momentarily arresting its contraction?
Even on the way down, our economy will remain cyclical.
But let us look at the quality and magnitude of the debt that we have to service with our taxed economy. Ultimately, the taxpayer will have to budget whether it is reasonable to follow current policies, indeed whether he has the financial capabilities to do so.  As shown in “Eye of the Strom” the margin of effort is not that large. Even if the paradigm of self-regulating and efficient markets has taken a good beating, many still seem to operate under the assumption that our system is much more efficient than it used to be without the tools of modern finance.
In reality, the all-pervasive and irreverent application of the tools of modern finance supercharged ongoing leveraging, and its mathematical approach to risk dissociated our financial businesses from the real risks in our markets. It encouraged harmful institutional transformations in our financial industry while these businesses were operating with deeply flawed risk management tools for decades.
What got us here goes much deeper than mere lack of capital or transparency. Just as the large banks strayed from their core business—relationship banking— financial markets strayed from their core function—the efficient allocation of risk and capital.
These distortive structures combined with an unprecedented expansion of debt should give reason to pause.
Is it reasonable to assume that after we shifted merely 5% of this debt away from clear sight we are back on track? What is a reasonable assumption for necessary write-offs when past crises had to deal with write-offs anywhere from 10% to 30% under conditions that were much more benign, i.e. with less than half the debt the US carries today and in a world that could always count on the US to come to rescue?
Today, it is the US that needs help, but having been the locomotive for 60 years has created economic weakness and dependence in most of the rest of the world. Some have renewed the hope that Europe or China will take the baton. I would put that in the “very, very unlikely” box.
Reality is that much of the final 7 years of the boom in the US was financed by rising asset prices and built on the consumption of imported goods from emerging markets (China). I travelled extensively in China during the boom years. It was remarkable to observe some 50 cities larger than 1 million population and 30 states, each with a population close to the size of Britain or France, compete for all the overseas investments and economic growth to be had. The $6 trillion invested since 2000 in China were openly visible everywhere and even at the height of the boom one could observe high vacancy rates and volume expansion strategies at the cost of ever thinning margins. As was to be expected, businesses in China and emerging markets projected ahead the enormous growth rates generated from years of export growth and built for that future.
What shall we expect from the fiscal investment package launched in China, which is now commonly but still cautiously hailed as having averted a Chinese economic downturn? The evidence is that the consumer in China doesn’t stand on its own feet, which means China is merely increasing its overcapacities. Amid all the arguments flying around pro and con this position there is one important one that I have always found necessary for a solid case for an independently strong consumer when a country emerges into the industrial world: imports. Generally, when a middle class is forming, imports start to expand more rapidly than exports and the composition of imports shifts towards consumption and services. Neither one is the case today in China that has consistently run a large and expanding trade surplus. Its economy, as have most emerging economies, prospered on export growth driven by an undervalued and pegged currency. Despite new popularity of the decoupling thesis, the economic evidence for this happening is lacking, a temporarily successful spending plan notwithstanding.
As was the boom, so is the crisis a global and globally interconnected phenomenon, unprecedented in size and nature. It will be interesting to observe the various reflexive developments and the time lags it imposes. It would be prudent to observe economic statistics with great caution. Today’s hope that the crisis is over is nothing more than hope and gravely irresponsible on the part of policy makers.
With a global perspective and much reason to doubt the quality of the past boom it appears very unlikely that this crisis has seen its bottom. In fact, it is much more likely that we have only seen the beginning.

Apr 16th 2009
From The Economist print edition
Financial crises can drag on because efficient remedies are politically unpalatable

The Curse of Politics,   Comment by Stephan Olajide

It is indeed appropriate to discuss the political process that seems to mangle all logic and sensibility nowadays. However, we have to go further than the Economist, as this is not merely an issue when a crisis hits and everybody scrambles for the exits. Everyone speaks of a crisis of confidence in our system when it really is a crisis of confidence in our political process that has failed us. In its ultimate analysis it is our political process, in which we have entrusted our lives and our taxes that has to take ultimate responsibility for the crisis we are facing.

How, for example is it possible that the Fed Chairman is left unquestioned for two decades on his proclamation of efficient and self-regulating markets?
How does a regulator allow an all- pervasive application of new theories and models in the system’s core, the financial industry without test-ground and thorough understanding?
How is it possible that politicians get away with paying lip-service to free and unfettered markets and completely neglect their responsibility as the manager and guardian of the system that was entrusted to their care?
How is the Fed Chairman allowed to guarantee the system (the infamous “Greenspan Put”) without a huge backlash from those who have learnt from history?
How has inflation come to be defined as the Core CPI?
How is it possible that politicians around the world were bombarded by warnings of many bright minds about the repercussions of the kind of system they are running without ever acting on any of it?

Yes, politics is the land of compromise amidst vastly differing views but some things are still governed by the laws of logic and sensible management.

Would you allow new theories to blanket and take over your system without testing, without questioning, without regulation and without oversight?
Would you proclaim the system’s efficiency while empirical data negates it?
Would you deregulate and feel happy about no regulation at all?

Would you not find it odd to have to guarantee a system that is supposed to be stable and efficient in itself?
As to our definition of inflation as the CPI, the consumer price index; Inflation is clearly the creation of credit, the increase of money in the system and not some hand-picked niche manifestation of it. The system of Bretton Woods, with its key characteristic being the U.S. dollar reserve currency, has been in force for more than 60 years and its dynamics are well known and discussed. The warning signs of the increasing imbalances brought about by this global system were well observed. Since the fall of the Goldstandard, we have run the longest global fiat money system that allowed (almost) unhindered credit expansion that was supercharged by Modern Finance and Reaganomics gone wrong and monetary policies that lack academic foundation.

Is this the leadership we deserve? Or is it the system that creates these more than mediocre results? Fact is that when reasonable, intelligent people congregate in Washington, the results have become too costly for society. The crisis moment merely highlights how broken our political process really is.

Current policy action in Washington and around the world does not recognise the extent of degeneration of our system, in particular our financial system and runs the risk of bankrupting the US dollar our global currency system. As a nasty side effect policies continue to expand the inequalities built during the boom years.