Russell Brand begins his financial education

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Fractional reserve speculation

Fractional reserve lending, as "Sonus" explains so clearly here, became possible when people accepted receipts for gold as payment, instead of insisting on having the gold itself. This opened up an exciting opportunity for the guardians of gold and silver; they could issue receipts for which there was no gold or silver at all, and get other people to accept them as payment. Then we ended up with a world in which you could borrow money that didn't exist, but when the scam burst, you'd have to pay it back with the roof over your head. Now there are voices calling for the return to money actually backed by something that might limit its growth; this will pass.

In much the same way, speculation in shares has changed. Once, investor A bought a share in a company from B, held it and received dividends. But the financial market exploded when it became possible to trade in shares without actually having the certificates.

Speculator C can "short" a share - agree to sell it to A (without yet having ownership) for $1, later buy it from B at 5oc (he fervently hopes), then when settlement time comes, A ends up with the share and C pockets the profit less trading expenses. (C can also "go long": agree to buy a share from B at 50c, sell it to A for $1 later, then comes settlement time when the share ownership is officially transferred).

C can multiply his bet if he trades "on margin", in effect making only a small down payment on his share speculation. If the margin is 10%, then he can (promise to) buy or sell 10 times as many shares, and (if his judgment is right), make 10 times the profit when settlement is made.

C experiences success in conditions of a bull market and expanding money supply. C is now trading in big, big quantities, with shares he doesn't own for most of the time, and cash he mostly doesn't have. C has gone beyond mere shares, and is simply betting on movements in the market. C has become a trader in derivatives; in effect, a high-rolling gambler. What a wonderful world! So much nicer than the school he went to! C has an abundance of worldly goods, worldly girlfriends and envious colleagues who laugh at his jokes. C has taken to introducing himself on the phone as "Nick with the big swinging d*ck". C is young, and has never known things to be different. C is complacent; C has become reckless.

But oh dear, if some of his enormous bets go wrong. C has losses, multiplied by the inverse of his margin, plus his trading expenses. Maybe C doesn't have enough money in his account to cover his losses. Maybe C has been trading with another gambler, D, and now can't pay him. Suddenly D is in trouble, too. And both have also been playing around the green baize with traders E, F and G; maybe with the whole alphabet of gamblers, maybe with the Greek and Cyrillic alphabets too.

But before he busts himself (and possibly his employer into the bargain), C has influence (since it is known that he never gets it wrong - until the day he does): news of his bets affect the market, especially when the market is nervous. When C shorts a share big-time, he can start a run - even if the company was basically OK before then.

Which is why Denninger is now calling for a return to the custom of getting the stock certificate when you buy the stock.

Good luck with that; and with ending fractional reserve banking. Denninger argues against the latter here, and prefers a system of minimum cash margins; perhaps it would be more logically consistent if he advocated the same for short-selling.

Personally, I'd go for whipping the money-changers out of the temple; but they always return.

Good and bad borrowing

Karl Denninger covers a lot of ground - perhaps too much in one posting - in his attempt to clarify fractional reserve banking and its consequences.

What seems to me a major point in his conspectus, is the difference between borrowing for production, and borrowing for consumption. If you borrow at 5% to get a machine that makes you 10% profit, that's fine; but borrowing for a private house to live in, a car for personal use, music and TV, alcohol and weekly groceries - madness.

Number crunching - fractional reserve banking

Supposedly, banks lend 10 times (or more) what they have on deposit. Yet in June last year, it was estimated that total UK consumer borrowing (mortgages, loans and credit cards) stood at £1.444 trillion, and in October savings and deposits reportedly totalled £1.17 trillion - a ratio of c. 1.2 to 1.

By contrast, total U.S. household debt at the beginning of last year was estimated at $14.4 trillion, and in October the Mises Institute reckoned the True Money Supply to be $5.5 trillion, a ratio of around 2.6 to 1.

On the face of it, the American consumer is in twice as dire a state as his British counterpart.

I expect that's an oversimplification - but simplicity is in very short supply. I'd like to understand more, but I can't find reliable, user-friendly data on where all the money and debt is. There's far too much secrecy, complexity and obfuscation in this business.

Monetary policy: chameleon on a tartan

Our government has contradictory objectives, and something will have to give.

1. It has ordered banks to rebuild their cash reserves, because they loaned out far too high a multiple of what they kept in their vaults. Normally, the way to do this would be to widen the margin between the interest they pay and the interest they charge, making bigger profits that could be salted away; or to become far more cautious in their future lending, increasing the ratio of good loans to bad ones. In a recessionary economy, where many businesses are more likely to fail, this would also imply calling in business loans and trimming their overdraft limits

2. It has called for banks to pass on the full benefit of recent cuts in interest rates, and to maintain lending, especially to businesses.

If (1) is not done, the crisis continues. And if (2) is done, it counteracts (1).

Besides, unless the government nationalises the banks, it's not in a position to force them to do (2). It must know this. Maybe (2) is merely for us punters and voters to hear, not for real action.

As Aeschylus said 2,500 years ago: "In war, truth is the first casualty. "

"End lending altogether" - Waldman

I've been wondering why we shouldn't bust our criminal banks immediately and replace them with a system that simply transfers money. For a half-serious proposal to end lending altogether, see Naked Capitalism on Steve Waldman.

Why banks?

Banks require re-capitalisation. The capital is required to cover losses. Capital is also needed for assets returning onto their balance sheet (as the vehicles of the “shadow banking system” are unwound). This capital is required to restore bank balance sheets. Additional capital will be needed to support future growth. Availability of capital, high cost of new capital and dilution of earnings will impinge upon future performance.

Satyajit Das (htp: Jesse)

Nope. Banks need destroying, as does all this bank-created debt. The mistake is to try to keep things as they are. How did we come to buy houses "on tick", then cars, and now our clothes and groceries? Why is there any lending for consumption, seeing how it only means reduced future consumption? Why should banks be kept going, requiring a significant proportion of our earnings, so that wages have to be high for us to live on what's left, making us uncompetitive with the developing world?

I am reminded of the pitiless response of the Comte d'Argenson to the satirist, Desfontaines:

Desfontaines: I must live.
D'Argenson : I do not see the necessity.

Hurray for a radical

I sympathise with Mish; but getting it done would be like a goat persuading a tiger to turn vegetarian.

If deflation is not the problem, what is?

The problem is fractional reserve lending that allows banks to leverage lending 12-1 and broker dealers like the now defunct Bear Stearns and Lehman 40-1. It does not take much to cause a run on the bank when leverage is 40-1. Fannie Mae is leveraged many times more than that.

Without that excessive leverage, no one would be in trouble over falling prices. Actually everyone would benefit. The cure is not to defeat deflation, the cure is to embrace deflation and stop fractional reserve lending and the serially bubble blowing activities of the Fed.

I support abolishing the Fed and the elimination of fractional reserve lending. Those are the only long term cures to the problems we face.

The dangers of harmony

I'm still convinced that many in the financial community deserve far harsher treatment than they've so far received - if they didn't know what would happen, they should have.

But I've been casting about for some deeper structural reason - what allowed financiers to kid themselves that they were acting reasonably, or at least assure themselves that they had followed official guidelines and were "covered"?

So I looked for something relating to the regulation of fractional reserves, and came across references to the Basel Accords (I and II). These are an attempt to "harmonise" central banking policies in developed nations, and perhaps can serve as an object lesson (especially for EU enthusiasts) about international legislation.

Here is the conclusion of an analysis of the two Accords (highlights mine):

One very important fact to assess is the achievements and limitations of each Basel Accord. The first Basel Accord, Basel I, was a groundbreaking accord in its time, and did much to promote regulatory harmony and the growth of international banking across the borders of the G-10 and the world alike. On the other hand, its limited scope and rather general language gives banks excessive leeway in their interpretation of its rules, and, in the end, allows financial institutions to take improper risks and hold unduly low capital reserves.

Basel II, on the other hand, seeks to extend the breadth and precision of Basel I, bringing in factors such as market and operational risk, market-based discipline and surveillance, and regulatory mandates. On the other hand, in the words of Evan Hawke, the U.S. Comptroller of the Currency under George W. Bush, Basel II is “complex beyond reason” (Jones, 37), extending to nearly four hundred pages without indices, and, in total, encompassing nearly one thousand pages of regulation.

The author's concern is that the rules can permit the risk of assets in emerging markets to be understated, and as it turns out the Trojan horse came in through another gate; but in complexity lies opportunity, and in rule-following lies the illusion that personal responsibility is thereby written off.

A fuss about banks

British banks are being criticised for not passing the 1.5% rate cut on to their customers, but retaining some or all of the difference. Presumably they are trying to rebuild their reserves, for running down which they have been much more justifiably criticised. Or do we wish them to remain insolvent, which, as Rick Santelli has admitted, they are?

As my wife said, what do we expect the banks to do: take in washing? Look after your pets in holiday time? Run daycare for the elderly in their conveniently-located, brightly-lit premises?

"An inflationary holocaust" - Jim Rogers

TBRRob posts a very useful YouTube interview with big investor Jim Rogers (the best analyses come from people who back their own judgments with their own money).

Despite the recent strengthening of the dollar, he is buying Japanese yen and Swiss francs; and commodities (especially agriculture), because they lead the way out of recession and their fundamentals are (he says) sound.

In the interview, he is challenged on his inflationary hypothesis: surely we are seeing "deleveraging" (reduction in borrowing) and don't we need more money in the system to deal with the liquidity crisis? Rogers cites past history and sticks to his guns

I think it was Marc Faber's comments that first helped me understand why all this public-money-throwing isn't going to help. It's NOT a liquidity crisis: liquidity is what has caused the problems (and anticipating the movement of the money tides is what has helped Faber grow his funds!).

It's a SOLVENCY crisis. If all your possessions are worth less than your total debts, borrowing more money will not help. So when the government creates massive extra funds for you to use, you will not wish to use them. And if your fellows are in the same position, you certainly won't wish to lend them any money you still have.

When you are insolvent, there are two ways out. One is to declare bankruptcy, in which case the money invested in you is lost and so excess liquidity goes down the drain. Good, though it's also painful (personal fortunes lost, people laid off).

The other way is to be unbelievably lucky, and have someone else pay-off your debts. When the government chooses to do the latter for the banks, it has to get the funds from somewhere, and ultimately that is the citizen/loyal subject. In this case, the liquidity is still in the system, and there is no drain to take it away. Sooner or later, it leaks out into the general economy and prices rise, because there is more cash to bid for the usual limited amount of goods and services.

(Or the government increases taxes, and uses the extra to pay-off debt. Nice idea, but increasing taxes slows the economy and creates more benefit dependants, which requires more taxes even as less revenue is coming in because business is suffering because people now have less spending money because taxes are higher, and...)

So there are two problems created: inflation, and moral hazard - the people who have been bought out in this undeserved way have no incentive to change their habits.

You may think that it's only a temporary problem and the government will recoup its investment when things get back to normal. The trouble is, "normal" means house prices dropping to about half what they were worth last year, because they doubled for no good reason in the five-year period before that. In the long term, I understand, houses are priced at 3 times income, not 6 times as during the recent period of monetary inflation.

So either the value of the excess credit is destroyed by bankuptcy, or by inflating away the money saved by more prudent people. Either the guilty (or foolish) suffer, or the innocent.

And here's another either/or: either we go this process again and again, or banks are prevented in future from increasing the money supply in the way they just did.

And the guilty must be punished.

Banks: justice will not be done

Financial website ThisIsMoney speculates that the FTSE could drop another 20%. I couldn't resist commenting there:

20% down would be about right. The banks have blown up a balloon for the past 5 years and then popped it - it's what they do. They cannot be punished severely enough, nor can the regulators who shrank reserve requirements. If the FTSE hits 4,000 I will finally be able to invest again.

This temple-cleaning call is also pretty much the view of Karl Denninger, but he's doing more emphatic bold, capitals and underlining - unconsciously betraying that he knows, deep down, that "it ain't gonna happen, Cap'n."

What bankers don't know about banking - or do they?

Those red and blue lines remind me of the song, Me And My Shadow.

This is from Mark Lundeen's 12 August essay on banking and inflation (htp: The Mogambo Guru). And here's another graph from the same:

(Is it my imagination, or does the curve begin in the 60s?)

Should we call the credit crunch the Shawshank Recession?

What I don't know about banking

London Banker reports that US deposit insurance looks compromised. I comment:

In my amateur way, I have suggested that we give up on fractional reserve banking for home lending and simply lend (create) money without any base at all (but with, perhaps, some State budget for how fast they can inflate the money supply). We're nearly there, but the current system is complicated by the expensive mechanics of taking in and returning deposits, and the threat of runs on the banks.

Perhaps deposit takers could be like the old Swiss banks and charge you for holding your cash, while the lending banks rot its value. Any votes for a separation of functions?

Fractional reserve banking - why bother?

Karl Denninger comments on the unfolding crisis of non-subprime mortgages, where he thinks losses will be even worse.

A question: why bother with any kind of reserve?

Once you've determined that banks can lend a high multiple of deposits, you may as well make deposits entirely irrelevant. In fact, it would save quite a bit on operating costs if you could have banks that specifically didn't take deposits from anybody - no cash in or out, so no tellers, no branches. Let the Federal Reserve or the Bank of England give a handful of providers a total lending limit, and then stand back and watch them pump away.

Insolvency? Loan-to-value not good enough? Raise the limits again, pump harder. Get a punter to overpay for one house and you increase the value of all the others in the street, so making their mortgages safer. And if the bank doesn't have to pay interest to depositors, it can charge as little as it likes for its loans.

I can't see the flaw here, any more than I can see the difference between a banker and a swindler.

I don't know why I didn't think of it before.

It really, really is a swindle

I am grateful to James Higham for directing me to this article by a very distinguished economist, explaining the scam of fractional reserve banking. Even when you understand how it works, you find it difficult to believe; it's a bit like finding out how babies are made, looking at your parents, and... naaaaah!

Where are the police?

UPDATE

I've been directed (see comments) to this video, "Money as debt", by Canadian Paul Grignon:



Here are the artist's own comments; here's the dedicated website; here's his professional artist's website; and here's a link to the Idaho Observer, with a little extra detail on the making of the film - cut off the last part of the address to see more of the Observer's output.

Whether it's right or wrong, simplistic or not, I'm heartened to see practical idealism like this.

FURTHER UPDATE

Karl Denninger explains why the money-lenders won't permit inflation to run away and destroy the basis of their wealth. And why this means the economy will hit the buffers.

All our banks are sub-prime

The Mail on Sunday reports plans by the British Government to borrow money from the Middle East, on Islamic Sharia terms - that is, without, technically, paying interest.

Never mind the Islamophobic subtext: Islam is not the only religion to object to charging interest (which was illegal in France up to the Revolution of 1789). According to The Merchants' Magazine and Commercial Review by Isaac Smith Homans, William B. Dana (1849) (found by Google search here):

The Jewish law prohibited all usury between Jew and Jew, although it was allowed between Jews and foreigners. (Ex. 22 : 25 ; Levit. 25 : 36, 37 : Deut 23 : 19, 20. Compare Ps. 15 : 5 ; Ezek. 18 : 8, 13, 17, Ac.) The reason of this distinction, according to Father Ambrose, was, that God designed usury as one of the ways of making war upon the Canaanites and other heathen nations.

The Canon Law, as it is called, i. e., the ecclesiastical law of the Roman Catholic Church, pronounces the taking of interest, even the least, to be a mortal sin, and declares those who defend the practice to be heretics.

The interpretation of usury as a form of warfare is resonant.

There is also the unreligious technical point, that the money supply must increase to cover the interest charged. Either that, or ultimately all the money in the world will end up in the hands of the money-lenders.

This may not have mattered quite so much when the world was not so monetized - when we built our own houses, grew our own food, drew water from wells and rivers, and made our own clothes. It has to be said that none of it, generally, was as nice as today (though at least water didn't come in plastic bottles that took seven times as much water to make); but as more and more of reality nowadays has a price ticket on it, the inexorable demands of interest must either create unbounded inflation, or by seizing all our assets, enslave us. Perhaps usury is indeed a form of aggression.

Which leads me to wonder where money came from in the first place. How can you invent something, define the world with reference to your new creation (and possession), and use it to claim - to seize - ownership of the world? This is to make the money-issuer - originally the King or Emperor - lord of all the Creation he can control. So is power the only game in town? Maybe civilised life, the quiet enjoyment of one's own hard-won personal property, is merely an illusion, a time-out in the game. But impoverish the middle class and all bets are off - as Germany found out in the 20s and 30s. How foolish must a State be, to allow its mismanagement of finance to threaten the social order. Still, the Germans weren't entirely responsible for the WWI peace treaty that led to the total wreck of their economy; by contrast, look at this latest from Karl Denninger on the current, State-permitted mess.

The power of the State to coin money is nothing to the way the banks multiply it. Something like a mere 3% of all money is in notes and coins; the rest is deposits and credit - i.e. promises. Instead being charged a modest fee for guarding your cash (which is, I understand, the practice of the traditional Swiss bank), you're paid what you think is a nice rate of interest - but thanks to fractional reserve banking, your deposit can be multiplied and loaned out, at even higher rates. No wonder the banks always seem to have the nicest locations, including converted Tudor houses in little Warwickshire villages.

Swelling the capital within the economy ultimately pushes up prices, though as money-lenders become more cautious and call loans back in, the opposite happens; but meanwhile, the expanded money supply also builds-in massive future inflation, because interest must come back, as well as all the existing capital. Even if some of this fake capital is lost because of asset write-offs, the lenders will seek to make up for it by charging more interest on the loans that haven't defaulted. And the difference between the small interest paid out to you on your little deposit, and the larger interest demanded on the much greater loan base, pays for all the overheads and leaves over enough, and more than enough.

Meanwhile, the temporarily bloated money supply inflates assets, including assets that really you must have, such as a roof over your head. In the UK, the M4 measure of money supply has approximately doubled since 2000 - and house prices have done almost exactly the same. But I don't have the power to say, I don't believe in borrowing money so I won't pay so much for your house. And since you (quite understandably) will refuse my lower offer, I will have to rent instead - at a rate that reflects the price of houses. What would houses cost - what would rents be - if home loans were illegal?

So now, in the wake of sub-prime (and other, earlier financial bubbles), we're all clapping our hands to save Tinkerbell's life. The government pumps yet more funny money into the economy to shore up the confidence tricks of bankers, and in the case of Northern Rock, their own voter base. If we understood what this "Tinkerbell" is really like, and what she's been up to, perhaps we'd be better off letting her die.

Except the law's on her side, and she'd take us and our families down with her. After all, by agreeing to borrow, we fix an obligation in nominal terms, even if (owing to events beyond our control, but not necessarily beyond that of the money-makers, and money-fakers) the assets decline in nominal terms. In fact, by first expanding and then contracting the money supply, it is possible for lenders to take your assets and any additional capital that you personally contributed, then reinflate the assets later. Hey presto, they've grabbed your cash. No wonder some Americans trash the house before mailing back the keys.

I think that for those who have the liberty to do so, escape comes in two stages: get your cash out, then buy whatever you need so that in future, you depend on the money system as little as possible. You should also stay mobile - the State needs captives, and a house is an excellent way to tie you by one leg. And the licence plate on a car is the next best thing to a tag clipped onto your ear. Unfortunately, in an overcrowded island like ours, this doesn't seem realistic, but maybe that's why an Irish girl told me, years ago, that farsighted (and typically pessimistic) Germans were buying into rural Ireland. Perhaps in America, or some other land blessed with a lower ratio of population to fertile land, we may escape with the raggle taggle gypsies. Velvet-clad slavery, or freedom and poverty?

What care I for a goose-feather bed?
With the sheet turned down so bravely, O!
For to-night I shall sleep in a cold open field
Along with the raggle taggle gypsies, O!

Uncertainty

A trio of articles from Safe Haven: Paul Tustain thinks that inflation, and even hyperinflation are indeed possible, because of support operations for the banking system; Michael Swanson reads the charts and thinks the stockmarket could be teetering on the edge; Adam Oliensis of The Agile Trader is man enough to admit he's baffled:

A couple of things seem pretty clear to me: first, that I haven't lived long enough to have enough experience to know whether the bulls or bears are right about just how far the ripples will spread from the credit market problem; second, that there's never been an economic cycle just like this one, so even the people who have lived long enough to know who's right are speculating at best. (highlight mine.)

So it's not just me that's confused. And we're in distinguished company: Marc Faber also says we are in a new situation, with the possibility of a first-time-ever worldwide bust.

If we're into guesswork, then mine is that for a while, the monetary inflation will offset the credit (or "fiduciary money", as I'm learning to call it) deflation.

And then? Here's what worries me, in my amateurish, hunchy fashion: balance can be achieved in different ways (an empty seesaw is not the same as one with an elephant at each end). There's been a massive buildup of energy within the system, and the question is, can the Xbox take it?

Bubble priced

"... my best estimate is that a full thirty percent of the market's current "value" is based upon fraud and deception, and not on actual value"

... says Genesis (Karl Denninger) on his site, Market Ticker yesterday. He has already organised a petition, and is now calling for a shatteringly large class-action suit against American banks.

Is the credit system cracking up?

Bob Hoye, in Prudent Bear (yesterday), discusses "the Unholy Trinity of central banking, derivatives and artificial rating of credit". He sees these as systemic risks - I'll say more about that when I come to Richard Bookstaber's interview on Financial Sense last Saturday.