19 June 2011

Sketching Sustainable Future for Finance (1/3)

Having been researching money, finance and economy for quite some time already, I should note that from time to time it becomes pretty depressing. This may at least partly be because of the fresh memory of the recent financial crisis that actually (once again) confirmed the concerns of people more serious about the topic. Strangely, the mainstream “solutions” (regulatory reforms like Basel III and Dodd–Frank, zero interest rate policy and “printing” more money, replacing consumer spending with public spending etc.) still ignore the very root causes of crises and crashes, and propose something that provides temporary bounce-back or relief at best. While it’s rather destructive to focus on pointing to the problems only, I thought it would be a good idea at least to try to sketch the sustainable future for finance.

Yet it is worth to start with repeating key issues once again. Namely these issues are the ones that so far have been ignored in current “solutions”, and that we are ought to deal with. The lack of action here is no surprise. As we shall see, the changes needed are rather dramatic, and there are lots of those who naturally oppose them because they either directly benefit from the current flaws or would need to leave their comfort zone which is scaring.

Firstly, THERE IS NO CONTROL OVER MONEY SUPPLY AND DEBT. Yes, until money is debt, central banks are not really in the position of controlling the amount of money in circulation. Even less are they in the position to control the amount of debt. So it comes, that inflation targets are difficult to follow and debt is accumulating faster than are cash and deposits for repaying it. Debasing money from gold and inventing creative financial structures starting from 1970s have considerably accelerated moving on the unsustainable path. I have described it more thoroughly in my earlier posts:
Suggestion to dig into the monetary theory may at first seem nerdy and boring, but it becomes interesting once you really grasp the “secrets of money”.

Secondly, very much related to the first point, it is clear that TOO MANY ASSETS ARE IN TOO FEW HANDS. As an illustration, a study by the World Institute for Development Economics Research at United Nations University reports that the richest 1% of adults alone owned 40% of global assets in the year 2000 while the bottom half of the world adult population owned barely 1% of global wealth. This is not only the difference between developed and developing world or a problem of poor countries; in fact, the disparities are immense also within the developed countries like US and UK (sources: Wikipedia and Yahoo! Answers).  Why does it matter from financial stability point of view? Well, until too much money is in too few hands, among others it is causing sub-optimal allocation of resources, bubbles here and there in equity prices, in commodity prices etc. At the same time real economy and employment are not picking up as people just do not have money for buying goods. This is what we see right now: quantitative easing just doesn’t help. Instead of private sector to take lead, public sector has been the driving force of the so-called recovery. The problem is that public debts are reaching unsustainable levels.

Thirdly, INTEREST RATES ARE FAR TOO VOLATILE. It comes down to central bank policy rates (consider for example the Federal funds effective rate in Figure 1) which are used to achieve monetary policy targets via influencing market interest rates.


Ironically such moves have unintended destabilising consequences. While trying to curb inflation and calm down overheating economies, such moves e.g.:
* from time to time lead to inverted yield curves which in turn cause crashing of business models that are based on funding long term assets with short term liabilities (and maturity transformation is one of the very functions of the financial system);
* cause disproportionately large increase of monthly payments in adjustable-rate loans (check it out by yourself: play around e.g. with the Freddie Mack’s adjustable-rate mortgage calculator and see how much the monthly payment increases when you change index rate e.g. by +1%; you should get something around 12%).
It’s of course not only about actual changes in policy rates. It’s also about expectations of such changes as well as changes in risk spreads.

The fourth thing, again closely related to the foregoing points, is embedded into the MECHANISMS THAT TRANSFER ASSETS FROM REAL ECONOMY TO FINANCIAL SECTOR AND RISKS FROM FINANCIAL SECTOR TO PUBLIC SECTOR. This is what makes rich people richer and the others relatively poorer. Transfer of assets from real economy to financial sector occurs as a result of the very design of monetary system: putting it simply, as by design there is not enough money in the world to repay all the outstanding debts plus interests some will default, and who defaults, has to hand over her/his collateral asset. If financial institutions make serious mistakes, the biggest ones of them are being bailed out with public, i.e. tax payers’ money (or with public debt or public off-balance-sheet liabilities like various guarantees). This is what transferring risks from financial sector to public sector means. There are also others dirtier mechanisms like accumulating assets impossible to value into mutual funds, selling fund shares to small investors, charging fund management fees and letting investors to take the losses. That such mechanisms work, is a consequence of lack of proper financial education.

The fifth issue relates to the MEASURES THAT ARTIFICIALLY PRESERVE IMBALANCES AND LET THEM GROW UNTIL THEY ARE TOO BIG. Some examples include:
* creation of artificial demand to government’s debt by introducing central banks’ asset purchase facilities and likes, and by classifying government debt as highly liquid asset suitable for meeting the new liquidity standards (so despite of the increasing risks, the price of money remains low for the government until liabilities are so large that confidence is utterly lost);
* explicit and implicit government guarantees that make money cheaper (especially, but not only) for the too-big-to-fail financial institutions than a proper risk-based price otherwise would be (so they have funds to take more risks than they should);
* re-financing de facto defaulted loans (incl. interests owed) with the new ones (so that debt burden is accumulating even without providing additional cash for the debtor);
* bailing out too-big-to-fail banks (so that they grow even bigger and more difficult to bail out next time).
So we are sitting on the huge pile of imbalances while trying to cure the hangover with one more drink (more money and more debt).

And last but not least, FINANCIAL WORLD HAS BECOME OVERLY COMPLEX AND INCONSISTENT. One of my earlier posts, Just Some Examples of Financial Innovations, provides an illustration here. After slicing and dicing we even don’t know what a so-called asset actually is. Among others, this creates lots of additional “opportunities” for cheating and benefiting from unfair advantages in a way that everything seems correct in legal terms.

The above list of issues does not pretend to be complete. Yet it should provide quite a glimpse of the issues with our money and financial system, and how lame are Basel III and other currently ongoing regulatory initiatives to address this. In our next post we will do our best to sketch the vision of a sustainable monetary and financial system.

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