Trade power and financial power

Source: Bank of England

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Source: Bank of England

The international trade in goods is one thing and the international flow of money is another.

I came across these two charts showing how China is at the center of world trade in goods, and the United Kingdom is at the periphery, and the UK is at the center of world banking and China is at the periphery.

Economic historian Adam Tooze said that the UK is trying to make itself China’s financial gateway to the world.  It is well positioned to do that.   The danger is that the greatest current threat to the world economy is a Chinese meltdown, he wrote, and the UK is even more exposed than the rest of the world.

LINK

Trade and Finance – Two Very Different Visions of the Twenty-First Century Economic Condition by Adam Tooze.

 

John Lanchester on the financial crisis

John Lanchester

The financial crash of 2008 was worldwide, and the failure of governments to address the causes of the crash also was worldwide.  Because the same thing happened in different countries under different leaders, the reasons for failure are systemic, not just the personal failings of particular leaders.  The solution must be systemic.  A mere change in leaders is not enough.

John Lanchester, writing in the London Review of Books, wrote an excellent article about the crash and its aftermath.  I hoped to call attention to it in my previous post, but, as of this writing, there has been only one click on the link.

I know people are busy and have many claims on their attention.  If you don’t want to bother reading the full LRB article, here are some highlights.  If you’re an American, bear in mind that, even though so much of what he wrote applies to the USA,  his focus is on British policy.

The immediate economic consequence was the bailout of the banks.  I’m not sure if it’s philosophically possible for an action to be both necessary and a disaster, but that in essence is what the bailouts were. 

They were necessary, I thought at the time and still think, because this really was a moment of existential crisis for the financial system, and we don’t know what the consequences would have been for our societies if everything had imploded.  But they turned into a disaster we are still living through.

The first and probably most consequential result of the bailouts was that governments across the developed world decided for political reasons that the only way to restore order to their finances was to resort to austerity measures.  The financial crisis led to a contraction of credit, which in turn led to economic shrinkage, which in turn led to declining tax receipts for governments, which were suddenly looking at sharply increasing annual deficits and dramatically increasing levels of overall government debt.

So now we had austerity, which meant that life got harder for a lot of people, but – this is where the negative consequences of the bailout start to be really apparent – life did not get harder for banks and for the financial system. In the popular imagination, the people who caused the crisis got away with it scot-free, and, as what scientists call a first-order approximation, that’s about right.

In addition, there were no successful prosecutions of anyone at the higher levels of the financial system.  Contrast that with the savings and loan scandal of the 1980s, basically a gigantic bust of the US equivalent of mortgage companies, in which 1100 executives were prosecuted.  What had changed since then was the increasing hegemony of finance in the political system, which brought the ability quite simply to rewrite the rules of what is and isn’t legal.

Ten years after the financial crisis

Canary Wharf financial district in London. Source: Quartz.

Ten years after the financial crisis of 2008, the U.S. government has failed to do anything necessary to avoid a new crisis.   I just read an article in the London Review of Books that says that the U.K. government’s policies are just as bad.

Like the U.S.-based banks, the British banks engaged in financial engineering that was supposed to create high profit on completely safe investments—which, as experience proved, couldn’t be done.

The British government had to bail out the banking system in order to save the economy.  There probably was no alternative to that.  But it then proceeded to put things back just the way they were before.

John Lanchester, the LRB writer, said there was no attempt at “ring fencing”—what we Americans call firewalls—to split up investment banks, which speculated on the financial markets, and retail banks, which granted small business loans, home mortgages and other services to the real economy.

The UK, like the US, engaged in “quantitative easing”—injection of money into the banking system through buying bonds.  The basic idea was that if banks and corporations had more money to invest, they would invest more, and the economy would grow.

This didn’t happen.  Instead banks and corporations bid up the prices of existing financial assets and real estate, which added to the wealth of the already rich.

Ordinary Britons faced austerity.  Their government cut back on the social safety net and public services.  British life expectancy, like American life expectancy, has actually fallen.

The British, like us Americans, had 10 years to fix their financial system.  Like us, they wasted the opportunity.  Now it may be too late to avert the next crash—even if the UK and US governments wanted to act.

LINK

After the Fall: Ten Years After the Crash by John Lanchester for the London Review of Books.  Well worth reading in detail.  Hat tip to Steve B.

Trump’s Fed protects banks from stress tests

Bill Black, an expert on banking and white-collar crime, described how Donald Trump’s appointees to the Federal Reserve Board are revising “stress tests” to free Goldman Sachs and Morgan Stanley from a requirement to prove they are solvent enough to weather the next recession.

To pass the “stress test,” they’d have to put a larger fraction of their profits into capital reserves.   Black said they could easily do this, but it would cut into bonuses and dividends.

He also noted that Germany’s Deutsche Bank in Germany can’t even pass the easier stress test.  Deutsche Bank is Germany’s largest bank and, according to Black, the only large bank willing to lend to Donald Trump’s businesses.

LINK

Fed Lets Goldman Sachs, Morgan Stanley Off Hook, Investors Profit Billions, a transcript of an interview of Bill Black for the Real News Network.

Magic formulas and failed corporate strategies

Clayton Christiansen

Clayton M. Christiansen of Harvard Business School is a brilliant management scholar who has written about how U.S. corporations fail when they neglect the basics of their business.  He wrote recently in Salt Lake City’s Deseret News about another reason the corporations decline when executives focus on the wrong things.

You have such concepts as Return on Net Assets (RONA), Economic Value Added (EVA), Internal Rate of Return (IRR), Earnings Per Share (EPS) and Gross Margin Percentage. They are all ratios.

By standardizing the definition of profitability, corporations lined up to optimize these profitability ratios. RONA provides a good example.  A company could improve its RONA by generating more revenue and put that in the numerator.

But the other way to improve this ratio is to reduce the denominator by a company getting rid of assets.  Reducing assets is much easier than increasing revenue.  So if a CEO is rewarded for a good RONA ratio, the incentive is to outsource aggressively. When there are no assets on a balance sheet, then this rate of return is infinite, and according to this definition, it might seems like such a company is doing better and better.

via Clayton M. Christensen

McDonnell-Douglas was an example, he wrote.  Its DC-3 transport was a powerhouse of the industry, but the company’s RONA was low.  The company started outsourcing more and more of its work, and its RONA rose to 60 percent.  But when the DC-10 had been put on the market, there was not enough cash flow to launch a DC-11.

The economist Milton Friedman said back in 1970 that corporate executives are employees of the shareholders, and that their object should be to maximize shareholder value.  Steve Denning wrote in Forbes, quoting Jack Welch of General Electric, that this was the “world’s dumbest idea,” which is not to say that Welch never believed in it.  Denning said the truth is that the executive is the employee of the corporation, and that the purpose of the corporation, in the words of management scholar Peter Drucker, to “create a customer.”

I find this discussion familiar, because I remember how, when I was reporting on Eastman Kodak Co. for the Rochester, N.Y., newspaper in the 1980s, Kodak exited or outsourced certain businesses because profit margins were not high enough, while its main competitor, Fuji Photo (now Fujifilm), simply tried to maximize its share of the market.  Like Kodak in the days of George Eastman, Fuji never gave up any basic technological or manufacturing capability.

Why are so many corporate executive beguiled by financial formulas at the expense of long-term survival?  Christiansen thinks it is because of dogmatism and Denning because of stupidity.  Probably they’re right in many cases.  But for certain categories of people, focusing on financial ratios makes perfect sense.   They include hedge fund managers, private equity fund managers who specialize in leverage buyouts and any other investor or speculator who wants to cash in and get out.

A bipartisan disaster in finance

Here is an interview with Charles Ferguson, director of the documentary movie “Inside Job,” about the roots of the 2008 financial crash.  It begins with pointed comments about conflicts of interest and Wall Street influence on the economics profession.

“Inside Job” is an excellent movie

Last night I saw an Charles Ferguson’s “Inside Job,” a documentary movie on the Wall Street crisis.  It is excellent journalism and excellent cinema.   Most people who see this movie will leave it not just angry, but better-informed.  Ferguson both names the culprits behind the crisis, and clearly explains the deeper systemic problems.

Ferguson makes the point that there has been no criminal prosecution of financial manipulators, unlike in the lesser savings and loan crisis of an earlier era.  Maybe there is not only such a thing as “too big to fail,” but “too powerful to prosecute.”  The Charles Keatings of that era had much less clout than the Henry Paulsons of today.

Ferguson does not go easy on the Bush administration, but he shows origins of Wall Street’s capture of the government in the Reagan and Clinton administrations and its continuation in the Obama administration which, as in so much else, continues the Bush policies with many of the Bush appointees.

He shows the conflicts of interest among top economists, who receive big consulting and directors’ fees from the financial industry they supposedly are analyzing impartially.  Long ago there was a scandal when radio disc jockeys accepted payola from record companies to play certain records.  We ought to be equally scandalized about payola to academics.  But in fact, these economists are still treated with respect by officialdom and the press, while the economists whose warnings proved true are still regarded as marginal figures.

Different tree, same monkeys

The new financial reform bill follows the pattern of the health reform bill.  Instead of changing the system is a straightforward way, Congress chose to create a new level of regulatory complexity which may or may not do good.

The main obstacle to progress is the Senate’s rule that 41 Senators can block a vote on any measure, and the Republican leadership’s willingness to use that rule to block the will of the majority.  A secondary obstacle is the Obama administration’s unwillingness to press for meaningful change.

The Senate rejected an amendment offered by Senators Ted Kaufman of Delaware and Sherrod Brown of Ohio to break up the six “too big to fail” banks so that they could no longer hold the economy hostage. But the bill does contain a provision allowing federal regulators to break up the banks if they pose a “grave risk” to the financial system.

The bill supposedly contains a version of the Volcker Rule, which limits the ability of banks to use taxpayer-guaranteed deposits to speculate in risky investments.  But according to Senator Kaufman the bill’s many exemptions and exceptions make this rule meaningless.

Instead of limiting the size of banks and the power of banks to gamble with taxpayer-insured money, the bill creates new regulatory agencies with new powers.  It trusts the regulators to be independent of the bankers and smarter than the bankers, and at the same time to refrain from using their power capriciously or arbitrarily.  Past history gives little reason for that trust.

The rule of law is almost always preferable to arbitrary regulatory power.  With a simple clear law such as the Kaufman-Brown amendment or a no-loophole Volcker Rule, both banks and the public would know where they stood and be able to plan accordingly.

The economy held hostage

Unless Congress passes legislation to re-regulate financial predators and break up the “too big to fail” financial institutions, we as a nation are in for repeats of what we’ve experienced in the past 10 or 20 years – long stretches of economic stagnation interrupted by economic crises.

Our future prosperity depends upon restoring the banking and financial system to its historic role of turning savings into investment in the real economy.

We know Wall Street financiers make big campaign contributions, and we know Wall Street executives have held and still hold high executive positions under Republican and Democratic administrations alike. But the source of the banking and finance industry’s greatest power is more than that. It is its power to drive up interest rates and crash stock and bond prices if the government’s actions displease it.

When President Andrew Jackson refused to renew the charter of the Bank of the United States, a privately-owned bank with roughly the same power as the Federal Reserve System today, the president of the bank, Nicholas Biddle, deliberately brought on a recession by restricting loans.  Jackson thought this was not too high a price to pay to destroy the bank’s financial and political power.

I don’t think today’s financiers and bankers would do anything that blatant, but they wouldn’t have to. The “automatic” working of the market would do the job.  This is a great danger when the federal government is running huge deficits, and needs low interest rates to keep them under control, and when the new economic recovery could be aborted by a fall in stock prices.

When Bill Clinton was President, he accepted as a fact that he could not do anything that would disrupt financial markets.  One of Clinton’s advisers, James Carville, famously remarked that if he died and was reincarnated, he wanted to come back as the bond market, because everybody would fear and obey him. But the financial markets are not a proxy for democracy. As long as we Americans are governed by the financial markets, we are not a self-governing people.

Usury as a religion

The bailout of the European banks, like the bailout of the U.S. banks, shows that society has assumed an obligation to the banking system that takes priority over all other obligations.  The Greek government did not default on its debts, nor did the governments of Portugal, Ireland, Italy or Spain.  The crisis arises from the fact that the big bankers feared Greece might default on its loans, and jacked up interest rates accordingly. This of course increases the risk, which is further increased by speculators betting on default. The rescue operation being undertaken by the European Union and the International Monetary Fund is not a rescue operation of the people of Greece, who are likely to have to endure high unemployment, lower wages and worse public services, but a rescue operation for the banks.

So the obligation to repay loans takes precedence over all other obligations.  And the nature of compound interest is such that the burden of a debt can increase without limit.  If you have a potentially infinite obligation that takes precedence over all other obligations, is this not the equivalent of a religion?

When I studied history and economics in college, I was taught that the traditional Jewish, Christian and Muslim teachings about usury were one of the chief obstacles to modernity and progress. Some 50-odd years later, seeing the stranglehold the financial system has over the part of the economy that produces goods and services, I think it is time to revisit those teachings.

I recognize, of course, that someone who borrows money has an obligation to pay it back.  And I recognize that lenders have a right to be repaid for their inconvenience and risk.  The problem is the unlimited nature of compound interest – that someone can pay back the principal of a debt many times over, and still be deeper in debt than before.  This was the basis of debt slavery in the Roman Empire and of slavery in many parts of the world today; it was the basis of indentured servitude and the old-fashioned company town.  It is the plight of poor countries to the International Monetary Fund and the international banking system.

I am intrigued with the idea of Islamic banking, which sets a cap on compound interest. This is done through various mechanisms. In one of them, the lender theoretically “buys” an asset or an interest in an asset that is being pledged for security, and then allows it to be bought back in installments at a greater price but a fixed price.

I do not think Islamic-type banks will compete successfully in the international marketplace, because their capital will increase at a slower rate than traditional banks.  But perhaps there could be a system for chartering banks organized on such principles, or for using such principles in student loans or other government loan programs.

A parable for our time

Charlie Munger, the long-time partner of Warren Buffett in his Berkshire-Hathaway investment fund, wrote a caustic parable which sums up very nicely the economic history and current economic plight of the United States. Click on this to read it.