Niall’s virtual diary archives – Monday 24th March 2008

Monday 24th March 2008: 6.53pm. Got back from the stag in Budapest yesterday and am slowly recovering today. I was so tired yesterday after the previous week so lacking in sleep that I was hallucinating quite profoundly - which certainly made the trip rather interesting!

I promised myself I wouldn't do any coursework today in order to give myself some rest. However, I wanted to continue the previous entry especially with the collapse of Bear Stearns last week - a classic, and very typical, example of how evil banks truly are - though, I must strongly add that Bear Stearns itself was hardly that evil and if anything, the fact it collapsed was precisely because it wasn't being evil enough. Before I begin, I use the term "bank" in a far wider sense than just the ones on the high street - I include investment houses, insurance companies, pension funds and private equity firms, and I even include the extremely wealthy (both individuals and corporations) who have always behaved a little like a bank by lending out money and investing in new enterprises. While I could use the term "investor" here, there is a huge difference between an investor off the street and these institutional investors.

Banks, since through their greed they partially caused the Great Depression in 1929 which let loose both Fascism and Socialism in the West, have ever since become partially protected entities by government - and thus in some ways, they have become a semi-official arm of government at the same time as governments have become semi-official arms of banks. I should explain that, because it's hardly a conventional viewpoint:- since well before the Roman empire, banks have bailed out governments with loans for wars and when the economy turns sour instead of raising taxes. However, since certainly the late 1970's, and many would say since colonial times, they have also told governments what to do and if governments don't comply, they are punished for it. Traditionally, governments were able to prevent banks having too much power by restricting capital movements, but with the advent of globalisation and instantaneous capital transfers, banks can both invest and withdraw vast amounts of capital in a very short time for almost no cost. Should a government be judged to not be behaving "well", its currency can be devalued, its industry starved of investment AND revenues and mass protest on the streets invoked.

However, there is a flip side. Banks compete with one another for profit, so when there is a boom they have a very nasty tendency of making ever increasingly unwise investments (this is called a "speculative bubble"). These seem wise at the time because when your colleagues do something, it becomes "normal" and more importantly, financial markets have always worked on a herd principle - and you can make a LOT of money by anticipating a herd movement and making an early investment. The problem is when the "correction" happens - when markets return to fundamentals, those last to react by yanking their money fail much like musical chairs.

Two banks who were very highly regarded in the last few years were Bear Stearns in the US and Northern Rock in the UK. They were so highly regarded because they were at the vanguard of the use of "structured investment" which is a variation by the way of the thing that caused Enron to collapse. Everyone you see had decided that Enron's managers were corrupt because "they had used structured investment to hide massive operating losses" - however, as is becoming severely clear of late, it is structured investment itself that is the cause of this problem. But I'll come back to that in a minute.

As with Bear Stearns and Northern Rock in Britain, taxpayers money to the tune of billions has been used to bail out failure in banks - that means less schools, hospitals and public services or higher taxes in return for keeping them afloat. This is a problem economics calls "moral hazard" because unlike in most industries, failure for any large bank in the financial industry since 1929 costs the taxpayer and not the bank itself - which therefore means that investors using banks (NOT the investors in the banks themselves) can happily egg on their bank to take obscene risks for obscene profits knowing that taxpayers will bail out failure.

In fairness, the industry itself tends to absorb its aborted own using government finance to prop itself up, and the government debt eventually gets repaid during the next obscene profits stage - not that, might I add, government sees any of that at all, they just get back their bonds (the loan) with interest repaid rather than getting a slice of the total profits made from their investment. Therefore, what is really happening here is that government (ie; taxpayers) insures banks against failure - government takes on the risk, while investors get all the profits. Thus the whole affair becomes a virtuous circle - government needs banks to prop up budget deficits through loans, while banks need government to bail them out every time they become too exuberant & greedy. Hence they effectively become convenient arms of one another - and each can "blame" the other to the taxpayers for when taxpayers lose out.

One can clearly see here that effectively the financial industry receives a massive public subsidy from the taxpayer, because these failures happen fairly frequently (roughly every seven years on average) and when they do, they are very expensive. How expensive might you ask? Well, you have to remember something very important - money doesn't exist ie; the value of money changes very rapidly indeed, especially in the modern world - and it changes FAR QUICKER than the book keeping shows because the accountants, working in retrospect, average it all out.

What do I mean by that? Well, why do these banks fail? The share price of Bear Stearns was trading at $93 a share only last month - it was swallowed by JP Morgan this month for just $2 a share. That in itself didn't wreck the company - almost all companies (and individuals actually!) fail for one reason alone - it's not the lack of money, it's the lack of cash flow ie; the lack of timely money. For example, if you want to move house, you need some extra money to pay for legal fees, time off work to look for new houses etc. - in other words, to effect change requires spending some money. Even if the house you're buying costs 25% of the house you're selling (so you'd have 75% of your current house's value in cash after the sale), if you have no money right now for those transaction fees then you are absolutely stuck. The nice, big, expensive house you currently own is worth nothing to you right now because you can't "liquidate" its value.

This is what is called "liquidity" in economics - the ability to convert some holding to cash. When the government bails out financial markets it is technically referred to as "pumping in liquidity" which simply means that government makes up some extra money and loans it to others, thus giving those others enough cash flow that they have time to sell off their big assets. Some of you might be exclaiming "the government 'makes up' some extra money"? Well yes - because governments at any time can literally print off as much money as they like, or gather in & burn as much of it as they like. At any stage they literally can decide "I had £100m. Now I have £200m" by literally pressing a few buttons on a computer keyboard.

So why doesn't the government just print off £1000 and give it to each of us? Unfortunately, if governments print too much money, inflation goes up ie; prices start rising, and your shiny new £1000 becomes rapidly worthless. That's what happened in the 1970's - a series of socialist governments tried just printing new money and giving it to poor people, and promptly money lost its value leading to all those riots and strikes. As the government currently bails out banks, we risk exactly the same problem - which is why just recently inflation has been rapidly shooting up with it well exceeding 4% in the US when bailouts have been running the highest.

Now we can see just how expensive bank failure is to the public - when banks fail, liquidity becomes very severely constrained indeed - in fact, it's why government has to step in with freshly printed liquidity because none of the other banks will loan any of its colleagues money. Why? Because of those unwise investments I mentioned earlier - when it becomes clear to everyone just how unwise those investments were, all the banks (quite correctly) lose trust in one another. One gets a vicious circle because cash flows become so constrained that failure sets in, then there is even more distrust that your banks are lying to you about how badly damaged their cash flow is by their unwise investments.

You have to bear in mind that in a large & complex organisation that no one can tell what the current cash flow is actually like. You can get some idea of what it was in the past - this is precisely what accountants are for - but it's next to impossible to know right this minute. Thus when sentiment turns bad, there is a suspicion of distrust that is very tough to break. Hence breaking it is very costly, because when the government loans that money, it is worth vastly more at the time than its face value - because put simply, you couldn't get that extra liquidity from anyone else at any price. Of course, none of this ever factors into balance sheets or official reports - but failure to inject liquidity in 1929 cost tens, maybe hundreds of trillions of dollars at today's prices given the whole world war that resulted.

I should quickly add here that inflation is actually the transfer of wealth from everyone in society to the government - it's literally a tax on everything. So therefore a 2% inflation rate means the transfer of 2% of ALL money's value to the government. Of course, the government sees almost none of that since the 1970's - most goes to the banks actually as they are the largest borrowers of freshly printed money, which is one of the reasons that the financial sector has been booming the last thirty years - and the rest goes to commodity producers, of which during the last thirty years it's mostly been to oil producers like Saudi Arabia. Even better, inflation is payback for past taxation ie; if you print extra money now you don't have to pay for it via inflation at least till a year later - equally if you stop printing extra money now, it takes at least a year for inflation to stop. As you can probably imagine, this is a horrendous temptation for governments especially running up to an election - which is why in the late 1970's, control over liquidity was given away by governments to central banks eg; the Federal Reserve in the US. They you see being bankers have simply handed out the inflation tax to their colleagues in payment for keeping inflation low.

So far so good? Banks make obscene profits during boom, some collapse during busts, the bigger of these get bailed out by government who steal off the entire of society by increasing later inflation in order to bail them out. That is literally a massive hidden tax - the US economy is worth $16 trillion in 2007, so when inflation rises from 1.8% to 4% in one year as it has in the US you can see that an additional $350 billion dollars has been reallocated from society to banks and commodity producers, and that was between a year to two years ago - we won't see the effects of the most recent bailouts for another year to eighteen months. Not all of that went to bailing out banks or to oil producers - quite a lot went to other commodity producers as we are running out of water, grain, meat, metals, gas and indeed all forms of energy or materials.

Ok, enough for tonight as I gotta go see Megan. I'll continue tomorrow - be happy!