Yves here. Das makes some statements in this post that I am certain will provide grist for reader discussion. For instance, he contends that growth is necessary for democracy. But is that true, or is that simply the only set of conditions we’ve had, in that the modern era featured (at least until recently) a widening of the franchise and an extension of rights at the same time the industrial revolution produced rising incomes. Yet Japan has had two lost decades and remains a democracy.
Similarly, Das contends that low interest rates helps debtors. That’s true IF they can refinance at those low rates. But the way this movie has worked out is that the better credit quality borrowers can refi and the lower credit quality ones can’t (witness the people who’ve gotten stuck with 24% or higher credit card balances). In fact, high inflation rates favor borrowers, since they get to pay back the obligation in cheaper currency.
But even if you quibble on some of the particulars, I anticipate you’ll agree on the extent of the damage done to trust at various levels of society and how costly it is proving to be.
By Satyajit Das, former banker and the author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011) and Traders, Guns & Money
In Jean Renoir’s 1939 film The Rules of the Game (La Regle du Jeu), a character observes that: “We live at a time when everyone lies.” Those words are equally true today.
All systems – social, cultural, spiritual, economic, financial- rely on trust. It requires the capacity to weigh up the costs and benefits of trusting others. It requires the ability to reciprocate in kind or seek redress when trust is betrayed. When it is working, the system enables strangers to deal with each other safely for their mutual benefit. It is the basis of liberal societies, democracies and economies.
In attempting to deal with the global economic crisis, policy makers have systematically undermined trust in instruments, trust in institutions, trust between nations and trust in the political process.
A Difficult Compact…
It is ironic that the breakdown should be caused by an economic crisis, not a political or social one. But the social compact within democratic societies requires economic growth – constant improvements in living standards and increasing wealth. The entire economic system and expectations cannot do without growth. John Steinbeck identified this tendency in his novel about the depression The Grapes of Wrath: “when the monster stops growing, it dies. It can’t stay one size”.
Today, strong economic growth may have come to an end. The global economy has stalled, entering a period of secular stagnation or contained depression. Employment, incomes, wealth and investment are stagnant or falling. Economy security has reduced dramatically for all but a select few.
The rapid rise of living standards and the size of the economy were driven, to varying degrees, by increases in debt levels, environmental damage and unsustainable consumption of non-renewable resources. The crisis has mercilessly exposed the limits of this economic model.
The crisis has also exposed the limits of policymakers’ tools to restore growth. Government spending to stimulate economic activity is severely restricted globally, due to increased investor focus on public finances and a reluctance to finance heavily indebted nations. With interest rates in most developed countries near zero, central bankers have been forced to resort to non-conventional monetary techniques, primarily quantitative easing (“QE”). The effectiveness of these policy instruments is increasingly debated, with repeated doses of familiar prescriptions failing to restore the health of the global economy.
The crisis has exposed other problems. In recent years, increasing concentration of wealth and inequality was disguised by artificially engineered housing booms and the availability of abundant debt to finance spending. Borrowing became a substitute for rising incomes.
As the top income earners’ share of wealth in many countries increased, strong economic growth papered over the problems of inequality. As Henry Wallick, a former Governor of the US Federal Reserve, accurately diagnosed: “So long as there is growth there is hope, and that makes large income differential tolerable.”
Economist John Maynard Keynes’ warning went unheeded: “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill done.” Politicians and policy makers struggling to deliver prosperity have turned to financial and political repression.
Financial repression, a term coined in 1973 by Stanford economists Edward Shaw and Ronald McKinnon, entails a variety of measures to channel funds to governments to help liquidate otherwise unsustainable debts. It can take the form of manipulating interest rates, forcing purchases of government bonds, controlling the free movement of capital and nationalising businesses or seizing savings. Ironically, financial repression is generally packaged as measures to ensure the stability and solvency of the economic and financial system.
Current government policy in most developed countries is to keep interest rates low for an unspecified but extended period. Returns are artificially set below the true inflation rate – money loses its purchasing power, the ability to buy real goods and services. As interest rates are the price of money, governments are now deliberately manipulating prices.
With interest rates at zero (known as ZIRP – Zero Interest Rate Policy), governments are increasingly forced to use QE to manipulate the amount rather than the price of money. In July 2012, Denmark’s central bank even instituted negative interest rates on deposits, setting the deposit rate at minus 0.2% per annum. Lending money to the Danish government required savers to accept a penalty. This was NIRP -negative interest rate policy. The European Central Bank (“ECB”) has also considered similar initiatives.
There is limited evidence that low interest rates actually stimulate economic activity. The effect appears temporary with spending reverting to normal levels once rates are normalised.
The major effect of low rates is to allow over indebted borrowers to borrow at lower interest rates and maintain higher levels of borrowing than could otherwise. Low rates help reduce the value of the debt, effectively decreasing the amount of borrowing. The policy subsidises borrowers at the expense of savers.
Low rates reduce the income of savers, including retirees. It undermines compulsory retirement saving schemes, designed to ensure a secure post work life.
In 2010, a “fully sympathetic” Bank of England Deputy Governor Charles Bean told the UK Parliament that retirees “shouldn’t necessarily expect to be able to live just off their income… It may make sense for them to eat into their capital a bit.” He pointed out that: “Very often older households have actually benefited from the fact that they’ve seen capital gains on their houses.” The implication of Mr. Bean’s speech was that retirees should sell their houses, camp in the local park and eat their capital gains.
Central banks insist that they can increase rates when they want to. All addicts believe that they can quit whenever they want to.
A sustained period of low rates makes it difficult to increase the cost of borrowing. Levels of debt encouraged by low rates become rapidly unsustainable at higher rates.
Japan’s public debt is 240 per cent of its Gross Domestic Product (“GDP”). The government spends more than $2 for every $1 of taxes they raise. They borrow the rest at interest rates of less than 1%. If interest rates increased to more normal rates then Japan would not be able to sustain its huge debt.
Desperate to get investors to buy government bonds the Japanese Ministry of Finance has found a new angle – sex. They are running ads promoting ownership of government bonds: “Men who hold JGBs [Japanese Government Bonds] are popular with women!”
These policies debase currencies, undermining money’s function as a mechanism of exchange and a store of value. Once an unquestioned store of wealth, investors in government bonds are now threatened by the risk of sovereign defaults or destruction of purchasing power. Jim Grant of Grant’s Weekly Interest Rate Observer noted that where once government bonds offered risk-free return, now they offer “return free risk”.
A Menu of Oppression…
More aggressive forms of financial repression are evident.
In the restructuring of Greek debt, retrospective legislation was used to deliberately prefer official creditors including the ECB, allowing them to avoid losses at the expense of other creditors. Subsequently, in the course of the bailout of Cyprus, in part because of the write-down in Greek debt held by Cypriot banks, significant losses were imposed on depositors. Unsurprisingly, commercial investors are now reluctant to finance some governments or banks, fearing adverse future changes to their legal status.
In some countries, governments have seized private savings or have directed it into approved investments.
In Spain, the approximately Euro 60 billion Fondo de Reserva was created to guarantee pension payments in times of hardship. The Fund’s investments now constitute primarily (97.5%) Spanish government bonds.
According to Bank of Spain data, Spanish government entities hold around 14% of the total government debt of around Euro 658 billion. Encouraged by the Spanish government and financed by the national central bank and the ECB, domestic banks hold a further 31.5%. In contrast, foreign investor holdings of Spanish government debt have fallen to around 37% from around 50% in 2011.
Purchases by such captive investors have helped the Spanish government finance itself and also reduced it cost of borrowing. The exposure to the government increases the risk of these investors in case of a restructuring of Spanish government debt and its ability to meet its future liabilities to their beneficiaries.
Portugal used its own pension fund to meet its 2011 deficit targets, having already raided Portugal Telecom’s pension fund the previous year. Argentina has seized pension funds, central bank foreign exchange reserves and renationalised YPF, the national oil company, allowing the government access to $1.2 billion of annual profits. Bolivia has nationalised Transportadora de Electricidad, Bolivia’s national power-grid company.
In India, tax authorities retrospectively imposed a large tax liability on UK telecommunications company Vodafone. Raghuram Rajan, an economist at the University of Chicago and recently appointed head of the Indian central bank, commented: “A government that changes the law retrospectively at will to fit its interpretation introduces tremendous uncertainty into business decisions, and it sets itself outside the law. [It] has missed a golden opportunity to show its respect for the rule of law even if it believes the law is poorly written. That is far more damaging than any tax revenues it could obtain by being capricious.”
The ECB, which oversees the 17-nation Euro-Zone, has implemented programs that entail “monetary financing”; that is, central bank funding of governments prohibited under European Union (“EU”) treaties. As Jens Weidmann, President of the German central bank, the Bundesbank, warned in November 2011: “I cannot see how you can ensure the stability of a monetary union by violating its legal provisions”.
Bad Banks …
The financial crisis and subsequent investigations revealed numerous instances of financial institutions placing their own interest before that of clients and exploiting unsophisticated customers for egregious profits.
On 14 April 2012, a former Goldman Sachs Executive Director Greg Smith published a sensational exit interview in the opinion pages of the New York Times. The letter criticised “toxic and destructive” practices and cultures within Goldman Sachs, one of the world’s largest, most important and influential investment banks. Former Chief Executives of the firm have held senior positions in the US and other governments – leading to the firm being christened “Government Sachs”.
The letter followed a series of earlier damaging disclosures about Goldman Sachs, labelled by Rolling Stones Magazine journalist Matt Taibbi as “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money”.
The criticism highlighted practices focused on getting clients to invest in securities or products that Goldman was interested in getting rid of. The letter highlighted the use of complexity to confuse clients and the focus on highly profitable and (sometimes) unsophisticated clients who did not fully understand the risks of the transactions that they were being encouraged to enter into.
In 2010, US government investigations highlighted suspect practices surrounding the sale of mortgage backed securities, known as the ABACUS and TIMBERWOLF.
Examination of several terabytes (billions of pages) of emails revealed Tom Montag, a senior Goldman executive, describing TIMBERWOLF as: “one shitty deal”. During a Senate hearing, Goldman’s Chief Financial Officer David Viniar was asked: “when you heard that your employees, in these e-mails, when looking at these deals, said God, what a shitty deal … do you feel anything?” Viniar responded: “I think that’s very unfortunate to have on e-mail”. Subsequently Goldman instituted policies against using swear words in emails, cleaning up language rather than sales practices.
The Securities and Exchange Commission (“SEC”) indictment cited Fabrice Tourre, a French employee of Goldman, who sold the Abacus deals to unwitting “widows and orphans”. Among tender emails to his girlfriend Serres, the “super-smart French girl in London”, Tourre observed in January 2007: “The whole building is about to collapse anytime now?.?.?.? Only potential survivor, the fabulous Fab standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!
He wrote that ABACUS was “pure intellectual masturbation”, ‘a “thing”, which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price. But Tourre had no self-doubt: “Anyway, not feeling too guilty about this, the real purpose of my job is to make capital markets more efficient and ultimately provide the US consumer with more efficient ways to leverage and finance himself, so there is a humble, noble and ethical reason for my job :) amazing how good I am in convincing myself !!!”
Goldman executives seemed to have trouble with the English Language. The following exchange took place during a US Senate hearing into these transactions:
Senator Levin: Don’t you have a duty to disclose an adverse interest to your client? Do you have that duty?
Dan Sparks: (head of Goldman Sach’s Mortgage trading): About?
Senator Levin: If you have an adverse interest to your client, do you have the duty to disclose that to your client?
Dan Sparks: The question about how the firm is positioned or our desk is positioned?
Senator Levin: If you have an adverse interest to your client when you are selling them something to them, do you have a responsibility to tell that client of your adverse interest?
Dan Sparks: Mr. Chairman, I am just trusting to understand what the “adverse interest” means…
The exchange mirrored a comedy sketch featuring British comedians John Bird and John Fortune:
Interviewer: “Can we talk about moral hazard?”
Banker: “About what?”
Interviewer: “Moral hazard?”
Banker: “I know what ‘hazard’ means, but what’s the other word?”
In July 2010 Goldman settled the matter, paying a $550 million fine, around 4% of its annual earnings of $13 billion. Charles Geisst, author of a history of Wall Street, was unimpressed: “a fine is not going to bother these people … [It] is like passing around the church collection plate and collecting a few extra bucks for sins.”
In April 2012, Goldman Sachs paid $22 million to the SEC to settle charges that it allowed select clients to receive non-public information about stocks – a practice known as huddles or Asymmetric Service Initiative. In both transactions, Goldman Sachs, a model for financial firms throughout the world, displayed a disregard for client interests.
Goldman Sachs was not alone.
In June 2012, UK and American authorities fined UK’s Barclays Banks £290 million ($450 million) for manipulating key money market benchmark rates, such as the London Interbank Offered Rate (“Libor”) and Euro Interbank Offered rates (“Euribor”). The UK Financial Services Authority released detailed evidence supporting that Barclays had breached various parts of the Principles for Businesses in manipulating rates in order to obtain financial benefits or, during the global financial crisis, due to reputational concerns.
Subsequently, other major international banks such as UBS, RBS and Rabobank, also paid large fines.
These rates affect a wide variety of transactions. For example, Libor is used to establish the interest costs of $10 trillion of loans, $350 trillion of [over-the-counter] swaps and over $400 trillion of Euro-dollar futures and option contracts traded on exchanges.
Beyond the final effect, the loss of trust is significant. Bank of England Governor Mervyn King observed: “The idea that one can base the future calculation of Libor on the idea that ‘my word is my Libor’ is now dead”.
Investigations have revealed alleged manipulation of benchmark currency and commodity price indices.
US banks, such as JP Morgan and BA, have also paid out large amounts as fines or settlement of claims in relation to mortgage lending undertaken prior to the 2007/2008 crisis.
But regulators too may be complicit. There are suggestions that regulators knew that Barclays as well as other banks were posting artificial rates which did not correspond to the actual rates that the banks would pay to borrow. It is alleged that regulators did not object because of fears that the truth would destabilise already panicked markets.
In the lead up to the financial crisis, finance executives received high salaries and bonuses, based on dubious often manipulated profits. Even in the aftermath of the crisis after governments were forced to support ailing banks, bankers’ voracious desire for large bonuses has continued. The inability or unwillingness of governments to rein in an industry which Martin Wolf of the Financial Times described as “a risk-loving industry guaranteed as a public utility” remains a point of contention.
Reviled and mistrusted, financial institutions throughout the world are losing legitimacy.
The Empire Strikes Back…
The rising lack of trust in governments, banks and global finance manifests itself in various ways.
To preserve the value of their savings, savers are reversing the historic trend to “the abstraction of property through paper currency”. There is a trend to switching from financial instruments to real assets – real estate, gold, commodities, farm land, fine arts and other collectibles.
There is growing interest in alternative paper money, such as the Bavarian Chiemgauer, England’s Lewes Pound or the Berkshares program in Massachusetts. Alternative currencies have limited acceptance within a small area and (sometimes) a finite expiry date. They are designed to encourage local business and emphasise community values.
Interest in digital currencies such as Bitcoin, also reflects, in part, increased concern about the monetary system. Irrespective of whether these alternative currencies succeed, they are testament to a growing distrust of governments and the financial system, representing a challenge to the authority and apparatus of states.
In the US, on Bank Transfer Day, an on-line phenomenon launched by an unhappy Bank of America client, disgruntled customers withdrew money from traditional banks transferring it to not-for-profit credit unions owned by members. The growth of peer-to-peer lending which facilitates the matching of savers and borrowers for small consumer loans also evidences this trend. Example include firms such as Prospect and Lending Club in America as well as UK start-up Funding Circle,
But the loss of trust in the financial system is potentially damaging. A switch to alternative currencies, precious metals and non-financial investments undermines growth and economic activity. Savings are locked in unproductive investments or unavailable to circulate freely. Bypassing banks may lead to a contraction in the availability of credit globally.
Loss of trust even extends to dealings between central banks. In early 2013, the Bundesbank, Germany’s central bank, announced that it would move around 674 tonnes of its holding gold bullion from foreign central banks (the Federal Reserve Bank of New York and the Bank of France in Paris) to Frankfurt.
While the move only affects about one-half of the Bundesbank’s gold reserves and officials stressed that there was no question of “mistrust”, Bill Gross, a founder investment firm Pimco, tweeted the obvious inference: “Central banks don’t trust each other?”
Monetary Colonialism …
Trust between nations is being destroyed.
The global financial crisis highlighted the problems of monetary colonialism -where some countries buy real goods and services from other countries, especially emerging nations, and in exchange sell them securities or I-O-Us with low rates of interest. Now, developed nations are pursuing policies to devalue their currencies, through a combination of low interest rates and increasing the supply of money.
These actions erode the value of sovereign bonds in which other nations, like China, Japan, Germany and others, have invested their savings. Between 2008 and 2012, the depreciation of the US dollar, resulted in a loss for foreign creditors of over US$600 billion. This undermines global trust.
Nations increasingly seek to manipulate the value of currencies to allow them to capture a greater share of global trade, boosting growth. But a calculated policy of engineered currency devaluations to gain trading advantages invites destructive retaliation in the form of tit-for-tat currency wars. These beggar-thy-neighbour policies exacerbate international tensions, manifesting itself in trade protectionism and disputes.
Many nations have used regulations and political pressure to force banks and investors to adopt patriotic balance sheets. This entails institutions purchasing their national government bonds and prioritising lending to domestic borrowers.
Low interest rates and weak currencies have also led capital to flow into emerging nations, with higher rates and stronger growth prospects. Since 2009, in excess of US$ 3 trillion have flowed into emerging markets. These frequently short-term, volatile money movements have the potential to destabilise these economies, derailing their development. This has forced some nations to deploy financial repression of their own – controls on capital flows into the country.
The devaluation of the US dollar had driven up the price of commodities, such as food and energy which are denominated in the American currency. In poorer countries where spending on food and energy, including everyday essentials like cooking oil, is a high proportion of income, this has caused hardship. These developments threaten to reverse progress in reducing poverty.
Higher commodity prices in combination with large flows of capital have created inflationary pressures in many countries which have forced authorities to increase interest rates which have slowed economic growth.
Under the guise of regulations needed to strengthen the financial system, the US has implemented measures whose extra-territorial application may give American banks a business advantage. Such measures do not foster international co-operation in regulating finance.