Yves here. While I agree philosophically with Richard Murphy’s belief that financial engineering should be recognized as a failed experiment, that was obvious after the 2008 blowup. Yet instead the authorities moved heaven and earth to recreate status quo ante.
One of the features of the world that produced the crisis was that regulators themselves, since the 1980s, had perversely been promoting regulatory arbitrage in the form of securitization and other approaches that reduced the need for perceived-to-be-costly bank equity. Regulators also chose to give a free pass to the growth of derivatives, when the big profits were in customized ones, generally for the purpose of tax avoidance or dressing up financial statements, as in activities with negative societal value added.
I anticipated, as Yankees are wont to say, that you can’t get there from here. ECONNED sketched out four possible responses to the crisis, and one was paradigm breakdown. From that discussion:
Recall that starting roughly in the 1870s, major European economies increasingly adopted the gold standard, and a long period of prosperity resulted. The regime was suspended in the UK and the major European powers during the war. Afterward, they moved to restore it, sometimes at considerable cost (England, for instance, suffered a nasty downturn in the early 1920s). But the aftereffects of the war meant the Edwardian period framework was unworkable. The deflationary forces they set in motion could have been countered by countercyclical measures after the Great Crash. But that was impossible with the gold standard. Indeed, as [Peter] Temin notes, “Holding the industrial economies to the gold standard last was about the worst thing that could have been done.”
Now readers may have trouble with that comparison, particularly since the conventional wisdom is that our policy responses have been so much better than those of the early 1930s. But the key point here is that the institutional framework locked the major actors into a particular set of responses. They were not able to see other paths out because they conflicted with an architecture and a set of beliefs that had comported themselves well for a very long time. It’s hard to think outside a system you grew up with. And remember, the gold standard did not break down overnight; the process took more than a decade.
Let’s use a different metaphor to illustrate the problem. Say a biotech firm creates a wonder crop, the most amazing creation in the history of agriculture. It yields far more calories per acre than anything else, is nutritionally extremely complete, and can be planted and harvested with far less machinery and equipment
than any other plant. It is tasty and can be prepared in a wide variety of ways. It is sweet too, so it can be used in place of sugar and high fructose corn syrup at lower cost. We’ll call this XCrop.
XCrop is added as a new element in the food pyramid and endorsed by nutritionists and public health officials all over the globe. It turns out that XCrop also is an aphrodisiac and a stimulant (hmm, wonder how they engineered that in) and between enhanced libido and more abundant food supplies, the world population rises at a faster rate.
Sales of XCrop boom, displacing traditional agriculture. A large amount of farmland is turned over from growing other types of produce to XCrop. XCrop is so efficient that agricultural land is taken out of production and turned to other uses, such as housing, malls, and parks. While some old-fashioned farms still exist, they are on a much smaller scale and a lot of the providers of equipment to traditional farms have gone out of business.
Twenty years into the widespread use of XCrop, doctors discover that diabetes and some peculiar new hormonal ailments are growing at an explosive rate. It turns out they are highly correlated with the level of XCrop consumption in an individual’s diet. Long-term consumption of high levels of XCrop interferes with the pituitary gland, which controls almost all the other endocrine glands in the body and the pancreas.
The public faces a health crisis and no way back. It would be very difficult and costly to put the repurposed farmland back into production. Some of the types of equipment needed for old-fashioned farming are no longer made. And with the population so much larger than before, you’d need even more farmland than before. The world population has become dependent on the calories produced by XCrop, so going off it quickly means starvation for some. But staying on it is toxic too. And expecting users simply to restrain themselves will likely prove difficult. The aphrodisiac and stimulant effects of XCrop make it addictive.
Advanced economies have become hooked on debt technology, which, like XCrop, is habit forming and hard to wean oneself off of due to its lower cost and the fact that other approaches have fallen into partial disuse (for instance, use of FICO-based credit scoring has displaced evaluations that include an assessment of the borrower’s character and knowledge of the community, such as stability of his employer). In fact, the current debt technology results in information loss, via disincentives to do a thorough job of borrower due diligence (why bother if you are reselling the paper?) and monitoring of the credit over the life of the loan. And the proposed fixes are not workable. The Obama proposal, that the originator retain 5% of the deal and take correspondingly lower fees, is not high enough to change behavior. And a level that would be high
enough to make the originator feel the impact of a bad decision would undercut the cost efficiencies that made securitization popular in the first place. You’d have better decisions, but less lending, and higher interest rates. That’s ultimately a desirable outcome, but as in the XCrop situation, no one seems prepared to accept that a move to healthier practices will result in much more costly and less readily available debt. The authorities want to believe they can somehow have their cake and eat it too.
Back to the current post, meaning now Richard Murphy.
By Richard Murphy, a chartered accountant and a political economist. He has been described by the Guardian newspaper as an “anti-poverty campaigner and tax expert”. He is Professor of Practice in International Political Economy at City University, London and Director of Tax Research UK. He is a non-executive director of Cambridge Econometrics. He is a member of the Progressive Economy Forum. Originally published at Tax Research UK
The last week has been interesting in the world of finance.
Greensill Capital collapsed. The provider of what might best be described as unusual forms of supply chain financing to what seem to have been vulnerable companies unable to offer what seem like conventional security for loans, the model ran out of steam despite the support of former Prime Minister David Cameron.
Significant numbers of companies are left vulnerable as a result, from the UK’s third-largest steel manufacturer to banks that had provided Greensill with its funding. They bet that they could fund a reward from financial engineering failed, as is so often true, and the edifice has collapsed.
Some of the same banks that will lose on Greensill, and most especially Credit Suisse, seem to also be exposed as a result of the collapse of the private hedge fund, Archegos Capital. That this was predestined to failure seems to have almost been assumed by its name, but still the banks funded it.
And as, once again, has happened before, providing funding for stock gambling has proved to be very expensive for those involved. Eventually the egos on display in these environments overrule sense. The cost is always significant. It will be many billions in this case.
Neither of these failures is the least bit surprising. Each relied on a punt that continual funding of leveraged financial positions would by itself provide the security required to make repayment. In effect, the size of the punts would, it was presumed, create growth that would yield the return to justify the risk within the differing, and yet similar in the sense that they were financially engineered, positions taken.
There is nothing new about this. The whole 2008 crisis was based on false assumptions of similar sort that by forever extrapolating a position no breakpoint would be found. Before that there was the failure of Long Term Capital Management in the 1990s. And there are ample others. The fool, whether they be technically described as a banker or not, and their money seems always to be willing to part with their money when offered returns that can only be realised if a market can continually grow.
We could, at one level, shrug this off. Both failures will be costly. David Cameron looks dodgier than ever. Some banks have been bruised. C’est la vie, it could be said. But that would be unwise.
I noted an article on inflation risk in the FT by someone called Andrew Parlin. To describe him as an inflation fetishist would be fair, but at least he had the honesty to lay bare his fear. He said:
[A]n entrenched inflation such as we have not known in decades and the need to slam on the brakes through aggressive rate tightening [is the risk that exists]. Given how inflated asset prices are, the bust that would follow would probably be unusually severe and protracted.
What he is suggesting is that there aren’t just isolated examples of excessive risk-taking on the basis of asymmetric betting right now, but that the entire financial market is currently built in it. Asset values are, as he is honest enough to admit, utterly distorted. The distortion has been created by low interest rate policy, linked to low inflation.
There is an inverse relationship between both low interest rates and inflation and financial asset prices. If financial assets pay broadly steady returns but interest rates fall asset prices rise to approximately equate the two. If inflation is also low then there is an extra boost for asset prices as lower risk discounts need not be applied. Both situations have existed for so long now asset prices are seriously over-inflated.
Parlin’s naked fear is that this situation might reverse if there was to be inflation, and that to prevent that asset price crash then the real economy must be sacrificed, in his view. Unemployment, austerity, and small-town corporate failures must all become the norm to maintain orderly asset pricing, even when it is recognised that those prices are seriously over-inflated.
Leaving aside questions of desirability (because it is patently undesirable to do this) and necessity (which is doubtful, as the inflation paranoia on display is not based on real-world risk, but on textbook ones instead, and the textbooks are wrong) what Parlin is saying is that financial markets are one entire asymmetric risky bet, all premised on the idea that interest rates will stay low in perpetuity. That may be true. But, when everything else in the economy has to be sacrificed to making good on that bet it is clear that the risk has moved from being routine to asymmetric. In other words, it can only continue to be justified by the perpetuation of the bet itself. That is the logic of the Ponzi, or pyramid selling scheme, of course. And that is where the whole of financial markets are.
Parlin wants effort to be directed to maintain this edifice. I rather suspect some self-interest in that desire. That self-interest might taint the views of many. But it should not stop us from realising that once a bet reaches this stage it is always, eventually, going to fail. It is only time before financial markets must adjust to the very obviously absurd valuations implicit in them.
That is not because interest rates need change, because I doubt there will. There is, in my opinion, almost no inflation incentive for that to happen. It is instead because the risk evaluation within markets is wrong. Most assets are being valued as if they offer near-guaranteed returns. But that is not true.
In finance, returns will fail because the bets are all wrong.
In energy, returns will fail because we have to reduce oil dependency.
In raw materials, returns will adjust to declining consumption.
In retailing, returns will fall as the shop beings increasingly irrelevant.
The same will be true in commercial property.
And the transport sector has not yet priced the adaptation to alternative energy, sufficiently.
Whilst tech has not priced changing tax rules.
Markets are going to decline because they gave mispriced risk. Oddly, inflation is not one of those risks. But that will not prevent a fall. The fall has simply been deferred by low inflation and low interest rates which have disguised the real risk of fundamental economic change.
Greensill and Archegos have failed because of mispricing risk, believing financial engineering can offset the real underlying economic factors that they chose to ignore. The signal that they provide is that the whole market is doing the same thing. But that does not mean we crash the real economy to maintain the financial edifice. We do instead invest in the real economy to create new worth.
We have to consign the era of financial engineering to history. But will we? It’s an absolutely fundamental question.
“We do instead invest in the real economy to create new worth.”
This, to me, is the key. It is clear that financial engineering is not investment in the real sense. Investment implies IMHO the employment of resources in an activity that adds something of benefit to individuals and/or society.
I am certainly no expert, but I think that taxation could be used to great effect to reduce the reliance of financial engineering (Tobin tax on algorithmic trading?). Unwinding of derivative positions could be facilitated by taxation as well. In fact, all secondary market transactions could be subjected to punitive tax regimes. Let’s return the stock market to its original productive capital raising purpose.
Maybe include a fairy significant financial transaction tax to slow down all that hot money too. It would have the net effect of leaving aside savers but punishing speculators.
In the last paragraph, when the author writes ” does not mean”, does he really mean ” should not mean” ?
And when he writes ” we do instead”, does he mean ” we should instead” ? Is this a difference between Britinglish and Ameringlish?
Or is the author being hopefully wistful, thinking that if he writes ” does not mean” instead of ” should not mean” and ” we do instead” instead of ” we should instead”; that writing it that way will make it so? That it really ” does not mean” and that we ” really will” and ” really do”?
As my former boss at the Bear observed long ago (the 1980s), “Asset inflation does not equal wealth creation.”
“When the capital development of a country becomes a by-product of a casino, the job is likely to be ill-done,” declared Keynes in The General Theory of Employment, Interest, and Money. Financial economist Michael Hudson believes this period of asset inflation will create a deflationary recession, or worse. My view is that Treasury and the Federal Reserve need to steadily let the steam out of this bubble, while Congress rewrites a tax code that encourages gambling instead of productive investment.
no one seems prepared to accept that a move to healthier practices will result in much more costly and less readily available debt. Yves
Because it’s not necessarily true? Would not negative interest on large accounts at the Central Bank (but with an individual citizen exemption to a reasonable account limit) encourage those with large fiat holdings to lend or invest them? To take risks rather than a certain loss?
And would not an equal Citizen’s Dividend provide some new funds for lending? Plus lower the need to borrow in the first place? Thus lowering the demand for loans?
Of course we need land reform too in addition to finance reform.
No, we’ve written at length as have others that negative interest rates absolutely do not lead to spending. They lead to even more savings due to the loss of interest income and on top of it, the loss of principal. The evidence is overwhelming. The Fed has made clear, privately, that no way is it doing negative interest rates.
The Citizen’s Dividend is a complete fantasy. Please don’t tout ideas that have zero following in policy or political circles. Michael Hudson’s Debt Jubilee is way out there but at least sometimes gets discussed in polite company.
Hudson’s ideas may get a smile in polite company but the response is anything but smiling. Debt peonage requires political peonage. The many, that don’t have the $400.00 that they may need right now, suffer both. Shoddy engineering is the parent of shoddy construction.
“In energy, returns will fail because we have to reduce oil dependency.
In raw materials, returns will adjust to declining consumption.”
I think this is the wrong way of looking at things. Due to peak oil (I believe this theory is valid) we will have to decrease oil usage. Due to a lack of raw materials we will have declining consumption.
Imo we are done. It’s over. Now it’s time for a low energy, low industry future. That’s what we are facing. But no-one really wants to face this. Forget electric cars. We might have electric bikes and scooters if we’re very lucky.
c, I regret it but I think that, in the long run, you may be right. Those with certain disabilities may need something akin to a car. Electric cars have certain characteristics that make it unsustainable to go that way — they use rare earth minerals. We can’t churn out millions of these every year and, to be anywhere near sustainable, they would have to operate ‘forever’. This would mean government subsidy to the industry.
Although no government is near adopting MMT, the US Senate is currently publicly critiquing the theory. So, if Gandhi was right, First they ignore you, then they laugh at you, then they fight you, then you win, then MMT is on the road. The ignoring and laughing stages of MMt are over. It is now being, reluctantly, taken seriously. But it is still a long and winding road. Will it lead to the right door? I wish I knew.
Rare earths may not be a barrier to electrification for long. This company has been in the news in the UK recently:
R, thanks for this. This clearly would be an advance. But how long would it take to get in a car, or, perhaps better, how long would it take for manufacturers to put their technology in such a car?
As we slide down the far side of Hubbert’s Peak and keep sliding till we reach our final resting place at the bottom of Hubbert’s Pit.
thanks Yves for Richard Murphy’s take on the big picture. I still recall Murphy’s response to Martin Wolf on why Wolf didn’t back MMT: it was the potential of the shift in the locus of power from private financial interests to more public ones, the possibility of coordinated policies shifting left between Treasury and the Federal Reserve (at a deeper level than the day-to-day cooperation needed to market and record the sales of public debt.)
This is a massive topic, thank you again for tackling it.
With your indulgence, some readers may find the following precis of Greensill’s “business” helpful, sourced from Wolf Street (I have heavily condensed their wording, so please consult the primary source).
Factoring is the reselling of (usually) receivables to third parties for quick cash. It is legal, but quite expensive. A healthy company can normally just pledge its receivables as collateral for a credit line at a regular bank, which would be a lot cheaper. Only companies that have trouble getting a line of credit would try factoring.
‘Reverse’ factoring refers to factoring of payables, a liability (vs of receivables, an asset):
1. A company hires a financial intermediary (like Greensill) to pay its suppliers promptly in return for the supplier accepting a small discount on the amount.
2. The company repays the intermediary later. Often much later….
3. Even though payables are a liability, the company does not need to disclose them as debt, maintaining its leverage ratios.
Reverse factoring can therefore be used to goose cash flow, understate debt levels and mask a badly deteriorating business position.
Large users include telecoms, consumer good companies, chemicals, retail, aerospace and, of course, the construction industry…..
Infrastructure projects may incur cost overruns to the tune of billions of dollars. This puts pressure on firms who have lowballed to win the work and are now facing liquidated damages (LDs).
Reverse factoring has long been used by Japanese corporations to hide debts, especially to domestically-based vendors. Ataka & Co, a sogo shosha (general trading house) which had practiced it with particular enthusiasm, collapsed in the late 70’s. Sumitomo Bank was forced to cover all Ataka’s losses to avoid a scandal of enormous proportions from blowing up.
In sum, this isn’t just a bunch of ‘nitvenders’ jawing up the price of tulip bulbs and robbing each other a la Gamestop. These shenanigans, global in scope, help mask ongoing malfeasance and rot in that ‘Real Economy’ we are counting on to Build Back Better.
There is a discussion in the post you linked to about if the liability is actually hidden, as far as I can tell the concerns in the comments were not addressed.
The gist of it is about short-term debt (usually debts falling due within 12 months).
Short-term debt can be owed both to banks and to regular suppliers.
The differences between getting a short-term loan from a financial institution to pay suppliers and doing reverse factoring are tiny. I do not think there are many credit professionals who would see any practical difference between the two – the debt is short-term in both cases and that is the major focus for people looking at cash-flow analysis.
What might possibly be done is that the company tries to change the liabilities from short-term to long-term – getting a long-term loan to pay off the short term debt. That might work for the short-term CEO & CFO, however, it will not take long before the trick no longer works but possibly the CEO & CFO plans to pocket their bonuses and leave before the debt becomes short-term again and let their successors deal with the situation.
Yves in your preamble about XCrop, you describe a positive feedback loop. Positive feedback loops cause failure and destruction, because they breach the safe limits of the system.
The Tacoma narrows Bridge failure is one famous response to a Positive Feedback – resonance in that case.
I just chased a house flipper of my front porch. I was a little rude, getting into a discussion of capitalism (he mentioned it first, not me!) and why house flipping wasn’t at all helping those who actually had to work for a living, goosing asset prices beyond any reasonable valuation.
This article makes me feel a lot better abut having done so.
I really wonder how much longer this can go on. Until every starter home is a million dollars?
I keep wondering that myself. Then, when the tectonic plates begin moving, the Fed steps in with some form of massive lubrication to calm the quake. They were last seen buying massive quantities of corporate and junk bond ETFs via their very special Special Purpose Vehicles. It seems to me that developing SPIVs for derivatives or whatever airy-fairy hedge is the flavor of the month during the next terrestrial movement would not be beyond their reach. Now that the Fed appears to be a firm believer in MMT this can probably go on for quite a while. Worst of all, nobody of influence will take any notice as long as the value of their real estate increases.
Financial Engineering was based on “bad bets.” And everyone is going to lose. Actually it was based on nothing. RM’s list of risks includes depleted resources. In fact all of RMs examples are examples of depleted or misused resources. Financial engineering’s name is mud, but that doesn’t mean we can not have a new sustainable social-environmental engineering, including a financial system based on sustainability. If the gold standard was a source of stability until the roaring 20s blew it out of the water, that’s actually a social issue. And a mass delusion about the value of gold. We need a balance and sustainability standard. When all the bets go bad (because they were bad to begin with) and the economy gets depressed the last thing we should do is give up; call in all the debts; foreclose; evict; starve. That’s just the final act of economic nuttiness. There is no reason on earth why we cannot base sustainable finance on Earth. Not to be too corny. That’s what MMT suggests – remember Kelton’s example of how a government must distribute money before it can ask for some of it back in taxes… We need to build a sustainable world and do it generously. We can distribute credit based on real resources. And then do some rational taxing. So if finance were actually based on reality, based on actual resources and a rational time scale it, would work much better than having financing based on …finance itself (pure meaninglessness) and the arbitrary demands of “financial time” running much faster than the economy. That really is absurd. It’s time for MMT. We should welcome a slow, steady and sustainable new world. I’m gonna watch Kate Raworth, see what she says.
OK, I just watched Kate’s Ted Talk. Most Ted Talks are pure drama. She’s a little overly-romantic, but she’s saying the same thing most of us are saying. Equity and sustainability. She’s a little short on getting down to the brass tacks of what we have come to know as “financing” – where the rubber meets the road. We need to start with some Direct Value Engineering.
Isn’t our present institutional framework, where the ever expanding financial engineering of the Federal Reserve continues to accelerate, while simultaneously beginning to use MMT insights, be duplicating the logic of the gold standard era–where as Yves indicates, “…the institutional framework locked the major actors into a particular set of responses (in which) they were not able to see other paths because they conflicted with an architecture that had comported themselves well for a very long time.”
In other words a framework (MMT) that was once seen as potentially revolutionary both politically and financially is now in the process of becoming a key instrument in support of the status quo.
‘Financial engineering’ is simply a house of cards. I left the “industry” after helping set up some of South Africa’s first passive and index funds.
The lessons we could have learned from Japan, but didn’t.
In the 1980s, it looked as if Japan would take over the world, but bad financial practices have seen their economy flat-lining ever since.
Japanese companies found they could make more money from their financial arms (Zai Tech) than they could from their traditional businesses, for a while anyway.
House prices always go up and their real estate boom would never end, until it did.
Jusen were nonbank institutions formed in the 1970s by consortia of banks to make household mortgages since banks had mortgage limitations. The shadow banks were just an intermediary put in place to get around regulations.
Japan has never recovered.
We probably should have learned from the Japanese experience in the 1980s.
We adopted those same bad financial practices that crashed the Japanese economy.