Chop Off Their Hands . . .

President Truman famously called for a one handed economist. The Carolingian kings of France would have accommodated him. They realised that a kingdom required a common currency under the control of the king and well regulated markets to sustain the confidence of the people.

At first mints were established widely, spread across the kingdom. Local barons began to profit from debasing the coinage, undermining confidence in the monetary system. So Charles the Bald established mints under his direct control and regulated the issue of coins:

C.12. Following the custom of our predecessors, just as it is found in their capitularies, we decree that in no other place in all our kingdom shall money be made except in our palace, and in St. Josse and Rouen, which right in the past belonged to St. Josse, and in Rheims, Sens, Paris, Orleans, Chalon-sur-Saone, Melle, and Narbonne.

C.13. And those who have control of the money, with no desire for favor or gain, should select faithful coiners, as if they were seeking our favor and the grace of God. And the coiners should themselves take oaths that they will perform their office faithfully, as well as they know how. And they should not coin a denarius of mixed metal nor one of light weight, nor should they consent to such a thing. And, without any deception or evil disposition towards those whose silver they accept for purifying, they should cleanse the silver, and without practicing any deception in weighing it, they should change the purified silver into denarii. If it be reported that any one has acted contrary to his oath, he will be tried by the judgment of God; and if it be proved that he acted contrary to his oath he will lose his hand just as was decreed for false coiners in book four of the capitularies, chapter thirty-three, and as a sacrilegious person and despoiler of the poor he will be subjected to public penance by order of the bishop;---for he committed no greater fraud if he coined a denarius of mixed metal or of light weight than he would have done by taking the silver of the State, or of the Church, or of the poor, in purging and coining silver with evil intent. In those regions where trials are conducted according to Roman law, he will be tried in accordance with that law.

C.18. And if a false coiner from those places, in which we have decreed that money shall be made, stamps money secretly or offers a false denarius in a business transaction, so that he cannot be caught and punished; he will be seized by our minister, just as has been decreed, if he seeks refuge in our fisc, in any privileged place, or on the estate of any powerful person whatsoever.

C.19. In order that this provision for the non-rejection of good denarii, and concerning the making of false denarii, might be better observed, we wish that every overseer cause the markets of his district to be catalogued, that he report to us what markets there were in the time of our grandfather, and what new ones began in the time of our father, and what were established by his authority, and what markets began to come into existence in our own time, which of them remained in their ancient locations, and, if they had been changed, by whose authority they had been changed.

Modern states gave control of monetary policy and markets to the barons of global finance. The experiment has resulted in the same disasterous outcomes as before. The barons have debased the coinage and corrupted the markets. The state lost control of the currency as central banks allowed the barons in banks and shadow banks to "create" money from securitisation and quantitative easing. The state lost control of markets as the SEC, FSA and others allowed those same barons to set up alternative trading platforms beyond any public scrutiny and to bastardise public exchanges with algorithmic trading and synthetic instruments priced against fraudulent reference rates.

Now that the whole system is falling apart, banks and bondholders - the robber barons and false coiners of our times - want to take more money from depositors and taxpayers to prop it up. The state, the taxpayers and the depositors should not be compelled to protect bank bondholders. Central bankers and market regulators should stop being complicit in debasement of the currency and corruption of the markets - taking the silver of the state and of the poor.

Enough already. Chop off their hands.

For Want of a Nail, the Ship Was Lost

Imagine a great ship dominating the skyline on a distant sea. Imagine the complexity of that ship: keel, ribs, planks, masts, spars, and an infinite number of less readily named components. Each component was hand-crafted by a craftsman skilled in his trade, to precise requirements, and secured in position to take the stress and strain of a life at sea.

Now imagine a crew. They didn't build the ship. The crew are told that the one and only purpose of the ship is to realise a profit for every man jack aboard. Any hand not contributing a profit will be turned ashore. Down below in the ship are nails. Thousands and thousands of nails. Nails are useful. Nails are much sought after in every port the ship enters. Nails can be readily sold and never traced.

The crew has been told that their purpose is profit. They have taken the lesson to heart. In every port they assess the value of the nails, and compare it to their function in the ship.

They tell themselves that the lubbers at Admiralty have no idea of ships. They specified too many nails in the regulations for ship procurement and licensing. The ship will be just fine with fewer nails.

So the crew below starts sneaking out the nails and selling them in the ports. They self-certify to their warrant officer, who self-certifies to the midshipman, who self-certifies to the lieutenant, who self-certifies to the captain, who self-certifies to the admiral, who self-certifies to the Sea Lords that every nail is where it should be and the supply of surplus nails remains adequate to meet unexpected reverses. And they turn a profit, so everyone is happy and the crew are given bonuses.

Until there is a leak, no one bothers to check the inventory of nails still in the woodwork. And when there is a leak, it is taken by all involved to be a localised problem that can be solved with a local solution, stemming the flow into the bilges from that one leak.

No broader inventory of nails is ever suggested. The crew are asked to conduct a stress test scenario that confronts a gale, or an enemy warship, and they self-certify that they would remain sound.

When RMBS valuations and ratings were questioned in 2007, it was taken to be a localised leak. Bear Stearns, Lehman and Northern Rock were sunk, but surely the rest of the fleet was still sound with a bit of extra liquidity to keep them afloat.

But a crew that is accustomed to enriching itself selling nails is unlikely to stop just because the Admiralty takes an interest and orders more nails be provided to shore up the creaking woodwork. They will take all the nails Admiralty is generous enough to provide and keep selling them in every port. Their purpose is profit, and profit they must. The ships still creak, the water gets deeper in the well each watch, but the self-reporting of the ships' condition improves in every dispatch to the Admiralty.

This is where we are, and this is what the LIBOR scandal reveals. Self-certified valuations of fixed income, OTC derivatives and other instruments not traded and valued on exchanges should all be suspect. Even the exchange valuations should be suspect, as they are influenced by the OTC positions. Some of those ships are being held together by the collective greed of the crews, unwilling to lose the means of profit at the Admiralty's (and taxpayers') expense.

No one suggests that we can let them all sink to the bottom as a lesson to seamen who follow. The navy is critical to our image of ourselves as strong and resilient. The navy must be saved. But how, when every nail that is sent aboard is sold in the next port to the profit of a man with no loyalty to the crown or the ship?

Lies, Damn Lies and LIBOR

I've been hesitant to write about the LIBOR scandal because what I want to say goes so much further. We now know that Barclays and other major global banks have been manipulating the calculation of LIBOR through the quotation data they provided to the British Bankers Association. What I suspect is that this is not a flaw but a feature of modern financial markets. And if it was happening in LIBOR for between 5 and 15 years, then the business model has been profitably replicated to many other quotation-based reference prices.

Price discovery is not a sexy function of markets, but it is critical to the efficient allocation of scarce capital and resources, and to the preservation of the long term wealth of investors and the economy as a whole. If price discovery is compromised by manipulation, then we will all be gradually impoverished and the economy will be imbalanced and unstable.

Over the past 25 years the forces of regulatory liberalisation and demutualisation of markets have allowed the largest global banks to set the rules, processes and infrastructure of global markets to their own self-interested requirements. Regulatory complexity and harmonisation benefit the biggest banks disproportionately, eroding the competitive stance of smaller, local banks and market participants. This has led to a very high degree of concentration in a very few banks in most markets that determine global reference rates for interest rates, currencies, commodities and investments. If those few collude with each other - as Adam Smith warned was always the result - then they impoverish us all.

We have allowed markets to evolve in ways that make supervision of markets almost impossible. Many instruments trade off-exchange or in multiple venues, making it nearly impossible for any single investor or regulator to supervise trading to prevent or detect manipulation or abuse. Many financial instruments are now synthetic compilations of underlying assets and derivatives, with multiple pricing components determined by reference to other prices or rates. Demutualisation and regualtory reforms stripped exchanges of the self-regulating interest in preventing manipulation and abuse by their members as mergers, profits and market share came to dominate governance objectives.

Off-exchange trading has been allowed to proliferate, creating massive ill-transparent and largely illiquid markets in almost every sector of finance. Pricing in these markets is based around calculated reference rates which, like LIBOR, are open to abusive quotation and data input practices. Many OTC derivatives are priced and margined using reference rates calculated against quotations unrelated to actual reported transactions. Synthetic securities such as ETFs are another example of an instrument that prices off a reference rate rather than the actual contents of an underlying asset portfolio. These instruments are open to consistent abusive pricing as a means of incrementally impoverishing those market participants who are the krill on which the global banks thrive.

How has it been possible for banks to grow from less than 4 per cent of the global economy to more than 12 per cent of the global economy without impoverishing others? How has it been possible for profits in the financial sector to be consistently higher than profits from other human endeavors with more tangible products or impacts on our daily lives - such as agriculture, transport, health care or utilities? How has it been possible that banks derive their profits not from the protected and regulated activities of deposit-taking and lending, but from the unsupervised and often unknowable escalation of off-balance sheet assets and liabilities? How has it been possible that pension savings have increased while pension returns have declined to the point where only bankers can expect a comfortable old age? Global banks have built the casinos and tilted the odds in the house's favour by rigging the data that determines the outcomes of most of the bets on the table. Every one of us that sits at the table long enough - whether saver, investor, borrower, taxpayer or pensioner - will be a loser. It is not a flaw; it is a feature.

There is a reason that financial infrastructure used to be dominated by mutuals. Mutual gain and mutual liability created a natural discipline on excess and on rogue elements that would impoverish their peers.

There is a reason why trading was restricted to exchanges, and exchanges and clearing houses used to be self-regulating, and even had responsibility for resolution and liquidation of their members. Direct responsibility, authority and financial control meant that they could exert very powerful and immediate consequences on those members identified as abusing the market or investors.

The investigations into market rigging are just beginning. Paul Tucker opened the box yesterday when he admitted that he could not know whether the abuses discovered in setting LIBOR had spread to other synthetically calculated reference rates. As events unfold, it may be that we begin to appreciate just how deeply vulnerable we have become to predation by bankers with no stake in a local economy or in the local quality of life of the people they impoverish. A reckoning is needed, and then a rebalancing toward more local and mutual provision of essential services and market infrastructure that serves markets rather than those few bankers on the board.

As a start, regulators should consider punitive restrictions on the sale of instruments which price on reference rates unrelated to reported market transactions or underlying asset portfolios. Pricing should reflect real market transactions rather than guesstimates talking the banker's book.

We need to rethink as a society what banks are for, what exchanges are for, and what clearing houses are for. If they are for the profit of the few at the expense of the many now, that is because it is the business model we have permitted. If banks, markets and clearing are protected because they have a social function, we should make certain that social function is adding value. If it isn't, then we need some new models and some new rules.

"Heads I win, tails you lose."

I was at a private lunch in the City some 15 years ago discussing whether hedge fund investments should be considered a new and distinct asset class. A very prominent hedge fund trader was asked his opinion. Surprisingly, he said that hedge funds were less a new method for investment, than a new method for higher remuneration. The appeal of hedge funds was in the outsize fees rewarding the fund managers rather than any superior returns for investors.

I was reminded of that lunch again this morning by two pieces in my inbox. The first referenced a paper from the Bank of England estimating the public subsidy of the UK's largest banks at more than £220 billion during the past couple years. These banks secure a funding premium in wholesale and deposit markets from the implicit state guarantee of obligations attaching to their too big to fail status. The subsidy distorts competition and risk taking, storing up even more future draws on beleaguered taxpayers. The second was a blogpost summarising recent comments of a Bank of England executive to the effect that all the cost savings generated by technology advances and automation in the banking sector had been paid away in increased bonuses and remuneration. IT efficiency gains fund bonus payments. The financial sector's appetite for technology investment is not driven by a desire to provide more efficient services, but to secure ever larger remuneration packages. In fact, rapid financial innovation and technology transformation has led to less efficient intermediation if evaluated on a cost basis.

Regulation has had a pernicious effect in driving technology and complexity. As Chris Skinner observes,

Put another way, in the first iteration of the Basel Accord there were seven risk metrics requiring seven calculations; by the time we get around to implementing Basel III, over 200,000 risk categories will require over 200 million calculations.

At some point policy makers will need to turn their efforts from reinforcing and bailing out the bankers who use any and every opportunity to take public support as private bonuses and instead evaluate much simpler, lower cost models of financial intermediation likely to yield domestic investment in domestic businesses and assets.

I can almost hear the shouts of "socialist" from the usual defenders of banks and markets. I am not advocating state nationalistion of banks, but state withdrawal of explicit and implicit bank subsidies.

It is a conservative principle that the state should intervene when markets fail. If the banking system has failed (and it has) and requires a taxpayer subsidy to continue to operate (which it does), then conservative principles dictate that the state must intervene to secure a resolution in the public interest. More of the same is not a conservative policy, but social welfare for bankers.

We currently have a system of excess regulatory complexity, hidden market distortions and public subsidies. Moving away from the status quo requires state action to identify and reduce subsidy through promotion of business models that are simpler, more transparent and more directly aimed at securing public benefit.

Your Bank: Fiduciary or Predator?

In the old days when banks were local, and owned either as partnerships or mutuals, bankers had a stake in promoting the prosperity of their clients. They wanted to see their clients do well so that savings in the bank would increase, and then the banker could lend more and do better too. Bankers were meticulous in evaluating the credit quality of local borrowers, because a loss hit their own capital and equity in the business.

Largely as a result of this happy local alignment of depositor/banker/borrower interests, bankers came to be regarded as trusted fiduciaries. Depositors expected the banker to exercise discretion in the lending of capital. Borrowers expected the banker to provide loans on fair and reasonable terms which would help the borrower's business to grow and perform on repayment obligations.

As we know, those days are long past. Banks are rarely partnerships or mutuals. Remuneration models that promote fierce competition and short term bonus mania are unlikely to leave much scope for ethical reflection on the promotion of either depositor protection or borrower prosperity. Modern bank funding models are focused on money markets and shadow banking conduits rather than making depositors secure long term. Their lending models are seeking ever higher margins on transactional speculation, cross-selling and hidden fees. They seek opportunities globally rather than the long duration lending that sustained growth of local businesses. Banks are no longer geographically dependent on the local community for either deposits or borrowers.

We are now forced to re-evaluate the role of banks. They clearly have little interest in performing as fiduciaries. They have a powerful interest in becoming predators.

But if banks are predators, then their beneficial social functions are undermined, and indeed, they become a threat to social welfare, economic growth and non-bank prosperity. If that is true, then they no longer warrant state protections.

It is the depositors and borrowers who now need the protection.

In the UK some banks have threatened to leave if the successor to Mervyn King is not less "hostile" to their predations.

This is like a fox threatening to go elsewhere unless the farmer makes the chicken coop more accessible. Worrying.

UPDATE: Today Greg Smith, head of equity derivatives at Goldman Sachs, very publicly resigned in the pages of the New York Times. It sums up his resignation to say that he preferred the days when he could be a fiduciary to the firm's clients rather than their predator.

Complexity Costs

I have had to deal with the idiocy of modern financial regulation rather more than I would like lately. The issue involves FSA regulations which create a bias in favour of the TBTF banks. (As almost all FSA regulation is biased in favour of TBTF banks, this isn't much of a clue.) The FSA acknowledges that their rule creates a bias. They acknowledge that the bias was created in error, without principled justification. (They allowed outside counsel retained by the big banks to write the rule for them.) They acknowledge that the restrictive rule is inconsistent with European Union directives on the subject matter, and inconsistent also with UK government objectives of reducing the implicit subsidy to TBTF banks and reintroducing competition to financial services. They acknowledge that a change to the rule could improve sector competition, consumer choice and reduce costs.

Will they change the rule? No. Changing the rule would require an expensive public consultantion and cost-benefit impact assessment that hasn't been budgeted by the relevant division of the FSA for this fiscal year. Additionally, there is no proof of a market demand for the benefits of the rule change, as the existing users of the rule - the TBTF banks - are telling the FSA that existing customers aren't asking for a rule change.

It's a good thing that this is a marginal issue for the business. If it were serious, I'd have to advise doing business elsewhere than the UK. It might be wise to do that anyway, as being subject to a regulator like the FSA will be such a miserable experience based on current observation that locating a business somewhere more sensible would probably help ensure the business succeeds longer term.

The frustration of this one case raises a broader issue. Is it possible to reform a failed regulatory system sufficiently to restore a functioning market?

Regulators operate monopolies and are virtually impossible to discipline for their errors. Being bureaucrats, most regulators do not really have a stake in whether their rules do more harm than good. No one outside the regulator knows or cares who had responsibility for crafting a particular regulation, much less how it promoted or restrained market efficiency in the long run. It's almost always easier and less risky to do what they are asked by powerful incumbents than to attempt to level the playing field in favour of consumer protection or increased competition. Fifteen years of the FSA pretty much proves this point, as complaints to the financial ombudsman were at record levels last year and financial services concentration is consolidating at a very rapid clip leaving consumers very little real choice.

And then there is the complexity of modern regulation. Changing any regulation requires a publication of proposals, a consultation period, a cost-benefit impact assessment, legal consultation to ensure compatibility with EU directives, etc. Consultation responses are more likely to be from TBTF incumbents with a stake in bad regulation, and very unlikely to be from ill-informed consumers or would-be market entrants who might benefit from good regulation.

The FSA is being disbanded for its failure to properly regulate UK banks in the run up to crisis. It will be split into three, with some functions going to the Bank of England, some to a new Prudential Regulatory Authority and some to a new Financial Conduct Authority. A change in structure does not necessarily yield a change in ethos or policy. Sadly, the same bureaucrats will turn up at the same desks and largely follow the same courses that led to failure of the old system. If anything, the added complexity of co-ordinating among the three new regulators will be an additional incentive to make as few changes as possible to regulations going forward.

I am reminded of a friend who went to Eastern Europe just after the Berlin Wall came down in hopes of investing there to modernise the economy. He came back determined never to venture an investment because the same bureaucrats as held office under Communism were still showing up to work in the ministries every day and following the same rules as before.

Greece - Cutting out the Middle Man

It seems that central bankers and politicians are endlessly resourceful when it comes to innovating ways to profit themselves and bankers at everyone else's expense. Where I had thought Greek default inevitable just two weeks ago, I no longer think so today. It appears that Sarkozy, Merkel and the Troika have decided to prevent a default regardless of what Greek politicians or citizens may choose to do.

The new plan is to take the EUR 130 billion that would have gone to Greece in the second bailout, and put it in an escrow account. The account may be labelled "Greek Government", but Greek politicians will not have any authority over the funds. The funds will be disbursed by a non-Greek overseer to pay holders of Greek debt. Official creditors will receive full payment. Private creditors will receive the new discounted rates agreed with the IIF for restructured debt. I am not sure what private creditors who reject the IIF proposal might receive, but it will not much matter as ISDA will find there is no credit event regardless.

The fear among the creditor states of the eurozone was that irresponsible Greek politicians might use any new money to pay civil servants and pensioners rather than bankers and hedge funds. With funds held in escrow and disbursed by a non-Greek overseer, they needn't worry about such excesses of sovereign generosity.

This plan amounts to cutting out the middle man - the debtor. Bailout funds are used to bail out Greek creditors, without ever passing through Greek hands.

Athens is left with uncertainty about whether any further funding will be forthcoming for actual Greek state expenses. This is intentional. The escrow overseer may withhold funding if Greek politicians do not live up to creditors' reform requirements. As Greece may have run a primary surplus in the fourth quarter of 2011, it is just possible that Greece may be able to manage on its austerity budget if the economy doesn't contract too harshly going forward.

More from the FT's Greek team:

If Greece agrees to the new programme, all the elements agreed in a high-drama October European Union summit will finally be in place: a debt restructuring that will see private bondholders lose half their holdings; €130bn in new bail-out funding; and tough new controls officials hope will ensure Greek reforms are forthcoming.

The question remains whether the restructuring of private debt will achieve the ultimate goal of getting Greece’s debt level down to 120 per cent of economic output by 2020, without calling for bigger public sector contributions.

While this plan solves the immediate problem of a March 20th Greek default, what this means for future repayments of sovereign debt is less clear. Despite never having access to the funds, the Greek government and Greek taxpayers will presumably be obligated to repay their Troika creditors at some point. And the EUR 130 billion will not cover debt payments for ever.

If I were a Greek politician, I could probably live with this deal. While it is humiliating to have the money held and distributed elsewhere, it is still money that forestalls an otherwise certain default. And Greece can always default later anyway, should that prove convenient to avoid repayment of the now even larger debts.

The can is kicked down the road for another quarter, and the bankers can pay themselves their 2011 bonuses.

After all, innovation is the driving force of economic growth, and deserves to be generously remunerated.

Hell, Handbaskets and Hellenic Default

Regardless of what the IIF and the Greek government may announce, Greece is heading inevitably for a destabilising default to some or all of its bond creditors. The most articulate and comprehensive account of the reasons why this must be so are documented in the ZeroHedge masterclass on Subordination 101: A walk thru sovereign bond markets in a post-Greek default world. Roubini concurs.

I've written before about what this implies for the financial system:

If any OECD state were to default there would be very serious implications:
- The Basel Accord zero risk weight of government debt would be proved fanciful;
- The assumption of government debt as a liquid asset suitable for bank Tier 1 reserves to meet unanticipated and sudden cash demands will become unsustainable;
- Banks would be forced to recapitalise at much higher levels, forcing even sharper deleveraging and contraction of lending;
- Governments would lose the captive, uncritical investor base they have relied on to finance excess public expenditure for the past 30 years;
- Central banks could be forced to suddenly monetise even more government debt if required to meet the cash demands of a run on their undercapitalised banks.

Worrying, but not unexpected. A few of us predicted back in 2008 that the implosion of RMBS and bank capital, leading to central bank and sovereign bailouts, would fuel a central bank balance sheet and sovereign debt bubble. The central bank balance sheets have since balooned to 20 percent of GDP for the Fed and Bank of England, and 30 percent of eurozone GDP for the ECB. Deficits have spiraled everywhere, despite promises of austerity. Now the sovereign bubble too may burst.

From Deflation Has Become Inevitable in December 2008:

In Lombard Street, Bagehot’s seminal tome on fractional reserve central banking, Bagehot advises any central bank facing a simultaneous credit crisis and currency crisis to raise interest rates. By raising rates they will ensure that foreign creditors remain incentivised to maintain the general level of credit available while the central bank resolves the local liquidity crisis through liquidation of failed banks and temporary liquidity support of stressed banks.

The very opposite policies have been pursued by central banks in the US, Europe and UK since the beginning of the sub-prime crisis in August 2007. They have cut policy rates drastically, and as the crisis escalated and spread, the yield on government debt has dropped to negative territory. Meanwhile they have shielded those responsible for the creation of record levels of bad debt from any regulatory accountability, relaxed transparency of accounts, and provided massive taxpayer-funded financial infusions to prevent failure and liquidation.

While in the short term these policies have expediency and the maintenance of market “confidence” on their side, in the longer term these policies must undermine any confidence a rational and objective saver or investor might have that savings or investment in the US, EU or UK will be fairly remunerated at an above-inflation rate, or that savings and investments will be protected by effective oversight and regulation from the sorts of executive debasement and outright misappropriation and fraud that are beginning to colour our perceptions of the past decade.

Anyone sitting on a pile of cash now is unlikely to want to either (a) place it in a bank, or (b) invest it in the stock market. As a result, the implosion of the financial and real economy must continue no matter how big the central bank’s aspirations for its balance sheet or the treasury’s aspirations for its deficit.

I'm sorry I was right. (sigh)

Survivor Bias and TBTF Tyranny

It's time to write again about insolvency, as the MF Global failure and the Greek debacle raise new troubling concerns.

As I wrote in Ring Fences and Rustlers before Lehman failed in 2008:

The key to having a happy insolvency, if such a thing exists, lies in ensuring that when a globalised bank goes bust, all the best assets are inside your borders and subject to seizure by [your banks or] your liquidators on behalf of your creditors.

If one were cynical, and one believed that Lehman was going to be allowed to fail pour encouragement les autres one might wonder if Lehman was quietly bidden – or even explicitly ordered – to sell off its foreign holdings and repatriate the proceeds to asset classes within the US ring fence. This would ensure that US creditors of Lehman received a satisfactory recovery at the expense of foreign creditors. It would also contribute to a nice pre-election illusion of a “flight to quality” as US dollar and assets strengthened on the direction of flow.

If one were really cynical, one might even think that a wily bank supervisor might arrange to ensure 100 percent recovery for its creditors with a bit of creative misappropriation thrown in the mix. Broker dealers normally hold securities and other assets in nominee name on behalf of their investor clients. Under modern market regulation, these nominee assets are supposed to be held separately from a firm’s own assets so that they can be protected in an insolvency and restored to the clients with minimal loss and inconvenience. Liberalisations and financial innovations have undermined the segregation principle by promoting much more intensive use of client assets for leverage (prime brokerage and margin lending) and alternative income streams (securities lending). As a result, it is often very difficult to discern in a failed broker who has the better claim to assets which were held to a client account but reused for finance and/or trading purposes. The main source of evidence is the books of the failed broker.

On the wholesale side, margin and collateralisation in connection with derivatives and securities finance arrangements mean that creditors under these arrangements should have good delivery and secure legal claims to assets provided under market standard agreements. As a result, preferred wholesale creditors could have been streamed the choicest assets under arrangements that will look above suspicion on review as being consistent with market best practice.

The official report of the court appointed examiner confirmed my worst suspicions. We now know that the Federal Reserve Bank of New York and the SEC co-located staff inside Lehman from March 2008 to oversee the global repatriation of assets and cash in the run up to the insolvency in September. The Fed kept Lehman on life support during this period with more than $20 billion of liquidity which it paid back to itself from Lehman cash on the day Lehman filed for liquidation. In the meanwhile, from March 2008, Lehman looted its affiliates and client accounts worldwide by using prime broker and securities lending mandates to lend assets to the US affiliate which were sold (hence the sharp fall in Eastern Europe and Asian markets and growing volatility eleswhere from March 2008) and the proceeds streamed to US creditors as margin payments on derivatives and other obligations. The official receiver elected not to challenge the cash transfer to the Federal Reserve or any of the transfers of cash or securities made to major Lehman counterparties and creditors.

Those following the MF Global failure have noted a strikingly similar pattern of conduct by JP Morgan in advance of failure as occurred with Lehman, although without obvious official mandate. Yves at Naked Capital has been covering the parallels admirably. Carrick Mollenkamp, Lauren Tara LaCapra and Matthew Goldstein at Reuters have provided a very substantive story of how JP Morgan used its superior knowledge of MF Global's trading and credit position to enrich itself at the expense of MF Global and its clients before precipitating the MF Global failure.

I am concerned that MF Global demonstrates that the too-big-to-bail banks have found a new and almost riskless way to make outsize profits. Because derivatives, repo and liquidity are so very highly concentrated now, and leverage is at pre-crisis levels again, these few players can rig the markets and liquidity to choose when and how their clients fail. Their top down view of clients' trading and custody portfolios and cash positions and flows puts them in a position to exercise tyranny. They can game their clients, taking advantage of superior information, credit and liquidity to ramp or crash targeted markets as needed to precipitate a crisis. They can demand the choicest assets as collateral, setting very high over-collateralisation thresholds, and then exercise during post-failure turmoil to retain everything they hold at rock-bottom prices.

In today's low volume markets, a crash or squeeze is even cheaper and less risky than ever before. Instead of working for their clients' success, an unscrupulous clearing bank - or several operating in collusion - can profit on engineering market instability or turmoil.

If one were a conspiracy theorist, one might suspect that such games were being played now in global markets. Perhaps gold is being used as collateral for margin and cash liquidity, sold by counterparties to bring the price lower, leading to margin calls for even more. A crisis arising from a major default (Greece, Portugal, a huge bank) would force the price lower still, when the collateral would be exercised on default. Following on, the price might rocket again to enable the conspirators to seize outsize profits. Just a scenario, mind you! (Although, I note that Lehman's counterparties reported record profits through much of 2009.)

What is left of the global markets becomes a game of engineered survivor bias. Only those operating outside the law and with unlimited regulatory forbearance can win while the rest of us lose. As I noted in 2008, after Lehman failed, in Financial Eugenics, "It's not your survival they're engineering."

I don't say absolutely that what I describe is actually happening. But it may be. Certainly market conditions are ripe for it, and MF Global reinforces the pattern.

Now over to Greece. I find the PSI (private sector involvement) negotiations for Greece's restructuring of its debts troubling because it shows the same determination to engineer survivor bias. One of the core principles of insolvency law is that all creditors of like standing should be treated equally in the resolution. The PSI approach is starkly contrary to this principle, despite the evidence that Greece is well and truly insolvent. First, the official bond holders (central banks, supranationals, governments and the ECB) are excluded from mark-downs of their debts, preferring to impose the burden of capital losses entirely on the private sector bond holders. Second, the private sector bond holders are divided between those with an interest in preventing a declaration of default (either unhedged or have written credit default swaps) and those who will profit from a default through claims on credit default swaps. Rather than being represented equally in the negotiations through a creditors' committee, the negotiations are being driven by the Institute of International Finance, a trade lobby of just the biggest banks. Why the IIF should have credence as representing hedge funds, pension funds and insurance companies holding Greek debt is beyond me.

Once again we see centuries of jurisprudence and decades of statutory law and market practice cast aside for the convenience of a handful of big banks. They argue that abandoning our principles is desirable to prevent destabilisation of the financial system - again. I am wondering if a system that requires constant sacrifice of all the principles of market price discovery, rule of law and equitable treatment of like behaviours is worth stabilising.

If the Greece negotiations fall apart, and Greece defaults, is it likely that the banks will embrace the rule of law and let their contracts stand? Or will they try to "reinterpret" their obligations or once again seek taxpayer reimbursement for their losses?

Tyranny takes many forms, but the essence is arbitrary exercise of power or despotic use of authority. Given their willingness to throw principles out the window whenever profits are threatened, it seems we are confronting a tyranny by a handful of bankers. Perhaps we should embrace some sacrifice of stability to forestall a more stable and much more dangerous tyranny.

UPDATE: Excellent, thorough analysis of the Greek debt situation is up on ZeroHedge: Subordination 101: A Walk Thru For Sovereign Bond Markets in a Post-Greek Default World. Well worth your time to read the whole thing as a primer on the potential pitfalls of all outcomes of the Greek debacle for global sovereign bond markets. Conclusion about the high stakes of the current standoff reads:

Finally, while we have no prediction of whether or not any of the above happens, one thing we are sure of: if the runaway central planners of the world believe they can legislate their way into an upper hand over the bond market, in ever more desperate attempts to avoid the day of reckoning, they will fail without any shadow of a doubt. Because demand for risk comes first and foremost from a sense of stability, of fair and efficient markets, and equitability: something which has long been missing in the stock market, and which may very soon be taken away, by force, from the bond market as well.

Banks are lawless dictators? Whose side are the police on?

First, hat tip to Barry Ritholtz for the articles linked here. I read two of the articles, written on opposite sides of the planet, one after another, and suddenly the dangers confronting us in political instability were much clearer.

Back in June I wrote:

It used to be that the role of the state in financial market regulation was to ensure efficient market operations, promote transparency of prices and liquidity, protect consumers from abusive practices, and to resolve failed companies according to principles of equitable distribution of assets among like classes of creditors. If the role of the state now is to shield HFT, dark pool and OTC markets from transparency, provide liquidity where the market fails, oversee the orderly fleecing of consumers, and to ensure that some creditors of failing firms always win while others always lose, then we no longer have a market economy. And as virtually all these regulatory policies have evolved in the absence of public debate and legislative scrutiny, we also no longer have democratic governance of markets.

The deficit that worries me most in terms of the future of our civilisation is the legal accountability deficit - or anomie as I use it here. This deficit is huge and still growing rapidly as decisions are taken behind closed doors to shield lawless bankers from taxes or criminal sanctions and dedicate more and more public funds and/or monetary expansion to the same lawless bankers with too little public accounting, scrutiny or recourse.

This morning a commentary by Robert Fisk crystalised this concern as a political crisis in the offing: Bankers are the dictators of the West.

Let's kick off with the "Arab Spring" – in itself a grotesque verbal distortion of the great Arab/Muslim awakening which is shaking the Middle East – and the trashy parallels with the social protests in Western capitals. We've been deluged with reports of how the poor or the disadvantaged in the West have "taken a leaf" out of the "Arab spring" book, how demonstrators in America, Canada, Britain, Spain and Greece have been "inspired" by the huge demonstrations that brought down the regimes in Egypt, Tunisia and – up to a point – Libya. But this is nonsense.

The real comparison, needless to say, has been dodged by Western reporters, so keen to extol the anti-dictator rebellions of the Arabs, so anxious to ignore protests against "democratic" Western governments, so desperate to disparage these demonstrations, to suggest that they are merely picking up on the latest fad in the Arab world. The truth is somewhat different. What drove the Arabs in their tens of thousands and then their millions on to the streets of Middle East capitals was a demand for dignity and a refusal to accept that the local family-ruled dictators actually owned their countries. The Mubaraks and the Ben Alis and the Gaddafis and the kings and emirs of the Gulf (and Jordan) and the Assads all believed that they had property rights to their entire nations. Egypt belonged to Mubarak Inc, Tunisia to Ben Ali Inc (and the Traboulsi family), Libya to Gaddafi Inc. And so on. The Arab martyrs against dictatorship died to prove that their countries belonged to their own people.

And that is the true parallel in the West. The protest movements are indeed against Big Business – a perfectly justified cause – and against "governments". What they have really divined, however, albeit a bit late in the day, is that they have for decades bought into a fraudulent democracy: they dutifully vote for political parties – which then hand their democratic mandate and people's power to the banks and the derivative traders and the rating agencies, all three backed up by the slovenly and dishonest coterie of "experts" from America's top universities and "think tanks", who maintain the fiction that this is a crisis of globalisation rather than a massive financial con trick foisted on the voters.

The banks and the rating agencies have become the dictators of the West.

The banks as dictators makes sense to me. In thinking about my dissatisfaction with financial regulation for much of the past decade, I see that a great deal of it is attributable to who the regulators see as their polity. Their idea of consultation on regulations is to ask the bankers, traders and rating agencies whether they approve. The idea of making public policy in the public interest if the bankers disapprove is unimaginable to them. And so the banks get the regulations they prefer - or at least did so until the crisis.

And my queasiness about David Cameron's behaviour in Brussels on Friday stems from the same concern. He threw his toys out of the pram and turned his back on the EU because they wouldn't guarantee to preserve the City from further taxation, regulation and scrutiny. It's very clear that the polity he was serving was not the United Kingdom's 62,300,000 people - but the one per cent that make their living in the City of London.

Immediately after reading the Fisk piece, I read the moving statement of Patrick Meighan, My Occupy LA Arrest.

My name is Patrick Meighan, and I’m a husband, a father, a writer on the Fox animated sitcom “Family Guy”, and a member of the Unitarian Universalist Community Church of Santa Monica.

I was arrested at about 1 a.m. Wednesday morning with 291 other people at Occupy LA. I was sitting in City Hall Park with a pillow, a blanket, and a copy of Thich Nhat Hanh’s “Being Peace” when 1,400 heavily-armed LAPD officers in paramilitary SWAT gear streamed in. I was in a group of about 50 peaceful protestors who sat Indian-style, arms interlocked, around a tent (the symbolic image of the Occupy movement). The LAPD officers encircled us, weapons drawn, while we chanted “We Are Peaceful” and “We Are Nonviolent” and “Join Us.”

As we sat there, encircled, a separate team of LAPD officers used knives to slice open every personal tent in the park. They forcibly removed anyone sleeping inside, and then yanked out and destroyed any personal property inside those tents, scattering the contents across the park. They then did the same with the communal property of the Occupy LA movement. For example, I watched as the LAPD destroyed a pop-up canopy tent that, until that moment, had been serving as Occupy LA’s First Aid and Wellness tent, in which volunteer health professionals gave free medical care to absolutely anyone who requested it. As it happens, my family had personally contributed that exact canopy tent to Occupy LA, at a cost of several hundred of my family’s dollars. As I watched, the LAPD sliced that canopy tent to shreds, broke the telescoping poles into pieces and scattered the detritus across the park. Note that these were the objects described in subsequent mainstream press reports as “30 tons of garbage” that was “abandoned” by Occupy LA: personal property forcibly stolen from us, destroyed in front of our eyes and then left for maintenance workers to dispose of while we were sent to prison.

When the LAPD finally began arresting those of us interlocked around the symbolic tent, we were all ordered by the LAPD to unlink from each other (in order to facilitate the arrests). Each seated, nonviolent protester beside me who refused to cooperate by unlinking his arms had the following done to him: an LAPD officer would forcibly extend the protestor’s legs, grab his left foot, twist it all the way around and then stomp his boot on the insole, pinning the protestor’s left foot to the pavement, twisted backwards. Then the LAPD officer would grab the protestor’s right foot and twist it all the way the other direction until the non-violent protestor, in incredible agony, would shriek in pain and unlink from his neighbor.

It was horrible to watch, and apparently designed to terrorize the rest of us. At least I was sufficiently terrorized. I unlinked my arms voluntarily and informed the LAPD officers that I would go peacefully and cooperatively. I stood as instructed, and then I had my arms wrenched behind my back, and an officer hyperextended my wrists into my inner arms. It was super violent, it hurt really really bad, and he was doing it on purpose. When I involuntarily recoiled from the pain, the LAPD officer threw me face-first to the pavement. He had my hands behind my back, so I landed right on my face. The officer dropped with his knee on my back and ground my face into the pavement. It really, really hurt and my face started bleeding and I was very scared. I begged for mercy and I promised that I was honestly not resisting and would not resist.

My hands were then zipcuffed very tightly behind my back, where they turned blue. I am now suffering nerve damage in my right thumb and palm.

I was put on a paddywagon with other nonviolent protestors and taken to a parking garage in Parker Center. They forced us to kneel (and sit--SEE UPDATE) on the hard pavement of that parking garage for seven straight hours with our hands still tightly zipcuffed behind our backs. Some began to pass out. One man rolled to the ground and vomited for a long, long time before falling unconscious. The LAPD officers watched and did nothing.

This account turned my stomach, as it demonstrates all too clearly that the sympathies of the state are with lawbreaking bankers and not the victimised masses bailing them out.

So that’s what happened to the 292 women and men were arrested last Wednesday. Now let’s talk about a man who was not arrested last Wednesday. He is former Citigroup CEO Charles Prince. Under Charles Prince, Citigroup was guilty of massive, coordinated securities fraud.

Citigroup spent years intentionally buying up every bad mortgage loan it could find, creating bad securities out of those bad loans and then selling shares in those bad securities to duped investors. And then they sometimes secretly bet *against* their *own* bad securities to make even more money. For one such bad Citigroup security, Citigroup executives were internally calling it, quote, “a collection of dogshit”. To investors, however, they called it, quote, “an attractive investment rigorously selected by an independent investment adviser”.

This is fraud, and it’s a felony, and the Charles Princes of the world spent several years doing it again and again: knowingly writing bad mortgages, and then packaging them into fraudulent securities which they then sold to suckers and then repeating the process. This is a big part of why your property values went up so fast. But then the bubble burst, and that’s why our economy is now shattered for a generation, and it’s also why your home is now underwater. Or at least mine is.

Anyway, if your retirement fund lost a decade’s-worth of gains overnight, this is why.

If your son’s middle school has added furlough days because the school district can’t afford to keep its doors open for a full school year, this is why.

If your daughter has come out of college with a degree only to discover that there are no jobs for her, this is why.

But back to Charles Prince. For his four years of in charge of massive, repeated fraud at Citigroup, he received fifty-three million dollars in salary and also received another ninety-four million dollars in stock holdings. What Charles Prince has *not* received is a pair of zipcuffs. The nerves in his thumb are fine. No cop has thrown Charles Prince into the pavement, face-first. Each and every peaceful, nonviolent Occupy LA protester arrested last week has has spent more time sleeping on a jail floor than every single Charles Prince on Wall Street, combined.

A deflationary collapse will lead to political instability. It always does, because deflation destroys the value of paper assets which are mostly held by the most wealthy - the 1 per cent. And when deflation destroys their assets, it destroys their power and creates a vacuum. We need to be very clear in such a case that the enemy of the people is not the state, because if the state uses its police powers to protect the guilty and punish the innocent, then popular resistance and revolt become all too probable.

In Europe, the politicians know this. Even the police know this. No matter what I think of any British government, the conduct of the LA Police would be inconceivable here. The police killing just one career criminal this summer sparked nationwide riots. Brutalising non-violent protestors would have all of us on the streets.

There are values which are independent of financial assets. Those of us concerned to retain those values as a legacy for our children need to be vigilant as the bankers are only concerned with the values they can cash short term.

Thomas Jefferson wrote, "When the people fear their government, there is tyranny; when the government fears the people, there is liberty."

Fisk and Meighan remind us that the people are sovereign. The protests are because our sovereignty is undermined when it is disrespected by bankers buying lawlessness or by the police or financial regulators using state powers against the public interest. We have a right as a free people to self-governance under the rule of law. We as a free people have a right to regulate financial services to ensure that it serves a socially constructive function in the economy. Applying the rule of law to bankers reinforces the principles of justice essential to capitalism and the preservation of private property. The banks are not sovereign, and do not have a right to laws, regulators and police that protect them and them alone. There's some work to do here, of course, but having the issue crystallised helps a lot.

Why I oppose Financial Stability

Financial Stability became a topic in the late 1990s, at a time of peak laxity in international financial supervision. The same minds which promoted the Financial Stability Forum (now the Financial Stability Board) also crafted the deeply flawed and destructive Basel II.

I have never understood why Financial Stability should be an objective of public policy. Desirable, measurable outcomes of benefit to the public should be the objectives of public policy. Stability is a silly and impractical goal in a capitalist economy. Success and failure of competitive firms are the basis for economic progress, capital allocation and market pricing. Capitalism requires recognition of failure, and failure always causes economic loss and some instability as past assumptions are re-examined and re-assessed more objectively in light of current painful reality.

The management of failure can contribute to better future outcomes, but only if the costs of failure are born by those who caused the failure and not by those innocent of it. The 1990s policies promoted by regulators during the Great Moderation aimed to forestall failure by disguising it, delaying it, and subsidising it. Since the collapse of securitisation and inter-bank credit markets in 2008, governments have been too willing to socialise the costs of failure (by then magnified with leverage) to taxpayers through serial bailouts.

One strength of the US banking system from the 1930s to the 1980s was that failures were dealt with quickly and certainly. Foreclosed properties had to be sold by banks within two years of repossession, leading to a quick and certain reallocation of assets from failed borrowers to new owners. The FDIC swiftly and mercilessly shut down failed banks. New owners - often buying at distressed prices - were encouraged to invest in making the assets productive and profitable. It was this simple recycling from failed managers to better managers that was largely behind the short recessions and strong recoveries during this period of American economic history. With forbearance now institutionalised at all levels of the US economy, we are seeing Japanification instead of recovery. And it is even worse just about everywhere else where dominant banks are much more influential.

Financial Stability - like national security - can never be objectively confirmed as achieved. It is more often used to disguise the ulterior aims of its proponents, or to misdirect attention in aid of bad public policy that harms rather than promotes the public interest. For example, the Greenspan Put was a brilliant mechanism for ensuring financial stability by preventing any adjustment of the markets in response to the S&L crisis or dot-com bust. The Bernanke Put and Paulson Plan were financial stability solutions to the securitisation fraud crisis that revealed the undercapitalisation of global banks and over-leveraging of real estate. Bank bailouts and special liquidity facilities were financial stability innovations to prevent mark downs of mis-priced and illiquid capital assets.

Rather than review whether massive financial deregulation and promoting concentration in a few incumbents was in the public interest, the Greenspan Put, Bernanke Put, liquidity facility innovations and public bailouts have disguised misallocation of capital by pumping the markets with taxpayer funds and monetary laxity whenever they began to flag. Financial Stability initiatives have therefore taught incumbent bankers that any disruption is an excuse to double down on bad bets as the central banks and state treasuries would flood enough cash to make bad bets come good. MF Global made this bet, and although it (and its clients) won't be collecting, I expect the creditors/counterparties that seized all its collateral assets expect to come out way ahead.

I oppose Financial Stability because it is the most misleading banner for a set of bad, harmful and expensive public policies protecting bad executive management and preventing recognition of realistic market outcomes.

So what would I promote instead? Resiliency and resolution. Resiliency means the ability to withstand stresses and shocks which will unavoidably arise in global, competitive markets. Resolution means the dispersion of assets to creditors - and competitors - when banks fail, in hopes the assets and enterprises will be better managed by other managers than the same ones that led the bank to failure. Together these two principles - if made the basis for public policy - would do more to restore sanity to global banking than anything else I can think of. Resiliency will favour more and better capitalisation, with a focus on marketable assets with transparent price discovery (e.g., traded on transparent markets and recorded on balance sheet). Speedy and certain resolution of failed banks will make management and shareholders conscious of the risks of failure falling first on them, then on unsecured creditors and bondholders, and never on the taxpayer.

We are a long way from adopting principles of resiliency and resolution, as demonstrated by the EU's continued efforts to forestall defaults while protecting incumbent managements and bondholders. Our policy makers continue to chase the chimera of financial stability, and make bad policies worse along the way.

Anomie Watch: EFSF and bailout lawlessness

Anomie literally means lawlessness. Although banks are burdened with many, many rules, they are seldom obeyed and largely unenforceable against the most powerful. Central banks are even more likely to ignore their enabling statutes and applicable regulations in innovating "financial stability" solutions. It is this lawlessness that was brought to the fore this week by a vote to reject the EFSF in Slovakia.

My post earlier this week coincided with a furore in Slovakia over approval of the European Financial Stability Facility. The EFSF is yet another mechanism for ill-transparently transferring taxpayer funds via governments and central banks to bankers, bondholders and bank shareholders.

An obscure leader, Richard Sulik, of an obscure minority party, SaS, objected to impoverishing his already poor countrymen to enrich foreign bankers. Under the terms of EFSF financing, taxpayers in Slovakia - the second poorest nation in the EU - would bear a disproportionate share of the EFSF burden relative to the size of the economy.

When the prime minister made support for the EFSF a vote of confidence, Sulik and his party brought down the government. The EFSF is likely to pass following a reorganisation of the coalition government, but in the meanwhile we have a teaching moment of real value.

I respect any politician who acts out of principle rather than self interest. Since the occurence is relatively rare, I was prompted to take a closer look at Mr Richard Sulik and his views on the EFSF. Fortunately he has documented his objections fully in a paper available online:

European Financial Stability Facility: A Road to Socialism

Just like it is impossible to extinguish fire with a fan, it is equally impossible to solve the debt crisis with new debts. The only thing that will help is to face the truth. Greece must declare bankruptcy, Italy must start saving and the rules set up by the eurozone upon its establishment must finally start being observed. It will hurt, but it is the only solution. . .

I would like to point out that this is not the same eurozone we entered in 2009. There are rules that should have been observed but all of them have been violated. Temporary EFSF and permanent EFSF will cost us 1 to 1.5 the amount of our annual state budget! Moreover, there is no guarantee that the attempts for the EFSF increase are over. . . .

EFSF ratification by the National Council will be a decision that will harm the citizens of Slovakia in the long run and to a great extent.

SaS will simply not sign up for something like this.

Whether you are for or against the EU, for or against the Eurozone, for or against bailouts, this is an important document to read. It catalogues the lawlessness and lack of accountability that made a bad financial crisis into a bad banking crisis then worse sovereign debt crisis and an even worse currency crisis.

I wish Mr Sulik had a career ahead of him in central banking or EU public policy. I fear after this week, he may once again be relegated to obscurity. His fellow Slovakians should be grateful for his principled stance and his foresight, and perhaps return him and his party to government when the costs of the betrayal of other parties become all too clear.

UPDATE: This just in! Berlusconi must face a vote of confidence tomorrow in the Italian parliament after defeat in a routine vote on government budget and accounts yesterday. Perhaps the Slovakian teaching moment will last longer than one day?

UPDATE (2): The three outgoing coalition parties have agreed with the opposition SMER party to pass the EFSF in a further vote to be scheduled before the end of the week. An election will be held on 10 March 2012. I hope the Slovakian voters remember then that the party that did not betray them to Brussels and the banksters was SaS.

Dexia, Mafia and Revolution

I knew I had seen the script we're living somewhere:

What I am saying is, we have now what we have always needed, real partnership with the government.

And this is what follows: Revolution!

What does that tell you? It tells me that when predatory bankers and their complicit government cronies cannibalise the real economy to the tipping point, then regime change is just a matter of time. Politicians are acting like bankers are their only paymasters. In reality the bankers are just the noisiest and most demanding paymasters - until the people rise up in anger.

This morning the 11 million people of Belgium have woken to find themselves the 100 percent owners of a bankrupt and unprofitable retail bank at a cost of 4 billion euros, and guarantors of a further joint 122 billion euros in liabilities with France and Luxembourg. The shareholders and bondholders will be grateful, and the markets are accordingly delighted, but pity the poor Belgian taxpayer. The CEO and Chairman of Dexia have admitted that the bank operated as a hedge fund, and yet they are given serial bailouts at the taxpayers' expense. The Belgians have already thrown out their government, so now what do they do?

UPDATE: Ironically, after putting up this post about how crony accommodation of the banksters can lead to revolution, the reality is unfolding even now in Slovakia. Slovakia was the last country required for unanimous consent to the extension of the powers of European Financial Stability Fund. The prime minister made the vote on the EFSF a vote of confidence in the government. Ooops. Looks like she loses her post and the government tonight, as one of the smaller parties took offense at the blackmail against the national interest.

My new hero is Richard Sulik, leader of the coalition's SaS party, who is willing to take down the government rather than betray his country's taxpayers. The vote, which has had the market on edge all day, has now been indefinitely postponed. Even if the EFSF vote passes this week, when the fecal matter hits the ventilator in the not distant future, the voters will remember that Mr Sulik tried to do the right thing.

FT.com:
“I'd rather be a paraiah in Brussels than have to feel ashamed before my children, who would be deeper in debt should I back raising the volume of funding in the EFSF bail-out mechanism,” Mr Sulik told parliament.

Mr Sulik resisted the entreaties of Ms Radicova and other officials, who stressed that Slovakia's credibility as a responsible member of the eurozone was on the line.

While the trials of countries such as Portugal and Ireland do find sympathy in Slovakia, which is the second-poorest member of the eurozone, there is very little feeling for Greece, which is seen by many Slovaks as having caused its own problems.

“Extending the EFSF is mainly for saving foreign banks, and it will be expensive for Slovakia,” said Mr Sulik.

Zerohedge is liveblogging the Slovakian Parliament for those who like their crony capitalism raw and in colour.

Transaction Taxes and Transparency

The City of London is in a stir over the EU proposal of a financial transactions tax. The great and the good are uniformly arrayed against such a tax. I am not so sure that it wouldn't be a good thing.

Here in Britain we now pay 20 per cent Value Added Tax on virtually everything we buy, except food, medicines and children's clothing. Yet the financial sector is exempt of any similar tax on transactions. This is patently unfair since approximately 5 pence of the 20 is required to finance the state bailouts of the financial sector. As a regressive and unfair tax, that is hard to beat.

In addition to raising revenues from an investment banking sector which has decimated public finances for a generation to come, a transaction tax might be a very good thing from an accountability and transparency perspective.

Those opposing say it would be anti-markets and drive trading offshore. Markets clearly do not work properly anymore at price discovery, liquidity aggregation or trade transparency. I rather think markets would work better if those participating had an economic stake in the transaction longer than a nanosecond, and a trading objective more durable than front-running real investors with HFT gaming.

More than that, a transaction tax would recognise that the state adds value to the market and deserves to be recompensed for that value. A huge part of the operational value of developed markets is derived from the rule of law. Taxing transactions would be recognising that each transaction benefits from the legal system which makes such a transaction valid and enforceable.

In my view, the way to make the transaction tax workable and cost-effective is to incentivise the reporting of transactions and the payment of tax. The way to do this is to legislate that transactions themselves will only be legally enforceable if there is a record that the tax has been paid. Anyone might choose not to pay the tax, but if they want to enforce a trade or debt obligation they are on their own. If they want recourse to the courts, rights to exercise on margin/collateral or a valid claim in insolvency, then they pay the tax as their ticket to rely on the legal system.

In the United States we see that the MERS scandal boils down to the wholesale attempt by US banks to avoid paying the transaction taxes on land mortgage registrations with local counties and states. As a result, the very enforceability of millions of mortgages is being thrown into doubt as a matter of law.

Had originators, banks, investment banks and investors been forced to register interests in mortgages in compliance with the law, some of the great abuses of securitisation would have become much more difficult to sustain for so long. In that sense, transparency would have promoted greater accountability and helped curb abuse.

The public has an interest in the integrity of markets. That integrity has been undermined horribly over the past 25 years by demutualisation of exchanges and clearing houses, fragmentation of markets to off-exchange systems and derivatives, leveraged shadow banking, and information assymetries between highly concentrated market insiders and everyone else. We now don't know who owns what and who owes what, and that means that economies are operating with dangerous blind spots. Relaxed accounting rules and forbearance on capital mean that mis-pricing and mis-allocation of capital are endemic and worsening, making any recovery even more doubtful.

A transaction tax on trades, as a pre-condition to legal enforceability, might restore some integrity to markets. That would help restore more efficient functioning to economies with much greater promise than further bailouts to banks.

Testimony of Marriner Eccles to the Committee on the Investigation of Economic Problems in 1933

Below are excerpts from the testimony of Marriner Eccles to the Senate Committee on the Investigation of Economic Problems in 1933. It is an historic document – laying out the future terms of the Federal Deposit Insurance Corporation, the management of money supply nationally through open market operations, the Bretton Woods Accord on currency stability, mortgage refinancing as monetary stimulus, and reforms of the Federal Reserve System to eradicate the excesses of untamed capitalism and financial dominance of Wall Street. He proposes higher income and inheritance taxes as essential to promote economic growth, curb inequality and forestall political instability. He encourages federal regulation of child labor, unemployment insurance, social security and other farsighted reforms. And he avows himself a capitalist throughout.

Although he was a titan of industry - with banks, railroads and corporations spanning the American west - Eccles was born the son of an illiterate, bigamist, Mormon, Scottish immigrant. He was about as far as you could get from the Eastern elite ranks that ran US banking on Wall Street. But he sure understood money, economics and trade, and had the personal drive and charisma to carry his point with the president and with Congress.

Following his testimony, the Utah banker was invited by Franklin Roosevelt to come to Washington to spearhead legislation to enact his proposed reforms. Within two years he had drafted and enacted the Securities Act of 1933 and the Banking Act of 1933(a.k.a., The Glass-Steagall Act, which separated investment and commercial banking and established the FDIC) and the Banking Act of 1935 (which created the modern Board of Governors of the Federal Reserve System and Federal Open Market Committee). He served as Chairman of the Board of Governors of the Federal Reserve System from 1934 until 1951.

Read this and know that just one person, with vision and principles, can make a difference to the world in a time of crisis, establishing the basis for decades of prosperity and growth.

[page 8]

Before effective action can be taken to stop the devastating effects of the depression, it must be recognised that the breakdown of our present economic system is due to the failure of our political and financial leadership to intelligently deal with the money problem. In the real world there is no cause nor reason for the unemployment with its resultant dsestitution and suffering of fully one-third of our entire population. We have all and more of the material wealth which we had at the peak of our prosperity in the year 1929. Our people need and want everything which our abundant facilities and resources are able to provide for them. The problem of production has been solved, and we need no further capital accumulation for the present, which could only be utilised in further increasing our productive facilities or extending further foreign credits. We have a complete economic plant able to supply a superabundance of not only all the necessities of our people, but the comforts and luxuries as well. Our problem, then, becomes one purely of distribution. This can only be brought about by providing purchasing power sufficiently adequate to enable the people to obtain the consumption goods which we, as a nation, are able to produce. The economic system can serve no other purpose and expect to survive.

If our problem is then the result of the failure of our money system to properly function, which today is generally recognised, we then must turn to the consideration of the necessary corrective measures to be brought about in that field; otherwise, we can only expect to sink deeper in our dilemma and distress, with possible revolution, with social disintegration, with the world in ruins, the network of its financial obligations in shreds, with the very basis of law and order shattered. Under such a condition nothing but a primitive society is possible. Difficult and slow would then be the process of rebuilding and it could only then be brought about on a basis of a new political, economic and social system. Why risk such a catastrophe when it can be averted by aggressive measures in the right direction on the part of the Government?

* * *

[page 9]

We could do business on the basis of any dollar value as long as we have a reasonable balance between the value of all goods and services if it were not for the debt structure. The debt structure has obtained its present astronomical proportions due to an unbalanced distribution of wealth production as measured in buying power during our years of prosperity. Too much of the product of labor was diverted into capital goods, and as a result what seemed to be our prosperity was maintained on a basis of abnormal credit both at home and abroad. The time came when we seemed to reach a point of saturation in the credit structure where, generally speaking, additional credi was no longer available, with the result that debtors were forced to curtail their consumption in an effort to create a margin to apply on the reduction of debts. This naturally reduced the demand for goods of all kinds, bringing about what appeared to be overproduction, but what in reality was underconsumption measured in terms of the real world and not the money world. This naturally brought about a falling in prices and unemployment. Unemployment further decreased the consumption of goods, which further increased unemployment, thus bringing about a continuing decline in prices. Earnings began to disappear, requiring economies of all kinds – decreases in wages, salaries, and time of those employed.

[page 10]

The debt structure, in spite of the great amount of liquidation during the past three years, is rapidly becoming unsupportable, with the result that foreclosures, receiverships and bankruptcies are increasing in every field; delinquent taxes are mounting and forcing the closing of schools, thus breaking down our educational system, and moratoriums of all kinds are being resorted to – all this resulting in a steady and gradual breaking down of our entire credit structure, which can only bring additional distress, fear, rebellion, and chaos.

* * *

As an example of Government control and operation of the economic system look to the period of the war, at which time, under Government direction, we were able to produce enough and support not only our entire civilian population on a standard of living far higher than at present, but an immense army of our most productive workers engaged in the business of war, parasites on the economic system, consuming and destroying vast quantities produced by our civilian population; we also provided allies with an endless stream of war materials and consumption goods of all kinds. It seemed as though we were enriched by the waste and destruction of war. Certainly we were not impoverished, because we did not consume and waste except that which we produced. As a matter of fact we consumed and wasted less than we produced as evidenced by the additions to our plant and facilities during the war and the goods which we furnished to our allies. The debt incurred by the Government during the war represents the profit which accrued to certain portions of our population through the operation of our economic system. No Government debt would have been necessary and no great price inflation would have resulted if we had drawn back into the Federal Treasury through taxation all of the profits and savings accumulated during the war.

* * *

[page 11]

How was it that during the period of the prosperity after the war we were able in spite of what is termed our extravagance – which was not extravagance at all; we saved too much and consumed too little – how was it we were able to balance a $4,000,000,000 annual Budget, to pay off ten billion of the Government debt, to make four major reductions in our income tax rates (otherwise all of the Government debt would have been paid), to extend $10,000,000,000 credit to foreign countries represented by our surplus production which we shipped abroad, and add approximately $100,000,000,000 by capital accumulation to our national wealth, represented by plants, equipment, buildings, and construction of all kinds? In the light of this record, is it consistent for our political and financial leadership to demand at this time a balanced Budget by the inauguration of a general sales tax, further reducing the buying power of our people? Is it necessary to conserve Government credit to the point of providing a starvation existence for millions of our people in a land of superabundance? Is the universal demand for Government economy consistent at this time? Is the present lack of confidence due to an unbalanced Budget?

What the public and the business men of this country are interested in is a revival of employment and purchasing power. This would automatically restore confidence and increase profits to a point where the Budget would automatically be balanced in just the same manner as the individual, corporation, State, and city budget would be balanced.

[page 12]

During the past three years there has been such tremendous liquidation and scaling down of debts that extraordinary measures have had to be taken to prevent a general collapse of the credit structure. If such a policy is continued what assurance is there that the influences radiating from a marking down of the claims of creditors will not result in a further decline of prices? In other words, after we have reduced all debts through a basis of scaling down 25 per cent to 50 per cent, what reason have we to expect that prices will not have a further decline by like amount? And then again, the practical difficulties of bringing about such a adjustment on a broad scale seem to be insurmountable.

The time element required would indefinitely prolong the depression; such a policy would necessitate the further liquidation of banks, insurance companies, and all credit institutions, for if the obligations of public bodies, corporations, and individuals were appreciably reduced the assets of such institutions would diminish correspondingly, forcing their liquidation on a large scale. Nothing would so hinder any possibility of recovery. Bank and insurance failures destroy confidence and spread disaster and fear throughout the economic world. The present volume of money would diminish with increased hoarding and decreased credit and velocity, making for further deflation and requiring increased Government support without beneficial results until we would be forced from the gold standard in spite of our 40 per cent of the world’s gold, and, at that point, an undesirable and possibly an uncontrolled inflation with all its attendant evils would likely result, and thus the very action designed to preserve the gold standard and re-establish confidence would destroy both.

[page 13]

We have nearly one and a half billion currency more in circulation at the present time than we had at the peak of 1929, and under our present money system we are able to increase this by several billion more without resorting to any of the three inflationary measures popularly advocated. There is sufficient money available in our present system to adequately adjust our present price structure. Our price structure depends more upon the velocity of money than it does upon its volume.

* * *

In 1929 the high level of prices was supported by a corresponding velocity of credit. The last Federal Reserve Bulletin gives an illuminating picture of this relationship as shown by figures of all member banks. From 1923 to 1925 the turnover of deposits fluctuated from 26 to 32 times per year. From the autumn of 1925 to 1929 the turnover rose to 45 times per year. In 1930, with deposits still increasing, the turnover declined at the year end to 26 times. During the last quarter of 1932 the turnover dropped to 16 times per year. Note that from the high price level of 1929 to the low level of the present this turnover has declined from 45 to 16, or 64 per cent.

[page 14]

I repeat there is plenty of money today to bring about a restoration of prices, but the chief trouble is that it is in the wrong place; it is concentrated in the larger financial centers of the country, the creditor sections, leaving a great portion of the back country, or the debtor sections, drained dry and making it appear that there is a great shortage of money and that it is, therefore, necessary for the Government to print more. This maldistribution of our money supply is the result of the relationship between debtor and creditor sections – just the same as the realtion between this as a creditor nation and another nation as a debtor nation – and the development of our industries into vast systems concentrated in the larger centers. During the period of the depression the creditor sections have acted on our system like a great suction pump, drawing a large portion of the available income and deposits in payment of interest, debts, insurance and dividends as well as in the transfer of balances by the larger corporations normally carried throughout the country.

[page 15]

The maladjustment referred to must be corrected before there can be the necessary velocity of money. I see no way of correcting this situation except through Government action.

[page 21]

Mr Eccles: Of course, the way I look at this matter is that we have the power to produce, just as in the period of prosperity after the war demonstrated when we had a standard of living for a period from 1921 to 1929 which, of course, was far in excess of what it is now. Yet in spite of that standard of living we saved too much a I have previously tried to show.

Senator Gore: You have got Foster in the back of your head?

Mr Eccles: I only wish there were more who had. We saved too much in this regard, that we added too much to our capital equipment. Creating overproduction in one case and underconsumption in the other because of an uneconomic distribution of wealth production. . . . Of course, we are losing $2,000,000,000 per month in unemployment. I can conceive of no greater waste than the waste of reducing our national income about half of what it was. I can not conceive of any waste as great as that. Labor, after all, is our only source of wealth.

[page 22]

There could be no waste in post offices or in roads or in schools. You would have something to show for it. With war all you have left is the expense of taking care of maimed and crippled and sick veterans. That is what is left from war. And it is all wastage.

Senator Gore: You have touched the point. The real cause of the existing trouble was the war, with destruction of over 300 billion dollars of wealth in four years. We are paying the price now. The boys paid the price in blood on the field. We are paying the economic price today. And you may just as well pass a resolution to raise the dead that fell in France as to try to pass laws to avert the inevitable consequences of that war.

Mr Eccles: It is true we are suffering the consequences of the war, but there is no reason why we should be suffering from the consequences of the war if it had not been for the international or the interallied debt that resulted from it. WE are suffering from a debt structure. We are not suffering from the waste, because after all, we know today that we have the power and the facilities to produce certainly all that the people of this country need and want.

* * *

We now see, after nearly four years of depression, that private capital will not go into public works or self-liquidating projects except through government and that if we leave our “rugged individual” to follow his own interest under these conditions he does precisely the wrong thing. Each corporation for its own protection discharges men, reduces pay rolls, curtails its orders for raw materials, postpones construction of new plants and pays off bank loans, adding to the surplus of unusable funds. Every single thing it does to reduce the flow of money makes the situation worse for business as a whole.

[page 24]

I am talking about private credit. If it is credit we need why do not say 200 of our great corporations controlling 40 per cent of our industrial output that are in such shape that they do not need credit – they have great amounts of surplus funds – if it is credit that is needed why do they not put men to work? For the very reason that there is not a demand for goods, that we have destroyed the ability to buy at the source through the operation of our capitalistic system, which has brought about such a maldistribution of wealth production that it has gravitated and gravitated into the hands of – well, comparatively few. Maybe several millions of people. We have still got the unemployment and have got no buying power as a result.

[page 25 – proposal of bank deposit insurance and failed bank resolution]

[page 27 – laying out the basis for what was later to be the FDIC]

However, there is always this danger about that class of thing [Government guarantee of bank deposits]. It encourages bad practices and bad management. It may put a premium on them, which of course we do not want to do, and if it is done there must be rules and regulations for the proper conduct of banks requiring eligibility, and if they fail to meet the eligibility they would be suspended after so much notice, and the fund would be drawn upon to take care of any loss.

[page 31]

Farm mortgages at present are possibly the most undesirable and frozen of all loans, and frozen loans are preventing, to some extent, the necessary expansion of credit. The plan I have proposed [to refinance existing farm mortgages at new lower rates] will very effectively and immediately make liquid billions of dollars of assets for which there is no market today, while at the same time it will bring about a reduction of at least one-third of the average annual payments on the farm debt now required to be made by farm mortgage debtors without requiring any financing or loss by the Federal Government, thus bringing about the necessary relief in the farm mortgage field. This plan has the advantage, as a result of the Government guarantee of the Federal land bank bonds, of diverting surplus funds carried in the great creditor sections into the indirect financing of farm mortgages where it is impossible even at a high rate of interest, which farmers can not pay, to attract those funds directly.

* * *

No program designed to bring this country out of the depression can be considered apart from the relations of this country to the rest of the world unless a policy of complete isolation is adopted and an embargo put on gold exports and our domestic economy adjusted to meet such a condition.

Our international problems are far more difficult and will be slower to work out because of our inability to control the action of other nations. These problems can be met only through international conferences over a period of time. The most important of these problems and the one which must be settled before any progress can be made in the meeting of our domestic or other foreign problems is the problem of interallied debts.

There is a great demand on the part of the public and most of the press of this country that these debts be paid. It seems to me that our political leaders have lacked the courage to face this problem in a realistic manner. This has greatly contributed to prolonging the depression. The public, generally speaking, is not fully informed as to the impossibility of our foreign debtors complying with these demands, which cn only be complied with at the expense of our own people.

[page 32]

It is elementary that debts between nations can ultimately be paid only in goods, gold, or services, or a combination of the three. We already have over 40 per cent of the gold supply of the world – that is not true; it is between 35 and 40 per cent – and as a result most of the former gold standard countries have been forced to leave that standard and currency inflation has been the result. This has greatly reduced the cost of producing foreign goods in terms of our dollar and has made it almost impossible for foreign countries to buy American goods because of the high price of our dollar measured in the depreciated value of their money. This naturally has resulted in debtors trying to meet their obligations by producing and selling more than they buy, thus enabling them to have a favourable balance of trade necessary to meet their obligations to us. If this country is to receive payment of foreign debts, it must buy and consume more than it produces, thus creating a trade balance favourable to our debtors.

* * *

We must choose either between accepting sufficient foreign goods to pay the foreign debts owing to this country, or cancel the debts. This is not a moral problem, but a mathematical one.

[page 33 – the outline of what later became the Bretton Woods Accord]

Cancellation, or a settlement of the debts on a basis which would practically amount to cancellation, in exchange for stabilisation of the currency of the debtors, together with certain trade concessions and an agreement to reduce armaments would be a small price for this country to pay as compared with the great benefits which the entire world, including ourselves, would derive therefrom. Without a stabilisation of foreign currencies it will be difficult, if not impossible, in my opinion, to substantially raise the price level in this country as long as we stay on a gold basis. Our debtors will default and we will likely be forced to abandon gold and depreciate our currency in relation to that of other countries in order to raise our price level in this country and to meet foreign competition unless we are instrumental in inducing foreign countries to stabilise their currencies on a gold basis, or gold and silver basis if action is taken internationally to remonetise silver.

[page 33]

Senator Shortridge: Then I take it you would have the tariffs reduced?

Mr Eccles: No. Debts cancelled. Then I think with the prosperity that you would get in this country you can collect more than that in income and inheritance taxes when you stop this loss of $2,000,000,000 a month through unemployment. You start the process of wealth, and even a capitalist is far better off. I am a capitalist.

* * *

The program which I have proposed is largely of an emergency nature designed to bring rapid economic recovery. However, when recovery is restored, I believe that in order to avoid future disastrous depressions and sustain a balanced prosperity, it will be necessary during the next few years for the Government to assume a greater control and regulation of our entire economic system. There must be a more equitable distribution of wealth production in order to keep purchasing power in a more even balance with production.

If this is to be accomplished there should be a unification of our banking system under the supervision of the Federal Reserve Bank in order to more effectively control our entire money and credit system; a high income and inheritance tax is essential in order to control capital accumulations (this diversion of taxes should be left solely to the central government – the real property and sales tax left to the States); there should be national child labor, minimum wage, unemployment insurance and old age pension laws (such laws left up to the States only create confusion and can not meet the situation nationally unless similar and uniform laws are passed by all States at the same time, which is improbable); all new capital issues offered to the public and all foreign financing should receive the approval of an agency of the Federal Government; this control should also extend to all means of transportation and communication so as to ensure their operation in the public interest. A national planning board, similar to the industries board during the war, is necessary to the proper coordination of public and private activities of the economic world.

Such measures as I have proposed may frighten those of our people who possess wealth. However, they should feel reassured in reflecting upon the following quotation from one of our leading economists:

It is utterly impossible, as this country has demonstrated again and again, for the rich to save as much as they have been trying to save, and save anything that is worth saving. They can save idle factories and useless railroad coaches; they can save empty office buildings and closed banks; they can save paper evidences of foreign loans; but as a class they can not save anything that is worth saving, above and beyond the amount that is made profitable by the increase of consumer buying. It is for the interests of the well to do – to protect them from the results of their own folly – that we should take from them a sufficient amount of their surplus to enable consumers to consume and business to operate at a profit. This is not “soaking the rich”; it is saving the rich. Incidentally, it is the only way to assure them the serenity and security which they do not have at the present moment.

[page 35]
I feel that one of two things is inevitable: That either we have got to take a chance on meeting this unemployment problem and this low-price problem or we are going to get a collapse of our credit structure, which means a collapse of our capitalistic system, and we will then start over. And I therefore would like to see us attempt to regulate and operate our economy which today requires more action from the top due to our entire interdependency than it did in our earlier days.

The quote I have bolded is my favorite part of this testimony, though it is not Eccles' own words. I would be grateful for anyone who can track down a proper citation for the quote. Eccles thought it was either Stuart Chase or William Trufant Foster.

If you've made it this far, you might also enjoy: Fisher's Debt Deflation Theory of Great Depressions and a possible revision