Inflation and Deflation revisited

In December 2008 I came off the fence and plumped for deflation as inevitable. Mostly I reasoned that debasement of accounting practice, mismanagement of financial intermediaries, captured regulators that collaborated in perpetuating failure, and extremely poor market pricing of risks and fundamentals meant that there was litte incentive to save and no place safe to invest. I predicted that when the last great bubble in sovereign debt popped, deflation would work its cleansing power to restore fundamentals.

It is now clear to me that policy makers in the West are determined to apply every available resource to underpinning failure, misallocation and executive excess. As this discourages the honest saver from parting with cash, policy makers are ensuring that deflation will wreak its havoc on the financial and real economies of the world. Only when that deflation has played out and rational policies that reward market-based management and returns are restored will it be worthwhile to invest again.

The Fed permitting dividend hikes at bailed out banks only deepens my cynicism about the poor quality of regulation and the inadequacy of management controls.

Obviously, I was premature about deflation as events in 2009 and 2010 proved, but I am not convinced I was wrong in the longer term. Events this week in Japan, and political upheavals this year elsewhere, have me thinking that we are at a turning point in many ways. When the numbness that follows such a mammoth series of tragedies wears off, the public in Japan is going to be very angry. They have suffered three great catastrophes in one week: the 8.9 earthquake, the tsunami that swiftly followed, and the failure of safety controls at six nuclear reactors. We still don't know the scale of the final disaster, or what it will mean for the country or the world.

The Japanese state is to be congratulated that strict building codes preserved much of the physical infrastructure from the earthquake, and regular tsunami drills doubtless saved tens of thousands of lives during the tsunami. The most serious failure was in management, risk assessment and regulation of the nuclear industry. The anger will be that an industry critical to the economy, with powerful lobbyists close to government, was able to capture its regulators and erode safety standards until a crisis revealed the tragic short-termism. The anger will increase when the Japanese come to appreciate that the serial depredations of the banking industry have left them over-exposed with few fiscal policy options to meet the financial challenge of rebuilding and resettlement of refugees.

If the government and institutions of Japan are forced to liquidate and repatriate foreign assets, then fears of rising Yen and destabilisation of G7 economies are well founded. I believe it was the collective self-interest in preserving stability that motivated today's central bank interventions. The Yen appreciated 20 percent in the three months following the Kobi earthquake, and the scale of the current disaster - particularly with the risk of nuclear contamination of some part of the country - is likely to dwarf the Kobi effect.

As radiation reaches California from Fukushima today, we might all consider that regulatory capture places us all at some degree of risk. The crisis in California sub-prime real estate was borne by the currents of international finance to the pension funds of Norway and the savings banks of Germany. Both the nuclear energy industry and the banking industry had parallel patterns of political influence leading to regulatory capture and debasement of best practice, and ultimately ruination for a suffering public. It will be interesting to see how much accountability is demanded of management and regulators in the nuclear industry in Japan, and compare this with the lack of accountabiity for serial financial failures and bailouts.

Japan has 20 years more experience of financial sector accounting abuse and bailouts than the rest of us. And the result has been almost continuous deflation - even in the face of mounting deficits, ZIRP and quantitative easing.

Another factor that leads me to fear deflation over inflation is the risk of popping of the great China bubble. My view is that the Chinese economy slowed markedly in Q4 2010 as monetary tightening and administrative regulation of bank lending began to bite, and that the slowing has accelerated in 2011. This view has been confirmed by Gavyn Davies on his FT blog. With another rate rise today by the PBOC, and the supply chain shock of Japan's industrial disruption and power shortages, we could be in for a sharp, deflationary global contraction in the next few months.

UPDATE 20/03/11: Days before quake, plant operator admitted oversight

Days before Japan plunged into an atomic crisis after a giant earthquake and tsunami knocked out power at the ageing Fukushima nuclear plant, its operator had admitted faking repair records.

The revelation raises fresh questions about both Tokyo Electric Power Co (TEPCO)'s scandal-tainted past and the government's perceived soft regulation of a key industry.

The operator of the Fukushima No. 1 plant submitted a report to the country's nuclear watchdog ten days before the quake hit on March 11, admitting it had failed to inspect 33 pieces of equipment in its six reactors there.

A power board distributing electricity to a reactor's temperature control valves was not examined for 11 years, and inspectors faked records, pretending to make thorough inspections when in fact they were only cursory, TEPCO said.

It also said that inspections, which are voluntary, did not cover other devices related to cooling systems including water pump motors and diesel generators.

The report was submitted after the regulator ordered operators to examine whether inspections were suitably thorough.

Sympathy and concern for Japan

Children of Adam all come from the same source,
When one is wounded, all share the pain,
He who cannot feel the pain of others,
Cannot call himself Son of Man.

- Saadi

Insurance and Banking: Risk, Resiliency and Harmonisation

I attended an interesting discussion of risk management in the City this week, bringing together insurers with bankers. The two sectors manage risk quite differently, which is why there are rarely insurance crises and frequently banking crises. Insurance crises tend to occur when insurers act like banks (AIG Financial Products, MBIA and other monolines). Bank crises tend to occur when banks act like investment banks.

Insurers must not underwrite risks that they will not be able to cover in the event, and must therefore have reserves sufficient to perform at all times. This makes the insurers much more cautious about taking on risk, about pricing risk accurately at the time of contracting, and about managing reserves to be liquid when claims require payment. Regulation is fundamentally about solvency and selling.

Banks undertake risks on their books that they can only cover so long as they continue to have access to liquidity (funding, deposits, repos or central bank support). Bank capital is never enough to ensure performance without market liquidity for reserve assets. Banks are generally much less cautious about taking on risk, rely overmuch on incomplete models to price risk, and manage capital to optimise returns rather than ensure survival. Regulation focuses on capital (never enough on its own) rather than conduct, common sense and functional suitability.

One risk manager observed that in insurance the risks are exogenous, generally independent in occurrence, and finite. In banking the risks are too often endogenous, correlated in unpredictable ways, and of unknowable magnitude. As a result, a single bank failing has systemic consequences for the banking system, where a single insurance company failure has no systemic consequences for the insurance sector.

An interesting observation both insurers and bankers agreed on was that international harmonisation of regulation had driven formerly diverse business models and management preferences toward uniformity by enforcing preferred models for capital and solvency. As a result, the risks of total systemic failure are much, much higher than before Basel II and Solvency II, because when the models are wrong, the whole financial system is compromised.

Models are always wrong because they are partial, approximate, and use historic data and correlations. In internationally harmonised regulation, the failure of models is even more assured as many domestic factors which have great implications for financial risk are ignored or discounted. Quite simply, models are illuminating, not correct.

What this means is that the 25 year drive to harmonise regulation using financial models is almost certainly counterproductive if the aim was to ensure wider financial integrity and stability. Instead of a global financial system constructed as a spider's web, such that the breaking of one strand does not compromise the whole web, we have a system that has bound all the threads into a single cable. And if that cable frays under stress . . .

There was controversy around the idea of functionally segregating the pedestrian but systemically important functions like payments and mortgage intermediation from the riskier eccentricities of modern of investment banking. About half the room thought it perfectly sensible, and half thought it couldn't be done. I'm of the view that "narrow banking" for some functions might be a very reasonable way to secure the taxpayer from future losses by reducing the scope for contagion in the banking system. And if we could do that, we could allow bad banks to fail, restoring some morals and some hazard to the management of banking.

Sap rising, a new job and the NHS

I’m starting this month mildly optimistic. Those who have laden our societies with inequality and our economies with debt are being repudiated wherever the public is permitted to speak or vote. No longer dulled by panic, policy makers are realising there are other options than doing as they are told by their bankers, and their duty to their enraged public requires them to at least evaluate other options before caving into further banker demands. Emboldened by examples of bravery and solidarity in the Middle East, many publics are re-evaluating their relationship to the state and the service they receive from their political elites, and then finding a new voice to demand better.

The corrupt political machine that surrendered Irish sovereignty to a more corrupt banking system has been voted out of office. Denmark has allowed a bank to fail, imposing real losses for the first time in this crisis on bank bondholders. The governor of Wisconsin is being reminded that he works for the people of his state, within the bounds of its constitution and its laws. Signs of a shift toward accountability perhaps? It is spring, and I choose to hope.

I am in England, where a fine mist softens the air and birds sing in the budding trees outside my window. Contributing to my good humour is the imminence of a new challenge that will not require me to travel further than central London. I spent much of the autumn looking at the world, looking at my country, and searching for a way to make a difference here at home that will endure as a lasting contribution to economic stability. I have been fortunate enough to identify such a role, seek appointment, and be given the chance to fulfil my aims. It will be another adventure, but one I pursue in familiar surroundings and among friends.

Wish me luck.

And now a word about healthcare, a subject I rarely write about. I saw a chart at Wall Street Cheat Sheet this week that forced me to realise how blessed I am to be British. If I were an American, I would be shamed by this - especially when more than 30 percent of citizens have no entitlement to healthcare.

Here's an example of what I get for the money spent on the NHS.

In December I received a form letter from the NHS (National Health Service) saying that the time had come around again for a routine diagnostic procedure to detect a condition fairly common to people my age. It was the run-up to Christmas and I did nothing at the time. Yesterday I received a reminder that I had not had the test, urging me to schedule it. My GP (general practitioner doctor) is at the surgery (doctor’s office) on the high street five minutes’ walk from my door. I called the surgery’s appointments line, and the friendly receptionist gave me an appointment for later in the morning. I showed up, was seen within five minutes, and back home twenty minutes later. The doctor was even happy to chat about another minor matter that had been on my mind. The test results will be sent by post within two weeks. This was as easy, convenient, stress-free and professional as anyone could ever wish. And no one ever mentioned money.

The NHS is one reason why there is unlikely to be a revolution in Britain. Each of us living here can actually see the benefits of having a government that provides for the people in the ways that truly count. I never have to worry about whether I can afford a medical procedure. When my children are sick, they are seen quickly, often the same day. I can get urgent care 24 hours a day. I have even been pleasantly surprised by a Sunday house call. When I took my children to the emergency room (long ago now), they were seen and treated with all the professionalism and concern any loving parent might wish. All of this is provided by my government, and I never worry even for a moment about the cost. As a taxpayer, I enjoy a tangibly better life because my government provides for my care and the care of my family whenever it is required.

The NHS is far from perfect, but it is a great deal better than any insurance-intermediated system I could imagine. And it is infinitely better than no insurance and no entitlement to healthcare at all.

Not all taxes impoverish me. Some of what I pay enriches me too.

UPDATE:
I've just received a form in the post to permit me to register for patient management over the internet. I'll be able to book and change appointments online with my doctor or other doctors at the surgery, and I can request prescription renewals. This is my NHS delivering value and efficiency to me as a taxpayer, and I am again grateful.

Mervyn King: From Bagehot to Basel, and Back Again

An American friend sent along the New York Times hatchet job on Mervyn King. It is a classic of its genre. The first four sentences include the prejudicial phrases "should command respect", "has been accused", "has been condemned", and "has so far been ignored". Since little appears in the American Pravda by chance, one wonders what and whose agenda is served by such a one-sided and un-journalistic attack on a Governor who has done pretty well in preserving Britain's financial sector, economy and currency when basket cases surround Britain on all sides (westwards not excepted). No one quoted as critical of Mr King in the hatchet piece is a working banker, I note.

This little propaganda reminded me that I wanted to blog one of Mr King's bravest speeches. Perhaps bringing what he said to light will help to explain the animosity of those behind the whisper campaign.

Below are excerpts from a speech Mervyn King gave at the Second Bagehot Lecture Buttonwood Gathering, New York City, October 2010. He had me from the mention of Bagehot in the title, but just the first few paragraphs will tell you why he lost Wall Street and Washington. He directly challenges "extend and pretend" as a solution to the crisis:

Banking: From Bagehot to Basel, and Back Again

Introduction

Walter Bagehot was a brilliant observer and writer on contemporary economic and financial matters. In his remarkable book Lombard Street, Bagehot brought together his own observations with the analysis of earlier thinkers such as Henry Thornton to provide a critique of central banking as practised by the Bank of England and a manifesto for how central banks could handle financial crises in future by acting as a lender of last resort. The present financial crisis dwarfs any of those witnessed by Bagehot. What lessons can we draw from recent and current experience to update Bagehot’s vision of finance and central banking?

Surely the most important lesson from the financial crisis is the importance of a resilient and robust banking system. The countries most affected by the banking crisis have experienced the worst economic crisis since the 1930s. Output is somewhere between 5% and 10% below where it would have been had there not been a crisis. Unemployment is up, businesses have closed, and the direct and indirect costs to the taxpayer have resulted in fiscal deficits in several countries of over 10% of GDP – the largest peacetime deficits ever.

The Practice of Banking

At the heart of this crisis was the expansion and subsequent contraction of the balance sheet of the banking system. Other parts of the financial system in general functioned normally. . . .

For almost a century after Bagehot wrote Lombard Street, the size of the banking sector in the UK, relative to GDP, was broadly stable at around 50%. But, over the past fifty years, bank balance sheets have grown so fast that today they are over five times annual GDP. The size of the US banking industry has grown from around 20% in Bagehot’s time to around 100% of GDP today. And, until recently, the true scale of balance sheets was understated by these figures because banks were allowed to put exposures to entities such as special purpose vehicles off balance sheet.

Surprisingly, such an extraordinary rate of expansion has been accompanied by increasing concentration: the largest institutions have expanded the most. . .

Bank of America today accounts for the same proportion of the US banking system as all of the top 10 banks put together in 1960. . . .

While banks’ balance sheets have exploded, so have the risks associated with those balance sheets. Bagehot would have been used to banks with leverage ratios (total assets, or liabilities, to capital) of around six to one. But capital ratios have declined and leverage has risen. Immediately prior to the crisis, leverage in the banking system of the industrialised world had increased to astronomical levels. Simple leverage ratios of close to 50 or more could be found in the US, UK, and the continent of Europe, driven in part by the expansion of trading books (Brennan, Haldane and Madouros, 2010).

And banks resorted to using more short-term, wholesale funding. The average maturity of wholesale funding issued by banks has declined by two thirds in the UK and by around three quarters in the US over the past thirty years – at the same time as reliance on wholesale funding has increased. As a result, they have run a higher degree of maturity mismatch between their long-dated assets and short-term funding. To cap it all, they held a lower proportion of liquid assets on their balance sheets, so they were more exposed if some of the short-term funding dried up. . . .

Moreover, the size of the balance sheet is no longer limited by the scale of opportunities to lend to companies or individuals in the real economy. So-called ‘financial engineering’ allows banks to manufacture additional assets without limit. And in the run-up to the crisis, they were aided and abetted in this endeavour by a host of vehicles and funds in the so-called shadow banking system, which in the US grew in gross terms to be larger than the traditional banking sector. . .

The size, concentration and riskiness of banks have increased in an extraordinary fashion and would be unrecognisable to Bagehot. Higher reported rates of return on equity were superficial hallmarks of success. These higher rates of return were required by, and a consequence of, the change in the pattern of banks’ funding with increased leverage and more short-term funding. They did not represent a significant improvement in the overall rate of return on assets. Not merely were banks’ own reported profits exaggerating the contribution of the financial sector to the economy, so were the national accounts. . . .

Moreover, a financial sector that takes on risk with the implicit support of the tax-payer can generate measured value added that reflects not genuine risk-bearing but the upside profits from the implicit subsidy. And even without an implicit subsidy the return to risk-bearing can be mismeasured. It is widely understood that an insurance company should not count as profits the receipt of premia on an insurance policy that will pay out only when a low-frequency event occurs at some point in the future. But part of the value added of the financial sector prior to the crisis reflected temporary profits from taking risk and it was only after September 2008 that much of that so-called economic activity resulted in enormous reported losses by banks.

It is possible to make a very rough estimate of the possible size of this distortion in the reported financial sector output data. If we assume that true labour and capital productivity in the financial services industry grew in line with that in the wider economy in the 10 years prior to the crisis, then, given the inputs of capital and labour over that period, the official estimate might have overstated UK financial sector value added by almost £30 billion up to 2007 – around half of the growth in the official measure. . . .

The theory of banking

It is this structure, in which risky long-term assets are funded by short-term deposits, that makes banks so hazardous. Yet many treat loans to banks as if they were riskless. In isolation, this would be akin to a belief in alchemy – risk-free deposits can never be supported by long-term risky investments in isolation. To work, financial alchemy requires the implicit support of the tax payer. . . .

For all the clever innovation in the financial system, its Achilles heel was, and remains, simply the extraordinary – indeed absurd – levels of leverage represented by a heavy reliance on short-term debt.

Modern financiers are now invoking other dubious claims to resist reforms that might limit the public subsidies they have enjoyed in the past. No one should blame them for that – indeed, we should not expect anything else. . . .

Finding a Solution

The guiding principle of any change should be to ensure that the
costs of maturity transformation – the costs of periodic financial crises – fall on those who enjoy the benefits of maturity transformation – the reduced cost of financial intermediation. All proposals should be evaluated by this simple criterion.

The first, and most obvious, response to the divergence between private benefits and social costs is the imposition of a permanent tax on the activity of maturity transformation to “internalise the externalities”. Such a tax, or levy, has been discussed by the G7, and introduced in the UK. . . .

Why Basel III is not a complete answer

Basel III on its own will not prevent another crisis for a number of reasons.

First, even the new levels of capital are insufficient to prevent another crisis. Calibrating required capital by reference to the losses incurred during the recent crisis takes inadequate account of the benefits to banks of massive government intervention and the implicit guarantee. . . .

One criticism of Basel III with which I have no truck is the length of the transition period. Banks have up to 2019 to adjust fully to the new requirements. Although some of the calculations of the alleged economic cost of higher capital requirements presented by the industry seem to me exaggerated (Institute of International Finance, 2010), I do believe that it is important in the present phase of de-leveraging not to exacerbate the challenge banks face in raising capital today. Banks should take advantage of opportunities to raise loss-absorbing capital, and should recognise the importance of using profits to rebuild capital rather than pay out higher dividends and compensation.

Large Institutions

The implicit subsidy to banks that are perceived as “too important to fail” can be
important to banks of any size but is usually seen as bigger for large institutions for which existing bank resolution procedures either do or could not apply. Moreover, most large complex financial institutions are global – at least in life if not in death. . . .

Solving the “too important to fail” problem will require ultimately that every financial sector entity can be left to fail without risk of threatening the functioning of the economy. . . .

More Radical Reforms

One simple solution, advocated by my colleague David Miles, would be to move to very much higher levels of capital requirements – several orders of magnitude higher. . .

Another avenue of reform is some form of functional separation. The Volcker Rule is one example. Another, more fundamental, example would be to divorce the payment system from risky lending activity – that is to prevent fractional reserve banking (for example, as proposed by Fisher, 1936, Friedman, 1960, Tobin, 1987 and more recently by Kay, 2009). . . .

The advantage of these types of more fundamental proposals is that no tax or capital requirement needs to be calibrated. And if successfully enforced then they certainly would be robust measures. . . .

Of all the many ways of organising banking, the worst is the one we have today.


Conclusion

I have explained the principles on which a successful reform of the system should rest. It is a program that will take many years, if not decades. But, as Bagehot concluded in Lombard Street, “I have written in vain if I require to say now that the problem is delicate, that the solution is varying and difficult, and that the result is inestimable to us all.”

At a time when bankers are keen to supersize bonuses and dividends, based on massively relaxed accounting and transparency standards and a huge public subsidy, Mervyn King reminds us that any so-called "profits" are the result of alchemy that socialises losses to the taxpayers and inflation-hit masses of the world.

He demands more equity capital, no public subsidy, division of systemically important functions from TBTF banks so that they can be left to fail, curbing of dividends while banks rebuild balance sheets and other policies inimical to Wall Street, global banks and their puppets in the Fed.

Look at Bill Isaac's plea for higher bank dividends in the FT this week. Look at insider selling by bank executives. (hat tips to Barry Ritholtz and Simon Johnson) On suspects some executives are desperate to loot their banks before they fail again.

Gee, why would the New York Times want to question Mervyn King's authority just now? This couldn't stink more if it had Judith Miller's byline on it.

Quotable

A Holding Company is a thing where you hand an accomplice the goods while a policeman searches you.
- Will Rogers, 1935

Plus ça change, plus c'est la même chose.

Egypt, China and Famine Futures

It's February already! When I was just 19 someone told me that when I turned 21 the speed at which time elapses would double, and then when I turned 45, it would double again. With January gone in a blink, the subjective acceleration of elapsed time is confirmed again. It makes me aware of how little time any of us have in our brief spans of life, and so how important it is to think forward to the future we help to create.

There are so many things I wanted to write about in depth, but perhaps what I need to do is just write something - especially since the comments may be the best part of this blog if the old Roubini posse hangs out here.

Along with the rest of the world, I am watching events unfold in Egypt and I am awed by the civilised and moderate nature of the Egyptian crowds. Students have formed protective rings around the most important heritage sites to prevent damage. Neighbourhood Watches have sprung up to provide civil security. Supplies of food and water are couriered to the protestors and shared with the police and soldiers. There is no obvious political leadership among the protesters, but their self-organisation is still impressive.

The looting that has occurred appears to have been a tactic of the security forces to prepare the way for an aggressive crackdown.

I wish it was only undemocratic regimes that used the technique of the agent provacateur, but there is too much evidence otherwise. Every post-9/11 group of "terrorists" arrested in the USA for bomb plots has had an FBI informant as the main agitator, planner and source of weapons or equipment. Here in the UK, we have police undercover agents infiltrating green and peace groups - sleeping with and even marrying activists - and they too foment unlawful violence. (It's worth clicking the link for the picture of the protestors in front of Scotland Yard.) At the G20 protests a couple years back, the peaceful crowd started to video an agitator and reported him to organisers and police, only to see him run for police lines and disappear among his colleagues. The agent provocateur has become a mainstream strategy of a political class which views organised, democratic resistance as a threat to entrenched privilege. The unscrupulous politician might even instigate violence to foment fear and justify further statist oppression.

A nation of 50 million Arabs is peacefully demanding democratic reforms and accountability. This is so starkly at odds with the narrative we have been fed by our leaders in the West that we should probably rethink what else they might have got wrong.

Now imagine if such activism spreads to China. I guarantee you that the Chinese elites are imagining it too. In a country where food and fuel take about half the money in the average consumer wallet, the risks of political instability from rising inflation are very real.

The monetary excressences of the central banks to maintain the dividends and bonuses of their corporate cronies are going to spur a political backlash as inflation takes hold. The Chinese elites, just like our own, have gained the disproportionate benefit of monetary laxity through their speculations in real estate and commodities. But now comes the inflationary backlash . . .

The current spike in food prices has exceeded the spike in 2008. Rice is limit up two days in a row. Storms and crop failures are threatening worse to come.

The role of public policy in worsening market failures in energy and food is worthy of deep and searching examination. As Barry Ritholtz points out, oil companies and agribusiness are among the top corporate welfare queens, sucking on the Treasury for subsidies while reporting huge profits largely secured from taxation by sweetheart tax breaks and global avoidance strategies. When real people go hungry, and many are unemployed, the offensiveness of this political and economic injustice becomes too great to stomach.

Egypt used to have a food surplus. Thanks to the miracles of modern agribusiness, population growth, and mismanagement by corrupt politicians, it is now a net importer of food. Food security is going to be a priority for any new leadership in Egypt. A recent UK study of food security makes clear that it is an issue we will all have a stake in resolving.

As the Year of the Rabbit dawns, China's elites will be weighing life without easy credit against life with political chaos and hungry protesters. I used to be quite confident that they would crack down on banks and the shadow banks that have grown like fungus in the warm, moist environment of monetary excess. Now I am not so sure. Like their peers in the banks, oil companies and agribusinesses of the West, many Chinese elites cannot imagine a world of financial constraint and fiscal austerity. Despite the risk that they could lose it all to political instability if they delay and inflation takes hold, they appear to be wavering.

Interesting times . . .

What is clear is that our systems for energy and food production and distribution have become so highly concentrated and so easily manipulated by the corporate few that a popular uprising might be the best hope of reform for the hungry many.

Professor Roubini has a piece in the FT today discussing the stagflationary risks of instability.

Writing this, I went back and read "Famine Futures" which I wrote in 2008. That post goes into more detail about how progressively more concentrated ownership of critical energy and food production, alongside free market reforms and financialisation of commodity markets, have led us to where we are.

What I don't know as I watch political change unfold, is where we go from here. I'm still thinking a few chickens in the back yard might be a good investment.

Update: Why US farm policy caused Egypt crisis, by Thomas Kostigen