THE BEAR'S
LAIR Machines from
hell By Martin Hutchinson
In an interview with Gideon Rachman of the
Financial Times, a senior German official
described the euro as a "machine from hell that we
cannot turn off". Personally, I am more positive
than most about the euro, provided it is managed
by grown-ups and not by Keynesians.
However, there is no question that our
current economic system contains a number of such
"machines from hell" that turning them off is at
least extremely difficult and that we will be very
lucky to survive their combined operation.
One long-standing such machine that has
recently reared its robotic head is the Chinese
banking system. Ernst & Young
estimated as far back as
2006 that that system had US$911 billion of bad
debts. Since then, the major Chinese banks have
all done immensely successful initial public
offerings, with international auditors suggesting
that bad debt levels were far below that amount.
Now we are told by the Financial Times
that the "stimulus" of 2008-2009, which was mostly
financed by the banks, has left them with $1.7
trillion of loans to Chinese provinces and cities,
mostly for dud real estate transactions, more than
half of which come due within the next three
years.
Needless to say, banks have been
told to roll the debts over, since a mass default
on that scale, 25% of China's gross domestic
product (GDP), would be hugely economically
damaging. "From a longer-term perspective, the
investment projects launched during the financial
crisis will have no problem generating a return"
we are told. Right!
This is a classic
"machine from hell." Writing off $1.7 trillion of
loans to provinces and municipalities would be
damaging, so like the corporate bad loans that
mysteriously disappeared after 2006, these debts
will be rolled over and will continue being
accounted for in the banks' balance sheets as
worth 100 fen on the yuan. The hollowing-out of
Chinese bank balance sheets will continue, until
eventually the entire system collapses. The
machine is from hell, and it is very unlikely to
be turned off.
A second machine from hell
is quantitative easing, the funding of countries'
gigantic budget deficits by central banks. In my
years as a US Treasury advisor, this was regarded
as a no-no. Emerging markets all over the world
were dragooned by International Monetary Fund and
US Treasury "experts" into inserting a specific
prohibition against extensive government funding
into their central bank statutes. Yet now all the
major economies are doing it, with Britain and
Japan the most enthusiastic, funding more than
half their budget deficits by these means,
devoting more than 5% of their GDPs to this
nonsense.
Needless to say, this machine
too cannot be turned off. Once the markets have
grown used to central banks as major buyers of
government bonds and politicians have got used to
being able to spend 8-10% of GDP more than they
take in through taxation, neither the financial
nor the political special interests will allow
them to stop. Federal Reserve chairman Ben
Bernanke, already buying more than $400 billion of
long-term Treasuries through "Operation Twist II"
will shortly begin direct Treasury purchases
again, citing the continued weakness of the US
economy as an excuse (even though housing, his
last excuse, is now showing strong signs of
stabilization and even recovery).
In every
country, one dreadful specter will keep the
purchases going: if they stopped, government bond
yields would rise sharply, which would destabilize
government finances further and, more important,
wreck the world's banking systems, overburdened as
they are with decades of reckless government bond
purchases.
Eventually we will see Weimar
Republic levels of inflation AND banking system
collapse, although the politicians may get off
lightly because of the collapse in the real value
of government's debts. That may appear unfair, but
in reality banks and voters are as complicit in
creating this machine as the politicians, so the
universal misery will be well deserved.
A
third machine from hell is the collection of
pension and medical systems worldwide that depend
on investment returns to fund ever-escalating
future obligations. These were mostly set up in
eras of rapid economic growth, young populations
and political optimism, such as the 1960s. Since
then, populations have aged, often with a bulge of
workers now entering retirement. However, three
additional factors have combined to make these
systems unaffordable.
First, since at
least 1995, interest rates have been held
artificially low by central banks temporarily
unrestrained by the fear of inflation (because the
Internet and modern telecoms had caused a
deflationary force that would have been highly
beneficial if it had been left unmolested by
monetary policy). Those artificially low interest
rates have reduced both individuals' savings rates
and investment returns on the already inadequate
funds being held to pay for their old age.
Second, the trust funds of these systems
have been raided for unrelated purposes. In the
US, the surpluses naturally arising in the Social
Security system have been used to offset budget
deficits elsewhere, and in 2011-12 the premiums
themselves have been artificially cut to provide
economic "stimulus".
A third factor
destabilizing these systems has been the tendency
of politicians to load costs upon them that they
were never designed to bear. In the United States,
the 1986 Emergency Medical Treatment and Active
Labor Act forces hospitals to treat the indigent
without reimbursement, thus loading intolerable
costs onto the rest of us.
Medical
malpractice lawyers have been allowed to run riot
with frivolous lawsuits, making insurance an
enormous fixed cost on every medical practitioner.
Drug companies have been allowed to load the
entire costs of their research onto US patients
and their insurance companies, while receiving
reimbursement from foreign payers at much lower
rates.
Insurance policies have been forced
to cover nonmedical needs, most recently
contraception, which are a modest burden on the
individual if paid for directly but become a
gigantic additional cost on the system as a whole
if provided free to consumers, thus making demand
and wastage essentially infinite.
Again
this machine, having been set in motion, cannot be
turned off. Opinion polls show that even the most
ardent Tea Partiers are prepared to cut government
spending on everything except their
"entitlements", which they believe have been fully
paid for. Since the mid-term elections of 2006,
attempts at actuarial soundness have infallibly
led to electoral disaster, and this unpleasant
backlash effect is becoming more extreme as the
systems become more actuarially unsound.
By the early 2020s, collapse will be both
inevitable and universally visible - the Baby
Boomers are destined for a poverty-stricken and
unpleasant old age, relieved only by premature
death from some readily treatable medical
condition.
As if there were not enough
machines from hell in the economy as a whole, the
financial services industry has in the last couple
of decades gone to great lengths to create new
ones. Originally, the derivatives markets of
forward contracts, swaps and options appeared
harmless hedging mechanisms, making the financial
world more efficient and earning modest
competences for their practitioners.
However, since the middle 1990s, the
markets have metastasized into gigantic risk
creators. Securitization, if it allows banks to
get rid of the loans they originate altogether,
creates moral hazard and therefore risk.
Collateralized debt obligations, by allowing the
creation of artificial securities, provide
mechanisms for banks to create $10 of risk for
every $1 of loans and bonds. Credit default swaps
allow banks to take short positions on credit
risk, then stand around yelling "Jump, jump!" when
a borrower gets in any difficulty.
Fast
trading allows its practitioners to trade on
inside information of deal flows, thereby
destabilizing markets and creating both bubbles
and their inevitable busts. Finally, modern risk
management systems, based as they are on
simplistic and inaccurate premises about financial
market risks, allow banks to pretend to control
risk without actually doing so.
Like the
other machines from hell, those in financial
services cannot be stopped. There are too many
bankers making money out of them and too many
lobbyists obfuscating the issues and paying off
politicians through campaign contributions to
allow their extinction. Obvious tax loopholes like
the "carried interest" tax treatment of private
equity funds and obvious regulatory loopholes like
the zero-rating of government debt in bank capital
requirements are allowed to remain in force for
year after year, under Republicans and Democrats
alike. Thus the regulatory system's ability to
prevent rent-seeking at taxpayer expense has
effectively been nullified.
Two questions
remain. First, why has our generation seen the
creation of so many and so varied "machines from
hell?" Mad scientists have been with us since
Frankenstein; why has this era been so fertile of
their economic doomsday machines?
The
central answer appears to lie in the area of fiat
money and its cousin, bank deposit insurance,
which a decade ago seemed unassailable and benign
parts of our modern economic system. Under a gold
standard without deposit insurance (or under any
other monetary/banking system that ensures
quasi-constant monetary values without state risk
assumption) most of the machines break down before
they can do too much damage.
Greek budget
deficits would have become impossible to finance
long before 2008.Chinese banks that created
excessive bad debts would have suffered bank runs
back in 2005-06. Quantitative easing would quickly
have caused an exodus of gold supplies, creating a
massive deflationary recession. Equity returns
would consist primarily of dividends, and debt
yields would be stable, so actuarial black holes
in pension and medical insurance systems would
become apparent while they were still manageable.
Financial engineering and creative risk
management would be so obviously dangerous to a
bank's well-being that sophisticated depositors
would withdraw funding well before retail
depositors began to panic. Machines from hell were
always in danger of appearing in a fiat money
system, but their proliferation derived from the
burst of money growth and speculative activity
after 1995, which was caused by central bank
laxity in the face of internet-driven deflation.
The second question, and the more
difficult one, is what we can do to prevent the
machines from hell from destroying our economy. In
most cases, the cure is still available, albeit
painful.
Greece must be thrown out of the
euro (thereby halving its living standards but
restarting its economy) and draconian deflation
imposed on the other country in the PIIGS group -
Portugal, Italy, Ireland, and Spain - under the
threat of similar retribution. China must
recapitalize its banks, borrowing the money from
international markets to do so (thereby
liquidating its $3 trillion of foreign exchange
reserves).
Quantitative easing must be
replaced by Volckerite monetary policy, with the
chips falling where they may in government
financing and banking systems. Social Security and
Medicare eligibility must be delayed until
recipients are aged 70 (easy) and the various
scams and "free lunches" in the medical arena must
be ended - bringing major short-term pain but a
long-term fall in medical costs that will benefit
everybody.
Volckerite monetary policy must
be combined with a tight "Volcker Rule" separating
deposit-taking from speculation (and tax
incentives for setting up mutualized
deposit-taking institutions similar to the British
building societies). Above all, "too big to fail"
most be abolished, deposit insurance cut back, the
government removed from housing, and rules
established to ensure that the Fed (if it is
allowed to exist) follows monetary policies
equivalent to a gold standard in their effect on
prices and markets.
Most likely, the
machines from hell will be allowed to rumble on
unchecked. In that case, collapse of our economic
system is inevitable.
Martin
Hutchinson is the author of Great
Conservatives (Academica Press, 2005) - details
can be found on the website
www.greatconservatives.com - and co-author with
Professor Kevin Dowd of Alchemists of Loss
(Wiley, 2010). Both are now available on
Amazon.com, Great Conservatives only in a
Kindle edition, Alchemists of Loss in both
Kindle and print editions.
(Republished
with permission from PrudentBear.com.
Copyright 2005-12 David W Tice &
Associates.)
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