Wow, an open discussion in Congress about fractional reserve banking. This is a must see.

 

The panel consists of Dr. Salerno, Dr. Cohran, and Dr. White. To see Misesians in Congress discussing true monetary reform is really a step in the right direction.

Written statements can be downloaded from here.

Enjoy.

Free healthcare? Subsidies for healthcare? Healthcare is governed by the laws of supply and demand? Really???

 

Enjoy. The bears are back, this time as humans.

If you can’t succeed, just rig the auction

In the following video clip, author and journalist of Rolling Stone Magazine, Matt Taibi, discusses the ongoing trial of one of the largest municipal fraud that has been perpetrated over the past decade.
This time, the state colluded with the key underwriters who floated state bonds, raking in a hefty kickback in the process.
To view the video, go to: http://www.foxbusiness.com/on-air/imus/index.html#/v/1699988827001/municipal-bond-rigging-robbing-americans-of-billions/?playlist_id=87057.
Enjoy.

The use of holistic aggregate systems as an excuse for government intervention

 

I actually believed that unlike the mainstream financial outlets in The States or elsewhere in Europe, my country would have a more grounded and unbiased picture of the state of the economy.

Unfortunately, I was mistaken. In a recent article in business.hr, there is an article named: “Do Croatian citizens have more purchasing power than their neighbors?”

“Gross domestic product (GDP) per capita in Serbia according to the criterion of purchasing power is 35 percent of EU average, it is evident from the data that was presented this week by the European statistical office Eurostat.

Among the countries of former Yugoslavia, according to Finance, Slovenia passed with 84 percent of EU average.

Lower standard than the Serbian, according to the criterion of purchasing power in Europe, were the only two countries - Bosnia and Herzegovina, with a GDP per capita last year reached 31 percent of the EU and Albania, whose GDP per capita was 34 percent of the EU average.

Among the countries of former Yugoslavia, Slovenia recorded the best result with 84 percent of EU average. This is followed by Croatia with 61 percent and better than Serbia, also last Montenegro and Macedonia.

The richest country in terms of purchasing power is Luxembourg. Luxembourg's GDP per capita in purchasing power of the criterion was 274 percent of the EU average. Followed by the Netherlands (131 percent), Austria (129 percent), Ireland (127 percent), Sweden (126 percent), Denmark (125 percent) and Germany (120 percent).

From countries outside the EU, Norway has reached 189 percent of average, 151 percent of Switzerland, Iceland 110 percent, which is considerably less than before the crisis.”

The first error in this analysis is comparing a meaningless holistic concept such as National Income and dividing it by the citizenry. It is impossible to grasp the concept such as subjective wealth, nor does it take in consideration of any discrepancy between the various differences between the groups of individuals who actually contribute to growth in societal welfare.

Second of all, it uses an ideologically bankrupt national accounting metric, called the GDP. In my view, any increase in GDP has to be incorrect because it accounts for the rise is nominal money supply that somehow adds to the nations productive structure. It doesn’t. Some would then argue, that the nominal number is deflated (removing inflation) to represent real growth. But again, this is wrong because as Ludwig von Mises stated nearly a century ago, it is the productive structure of the economy that matters, not the stock nor flow of money in the economy.

GDP is also a term that has the word “gross” in it. Because it counts the differences in inventory growth from quarter to quarter. But this is in no way gross, because it doesn’t include the nominal values of intermediary goods which are used up in the productive structure. This is omitted because it would amount to double counting. But, adding in this value would get a picture of the capital stock of the economy and the total “capital buffer” in case of rampant consumption.

The government likes to use these numbers because they can point at discrepancies between per capita GDP among nations and neighboring countries and rationalize intervention as a prelude to boosting nominal GDP. The tarnished GDP metric is closely used with the “Gini coefficient” to measure income inequality. Government sees that any discrepancy from a solely chosen arbitrary number is a pretext for meddling and redistribution. If that doesn’t work, they try to figure some other holistic form of gauging the wealth of nations, such as the HDI or the “happiness” index. Trying to correlate happiness by weighting certain variables in a model such as the number of vacation days in a year, number of children in the family or the marginal difference in taxation between different income groups is futile. According to the HDI, Ireland was called developed because it had a 0,959, which is excellent, until their economy crashed and it fell to 0,908. Even though it is a high number, how does a bailout of the banking system funded by taxpayer austerity amount to a high HDI?

Maybe if the government would stop deficit financing through monetary expansion and wasteful resource allocation, it would see that the market in its own virtue, distributes income to individuals who are rewarded serving the consumer.

The difference between the effects of a legitimate default on a loan issued by an inflationary banking system and a noninflationary banking system

 

When trying to differentiate the positive from the negative impacts of modern banking on todays complex economy, we have to understand the mechanics behind the process itself. And by process, I mean the way the intermediary institution of banking operates.

We shall, first of all, separate two very distinct, but in the evolutionary banking process, blurred phenomena. One is deposit banking and the other loan banking. Well shall focus only on loan banking. Deposit banking is the art of safekeeping ones possession. In this case, the possession is money. In loan banking, the accumulated funds are loaned out of the bank to an entrepreneurial endeavor.

In this second case, funds are shifted from the saver to the lender, leaving the bank for an agreed upon time. In any case, these funds that leave the bank cannot be redeemed at any time at their nominal value. The funds shall be relinquished only after the term of the saved funds at interest only if the mirror image of the savings – the loan, is to be returned to the bank. The bank is rewarded for its services as an intermediary and the saver is rewarded with additional purchasing power with which he/she can purchase additional goods and services (more than if the saved funds were consumed at the beginning).

The question we pose is: What happens when the entrepreneur defaults on his loan in an inflationary banking system, and one in an noninflationary banking system?

In the first case, diverted funds which are legitimately loaned out. What this means is that funds are diverted from legitimate savings and NOT from deposits which are redeemable on par. If for example, these funds are saved for a 3 year period and loaned out for exactly the same period, the money supply hasn’t expanded nor contracted. It remains the same, just the term structure of accumulated resources are utilized in a different manner. If the entrepreneur overestimates his future revenue stream, he is in trouble, and unable to return the loan. In this case, any capital goods that are diverted to his/her project will be lost as they do not successfully fulfill the consumer demands along the structure of production.

These capital goods, to be of any use must be firstly liquidated to have any meaningful purpose. This usually involves high conversion costs, trapped idle resources and a lower standard of living. The lower standard of living is reflected in higher nominal wages as the funds flow back to the stage of production closest to consumption. With more units of exchange a deficient amount of goods can be purchased to satisfy greater desires, as the resources are trapped (momentarily or permanently) in useless lines of production. Society does get poorer in this case, but there is NO business cycle, NO contraction in the money supply.

The second case is when the commercial banks flush with excess reserves from the central bank decide to expand demand deposits in the economy, by pyramiding on a fraction of cash deposits. This exerts an artificial impact on the economy’s structure of production. An inflationary loan adds “shadow” savings in the economy as a fake euphoria (optimism) enters the economy. Capital goods rise in price as well as the general price level, and unlike the previous example, inflation exerts its negative influence on the productive structure. A loan that defaults in this sort of environment will exert a negative cascading effect on the entire economy, because, just as easily as new loans are brought into existence through credit expansion, the elasticity of the money supply reverses and collapses in on itself leaving a POORER capital structure than before. The loan itself will default if not for an ever accelerated dose of monetary expansion than before. If it happens sooner than later, not only will their be losses on the created loan, but a depleted capital structure as capital consumption is also experienced as the malinvestments are worked through.

This is a rough exposé of what happens in different systems. To fully understand this process is to thoroughly grasp capital theory and the impact of credit expansion on intertemporal preferences among the various economic actors. I would suggest reading Jesus Huerta de Soto’s masterpiece – Money, Credit and Business Cycles and for a short treatment of this subject:  A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis by Joseph Salerno.

Two wrongs don’t make a right

 

The following excerpt is from Euro Pacific Capital’s website and is authored by Peter Schiff.

Peter is one of the few CEO’s and respected businessmen in the financial spectrum who correctly called the housing collapse and testified on a Senate subcommittee regarding additional loan guarantees provided by the FHA for multifamily housing. The following can also be found as a video clip on Youtube.

“I was invited to testify about the Federal Housing Administration's (FHA) policy in the apartment lending market. Although this was a fairly narrow issue, I told the congressmen the same thing I did last year when I was invited by a different subcommittee to testify about job creation: government programs don't solve problems, they just create new ones. While I thank the Committee for inviting me, I believe the congressmen may have gotten more than they bargained for. […]

The subcommittee was considering whether to expand the activity of the FHA to insure loans for multi-family (apartment) buildings. The mechanism to achieve this was to extend FHA guarantees to pools of collateralized mortgages backed by multi-family residential housing units.

I have absolutely no objection to the idea that a healthy rental housing market is needed. However, I believe that market forces are sufficient by themselves to create it. The average American family now only has $7,000 worth of savings, which would not be nearly enough to afford a 20% down payment on the average American house. This means that most Americans should be renters and not owners. […]

Normally, these simple facts would attract investment capital to build affordable rental properties. However, these forces have been blunted by Federal tax and housing policies that have exaggerated the economic benefits of home ownership and have drawn excessive amounts of investment capital into that sector. To correct the distortions, the Subcommittee was considering, you guessed it, more distortive regulations. It never occurred to them to simply scale back the original regulations that are the root of the problem.”

Government officials liken the idea that whenever there is a problem that cannot be serviced immediately by the free market, they have to jump in and make a utter and complete mess regarding the “apparent” problem at hand.

Taking money from John to give to Jim and dismantling the capital structure in the process

 

There is really no end to the constant political influence of our representatives when the economy (locally or on the state level) is concerned. The next headline comes from www.zagrebancija.hr.

In the article which is making headlines all across Zagreb, a massive government spending program is being initiated. The following picture that was taken shows the construction team in place already demolishing the previous meadow. This meadow is adjacent to the National Library Building. The meadow is really huge and one of its purposes used to be walking dogs, recreational walks and the such.

 

Our great major, Mr. Bandic has decided to implement a 20 million HRK project to build a fountain. Yes, that’s not a typo – he is spending 20 million HRK ( = $3,6 million) to build a fountain.

Now, a typical Keynesian economist will say that the G in GDP = C + I + G + (X – N) is government spending, and an increase in this variable will lift the national income statistic and give a boost to GDP. Arithmetically, this is true; economically, this makes no sense. The government in its infinite wisdom has decided how to spend my money and transfer this purchasing power to the construction company which I am sure got a deal with a large premium over the market. The building materials and labor hours will be wasted in the process and the lost factors of production and resources will be diverted from either home building, sewage construction or just used as idle capital stock as an insurance in case of future economic need for real purposes.

An economy doesn’t grow by spending money. Especially in this way when to generate this growth, you have to take the resources from the economy and implement such a project. In essence, this pork barrel project is nothing but a large shell game. A wasted resource is undermining the capital structure of the industries that need these resources, creating a permanent loss for the local government budget.

The main point is, spending money doesn’t do anything. Its resource utilization that matters. Why not build 1000 fountains? Because it makes no sense. This so called meritorious good benefits only the individuals that have a direct contact with this good or service. In this case, only the construction workers that will get a boost to the detriment of the rest of fellow Zagrebites and the politicians are ensured a sure vote.

Present goods in form of money are wasted in such projects and society therefore gets poorer.

A bankers dream: Subsidies and bailouts

During the recent bubble in real estate in Spain, banks amassed a nice gargantuan sum of loans (created more or less ex nihilo through the fractional banking process) which are now not worth their carrying value.
To match their balance sheets with reality, they are forced to write these assets at market value. This will mean a massive balance sheet contraction and a subsequent unwillingness of banks to further expand credit due to losses, and a weak economic outlook forces them to retrench without additional credit demand.
According to business.hr, Spanish banks need 65 billion euros of fresh capital.:

“Eurozone finance ministers agreed on Saturday that the Spanish government needs to borrow up to 100 billion euros to help banks after the bursting bubble in real estate markets and banks have problems with uncollectible loans.”

Well, this is what happens when you try to short circuit the wealth generation problem through credit expansion. Interest rates shoot up to signal a shortage of available savings to complete the initiated projects and the asset side of the balance sheet contracts. Gee, I wonder where the money is going to come from? Savings? Future taxes? Credit expansion?
Its really unbelievable that even after the crash, politicians are still fixated on generating overall aggregate demand to offset the credit collapse. They are fixing a debt issue with more debt. Brilliant. And after the banks receive this cash, just as they did with LTRO and LTRO II, where are they going to use thus liquidity? To increase loaning out to business ventures. I doubt it. They will use these funds to offset their loan losses and add to their loss provisions.
Certainly, they will pay no taxes in the immediate future, thanks to the tax carry forward loss.  Lavish bonuses will be paid and everything will look fine until the bill is due once more and the loan has to be rolled over at an even higher yield.
The ring-around-the rosy continues.

Common economic sense

 

I’ve decided to post an interesting cartoon that may escape the most literate mainstream economist of our day – the simple truths are the ones that evade us the most.

Straight from the Circle Bastiat, a glimpse into the puzzling world of “why does GM manufacture cars that nobody wants”. Enjoy.

Hedging vs. asymmetric hedging

 

Due to the large viewership of the blog post titled A short explanation on J.P. Morgan’s Derivatives Loss, I have decided to delve a little deeper and explain the difference between hedging and a strange phrase dubbed asymmetric hedging.

Jamie Dimon, CEO of J.P. Morgan Chase Corp., has attributed the recent massive losses due to asymmetric hedges the firm took. These losses were revealed in advance and ahead of the Q1 earnings report. What is interesting is the manner that the CEO described the loss, calling it a hedge gone wrong.

Now, to reiterate, to hedge means, to offset. An example would be to go long in an interest rate swap contract, in which J.P. Morgan pays a fixed rate of 500 basis points + spread between a AAA corporate bond and the 10 year Treasury security and receives 500 basis points + LIBOR. The transaction is settled quarterly and netted. This means that if at the settlement date, LIBOR is higher than the 10-year spread, J.P. Morgan, receives the interest difference between the two. This discrepancy is usually based on historical returns and current market fluctuations. In this case, the cash flows usually cancel each other out.

Now, in an asymmetric hedge, an example would be as follows: J.P Morgan would agree on a swap that includes paying 500 basis points + LIBOR and receives 500 basis points + the return on a thinly traded security or index. Now, in this case, the probability of small netted returns and cash flow netting is smaller, than in the previous example.

If for example, the thinly traded index fell 40% at the settlement date, J.P. Morgan would not only pay its cash flow, but the difference in the index between the two dates as well. It would have to book a massive loss for doing so.

That is an “asymmetric” hedge. Using leverage compounds the loss, and offsetting the position can also be very costly if the ongoing fundamentals for the swap is negative for J.P. Morgan.

The example doesn’t even resemble a classic hedge, but rather a speculative position. Even if J.P. claims that is making a market and offsets the position with its client through the hedge, seeking asymmetry is more something a hedge funds would do.

Fraud as the final step in a credit boom

 

There has been great many discussions about introducing new legislature concerning the overhaul of the financial industry. There has been calls for Glass-Stegall to be re-introduced. The Dodd-Frank overhaul act of 2010 is a massive 800 page juggernaut aimed against the “egregious” acts committed by Wall Street during the latest  recession. But, do laws really help against fraudulent behavior or are there deeper roots regarding this problem?

During the boom faze of the credit cycle, prices of factors of production and capital goods rise in value, the stock market rises and there is a sense of general euphoria. Companies are willing to go into debt to finance and expand entrepreneurial projects. They are romanced by the banking sector and the cheap funds that are all of a sudden granted to businessmen almost at no cost. Profits soar, and the balance sheets of companies have never looked stronger.

Assets are inflated in value, along with revenues. Projections based on current sales and expenses are prolonged into the future with expected double digit YOY growth. Companies in this period don’t really run high capital buffers to protect them in case of a sudden fall in ongoing revenue. They rarely engage in any accounting for reserve losses on their accounts receivables and a hectic schedule of ever increasing demand reduces their inventory amounts. The demand can be so excessive, that companies frequently neglect the qualitative value of there assets, as the only goal is to satisfy the voracious appetite of the consumers at large.

However, the fairytale economy built on money creation is an illusion, and soon companies will find themselves in trouble. The first thing that comes about is a cry for more liquidity; that is, the business community starts holding a grudge against the government due a “note shortage”, a situation where there isn’t enough funds in the economy for completing there projects of longer durations. Businesses are frightened due to rising interest rates and higher costs of going into debt or rolling over their current debts. Funding becomes an issue.

The only way for businesses to appear in good health is to engage in deceptive accounting or sometimes go so far and engage in embezzlement and fraud. Companies, which are first effected try to get rid of poor performing assets. But, instead of selling them, they usually engage in complicated repo transactions, where they try to ”window dress” their current financial mess.

(This closely resembles the situation and fraud perpetrated by Olympus in Japan. They tried to hide losses for over a decade in an ingenious scheme that finally unraveled a couple months back. For an accounting description of what happened read this post by an independent CPA from San Francisco located on retheauditors.com.)

But the window dressing and repo shams can last only for so long. The company will eventually run into problems paying back their vendors. They again decide to engage in aggressive accounting techniques using vendor financing. The troubled firm will sell their account payables for note payables. The cash injection will be recorded on the cash flow from operations (under IFRS) and when the note comes due, they may resort to booking it on the financing portion of the cash flow to make it appear that the firm is on steady grounds when its core business is concerned.

Fraud, in this context was generated not by an evil ambition of the businessman, but by a desperate attempt to stay afloat. That is usually what happens in a boom period. I am not vindicating this behavior, just stating the catalyst that brought such dubious behavior.

In a “normal” economy, these things happen as well, but are more profound during the end of the boom faze. Some other ways to manipulate earnings or financial statements is to: book revenue without shipping the product (bill and hold), booking a revenue when accrual accounting doesn’t allow it, lowering contra accounts to artificially prop up assets, capitalizing an expense when conditions are not made for it to be capitalized, engaging in aggressive securitizations, manipulating the life cycle of an asset, booking future profits, lowering the carry of defined pension benefit plans, using an asset as an operating lease instead of properly booking it as a finance lease etc.

The politics of employment

 

It is really sad that in todays world, one would get a job not because of his/her merit, but because of politics. This next article from business.hr really makes me sick:

“Minister of Environmental Protection and Nature Mirela Holy, in a written request addressed to the President of Railways Holding Renu Valcic tried to save one secretary from being fired reports HRT Broadcasting.

The written request in the first sentence emphasizes that the  the secretary is the wife of  a party colleague, but the CEO of Railways Holding Valcic rejected this request. Holy says that it is not a political intervention, but it is a recommendation for a humane attitude toward an employee of the Railways, the reports of HRT.  I appealed. I sent an official request from the mail, but mail from the party to a party colleague, "said the show 'Open'.”

Not a political endorsement? Humane attitude? This is one of many real life situations in which individuals wishing to resume a status quo situation are left begging to the government to save their rightfully earned workplace.

Insomuch, I wouldn’t be surprised if this individual earned twice as much as she would have earned in an unsubsidized industry subject to the laws of supply and demand for wages.

Fractional reserve banking and its effect on maturity mismatching

 

The following is an excerpt from my presentation at the 3rd International Student’s Conference: Time to Rethink Economics, Beyond Frontiers that took place in Zagreb, Croatia in June, 2011. The title of the working paper is: Dangers of maturity and currency mismatching in a fractional reserve banking system with the example of Iceland and a look at alternative banking models.

Fractional reserve banking and its effect on maturity mismatching

For one to understand modern banking, history is an essential backbone unto which the pillars of modern financial intermediation are to be analyzed. The first and foremost example is Ancient Rome and the introduction of Roman Classical Law. In the time of great advances in philosophy, the beginnings of primal government structures and other forms of key institutions, a form of so-called jurisprudence evolved. Jurisprudence came about from the nature of societal and human understandings championed by Roman scholars, as” […] they embarked on an interpretation of legal customs, exegesis, logical analysis, the tightening of loopholes and the correction of flaws; all of which they carried out with the necessary standards of prudence and equanimity.“ (de Soto, p. 24)

The work of the jurisprudence was subsequently archived thanks to Emperor Justinian during the middle of the six century, as to be later on compiled into one monumental book, the Corpus Juris Civilis. Roman legal scholars, as part of this jurisprudence came to a conclusion that haunts modern banking to this very day. The pivotal conclusion regarding not only banking, but the core social edifice of society, but in the realm of banking, was the distinctive and fundamental difference of demand deposits which represent a sum of money deposited at a depositary institution, receiving the name of a monetary irregular deposit (to be shortly explained) also known as a tantundem, and a loan contract, under which an individual relinquishes his/her monetary sum for a distinctive period of time, at interest, also known as a mutuum contract.

A monetary irregular deposit stems from the notion of fungible goods deposited at a depository. This means, that if someone wishes to place a certain good at a bank for safekeeping, for example, oil, grain and so forth, it is in the depositories obligation to immediately relinquish this good at the demand for the depositor. Since grain and oil are by nature fungible, it is economically inappropriate to keep these goods separated or compartmentalized for the marginal cost would be too great. Therefore, grain and oil are kept together, since no qualitative or quantitative standards are violated.

Moreover, this fungible asset is, in its essence, a demand deposit. Any failure of delivery results in a law suit against the depository not being able to bring about this demand to its rightful owner. “In other words, the owner of the grain warehouse or oil tank can use the specific oil or grain he receives, either for his own use or to return to another depositor, as long as he maintains available to the original depositor oil or grain of the same quantity and quality as those deposited“. (de Soto, p. 59)

A demand deposit is not relinquished for any time. It does not represent a transfer of present consumption for future consumption, unlike a loan (mutuum). A loan transfers present for future consumption, in line with consumer preferences. One of the key roles here is the charging to interest.

Why banks grant interest payments to depositors? There is clearly no transfer of consumption patterns when a deposit is kept for safekeeping. A monetary loan on the other hand signifies a transfer of ownership where a demand deposit does not. In that case, banks are obligated to maintain a 100% reserve requirement for demand deposits.

However, fractional reserve banking manipulates this legal and economic understanding of not only ownership transference, but time transference of funds. Notable examples of this misconception derive all the way from ancient times to modern day banking with the clear deviation from logic, adopted in Anglo-Saxon Law. The practice of loaning out demand deposits and concealing them as loans is a concept known in the Middle Ages as depositum confessatum.

Under this veil, banks had the ability to pay out interest to depositors, even though it should be reversed, the depositors for various reasons, decide to safe keep their funds, and must pay a service fee, not the other way around!

Economic activity is therefore altered, for confusion enters the market, and one doesn’t know if funds are genuine savings, as in loaned out, or funds are safe-kept, to be instantly used. Primary examples include the government sponsorship of these actions in the past, so-called ius privilegium. Under such circumstances, banks were allowed to create credit out of nothing, loaning out deposits that should have been backed by a 100% cash reserve.

Fractional loaning of demand deposits, therefore, when visualizing from an accounting perspective, transfers leverage and unjustified profits from society to banks practicing this form of intermediation, creating a profound and unjustified act of usury.