Sunday, October 09, 2011

Sir Mervyn King, Montague Norman and fractional reserve destruction.

 Politicians and economic commentators are still scratching their heads over the Bank of England governor, Sir Mervyn King's remark last week that the financial crisis is worse than the 1930s.  "Cheer up, Mervyn, it's not that bad" said Hamish Macrae in the Independent.  "Talking us into recession"  - said the Express.  Not since Montague Norman took to his bed during the gold standard crisis in 1931 has a central banker been so publicly distressed about the state of the economy.


  Perhaps that's the key.  Sir Mervyn worries he might be the Montague Norman of the 21st Century, forced to preside over the collapse of the international financial system.  Norman took to his bed when the British banks nearly went under in unison during the Great Depression as Britain's gold reserves dried up. He had been governor during the roaring 20s and was a bit of an international financial celebrity, like Alan Greenspan until the crash of 2008.


  Sir Mervyn presided over what he called the "NICE age" of the noughties.  "Non-Inflationary Continuous Expansion".  This turned out to be a massive Ponzi scheme built on a massive property bubble. Right until it went pop, King insisted that there was no unsustainable inflation in property prices - even when banks like Northern Rock were handing out 125% mortgages. 


   He thought he had saved the day by cutting interest rates to the lowest in 300 years and by printing money.  But clearly, he hasn't, and now the chickens are roosting all over Threadneedle St..  And all over Europe.  The coillapse of the French-Belgian bank Dexia suggests that another wave of banking collapses is in the offing.   King has warned banks not to expect another bail out, which can only mean one thing:  that governments will have to step in and do the restructuring of the debt - seizing bank assets and managing a mega default.


  Banks make money because of a trick called fractional reserve banking - lending money they don't actually have.  At any one time a bank may only have £1 of capital for every £100 lent out.  If only 1% of the bank's loans go bad, that means they are insolvent.  Businesses, bond-holders and ordinary depositors will queue up to find that the money they thought they had safely in their accounts is no longer there.  Fractional mass destruction then wipes out huge swathes of the economy.  This is unlikely to make people well disposed to the central banker who didn't see it coming. 









"This is the most serious financial crisis we've seen at least since the 1930s, if not ever," says Sir Mervyn King, the Governor of the Bank of England. Yes, it's official: this could be worse than the 1930s, the Great Depression. Men slumped on street corners and kids with bare feet. Inflation, fascism and economic war in Europe.

Now, I may be missing something, but isn't this just the kind of alarmist headline-grabbing remark that central bankers are supposed NOT to make in case it spooks the markets? It's people like me who're usually criticised for resorting to sensational forecasts about Great Depressions and the like. The commentariat's being done out of a job by the godfather of prudence. Whatever happened to “Keep Calm and Carry On”?

The Prime Minister, David Cameron, is said to be livid. Only the 24 hours before King forecast the end of civilisation as we know it, Cameron had told the country to“bring on the can-do optimism”. Well, not in the Bank of England, clearly. It's hard not to read this as an implicit condemnation of government economic policy. At the very least, the Prime Minister and his Chancellor, look as out of touch as the Labour PM, Jim Callaghan, when he said “crisis, what crisis” just as the IMF were about to take over the reigns of the British economy in 1976.

So what has spooked Mervyn? Well its the Greeks isn't it, stupid? Actually, it isn't the Greek default. It's us. Mervyn's panic attack coincided with the news that the rating agencies had downgraded the status of a raft of British banks just as interbank lending was seizing up. In real money, this means that financial advisers like Moody's are warning people with money in banks like RBS, Santander, Lloyds etc that they might not get it all back. Why? Because the banks are becoming stressed again, just like 2008, and there is no chance that this time the government will have the will or the means to bail out the banks with public money. There's very little public money left and the economy is slowing to a halt, which will make it hard for the government to pay it s own debts, let alone the banks'.

The bail out of the UK banks in 2008/9 required £1.3trillion – according to Mervyn King's own figures. And what did we get for putting up all that money? Well, Stephen Hester of RBS got £11 million last year. Bank bonuses accounted for another £13 bn.. The rest disappeared into the bowels of our rapacious financial institutions. So what do we do now? Well, if there isn't any public money, let's just print it anyway. The last round of quantitative easing, that's money printing, placed £200bn in the banks' accounts in 2009.

What happens is this: the Bank of England electronically creates money which it uses to buy bonds from the banks. This injects funds directly into the banks' balance sheets, wiping out their losses, and “restoring the health of the financial system”. The money is supposed then to be lent to small businesses and people wanting mortgages,boosting economic growth. Except that this didn't happen. The banks hoarded it instead and paid themselves huge bonuses. All QE 1 really succeeded in doing was increase inflation to 5%, which is generally what happens when governments print money. This has eroded peoples' savings, pensions and salaries, meaning that they haven't been buying much in the shops. Which in turn is why the economy is sliding back into recession. Britain has one of the lowest growth rates in the OECD and has one of the highest fiscal deficits. Stick that in your budget, Mr Osborne.

So why on earth is the governor printing another £75bn of QE? It looks like the economic equivalent of blood letting: a pointless medical procedure that only weakens the patient. This is the great unanswered question of the age: why are policy makers unable to see any solution to economic crisis that doesn't involve stuffing the mouths of bankers with gold? When historians look back at this period they will criticise governments for inactivity, short termism and denial.. But they will condemn them utterly for throwing oceans of public money at the very people who caused the crisis and were least to be relied upon to resolve it.

Instead of handing money to banks, in the vain hope that it will boost economic activity, why doesn't the government hand it to poor people? I'm not joking. At least lower income groups can be relied upon to spend the cash in the high streets – in shops like Tescos, which has just announced its worst sales figures for 20 years. Give them VAT rebates, interest free loans, tax 'holidays', elderly care grants, home improvement loans - anything to get money into the system. Giving liquidity to people who don't have it is the surest possible way of boosting economic activity. QE is like trying to get the car started by giving money to oil sheiks in Saudi Arabia.

Of course, the bankers would respond that, yes it's all very well giving money to people other than us. But if you don't hand over your cash, we'll just go bust like Lehman Brothers, and that will cause a global financial and economic collapse. Ha ha. And of course, they're right – they are too big to fail. If say, RBS went under the shock waves would be so great that bank lending would halt overnight. This means that companies who depend on short term loans from banks to manage their accounts would go under too. International trade would freeze because there would be no credit for exporters. There would also be a run on the banks, as happened in October 2008, when people and businesses withdrew their cash from banks like Northern Rock and HBOS because they didn't believe their funds were safe. In 2008 according to the then chancellor, Alistair Darling, Britain was 24 hours away from the ATMs closing and people being denied even cash withdrawals.

Could we really be going back to all that? Well, yes - the Belgian-French bank, Dexia has just gone bust for the second time in three years because people started withdrawing funds at an unsustainable rate and its share price collapsed. It could be the first of many, and governments cannot bail them all. Which means that if you are lucky enough to have more than £85,000 in any one bank – that's the limit of the deposits guaranteed by the government's deposit insurance scheme – then you'd be well advised to get it out sooner rather than later. I know that sounds alarmist, inflammatory, but listen closely, and that's what the Guvnor is saying.

But there is an alternative. Instead of pouring more printed money into the banks, why not nationalise them completely? We already own RBS and most of Lloyds. The nationalised banks could be used to set up smaller, more responsible banks with a remit to lend to industry rather than speculate on derivatives and the commodities market, which is what they have been doing since 2009. If the financial crisis really is as bad as the Governor says it is, and we are about to drown in a hyper-inflationary sovereign debt crisis, then the government would be able to freeze asset deposited in the banks and conduct a kind of debt 'triage'. Those with more than £85,000 in deposits would be required to accept a proportionate reduction in the value of their deposits in order to stabilise the financial system and remove the debt burden on the state. This could be done by converting bank deposits into government bonds redeemable at a later date. This is rather like QE in reverse. Needless to say, all bank bonuses would be scrapped, and bankers put on civil servants' salaries.

There would be howls of anguish from the rich at their wealth being hi-jacked in this way. But they should be told that the alternatives are much worse: a run of bank failures, which mean they would lose ALL their funds over £85,000. Bond holders would not just have a haircut – they would be decapitated by default or by hyper-inflation. There is still a great deal of wealth in Britain, £7 trillion in household assets alone, according to the Office for Budget Responsibility, but this is largely held by the very wealthy and 'sterilised' in property and other assets. If we are facing the ultimate crash, the government will have no choice but to commandeer these resources and use them constructively to manage the national finances. Roosevelt did something similar in 1933 when he ordered all the gold held by individuals to be deposited with the government.

I doubt if any politician has the cojones to put this kind of scheme forward right now – most of them are intellectually in hock to the City of London anyway. But what is not in doubt is that that the Bank of England is already thinking the unthinkable. Various schemes for crisis debt restructuring are surely already being run the Bank of England's computer models, and though they can't admit it, this will inevitably involve some control of bank deposits and an orderly run down of debt. The government will probably opt to raid pension funds first, because they are harder to move off shore. This is what the Argentine government did in 2001 when it defaulted.

What the Governor is warning of is a truly apocalyptic financial event. The government has already seized large parts of the banking system and resorted to money printing. It may not be long before it breaks into peoples' accounts directly. You have been warned.   

4 comments:

Edward Harkins said...

It seems to me that Mervyn King’s gnomic statements can be seen as preparation for a reenactment of financial repression practices by Governments across the advanced economic world.

This field has been covered in masterly fashion in the ‘financial repression’ thesis by Carmen Reinhart and others. Her work analysed how the USA and UK, in the three post World War 2 decades in particular, had practiced a form of dictatorship and repression over global financial system and markets.

At the end of WW2 the USA and its Western Allies were faced with a catastrophic post-war economic legacy. War debt, the collapse of international trade and the physical destruction of countries’ economies meant that global bankruptcy beckoned. The solution was to gently inflate away the debt. But institutional investors were not going to willingly leave their funds in government gilts and other forms of sovereign debt when they knew that inflation deliberately induced by governments would eat away at the true value of those investments.

The result was that Western (USA-led) Governments used any and every device to force institutional investors to hold Government debt in their portfolios: banks and pension funds were forced through regulation and strictures to hold government bonds, for supposed ‘liquidity’ reasons; interest rate ceilings were imposed on private lending for reasons of prudence and to prevent inflation (irony upon irony); for much of the post WW2 era, governments manipulated exchange and capital flows controls to entrap investors in under-paying domestic markets.

It always struck me that there continues to be a strange ‘half-view’ of the post WW2 decades – the economic salvation of Western Europe and its rescue from communism (or, rather, from USSR colonialisation) is usually ascribed to the USA funded Marshall Plan. But the hugely significant role played by financial repression is still little recognised.

IMO, it seems highly possible that we are likely about to see a return to a regime of financial repression.

Anonymous said...

Explained in a way that even an economically illiterate reader, such as me, could understand it, Iain. Thank you.

Anonymous said...

Jeez! I'm away to lie down, maybe I'll manage a comment later

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