Archive for June, 2011

Irresponsible borrowing and irresponsible lending

Tensions in Greece are reaching melting point. And the debate is a clear and straightforward one. What we are witnessing is a propaganda battle between the forces calling for Austerity and those (perhaps indirectly) proposing Default.

Those calling for Austerity claim lazy workers, socialism and corrupt politicians created a dire fiscal problem that Greece must now pay up for. The sins of the past must be repented through public sector belt tightening (a squeezing of living standards) and large-scale land and infrastructure privatisations (i.e. asset sales).

Those calling for default state that the very Sovereignty of Greece is being challenged by external enforcement of debt peonage. Debt that was foisted on them without due care or consent.

The justification for Austerity is that Greece must own up to its responsibilities and pay back these debts. It is the honourable thing to do, we are constantly told. This mantra is voiced by many economists, politicians, the Prime Minister of Greece himself and would no doubt be the de facto position of the majority of citizens in Europe. Default is treated with emotive disdain, and the spectre of financial Armageddon is wielded around with fear-mongering fanaticism to scare any wavering spirits into submission.

The suggestion being is that default would reward the feckless and punish the prudent. However, this conclusion misses out some more profound behaviour re-enforcement which could be demonstrably more harmful.

Here are at least six very sound reasons why the implementation of Austerity would be morally, socially and legally reprehensible:

1) Shared responsibility

If a bank made a stupid loan to me or my business, who is the greater fool?

Surely, in cases of poor lending circumstances, an irresponsible lender should be just as much to blame as an irresponsible borrower. To enforce total accountability on the borrower is tantamount to supporting loan shark type tactics. In a civilised world, the lender of money has a duty of care to ensure the standard of lending, and this should manifest through the acknowledgement of accountability in times of poor judgement.

2) The symmetry of risk & reward

The voices calling for Austerity also seem to be the most vocal ones with a conservative / libertarian bent. Yet they don’t even realise the sheer hypocrisy of demanding such asymmetric punishment when the very mantra of the true Laissez-Faire Capitalist is the cure of poor investment stakes through default!

Hence the very principle of Equity Investment which correctly balances risk & reward. Debt peonage is not the symmetrical solution as defined under Libertarian principles. One has to be either deluded or an ignoramus to accept the blatant contradiction of extracting all reward (interest AND principal repayment) for no risk.

3) Incompetent lending

In addition to the concept of shared / symmetrical responsibility, it should be clear that in all respects a lender should be more accountable for bad investment decisions, as after all they are deemed to be specialists at lending. I am not a professional borrower of money, but my bank manager is a professional lender. They are deemed to be competent, qualified and professional stewards of investment capital.

So let’s review the performance of these lending professionals.

Taking the historical track record of Greek sovereign debt; it has spent 50.6% of years since 1824 in default or re-scheduling. It suffered a severe banking crisis between 1991 and 1995. This is not an auspicious start point, is it? The banking “professionals” may well proclaim that they relied on elaborate and professional risk assessment criteria using the very latest in sophisticated statistics. But a cursory examination of the situation using the techniques of one Rev’d Thomas Bayes would reveal that the Prior Probability of Greek default was in the order of 50%! And in fact, the course of events is no doubt going to support the accuracy of risk assessment by the humble Bayesian probability over the wildly naïve Gaussian statistics of high finance.

Therefore, it’s not just irresponsible lending that has happened, but incompetent lending!

Bear in mind that bankers justify very high salaries and bonuses because they claim to be very good at their job and that they perform socially beneficial activities. Clearly they are not using reliable tools for assessing levels of risk, and nor have they conducted appropriate due diligence on the country’s ability to pay. Not only this but their self-proclamations of societal benefactors is crumbling before our eyes.

4) Odious debt

So we have seen how the lender has to accept an element of responsibility, but now to turn to the borrower. What many voices seem to declare is that each of the people within Greece have been personally complicit in this excessive borrowing. But this is to accept the idea that all nationals are fully accountable for the conduct of their “representative” leaders. It is the notion of “borrowing by proxy”.

In a way our Gvt in the UK has also done this covertly. It has taken private sector debt problems and soaked up the responsibility onto the nation’s balance sheet. How many people in this country are aware that our banks have liabilities 5 times our national GDP? Was I consulted on this? Did I vote for this? Did I sign a declaration of acceptance of these terms? No, I did not.

There is a term for this situation and one which may become more prominent in months to come. It is that of “odious debt”. Debt which was incurred for purposes that do not serve the best interests of the nation, and therefore should not be enforceable:

Zerohedge – Odious debt

Iceland serves as an example of this principle in action. The people of Iceland have refused to underwrite the extraordinary liabilities of private banking institutions. They understand all too well the morally unjust nature of letting a few wealthy people prosper during the good times, and the scarper when it goes bad (in fact they are charging their Prime Minister for financial negligence for tolerating such leveraged liabilities).

5) Debt for foreclosure

Returning to the national stereotypes mentioned above, then why in the world would anyone invest money in such a country and then expect to get it back? One can’t turn around and forcefully demand the repayment of debt from a nation, whilst at the same time claim that those peoples were never really good for it in the first place. This is an overt admission of not doing one’s homework, but then still demanding full and fair entitlement. It is nothing less than a deliberate intention to ensnare.

Economist Michael Hudson tells an intriguing story of this very strategy in action more than 200 years ago in the US:

“[In] colonial times, when British speculators eyed rich New York farmland. Their ploy was to extend loans to farmers, and then call in the loans when the farmer’s ability to pay was low, before the crop was harvested. This was indeed a liquidity problem – which financial opportunists turned into an asset grab. Some lenders, to be sure, created a genuine insolvency problem by making loans beyond the ability of the farmers to pay, and then would foreclose on their land.”

“They sued under the fraudulent conveyance law, which says that if a creditor makes a loan without knowing how the debtor can pay in the normal course of business, the loan is assumed to have been made with the intent of foreclosing on property, and is deemed fraudulent.”

In other words, it is a pre-planned strategy on the part of the lender to push the borrower into such a corner that they have to sell up at firesale prices. But, clearly this strategy needs some form of social compliance and legitimacy, otherwise it would / should be deemed legally fraudulent!

To socially and legally tolerate it is to explicitly legitimise loan sharking:

“high finance is seeking to turn public infrastructure into rent-extracting tollbooths to extract economic rent (the “free lunch economy”), while replacing labour unions with non-union labour so as to work it more intensively. This new road to neoserfdom is an asset grab.”

Michael Hudson: How Bankers are using the Debt Crisis to welcome in the Financial Road to Serfdom

6) And finally, but what if the devil turns on you?

There is a scene in the play “A man for all seasons” in which the young Roper is debating with Thomas More:

More: What would you do? Cut a great road through the law to get after the Devil?
Roper: I’d cut down every law in England to do that!
More: Oh? And when the last law was down, and the Devil turned ’round on you, where would you hide, Roper, the laws all being flat?

There is a stark warning for us all in the events in Greece. If you are happy to play along with the Neoliberal asset stripping and cheer the Austerity along in other countries – then don’t complain when they turn their sights on us. As highlighted above, the UK’s implicit sovereign liabilities are 5 times our GDP (and therefore more than twice our whole country’s national wealth).

Hudson’s article later extends the actions happening in Greece to the wider western world. He situates this as a general rolling back of progressive principles which were enacted primarily Post WWII:

”The asset stripping that Europe’s bankers are demanding of Greece looks like a dress rehearsal to prevent the “I won’t pay” movement from spreading to “Indignant Citizens” movements against financial austerity in Spain, Portugal and Italy. Bankers are trying to block governments from writing down debts, stretching out loans and reducing interest rates. “

Also from Zerohedge again:

“The war between liberals and conservatives is a false divide-and-conquer dog-and-pony show created by the powers that be to keep the American people divided and distracted. So before assuming that privatization is a good thing, read on.”

America is being raped just like Greece

Certainly anyone for whom their personal interest will be clearly served through the enactment of Austerity will never even raise these points or acknowledge their legitimate discussion. But if we are to hope for an enlightened resolution to the mounting debt woes of the world, we must at least confront each one of these points with the full force of conviction. To have no debate on these points is to unconditionally surrender ourselves to economic genocide.



This post is now available in Spanish, courtesy of!


Potemkin Firewalls

In today’s news we are hearing that George Osborne is endorsing the UK’s Independent Commission on Banking (ICB) interim recommendations for ring-fencing Retail & Investment Banking. This is being couched as a tentative step towards the re-instatement of Glass-Steagal type separation of banking practices. On Radio 4’s Today programme Robert Peston declared the move one of the most fundamental aspects of financial sector reform in recent decades. However, this conclusion might be a little hasty on his part, for in reality the reforms do not tackle the fundamantal operating structure of modern banking, and instead mask more profound issues.

Deregulation of the banking sector since the 1990s has led to the feasibility of banks selling-on loans, known as the “originate and distribute model”. This has led to a fundamentally different market structure whereby an increasing proportion of loans are packaged up and traded as securities on a secondary market (e.g. Asset Backed Securities such as Collateralised Debt Obligations – CDOs).

The importance of securitisation to the ICB was clearly outlined in their opening position paper:

“It was argued and widely accepted during the pre-crisis period that diversifying exposure to credit risk through securitisation made the financial system more stable…the events of the financial crisis showed the opposite.” (ICB Calls for Evidence Paper 2010, Section 2.9)

Yet they seem to have glossed over this issue in their interim report. The important shift in modern banking is not the emergence of the universal banks per se, but the fragmentation of the loan process, i.e. the principle of Securitisation itself.

Under this regime, tasks that would normally be the integrated responsibility of banks become dissected, with one of the most critical aspects, the pricing of risk and the supervision of borrower behaviour, being placed within the hands of secondary markets. However, with credit risk assessment (by the Originating bank) becoming separated from credit risk responsibility (resting with the Holding institution) it seems highly unlikely that the quality of loan evaluation would improve. Indeed evidence collected and published on the cusp of the crisis in 2008 demonstrates that securitised loans severely underperformed!

The very structure of securitisation could be facilitating the exploitation of moral hazard and asymmetric information concerns that have dogged banking for centuries. Borrowers themselves may be making inferior loan judgements (with easy credit enabling an “extend and pretend” lifestyle which they can’t realistically sustain), and/or loan originating firms could develop a tendency to ignore weak borrower circumstances (such as the spate of “self certification” mortgages).

The Independent Commission on Banking may well conclude that firewalls should be erected between Retail and Investment banks. However, the role of securitisation both maintains a mutually interdependent link between the two types of institution, plus places the overall system at higher risk by creating perverse incentives for lower quality lending within the economy. This is no longer a closed system, but instead an open system where risk ownership and responsibility can become complex and obfuscated.

At the time of the crisis in 2007/2008 both Northern Rock & Lehman Bros already sat either side of the notional banking firewall. This argument has been used to dismiss the potential effectiveness of such a compulsory demarcation. Such a split would indeed be little more than a Potemkin firewall; a flimsy masquerade that would provide no genuine safeguards at all. But this should not be concluded at the expense of ignoring a more fundamental point. These two fragile institutions shared in common a heavy reliance on Securitisation. Much of the debate about the market structure of banking seems to ignore this crucial issue, yet it seems certain that this was the underlying cause of their financial distress.

We mustn’t forget that the practice of Originate and Distribute is still new territory, and currently one with a very patchy record. Given that the vertical fragmentation preserves an umbilical link between two distinct systems (one required to be totally watertight, the other free to be more risky), it seems that we can’t yet declare that the future of banking is as safe as houses, until we confront this specific issue head-on.

Categories: Finance and money

Wall of illusions

I have just finished reading Karl Polanyi’s “Great Transformation”, and it is poignant to see the parallels between our current situation and the early part of the 20th Century.

Polanyi’s view is that the free-market should be a servant to Society, not its master. The economic and political tensions throughout the nineteenth and twentieth century are viewed as responses by society to tame and limit un-abandoned free-market policies.

Polanyi was referring to “market-economy” as the market for land, labour and money, whereby these “fictitious commodities” are traded (and therefore priced / valued), as if they were real commodities:

“A market economy is a self-regulating system where everyone is assumed to behave in a way that maximizes money gains. It assumes that in the market supply price will equal demand price. Money is assumed to exist, and the market sets prices. There are markets for everything from goods and services to labor, land, and money. In this ideal system there is not external regulation of prices, demand, or supply.”

Source: Polanyi – Great Transformation

The two key concepts in defining a market economy are firstly that people should be incentivised to act in self-interest (as the assumption is this then benefits society) and secondly that to achieve the utopian vision all aspects of control or regulation of land, labour and money should be abandoned. The true free-marketeer craves de-regulation of the three “fictitious commodities” in order that the market can then price them purely through the mechanism of exchange. Therefore, every man has his price! Society is then a conglomeration of mercenary exchanges by mercenary actors.

It is easy to forget that the relentless pursuit of international trade and liberal Capitalism as defined above was heavily embedded throughout the nineteenth century. Far from a very modern invention, the world had embarked on a grand experiment throughout the Victorian era. So how did it fare back then?

Polanyi describes an era where relative peace in international terms was held together thorugh the Gold Standard, and the military notion of the Standard of Power (whereby Britain could defend against an alliance of the next two most powerful nations). At the national level a liberal state was doing its utmost to implement the utopian self-regulating market. To outside appearances a relative calm existed, but to Polanyi this because inherent tensions were pushed under the surface:

“A hundred years peace [1815-1914] had created an insurmountable wall of illusions which hid the facts.
No people could forget that unless they owned their food and raw material sources themselves, or were certain of military access to them, neither sound currency nor unassailable credit would rescue them from helplessness.”
p198 (my emphasis)

“Within the single nations the tension remained latent as long as world economy continued to function” p228

But towards the end of the nineteenth century the world economy started to fracture. National resistance against the liberal state’s free-market methods was coupled with a breakdown of international finance.

The first world war failed to address the inherent problems as many nations tried to kick start the Laissez-Faire agenda, culminating in the boom and bust of the late 1920s. In his view protectionist policies emerged in the 1930s as a reaction to the failure of un-fettered Capitalism. In their own different ways the New Deal, Communism and Fascism were the social responses to the collapse of International Capitalism; a way for society to re-assert it’s primacy over the market.

The second world war all but eliminated Fascism, and instead left the two models of Communism and the social Democratic approach. The mixed economy of the West saw it through its heyday of the 50s/60s but started to wobble in the 70s. Since the 80s, however, the liberal economic model crept back in to the frame. In a way it was the resurgence of this utopian free-market that crushed Communism in the East, whilst covertly mutuating the semi-protectionist mixed economies of the West.

In its current guise of Globalisation, the free-market has reigned supreme; with Russia, China, Asia etc. adopting this model from the 1990s onwards. The twin pillars of self-interest and de-regulation as the Modus Operandi of Laissez-Faire. But at what price? Perhaps latent tensions exist today, much as they did as the world entered the twentieth century. Polanyi lists the sources of friction as follows:

– Unemployment
– Class divides
– Currency pressures / exchange rates
– Imperialist rivalries

As we take stock of the recent financial crisis, it is important to keep track of these potential flash-points. Unemployment is rising in many countries yet the wealth / income gap widens. The cost of living is increasing yet wages are stagnating. And the contest for dwindling resource supplies in and around the middle-East could provoke tensions between the imperial giants of China and America.

The friction between the market system and society is growing day by day; whether in North Africa, the middle-east or Southern Europe. The Wall of Illusions is starting to crack and crumble, and we dare not wish to peek beyond it.

Does the world have the stomach for another revolt against the global Laissez-Faire pillage? And if so, what kind of form will it take this time?

——- Update 9/9/2013

Summary of Polanyi’s work is found here:

“Land, labour and money are crucial to the efficient functioning of a market economy. Appropriating the functions of these alters and harms central social mechanisms governing human relations.”