Archive for the ‘US Banking System’ Category



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I COMPLETELY agree with the points made by Bill Gross in this article.  Here is an excerpt and the link:

“Faced with these two decidedly different routes to “level the playing field” it seems obvious that the United States is opting for “Easy Street” as opposed to “Buckle Down Road.” Granted, “The Ben Bernank” as a YouTube cartoon rather hilariously labeled him, has for several months importuned Congress and the Executive Branch to institute substantive reforms, while he attempts to keep the patient alive via non-conventional monetary policy. But very few others are willing to extract their heads from the sand. The President’s debt commission with its insistence on low personal and corporate income tax rates and a mere 15 cent increase in the gasoline tax was one example. The Republicans’ reluctance to advance detailed ideas for budget balancing is another. And the Democrats’ two-year focus on the biggest entitlement program since Social Security – healthcare – as opposed to fundamental reforms to counter our lack of global competitiveness – is perhaps the most grievous example of lost opportunity. Unlike the United Kingdom, where Prime Minister Cameron has championed fiscal conservatism, or even Euroland, which is being forced in the direction of Angela Merkel’s Germanic work ethic, the United States seems to acknowledge no bounds to what it can spend to bolster consumption or how much it can print to support its asset markets. We will more than likely continue to “level the playing field” via currency devaluation and an increasing emphasis on trade barriers and immigration, as opposed to constructive policies to make this country more competitive in the global marketplace.”


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Here is an interesting argument from Jeremy Grantham (and my response):

“Let’s start with the Investment Industry component. It is so obvious in this business that it’s a zero sum game. We collectively add nothing but costs. We produce no widgets; we merely shuffle the existing value of all stocks and all bonds in a cosmic poker game. At the end of each year, the investment community is behind the markets in total by about 1% costs and individuals by 2%.

And the costs have steadily grown. As our industry’s assets grew tenfold from 1989 to 2007, despite huge economics of scale, the fees per dollar also grew. There was no fee competition, contrary to theory. Why?

a. Agency problems – we manage the other guy’s money,


b. Asymmetric information – the agent has much more

information than the client.

Clients can’t easily distinguish talent from luck or risk taking. It’s an unfair contest, nothing like the fair fight assumed by standard Economics. As we add new products, options, futures, CDOs, hedge funds, and private equity, aggregate fees per dollar rise. As the layers of fees and layers of agents increase, so too products become more complicated and opaque, causing clients to need us more.

As total fees in the past grew by 0.5%, we agents basically reached into the clients’ balance sheets, snatched the 0.5%, and turned it into income and GDP. Magic! But in doing so, we lowered the savings and investment rate by 0.5%.  So, we got a short-term GDP kick at the expense of lower long-term growth. This is true with the whole financial system. Let us say that by 1965 – the middle of one of the best decades in U.S. history – we had perfectly adequate financial services. Of course, adequate tools are vital. That is not the issue here. We’re debating the razzmatazz of the last 10 to 15 years. Finance was 3% of GDP in 1965; now it is 7.5%. This is an extra 4.5% load that the real economy carries. The financial system is overfeeding on and slowing down the real economy. It is like running with a large, heavy, and growing bloodsucker on your back. It slows you down…”


Although, in principle, I accept that the financial sector creates nothing (tangible) but carries a significant cost to the “real” economy, I think this investment manager might be selling the industry short in several ways.  Here’s a slightly different telling of a similar tale:

It is widely accepted that governments do not allocate resources as efficiently as private actors.  The failure of the Soviet Union clearly demonstrated that the allocation of capital, in other words the quality of investment decisions, has an immense impact on the growth and health of the “real” economy.  Now consider how to best allocate resources within a capitalist economy: how should a private financial system connect savers with borrowers?  Simple commercial banks were an early step, offering low rates of return on deposits by extending credit to businesses and financing mortgages.  These banks were better positioned to vet their borrowers and allowed the pooling of risks, making the investments palatable for America’s everyman.

Now fast-forward quite a few decades.  Are these local banking outfits well equipped to choose between investing in a biotech startup or an infant electric car company?  Doubtful.  In contrast, venture capital companies, private equity firms and investment banks are better suited to making these complex choices.  These organizations cost more to sustain as their employees are, necessarily, highly intelligent, motivated and well-educated individuals.  Opportunity cost mandates a very high wage but it seems intuitive that these well compensated organizations add a great deal to our real economy by allocating resources more efficiently than would otherwise be the case.  Similarly, it could be argued, that hedge funds create value by helping to properly price assets and, thus, more efficiently allocate resources (ever heard the phrase “the smart money”?).  To me, this logic can most easily be understood by likening the financial system to the brain of the real economy.

Now here’s where I start to agree with Grantham:  As I describe above, it’s the job of these organizations to know more than we do.   Considering they are bright, well educated people who spend their lives thinking about these questions, I’m sure they’ve got an edge.  This immediately creates a gaping information asymmetry.  How do I compare 2 mutual funds?  Not like I compare 2 bags of frozen peas, that’s for sure.  A tech mutual fund looked great alongside a contrarian competitor from 1994-1999.  How should I have known the doom-sayer was the superior product all along?  And further, how should I know how much to pay either of these clowns??  This is just the beginning of the information problems that distort the markets for financial services and may, ultimately, lead to the leaching effect Grantham describes.

This diagnosis means that, in my mind, the solution is not to hold these new financial organizations in contempt but instead to implement strong and well thought out policies to increase transparency.

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The FT votes “Aye.”


The WSJ rides the middle line.


The Economist’s vote is still out…

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This is brilliant.  We really do need to differentiate between industry interests and free market interests.  I think many of Geldon’s points about the credit card and securitization industries also apply to the US cell phone industry.  Are they competing transparently on price and quality?  Absolutely not.  Contracts are intentionally indecipherable and exclusivity agreements between phone manufacturers and carriers divide the market.  Perhaps free markets aren’t created by the absence of government involvement but instead are a result or condition that exists when markets are properly fostering transparent competition.  In the past, governments may have been most responsible for preventing this outcome but perhaps now it is private entities who are to blame.  Might intelligent regulation be just the medicine these industries need to function properly?  An interesting thought.

For those that contend the recent crisis diminishes the case for free markets, I also would like to point out that the US housing market was about as far from being a purely private free market as any utility.   Fannie, Freddie, huge tax incentives, federal housing initiatives – who knows what the US residential real estate industry would be like without all this.

“Over the past year, there has been much discussion about how the financial crisis exposed weaknesses in free-market theory.  What has attracted less discussion is the extent to which the high priests of free-market theory themselves destroyed meaningful contracts and other bedrocks of functioning markets and, in the process, created the conditions for the theory’s weaknesses to emerge.

The story begins before Wall Street’s capture of Washington in the 1980s and 1990s and the deregulatory push that began around the same time.  In many ways, it started in 1944.

In that year, Frederich von Hayek published The Road to Serfdom, putting forward many of the ideas behind the pro-market, anti-regulatory economic view that swept through America and the rest of the world in the decades that followed.  Von Hayek’s basic argument was that freedom to contract and to conduct business without government meddling allowed for free choice, allocated resources efficiently, facilitated economic growth, and made us all a little richer.  Milton Friedman built on Hayek, creating an ideology that resonated with conservatives and ultimately became the prevailing economic view in Washington.

While many have noted how information asymmetry, moral hazard, and agency costs reveal glaring holes in free-market theory and contributed to the current crisis, few have focused on the extent to which the supposed heirs to von Hayek and Friedman directly and purposefully created market distortions and, in the process, destroyed the assumptions of free-market theory.

In other words, the same interests that claim the mantle of von Hayek and Friedman pulled the threads from the free-market system and exposed the theory’s greatest weaknesses.

In the years leading up to the crisis, the proliferation of fine print, complex products, and hidden costs and dangers – and the push against government regulations over them – exemplified the larger pattern.  While touting complexity as a form of innovation and railing against every attempt at government interference, supposedly pro-market forces used that complexity to clog the gears of free market machinery and to reduce competition and maximize profit.

The greatest lesson from the crisis that we haven’t yet learned is that “industry interests” and “free-market interests” are not the same.  In fact, they are more like oil and water, as the industry profits most in the absence of true market competition.  And so it should be no surprise that Wall Street has devoted itself to making contracts indecipherable, building boundless negotiating leverage and fighting for favorable breaks and regulation at every turn.  What should be a surprise is that the same scoundrels that killed our markets (and also, mind you, wrecked the global economy and demanded taxpayer bailouts) have so ably sold themselves as natural heirs to von Hayek and Friedman — and that so many of us have let them.”

-Dan Geldon


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I thought this Economist article contained an interesting combination of ideas.  First, it’s astonishing to note that although the level of our trade deficit with China has decreased, over the same period, our trade with China has grown to represent a greater portion of our total trade deficit.  The article presents several plausible explanations of why China’s share of global exports is rising but I am left wondering why the US/China trade relationship has changed so dramatically.

Even more interesting to me is Paul Krugman’s endorsement of currency-adjusting tarriffs as an appropriate response to Beijing’s stubbornly pegged Yuan.  Although I strongly believe China’s subsidized currency has created massive damaging distortions in world trade and capital flows, which are disturbingly ignored in Washington as senators seemingly prefer berating Wall Street “barons” to seeking actual cause,  it is ironic to me that Krugman, the borrow and stimulate Keynesian, doesn’t seem to realize that trade is a two way street.  America has completely lost touch with the reality that wealth is created through parsimony and hard work.  As much as I agree with Krugman’s diagnosis, Greenspan is also on board in spirit (see Greenspan’s March 2009 WSJ piece), I wish Krugman would recognize his part in the problem.

‘China takes an even bigger slice of America’s market. In the first ten months of 2009 America imported 15% less from China than in the same period of 2008, but its imports from the rest of the world fell by 33%, lifting China’s market share to a record 19%. So although America’s trade deficit with China narrowed, China now accounts for almost half of America’s total deficit, up from less than one-third in 2008.

Foreign hostility to China’s export dominance is growing. Paul Krugman, the winner of the 2008 Nobel economics prize, wrote recently in the New York Times that by holding down its currency to support exports, China “drains much-needed demand away from a depressed world economy”. He argued that countries that are victims of Chinese mercantilism may be right to take protectionist action.

Some forecasters, such as the IMF, expect China’s trade surplus to start widening again this year unless the government makes bold policy changes, such as revaluing the yuan. However, Chris Wood, an analyst at CLSA, a brokerage, argues that China is doing more for global rebalancing than America. Rebalancing requires that China spends more and America saves more. Mr Wood argues that China is doing more to boost domestic consumption (for example, through incentives to stimulate purchases of cars and consumer durables, and increased health-care spending) than America is doing to boost its saving. America’s total saving rate fell in the third quarter of last year to only 10% of GDP, barely half its level a decade ago. Households saved more, but this was more than offset by increased government “dissaving”.’


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I have read many articles recently focused on executive pay and our “bloated” financial sector with a tone similar to that taken by Stiglitz in the excerpt below.  While I agree that our economy hardly awards pay in line with productivity, this allocation of blame forgets that many many of this country’s citizens leveraged themselves to hilt with loans from credit cards and multiple mortgages.  The national savings rate was briefly negative.  I’ve heard the stories of deceptive subprime mortgage salesman with disgusting incentives, but it still takes two to tango.  I place at least as much responsibility on the “less informed” for their poor choices as I do the misinformation of snake oil salesmen.  That said, our banks need to take a long pause to consider their longterm role in society and act appropriately.  Goldman would be very foolish to declare even near record bonuses this year.

Without any other compass, the incentive structures they adopted did motivate them – not to introduce new products to improve ordinary people’ lives or to help them manage the risks they faced, but to put the global economy at risk by engaging in short-sighted and greedy behavior. Their innovations focused on circumventing accounting and financial regulations designed to ensure transparency, efficiency, and stability, and to prevent the exploitation of the less informed.

There is also a deeper point in this contrast: our societies tolerate inequalities because they are viewed to be socially useful; it is the price we pay for having incentives that motivate people to act in ways that promote societal well-being. Neoclassical economic theory, which has dominated in the West for a century, holds that each individual’s compensation reflects his marginal social contribution – what he adds to society. By doing well, it is argued, people do good.

But Borlaug and our bankers refute that theory. If neoclassical theory were correct, Borlaug would have been among the wealthiest men in the world, while our bankers would have been lining up at soup kitchens.

Of course, there is a grain of truth in neoclassical theory; if there weren’t, it probably wouldn’t have survived as long as it has (though bad ideas often survive in economics remarkably well). Nevertheless, the simplistic economics of the eighteenth and nineteenth centuries, when neoclassical theories arose, are wholly unsuited to twenty-first-century economies. In large corporations, it is often difficult to ascertain the contribution of any individual. Such corporations are rife with “agency” problems: while decision-makers (CEO’s) are supposed to act on behalf of their shareholders, they have enormous discretion to advance their own interests – and they often do.

Bank officers may have walked away with hundreds of millions of dollars, but everyone else in our society – shareholders, bondholders, taxpayers, homeowners, workers – suffered. Their investors are too often pension funds, which also face an agency problem, because their executives make decisions on behalf of others. In such a world, private and social interests often diverge, as we have seen so dramatically in this crisis.

Does anyone really believe that America’s bank officers suddenly became so much more productive, relative to everyone else in society, that they deserve the huge compensation increases they have received in recent years? Does anyone really believe that America’s CEO’s are that much more productive than those in other countries, where compensation is more modest?

Worse, in America stock options became a preferred form of compensation – often worth more than an executive’s base pay. Stock options reward executives generously even when shares rise because of a price bubble – and even when comparable firms’ shares are performing better. Not surprisingly, stock options create strong incentives for short-sighted and excessively risky behavior, as well as for “creative accounting,” which executives throughout the economy perfected with off-balance-sheet shenanigans.”

On the other hand, I am very happy to see that political powers have begun  to acknowledge the continuing threat of global trade imbalances to the economy and, to a lesser extent, their role in the crisis we are exiting.

“U.S. Federal Reserve Chairman Ben Bernanke warned on Monday that Asian export-promotion policies and large U.S. budget deficits could refuel global economic imbalances and put efforts to achieve more durable growth at risk if not curbed.” http://www.nytimes.com/reuters/2009/10/19/business/business-us-usa-fed-bernanke.html

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