Wednesday, April 24
Money, Wealth and You, Part 1: "We're drowning in a sea of complexity"
MICHAEL WRIGHT: What happened in the gold market last week? Every gold expert has a different opinion about what caused the price crash.
PUNDITA: When you mix millions of unsophisticated investors with sophisticated ones, toss in high-speed computerized trading mechanisms, and shake this together with the monetary policy of major central banks and the bottom lines of mega-hedge funds and exchange-traded funds, then add the Twitter Knee-jerk method of news dissemination, anything can happen. And it can happen with blinding speed. If you pile on top of this sophisticated investors chewing their nails to the quick about the present state of the global economy and the Federal Reserve's dollar-creation spree, you're looking at chaos. That's what happened in the gold market last week.
MICHAEL: You're saying you know what happened to gold but because you know you're not going to say.
PUNDITA: The crystal ball is out for repairs again. I have a guess as to what toppled the first domino but my guess is as good as anyone's. The point is that this is the Age of the Masses, so whether it's war or money or gold, there's an awful lot people in the mix; they're generating an awful lot of factors that combine in an awful lot of ways. This situation is the real 'Black Swan' in this era. It's not any single catastrophic event; it's the Age of the Masses interwoven through all the large events that impact societies.
Recently a former FDIC official said it best: "We're drowning in a sea of complexity." She was referring to the huge number of hideously complex regulations strangling the U.S. banking industry, but the observation applies across the board.
What she didn't say is that it was the attempt by American banks to escape from drowning in the sea of complexity that fueled the expansion of the shadow banking system, which at that time was almost completely unregulated. At first the expansion was a good idea; it allowed money to flow to freely, which kept business expansion --
MICHAEL: Hold on; this isn't a criticism but you analyze so many factors that often when you talk I can't keep up.
PUNDITA: Okay; here's a way to understand fast. A portion of the illegal traffic from Mexico to the U.S. for decades wasn't really immigration; it was Mexicans fleeing their banking system. This was because it could take them years and huge bribes just to attempt to get a loan from their bank -- any kind of loan, small or large. This was killing legitimate business in Mexico. Business loans are the lifeblood of an economy and the blood couldn't flow freely through the arteries of Mexico's economy. So borrowers applied to American banks for loans. They had to do this in person, which meant crossing the border illegally in a lot cases. And they couldn't walk into an American bank and say, "Hi, I've just popped in from Mexico. Can you lend me a half million dollars?" It was a process that could involve staying in the USA until the loan came through.
However, something like that situation was also happening to American borrowers. This is the hidden part of the boom in offshoring U.S. manufacturing to China and other low-wage countries. Governments in those countries, through their banking system, were making instant, no questions asked loans to Americans who wanted to set up a manufacturing plant in the country. There was no way American banks could match that deal because they had to operate within the U.S. business-banking model, which includes a huge number of regulations.
Add to this, the banks in offshore tax havens were doing the same thing that banks in offshore manufacturing hubs were doing. If an American company had money in a small offshore tax haven, that was the company's ticket to getting fast loans from the banks in the country, and often bigger loans than an American bank might be able to provide given the regulations in the U.S.
MICHAEL: So the big flight of money from the USA wasn't all about getting tax breaks.
PUNDITA: Right. The upshot was massive capital outflows from the United States -- and from the U.S. banking system. The big U.S. banks took one look at all this and instead of doing a John Galt -- folding their arms and saying, 'We'll just wait for the house of cards to collapse,' they came up with an ingenious way to beat the dealer. The dealer being a combination of U.S. banking and business regulations and China's lack thereof.
Beating the dealer involved a lot of complicated paperwork, but the basic idea is simple: If a bank can't write the kind of loans a business asks for, it can do this in a roundabout way. How? Set up investment divisions and financial investment vehicles for corporate customers that allow them to quickly raise capital from financial markets. And because technically these money transfers aren't legally defined as loans but as investments, banks and their borrowers could circumvent masses of red tape.
That's how the shadow banking system, which had always existed in a small way for the banks' biggest customers, took off.
Expanding the shadow system was a great patch to the creaky machinery of the U.S. banking system. But it didn't factor in the Age of the Masses. When millions of individual and corporate investors and thousands of non-bank institutions from around the globe piled into the shadow system, this created huge markets in derivative paper -- basically, investment vehicles derived from nothing more than betting on the direction of various financial markets. These markets are now so various I wouldn't be surprised to learn there's one that trades on price moves in loans made to tea shop owners in Tahiti. So even if the bottom hadn't fallen out of the mortgage derivatives market, it would have eventually fallen out of another kind of market.
MICHAEL: By trying to get away from one house of cards American banks helped create another.
PUNDITA: That's one way to put it. If you drill down to bedrock that's what happened to gold. To really understand the gold story you need to see the gold market as getting tangled up with the shadow banking system. This led straight to the proliferation of what's called the paper gold market -- investment instruments based on the action of the gold market.
MICHAEL: Chasing its own tail.
PUNDITA: Pretty much. Now, in February, if I recall, there was an unsettling news story related to gold. The reaction to the news might have toppled the first domino, but this is getting into the weeds. The important concept is that trading in paper gold is just one part of the complexities of shadow banking.
The shadow system got so complex that only two people in the entire world were able to correctly estimate its size in the United States. These were two guys at the International Monetary Fund. They pointed out that no one -- no one, to include central bankers and government economists and the IMF -- had thought to figure rehypothecation into their calculations. Don't ask me what rehypothecation is because clearly only two people actually understand it -- those guys at the IMF.
Once they corrected everyone's math, this showed that the size of the shadow banking system, just in the USA, had been underestimated by roughly half. So instead of $5 trillion, it was about $10 trillion. When this corrected figure got into the London Financial Times, the ground shook. It wasn't an earthquake. It was American economists and bankers fainting in unison from shock.
That was in 2010. What the size of the American shadow banking system is today -- maybe only those two guys at the IMF have a good guess. But just to give you an idea, BlackRock currently manages $4 trillion. That's more money than the Federal Reserve manages. Think of it: a single Wall Street investment firm manages more money than the central bank of the United States of America.
MICHAEL: Then American monetary policy is a joke.
PUNDITA: Well the Fed policy of keeping the rate of borrowing money very low since the 2008 crash is a big factor in both the current size of the shadow banking system and BlackRock's portfolio. So while the Fed's current policy of easy money is questionable, it's not a joking matter. However, given the scope of the shadow system, it is a joke for anyone to claim that nationalizing the Federal Reserve, or abolishing it, would fix what's wrong with the U.S. economy and the banking system.
MICHAEL: From what you're telling me, fiscal policy is the caboose on a runaway train.
PUNDITA: Age of the Masses. Combine penicillin with democracy and this is what you get. Unimaginable amounts of money chasing any scheme that might return a profit. You just try putting fiscal or even monetary policy up against that tsunami.
Now just see, this is one benefit of tyrannies; people living under them are so scared they keep what money they can scrape together sewn into their clothing. Once government lightens up, they have money burning a hole in their pockets. There are uncounted millions of people who are very happy to help them invest it, and save it.
MICHAEL: And spend it.
PUNDITA: Oh they never say spend. They always say save. "Look! Save 60 percent if you act now!"
So there is a correlation between the rise of democracies and the rising waters in the sea of complexity.
MICHAEL: Nobody but the strongest can swim in that kind of sea. How are people supposed to live, to raise a family and build a career, when they're up against so much complexity just trying to manage their personal finances? There's a lot of fear right now; people are afraid they're going to be wiped out again when the next market bubble bursts. It's a vicious cycle and it keeps getting more violent.
PUNDITA: It's not called a vicious cycle for nothing. However, there might be a way to short out the cycle without crashing civilization as we know it. Doing this would allow American individuals to build and preserve wealth and without trying to navigate the sea of complexity.
MICHAEL: I'm all ears.
PUNDITA: Okay, we can talk about it the next time.
MICHAEL: Thank you. This conversation has been illuminating for me. I'm still chewing over the idea of using tax havens to scare up loans.
PUNDITA: Yup, that's the deal for many American businesspeople. Park your money in our bank in our glorious downtown banana republic, and we won't put you through a ringer to get a loan.
MICHAEL: People talk about drug lords doing money laundering by setting up businesses. Could the laundering also include writing a lot of loans? At least since the 2008 meltdown. American banks got stingy with loans after that.
PUNDITA: [laughing] Michael, anybody can be a shadow banker -- you, me, drug lords, anybody. That's what peer-to-peer lending is about, although technically it's too informal to be considered part of the shadow system, and such arrangements are confined to outright lending. But the rise of P2P, which can be done by anyone with money to loan, illustrates why attempts to regulate the shadow system are just piling more complexity on top of chaos.
MICHAEL: After tying up the banking system, the regulators want to bring on the same conditions that led to the huge shadow system?
PUNDITA: Not only that, they plan to actually enforce regulations on the shadow system. That will only create a bigger and more complex and diffuse shadow banking system than exists now -- a shadow-shadow system.
Try to imagine the enforcement mechanism at that point. Millions of employees from a global version of the Federal Deposit Insurance Corporation fanning out to interview the owner of every pizzeria, fast food stand, halal butcher shop and kosher bakery on the planet. "Hi, I'm from the Global Deposit Insurance Corporation. I need you to fill out these forms so we can see if your capitalization rate is sufficient to write loans."
[laughing] Welcome to the Three Stooges era of banking.
MICHAEL: You're having fun. After almost 12 years of being immersed in war maybe you needed a break.
PUNDITA: Heck, all I've done is switch from watching the Ghost of 1939 chase defense policymakers in circles to watching the Ghost of 1929 chase economists in circles.
Ben Bernanke won't stay in the Federal Reserve building in Washington after midnight because of the Ghost of 1929, which considers the Fed its personal domain. The ghost entertains itself in the wee hours by making a racket that sounds like 40,000 1930's-era bank teller windows slamming shut at the same time.
The Ghost of 1929 even put in appearance at Davos this year. A brainstorming session on how Big People can restore Little People's trust in the financial system was interrupted by mysterious squeaking noises. These were finally identified by a student of the French Revolution as the sound of a portable guillotine being wheeled into place. So much for the lore that the ghost won't hang out in Switzerland because it's scared of Swiss bankers.
MICHAEL: [laughing] You really are having fun.
PUNDITA: Jump in, the water here in the sea of simplification is nice and calm.
MICHAEL: Societies live with their ghosts.
PUNDITA: Yes they do. In the USA we live with the Ghost of 1939 and the Ghost of 1929. That's understandable when you consider the trauma that World War Two and the Great Depression visited on Americans. So it's only natural that policies were created in the attempt to insure that such horrific events never again happened to Americans. Yet when it gets to the point where policymakers are chased into vicious cycles by reactions to trauma, it's time to realize we don't need more policies. We need ghostbusters.