Part 2 - Causes of the Global Financial Crisis - Flaws in the mathematics of Risk Analysis

In part 2, I try without using mathematics to explain some of the fundamental problems with how the very financial tools used by financial markets underestimate risk.  I also ask the question do we live in a free market economy?

Economics as a discipline was very diverse in the 1920 and 1930’s with many schools of thought and various frameworks for looking at how the economy worked. The field was also grounded in the notion that it was in-exact and was dealing with the vagaries of human herding instincts.

Economics after WWII underwent a focus on mathematical modeling.  Effectively trying to use Physics as its founding paradigm the core assumptions became that the economy could be precisely studied as if it were a machine. To make the math more consistent the assumption of stability is central to all mathematical modeling in economics and finance.  The primary models focused on “equilibrium states” so the profession assumes that entire economies and their components tend to be stable, or are systems that tend towards a stable state (ie: equilibrium).

Ideologically this results in the notion that government intervention is not needed as markets and economies tend to stability. Given the scope and pervasiveness of the use of government subsidies by business, the historic distinction between private companies and the state has broken down.  The very definitions of free markets become ambiguous, as the Economics profession has not evolved a terminology to accurately describe the way the US and other developed economies are structured. This becomes very obvious when one looks at the financial bail-outs in the US.   

The tendency towards Equilibrium really breaks down in financial markets – especially credit markets. These markets tend to boom and bust cycles- so they don’t operate in ways that can be defined in terms of equilibrium conditions.  In strict mathematical terms Financial markets do not tend to equilibrium, and this is one of the key causes of the current financial crisis.

All mainstream financial models have assumptions in them that understate risk (this makes the math easy).  So if you use the well-established models in managing financial risk you end up taking more risk than what the models specify.  If you also assume a tendency towards equilibrium, then this further aggravates the problem.

In the last 20 years, technological advances have enabled the development of complex trading systems that effectively operationalize financial models and make decisions based on them. The development of high frequency trading has also fundamentally changed the nature of financial markets. Coupled to this is the massive derivatives overhang and it becomes difficult to call financial markets anything but casino’s as they do not perform any of the functions of financial markets other than speculation. So at many levels the profession of Economics and Finance has not really dealt with the reality of how Financial markets work, it has simply imposed an idealized set of mathematical simplification, which operates on assumptions that are clearly inaccurate.

This fact makes the debate on what to do about the current crises mired in obsolete ideology.  The large wall street banks do not operate in a free market, due to the high barriers to entry required of any firm wanting to compete with them.  They also effectively enjoy privileged access to capital (Again contravening free market principles). Although all financial institutions operate in a regulatory framework, the large US banks are clearly no longer constrained by market consequences.

In the overall economy through the developed world we find very few sectors in true free market competition. Yes there are portions of the economy that operate in market based competition, yet these are few and far between.  Organizations that look and operate with all the trappings of Corporations exist, but just because they have boards and shareholders does not mean that they are market based institutions. The economies of the developed world are dominated by large corporations, who increasingly derive competitive advantage from government support in some way (either in research and development credits, subsidies or in tax incentives).

In 2007  $750 Trillion in derivatives were overhanging a global GDP of $50 Trillion.

What this means is that the risks created by the financial overhang of derivatives can overwhelm the real economy it is supposed to support!

Mathematically when capital markets become more like casino’s they become in-efficient at their primary function which is to allocate capital and distribute risk.  At some point the question will have to be posed, do these markets merely serve the purpose of wealth extraction from the real economy?

Let us look closely at the bailouts involving sub-prime loans: 

For every Triple B sub-prime bond you had 10 times the value in derivatives overhanging them (either hedging or involved in some form of side bet). That is what caused the crisis--the leverage of all of the instruments on top of the Sub prime bonds.

Their were two $750 Billion bailouts, one by Hank Paulson in 2007 and one by President Obama.   This should have been enough, had the sub-prime bonds been the only problem.  But what the media did not discuss, was that surrounding these sub-prime bonds were significant derivative hedges whose value was difficult to estimate.

At least another 5 to 15 Trillion in derivatives that still has to be worked through. 

To be fair to the financial institutions involved:

It is difficult for many of the institutions to put accurate values on their exposures.

There is a lot of double counting; exposures are often hedged multiple times. As these markets were not regulated there was no central reporting mechanism. So there is no methodology to determine the full extent of the risks.  This is why AIG and Bear Stearns were quickly bailed out as no-one new the full extent of the consequences of letting them fail.

Essentially if these companies were on one side of a hedge, and they failed then the aggregate exposure would have been considerable as there is no way for the counterparties to be hedged.

The banks are now so well entrenched in the regulatory process, that there is no way to make them accountable, and no way to recover the monies given to them.  So effectively the wall street banks are not really private sector companies, but rather highly subsidized corporations that should not have survived if they existed in a free market.  Ideologically this makes the whole debate rather difficult because Economics and Finance revolves around the core assumption that Free markets work.

Well free markets do work, but we do not live in a free market economy, because we have a central bank, and all of the distortions that this brings.

In part 3, I will look at Central Banks and the structure of the Global Banking system.

4 warnings of Hyperinflation from credible sources!

Ok, so you think we are in a deflation in the US, and Hyperinflation is a remote possibility.  Well things are not so simple.

Inflation and Hyperinflation are two very different things. Inflation relates to excessive economic growth, while Hyperinflation relates to a loss of faith in the currency.

At this time, the Federal Reserve is buying US Treasuries if there is no demand for them. All it will take is a run on treasuries, that will trigger the Federal Reserve to raise the rates offered on US Treasuries to stop a run. Unfortunately , any increase in interest rates will create a severe fiscal problem as the US Government will then see significant increases in their annual deficits.

This is the most basic scenario that could lead to a loss of confidence in the US dollar (aka-- hyperinflation).

Currently inflation in the US is running above 5% (that is the measured reality, unfortunately the official number is much lower).

Without getting into too much economic Jargon:

The US Monetary base (ie: notes in circulation, what is often called "base money") has been stable at around 1 Trillion for the past 10 years. Since 2008 it has more than doubled to 2 trillion.

The Monetary Base has doubled since 2008 (grey).

In our fractional reserve system, this money is then lent out to banks, and through repeated cycles of lending becomes the money supply whose measure is M3.

The Federal Reserve stopped publishing M3 the broad measure of money in circulation in 2006. It can be calculated indirectly and the above chart shows what is happening.  Since 2008 M3 has gone from from 15 Trillion to nearly 20 Trillion.

Not since the great depression, have we seen a contraction in M3 as it has since the middle of 2009 contracted back to 17 Trillion effectively indicating a decline in money stock, even though base money has been increased.

So right now the US is in a deflation, but with all of the increases in base money, inflation will pick up in the long run (ie: 3-5 years from now).

If there is a loss of faith in the US currency, then Hyperinflation will occur. That risk is increasing now as we enter the second leg of this crisis.



Over at Zero Hedge:

Zero Hedge Article on Hyper-inflation


Over at Market Watch:

Market Watch commentary on warning by Schulz

and Shadow Government Statistics has issued a full warning:

SGS Special Report on Hyper-inflation

Alan Sinai

Bloomber Interview with Alan Sinai



I am currently researching the US Budget , and will be posting Part 2 of what caused this crisis, in a few days.

Part 1 : The root causes of the current economic crisis ( first in a 4 part series)

I have been asked several times: "what is causing this crises".  The answer is simple--it is the debt based money system where 95% of the money in the system is debt.  


When you study economics they first thing they teach you is that Economics is a “positive” science and not a "normative" science.  This makes economics unique, in that they tell you up-front that they are essentially hiding something (Since no other science holds to seeing a conflict between the positive and the normative).

An education in Economics also suppresses the American system of Political economy that was established in the US, by Franklin and Carey.  This system of sovereign credit creation, support for local enterprise, negotiated fair trade policies and controls on government resulted in America becoming a prosperous nation.  Friedrich List in Germany (1841) studied it and influenced the Germans to establish the core ideas of the American system resulting in Germany’s rise as an economic power. List argued that it was the government's responsibility to foster the "productive powers" of a nation and, once these were in place, then free trade could ensue, but not before.

The other critical factor that is purposely ignored in Economics is the money system's role in how a market functions and in the political economy. I am not aware of any Economics curriculum in a North America university that teaches alternate monetary systems (especially that of Pennsylvania under Benjamin Franklin) .  My own experience involved going to the library and reading up on American History and then having to seek out the writing of the founding fathers, and Abraham Lincoln.  The other source of key information was surprising, it was the writings of a Nobel prize winning chemist Dr. Frederick Soddy (Nobel in 1921)

"There is nothing left now for us but to get ever deeper and deeper into debt to the banking system in order to provide the increasing amounts of money the nation requires for its expansion and growth.  Our money system is nothing better than a confidence trick....

"The "money power" which has been able to overshadow ostensibly responsible government is not the power of the merely ultra-rich but is nothing more or less than a new technique to destroy money by adding and withdrawing figures in bank ledgers, without the slightest concern for the interests of the community or the real role money ought to perform therein...

"to allow it to become a source of revenue to private issuers is to create, first, a secret and illicit arm of government and, last, a rival power strong enough to ultimately overthrow all forms of government.

...An honest money system is the only alternative."

From his book : Wealth , Virtual Wealth and Debt (1926) ( a link is placed at the end of this article)

What is interesting about Soddy is that he made 5 policy recommendations which were taken at the time as evidence that his ideas were unworkable.

These recommendations were:

1) Abandon the gold standard

2) Allow international exchange rates to float

3) Use federal surpluses and deficits as macroeconomic policy tools that could counter cyclical trends

4) Establish a Bureaus of Economic Statistics (including a consumer price index) in order to enable counter cyclical intervention


Interestingly all of these recommendations are now practiced. 


His fifth recommendation, which remains outside the bounds of conventional wisdom was to stop banks from creating money and debt out of nothing. 


Effectively what Soddy was proposing, was a 100% reserve requirements on demand deposits. This would begin to shrink what is "the enormous pyramid of debt that is precariously balanced atop the real economy, threatening to crash."


Banks would still exist, and would support themselves by charging fees for safekeeping, check clearing and all the other legitimate financial services they provide. They would still make loans and still be able to lend at interest "the real money of real depositors,".  In effect people who forego consumption today by taking money out of their checking accounts and putting it in time deposits - CDs, passbook savings, RRSP's, 401 K's etc. In return, these savers receive a slightly larger claim on the real wealth of the community in the future. 


In such a system, every increase in spending by borrowers would have to be matched by an act of saving or abstinence on the part of a depositor. This would re-establish a one-to-one correspondence between the real wealth of the community and the claims on that real wealth. (One would have to completely remove money creation power from financial institutions in that they would not be allowed to create subprime mortgage derivatives and other instruments of leveraged debt.) This effectively amounts to ending central banking, and returning money creation power back to governments.  At this time only the state bank of Montana, engages in money creation. Minnesota is about to pass legislation enabling the state to fund a transit system directly rather than though Wall Street. The legislation is being sponsored by bankers. 


If at this point such a major structural overhaul of the economy sounds hopelessly unrealistic, it is prudent to consider that in 1926 so did the abolition of the gold standard and the introduction of floating exchange rates. All of Soddy's work was built on the laws of Thermodynamics. If his analysis of their relevance to economic life is correct, we have to seriously look at re-thinking what is realistic. 

This post outlines the root cause of the problem and what I believe is the only viable long term solution. 

The next few articles will provide the background as to how I have reached this conclusion.

I would highly recommend the following web-page :


The Money Masters



Their video series has been posted on Youtube, and their new "Money as Debt II - Promises unleashed"  is an excellent backgrounder on how the current system works.  

Below are some links to books and DVD's that provide a very good picture of the real global power structure.

 

Comparing the current US Deflation with Japan's lost Decade (Things are not similar)

To start off, I would like to point out that 70% of the US economy is based on consumer spending.  What this means in life-cycle terms is that as the baby boomers pass the age of 46 they leave the highest period of discretionary spending and enter a period of relatively low spending.

This transition occurred in Japan in 1990, it is occurring now in the USA.  This effectively becomes a baseline for comparison as it ties the two country's consumption patterns together across time.

In Japan the period from 1986-1990 was the period of the real-estate bubble, which was effectively fueled by bank lending being based on real-estate values. This lead to excessive liquidity entering real-estate markets and a booming Nikkei index, which effectively peaked in 1989. The bubble burst in 1990 and Japan entered a recession.

At this point in Japan's economic history, the country had:

• A high savings rate- averaging over 8% during the 1980's
• Relatively low unemployment in 1989 of 2% rising to 4% as the recession got underway
• Debt to GDP of 20%
• No foreign debt (Most Japanese Treasuries were held within Japan)

Data from BOJ, graphed by me

In 1992 the Bank of Japan in conjunction with the LDP party executed the first known combined fiscal and monetary stimulus, by bringing the prime rate down to 1% and then eventually to 0.00% in the middle of 1993.  The Governing LDP party lost its majority in 1993 and a coalition of parties approved aggressive Fiscal stimulation from 1993 onwards.

As the Graph on the right shows Japan's Consumer Price Index remained deflationary till 1994, and only after the zero rate policy went into effect did the CPI return to the 100 level, rising to 102.62 in 1996.

What happened to Japan's Debt to GDP? It went from a healthy 20% in 1990 to the current level of 235%, which effectively amounts to the complete destruction of Japan's savings. So in Summary, Japan begins the "lost decade" in a relatively strong position.

For the US the situation is completely the opposite!  Lets start with the Unemployment rate which is currently running at 9.7% this is known as the U-3 measure. The broader U-6 measure is 16.8%, and if one adjusts for the Clinton era changes in measuring unemployment the U-6 rate would be 22% (the discouraged workers were banished from the measure during the Clinton era in order to make the numbers more palatable).

Source Bureau of Labor Statistics

Inflation measurement in the US has also seen significant politically introduced changes.  So a comparable chart to Japan's inflation chart would involve making adjustments to the series from 1990 onwards.  The Bureau of Labour Statistics does publish the Historic CPI-U series that uses 1982 as the index point of 100, from this series in 2007 CPI was 4.7%, and is 1.2% today in 2010. This measure of inflation is very problematic and I will delve into this later.

In 2010 the US Debt to GDP is 94.6% , not counting unfunded liabilities, if these are added the debt obligation becomes approximately 80 Trillion and that gives us a true Debt to GDP of 540%, so this is one of the key differences between US and Japan. The other difference is that the US holds the world's reserve currency and can borrow from the world to finance its deficits. The holders of US treasuries are largely foreign while the holders of Japanese Treasuries are entirely domestic!

In effect Japan can continue on its high debt path, since it is borrowing largely from its own people, clearly the US cannot. This is the key fact that points to problems ahead for the US, since Japan holds 1 Trillion of US Treasuries and will eventually stop rolling these over (as they have to meet their own internal debt obligations).

There are two core arguments moving forward: a) The US like Japan will experience a prolonged deflation or b) The US is unlike Japan in the structure and size of its debt and will over time face Hyper-inflation.

So which argument is the correct one? Are their factual evidence based approaches to determine the long term inflationary trends for the US?

The answer to this question is quite simple.  Essentially we are in a period of deflation due to the massive increase in the size of the Federal Reserves Balance sheets. Since the Federal Reserve has never been audited we do not know the extent of bad debts on its books. An expansionary monetary policy will not have much effect in the face of large and hidden bad debts, since the banks will simply absorb the stimulus. Moving forward one should start to see inflationary signs in commodities as money leaves the equity markets and flows to commodities, especially gold.

Is their a way to adjust inflation measures to reflect a truer value? John Williams of Shadow Government Statistics has done just this. As shown on the chart there is a significant difference between CPI-U and John's SGS Alternate CPI, current rates of inflation are running at 7%+.

Source: Shadowstats.com click on image to visit shadowstats

This clearly validates the later argument that the US will be seeing higher levels of inflation in the future.

Is Hyperinflation a possibility? I think looking forward, 2013 and beyond it is a clear possibility.
Certainly we are not in a double-dip recession, what we are in is a stagflationary recession, with real inflation having reached 12% in 2008, and then declining only to 5% in 2009, in stark contrast to the official below zero levels we often see reported in the media.  The current fiscal budgetary framework of the US government assumes no major increases in interest rates for the next 4-5 years, hence the published National Accounts do not reflect this clear risk.

Simply put the US governement assumes that the interest it pays on its debt (Treasuries) will not change significantly moving forward. The problem of course is that the appetite for purchasing more US debt is now waning globally as the major holders of US Treasuries have begun openly signaling that they wish to diversify into precious metals (The Saudi's and Chinese have made open statements to this effect). The Japanese will not be able to keep purchasing more Treasuries as they have to service their own burgeoning deficits. So it is highly unlikely that the US government will be able to attract buyers of treasuries without offering higher interest rates.

Since none of the countries want to see a run on the dollar, induced by large sales of US Treasuries, they have simply reduced further purchases effectively forcing the US government to find other ways to pay for its debt.

To get around this problem the most recent meeting of the Federal Reserve announced plans to monetize the sale of Treasuries. Essentially the Federal Reserve will create money (out of thin air) and use this to buy up Treasuries. This avoids the need to offer Treasuries to foreign buyers at higher interest rates.  Unfortunately this means more inflation in the US, as this effectively injects more money into the economy. Hence the term monetizing debt--effectively you try to get rid of your debt by creating inflation and paying back the amount owed with devalued dollars. 

According to the minutes of the Federal Reserve meetings, they are fully aware that monetizing debt will be inflationary, but they feel that "monetary easing" will be a good thing to address a slowing economy.  Clearly we have an interesting play on semantics, in that a misleading measure of inflation is being used to justify a policy of inflation. 

The data I have present clearly show that we are not in a deflation, but rather in a stagflation, and so massive fiscal stimulus will eventually lead to hyper-inflation. 

According to GATA - the Gold Anti- Trust Action committee, the only way to hide the reality of inflation is to naked short gold. They claim (with considerable evidence) that their has been price manipulation of gold markets, and that use of derivatives without any physical backing has enabled this manipulation.

Controversial as GATA's hypothesis is, the price of Gold has been increasing steadily since 2001.  So regardless of the veracity of GATA's hypothesis , the price of Gold is showing the reality of inflation (and the general flight to safety that Gold has always represented).

As there are many commentators on the web who talk about gold and silver, I will not delve into these markets, only observing that at the present time silver is clearly undervalued with respect to gold and will likely see significant price appreciation.

Another strategy not explored in such times is FOREX, and for many who are inexperienced in these markets I would recommend that you look at automated trading advisory systems such as OmniForex, or Bulletproof Forex. The recent declines in the Euro, also point to the need to hedge currency positions especially those exposed to the US dollar on a long term basis.

Finishing up Research on the Parallels between the US and Japanese Deflation

This Blog will focus on Fundamental Economic Analysis and look at the experiences of various countries in dealing with Economic Crisis. I hope to tie this into the current situation in the US.

I also plan to look at practical ways people can solve their financial problems and provide useful information along these lines.

I spent a great deal of time in Japan during the late 1990's and while working there, I studied their economy closely. The Japanese began their deflation in 1990 from a position of strength.  Despite significant fiscal stimulus , 20 years later Japan still has not fully recovered.

In contrast to this the US is in a deflation but has entered it from a position of significant weakness, very high deficits, the current U6 unemployment rate is 16.5%, and a debt to GDP ratio that is actually much higher than officially stated.

I hope to have the report completed this weekend and will be posting it then.