----- Original Message -----
From: "Brian davey" <[log in to unmask]>
To: <Undisclosed.Recipients:>
Sent: Tuesday, January 22, 2008 11:49 PM
Subject: Understanding the fundamental principles behind the banking crisis
This is an article by Martin Wolf of the Financial Times on the banking
crisis
and my comment on the article that the FT plus some further comments on how
communities may need to find grass roots responses to the developing
monetary
and financial crisis. In effect it is Professor Wolf who decides what is
published and he decided against it appearing - which I suppose should not
surprise. Brian
The original article
Regulators should intervene in bankers’ pay
http://www.ft.com/cms/s/0/73a891b4-c38d-11dc-b083-0000779fd2ac.html
By Martin Wolf
Published: January 15 2008 17:35 | Last updated: January 16 2008 05:16
You really don’t like bankers, do you?” The question, asked by a former
banker
I met last week, set me back. “Not at all,” I replied. “Some of my best
friends are bankers.” While true, it was not the whole truth. I may like
many
bankers, but I rather dislike banks. I recognise their necessity, but fear
their irresponsibility. Worse, they are irresponsible partly because they
know they are necessary.
My attitude to the banking industry is not a prejudice. It is a “postjudice”.
My first experience with out-of-control banking was when I watched the
irresponsible lending that led to the devastating developing-country debt
crises of the 1980s.
The world has witnessed well over 100 significant banking crises over the
past
three decades. The authorities have even had to rescue important parts of
the
US financial system – on most counts, the world’s most sophisticated – four
times during the same period: from the developing country debt and “savings
and loan” crises of the 1980s to the commercial property crisis of the early
1990s and now the subprime and securitised-credit crisis of 2007-08.
No industry has a comparable talent for privatising gains and socialising
losses. Participants in no other industry get as self-righteously angry when
public officials – particularly, central bankers – fail to come at once to
their rescue when they get into (well-deserved) trouble.
Yet they are right to expect rescue. They know that as long as they make the
same mistakes together – as “sound bankers” do – the official sector must
ride to the rescue. Bankers are able to take the economy and so the voting
public hostage. Governments have no choice but to respond.
Nor is it all that difficult to understand the incentives at work. I gave
the
broad answer in my column, “Why banking is an accident waiting to
happen” (FT, November 27 2007).
It is the nature of limited liability businesses to create conflicts of
interest – between management and shareholders, between management and other
employees, between the business and customers and between the business and
regulators. Yet the conflicts of interest created by large financial
institutions are far harder to manage than in any other industry.
That is so for three fundamental reasons: first, these are virtually the
only
businesses able to devastate entire economies; second, in no other industry
is uncertainty so pervasive; and, finally, in no other industry is it as
hard
for outsiders to judge the quality of decision-making, at least in the short
run. This industry is, in consequence, exceptional in the extent of both
regulation and subsidisation. Yet this combination can hardly be deemed a
success. The present crisis in the world’s most sophisticated financial
system demonstrates that.
I now fear that the combination of the fragility of the financial system
with
the huge rewards it generates for insiders will destroy something even more
important – the political legitimacy of the market economy itself – across
the globe. So it is time to start thinking radical thoughts about how to fix
the problems.
Up to now the main official effort has been to combine support with
regulation: capital ratios, risk-management systems and so forth. I myself
argued for higher capital requirements. Yet there are obvious difficulties
with all these efforts: it is child’s play for brilliant and motivated
insiders to game such regulation for their benefit.
So what are the alternatives? Many market liberals would prefer to leave the
financial sector to the rigours of the free market. Alas, the evidence of
history is clear: we, the public, are unable to live with the consequences.
An alternative suggestion is “narrow banking” combined with an unregulated
(and unprotected) financial system. Narrow banks would invest in government
securities, run the payment system and offer safe deposits to the public.
The
drawback of this ostensibly attractive idea is obvious: what is unregulated
is likely to turn out to be dangerous, whereupon governments would be
dragged
back into the mess.
No, the only way to deal with this challenge is to address the incentives
head
on and, as Raghuram Rajan, former chief economist of the International
Monetary Fund, argued in a brilliant article last week (“Bankers’ pay is
deeply flawed”, FT, January 9 2008), the central conflict is between the
employees (above all, management) and everybody else. By paying huge bonuses
on the basis of short-term performance in a system in which negative bonuses
are impossible, banks create gigantic incentives to disguise risk-taking as
value-creation.
We would be better off with Jupiter’s 12-year “year”, since it takes about
that long to know how profitable strategies have been. The point is that a
year is an astronomical, not an economic, phenomenon (as it once was, when
harvests were decisive). So we must ensure that a substantial part of pay is
better aligned to the realities of the business: that is, is made in
restricted stock redeemable over a run of years (ideally, as many as 10).
Yet individual institutions cannot change their systems of remuneration on
their own, without losing talented staff to the competition. So regulators
may have to step in. The idea of such official intervention is horrible, but
the alternative of endlessly repeated crises is even worse.
The big points here are, first, we cannot pretend that the way the financial
system behaves is not a matter of public interest – just look at what is
happening in the US and UK today; and, second, if the problem is to be
fixed,
incentives for decision-makers have to be better aligned with the outcomes.
The further question is how far that regulatory net should stretch. I
believe
it should cover all systemically important financial institutions. Drawing
the line will not be simple, but that is a problem with all regulation. It
is
not insoluble. The question the authorities need to ask themselves is
simple:
if a specific institution fell into substantial difficulty would they have
to
intervene?
If the conflict of interest that dominates all others is between employees
and
everybody else, then it must be fixed. All bonuses and a portion of salary
for top managers should be paid in restricted stock, redeemable in
instalments over, say, 10 years or, if regulators are feeling generous,
five.
I understand that the bankers will not like this. Yet one thing is surely
now
quite clear: just as war is too important to be left to generals, banking is
too important to be left to bankers, however much one may like them.
[log in to unmask]
My Unpublished Comment
Well spotted Martin. The money system is something that everyone in society
has to use and benefits from. We have no choice over that. Moreover, since
the money system was not invented by the brilliance of any individual or
created by the hard work of any other individual or group, but evolved out
of
a long social-historical process involving the whole of society, rather like
language or the legal system, it is hard to justify the idea that any
individual or corporation should have the right to use the monetary system
as
if they owned it. Yet this is what bankers to. They have, in fact,
privatised
a social and cultural commons.
This privatisation is obviously highly advantageous because it confirs the
right to create money. If monarchs or states have that right then their
first use of money, seignorage, without having to give anything in exchange,
means they can spend out of the social product (on wars for example).
Bankers
by contrast obviously create money because someone is prepared to sign a
contract with them for a loan to be paid back with interest. (Or that was
how
it used to be before bankers earned fees for selling the loans they have
created to some other sucker that carries the risk).
As you say there is clearly a conflict here. Precisely because the money
system is a commons that we must all use it cannot be allowed to collapse.
That means the institutions that create the money as debt in their private
interest cannot be allowed to collapse either. Nice position to be in. As
you
say we can all be held to ransom. That is not something that can be allowed
to continue.
However this is not simply a problem of bankers failing to carry the can for
their mistakes. There is a deeper and more fundamental problem behind it. In
an article a few weeks ago you were more or less saying that unless human
ingenuity can come up with some specular innovations then we will shortly be
entering a zero sum economy. It is only if the economy is still growing -
positive sum in your words - that there is additional real output to be sold
to pay for the interest. Without the extra output there will be a lot of
foreclosures and re-possessions. In a zero sum economy if bankers are going
to get repaid with interest then everyone else is eventually going to end up
having their possessions taken over by bankers at some rather vicious fire
sale prices. Clearly that doesn't sound like a functioning economy with much
of a future.
In fact if the real economy doesn't grow (fast enough) then an expansion in
credit and the banking sector is only possible through asset price
speculation - which is bound to come a cropper eventually as it becomes more
out of line with underlying economic fundamentals.
Would your proposed reforms solve that? I don't think that tinkering with
the
system of incentives and bonuses which encourages excessive risk taking and
which would make managers think more long term will get to the heart of
these
more fundamental problems. The monetary system must be managed as a commons
that serves us all. The banks right to create money as debt needs to be
abolished.
Subsequent comment
There is little chance that the government and bankers will pay any
attention
to these kind of ideas - and they will certainly give no publicity to them.
This means that if one wants to see an alternative monetary system one must
create it oneself. If, as is not impossible, the financial and monetary
system goes belly up over the next few years as the world economy overshoots
the limits to growth, the need will be to develop local and DIY currencies
to
replace bank and debt money rather than "calling on" government and bankers
to reform themselves. (Some chance of them paying any attention to that!)
One approach is to issue local currencies starting them up as if they were
book or gift tokens. In the initial stages they can be converted back into
the national currency at a fixed rate and are accepted as payment medium in
a
local community just the same as national currency notes and coin. Once they
are in general circulation and generally accepted as payment in a locality
then, with general agreement, one can remove exchangeability. The key to
getting a currency to function as a currency is acceptance and familiarity.
This depends on having a community based organisation that is trusted to
manage the money system in the interests of all rather than in the private
interests of bankers and individuals - bound by a constitution that keeps a
check on the money makers....
Local currencies spent into existence by local authories in Argentinia
became
generally accepted when there was a currency crisis in that country. They
were withdrawn later as the central bank was frightened that Argeninia would
break up. All such alternative systems eventually come under intense
pressure
to be packed in when the national currency and monetary system is on the
mend. This happened in Austria in the 1930s when a local currency system
succeeded in dramatically reducing unemployment in the town of Woergl in the
Great Depression. Tough - it threatened the bankers and they stepped in to
put a stop to it.
However, we should seriously think of the implications of this. The banking
system is a major system underlying the growth economy. Once the growth
economy is broken by peak oil and peak gas and climate change it is to be
doubted that a debt based money system that requires and assumes growth is
either viable or desirable....Doubtless the bankers may try to use the law
to
break local currency systems - but it is worth bearing in mind that while it
is illegal to create money by trying to forge bank notes it is not illegal
for bankers to create money by lending it into existence. As the noted
economist JK Galbraith put it
"The process of money creation is so simple, the mind is repulsed"
-J.K. Galbraith
On the BBC today there was an article in which financial journalists talked
with enthusiasm about the financial crisis - because it was interesting. In
a
year or so it may be more than interesting it may be a source of mass
misery.
We should not forget the system that set this catastrophe in motion - it
needs replacing. People like Wolf realise that it will be seen as having a
credibility crisis and are already putting in place their alternative
political programme for banking. Something much more fundamental is needed
that Wolf describes.
http://www.youtube.com/watch?v=cy-fD78zyvI
http://www.youtube.com/watch?v=hfXavRTM4Fg
http://www.youtube.com/watch?v=_yvRZoM-2r8
http://www.youtube.com/watch?v=f0p8LepIuVM
http://www.youtube.com/watch?v=PzXZ_Hs1g6U
Brian
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