Showing posts with label synthetic leverage. Show all posts
Showing posts with label synthetic leverage. Show all posts

Tuesday 8 August 2017

What Is Money?

The system runs on borrowed money

The cliché that “The system runs on borrowed money” is well known.  You might imagine that you are somehow removed from that “system.”  Whether you are aware or not, your country, state or province, your school, your job, your church, your city, and your household are all run on borrowed money.  Nonetheless, “borrowed money” is a funny/peculiar expression because it is redundant.  There is no other kind of money.

What is money?  Experts aren't sure.

Reading Graeber’s Debt:  The First 5000 Years I was bemused to discover that there is no consensus among the experts on what exactly money is.  (See   When Should You Repay Your Student Loan? ) Of course, we all know what money is, but it is one of those obvious, everyday concepts that makes perfect common sense until you start to think about it.

IOU or Commodity?

Historically, the debate has been between seeing money as a commodity like gold or silver (something that has a value) or viewing it as an IOU, a promise to pay issued by the government of a particular country.  These days money is either paper or, more likely, pixels on someone’s computer screen—nothing of value in itself.

Money:  Without the gold standard, a debt that can never be paid.

However, if money is an IOU, it is a very strange kind of debt because no-one ever expects it to be paid.  (In the old days, countries were expected to have a supply of gold in storage—the “gold standard”—to back up their currency and, in theory, you could request an exchange of paper money for gold.  Those days are long gone.  (See   When Should You Repay Your Student Loan? .)

Money is simply a system of measurement

If money isn’t a commodity and it isn’t an IOU, what is it?  Graeber points out that the dominant theory in major economies like those of the USA and Germany—and I must confess it has taken me a long time to get my head around this idea—is that money is just a measurement system like feet and inches or litres and cubic centimetres. 

“Credit Theorists insisted that money is not a commodity but an accounting tool.  In other words, it is not a ‘thing’ at all. You can no more touch a dollar or a Deutschmark than you can touch an hour or a cubic centimetre.”

Money is a measurement of debt.

This is where the idea of “borrowing money” starts to get strange.  If money is just a measuring tool, imagine that you owe your buddy Georges 100 yards or you borrowed 300 miles from the bank to buy a house.  A hundred yards of what? Three hundred miles of what?  

Graeber writes:

"The obvious next question is:  If money is just a yardstick, what then does it measure?  The answer was simple:  debt."

The leverage ratio:  Why money doesn't really exist

“Borrowed money,” then, is just a way of saying “borrowed debt” or, more precisely, "a borrowed quantity of borrowing."  Once you’ve grasped this concept everything else in the financial and banking system begins to make sense—sort of.  As I’ve pointed out a couple of times, the mainstream, conservative banking system uses a leverage ratio of 4%; that is, 1 to 25,  meaning if the bank has 1 million dollars, it can lend out 25 million or 25 times more than it actually has.  “Actually has” (in the previous sentence) doesn’t mean to possess in a physical sense because as we have just learned money is “not a thing at all” so “has” does not apply in a physical sense.

When you borrow, you create money, which is the measurement of your debt

To trace the chain of “borrowed money” backward:  if you get a mortgage from the bank for $300,000, you will never get to see or touch or smell that money, but it is understood that you now have 300,000 dollars (i.e., money = debt).  You don’t have the money in an ontological sense (that is, in the sense that it actually exists), but you and the banks have an understanding.  

The more we “follow the money” the more imaginary and less real money becomes.  Following the leverage rules, it is understood that the bank does not have (in any sense of the word "have") the money it is lending you.  It is even understood that the bank has no understanding with anyone about the $300,000 you are borrowing prior to you borrowing it. Your $300,000 mortgage debt is created out of nothing, out of pure imagination.  It is a debt which you now owe to the bank.  It only exists as a piece of paper which you signed, meaning you created it for the bank's benefit out of nothing and which, by the way, the bank can turn around and sell or keep and claim as an asset in its bookkeeping. 

Synthetic leverage: how $1 becomes $40

In After the Music Stopped:  The Financial Crisis, the Response and the Work Ahead, Alan S. Blinder, an economist and former vice-president at the Federal Reserve, is adamant that “We need a financial system with much less leverage” (his italics, page 55).  Banks may give the impression on their books that they are leveraged to a conservative ratio of 1 to 10 but, as Blinder points out, the largest investment banks in the USA were creating “synthetic leverage” (using leverage to invest in something that is also leveraged; therefore leverage on top of leverage) to create leverage ratios of up to 1 to 40. 

Leverage and bankruptcy

If you want to understand what people are saying when they claim that the financial system was near collapse in 2008, consider a couple of salient facts.  The five companies that Blinder is talking about above—Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs—were the five largest in the USA.  Goldman Sachs, according to a French documentary I watched recently, has greater assets than the country of France (Goldman Sachs had $1.12 trillion in assets in 2007 according to Blinder).  Lehman Brothers, with assets of $691 billion, was allowed to go bankrupt.  To avoid bankruptcy, Merrill Lynch, with assets of $1.02 trillion, was forced to merge into the Bank of America.  As bankruptcy approached, Bear Sterns, with assets of 395 billion, was bought up, under government pressure, by JP Morgan Chase.  With these kinds of assets, how is it possible that these companies faced bankruptcy and needed government bailouts? 

The simplest answer is that no matter how rich you are if you are lending 40 times more than you have on paper (or in pixels, if you prefer) then a 2.5% mishap can send you spiralling into bankruptcy.  Think about it.  You have a billion dollars on paper, so you lend 20 of your friends 2 billion each.  One of those friends screws up and comes to tell you that he can’t pay you the 2 billion.  He’s bankrupt.  Guess what, so are you now.  Remember you only had a billion dollars on paper (in pixels), so now you can’t claim that you have those pixels anymore.   But are you really bankrupt now?  Sure you can’t say you “have” a billion dollars anymore (whatever “have” means in this context), in fact, you are a billion dollars in the hole.  According to the banking rules, you can’t lend out any more money because you don’t “have” any money to leverage—which is a problem if you are a bank because lending money is what banks do.  However, since money is just a measurement of debt, you still “have” the other 38 billion that you lent to your other 19 friends—don’t you?

Zombie Banks [Updated Nov. 3, 2018]

Listening to Yanis Varoufakis, former Greek Finance Minister, I learned there is an expression for what I described [above] a year ago:  Zombie Banks.  When banks no longer have the cash, the liquidity, the seed money, the "pixel dust," or whatever you want to call the million dollars that allows them to lend out 25 million, they stop lending money.  "Lending money" is the only reason for a bank to exist.  The bank is dead, insolvent, bankrupt, a zombie, but it continues to exist by receiving money from the national treasury, from taxpayers, which it hoards to itself to preserve the illusion that it is still a functioning bank.

High finance is like musical chairs until the music stops

The money game is a game of pretend.  The game only works if everyone believes or, as we say in literary studies, “suspends disbelief.” The game starts to fall apart when too many people start to notice that a billion-dollar or a trillion-dollar company doesn’t seem to have any money. You win the game by pretending that you “have” the money, even when it becomes obvious that no-one “has” the money.  All we have is the understanding that we all owe each other and the debt is measured in dollars or pesos or euros, etc, which is fine as long as we all understand the game and follow the same rules.


In my previous post, I described money as “pixy dust”—the magic stuff that Tinker Bell spreads with her wand in Peter Pan.  It wasn’t a metaphor that I thought about very much, but on second thought I’m a bit shocked by how accurate, how close to reality, that metaphor is.  Realizing that money is a kind of strange fiction that we have been convinced is the ultimate reality answers some of the questions I have asked in the past.  How is it possible that the USA is 17 trillion dollars in debt?  That the USA owes more American dollars than actually exist in circulation?  That every country in the world is in debt?  That the unregulated “derivatives” market is said to be between 700 trillion and 1.2 quadrillion dollars?  Since all these numbers are measurements of something that doesn’t really exist, they have no limits.  Nonetheless, I shouldn’t have called money “pixy dust.”  I really wish I had called it “pixel dust” the first time.  "Money is pixel dust!"  Spread it around!

Thursday 23 March 2017

Saint Mathew Pray for Us! Bank Deregulation Is Back!

Shock and awe and bank deregulation

Amid the boom and flash of the spectacular political theatre going on right now, you may not have noticed the announcements in a single utterance on television or in columns in the back pages of your local newspaper—“banks need to start lending money again,” (Trump on CNN), “President Donald Trump promised a meeting of community bankers to strip away some Dodd-Frank financial regulations” (B3 Globe and Mail 10 March 2017) and White House fires Preet Bharara “the high-profile Manhattan prosecutor known for his pursuit of public corruption and Wall Street crime” (A18 Globe and Mail 11 March 2017)—bank deregulation is back! “Bank deregulation” was the precursor to the financial collapse of 2008 causing banks and financial institutions to go bankrupt, individuals to lose homes, jobs and pensions, and triggering the government bailouts of the banks costing taxpayers what is now estimated to be a trillion dollars.  (Historically the British and Americans defined “billion” and “trillion” differently, but these days the American definition seems to prevail.  In the American system, a “billion” is a thousand million and a “trillion” is a thousand billion. Here is a more visual and visceral sense of how much a trillion is.)   The “Dodd-Frank regulations,” about to be "stripped away," were the rules put in place to prevent the collapse of 2008 from happening again.

Saint Mathew, the patron saint of bankers and accountants

Saint Mathew was an apostle of that Jesus the Anointed (who was voted “God” by the Council of Nicaea in 325).  Mathew is the alleged evangelical author of the first gospel of the New Testament  (although his name was not attributed to the text until after he was long gone, and oddly, in the gospel, he refers to himself in the third person--but then again so do I sometimes), and the patron saint of bankers and tax collectors (these days we might suggest that he choose a side), of accountants and money in general  He has a lot to answer for.  Even though I have graduated from agnosticism to atheism since beginning this blog, I’m recommending prayer in this case, because there really don’t seem to be any other options.  Bank deregulation isn’t just on the agenda, it seems a foregone conclusion.  

Bank regulation, bank-robbery deregulation; tomato, tomaato

I have to confess that I broke my pedagogical rule of Do No Harm Part II: Avoid Irony in my last post on bank robbery, but the point I wanted to make is that the next time you hear someone talking about “deregulating banks,” you can substitute “deregulating bank robbery”  and discover that the arguments, the logic and justifications turn out to be the same. So what?  We may be living in a global oligarchy these days with wealth dictating government policy and the law, but perhaps there is some measure of solace in being able to say, “I know you are going to screw us because you have that power, but forget being smug and self-righteous because we know what you’re doing.”

Step one of being un-fooled is to understand what the expression “bank deregulation” means.  Here are three words that you need to know in order to know what "bank deregulation" is all about: "derivatives," "leverage," and "rent-seeking."

  • Derivatives.  I may have talked “derivatives” to death in my earlier post, but basically what you need to understand is that “derivative” means that banks and financial institutions can “bet” on the stock and bond markets.  “Bet” is the important word here.  As described in The Big Short (both book and film), these “derivatives” are not investments in companies or products or services, they are simply companies and individuals betting that a stock will go up or down without actually investing in the company they are betting on or against.  Finance people make “derivatives” sound reasonable by describing them as “insurance”; as in you buy an insurance policy on your house to protect yourself against the possibility that it might burn down.  However, a derivative is more like buying an insurance policy on your cigar-smoking, alcoholic neighbour’s house in the hopes that his house will burn down—so why not buy him a bottle of vodka and a box of cigars for Christmas, his birthday, etc?  In the film version of The Big Short derivatives are shown as being like following your neighbour to the casino and when he bets two dollars on the roulette table, you bet 10,000 dollars with someone else that he is going to lose his two dollars, and someone else bets 100,000 dollars that you are going to lose your 10,000—that’s the derivatives market.  The derivatives market is estimated to be between between 710 trillion and 1.2 quadrillion US dollars.  (see "The Size of the Derivatives Bubble").  Just to put those numbers in perspective once again the total GDP of the USA is 17 trillion.

  • Leverage. How are these crazy numbers possible?  How is it possible that so much money—40 to 70 times the total wealth of the USA, 700 to 1000 times the amount of US paper currency which actually exists in circulation—is being gambled?  The answer is “leverage” (that’s chapter six in The Art of the Deal, the book which Trump’s ghost writer, who wrote the book, called “a tissue of lies”).  “Leverage” is what “bank deregulation” is all about.  If a bank has assets worth one million dollars, the average person might imagine that a bank can therefore lend out to clients up to one million dollars.  Under current US banking regulations the leverage ratio is 4%, which translates as a ratio of 1 to 25.  In other words, if the bank has 1 million dollars, they can lend 25 million dollars.  That’s right; for your mortgage or your car or your kid’s education, they can lend you 24 million dollars that they don’t have—but you, of course, must repay in money that you actually have.  (By the way, the mortgage that you owe to the bank is considered one of the bank's assets.  If you owe the bank $200,000, by regulation the bank is considered to have that money within its assets.)  The current "leverage ratio" (1 to 25) is the key regulation that banks find too onerous, limiting and difficult to comply with.  They want to change the leverage ratio so they can lend you even more money that they don’t have.
  • Rent-seeking.  This is the concept that we really need to watch out for.  The idea has been around since the 1970s, and is being much discussed in financial circles.  I found out about it reading Christia Freeland's Plutocrats:  The Rise of the New Super-Rich and the Fall of Everyone Else.  You might imagine that with all this money floating around it should be easy to cure cancer, end world hunger and poverty, offer everyone daycare and free education from kindergarten to PhD, but as the operations of rent-seeking become more obvious, it is becoming apparent that all this fabulous wealth doesn't actually produce anything, and it isn't the result of anything being produced.  Monumental wealth is being produced simply through the manipulation of government regulations, in particular the laws govern finance and banking. "Money" has become like Tinkerbell's pixie dust, not tied to anything of value, but available to the super rich to sprinkle on politicians, and for politicians to sprinkle back in greater measure on the super rich by adjusting the regulations for banking and finance to their whims and favour.  The disappearing middle class can look back on "trickle-down economics" and crumbs from the big table as "the good old days" because pixie dust may float in cosmic clouds above  but the .1% are exceptional at keeping it afloat and have little motivation to let it fall on the rest of us.

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