Sunday, 12 October 2008

Manton's Seppuku Puzzle

The Diogenes Club was strangely quiet when I walked into the grand entrance hall. As I shrugged off my coat, I noticed through the open doorway that there were far fewer members in the dining room than was normal, and what conversations there were, were somewhat muted. The first chill of winter was in the air, but I didn't think that was the reason for the poor turn out.

"It's quiet today, Henry." I said, as he took my scarf and gloves.

"Indeed, sir."

"Are any of the others here yet?"

"Just Mr Manton, sir. Mr Abrahams and Mr Treworthy have telephoned to say that they may be a little late."

"Did they say why?"

"In Mr Treworthy's case, an emergency board meeting - he indicated that due to some innovative corporate investments in certain European banks, some question marks had arisen over the company's short term cash-flow."

"Hmm. I don't know about you, Henry, but I always get worried when the words 'innovative' and 'investment' crop up in the same sentence."

"Quite so, sir."

"And Mr Abrahams?"

"He didn't say, sir. Your usual drink, sir?"

"Yes please, Henry. And one for Mr Manton."

"Yes sir."

I walked into the warmth of the library. It was just the same, one fixed point in these uncertain times. A warm fire, the walls lined with books, and large armchairs with side tables.

"Hello Manton." I said, as I eased myself into the chair next to him.

"Thank God you're here," said Manton, throwing his newspaper aside with unnecessary venom. "that bloody thing was driving me mad."

"You don't usually have that much trouble with the Times Crossword."

"Oh, I finished that in about fifteen minutes. I was so bored that I was reduced to having a go at one of those bloody Seppuku puzzles."

"I think you mean Sudoku. Seppuku is an act of ritual suicide by cutting open one's stomach, otherwise known as hari-kari."

"I know exactly what I mean. The damn things could be solved by a computer. At least a good crossword has a bit of wit, some...some soul. And you might end up learning a few new words."

Henry arrived with our drinks.

"Cheers, old man." said Manton, gulping down the remains of his existing glass before taking the one that I had bought for him. "No word from Abrahams, Henry?"

"Nothing further, sir."

"Oh well, it looks like it's just you and me today, old boy."

"What about Travis?"

"I don't we'll be seeing him for a while. I suspect that global economic meltdown and the possible end of capitalism might be occupying his time at the moment. Mind you, it's something that will affect us all."

"Yes - it all seems a bit abstract to me, to be honest. I haven't really got any money to speak of. I manage to pay my mortgage and taxes and have a bit left over to buy the occasional book or shiny disk, but that's about all. You don't seem too bothered by it, Manton."

"Oh, it bothers me alright. I'm just not very surprised. I've been waiting for this to happen for the last thirty years."

"What do you mean?"

"Ever since I read one of Galbraith's books. Didn't you have a look at that film that I told you about?"

"The money as debt thing? No, not yet. Been a bit busy."

"Well, it essentially explains what a bank is, and how it creates money."

"I thought Government's created money, in the mint."

"Only a small amount. Most money is created by banks, which, don't forget, are private corporations."

"Yes, but it's backed up by the deposits of the customers, isn't it?"

"No, they just create it out of thin air."

"You're kidding." I laughed, but Manton's face was deadly serious.

"Not at all. The film uses the story of the Goldsmith's Tale, to try and explain how banking got started.
       For a long while, people used all sorts of things as money. Shells, stones, bushels of wheat, pieces of gold. As long as everyone had faith that it could be exchanged for things that people wanted, like food, there was no problem."

"Of course. We learned that sort of thing at school."

"Really - the British education system has clearly improved since my day.
       Anyway, once upon a time, around the fifteenth century, in place like Venice, or Amsterdam or London, there lived a goldsmith. As well as jewellery, he made coins, which people liked because they were a convenient way of carrying around their wealth. Of course, he needed to keep his wares safe, so he built himself a vault.
       Pretty soon. other townspeople were knocking on his door, because they wanted to rent space in his vault so that they could keep their own valuables safe as well.
       The goldsmith was soon renting out all the space in his vault, and making a nice little profit into the bargain. After a few years the goldsmith realised something quite important. People rarely came in to take their gold out of the vault - and if they did, they didn't all do it at the same time. Any idea why?"

I took a sip from my whisky. "No, not really."

"It was because every time someone deposited some gold in his vault, the goldsmith had given them a receipt. A paper claim note that they could use to claim back their gold."

"And the paper claim notes were being used in the market place to buy and sell things, as if they were the gold itself." I exclaimed, triumphantly.

"Exactly. Bank notes. Paper money. It was quite a radical idea."

"And so that is why a bank note 'promises to pay the bearer on demand'."

"Yes - notice that it doesn't say what they will pay you in, though."

I got a fiver out of my wallet, and studied it carefully. "No, you're right. I suppose I had always assumed they would give you... I don't know, gold coins, or something."

"I'm afraid things have moved on since then. You see, the goldsmith decided to start up a new business. He decided to lend out his gold to people who needed it, in return for a payment, which he called interest. The longer you wanted to borrow some of his gold for, the more interest you had to pay. Because his paper claim notes were in such widespread use, people asked for their loans to be paid to them in claim notes, instead of the actual gold."

"Well, that doesn't seem to bad."

"No, I agree. But, as the country got richer, and industry expanded, more and more people started to ask the goldsmith for loans, and this is when he had another brainwave. Because hardly any of his depositors ever asked for their gold back, he decided to make loans based on their gold, as well as his own."

"Hang on, that's a bit cheeky. Did he ask for their permission?"

"Well, not as such. After all, as long as the loans were always repaid, the depositors would be none the wiser, and no worse off. And he would make a much larger profit than he would otherwise be able to with just his own gold."

"I know, but he's taking a bit of a risk."

"Well, as they are always saying on the news, the economy grows because of risk takers. The spirit of the entrepreneur and all that." Manton took a mouthful from his glass. "At least, they used to. You only get the occasional hedge fund manager with a death wish saying it now."

"So what happened next?"

"The goldsmith grew hugely wealthy, far more than his fellow townsmen. You know the sort of thing. Several villas, each with their own retinue of servants, and a holiday home at the coast. His own private yacht. A huge collection of carriages, and horses to pull them. The finest clothes."

"But... he wasn't really doing anything, was he. Not really."

"Funnily enough, that's what the other townspeople thought. Rumours grew that he was actually spending his depositors' gold. One day, they turned up at his vault and threatened to withdraw their gold unless he told them where his wealth was coming from.
       He showed them the vault and they could see that their gold was still safe - but they still weren't satisfied, so he told them that he had been making loans based on their gold as well as his own. They demanded a cut of the action, and so the goldsmith agreed to pay them a share of the interest that he was earning on the loans based on their gold."

"Well, that does seem fairer. After all it's their gold."

"Indeed. And that was how banks started. The bank would make loans which were guaranteed by the depositors' gold that was held in the vaults, and charge a high interest to the lender. Instead of being able to pocket all of that interest, the goldsmith now had to pay some of it on to the depositors whose gold he was looking after, but he paid them a lower rate of interest, and used the difference to pay for the costs of running his bank - which obviously included his own salary. And the occasional bonus."

"Well, villas in the south of France don't pay for themselves, Manton."

"How true, how true. Those are very wise words." He looked at his empty glass. "I think it's my round isn't it? HENRY!"

As Henry brought the drinks over, I thought about what Manton had said.

"That's all very well, but none of this really explains what is going on at the moment."

"Well, I haven't finished yet. You see, most people think that this is how the banks operate today. That they make loans, based on their depositors' money, for which they charge high interest rates, and pass on some of the interest to their depositors. But the goldsmith - actually, I think we had better start calling him a banker now - the banker had another brainwave."

"I'm starting to get a bad feeling every time that happens."

"You see, the banker wasn't content with the amount of interest that was left after he had paid off his depositors - and the need for credit was growing - great expeditions were being sent out to explore the recently discovered continent of America, and there was much growth in new industries. There wasn't enough money available for everyone that wanted some."

"Why not?"

"Because it was tied to the amount of gold in the banker's vaults. Whether it was his gold or his depositors gold, there was still only a fixed amount."

"So what did he do?"

"It was a stroke of genius. Because he was the only person who knew how much gold was actually inside the vault, and because he knew that his depositors would never want to withdraw all of the gold at the same time, he realised that he could issue claim notes on gold that didn't even exist!
       So long as he didn't get too many people wishing to claim back their gold at any one time, how would anyone ever find out?"

"What!?" I spluttered, whisky spilling over my waistcoat as I tried to stop choking.

"I know, it's breathtaking isn't it."

"He can't do that! It's illegal. It's .... it's..... how can he do that? It's outrageous!"

"That's precisely why the scheme worked - and rather well, as it turned out. Needless to say, the banker became even more incredibly wealthy than he already was."

"I'm not surprised. It's one thing to get interest for loaning out his own gold, or even his depositors gold, but making interest for loaning out gold that doesn't actually exist.... of course, he doesn't have to pass on any of that interest to despositors, does he. Because the gold doesn't exist, the depositors don't exist."


"It's a damn sight more risky now, though. Not only might he have to pay out his own gold, or even his depositors gold - he might have to pay out gold that he doesn't have. That he has never had."

"But people hardly ever want to claim their gold - certainly not at the same time. Well, not usually."

"Well, if I had been him, I would have been bloody careful not to draw attention to myself. He'd have to scale back on his ostentatious spending - if anyone suspected foul play and called his bluff, the whole thing would come crashing down."

"Yes, you'd think so. For a long time the idea that the banker was creating money out of nothing was so outrageous, it did not occur to people that this might be what was going on.
       Of course, the power to just invent money went to the bankers head, as you can well imagine. He just bought more 500 room mansions, art collections and so on. He would spend, on one suit of clothes, what another person might spend on food in an entire year."

"But didn't he see how dangerous that was - if only out of a sense of self-preservation?"

"It seems not. Of course, the inevitable happened, and in time, the bankers ostentatious wealth triggered suspicions amongst the townspeople once again.
       Some borrowers started to demand real gold, instead of paper claim notes, when they took out their loans. More rumours spread.
       Suddenly, several wealthy depositors turned up to withdraw their gold. The game was up. A sea of claim cheque holders surrounded the bank, all wanting to get their gold out. The banker had to close the bank because, of course, he didn't have enough gold in his vaults to redeem all of the paper claim notes that he had put into circulation."

"And people realised that their paper claim notes were worthless."

"It was the first run on a bank. It is what every banker dreads. Not just because it can ruin an individual bank, but more importantly, because it shakes confidence in the very idea of a bank."

"Yes, but after this run happened, everyone could see how dangerous it was. I mean, the government must have outlawed the practice of creating money out of absolutely nothing. It's just plain madness. It's never a good idea to live beyond your means."

"Well the government could have done that. Unfortunately, the large amounts of credit that the banks were offering had become essential to the success of European commercial expansion - and also essential to the political success of whoever was running the country at the time. You wouldn't last long in power if your opponents could promise to make the country more wealthy than you.
       So instead, the practice was legalised, and regulated. Bankers agreed to abide by limits on the amount of fictional loan money that could be lent out. The limit would still be much larger than the amount of actual gold and silver in the vault though. Usually the limit was 9 to 1. The bank agreed to only lend out 9 dollars for every 1 dollar of gold that they had in their vault."

"And the government trusted them?"

"No, the rules were enforced by having surprise inspections of banks. It was also arranged that every country would have a central bank. If a local bank experienced a bank run, the central bank would support it by sending it extra consignments of gold to enable them to pay their depositors."

"And that's what the Bank of England does here, and the Federal Reserve Bank in America?"

"Got it in one. The central bank is the lender of last resort.
       As I've said, it was very unlikely that all the depositors would wish to withdraw all of their funds at the same time, unless the bankers did something incredibly stupid, like accumulating enough wealth to make even King Midas himself blush.
       And it was even more unlikely that all of the local banks would need extra reserves from the central bank at the same time, unless they did something even more incredibly moronic like spending lots of money on 'financial packages' based on the American mortgage market when they have no idea of how much risk is tied up in them."

"That wouldn't just bring one bank down, would it - that would bring all the banks down. Including the central bank."

"That's right."

I sat quietly and thought for a while. The logs crackled in the grate, interrupted only by the slow, regular sound of the Grandfather clock.

"I think I'll get very, very drunk tonight."

"Capital idea, old man. I usually end up thinking I'll get very, very drunk every night, but that's mostly due to my ex-wife. Mind if I join you?"

"The more the merrier." I finished off my glass, flinching as it hit the back of my throat. "So is that how the system operates now?"

"No, not quite. It's even more terrifyingly divorced from reality now, but I think we need to have considerably more pure malt whisky inside us before I go on, or you'll never believe me."

At that moment, Abrahams came into the room waving a newspaper. "Have you heard?"

"My God, Abrahams, where did you spring from?" said Manton, trying to not to spill any more of his whisky.

"It's completely unprecedented. Unheard of."

"What is? What the devil are you talking about?" said Manton.

"It says here, the US Treasury Department, for the first time in its history, is to begin selling bonds for the Federal Reserve in an effort to help the central bank deal with its unprecedented borrowing needs. Treasury officials said the action did not mean that the Fed was running short of cash, but simply was a way for the government to better manage its financing needs."

"Manton," I said, "you said the central bank is the lender of last resort. That's what is stopping the whole thing from collapsing. If they need to borrow from someone else...."

"HENRY! Bring the bottle. It's going to be a long night."

Friday, 3 October 2008

What is Money?

The other day, a fellow Diogenerian, a wise and learned man, asked me a question:

What is money?

It is a question that has arisen amongst fellow members before, as detailed here.

Like all good questions, it is very simple.

The answer, it would appear, is also simple.

Money is debt. And more importantly, debt is money.

And before you ask, that isn't one of the quotes that George Orwell attached to the walls of the Ministry of Truth - it is the message put forward by this film, which has been split up into 5 ten minute clips.

I should warn you that it has clearly been made by some left-wing lunatic - witness the cheap, cartoon-like graphics - and furthermore, someone who doesn't understand the extremely complex nature of the global economic system, which is monitored and controlled by extremely intelligent men and women, who deserve every penny of the extremely large salaries and bonuses that they receive.

I will say that it summarises my understanding of the global money markets, arrived at after many years of thought.

I don't really want it to be true, so if anyone who is more knowledgeable in these matters can point out the logical flaws in the arguments put forward, I would be extremely grateful.

Thursday, 2 October 2008

Going, Going, Gone!

Another extract from Robert Peston's blog on the BBC website:

And now for the complicated and scary stuff. Today is the beginning of "auction season", when the International Swaps and Derivatives Association starts a series of auctions to settle who pays what to whom on a plethora of credit derivative contracts relating to businesses that have gone into default.

It's settlement time on those humungous insurance policies for corporate debt, called credit default swaps. [...]

In the coming three weeks, payouts of hundreds of billions of dollars may be made - or at least demanded - to cover losses arising from the defaults on the debt of Fannie Mae, Freddie Mac, Lehman and Washington Mutual. [...]

Now the problem here is that for every beneficiary of these payments, there's an underwriter - those who provided the CDS insurance - which has to find the cash.

I'm sure that there is no need to worry about the fact that this was a largely unregulated market.

Regulators just get in the way, with their fussing around, needlessly checking up on trivial things like: "Has the underwriter actually got enough money to pay out on all the claims that may be made upon it?"

And if those companies should find out that their insurance policies are worthless, well, it's not the end of the world.

Indeed, the really clever ones will not only have an insurance policy to protect them from their customers defaulting on their debts, they will have another insurance policy to compensate them in the unlikely event that their first insurance policy proves to be worthless.

And the really, REALLY clever ones will have yet another insurance policy to protect them from the even more unlikely event that THAT insurance policy should fail.

And so on. And on.

So the chances of actually having to pay out on THOSE insurance policies are so incredibly remote, it makes perfect sense to take on as much of that business as you can, because you will never have to pay out on it. There's no need to have any capital in reserve, because it will never be needed. You could, instead, pay it as bonuses to your executives. It's a licence to make money. People just pay you to do nothing.

Of course, you are in trouble if there IS a claim, because you can't pay it - which means that the next company won't be able to pay out on their (bigger) claim, which means that the next company won't be able to pay out on their (even bigger) claim.

And so on. And on.

Which means that a lot of companies might find out they have got less money than they think they have.

But that's ok.

They should be getting used to that by now.

Wednesday, 1 October 2008

What Was The Derivatives Market, Daddy?

As I have mentioned in previous entries, it is important, in these times of financial crisis, that we don't give in to gloom and despondency.

An article has come to my attention that starts with the following paragraph:

While it may look superficially similar to the recent implosions of such investment giants as Fannie Mae, Freddie Mac and Lehman, the takeover and bailout of AIG is quite different, and means that the market is entering the next and even more dangerous phase. What is driving the fall of AIG – and potential government losses that may far, far exceed the $85 billion bailout announced late on September 16th - is not mortgages or real estate (directly), but fears that AIG’s huge, global credit-default swap positions will unravel. The $62 trillion dollar credit derivatives market is 50 times the size of the subprime mortgage derivatives market, and is indeed larger than the entire global economy.

I feel that the last sentence is unnecessarily inflamatory, and I would urge everyone to make sure that they do not read the article

under any circumstances, as it provides a clear explanation of the derivatives market, and so could create panic and despondency amongst the general populace.

And whatever you do, don't let your wives, children or servants read it either. These things are far to complex for them to understand, and there is no need to worry them unnecessarily.

I know you won't let me down.