“To be, or not to be, that is the question,

Whether ’tis nobler in the mind to suffer

The slings and arrows of outrageous fortune,

Or to take arms against a sea of troubles,

And by opposing end them.”  Hamlet, Act III, Scene 1.

It seems, after nearly 30 years of deregulated markets, that we face a sea of troubles ourselves. An extreme global debt deleveraging is upon us, the numbers too outrageous to even consider. Not only have we consumed beyond our means, we have mortgaged our future. Whereas once credit was difficult to come by and banks conservative in their lending (can you pay this back?), the brave new world brought us access to unlimited treasures, all paid for on a credit system, which had limited restraint.

As financial models became more complex and debt could be packaged, securitised and sold off, all sense of restraint was lost. Who owed whom was lost in a parallel universe of metaphor: swap, hedge, collateral, obligation, repurchase. Repaying principal and interest, in the old fashioned sense was put to one side. Can you afford the interest? Don’t worry about the principal, that will pay itself off as the price rises! Can’t afford the interest? Don’t worry, we’ll lend that to you as well, or have a holiday (from interest that is….keeps charging but pay it some other time). Tick, tock, tick, tock.

Maybe Hamlet wasn’t as crazy as he sounded.

As I explained in a previous post on the Euro, deleveraging debt is a painful process. As debts are written off, the money supply contracts, causing a contraction in the general economy. This creates a spiral where demand for new credit drops and this causes further losses to business, resulting in more job losses and so on. Traditionally, this has been dealt with by the lowering of interest rates, which hopefully stimulate demand for credit and reduce interest burdens. Sadly, this doesn’t work until the overhanging debt has been cleared out, by which time unemployment has risen and economic output has contracted to severe levels.

The road to austerity is a self-fulfilling process. Clearing the debt mountain will take many years and, perhaps, like Japan, it could be a decade or more. During that time people will be unemployed, machines will sit idle and resources will be untouched. In the 1930s governments stood back, waiting for the miracle of the market. None came. That is not a road we want to travel down.

As the shadow banking system starts to fall apart, it is time to plan and look forward to building a stable and local supply of money to see us through the hard times. Continuing to rely on overseas capital and ever increasing borrowing is a road to ruin. Our gross debt will hit $90 billion  by 2016, according to Treasury forecasts. The government talks of returning to surplus by 2015 but that is very optimistic. Even then we will still carry this debt for many years to come.

So is printing new money and spending it directly into the economy a better idea? I talked about this in a recent interview with Kim Hill and Radio NZ National, which you can catch here.

RadioNZ National Kim Hill interview

I have had an incredible amount of positive feedback since the interview and, interestingly, from a very wide range of people. There were a few comments about “funny money”, including a little pop from Nevil Gibson at the NBR. My answer to that is if you think this is funny money, try explaining the nearly $4 trillion that’s been used to buy debt off US banks! The feedback has confirmed the following: that there needs to be a clearer explanation on how the money creation process actually works (even though the RB has published on this here), that inflation needs to be better understood and that people are extremely concerned about the way the financial system is structured. We will be working on producing a simpler explanation to those issues.

In the meantime, around the world, there is a lot of new work being undertaken around the quantitative easing process and how that is not really working. Sushil Wadhwani (Goldman Sachs and MPC member in the UK) and economist (and former colleague of mine) Michael Dicks have looked at more direct interventions into the economy, noting that QE is a very roundabout way of trying to stimulate an economy. They look at directing lending to companies from the central bank and, more interestingly, at simply giving households a voucher to spend. You can read the brief paper here. Their proposals are in the right direction but do not go far enough. Nouriel Roubini recently wrote that direct spending on new infrastructure in the US would be much more useful than simply buying toxic bonds off failing banks.

What’s clear is that more and more economists and policy analysts are realising that QE is a sop to the banks, boosting their balance sheets and stock prices, at the expense of the taxpayer. Clearly this is a misallocation (and perhaps misappropriation) of taxpayer funds. Furthermore, even with trillions of $ of QE, there has been no inflationary effects at all. This is important to note when considering the direct injection of new money, as we have proposed, for the Christchurch rebuild.

As I noted in this recent piece for ChangeNZ, as long as there is surplus labour and resources, there will be no inflationary effects from new money. This has been confirmed from business sources, who note the economy is limping along at between 33-50% of capacity. So there is little concern over the direct effects of the new money in raising prices. The indirect effects through the banking system are also likely to be minimal, given a very low demand for credit across the economy. Indeed, with debt deleveraging in full swing, we are likely to see further reductions in debt, offsetting any new potential demand for credit. Still, credit numbers will need to be watched carefully and, at the same time, it’s important to note that the amount we are suggesting is only $5 billion. Ultimately the goal is a strong and locally managed financial system with price stability. That is something we have not had, despite the continuing myth of a central bank induced low inflationary environment. The time is right to consider an alternative way forward.

Perhaps we should leave the final words to Hamlet, as we ponder the road ahead:

“The undiscovered country, from whose bourn

No traveller returns, puzzles the will,

And makes us rather bear those ills we have,

Than fly to others that we know not of?

Thus conscience does make cowards of us all,

And thus the native hue of resolution

Is sicklied o’er, with the pale cast of thought,

And enterprises of great pitch and moment

With this regard their currents turn awry,

And lose the name of action..…”

We are all conditioned to think and live within a certain paradigm or system. For many of us (especially readers of this blog), it’s considered to be democratic, liberal capitalism. More realistically it’s a neo-liberal system where free markets dominate at the expense of any concept of the public good. Markets will solve any problem. Actually that’s a truism. It’s the outcome that is often of dubious merit.

When I look at the Occupy Movement, I see a protest against this system, a system where people are secondary to profit, and the public is considered to be a wasteful and unnecessary construct. As John Key noted of the Christchurch post-EQNZ insurance problem, eventually the markets will sort it out. Again they will but there may not be any insurance for anyone for a while. This mirrors the government’s approach to managing our prisons: simply contract it out to private operators, who will manage it more “efficiently”. The belief in the idea of the “public” is slowly being eaten away by this neo-liberal fantasy that for profit organisations will always achieve the best outcome.

It will be interesting to see how this protest develops but it feels like it has legs. The outrage is fair and justified: the corruption at the heart of the political-financial system; the gaping inequalities; the disenfranchisement and the feeling that the whole system is built on sand. Over time the picture will be clearer and the protests may coalesce around a series of concrete demand but the consultative and participatory process is a fascinating starting point. Participatory, as opposed to representative, democracy is messy, frustrating, turgid, slow, tedious and annoying but that’s the whole point. It is built on allowing all people a voice and on allowing a process to develop. It is a far cry from the many bills rammed through under “urgency” in the NZ Parliament, with little debate or scrutiny for even our partially elected representatives.

I wish them well in their endeavour. In the meantime, I have three simple proposals to offer, as a starting point:

1) Monetary Dialysis - No more public debt; new public money; raise limits on bank credit.

2) Trucost pricing - Start pricing ecosystem goods and services.

3) Participatory Universal Income - Basic Income for all those participating in society; rebalanced tax system; provision of key public goods.

I focused on the first 2 ideas in my presentation, the outline of which is below. By repricing our economic system, both in the cost of goods and services, as well as the creation and volume of money, we will immediately realign it towards a path of lower volume but higher quality consumption. We will reduce the burden of compound interest, this alleviating the constant pressure to produce and consume. The UPI will restore the public good in reflecting all contributions to society and laying the foundations for a more stable, harmonious and prosperous world. Far fetched? Not really, when you think about it for a bit. My turn is over for now. Who is next in the stack?

But still there is confusion around what to do about it. “Saving” has become the new buzzword, sitting squarely alongside “austerity”, as private individuals are urged to save more and governments are urged to spend less. That sounds like a sensible way forward. But watch the economy tank when that happens. Why?

Simply because when debt is paid down (and no corresponding new loans made) the money supply contracts as the debt is destroyed. The debt never existed as “money” in the sense of notes and coin but as an asset and liability for the bank. The interest is collected and the debt destroyed, leaving the profit for the bank. A monetary system based on debt will always lead to booms and busts as the interest charged overwhelms the ability of the productive sector to pay it. Ironically the system always needs infusions of new debt to stay afloat as the amount of money in the system declines.

Of course, when companies start to lay off workers (their first cost saving option) this creates uncertainty and an unwillingness for new borrowing to take place. This creates a self-reinforcing cycle which in some cases leads to recessions and occasionally to depressions. So what’s the best way out of this?

Austerity? No. Austerity will keep some investors happy but generally this will simply lead to slower growth and higher unemployment. But austerity is also a fact of life. When you have borrowed money and spent it, you know one day you have to pay it back. If you haven’t saved for that day then you will have to forego consumption for repayment. If you are in that position, which many governments are, you have, in fact, over consumed your income and eaten into your future. That’s not a pleasant space to be.

Is there an alternative?

Yes there is. I’d like to propose what i term “Monetary Dialysis”. This process seeks to replace debt money with real money (let’s assume for the moment that fiat money is real). The difference between debt money and real money is two fold: firstly, real money is permanent and once it enters the banking system it remains there; secondly, real money enters the banking system without interest, with no charge for its creation.

This two key differences will lead to new outcomes: a more stable money base and a less inflationary one.

How will this process take place?

The government, instead of issuing new bonds to raise money (primarily from overseas investors), will directly spend the money into the economy. In other words public spending will be funded by new money, not new debt. Immediately there will be a saving in interest costs, with current funding costing 5-6% per annum. The current annual bill (previous to the recent enlarged debt issuance) has been running at close to $4billion a year which is a hefty sum (I am only talking government borrowing here).

I use the term dialysis as a representation of a monetary system that is malfunctioning, not just here but globally. I propose a slow transfusion with the goal to end government borrowing completely by 2017.

Where’s the catch? Ok clearly there needs to be some balancing on the other side of the equation. As well as issuing new money instead of new debt, another part of the monetary dialysis approach is to create stronger limits on the abilities of banks to increase the money supply through the issuance of new debt. This can be done in many ways, using a variety of macro prudential tools, whether it’s increasing capital requirements or other similar actions.

Monetary Dialysis is the first step to cleaning up our monetary system. It will lead to a more stable money supply, lower inflation and clear savings in interest costs. The reduction in public debt will be highly beneficial for the economy and the country as a whole. The cost savings from this clean up will be in the order of $20billion over 6 years.

Now that’s something to really think about.

At current government bond yields this is likely (presuming the issue is in longer term bonds) to cost over half a billions dollars a year. That’s right $500-550m a year in cost, just to access the money we need.

Bill English has our recent proposal to use new public money in front of him but so far we have heard nothing back on it. Other than an earthquake levy, which has been ruled out also, there are no other proposals on the table.

I look forward to hearing why the Finance Minister thinks paying $500m a year is a good idea for something we could do ourselves.

It all comes down to leverage which now is well understood. The new capital requirements simply squeeze poorly capitalised banks a bit harder but really make sod all difference to the underlying problem which as we all know is excess credit creation. This credit creation is also known as money supply expansion. Are credit and money the same thing? well yes and no. When you get a new loan from the bank, you have received credit. This credit appears as money in your bank account and can be converted (though usually ins’t) into note and coin. But here’s the nub. Whilst money, the the form of note and coin, cannot be destroyed (ok you could burn it), when you pay back your loan that money is cancelled…in a puff of smoke. It only existed in your imagination. Of course that same “money” can be relent but new credit can always be created as long as there is enough “equity” in the bank…….come in Tier 1 capital and other assorted IOUs.

For example, the money supply in New Zealand has contracted by nearly $10bln in the period from Feb 09 to Jul 10. That’s why there’s no money in the economy……it’s goneski. But if we dealt in real money it would never disappear; once it was created it stayed in circulation or under your bed but it could not be destroyed.

The ability of banks to inflate and deflate the economy is still very much theirs with central banks acting like the lunatics they are by playing important games with their interest rates. They haven’t quite worked out the mess they made over the last 15 years by focusing on inflation and forgetting about asset prices, leverage and moral free speculation.

Gareth Morgan notes this in his take on it but again misses the real point, as does Basel 1,2 and 3 (and probably 4 and 5). It is the quality of money supplied into an economy that is the most important aspect of the economy. Copious amounts of speculative credit has blown out the “real” economy creating a mess which could take decades to unwind.

But we need to address this sooner or later….otherwise we will get the same maneuvering again ………or is it the same manuva?

But it’s useful to sit back and consider the element of contract here. When we borrow we commit to a contract that is so ancient so as to be part of our very soul. From Faustus to Scrooge, the spiritual nature of this bargain is ever present. I must mention here the fabulous work by Margaret Attwood titled “Payback: Debt and the Shadow Side of Wealth“. It reminds me somewhat of Arundhati Roy’s venture into non-fiction in “The Cost of Living“. I like brilliant writers who veer off into interesting worldly issues and Attwood’s book has certainly inspired this post and much thought on the nature of debt itself.

It’s not the type of book I would expect from an author of fiction but it’s really a masterpiece on the understanding of debt and our long relationship with it. When we look at debt and debt slavery we realise it has been around since the beginning of time. The ability to hock one’s wife and child into servitude is not a recent phenomenon. The Faustian bargain is long known even if these days it’s for a consumer good (take your pick) on a 5 year no interest deal: no interest? do people actually believe that? Yes they do.

The focus is always on the weekly amount…..’oh that’s $15 a week. yes i can fit that into my budget”….shame it’s $15 a week forever!! and that television or sofa has cost you double, treble of even more than the advertised price…..oh and it’s worth sod all to sell.

Anyone remember Polonius? The father of Ophelia and general rambling windbag in the Kingdom of Denmark (That’s Hamlet for you who didn’t have the joys of Shakespeare at school).

“Neither a borrower nor a lender be”.

Famous words reprised many years later by Keynes at Bretton Woods when he proposed that countries should keep their trade accounts balanced as much as possible…..that applied to those in credit as well a debit.

And look where we are now……we’re at Payback time. But where is Mephistopheles? Who is going to do the collecting? To pay or not to pay? That is the question said Hamlet…perhaps.

The imbalances in the system are so great that there is no amount of money available to repay the debts. Perhaps they should all be written off as a bad idea and we should start again from scratch….but hark I hear Shylock coming…is there a pound of flesh available? Land…not transportable…but commodities from the land…maybe.

At some point the contract must be addressed; At some point a bargain must be made; At some point there will be the mother of all restructuring. Who will pay…now that really is the question.

I’ve just finished Michael Lewis’s “The Big Short”. It’s an amazing book, not just because it informs us of the road to the subprime mess but he creates a story around the protagonists. He also manages to expose the whole wretched mess, the fictionalisation of risk and yield laid bare. He introduces us to the main players in the debacle through the eyes of a few weird and wonderful players who worked out that something was terribly wrong and bet against it. These colourful characters expose the whole damn scheme as nothing more than a paper pyramid.

As Lewis sums up the Collateralized Debt Obligation (CDO) on page 73:

“The CDO was, in effect, a credit laundering service for the residents of Lower Middle Class America. For Wall Street it was a machine that turned lead into gold”.

Simply put a CDO was a collection (a tower) of subprime loans that had miraculously transformed from junk status to triple A (AAA) credit and therefore it was investible by major funds (referred to in the book as dopey Germans).

So what was the short? Well on one hand you had investors who sold insurance on these debts defaulting. They believed (incorrectly) that it could never happen and therefore they were picking up free money. The shorters realised the were getting amazing odds on the loans defaulting and piled in.

At the bottom of this was an average person with no money and a big mortgage, usually 100% or more. Any fall in the price of their property would immediately put them in a default position. Yes it was a giant pyramid scheme. The real laugh is that even the guys going short didn’t really understand what it was they were shorting so opaque was the structure and process.

I recommend the book very highly. It’s a gripping read and manageable for the layperson.

You’re left wondering how the bankers got away with it. The answer given by the bankers (well laid out in Sorkin’s book) was that they were too big to fail.

This sets us up nicely for the next round.

P.S.

Today the SEC is launching a case against ICP Asset management for their role in handling CDO investments. Along with the case against Goldman Sachs we can expect more companies to be investigated for their role in this financial fraud. It will also be interesting to see when the rating agencies themselves will come under review. They were the ones who gave the AAA blessing to these products they really knew very little about. Makes you wonder about the whole darn shooting match!

Simply put this is how you can buy a house with no deposit or a small one. Consider the reality of leverage:

You buy a house for $500,000 and put down a 10% deposit of $50,000.

In a few years (certainly recent times) you sell it for $600,000. You have just made $100,000 from an investment of $50,000…a 200% return. Of course you have to subtract your interest but that is what you would have paid in rent anyway or so the theory goes.

In recent years this has been the name of the game. Between 2000 and 2008 New Zealand house prices rose 169%……..!! Yes that’s an incredible number………21% per annum on average. No wonder people thought this was an easy game. No wonder leveraged investments in property became the biggest game in town. But hold on: we are talking about houses not tulips. How could such an unusual bout of asset inflation happen right under the noses of the inflation focused RBNZ.

Well house prices are not included in the CPI calculation. Call me old fashioned but that’s ridiculous.

The major problem with any bubble is that it ends. In this case NZ has not had the same end as the USA with its sub-prime mortgage induced property collapse though the NZ finance company sector did its best to compete.

But the leverage has not been washed out of the system yet. House prices have recovered from the 2008-9 fall and now are back up close to their historic highs. Why is this? Why hasn’t the NZ housing market fallen back to more realistic levels?

There’s no clear answer but I’d like to suggest one: It’s not in the interest of the banks for prices to fall heavily. Why? Because they are the ultimate owners of the housing stock. If they lend 90% to a borrower and the price of that house falls 10% then the borrower has lost their equity and the bank owns the rest. That’s how leverage works on the downside. If the price falls further than 10% the borrower is into negative equity. So far so normal. The bank will just hoover up any savings or other assets held by the borrower. But at some point the bank is left holding the security. Banks don’t like that very much so they seek to sell the asset and recover as much cash as possible. If the borrower cannot cover the loss then the bank has to write that off.

But in a bubble situation the banks have to be very careful not to knock down the price of all property. Otherwise their entire lending portfolio will take a hit not just the one loan which went bad. So banks have a vested interest in keeping prices from falling too far.

Back in 2008 I called for land prices to fall 30%. They haven’t yet but it’s simply a matter of time. In fact they only fell 8.5%…not much of a fall considering the enormity of the rise. Wages are not rising at a rate which can cover the compounding interest on the debt pile (see upcoming post on debt) so the strains of maintaining the illusion will continue to show through. Therefore the banks have a big part to play in making sure house prices do not rise or fall too much whilst they reorganise their lending practices.

What needs to happen? Well a reversion to traditional lending practices will come back into vogue: where you can borrow 2-3 times your salary. Imagine that. Median wage in Christchurch is somewhere between $30-40,000 depending where you look and the average house price is $360,000. Scary……so the banks who are operating on the interest/cash flow model (see upcoming post on definancialisation) will find switching back to the traditional model simply isn’t possible as house prices would fall by rather a lot. You couldn’t find a house for under $200,000 these days so we would have to see a severe correction, probably in excess of 30% though very low borrowing costs would help ease that.

It’s clear that the same financial practices that we have seen employed in the global bond markets have also been applied to residential lending. The valuation model shifted from the established practice of ability to repay the mortgage to the ability to cover the interest. Why? Because the price of the house would always go up. Really? Isn’t delusion fun. The fact is that prices did go up….and up…and up. As they say the market can be wrong a lot longer than you can be right.

All this creates a major dilemma for banks (who are probably aware, one hopes, of their position) and regulators who clearly are not (always happy to be surprised): How to withdraw leverage (which was a ponzi scheme) from the residential mortgage market without causing a crash? How to realise that we have been deluding ourselves as to the  ”value” of our houses. How can we explain that 169% rise? Did we suddenly become more wealthy? Er no our trade balance for the period March 2000-2008 was minus $30.7bln!!!!

No we simply revalued our property again and again for no reason other than the banks were happy to go with the valuations (also pushed it has to be said by overseas immigrants paying cash prices) which just kept going up. If house A in one street sold for 20% more then all the other houses must be worth 20% more. Housing became a commodity and so was able to enjoy the commodity style price action……….of course housing isn’t a commodity as people actually live in them. And that is what is keeping the market afloat…..but don’t look too hard at the numbers. They might make you wonder exactly what it all means.

More on that in the upcoming posts on debt and definancialisation.

So the chickens have finally come home. And now the Euro project is in harms way. Or is this just the next stage in complete sovereign consilience? It’s fiscal consolidation or that’s the end of the road.

The real problem, if you look hard enough under the falling limbs of the EU forest, is simply debt and its modern bedfellow, leverage. The financial binge of the last decade, built upon market deregulation in the 80s, has simply finished. Apres le binge, le deluge as they might say in Paris. A bad hangover is one thing but watching bankers get on the big white telephone is no fun at all.

The debt binge primarily was brought about not so much by low interest rates (though that helped) but by the belief that capital gain was guaranteed. Stocks always go up in the long run, property always goes up in the long run…..don’t worry about income, just borrow as much as you can and buy an asset. These financial assets have become a magnet for all investors and, naturally, sellers of investment products. I wonder how many people are holding derivative products which allow them to catch the upside of the stock market with no risk unless the market falls 50%….oops. Certainly Mr Buffet has a few of those.

The return to a time when people invested in companies based on their fundamental performance and bought houses to live in is long overdue. That people cannot afford to buy a home is without doubt the result of excessive lending by banks over the last 30 years. This is the root cause of the problem. Banks have actually created the inflation we have seen in financial assets….unearned income to be exact. That asset price inflation has seen real wages fall heavily over the years consigning the average wage earner or those unable to access leveraged credit to a lifetime of renting and debt.

The maths of excessive leverage is the simple maths of compound interest….compounded.

As Paul Volcker noted in this recent piece,

“There was one great growth industry. Private debt relative to GDP nearly tripled in thirty years. Credit default swaps, invented little more than a decade ago, soared at their peak to a $60 trillion market, exceeding by a large multiple the amount of the underlying credits potentially hedged against default.”

The bottom line is very simple: we have spent our GDP already….for many years hence.

Now it’s payback time. The payback process could take many forms: bankruptcy, forced asset sales or a slow descent back to a normalized level of activity – actually living within our means. Stripping away the financial sector so it works for people and business rather than conspiring against them will be the first requirement: not so much regulation as reengineering.

Whichever route we take it will be a painful adjustment made worse by the fact that those who are in charge are actually responsible for perpetuating the current system or refusing to question and change it.