What a great idea. It’s a shame no one has actually tried it out or bothered to let homo rationalus economicus that it’s an urban myth. We operate mainly in a state sponsored system of capital markets underpinned by arcane and often opaque trading rules and regulations.

The provision of capital is key to any functioning economy and has been since the beginning of time. Each empire had its own approach to coinage to support trade and the governing class or head of state. The first pillar of modern capitalism was established in 1694 with the formation of the Bank of England. Thus began the first stirrings of the fractional reserve banking system and the modern financial system.

I’ve previously covered the many bailouts experienced by the banking system and the Bank of England itself and in some ways our current malaise is no different. The central precept of free markets is that they should operate on their own merits – caveat emptor.

I’m not going to discuss that fallacy here but focus on the problems of bail outs. Why should a failing business be rescued by the state? The simple answer to that is when it has implications for the national economy or issues of national security (often regarded as twos sides of the same coin). We have seen the fiasco in the US, the UK and Europe. We have seen the banking system bailed out, private companies bailed out and yet we still hear the mantra of free markets, trade and market liberalisation and privatisation repeated.

Here in NZ we have seen South Canterbury Finance bailed out and most recently AMI. On both occasions the government intervened to provide capital from taxpayers for businesses which had clearly failed. In the case of SCF depositors were guaranteed under a standard deposit guarantee framework but bondholders also benefitted to the tune of $350m. Those bonds should never have been covered under a deposit guarantee scheme. Investors enjoyed a big free lunch here at the expense of the taxpayer. In the case of AMI, the government intervened to support an insurance company who didn’t have enough reserves on hand post the February 22nd quake. The government could easily make a good case for supporting AMI, in terms of providing it with backstop liquidity but in doing so it needed to be very clear that it was suspending any belief in free markets.

The moral hazard is clear but the implications have not been explored. On one hand the government wants to bail out private companies who are clearly responsible for their own position. At the same time they want to promote policies like privatisation because, wait for it, private companies are more efficient than public ones.

It’s very clear that the neo-liberal dream is in tatters but no one seems to want to wake up and smell the reality. Market morality is indeed quite hazardous.

There are some key human requirements for any society. We are lucky to be blessed by all of them: plentiful water, energy generation and food production. Any decent society with these assets should be able to provide them to all people at the lowest possible cost. Why? Because it can.

We are already well into a fight over NZ’s water assets and consumers are paying through the nose for basic food items especially dairy in which we are global leaders. Energy is also costing us more and more each year as the dysfunctional electricity market continues to fail.

Contact Energy has already been sold off to foreign investors with Australian energy company Origin owning 51%. Expect more pain in the pricing policy we have witnessed since this company was first floated. I have never understood the need for energy generation (water is even more inexplicable) to be a competitive process between private companies. Deregulation has not delivered cheaper prices and yet more privatisation is on the cards.

The deregulation of the 80s made was driven by a desire for greater efficiency and more dynamic management as well as the demand from financiers for new investment prospects. But change could have been brought about in different ways such as simply instituting new management, guidelines etc. It would be very possible to run a state owned company focused on providing electricity, in all forms, with the sole focus of the customer.

So instead of selling off more energy assets we should be thinking about changing the model. I favour looking at some form of  quota based allocation which comes at the cheapest possible price (a break-even number) with market pricing on top of that. These quotas could be traded (as in DTQs 0r Domestic Tradable Quotas) as part of a generalised carbon trading scheme. But the important issue is that energy is a basic human need and in New Zealand this can and should be provided at the cheapest possible cost. I do not believe, and have seen no evidence, that the current system delivers this.

We should also address the silly argument about “mum and dad” investors. Please no more of this patronising label. Lots of people are investors, not just these mythical and no doubt unsophisticated “mums and dads”. But let’s point out the very obvious hole in this argument. We already own these companies, yes us taxpayers, mums, dads and bubs…we own it already so why do we need to re-buy into it? plenty of money for the investment banks involved in the float (they have been pushing this for ages). More importantly there will be losers: low income people who simply could not afford to buy into the share bonanza….it’s just another process for transferring wealth from low to high income earners. This will look great for some but ultimately we all lose in the end and inequality is further increased.

Privatisation is only going to make things worse. It’s time to put people before profit.

Sorry John, there is an alternative.

I guess we can call this Basel III or maybe a souped up Basel II. Who knows? When you have an inherently unstable system any new plan for control is likely to end up in the round filing cabinet before it has a chance to be implemented.

But one thing is clear from the latest global pow-wow: monetary stimulus will remain in place for some time as extra tightening through higher capital requirements sucks in more capital. With all the talk of recovering economies and poistive GDP reads in some countries, it is easy to forget the amount of wealth that has been sucked into the black hole of balance sheet never never land.

Who would be a bean counter these days?

It reminds me of the time I was working on the ticket sales operation for the Brisbane Expo back in 1988. It was a $60m take and I was drafted in to make the numbers balance. It was a lot of fun and eventually I got to the point where I had accounted for everything but there was still a pesky $110 I couldn’t reconcile. It simply didn’t make any sense to me but in the end I just gave up and figured it didn’t matter that much.

Now the numbers seem a bit larger when it comes to bank meltdowns. We have a long way to go before we actually can understand where the money has gone, who owes it, who lost it and what the actual impact on the supply of money is.

So in this case G20 are spot on. Deflationary forces abound. I have no worry about inflation at all. Sure we will keep seeing short term rebounds in some statistics and small sighs of relief. Let’s face it, the markets ahve had an enormous rally in the last 6 months. But do they reflect the underlying reality? Nope.

That’s because the crevasses have been papered over with huge swathes of new paper. But underneath they lie there waiting for some poor fool to fall in again. Slowly it feels like the bankers are starting to understand that they let credit growth go bananas and that their carefully constructed inflation numbers didn’t always tell the truth about asset prices.

We still have major systemic problems to deal with. Tightening credit will cause severe pain but low rates will help ease some of that. But catching the tiger by the tail is the only way forward.

As I’ve discussed before there is a major shift underway in the way the global market is structured. Not just in terms of currencies but also trade and influence. The BRICs have a powerful case to make: 40% of global currency reserves and almost half the world’s population (though Russia’s population is declining, a somewhat serious issue).

There is a strong feeling that the US has acted recklessly overt he last 30 years in flooding the world with $ and creating huge imbalances which have caused such chaos in global markets. So whilst there is always plenty of posturing and grandstanding, especially from the Russians, there is a real case for the US to answer:

- Global trade imbalances.

- Cowboy capitalism.

- Turbo boosted monetary expansion.

- Instability in global financial markets.

It’s also interesting that the meeting of the SCO (Shanghai Cooperation Organization) was held at the same tim and the US was not invited even though it wanted to attend. There is a strong argument that there is no real alternative to the $ but that doesn’t excuse the facts. One dominant currency has not helped create a stable system. It has simply allowed to issuer to experience huge profits from seigniorage and wield extraordinary political and economic power.

And can we really take the rating agencies seriously? They are all US based organisations. Ultimately whether the $ loses influence or not depends on the alternatives. I still believe a commodity backed currency is a likely development, given the nations involved.

At the same time the development of local currencies will help create a more stable and complex system. For now though expect more talk about a $ alternative and expect it to be driven by the BRIC crew starting with the upcoming G8 summit in Italy.

In the last few months we have seen markets bottom and even recover some poise, aided and abetted by the action of nearly last resort, quantitative easing. There was nothing left in the toolbox really.

So far so good in some respects. The S+P has rallied 37% off its lows…….mind you its lows were 57% down from the highs and the index still stands 42% off the highs of the last few years. Not that the numbers really matter. The main news is that markets are functioning…still.

And the $ balloon has finally burst with QE signaling a chance to sell the $ without worrying what the equity markets were doing. The Kiwi$ has rallied 32% from its March low even outpacing the hammered Pound, up 21% from its low of $1.35.

Markets can do very strange things. Even whilst the $ was rallying to extreme highs against all currencies, no one really wanted to own it. Now people really really don’t want to own it.

This is all very well but this type of volatility is impossible to manage. How can any investment manager talk about average returns of 10% a year when markets are moving at this rate. How can any business hedge currency risk when currencies are moving like this.

The bigger problem for the US is trying to stop the snowball effect that may happen if markets really decide to dump the $. The noises coming from China may be regarded as monetary brinksmanship but with Russia, looking very wolflike these days, nibbling in behind, it’s becoming a more serious issue.

There’s a lot of politics involved in this but the positioning is clear: the US is weak not just economically but militarily. The exhausting foray into Iraq has stretched the US war machine as well as seriously impacting on its reputation. Historically the ability to create coin or currency was usually backed up by military power. One of the first actions by invading nations was to replace the local currency with its own.

This makes currency both a political and economic issue. So whilst there is unlikely to be any immediate change in the $ role as global reserve currency, there is no doubt that the dance of change is underway.

The short term problem for China is its huge ownership of US bonds and other paper. So they wouldn’t be happy with a complete collapse right now but it seems like less money will be staying in $ and more will be finding a new home whilst they work out how a new global currency system might operate.

But with GM falling apart and US unemployment rising to severe levels, concerns over the health of the $ will only continue to mount.

Of course in a case such as this the ending barely surprises. In fact we never seem to be surprised at how excess and gluttony ends in tears. So perhaps its normal like a child who has too much ice cream, sweets or cakes. We know the ending but somehow stand by and watch because ultimately the child has to learn.

Nothing much really changes though.

The financial warriors of the ice nation rampaged through the European bazaars picking up companies like confetti. A sad tale signifying what? Same old, same old.

Th reality is that we always succumb to the bubble. It’s in our nature, it’s part of our make-up: a relentless and cored belief that somehow it’s all going to work out and we will have something for nothing.

And even in the deepest mess that is the US financial system crazy stories still appear. John Thain and his $40k or whatever toilet. Nice.

Nothing is new. Nothing has changed. It’s just bigger and makes a lot more noise.

As Frank Rich mused on Obama and the End of the Gilded Age,

He spoke of those at the economic pinnacle who embraced greed and irresponsibility as well as the rest of us who collaborated in our “collective failure to make hard choices.” He branded as sub-American those who “prefer leisure over work or seek only the pleasures of riches and fame.” And he wasn’t just asking Paris Hilton “to set aside childish things.” As Linda Hirshman astutely pointed out on The New Republic’s Web site, even Obama’s opening salutation — “My fellow citizens,” not “fellow Americans” — invoked the civic responsibilities we’ve misplaced en masse.

Let’s face it we all want to make loadsamoney……on our houses, investments, crazy schemes…..but the truth is it’s just a facade. But like Versailles it will linger on in our minds for years to come.

Well his mani point is that markets do not tend towards equilibrium but can be quite extreme in their pricing. I completely agree with this. But do they alwats revert to an equilibrium point? I think so but unfortunately for many it’s like an elastic band. It either rebounds on you causing a sharp pain or actually complete explodes.

This leads us to the greatest maxim of trading and investing: buy low, sell high.

The best traders are those who are completely detached from the instruments they trade. The ego is removed and there is no emotional investment about being right. But markets move on emotion of crowds since that is what the market is. The market can also be seen as a system in which intentionality is the main driver. Yes the fundamentals (price, yield, forecasts) play an important part in determining a basic price but it is the intention of the market, whether to buy or sell, that really drives the price.

So stock markets happily trade a twice their preceived fair value earnings. Currencies happily trade at a huge premium or discount to perceived fair value. Why does this happen? It’s simply the collective outcome of countless intentions.

And many fortunes have been lost betting against the wisdom of the crowd.

Soros suggests regulators have a part to play here in smoothing or preventing bubbles. He says that the control of the money supply itself is not enough but that credit conditions need to be managed. In essence this is the same thing depending on how you view the money supply.

He thinks margin and capital requirements for banks should be used to make credit less or more available.

He’s right to a point. But he missed the real problem which is the creation of the money supply by the banks.

Banks control both the money supply and the supply of credit . How? Well nearly all money is credit.

Now there’s something for Geroge to get his teeth into.

A $50bln ponzi scheme. It’s so daft i can’t bring myself to write about it. As usual others cover this story better than I could. But it seems the US financial markets are receiving the greatest hosing out since Hercules cleaned up the Augean stables. There is no doubt more to come as rogue players just fess up and come clean. This may take some time as the initial reaction is to close ranks and pretend everything is fine.

The unveiling of dubious credit structures over the last 18 months is way overdue and may at least provide an opportunity for another look at how our money system works. Bubbles come and go, part of human nature, but never has a bubble so exposed the inner workings of the banking system.

The giant hubris of “tamed inflation”, “end of history” and “the end of boom and bust” has been exposed for the posturing it always was.

Time for a major serving of humble pie all round. But will those in power get down and start eating it?

The BBC has provided a platform for Sir Evelyn de Rothschild, one of Britain’s most noted financiers, to express his views on the global financial situation:

All of us – countries, corporations and consumers – have neglected basic principles.

Ethics – we have lost sight of an honest day’s work for an honest day’s pay.

Careful management – we have indulged our wants without the taxes or the prices or the cash to pay for them.

Oversight – public relations and spin have replaced disclosure and transparency; casual yet complex accounting and accommodating rating agencies left us blissfully unaware of the problems, and we revelled in our ignorance.

Hubris has replaced community responsibility as a requirement for executive positions.

American automobile executives and British bankers have been unable to form their lips into an apology.

Yet their institutions lie in ruins and the rest of us are left feeling embarrassed for them.

Their customers worry that their savings or their working capital will just vanish, their mortgage will be transferred to a new institution they have never heard of.

Their employees wonder which of their colleagues – or they themselves – will be unemployed in the coming week, with bleak prospects for working again anytime soon.

Where is the shame of those who only months earlier boasted of ever increasing profits, of ever more clever products, of ever easier loans?

Remaining credit

The US automakers may be the worst of the lot, so far.

Years of incompetence and now manoeuvring in the halls of Congress for a massive bailout.

Management prefers to hold onto private corporate jets rather than push for fuel efficiency standards to make their products more competitive.

Union members would rather hold onto their gold-plated pensions for life than to save their companies.

Why should taxpayers help those who have so frequently refused to accept responsibility themselves?

If the US government uses up its remaining credit to help the auto industry carry on as usual, who will lend the country the money to repair its bridges, build its power stations, clean its water, fuel its navy?

Slow revival

Thirty years ago, New York City found itself in a position similar to GM, Ford and Chrysler today.

They asked Washington for help. The government refused.

The Daily News summed it up in its front page headline – Ford to City: Drop Dead [ed. the president]

Instead New York balanced its budget, taxed itself, reduced hiring, negotiated better labour contracts and gradually worked itself back to fiscal health.

It took more than 10 years.

Take responsibility

This era of struggle may last as long.

Until we can be generous in accepting fault for our predicament, we will have difficulty dropping our suspicions about others so that we can get on with repairing the damage.

Unless action is taken soon, we can only see a long time of difficult and very onerous problems continuing.

Could be one or two years.

It is therefore essential that management must take a firm look at its problems and accept its faults and redeem them.

A lot of talk and a lot of words have been written.

But in the end action has to be taken and action must be taken very soon if we are not going to see this stretched out over many years.

What we have to remember is that the crisis we are in the midst of is a financial one. A crisis of the syntheticism of money.

Like a cancer this is slowly being removed from the system. What is left of the corpse remains to be seen. But the end of the derivatives trade, especially the highly structured piece, cannot come too soon.

The role of interest (unearned income) in our economy needs to be reviewed. We need to refocus on the productive economy and the ability to invest in it i.e. by purchasing shares in companies are receiving dividends or, in the case of new innovative companies, an opportunity for capital gain commensurate with risk.

My own investment philosophy is simple. Buy low and sell high.

When interest rates (here in NZ) were low in 2003 i bought commercial property which was then yielding 9% (against an interest rate of 6.5%). In 2007 when interest looked like they were going higher (over 9%) I sold the properties which were then yielding 7.25-7.5%).

The market kept going for another 9 -12 months and has now fallen heavily.

I didn’t buy shares as dividend yields were lower than interest rates and p/e ratios were too high.

I put the cash in the bank.

Now I have started buying shares. Why? Because dividend yields are sky high (although earnings will continue to fall), p/e ratios are in single digits and interest rates are falling. Shares could keep falling for sure.

But the point I’m making is investment is pretty simple. Ignore the hype and focus on the numbers.

The hardest skill to learn as an investor (and we are all investors to some extent) is knowing when to sell. When the market is flying high its so hard to sell because you worry you’ll miss out on more. When its falling you secretly hope it will somehow bounce back.

As Evelyn reinforces, its all about basics whether values, ethics or simple strategy.

We’ve been living in a fool’s paradise for a while now and its time to get back to reality.

Buying a house used to be so simple. 2-3 times your income or 3-4 if you had joint ones. This was before the days of the grand pyramid scheme known as financial deregulation. The formula was fixed at a level that had been shown to be affordable.

So what happened to the simple model?

This quote may explain it.

It’s from a piece on the sub-prime web by Michael Lewis of Liars Poker fame,

“He called Standard & Poors and asked what would happen to default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative number. They were just assuming home prices would keep going up“, Eisman says

Nice one. This idea, that things keep going up, seems to have become instilled into our eco-social fabric. Buy houses, buy stocks….they always go up…..well at least in the long run.

The dreaded long run that usually ends in death, mercifully for some.

With a belief system like that it’s no wonder that the recent crash will go down in the annals of history alongside the South Sea bubble, Tulip Mania and the Great Depression.

But really it’s quite simple: learn to trust numbers. They never lie.