The Big Lie

Yesterday's Goldman Sachs results have been illuminating. The investment bank that everyone loves to hate produced record returns for its shareholders (and management) with a quarterly profit of USD 3.4bn . Its prowess in financial markets trading is unparalleled in the finance world and they certainly deserve it...or do they?

An institution that was on the verge of bankruptcy just nine months ago and required public financial assistance is now producing record profits and paying oversized salaries to its top management. It seems that many financial institutions will follow suit in the coming quarters. Where are the returns on the public investment?

The “Big Lie” that we have been fed by a compliant press is that the stimulus packages which have been implemented in major economies were designed to support the real economy. In fact, these packages have been used primarily to prop up the banking system, a worthy aim in itself had not the main beneficiaries been shareholders, bondholders, and management. In plain English, taxpayers have had their pockets picked to support investors and top management in financial institutions.

I think that no reasonable economist can disagree with the need for the government to step in to save the money centre function of banks by safeguarding retail deposits and clearing relationships, but I can see no worthy use of taxpayer funds in supporting the financial rewards of institutional investors and management. The latter, after all, are trading risk for return. In 2008, after many years of return, risk reared its head and proceeded to destroy the value of financial instruments in a violent and unprecedented move. In my opinion, it is only fair that financial rewards for shareholders and management should have been wiped out. It is a basic premise that owners and management are responsible for the actions of the financial institutions they control.

Not content with direct assistance to the industry, monetary authorities have also stepped in to ensure that banks quickly start making money. How is this achieved, you may ask? It is as simple as enabling the carry trade...central banks have flooded markets with liquidity so that short term interest rates have collapsed. Banks can then borrow cheap short term money and lend longer term without taking on much risk. Call it a licence to print money.

Ostensibly, the policy of cheap money was designed to save the real economy but I don’t believe that a real investment project is sensitive to rates at levels below 5%. The only institutions that measure returns in basis points are financial institutions, given their high leverage and portfolio of financial assets. The fact is that rates have been reduced with massive liquidity injections because they assist in the repair of banks’ balance sheets by providing access to carry trade income. Again, governments have used public policy tools to protect well connected shareholders and top bank management.

Further evidence of mis-use of public funds is implicit in the conflict of interest of regulators. Ask these questions: How many of the financial sector regulators own or have friends/relatives that own substantial stakes in bank shares? Are they chummy with top management or do they get access to perks? I suspect that regulators are responding to hidden incentives in many instances....help your friends and they will help you; with a job in the future, or maybe access to holiday homes, yachting holidays and “business” opportunities.

In Spain, the lack of freedom of press has led to few and far between debates about the convenience of using tax-payer funds to save bank shareholders and stakeholders in Cajas. When referring to stakeholders, I include management and the political establishment which has benefited from the largesse provided by directing savings from depositors. Much in the same way that industrial companies used to own banks in order to provide cheap funding for their industrial activities, politicians have continued that ancient tradition to channel funds to pet projects. The lack of debate regarding the recent restructuring fund set up by the government has been egregious.

We live in a world in which society at large has been skimmed to pay for the returns of stakeholders in banks: so called sophisticated investors and management. Once more, prudent economic agents have had to bail out the aggressive imprudent agents, reinforcing the moral hazard which will inevitably encourage the next financial bubble under this “let’s socialise the losses and privatise the profits” policy.

Spanish party politics...and I'm not referring to "fiesta"

Let’s take a look at why Spain is going the way of Citigroup. I think it is important so that once the crisis is over, politicians and institution builders are able to recall history and avoid past mistakes.

First, the Spanish political system is reminiscent of nouveau riche antics. It was developed and executed in the latter part of the 1970s, when the combination of ideological enthusiasm and democratic inexperience led to the creation of a political system that has outlasted its usefulness. The ideologues of the system wanted strong parties, regional representation and democratic principles as the basis of the system. Over the years, strong parties and regional representation have cast out principles-based management to create a system that is on the verge of moral bankruptcy. Check out this link:
http://www.elpais.com/articulo/opinion/maquiavelico/sistema/electoral/espanol/elpepuopi/20080216elpepiopi_11/Tes

Today, over 30 years after the death of Franco, the key indicators of health of a democracy such as voter turnout and strong independent institutions are weaker that at any time in recent history. A primary reason for this democratic deficiency is the Spanish electoral system. Numbers always help; let’s look at the results of the March 2008 elections (click on image):

Several conclusions can be drawn from this table. The first column in red provides the percentage number of total seats assigned to each party. Note that PSOE and PP each were assigned 48.3% and 44% of the seats, despite obtaining only 43.9% and 39.9% in number of votes, respectively. Note also that Izquierda Unida was assigned only 0.6% of the seats despite obtaining 3.8% of the popular vote. Therefore, large parties and strong regional parties are over-represented, which inevitably leads to under-representation of dispersed national parties such as Izquierda Unida and UPyD. Another disturbing fact is that 4.1% of the people who voted had no representation whatsoever. When you add this voter base to the 24% of registered voters who abstained from voting, an astounding 27% of registered voters are not represented in the Spanish parliament. Surprised?

Spain has 52 electoral districts (or circunscripciones) with 2 representatives allocated to each and 248 distributed on the basis of population, for a total of 350. The d’Hondt method of seat allocation ensures that the strong candidates within these electoral districts get elected. As a result, strong national parties and regional parties are over-represented in contrast to parties which have a voting base spread across all the electoral districts. The d’Hont method works like this:

-Within each electoral district the first seat goes to the most voted party
For calculation of the second seat allocation, the party that obtained the first seat divides its number of votes by the number of seats obtained plus one (i.e. two).
-The second seat is then allocated to the most voted party (note that, under 2 above, the party that got the first seat has halved its votes for calculation purposes)
-For calculation of the third seat, the party that obtained the second seat divides its number of votes by the number of seats previously obtained plus one (i.e. if it is the same party that got the first seat this would be three, otherwise it would be two)
-The process is repeated until all the available seats are assigned.
-For mathematical minds the test for allocating each seat is based on: V/S+1; where V= number of votes and S=seats previously obtained

Therefore, we have an electoral system that is not representative, at least for many people. Strong parties and regional parties have run the country for 30 years and made it what is now, a nation which is close to becoming a banana monarchy.

To add insult to injury, a closed list system has also been implemented. In closed list systems the party has pre-decided on who will receive the votes in the elections, that is, the candidates positioned highest on this list tend to always get a seat in the parliament while the candidates positioned very low on the closed list will not. There are no prizes for guessing to whom candidates owe their loyalty. It’s not to the voter.

The outcome of this electoral system is plain for all to see, yet the players involved have no desire to change a system that works to their benefit. Why would the PP or PSOE want to change a system that allocates them disproportionate influence? Regionalists, in turn, have wielded their power in national politics to force the central government to transfer power to the regions, regardless of whether this was efficient or effective. Why would the regionalists want to change this system?

Therefore, it is highly unlikely that the system will change, unless a political crisis forces change and the current economic and financial crisis seems to be brewing future strife. Our current rulers have managed to dispense enough mortgage debt and football entertainment (“panem et circenses”) over recent years to keep the populace quiet, but as defaults soar incentives will change....and they call this a democracy.

From the fire into the frying pan

As I reflect on the course of action that governments around the world have taken in addressing the current financial crisis, I realise that there is something profoundly disturbing in these actions. If the underlying problem is an investment bubble financed by savings which have been invested into projects that are based on wildly unrealistic expectations, then shifting these inflated assets from the balance sheets of the private sector to the balance sheet of the public sector is not going to solve anything. It will buy time for a short period until investors realise that the underlying premises which supported the valuation of these assets are still as wildly unrealistic as they were before, only now a government guarantee has been slapped on. Governments, however, will still have to pay for the bill... and how will they do that? As little, if any cash will be forthcoming from these investments, my hypothesis is that they will either: (i) eventually raise taxes or (ii) print money which will lead to inflation (another form of tax). As a consequence, the losses will have been transferred from those who held the risk of these inflated assets to society at large.

Losses, like the previous 15 years of profit, should accrue to those that took the risk in investing in these assets. Share and debtholders in financial intermediaries should be wiped out where appropriate, shareholders in general should also suffer from the new revised valuations, and real estate should similarly adjust (these are, after all, risky assets). The necessary wealth destruction and consequent deleveraging should take place, fast. I suspect, further, that bearing these losses will not lead to serious social unrest as most of these investors have alternative sources of wealth. The only part of the financial system that, in my opinion, merits government intervention is the payments system and commercial bank accounts. Another possible alternative, if the level of uncertainty is such that a liquidity freeze sets in, could be for the government to set a floor at, say 25-30%, of peak prices in certain markets. It is highly unlikely that this level would ever be reached but it would provide support and comfort to an unstable market.

On the economic side, I concur with the idea that governments use their borrowing capacity to undertake investment projects which can have an effect on productivity; primarily infrastructure investments . These projects can act as a cushion on reductions in aggregate demand, temporarily alleviate unemployment and promote future competitiveness. Eventually, however, reality must kick in and economic players (capital and labour) will have to adjust to lower returns, or, better still, a new productivity model will have to be found. If the right incentives are provided, I have no doubt as to mankind’s ability to develop another groundbreaking development. Just think how much the world has changed (positively) in the last 100 years.