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The Fall Guy is in Place for the Next Financial Crisis

By Vinay Kolhatkar

February 3, 2015

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A con game is being set up—some regulators are smart enough to know that the next crisis is unavoidable, so a decoy, a Fall Guy, has been set up that absolves them of blame.

In late 2014, financial regulators began issuing warnings via mainstream media that there is a whole industry—they called it “Shadow Banking,” which threatens the stability of the global financial system. Shadow banking is banking, except that it is outside the direct control of financial regulators.

The initial illusion is that the real story is in the subtext: “Give us more control over Shadow Banking otherwise we could have another global financial crisis.” However, no request for such control is spotted. So, keep peeling the onion, and one may perceive a con game being set up—some regulators are smart enough to know that the next crisis is unavoidable, or at least highly likely, so a decoy, a Fall Guy, has been set up that absolves them of blame. Just in case.

To arrive at what seems like a conspiracy theory, one must first discuss fundamentals.

So what exactly is a financial crisis?

Whether we are focusing on a single corporation, or an entire sovereign economy, or indeed, even the world economy, a financial crisis is a reflection of an underlying malaise.

To understand that, let us look at a simple illustration: Assume that a corporation is solely in the business of owning and leasing out $1 billion worth of container ships. In one unfortunate accident, $300 million worth of ships sink. The salvage operation is uneconomic. There is a loss of $300 million of wealth. Someone, somewhere, must bear the total cost. It could be the insurer. If the ships were uninsured, the corporation bears that loss. If the corporation is funded with equity alone, the equity holders lose 30% of their value. If the corporation is funded with 20% equity and 80% debt, it is insolvent, and even the debtholders have lost one-eighth of their value.

The underlying malaise is that valuable ships have sunk. Somebody’s financials, in aggregate, must reflect that cost. The loss of the ships is the economics of it. Financial statements need to reflect the real-world economics.

Was the 2009 “financial crisis” an economic crisis? Yes.

The economic crisis in 2009 was not set off by asset destruction. However, overinvestment in a sector causes value loss. If social engineering causes more houses to be built than can be economically justified, eventually reality steps in, and the capital stock loses value.

Now, in a free and dynamic economy, value shifts often occur. When rent-paying, physical-location travel agencies lose business to internet-based offerings of the same service, there is a value shift, but not a dead loss. In the years leading up to 2009, there was an absolute value loss. Once the deadweight value loss had accumulated to the point where the bubble burst, it had to show up on financial statements somewhere. Banks that instigated the overinvestment at the Government’s behest, took some of the loss themselves, palmed some off to investors who bought into that risk, and sold some of it to Government agencies that underwrote that risk. The sum total of “someone, somewhere” must bear the aggregate value loss in some proportion.

Can banking create large value losses?

Shadow banking that concerns the regulators is in the business of making loans to those who invest. Certainly, banking can facilitate mal-investment. However, banks, shadow banks, and their clients are not in the business of creating losses. Losses are unanticipated outcomes, the cost of operating in a dynamic economy.

Can derivatives create a net economic loss?

A derivative is essentially a wager. If I bet you, $50 that it will rain in Chicago tomorrow, and it doesn’t, I lose $50, and you gain $50. That’s a zero-sum game. Some wagers between banks, shadow banks, and their clients are exceptionally large, but in a credit netting system, their outcomes are netted off; in any event, they can only create large transfers of wealth and value.

So what can create large, widespread, unanticipated losses of value?

It is the Government, which sets up a favoritism system, and the central bank, which bastardizes interest rates, which create conditions for endemic net value losses.

Those then are the fundamentals.

But what’s the narrative out there?

The IMF released its Global Financial Stability Report in October 2014. In November 2014, the G-20 Financial Stability Board (FSB) released a data-rich report on Shadow Banking.

News outlets from the Guardian to the New York Times, from News Limited to the Australian Financial Review, pounced on both reports. As recently as 14 January 2015, Bloomberg was reporting, “The scale of it [shadow banking] is almost unfathomable: $75 trillion worldwide. The Financial Stability Board says it poses “systemic risks” to the global financial system. It’s growing at phenomenal rates in China and India and booming in Western banking capitals as well,” and, further, “With so much money sloshing around outside the official system, shadow banking makes it harder for countries like China and India to control their economies by changing interest rates or jiggering the money supply.”

It was just too easy for news outlets to pick at the salacious, newsworthy bits and send out exactly the messages that the regulators wanted to, which were:

  1. Extensive use of the word ‘shadow’ to connote shady or obscure activities;
  2. Shadow Banking caused the 2009 financial crisis;
  3. Shadow Banking could cause another crisis not only because regulators can’t supervise them, but also because they thwart the do-gooder monetary policy; and
  4. Clamping down on this activity to prevent future risks is warranted, but is prevented by the superrich folk behind these schemes, and fierce lobbying by the financial industry.

Now that’s the narrative. But what’s the truth?

  1. It’s no longer called non-bank financial intermediation, or even non-bank credit, yet virtually all definitions (See IMF Report Chart 2.15) place it precisely there, encompassing everything from money market funds to hedge funds, from securities lending to securitization vehicles. Many of these vehicles were started by banks themselves, to escape the constraining regulations imposed upon them, or to offer decent returns to savers;
  2. A financial crisis is always an economic crisis. The 2009 economic crisis was caused by a raging overinvestment in real estate, triggered by the U.S. Government’s social engineering;
  3. Some non-bank institutions are taking on illiquidity risk without central banking support. However, widespread insolvencies in financial intermediaries do not cause a crisis—they are the visible symptom and consequence of either value or asset destruction; and
  4. The IMF report recognizes that economic growth is facilitated by the circumvention of too-low interest rates and excess regulation, and acknowledges that regulators themselves are thus rightfully wary of expanding their regulatory boundary.

So will there be another global financial crisis?

The short answer is yes.

If not shadow banking, what will cause the next global financial crisis?

Sovereign debt. Over US$61 trillion of debt stands issued by major world Governments. On top of that, there are guarantees, non-sovereign state, provincial, city, and county debt that add substantially to the burden. Since the bulk of the money is not invested in any current or future income-producing asset, it is, economically, unrepayable.

Imagine a manufacturing corporation, which has issued large amounts of interest-paying debt. But instead of investing in plant and machinery, it donates the money so raised. Even if the donations are, in the perspective of some, to noteworthy causes, like subsidizing healthcare, and sponsoring the arts; for the corporation, the day of reckoning is inevitable.

For each sovereign, however, there are three ways out of this situation:

  1. Austerity
  2. Default
  3. Theft

One is the “lose office if in Government” scenario (e.g. Greece, Queensland) and Two is an instant panic, riots-in-the-streets, scenario. In Austerity, the return-budget-to-surplus pain hits those who lose benefits, and those who lose income via unemployment. Default hurts the institutions who invested in the government bonds, and they pass the damage on to specific, identifiable investors. Theft is executed by cheapening the currency, as the U.S. Federal Reserve and the ECB are currently undertaking—taking value from savers, basic-goods-biased consumers (the poor), the old, and the unemployed, to repay bondholders in nominal terms. In Theft, the precise spread of pain is unpredictable.

Nevertheless, whether Austerity, Default, or Theft—the mechanism does not alter the fact that someone, somewhere, (in aggregate) will bear the loss of value that has already piled up. Then the media will look for blame. And the agencies that can foreshadow this occurrence, have set up the perfect Fall Guy for the media narrative: Shadow Banking—the shady sharks of high finance, the wheeler dealers, the derivative contracts, the clandestine lenders that actually try to give savers a true interest rate, the unlit operations of the hedge funds operating out of the Cayman Islands.

With strident righteousness, the derelict mobsters—politicians, central bankers, and their sycophantic economists, will make their getaway, and start pouring the next round of a heady drink called Stimulus.

This time, many more than a few innocent practitioners, the Fall Guys, quickly tried and condemned by the court of brainwashed public opinion, will land in jail for decades. Overzealous prosecutors, anxious for trophy heads, federal judges, as ignorant of economics as they are knowledgeable of law, and mainstream media, playing to the public outcry baying for blood, will unleash a bloodcurdling symphony that will make elephants stampede and send tigers scurrying back into their dens. It won’t help that some of the Fall Guys will have broken a law or two; one, maybe two, will even be guilty of fraud. An entire industry will be tainted. With strident righteousness, the derelict mobsters—politicians, central bankers, and their sycophantic economists, will make their getaway, and start pouring the next round of a heady drink called Stimulus; it was the tonic that flattened the Roman Empire.
 
Groundhog Day, replete with déjà vu, beckons.
 

 

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