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Talk : "The Broken World of Finance"

presenter: Dermot Smyth

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You can download Dermot's notes here Broken world speaking notes.doc )

The broken world of finance: talk notes

By Dermot Smyth: Member of Socialist Workers Party (personal capacity)

and member of Positive Money Campaign (personal capacity)

Yes, the financial system is broken – from point of view of:

Us – the 99%  – millions have lost jobs, pay, working conditions, pensions, their homes, benefits – under the name of austerity.

The crisis was triggered & is maintained by the financial crisis.

Relationship between Positive Money and investment banking

I’m going to extend Positive Money’s ideas into investment banking.

Synonyms: global (high) finance – investment – casino – shadow banking.

PM generally uses high street (retail) banking:

• To expose how new money is created by private banks with every loan.
• To propose banning leveraged loans altogether. Excessive or not.
• To allow banks to fail safely – no more too-big-to-fail banks.

Same principles apply  in investment banking – plus extra complications.

Real economy

In academic economics – real only much used in narrow sense. (E.g. real wages have increased 10% - inflation adjusted.)

Real economy used more widely in the media and by Positive Money – and it is useful but a rather loose term.

Definition of real economy:

• Physical production and consumption of goods and services.
• Plus high street banking: Cash in circulation – current A/Cs – instant access savings A/Cs. That is – any money that is not more than one step removed from production and consumption of goods and services.

Start in a high street bank (real economy bank).

£100,000 Loan (house or new machine in factory)

There are 2 A/C’s at the bank. The sum of £10,000 is typed in twice:

Current A/C                                                (New) loan A/C

+ £100,000 – in credit                               - £100,000 – a debt

Is the loan ‘zero-sum (game)’?

It appears to be. The positive sum on right balances with the negative sum on left. They cancel out. Algebraic sum is zero.

But:

The positive money goes into circulation – where it is spent/earned/spent/ earned…

The debt sits there – until repaid – then both disappear. Apart from the interest.

In its banking context, the overall effect is not symmetrical. It is not zero-sum .

Positive Money focuses on the credit side.

But, what happens to the debit side? Does it just sit there quietly (sleeping?) (Reference: the film, Wall Street: Money never Sleeps).

No. The £100,000 debt is entered under ASSETS on the bank’s annual accounts.

It can then be used as collateral (security) for borrowing money.

It can also be traded directly in markets that exist for that purpose.

Example: the now notorious CDOs (Collateralised Debt Obligations) used in the sub-prime mortgage scandals of the 1990s and the 2000s.

CDOs are derivatives – bundled together – like the barrow boy’s apples, the bad ones are hidden behind the good ones. They are bought and sold.

Enter – investment banking

Widespread belief that this is a ‘zero-sum’ game. Mervyn King said so last year.

Again, it appears to be zero-sum. Yes, some investors make money, others lose the same amount – which cancels.

But

borrowing to invest – new money enters – so investment banking is not zero-sum.

Also – existing money enters the financial system from the real economy.

Total quantity of traded capital tends to inflate.

Causes of the crisis – not just individual/corporate – but systemic.

By 2007-2008 all of the following had become normal, accepted features across the whole sector.

There is a long list of popular systemic causes within investment banking in addition to the features of Positive Money mentioned above. Examples

• Weakening or complete abandonment of regulations.
• High-speed, computerised trading.
• Derivatives – secrecy, complexity encourages deception.
• Macho, competitive culture – leading to excessive risk-taking.

• Salary and bonus incentive structures that encourage all the above.

Doubts? – see the dozen books by Michael Lewis – deception & fraud (legal) 

E.g.: Liar’s Poker (1989) – Big Short (2010)

These popular causes certainly exacerbate or accelerate the problems. But they are not root causes.

4 better contenders for systemic roots of crisis:

In global finance:

• Overall size of debt outstanding
• Unknown & unknowable – but certainly large – amounts of bad debt
• Interconnectedness of the world’s investment banks – terrifying.
• Borrowing to speculate – new money entering system continually.

Estimate, 2009 Robert Peston,: Total world bailout for banks $15 t (est.)

Total write-offs and write downs?? $15 - $50 trillion.

Much of the debt shuffled around rather than actually taken out of the system.

Size of problem

See: £billions & £trillions & $quadrillions on the MONEY STACK SHEETS.

Economic causes

Not merely the usual boom/bust cycles – 1950s-mid 1980s: global average company gross profit rates in “real economy” fell from 15% to around 5% (very approximate).

Crisis not caused by, but  it was triggered from within investment banking. The root cause was/is within the real economy.

Financialisation of the capitalist system?

Controversial – significance of global finance? – is it a new system?

Financialisation certainly happening – new level dominance of the money markets.

But, it is not a new system.

Example – USA – in recent years – around 50% of corporate profits in the manufacturing sector came from playing the money markets with their famous cash piles. More than 50% in one year.

But – this is not a new economic system – the same people are involved in the real economy as in investment banking.

And/Or – they work closely together – new methods of making money are added to – and integrated into – the old ways.

Investment banking (AKA shadow banking or casino banking)

Biggest single problem is borrowing to speculate.

Creates too much capital. This effect is magnified according to the leverage ratio. This creates massive uncertainty: is this asset actually realisable? Or is it toxic debt – bad debt?

Speculation vs. investment

Speculation makes investment banking like a casino – a metaphor.

Some types of derivatives are a casino – no metaphor – literally.

Derivatives 

(All these funds and schemes are known as ‘financial instruments.’ – sounds like a torture device!)

These are funds or transactions that derive from the price of an underlying stock or commodity – but nothing ‘real’ is actually bought or sold. Big debate about what they are, where the borderline is between derivatives and normal trading and whether they are harmful or not.

Short-selling (betting that the price of a stock will fall in price)

• A trader borrows (or hires) shares with the permission of the owner. These are returnable on demand. The broker keeps a record of what is available and what is already out on hire. A small fee is paid to owner of stock.
• The trader then sells the shares to a third party, who is typically unaware they are not actually owned by the seller. If the price falls, the short is successful.
• He can then buy the same number of shares on the market and return them to the original owner and pocket the difference. If the price rises, the short loses money.

But it gets worse:

Naked short-selling (or synthetic trading)

No shares need be actually bought, sold or even borrowed. Nevertheless, two individual players (their name for themselves) agree on a specified batch of shares, agree a certain future date and agree a price. When the date comes, they settle up according to who would have made a profit had the stock been actually traded.  

This is risky as everything needs to be sorted out before the end of the clearing term.

No connection between the two parties and the actual stock. Just like going to the races and betting on a horse. Literally.

Hong Kong made naked short-selling  a criminal offence in the wake of the Asian crisis in the late 1990s. Officials there believe this has been helpful in the current crisis.

Also: Angela Merkel suddenly announced and rushed through a ban on naked short-selling in Germany in 2010 for a year only. I can only presume that she flew into a rage when someone told her what a naked short-selling was. If so, she was right. Pity the ban wasn’t permanent. The EU Parliament banned naked CDSs, from 2011, but the ban is only on government debt.

These activities are a casino – no actual buying and selling of anything economically real.

Implications for Positive Money

Single-issue campaigns – movements – are necessary – we need more and better ones. Hundreds of injustices and scandals. Need to be sharply focussed. Positive Money is brilliant in this.

But, at some future date, if/when Positive Money start to have a wider effect – circumstances will require decisions on strategy and tactics depending on the wider situation at the time. The more activists that have anticipated this, the fewer squabbles will occur.

Questions and Answers

facilitator : Sue

Q: Why do banks call debt an “asset”?

A: (i) Banks assume that the debt will be repaid.

(ii) In standard accounting practice, creditors - parties that the business owes money to (eg. suppliers) - are liabilities on the balance sheet; debtors - parties that owe the business money (eg. customers) - are assets.

Q: What proportion of derivative trading is “naked”

A: Don’t know – hundreds of trillions is traded daily.

Q: What caused the rate of profit to fall 1950-1980?

A: (i) Productive demand was high post-war globally.

(ii) The capitalist system has inherent potential for over-production - competition drives ever-increasing “productivity” of labour, reducing the ability to extract surplus value.

Q: Some people say that speculation is a positive thing, as it ‘transmits information’ to the market.

A: Who knows what the ‘right’ price should be in a speculative market? eg. diamonds and gold don’t respond to normal supply & demand, the price depends on scarcity.

Also house prices – speculators don’t want to increase supply!

Q: What is the difference between speculation and investment?

A: It’s what’s in the head – short-term profit (making money) vs. long-term interest in the business.

Q: How can £900m of student debt be sold off for £150m?

( http://www.bbc.co.uk/news/business-25084744 )

A: It’s an example of not knowing what debt is really worth on a balance sheet.