The Tail that Wags the Tail …

Not ready for prime time, come back later!

When the tail wags the dog, the dog is in ... trouble. When a small and relatively insignificant part (the tail) of the whole (the dog) is so powerful that the whole does what the part dictates, something is wrong. Cancer works this way; a few cells begin to multiply out of control and the body begins its march toward inevitable death. But when the tail wags the tail that wags the dog, it is as though a flea in the tail is wagging the tail that wags the dog; here, things are really not the way they should be. The Dog in our parable is the Economy, the national economy or the world economy. The Tail is Finance, or the Financial System. The financial system is those “industries” whose sole “product” is money. Banking, insurance, brokerage and – lest we forget – gambling. All other industries deal in real products and services, things we can actually touch and see and feel; only Finance has no real product and no service that is not an instance of Paul trading money with Peter. Banking pays you interest for your deposits, and gives you loans and mortgages for your promise of future payments of returned principal and the interest thereon. Insurance isolates you from low-risk but high cost phenomena in your lives, like your home burning down or your needing major heart surgery. Brokerage lets you invest in some piece of the overall economy, taking a small risk to get better returns on your capital than would otherwise be available with a savings account from your local "commercial" bank. And gambling, an industry of negative social utility that seduces you into the belief that you can get rich with no real effort and then swallows all your money, but not before assuring you that you will do better next time, guaranteed! This is Finance.

Over time, Finance has become the largest and most important sector of any and all economies; as goes banking (et al), so goes the economy. Until recently, when “Shadow Banking” – the tail that wags the tail – has assumed this most powerful place. Shadow Banking is those elements of finance that gamble with each other’s money. Unhappily, not only does Shadow Banking allow a few powerful players to play with others’ money, but the amount of money that is in play within that artificial world is a multiple of the amount of money in that real economy. So, when the Shadow comes on hard times, everyone feels the pain. Even though only the high and mighty may play in this game, should things go wrong, you – dear reader – not only will feel it, you will pay for it. You thought that the Great Recession of 2008 was painful? You thought that the Great Depression was super-painful? You ain't seen nothing yet. Our next Great Depression will in many ways be as devastating as a Third World War.

Shadow Banking – the superimposition of gambling on top of Finance – is the tail that wags the tail (Finance) that wags the dog (the Economy). Gambling? With Other People’s Money. Of the “Heads We [Finance] Win, Tails You [citizen taxpayers] Lose” variety (this feature of Big Finance has the elegant name “Moral Hazard”). With more money than actually exists in the world’s economies.

And until we get smart and isolate Shadow Banking from the rest of Finance (with a "Wall of Separation"), we will continue to be subject to the worst ravages of a thing called Capitalism, otherwise the thing that has been more responsible than anything else for the decent lives that so many lucky human beings world-wide live. Let the tail continue to wag the tail that wags the dog, you will sooner or later witness the system crumble; and all because you did not understand that while gambling with other people’s money is not a good idea, gambling with everyone’s money, or a multiple of everyone’s money, is an even worse idea; and all because the people (that's you, dear reader) were not smart and aggressive enough to demand that our political leaders regulate Finance, for our own good.

Take a look at this.  Play it a few times, this is not easy stuff.

Think about it.

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What then are the root causes of shadow banking, or to ask the question in a different way, what are the root causes of depressions? First, what is a depression? The technical definition of a recession is two quarters of declining GDP; there is no technical definition of a depression other than a severe recession that lasts longer than a recession. The real-life definition is too many people within an economy who are unemployed, too many people who lose their homes to bank foreclosure because they can’t make payments on their mortgages, too many people who do not have enough money to pay for food; in short, a depression is an economy that does not work for too large a share of the population. It is the nature of a depression for it to get really bad before it gets better; waiting for it to come to a natural end (which is what President Herbert Hoover did for 3 ½ years) is a fool’s response (while it may fix itself given enough time, it will never fix the people who it made suffer).

There are elements of an economy that create shadow banking, that create the conditions for depressions. Yes, shadow banking is a necessary condition for depressions and if your economy permits shadow banking, depressions will occur.

Let us take a brief tour through economics and see if we can discover how we get to depressions.

Money

Origins: Mesopotamia, 3000BCE; Coins, Mediterranean, 600BCE

Once upon a time, in a galaxy much like ours, there was no money. Without money, if I, who raise sheep, want to buy vegetables and grain, I must find someone who sells these things and who will accept sheep as payment. Barter. Money is a “medium of exchange.” Money allows me to buy and sell with anyone. I can buy grain and vegetables from the first man I see who sells them at a fair price and I can sell my sheep to the first man who wants them and is willing to pay me a fair price. In itself, money is valueless (paper currency, computer data); its value is based on mutual trust, trust of the value of money. Once we withdraw our trust, money loses its value. It can actually become worthless (e.g., Confederate money, the German paper mark in the Weimar Republic of early 1920’s). In a healthy economy, money retains its value (a little bit of inflation helps grow an economy). Finally, a society without money is a society without an economy; no money no economy.

Banks

Origins: Assyria, Babylonia; Modern Banking: Renaissance Italy, 14th century

Banks are economic institutions that accept money deposits from people (because it is safer in the bank’s vaults than under your mattress) and then loan that money to other people to begin or expand a business or to buy a house or an automobile. Savings accounts complicate matters slightly as the bank must take in deposits at an ever-increasing rate so it can pay interest on savings accounts. But economies typically expand, and faster than the interest rates that banks give to typical savings account holders.

Stock Exchanges

The first stock exchange was in Amsterdam around 1602 (1460?).

Businesses have creators or founders. As time goes on, these entrepreneurs want to expand their business and they take on partners, or part-owners, in exchange for an infusion of new capital. Modern economies have stock exchanges that facilitate the buying and selling of part ownership in businesses. A stock exchanges is an essential institution in modern capitalism, you and I can own shares of a business and share in its (hoped for) future profits. The price of a share in the stock of a business may be $100 today and it may be $100.25 tomorrow or $99.75, with no particular reason for its growth or retreat other than there are more sellers than buyers (price decline) or more buyers than sellers (price increase), which varies from day to day for no particular reason (a stock holder’s itch). Good news and bad news – about the economy, about the particular business – will cause real movement in stock prices. So, while stock prices go up and down, they typically reflect the true value of the underlying business. No shadow banking, no depression.

Bubbles

“Tulip Mania” (Netherlands, 1630’s) was one of the first speculative bubbles; look it up, it’s a fascinating tale, whichever version you encounter.

When the price of a share of stock increases (or decreases) at nearly the same rate as the value of the underlying business, things are operating the way they are supposed to. But investors get greedy and they imagine a brighter future for their holdings than is justified based on their stock’s real value, and they bid up the price of their stocks. Other investors don’t want to lose out, so they bid up the stock even more. Prices increase, fast. This is a bubble. Everyone who owns stock loves bubbles, but bubbles are invariably followed – eventually, inevitably – by busts, and prices of stocks fall to depths much lower than the real values of their underlying businesses. Bubbles are wonderful (the Roaring Twenties) but busts (e.g., the Great Depression) pay for them, in spades.

Central Banks

Origins: Modern Central Banks, various cities in Europe, 17th century

Central Banks are lenders of last resort in a nation’s economy. When a bank gets into trouble, when there is a run on the bank, the bank can hold off disaster by borrowing funds from the Central Bank. Central Banks are usually private banks, though they are heavily regulated by the government. Central Banks also manage the nation’s currency and the Money Supply, they buy and sell Treasury Bonds and indirectly dictate the interest rate, and they supervise and regulate commercial banks (where you and I keep our money).

Economics

The Scottish philosopher Adam Smith (1723-1790) is the father of modern economics. His most famous work, An Inquiry into the Nature and Causes of the Wealth of Nations (1776), is the Bible of modern capitalism (while never mentioning the word). Much of what you have heard that he said just isn’t so. For example, he is NOT an advocate of unregulated free-market capitalism; he is aware of unregulated capitalism’s problems and he suggests solutions that most economists agree on, even while partisan politicians do not.

Futures and Derivatives

The first modern market for the trading of futures or derivatives was the CBOT (Chicago Board of Trade) in 1848.

When you own stock, you own a piece of the underlying business and your fortunes do well or poorly in step with the business’s fortunes. Futures are not ownership, futures are contracts between people. For example, you could buy (or sell) a futures (contract) which declares that you could buy contracts of West Texas Intermediate Crude Oil (WTI) at a price of $52.50 / barrel, 1000 barrels / contract on or before July 4th. Because you are buying a futures contract, you have a finite time to liquidate your position. You are betting that the price of WTI will rise and thereby make you a profit. If you buy 10 contracts of 1000 barrels, and the WTI contract rises from $52.50 to $53.25, you profit by $7,500 (10 contracts * 1000 barrels / contract * $0.75 / barrel price increase). On the flip side, because it is a futures contact, you could sell the contract first with the intention of buying it back at a lower price at a future time. However, if the market continues to rise, you have unlimited risk, because in theory the price could go to $500 a barrel (a loss of about $4.5 million – 10 contracts * 1000 barrels / contract * $447.50 / barrel price increase). The risk on the buy side is limited to the loss of your original investment. So, at all times, you know your risk. But this futures contract is nothing more than the terms of a wager, a gamble, a gamble for the big guys. People buy and sell futures contracts rather than underlying stock because the upside is huge (even while the downside is a wipeout). Optimism reigns! Greed reigns! But futures contracts all by themselves are not implicated in causing depressions, as they can wipe out individual investors, not economies.

Reserve Ratio

A bank’s Reserve Ratio is the %age of its total deposits that it must keep on hand – keep in reserve – to be able to handle withdrawals of its depositors; it can loan out the rest. For example, a Reserve Ratio of 10% (dictated by our Central Bank, the Federal Reserve System) allows a bank to loan out 90% of its total deposits. This is a boon for a growing economy, a hallmark of capitalism at its best. There is a downside though: should a large enough portion of depositors (assuming a reserve ratio of 10%, that would be 10% of depositors) want to withdraw their money from the bank at the same time, the bank will not be able to cover those withdrawals as it has loaned out the rest of its deposits. As long as the Reserve Ratio is set high enough, there should never be an instance when that many depositors (10% in our example) want to withdraw their deposits at the same time (a “Run” on the bank); it would only happen when the public loses confidence in the bank or with the banking system altogether. So, any Reserve Ratio, the permission to loan out most of a bank’s deposits, opens the real possibility that there may be a run on the bank that a bank cannot cover, a precondition for a depression, and a real problem of the Great Depression until FDR declared a “bank holiday” in his first week as President.

Margin

Wall Street, 1920’s

Imagine, you like business X and you want to invest because you see a great future for this business. You have only $1000 to invest but you want to buy $10,000 worth of stock (200 shares at $50 apiece). “No problem,” says your stock broker, “we will loan you the extra $9000!” Margin. The stock’s value increases by $1 and your wealth increases by $200, instead of $20 without the margin loan! But margin has a downside: if your shares lose value, you have to “cover” that loss with your broker. For example, should your stock suffer a 10% drop, it would wipe out the money you have on account with your broker/loaner, you would lose your entire investment. Just as a 10% increase in share value would be a 100% increase in your investment (because of 10% margin), so too a drop of 10% in share value would be a drop of 100% in the value of what you own. Margin is a great financial tool for optimists who can’t imagine that their stock picks will ever go down; margin leverages gambling into hyper-gambling!

FWOMD

The killer app of the latest would-be depression, the Great Recession of 2008, was “Financial Weapons Of Mass Destruction” (Warren Buffett). These were futures contracts (gambles, bets) based on “sub-prime” (risky) home mortgages. You can write a futures contract on anything whose value fluctuates over time, anything! It is just a BET, after all. Investment Banks “bundled” mortgages into bunches and “financialized” or “securitized” them by making them the underlying source of value for a futures contract. They were considered safe because 1) the need for housing always increases so the housing market always rises, and 2) the more mortgages you group together, the less likely one default will have a financial impact on the whole set of mortgages (safety in numbers). But housing markets always slow down and go in reverse for a while after a run-up, and there is safety in numbers only when the items in the bunch are not similar items from a single market. Housing is one market and it goes up and down just like any other market. The financialization of mortgages was killer app #1. Killer app #2 was who bought and sold them. They were not listed on the stock exchange – you could not have bought them – they were traded among big players in the game, investment banks and their clientele traded them. And when the housing market stopped expanding, all these financial institutions were left holding the bag and … crash!

Huh?

Investment Banks are banks that cater to high net worth individuals and economic institutions (hedge funds, corporations, unions, pension funds, etc.); investment banks are far less regulated than commercial banks too. Commercial banks are the banks that cater to folks like you and me, “boring banking,” deposits and loans. In recognition of the damage that Investment Banks did to boring banking in the Great Depression, a bill was passed to prevent its happening again. The Banking Act of 1933 (https://en.wikipedia.org/wiki/1933_Banking_Act) was a reaction to the Great Depression; it created the FDIC (Federal Deposit Insurance Corporation) which protects your deposits from a bank failure, and it separated investment banks from commercial banks. This latter part was called Glass-Steagall after its sponsors, Carter Glass (Democratic senator, VA) and Henry Steagall (Democratic Congressman, AL), Southern Democrats who were fiscally as hyper-conservative as would embarrass today’s so-called fiscally conservative Republicans (FDR’s “reforms” were not all “liberal”). The Glass-Steagall wall of separation was dismantled officially in 1999 (66 years later) under not-so liberal President Clinton. So, when investment muses were orgasming over the profits to be made trading these financialized mortgages, when the bubble burst, the losses were felt by banks that wrote your mortgages and loaned you money to build your business. Bailout was necessary as Wall Street’s actions impacted Main Street.

Many sober Americans wondered why “we rescued the big banks but let small mortgage holders drown” (by foreclosures). A good and necessary response, but not so important as “why did it happen and what can we do to keep it from happening again?” It was bound to happen as all the preconditions were there: a) in capitalism, bubbles happen and all bubbles burst; b) financial weapons of mass destruction leveraged gambling beyond sanity; and c) finally, the thin wall between investment bank gambling and boring commercial banking did nothing to protect Main Street from Wall Street’s insanity. After the Great Depression, the Hoover administration did nothing to address the sorry economy and it got worse for 3+ years until FDR did something; the Great Depression of 2008 was checked by stimulus money, although more of it would have done more to speed up the recovery.

What should be done to protect us from doing the same damn thing again again again (let’s face it, we do NOT learn from history)?

1. Limit the Reserve Ratio to 20%. The higher the ratio, the less likely a future nationwide run on the entire banking system. This is how banks fail, by not being able to meet customers’ obligations (withdrawals).
2. Stock Markets are an indispensable feature of any capitalistic economic system and they only do damage when inevitable bubbles inevitably burst. Folks without an excess of savings ought to stay away from gambling on the stock market, either with derivatives (e.g., options) or with over-investing in “sure things” (which never pan out). They need to resist the urge to gamble for short-term winnings. There is a saying on Wall Street: big money always wins and small money always loses.
3. Rebuild the wall of separation between investment banks and commercial banks; restore the Glass-Steagall Act.
4. There are financial institutions that are literally “too big to fail.” When an institution is too big to fail, its failure affects people with no connection to that institution (when AIG began to fail, we tax payers paid to keep it solvent). In capitalism, failure happens; but when there are failures within the Financial System, especially Shadow Banking, Main Street suffers; either tax payer money keeps the system from collapsing, or our money loses its value.
5. Whenever (if ever) we lend money to keep a financial firm from going under (which we should never have to do again, but we will as we have not reacted adequately to the stimulus of the Great Recession of 2008), golden parachutes must disappear, and bonuses must NOT be handed out to “keep the talent.” Contracts be damned!

Finally, if some folks don’t get sent away to prison for a nice stretch, the people should revolt.

You think this was simple-minded and too simplistic? There are dozens of books that were written following the Great Recession of 2008. I wrote this post for folks who are interested but don’t have the time or level of interest to read a half-dozen books on the subject. I welcome suggestions for its improvement.