It’s the capital, stupid

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The problems are simple and the solutions are simple, so why is it so difficult for many to see this and act accordingly?

I’m a practitioner, not an economist but I know what I know very well. So does, it appears, all the contributors to MB who are practitioners or economic practitioners, which is certainly why I’ve learnt so much from them. On the other hand, mainstream economists are good at analyzing economic data and attempting to explain why an event occurred. I do find most economic analysis produced in the media or for the media very useful, if only for amusement value.

But I cannot understand why being an economist gives them the right to think or even have the expectation that they can actually use their high level analysis to correctly predict the future. At the risk of offending many I’m about to challenge the usefulness of the economic world as it relates to the financial system

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What most economists don’t know is how the many systems that make up the financial system work, only practitioners know this and only in their fields of expertise. Practitioners look at what will happen when a certain set of circumstances come together and how the system has previously reacted but also how the system is able to cope with those circumstances and individual reactions. Practioners have to know how to use this information for a tangible use which means being right most of the time and in some areas, nearly all of the time. Careers are dependent on this knowledge and forecasting.

Economists, on the other hand, are generally not even aware systems exist. They analyse historical events, try to find correlations in the data which fit with whatever economic theory or bias they are attuned to at that time. Give them enough data and they’ll make any correlation fit to whatever answer they want. Using such a process will only giving you the predicting power of a roulette wheel. A very good economist of a previous era, Ray Block once told me that he was easily the best economist in Australia as he was always wrong in his predictions. No one else had such consistency. It was only many years later that I understood what he meant.

So why are economists, even plainly bad ones lauded in the media? Because as tools of, for instance, the politico-housing complex they are very useful in telling the story which keeps the property meme alive and gives most publicity. The credibility that this publicity gives economists is very useful in influencing the thinking of the masses, part of the disease of the last 20 odd years. However, I believe that this influence at the level of the masses has all but ended, not just in Australia but globally and the following is my reasoning and the result

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Earlier this week, MB hosted a robust discussion about where bank deposits or actually any borrowings, come from. Whilst there was some great information posted, it did seem that there was no universal understanding on how a simple banking model works and what are the levers of control?

Let’s build a simple Australian banking model from the ground up. Let’s say Australia has one bank with one source of funds ie deposits, and one asset ie mortgages. I have one depositor to start who loans the banks $1000 in funds which it then lends to a borrower as a mortgage which is used to purchase a house from a vendor who deposits the $1000 in said bank as the second depositor, and the process continues every day for a year at which point the bank has $365,000 in both deposits and loans. Under this model, the bank as it makes money from charging the mortgagor more interest than the depositor, is motivated to undertake an infinite number of borrowing and lending transactions. Except for three things the bank would just keep growing at an ever quicker pace and in the process create more and more money in its computers, to a limit which would theoretically equal the borrowing capacity of the population. The first two things are that a depositor may want its money back before the borrower repays, ie liquidity, and/or a depositor may take some of the funds and buy some goods from a vendor outside the loop ie a deficiency of funds. Lastly a borrower may not pay on time or at all ie default.

To solve the banks’ liquidity and deficiency issues, the bank looks around for other funding sources which they find offshore in the form of long term bonds because international investors love the Aussie mining industry. FutureBoom! is seen as the means to repay those lenders. The bank makes up its deficiency in the mortgage market and uses excess funds to buy, say, Australian government securities as a liquidity buffer. Until the offshore borrowers want repayment or don’t increase lending the party can continue unabated. This particular solution for the bank has a double whammy effect for the economy as well as it allows for a continual stimulus of merry go round spending as our depositor deficiency is now able to be used to maximize the amount that is spent on consumables in and outside the country.

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Except for the last problem that is. The bank needs to find buffer funds to protect its business model and its depositors from default. That’s the dreaded capital that every banker hates. The bank needs to raise equity which is not repayable for every loan that it makes. That capital should not be just enough to cover losses in a stressed scenario, but also must be sufficient for the bank to stay in business if the stress occurs and to motivate against reckless lending. This is not so easy and is the main lever that is meant to control unabated credit growth. Equity is hard to raise, is expensive and careers are judged on equity returns generated. Clearly then, it’s also where the banksters direct a large effort into rorting the system on capital requirements. This is the brake on growth and bonuses which when you’re taxpayer supported is the free money banksters want. But it’s also the motivator for beneficial innovation if managed well.

My simple banking model, which appears to actually be pretty close to what exists in Australia, raises fundamental issues on sources of funds. So why do I read reams of pages of media from economists dedicated to minor interest rate movements and none discussing the debt and capital issues? Especially the question of what happens when the offshore money stops flowing and bank capital is proven to be inadequate?

The answer has little to do with the issues and more to do with why media economists exist. I include public and private sector economists in that description. That is these economists are simply tools of the Politico-housing complex

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Now my final thrust is at the hearts of the economists and their relevance.

As a practitioner, I don’t look at a borrower based on some economic median income to borrowing ratios and try to rationalize a population’s ability to repay. I try to fathom how many borrowers really can’t pay, how many borrowers can pay but only if they give up any other life to do so and how many potential borrowers are going to take an ever increasing burden of debt to keep the merry go round functional.

My observations are that Australia has reached tipping point on all the above. The only real debating point is whether there is still enough mug punters out there willing to take on the massive debt burden. The US was over the cliff quite some time ago and it’s clear that economic theory is floundering in every bias. What does that mean for the current economic debate?

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To put it simply, reducing the cost of debt will no longer produce results economic theory predicts. The issue is the amount of debt and the value of money. In Australia, reducing the official cash rate will simply swap interest payments and returns between an almost equal amount of domestic retail borrowers and domestic depositors. Without stimulating an increase in borrowing, reducing rates will have little effect and perhaps a negative effect as the population starts to, at an ever increasing pace, lose faith in the whole financial system and the value of money. Isn’t this exactly what has happened to the populations of the US and Europe?

Governments love low to nil interest as it allows them to increase debt without the responsibility of its cost. Keep borrowing money, stimulating, without minimal care or cost to the budget interest. All motivated by the desire to win the next election at any cost to the future. However, in the end, this destroys the value of money and capital. It destroys motivation and innovation and ultimately everyone’s wealth, especially the rich.

For none of the reasons that media economists have reported, I believe that interest rates should not decrease in Australia but should increase by about 0.5% to a long term sustainable level and stay there come what may. The UK and Europe should follow that lead and do exactly the same. Restore some accountability for the cost of debt to governments and provide the people with a standard for the value of money. If this is not done, the system cannot drag itself out of the hole. It was never designed for free money and endless debt growth.

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