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Wednesday 2 November 2011

Ending The Divine Right of Bankers

"The bank mania... is raising up a moneyed aristocracy in our country which has already set the government at defiance, and although forced at length to yield a little on this first essay of their strength, their principles are unyielded and unyielding. These have taken deep root in the hearts of that class from which our legislators are drawn ... and thus those whom the Constitution had placed as guards to its portals, are sophisticated or suborned from their duties."
Thomas Jefferson, Letter to Josephus B. Stuart, May 10, 1817

Kings By Any Other Name

Thomas Jefferson's fears about the potential capture of government by a wealthy minority mirrored his experiences in Europe where, acting as the American ambassador to France before and during the French Revolution,  he saw at first hand the effect of government under the control of the rich and the powerful, where hereditary monarchs ruled by divine right: by the will of God. In Jefferson's view the American constitution needed to ensure that the state was prevented from setting aside its revenues for a favoured few: because otherwise the difference between the actual aristocracies that governed Europe in their own interests and the "moneyed aristocracies" overseeing the United States would differ in no way meaningful at all.

Equating this version of democracy with capitalism is no great leap: if everyone is possessed of equal rights and opportunities then that some succeed and become wealthy and others fail and don’t is to welcomed. However, if the rich and powerful can suborn the government to protect their interests at the expense of everyone else, then this is not capitalism; and it risks being not democracy, too. That those who rig the markets in their favor then accuse those who protest of being anti-capitalists is no surprise, merely the behavior of tyrants everywhere.  Capitalism requires that those who take risks and win should be rewarded, and that those who lose should be punished, not bailed out by a compliant state like a medieval monarch dispensing largesse by divine right.

Foxtrots and Rumbas

Over the past few years one of the most extraordinary things we’ve witnessed, both in America and in Europe, is the sight of markets and commentators demanding that elected governments dance to their tune. And, by and large, they have; admittedly the Europeans have tended to waltz around without quite getting the hang of things, while the quickstepping Americans and Britons have been rather faster to dole out cash to save the world. In doing so, however, they’ve collided head on with the unforgiving nature of markets: not only are they not thanked but they’re now being punished in a way that politicians absolutely hate – by testing their decisions in full and clear view.

Politicians spend their lives engaging in doublespeak; ambiguity is the first refuge of our leaders. The idea is to say something that everyone can agree with, even though it may actually mean different things to different listeners. By cloaking intentions in shades of gray many officials have managed to say things that they were later able to explain away through radically different interpretations of the words. It’s just another form of language manipulation, the like of which we saw in Euphemisms for Morally Disengaged Managers: a way of distancing yourself from the nasty realities in everyday life, and avoiding taking responsibility for your decisions.

There may be good reasons for this ambiguity as Alberto Alesina and Richard Holden record in Ambiguity and Extremism in Elections:
"What drives extremism and ambiguity is the parties’ need to trade-off two forces: the gains in votes obtained by converging to the middle and the benefit of campaign contributions that influence voters’ behavior. Contributions often accrue to the parties if they move away from the middle ground and towards extreme groups that feel especially strongly about certain issues. Ambiguous polices allow the parties to attract contributions without committing to extreme policies that would alienate middle-of-the-road voters."
Austerity Rules the Road to Hell

When applied to the markets, however, we have a situation in which weasel words face an unstoppable force, and get flattened. Markets are prepared to test the promises of governments, no matter how cunningly phrased, to destruction if needs be. By pouring billions of dollars into failing financial institutions and subsidising them with unnaturally low interest rates politicians have conspicuously allowed failure to be rewarded and have simultaneously blown a huge hole in their own finances. In a world in which the gears of debt are grinding into reverse this is causing all sorts of problems for speechwriters, trying to find ways of making “austerity” sound attractive, or at least rhyme.

What is really making life uncomfortable for the governing classes, however, is that they’re now finding themselves subject to the same unforgiving market forces that they tried to overcome with mass bailouts. We can see this through various attempts to bring the markets into line: investigations into credit-rating agencies, bans on short-selling financial stocks, suggestions of the introduction of bank transaction taxes, and so on. They might as well try to stop the Earth spinning.

Although these issues have taken a few years to work through the financial system we now find ourselves in an economic position that might be best described as “tenuous”. With hindsight we can see the road to hell. Governments stepped into to prevent a collapse of the global economic system – after, of course, they’d  already run up deficits during favourable economic times, while failing to properly regulate and even encouraging the monetary madmen running the world’s largest financial institutions. However, by deluging banks and other entities in government cash, they expanded their own debt to levels where it became unclear whether their economies were strong enough to pay the money back.

In fact this attempt to manipulate the markets was virtually bound to backfire:
"Rigging the markets—through corruption or denying them transparency—can only bring short-term relief. The markets always know, and they impose a heavy penalty. The discipline of the market is not always welcome, but it is a powerful ally of truth, efficiency and transparency."
That was the late British foreign secretary, Robin Cook, talking about the Asian financial crisis in 1998.  Seems a long way off now, and very ironic.

The Earth’s Debt

As related in Boomerang, Michael Lewis' book on the global debt crisis, the world, as of this moment, owes itself around $200 trillion. Which is a big number. However, when you put this into the context that the total GDP of Planet Earth – that is the total economic output of the entire planet, per year, is around $70 trillion, you get an idea of exactly why markets are nervous about whether they will be repaid. And hence, we get to austerity and the unusual prospect of governments trying to live within their means. Unfortunately this potentially impacts economic growth – and you can see why that’s so disturbing, because that mountain of debt isn’t going to shrink of its own accord. If governments go into austerity mode you end up with economic growth reducing until budgets are balanced, or we revert to a system that involves bartering chickens for shiny beads. When you look at it like that a bout of inflation doesn’t look quite so bad.

Whether intentional or not what this looks like to the average voter is that the rich and powerful took massive gambles and failed. In a negation of capitalism their losses were then neutralised by governments who are now imposing austerity measures and tax increases on the middle classes in order to balance the books.  In the meantime the same people who were rescued with public money are using that money to lobby against reforms to ensure that these events can’t happen again. It’s not surprising that the average voter is increasingly viewing their governments as a plaything of the rich and powerful, controlled by Jefferson’s “moneyed aristocracy”.

Government by the People, For the People

The rise of protest movements, from the Tea Party to Occupy Wall Street, are a reaction to a perception of the subversion of democracy. Governments have found that they can’t stem the pressure of markets; markets may soon find that they can’t stem the power of democracy. The political paralysis that we’ve seen both in Europe and in America may well be the first outward sign of this. In the United States we have stalemate between Congress and the President. In Europe the German parliament will not allow their credit to be used to bail out insolvent and imprudent southern states: leaders’ room for manoeuvre is being increasingly cramped. Economic commentators bemoan the failures of politicians, perhaps they should be exalting the strength of democracy.

Slowly, political reality is being shaped by voters’ intentions. Markets don’t like it, because they’ve had a decade or more of having governments dancing to their tune – but they’d better get used to it, because the political model that Thomas Jefferson shaped, which has been adopted across our planet, is ultimately resistant to its capture by any particular lobby group. That was the genius of the founders of the American constitution, and their greatest gift to the planet.  It takes time, but it’s happening. It’s not anti-capitalist, it’s pro-democracy and it’s going to determine our future. For better or worse, investors had better get used to the idea.


  1. the Bible tells us not to steal
    it’s there in black and white
    our laws are based upon it too
    do not do wrong - do right

    but somehow since these laws were writ
    we've seen the system fail
    but things will change for all the best
    when the bankers go to jail

    when the bankers go to jail

  2. Hmm, I've not read the new (always entertaining) Lewis, but that $200 trillion presumably nets out. i.e. For the debtors there must be creditors.

    Also, while the income of the world might only be $70 trillion, what are the assets? That's the missing part of this equation.

    Still, you get a link from me as so often for bringing your usual hyper-smart take to the subject! :)

  3. Is the debt owed by Greece covered by the country's realisable assets? To be fair the real (and unstated) point is that the pace of debt expansion is unprecedented, doubling between 2002 and 2008, and the strong suspicion is that this wasn't backed by real assets but by overoptimistic assumptions of future earnings and asset valuations, which now look a wee bit tenuous: the question, really, is how big is that imbalance? And, if we're considering worldwide debt and GDP figures unfortunately we have to ignore asset valuations, unless we're going to appeal for an extraterrestrial bailout ... :)

  4. "unnaturally low interest rates"

    This is not right. The "natural interest rate" is that which keeps output stable. The problem for monetary policy in e.g. the UK and the US is that the "natural" rate of interest went negative, yet policy makers could not - or would not - impose negative nominal interest rates.

    So in fact, by holding interest rates at 0%, they have been unnaturally high;
    monetary policy has been tight. Hence the switch to use of "non-conventional" monetary policy.

    "Low interest rates are generally a sign that money has been tight"

    - Milton Friedman

    "Unfortunately [austerity] potentially impacts economic growth"

    Key word being "potentially". With a central bank doing inflation targeting, government spending cuts should not impact economic growth. The central bank must set the level of aggregate demand correctly to meet the inflation target *regardless of fiscal policy*.

    -> Lemondy.

  5. At some stage, people will recognize that democracy is no more than 'the least objectionable method of ruling' rather than attempting to give it some type of moral standing. The proposed Greek referendum (which would presumably ask investors to choose between something akin to a. "Giving up everything for the next 10 years" b. "Tell Germany to sod off because we're not paying out") caused great concern because one of the unfortunate outcomes of democracy is that people with little money can 'legally' take it away from people with more. It is not always obvious that this is a good thing.

  6. Hi Lemondy

    “Historically” rather than “unnaturally” might have been a better phrase: although even that’s not quite true if you go back long enough. Nonetheless we have a situation in the UK where interest rates are set at 0.5%, which is roughly what banks can borrow at, mortgage rates are around 4%, savers get about 2.5%, inflation is probably above 5%, all while the Bank of England has an inflation target of 2% and has failed to deliver this for getting on for three years.

    So you may well be correct, and central banks are actually trying to promote growth, and loosely targeting the natural interest rate, even while paying lip service to inflation targeting. This is, however, a transfer of money from savers to borrowers and also to banks, who can make historically high returns by borrowing low and lending (relatively) high. You can argue that this is economically necessary, but it’s certainly hard to argue that it’s just. If bankers use this historic freebee to generate excess returns and then reward themselves on that basis it’s hard to argue it's fair either.

    In any case, the concept of a natural rate of interest has a couple of problems. Firstly it’s always a bit of guess what it should be: it’s generally estimated using statistical models which are sensitive to the future assumptions, which are invariably wrong. Secondly, it’s a prediction of equilibrium economics, a model of finance based on an inadequate analogy with thermodynamics; and if that’s not a busted flush these days it’s hard to know what is.

  7. one of the unfortunate outcomes of democracy is that people with little money can 'legally' take it away from people with more. It is not always obvious that this is a good thing

    In democracies high levels of wealth inequality tend to lead to higher taxation, in other systems to revolution. On balance I think I'd rather lose the top 5% of my income than the top 5% of my body. Oddly, though, this reaction doesn't happen all the time, and there is a moral message in that ...

  8. This is, however, a transfer of money from savers to borrowers and also to banks, who can make historically high returns by borrowing low and lending (relatively) high.

  9. This is, however, a transfer of money from savers to borrowers and also to banks, who can make historically high returns by borrowing low and lending (relatively) high.