Rules are power

The IMF recently had an earnest discussion about the future of macro economics. The topics were monetary policy, macro-prudential policies, financial regulation, fiscal policy, exchange rate arrangements and capital account managements. I would add another topic. What is money and what do we want it to do? Because what has been happening is not about ho we should manage within the existing system, but how we have let the system turn into something that no-one understands and which is inherently dangerous.

The sign of this peril is the general uncertainty about how to respond to what is happening, as seen in IMF economist Olivier Blanchard note:

Five years into the crisis, the contours of the macroeconomic policy of the future are only slowly coming into focus. From macroeconomic to financial stability, policy makers have realized that they have to watch many targets. They have also realized that they have potentially many more instruments at their disposal, from macro prudential tools to unconventional monetary policy. But how to map instruments to targets remains very much a work in progress.

This is a point of view from within the conventional system of money and this is the problem. Think of the current system as three layers. Level one is economic transactions, GDP etc. About $60 trillion. Level two is familiar financial assets, shares, bonds, bank debt. This is about $250 trillion (add about another $100 trillion for land). The top level is the dangerous one: derivatives or meta money. The BIS puts this at about $700 trillion.

It is that top level that is dictating what is happening in the markets. That is, the system should be analysed top down. But because that level is so complex, hidden and inherently unpredictable, largely because it is a self referring system that tends to amplify volatility, the analyses focus instead on what happens in the “real” economy, then how that will affect financial assets — i.e. bottom up. So we get this confusion of a sputtering recovery and stressed financial assets.

What is happening is a debauch with money, a game of Russian roulette with the means of exchange. Money is rules, and financial deregulation has allowed traders to make up the rules instead of governments stipulating them This almost destroyed the world’s banking system on one day in September 2008.

Here is the crucial bit:

On Thursday Sept 15, 2008 at roughly 11 AM The Federal Reserve noticed a tremendous draw down of money market accounts in the USA to the tune of $550 billion dollars in a matter of an hour or two. Money was being removed electronically. The Treasury tried to help with $150 Billion. But could not stem the tide.

It was an electronic run on the banks

The Treasury intervened, had they not closed down the accounts they estimated that by 2 PM that afternoon $5.5 Trillion would have been withdrawn and the US banking system would have collapsed and within 24 hours the world economy.

On that fateful day, the US Treasury finally decided to govern by closing all money market accounts and underwriting every bank deposit in America up to $250,000. After 25 years of “financial deregulation” – a logical nonsense, given that finance is a system of rules – they finally decided to govern. The Treasury came in and said: “these are the rules”. They probably did not have the money to underwrite every bank deposit, but that was not important. What was important was who was setting the rules.

To consider the absurdity of the situation, ask this question: “Where did those fleeing the US banking system think they could put their money when there was no longer a global banking system?” The meta money traders just assume there will be a system that they can exploit. It never occurs to them just how dangerous what they are doing is, or if it does they don’t let it get in the way of their greed.

The traders and private banks exert immense political power, and their irresponsibility will continue. Perhaps the best outcome given the failure to govern the system, is sputtering economic activity, small crises like Greece and Cyprus and underperforming financial assets. Because the big investment banks are not going to release their grip, they are going to continue to insist that they set the rules, not governments.

Dr Robert Johnson executive director of the Institute for New Economic Thinking recently commented that the Thatcher era – when financial “deregulation” was instituted mainly using Friedman – was “selling snake oil” and the illusion that markets were stable and self correcting. That is the origin of the problem, at least in terms of intellectual history (the main driver is old fashioned greed).

He says the attorney general of the US, Eric Holder has said he cannot prosecute crimes in the largest banks because it might undermine confidence. That is, the umpires can’t umpire because the game has been handed over to the players.

“The system of society in the United States is a money politics system. The derivatives system according to securities analysts is 97% dominated by six banks. They make about $35 billion a year. And the analysts estimate if you properly structured derivatives, put them on exchanges, made them more transparent, properly capitalised exchanges, they would lose 20% of that profit per year. $7 billion a year. You get a financial bill through Congress about every 5 years. So the excess profit is about $35 billion. As it turns out the banking lobbies spend about $600 million which overwhelms American politics. It is the dominant force in American politics given the importance of money and how our society works. For $600 million these guys can protect $35 billion of profit. Fabulous risk return for them. Terrible for society.”

The traders will inevitably undermine the rules again. The Russian roulette will continue. But next time governments will have very little fire power left. They will simply have to reset the rules – and be forced to finally rule out meta money, one suspects.