Little Interest in Pre-Article 50 #Brexit Discussions With British EC Staff?

The crowdfunding campaign against the ban on British European Commission staff, in particular, discussing Brexit plans with UK officials before the UK triggers Article 50 has raised less than a tenth of the £35,000 target from only 109 people, with 18 days to go.

The campaign is intended to attack the ban on all EC staff announced by EC President Jean-Claude Juncker in June: "No notification, no negotiation."

But it seems few people are interested in pushing the issue. Perhaps another reason for doubting that the UK will ever be adequately prepared to trigger Article 50?

Economic Impact of #Brexit (If Any) Is Years Away...

Not a day goes by without someone declaring that the economic  impact of Brexit has been either overestimated or is being underestimated. 

This has to be utter rubbish. 

The UK is still in the EU. Situation normal. Nothing has changed. Changes in the economic data must be due to other causes.

While the impact of the referendum itself - and the related political nonsense - might have affected some figures, I don't see how the actual impact of the UK leaving the EU could be reflected in any way. 

When might any impact be felt, if ever?

Not only is the UK still waiting to decide exactly when to trigger the formal two year 'Article 50' leaving process, but it is also still trying to figure out the list of issues that need to be resolved and the appropriate negotiating strategy and tactics to resolve them favourably (if possible), not to mention how to recruit the people who are supposed to be doing the negotiating. 

Personally, I doubt the UK is capable of getting this done in any conceivable time frame, and to trigger the Article 50 process without figuring these things out would be insane. So it would not surprise me if the UK never actually manages to trigger the Article 50 process (the wisest course). 

Which would mean Brexit itself would have zero economic impact. 

There may be economic volatility while the implications of triggering Article 50 are being worked through, but that would still not really be the result of actual Brexit. The referendum experience has shown that people don't really look beyond the horizon, so they would not be reacting to an actual decision either way, just the trigger decision itself.

If the UK does manage to trigger Article 50, then we would see another burst of economic volatility while everyone digests (the madness of) that decision and what it might mean when the leaving process is complete. The chief issue would be whether the UK would be able to complete the necessary negotiations within the two year time limit, in order to avoid the default trade position (the worst case, unless of course the UK manages to negotiate an even worse set of deals than that - not inconceivable!).

There would then be all sorts of fresh economic volatility during the two year Article 50 period, while everyone reacts to the latest news about each of the trade negotiations might affect them and their sectors. Speculators would have fun, but everyone else would need to wait and see what actually shakes out. Meanwhile, any news about the plight of other EU members and the EU itself would also affect everyone's view.

Of course, if the leaving process were completed, there would be reactions to how the various deals actually unfold and whether they would be extended or renegotiated. But that position would be the 'new normal', so not really Brexit related at all.

Will This Book Stop The Dogmatists Waving Their Fallacies Around?

As one who loathes the use of party-political dogma to muddy the waters of sensible debate, I was delighted to read Tim Worstall's list of the top "20 Economics Fallacies" that political types wave around to justify some of their weirder ideas, and exactly why they're false. Maybe this book will help focus debate on the real issues.

At any rate, with the next general election less than a year away, you'd do well to keep a copy by the armchair to guide you through the evening's political interviews. So long as you can resist the urge to throw it at the screen.

Dirty Data

Westiminster recently feigned shock and horror that the UK's coppers cook the crime figures. But Simon Jenkins says we've known for years that the numbers are meaningless and they should be banned as "they spread confusion and fear".

But 'plod' is not alone in mis-classifying, mis-recording, ignoring or otherwise presenting data in a way that suits himself. We've had many financial trading scandals where banks apparently had no idea of the exposures they faced, either because transactions were concealed or perhaps no one was looking hard enough - the global financial crisis was a function of poor due diligence.

A possible root cause of the problem is that humans are involved too early in the data collection and reporting processes. Rarely are we responding to the 'raw' data, as opposed to figures that have been 'gathered' and 'rolled up' through a series of other people's filters, manipulations and interpretations (which are often taken out of context). It's puzzling why regulators' systems don't receive a feed of the actual trades straight from bank trading desks - or from peer-to-peer lending or crowdfunding platforms - rather than relying on periodic reporting of summary data.

Maybe GCHQ can help...

At any rate, we should focus more on 'clean' mechanisms for capturing and presenting raw data rather than someone else's interpretation of it.

Image from TraceyNolte.
 

Help To Bubble

I just don't get it. The UK is awash with debt it can't shift, yet the UK government thinks it's a great idea to ensure that people get £130bn of mortgages they can't otherwise afford. 

A Treasury spokesperson is quoted in today's FT as saying that "there are rules ensuring that people can pay the mortgage that they have taken on." But if they couldn't have got the mortgage in the first place, how is that so?

It would be fair enough if someone were able to point to specific, unreasonably restrictive bank lending practices and get them changed. Yet neither the Treasury nor the Bank of England has been able to bring the banks to heel, so putting the taxpayer on the hook for 15% of a bunch of new high loan-to-value mortgages seems a little careless to say the least.

But maybe it's too late. Maybe we're just seeing the inevitable consequence of the fact that the UK state is already standing behind £491bn of UK mortgage debt, or 42%. The state simply has to be back even more. The US introduced this nonsense as a 'temporary measure' 70 years ago and, as Gillian Tett recently pointed out, is now behind 90% of the US mortgage market. How's that working out for them? You be the judge.

Welcome to Bubbleland.

Image from LuxLifeMiami.

Either Gillian Tett's On Fire...

Ominous bursts of smoke have been rising from Gillian Tett recently. 

On September 12, the lady who gave us Fool's Gold pointed out that six key aspects of the financial system in 2008 are far worse now. 

The banks are bigger. Shadow banking is bigger. Investor faith hinges on central banking 'wisdom' and liquidity, while the top 5% of bankers are soaking up 40% of that support in bonuses. No one has been jailed for their role in the sub-prime fiasco. And the US government agencies now account for 90% of the mortgage market...

Today's smoke is rising over the Federal Reserve's decision to keep buying smack bonds at the rate of $85bn a month. It appears to have concluded that the West simply can't handle the withdrawal symptoms. Meanwhile, the UK regulatory elite has finally started to ring the bell over the fact that only 10-15% of the money our banks create actually goes to productive firms, while the rest is stoking financial asset bubbles... And, oh look, the real estate agency, Foxtons, has soared on its return to the stock market.

Either Gillian Tett's on fire, or something else sure as Hell is.

Image from JetSetRnv8r.

Towards A Diverse, Sustainable Financial System

It's not every day you get to brainstorm ways to bring diversity and sustainability to Britain's ailing financial system amidst a broad cross-section of officials, economists, entrepreneurs, think-tanks, technology suppliers and advisers. And yesterday's Finance Innovation Lab workshop was a golden opportunity to do just that.

While the Lab will report the output in due course, I thought I'd share a summary of my notes from the breakout sessions in which I participated. These looked at regulatory barriers and lack of financial awareness. Others explored the unfair advantages enjoyed by estalished providers and ways to encourage innovation. We operated under the Chatham House Rule, hence the absence of names or affiliations.

The UK financial system is neither diverse nor sustainable. 

There is plenty of evidence that the UK's financial system is suffering from a lack of innovation and competition, and is unsustainable in its current form. Rates of market entry and exit are low, relative to other industries. Few customers switch and customer trust is lowest for financial services on several leading surveys. The unit cost of intermediation remains high in financial services compared to other retail markets, while management and staff have reaped the benefits of any increased operational efficiencies (even while legacy systems remain prevalent). Banks rely on a huge back-book of deposits on which they pay little or no interest to finance loans to fund trading in financial assets rather than loans to productive businesses. After all, a single giant property loan does more to grow the bank's numbers than lending the same amount of money to thousands of small firms. 

Regulatory barriers

 

Against this background, we concluded that the current regulatory framework, including subsidies and incentives, is essentially designed to both protect the 'financial system' and 'customers' - i.e. to minimise the risk that consumers and small businesses, in particular, will be mis-sold 'products' by unscrupulous suppliers. 

In effect, however, that framework obliges policy officials (Treasury) and regulators (FSA) protect the system as it is, rather than to ensure that it evolves to encourage and accommodate innovation in line with customer requirements. That's because the framework and those who police it are organised in silos according to existing product types and types of suppliers, and not according to types of customers' and their day-to-day activities. 

The customer protection regime mirrors this approach, being organised according to limited sets of product types and types of suppliers, as well as types of promotional and business activities in which suppliers are engaged (not their customers). As a result, the impact of regulation, complaints and potential for changes are all viewed through the lens of existing products and firms, and any actual changes reinforce those lines of distinction. 

The perverse nature of this can be seen in the fact that, if I want to allocate £100 to a project that I'd like to support, it's easiest for me to donate the money, a bit more complex if I want the money repaid with interest (as a loan), very complex if I want to be able to freely trade that right to be repaid with interest (a bond) and the most complex thing of all is to receive an equity share in the project. This discourages diversification and the search for opportunities to get a decent return on surplus cash; and limits the availability of funding to new businesses, on which most new jobs depend.

Hard-wiring the markets according to types of products, suppliers and ways of dealing with them also artificially limits the number and range of suppliers, product types, and the corresponding markets. In addition, taxpayer guarantees and subsidies in the form of savings and pension incentives are aligned with existing regulated suppliers and product types. Therefore, the regulations and incentives work together to enable the suppliers in the regulated markets to charge higher fees, make higher margins, reward staff more generously and pay more for marketing - resulting in less innovation and competition.

The overall result is a financial system that is not designed to evolve in line with the requirements of consumers, small businesses or even big business. It is designed to suit incumbent suppliers - those who play well with the system, regulators and policy officials. Yet there is no single set of policy officals or regulators tasked with understanding how the regulations, subsidies and incentives actually work together as a whole or whether they distort any aspects of the financial system within or outside the regulated areas.

A broad range of solutions were suggested, as you can imagine, and the Lab will report on these shortly, and include them in a submission to the Parliamentary Commission on Banking Standards. However, suggestions included: 

• creating a Parliamentary Select Committee to focus on encouraging financial innovation;

• limits on market share by product type;

• controls on gross leverage; 

•  separate banks' credit creation process from financial intermediation (the process of allocating that credit);

• central bank guidance to banks on how much to lend productive firms;

• levelling the playing field on subsidies and tax incentives/allowances;

• a target of 200 new local banks by 2016;

• publishing details of national banks' regional/local banking activity;

• making it easier to get low risk financial businesses authorised;

• publishing the amount of the subsidies to major banks and oblige them to set aside a proportion of their subsidy for future crises;

• treating payments systems and credit reference data as utilities (i.e. public goods).

Lack of financial awareness

The scale of financial mis-selling across many different types of products and lack of diversification by investors suggests a widespread lack of understanding of financial services. This was seen to be caused by a lack of financial education, on the one hand; and by product complexity on the other. In turn, product complexity is driven by both regulatory complexity and an unwillingness to invest the extra effort required to simplify products and better align them with customer requirements.

The lack of financial education is essentially a failing of our education system. Yet there is little faith that the Department for Education accepts any responsibility for delivering a sound financial education. It's also clear that no other government department sees this as part of its mission. Rather, financial education seems to be a specialist area confined to universities and business schools or professional bodies. It was felt that this will only change with a determined effort by the Department for Education to measure financial 'literacy', collect best practice for teaching it and including those measures in the national curriculum. Measures of success would include improvements in financial literacy exam results, fewer complaints to the Financial Omudsman Service and improved diversification amongst savers and investors.

Removing product complexity requires a commitment to reducing regulatory complexity, the removal of the regulatory barriers to innovation and competition discussed above, as well as incentives that drive both simpler products and diversification, rather than the concentration of funds into a few regulated asset classes.

In short, more pragmatism and less politics should go a long way.

More Sunlight Needed On Perverse Tax Incentives

Our continuing economic woes seem to reveal a UK Treasury that has lost touch with the fundamental tax and regulatory problems in the UK economy and is unwilling to engage openly and proactively on how to resolve them.

Not only did the Treasury lose any grip it had on the financial system when it mattered most during the last decade, but the rocky passage of the Financial Services Bill and the need to create a joint parliamentary Commission on Banking Standards also reveal that any such grip remains elusive. This, coupled with the UK's bizarrely complicated system of stealth taxes and incentives, demonstrates the urgent need for more transparency and openness in how the Treasury is going about the task of addressing our economic issues.

The latest example comes with the news that the government might revisit the bizarre decision to delay the revaluation of business rates, which are still based on the higher rental values of 2008. The task of setting business rates every five years lies buried in the Valuation Office Agency, an 'executive agency' of HM Revenue and Customs within HM Treasury. So it's nicely insulated from anyone who might complain about the impact of the rather occasional exercise of its responsibility. Instead, businesses have complained to Vince Cable, over at Business Innovation and Skills, and he's bravely (insanely?) promised to do what he can. However, the hermetically sealed nature of civil service silos means the Valuation Office Agency can safely ignore the issue.

Anyone else afflicted by perverse public sector tax issues faces the same problem. 

UK-based retailers are wasting their time by complaining they are disadvantaged compared to international businesses that are better able to minimise their tax liabilities. Not only is this a welcome distraction from the bigger issue of how the public sector wastes money, (which the Cabinet Office has been left to address), but the Treasury hides behind BIS, no doubt laughing-off the complaints as an example of businesses not understanding how the arcane world of taxation really works. The trouble is the Treasury doesn't understand how that world really works either. Nobody does. That was the whole point of Gordon Brown's stealth approach to taxation. But this should be no excuse for the department that's supposed to be in charge. The Treasury needs to take responsibility for understanding and explaining how it all works, including the unintended consequences.

Similarly, the Treasury needs to take responsibility for the fact that the UK's small businesses face a funding gap of £26bn - £52bn over the next 5 years. Here, again, BIS has had to act as a human shield, even threatening to launch its own 'bank'. Yet HMT has allowed four major banks to get away with controlling 90% of the small business finance market while only dedicating 10% of the credit they issue to productive firms. This, despite the fact that small businesses represent 99.9% of all UK enterprises, are responsible for 60% of private sector employment and are a critical factor in the UK's economic growth which has slipped into reverse yet again. Meanwhile, the Treasury continues to resist allowing a broader range of assets to qualify for the ISA scheme, which currently incentivises workers to concentrate their savings into low yield deposits with the same banks that are turning away from small business lending just when it's needed most.

More sunlight please!

Bailout Fund Ratings And Snake Oil Don't Mix

The response to the downgrade of the Eurozone bailout funds from Aaa has yielded a fascinating political response from the head of the fund. 

Moody's, the ratings agency, says the €700bn European Stability Mechanism (and the the EFSF it replaces) is now a riskier proposition since France lost its Aaa rating earlier this month. It considers that, if the full fund were needed, France would have to stump up 20%. The whole purpose of the fund is to invest in the debt of weaker Eurozone member states whose creditworthiness is highly correlated. So, if one runs into economic trouble, they all do. That also makes for a "highly concentrated credit portfolio." And if push came to shove, Moody's doesn't think France would prioritise it's ESM contributions above its own debt payments. Similarly, in that event it would be unlikely that other member states would make up France's shortfall.

Both the chairman and managing director of the ESM were keen to claim political support for the fund. The ESM's chairman said:

"The 17 euro area Member States are fully committed to ESM [and EFSF] in political and financial terms and stand firmly behind both institutions."

And the ESM's managing director said:

“Moody's rating decision is difficult to understand. We disagree with the rating agency's approach which does not sufficiently acknowledge ESM's exceptionally strong institutional framework, political commitment and capital structure."

Of course, the political reality is actually the flaw in the single market and Euro fantasy: there's no credible plan to discipline profligate states, as the continuing Greek tragedy demonstrates. Those who negotiated the Maastricht Treaty foolishly believed such states would ultimately behave in the interests of the Zerozone, just as Alan Greenspan thought the boards of Lehman Brothers and others would refrain from driving their firms into a wall out of concern for the interests of shareholders and taxpayers... snake oil. 

The only real disciplinary option is for creditor states to 'send the boys around' to the debtor states. In that event all political solutions will have been exhausted, and the 'European Union' long gone. 

So Moody's is right to discount the politics - and the ESM's credit rating.

If the politics is not to further undermine the ESM, politicians have to demonstrate that the disintegration of the Euro zone is survivable. 

Does Ana Botín Have Any Clothes?

In a fawning interview in Monday's Telegraph, Ana Botin, CEO of Santander UK and billionaire's daughter, is lauded for having run a start-up and quoted as saying she will be “accelerating” the expansion of the bank’s small business lending. But does this really justify such fawning tributes, or does the emperor have no clothes?

According to BIS, the stock of lending to UK non-financial corporate businesses was £506bn in December 2011.  The department estimates a potential credit gap over the next five years of between £84bn and £191bn for the business sector as a whole, of which between £26bn and £59bn is estimated to relate to smaller businesses. BIS says bank lending may grow, but the ability of bank lending to increase may be constrained by the ability to raise capital and meet higher funding costs. The big four banks control over 90% of the business finance market, leaving the likes of Santander with very little indeed.

At any rate, the important factor here is not the amount that Santander actually dedicates to small business lending. It's the proportion that its small business lending activity represents of its overeall credit creation. Richard Werner, the economist, estimates that UK banks generally dedicate only 10% of their credit creation activity to productive firms. He says that it's critical to grow that proportion because credit aimed at productive firms is the only signficant driver of economic growth as measured by GDP - which is flat. Credit that goes to consumption only fuels inflation, and credit for the purchase of non-GDP assets simply drives up the prices of those assets. In Germany, by contrast, 70% of banks (about 2000 of them) only lend locally and supply about 40% of SME finance.

Against this backdrop, Santander's claims don't merit much attention at all. To achieve it's proposed 'acceleration' of lending to small businesses, Santander UK suggests it will use some of the £2bn capital allocated to its failed acquisition of 316 RBS branches and some of the £1bn it has drawn down as part of the public subsidy given to banks in the form of the Funding for Lending Scheme. The bank announced £500m additional asset financing last Thursday. Yet its gross business lending only stands at £10bn, even having grown 20% year on year since 2009. “This is net new lending,” claims, the CEO, but then says this represents switching from other banks. So it may not be net new lending to SMEs generally, i.e. funding that is going to SMEs who can't otherwise get it.

So, while she talks a good game, Ana Botin and the bank she runs have no clothes. 

Image from ElaineByrne. 

Credit Drives Growth (Not Interest Rates)

Thanks to IPPR and The Finance Innovation Lab for an invigorating seminar on bank reform this morning. I've noted some of the highlights below, but in summary: Chris Hewett gave a great overview of the range of proposals; Richard Werner debunked the myth that interest rates drive economic growth and explained why the Bank of England must guide bank credit away from speculation and into productive firms; and Baroness Susan Kramer explained the work being done in Parliament.

Chris's 'policy map' in particular is worth studying in particular (zoom out of his presentation to find it). It reveals the ideas that are merely 'a glint in the eye', those that are attracting support and those that are being fought over by stakeholders in a way that is likely to produce change in the near term. 

Richard showed that interest rates do not drive economic growth. Rather, they lag changes in economic growth by as much as a year. So it's a myth that lowering interest rates will increase economic growth, or that raising them will slow growth. Instead, the evidence proves that those in charge of monetary policy merely react to a slowing economy by lowering interest rates, and react to a growing economy by raising them. In other words, economic growth drives the setting of interest rates not the other way around (so GDP growth and interest rates are positively correlated, not negatively correlated as many people suggest).

So the current low Bank of England base rate merely reflects the current economic malaise, and changing it one way or the other won't drive economic growth (GDP). Mortgage rates are already much higher, anyway, and it may be doubted whether banks would pass on any rise to savers.

In fact, Richard observed that the only driver of growth in GDP is bank credit that is used for productive investment. Credit used for consumption merely raises inflation, and credit used to buy financial assets (which don't count towards GDP) merely drives up non-GDP asset prices.

Richard explained the importance of recognising that we derive 97% of our money supply from banks extending credit. They 'create' money every time they make a loan. But here's the killer: only about 10% of credit created by UK banks actually goes to productive firms. The rest of the credit created is used by investment banks, hedge funds, private equity and so on to speculate on non-GDP assets.

In addition, the risk-weightings under bank capital rules discourage banks from lending to small firms (as I've also mentioned before), effectively encouraging lending to fund speculative property deals - even though the overall risk profile of loans to small businesses is lower than lending for speculative purposes, and in spite of the fact that small firms represent 99.9% of all enterprises and are responsible for 60% of private sector employment).

Richard explained that Project Merlin and the more recent efforts by the Treasury to shame banks into lending to productive firms all fail because the banks can afford to ignore the Treasury. But central banks have been successful in guiding credit to the right sectors previously, because the banks rely on the faith of the central bank to stay in business. The IMF has previously discouraged the use of this so-called "window guidance" because it has been abused in certain countries (e.g. to aid speculators or political cronies). But a transparent programme could work. A longer term alternative is to create new banks that never lend for speculative purposes - in Germany, for example, 70% of banks (about 2000 of them) only lend locally. Spain had a similar system, but then required its local 'cajas' to lend nationally, with devastating effects.

Finally, Richard said that the banks' could lend more to productive firms and still meet their capital requirements. But they need to lower the bar to obtaining credit (which German banks have commonly done during a downturn) and to incentivise staff for making productive loans. Currently, it's easier for bankers to earn bonuses for supporting speculative activity.

Baroness Kramer explained that Parliament is focused on four main aspects of the financial crisis: the market failure to provide bank credit to productive small firms; capital/cost barriers to launching new banks; encouraging peer-to-peer finance platforms; and ensuring that the Financial Services Bill and the up-coming Banking Bill are fit for purpose. 

Susan said that the Joint Parliamentary Committee on Banking Standards should have the membership and resources to get to the root cause of market failures and make improvements to fix them. While the evidence of market failure is clear, more evidence of the underlying problems and causes is very much welcome (even after the deadlines for submissions have expired). There is a belief amongst some in the House of Lords that the same regulator should be responsible for addressing market failure, as well as enterprise risk and market abuse, because they are all linked. The FDIC in the US provides an example of how this can work.

Proposals to reduce capital/costs that prevent the launch of new banks include reduced capital requirements for local banks that won't be systemic; and the regulation of a common banking platform that takes care of most operational risks, so that small banks could simply 'plug-in'. Susan observed that credit unions only cover about 2% of the borrowing population, so are not a replacement for new, local institutions.

Baroness Kramer has led the way in proposing amendments to the Financial Services Bill to proportionately regulate peer-to-peer finance. In the course of discussing those proposals, it appears that the Treasury has conceded that there is already a provision in the Financial Services Bill that could enable such regulation. However that still leaves the job of agreeing the detailed secondary legislation (and any further enabling legislation) required, so the industry should keep up the pressure in that regard.

Finally, Susan praised the white paper that underpins the Banking Bill as containing 'pretty good' language on enabling new entrants to the banking industry. However, it is going to be important for everyone to be vigilant in ensuring the spirit of this is captured in the provisons of the Bill.

The Enemies of Growth

The Economist article on The Question of Extractive Elites certainly resonated with me last week, as it did with those involved in the subsequent discussion on Buttonwood's notebook. It's another way of looking at the difference between 'facilitators' and 'institutions'.

In “Why Nations Fail: The Origins of Power, Prosperity and Poverty”, Daron Acemoglu and James Robinson, suggest "extractive economies" experience limited growth because their institutions “are structured to extract resources from the many by the few and... fail to protect property rights or provide incentives for economic activity.”

"Because elites dominating extractive institutions fear creative destruction, they will resist it, and any growth that germinates under extractive institutions will be ulimtately short-lived."

Acemoglu and Robinson place certain 'third world' economies into the "extractive" category, but place the developed world into an "inclusive" category on the basis that their institutions tend not to be extractive. But as Buttonwood notes, there are elements of developed economies that fit the description of extractive economies, citing banks and the public sector as the most likely candidates - although I would add the institutions that comprise the pensions and benefits industry as another example. And we should define "public sector" quite broadly to include political parties, unions, quangos and so on.

These extractive institutions tend to be linked, since the public sector is not only capable of extracting resources in a way that starves business or crowding out private investment, but it is also responsible for regulating the private institutions that are themselves extractive.

As previously discussed, high levels of public spending and national wage bargains are partly to blame for throttling the UK economy and preventing the development of manufacturing, particularly in regions which struggle to capitalise on the lower cost of living to keep wage costs down. The tax and regulatory framework favours banks and regulated investment institutions over new entrants. 

The current UK government is trying to spend less, but it's refusal to regulate means extractive frameworks are not being overhauled. Of course there is a danger that the new entrants seeking a level playing field may be tomorrow's "extractive institutions". But that would at least imply significant creative destruction in the meantime. Ideally the rise of "extractive institutions" would be kept in check by more dynamic regulatory intervention, but future overhauls may be required.  

That is the politicians' job. But they, too, have a tendency to be the enemies of growth.

When in Doubt, Stay Out

I’m with the Tories on the EU treaty veto. There are just too many unanswered questions for anyone not already implicated to sign up. Even other EU leaders are now saying they'll struggle to sell the treaty nationally. 

Key among those questions is how the EU can democratically enforce its fiscal rules. I say ‘democratically’, because the whole point of the European Union is to avoid the diplomatic equivalent of ‘sending the boys around’.

Graham Bishop tries to address this in his short book, "The EU Fiscal Crisis: Forcing Eurozone Political Union in 2011?".

Perhaps the best place to start is Graham's point that “Wrong behaviour in misleading investors is still wrong even if the motive is patriotism, rather than personal greed.” During the Maastricht Treaty negotiations in the early ‘90s, Graham wrote some papers that “doubted the willingness of finance ministers to discipline profligate states”. The issue was ignored at that time on the basis that member states assumed it would always be in a profligate state's interest to want to do the right thing - a version of the efficient markets hypothesis, royally debunked first by Lehman Bros et al and now Greece. Even Alan Greenspan has had to admit that, left to itself, when any organisation is in trouble it is likely to behave in a way that suits those in 'control', which is why a taxpayers' guarantee constitutes a moral hazhard.

After gamefully attempting to explain the alphabet soup that comprises the EU financial bandaid stability aparatus, Graham recommends four principles of more effective fiscal supervision:

1.       Recognise there is nominal credit risk in the debt issued by a state that can’t print its own money – traditionally, there is assumed to be no nominal credit risk on loans to central governments held to maturity, since it's assumed that if the government needs more money it will simply print it (even though this may create other problems) - this is clearly wrong for Greece, for example;

2.       Make it progressively harder for EU banks to finance the excesses of an EU member state;

3.  Insurers, pension funds and other caretakers of peoples’ savings should be similarly disincentivised from concentrating on risky public debt;

4.      “Develop necessary flanking measures".

Funnily enough, non-Eurozone investors seem to be playing by these rules, even if the Eurozone isn't.

Little wonder private investors are working hard on contingency plans for Eurozone break-up.

Bad Data In...

The IMF seems to be having a bad year. First it was accused of 'groupthink'. Then it was rumoured (again) to be considering Gordon Brown as its leader.

Now it's The Economist's turn to sink the slipper. It points out that the IMF's forecast of China's current-account surplus assumes a steadily depreciating yuan, and a widening surplus. That provides ammunition for protectionists to impose tariffs on Chinese goods. Yet China's current-account surplus has actually declined since 2006.

But let's not just pick on the IMF. In "Botox and Beancounting", The Economist also points out the cosmetic effect of US official measures of government debt, productivity and economic growth compared to European measures. "The snag comes if investors fail to grasp that official national figures can show the American economy in an overly flattering light."

Of course, none of these is an isolated incident. There are also fundamental problems in comparing corporate financial data, for instance, given differing accounting standards.

And we live in a world where auditors are still trying to figure out what "scepticism" means...

But we don't have a problem detecting bad data. Plenty of people warned others about what Madoff's fraud, for example, and investment analysts routinely uncover issues such as The Economist has reported. Short-sellers make this their business. No, as David Einhorn elucidated in "Fooling Some of the People All of the Time", the problem is how to give the same weight of publicity to the prudent interpretation of the data as is given to the release of the data itself.

The media and social media clearly play a significant role. But even if we create an Office of the Devil's Advocate, ultimately each of us must accept responsibility for thinking critically about the data we're given if we're to avoid making some big mistakes.

Image from TraceyNolte.

Localisation

I've often berated the European Commission's vain attempts to catalyse cross-border markets using Directives. The law follows commerce. And recent sociolinguistic research has shown that the way language evolves locally has not been altered by, say, the global distribution of Hollywood films, immigration or mass-market travel. So it was interesting to see Schumpeter put "the case against globaloney" based on World 3.0, the new book by Pankaj Ghemawat that demonstrates how thin the evidence is that globalisation has really taken hold - a must-read for Eurocrats.

Image from Translation-corner.

Of Models and Short Regulators

Yet another tip of the hat to Gillian Tett for her article on "Metaphors, Models and Theories" by Emanuel Derman, author of My Life as a Quant, currently a professor at Columbia University and the head of risk at a fund manager. He also blogs here.

Derman's paper helps one get to grips with the financial crisis by succinctly explaining the shortcomings of financial models. Importantly, he points out that:

"Models are analogies, and always describe something relative to something else. Theories, in contrast are the real thing. They don't compare; they describe the essence, without reference."

While Derman gives examples of various theories that can be expressed in mathematical equations, he shows that finance is not capable of such expression. "There are no genuine theories in finance... Only imperfect models remain."

Derman suggests that we "use models as little as possible, and to replicate making as little (sic) assumptions as [we] can," and that we adhere to five rules:

1. While every financial axiom is wrong, the question is "how wrong, and can you still make use of it?"
2. "Build vulgar models in a sophisticated way", "using variables the crowd uses... to describe the phenomena they observe."
3. "A user should know what has been assumed when he uses the model, and... exactly what has been swept out of view."
4. Models can't be truly right. "You are always trying to shoe-horn the real world into one of the models to see how useful an approximation that is."
5. "To confuse the model with a theory is to embrace a future disaster driven by the belief that humans obey mathematical rules."

Of course, such limitations could also be said to extend to non-financial models deployed in and around the financial markets, demonstrating the enormous challenge inherent in the regulation of markets for complex products.

Financial models don't operate in a vacuum. The debt markets comprise at least as many models with inherent assumptions about how various aspects of those markets should operate as there are roles, functions, systems and controls, whether they be related to accounting, regulation, underwriting, collections, rating, marketing or audit. Everyone is operating on models - rating models, asset pricing and valuation models, accounting models that assume a company's health is reflected in its financial statements, regulatory models that may be either 'light touch' or heavily prescriptive. And everyone is operating on his or her own model of how these models work together.

The shortcomings of financial models apply equally to all of them.

However, all these models only ultimately 'bite' when a transaction occurs. And since transactions only occur between buyers and sellers (or their agents), only their beliefs about how models 'work' affect each transaction - capitalism keeps the authorities and everyone else on the sidelines. So the 'protective' models deployed by support functions and external actors can only be effective if they are properly deployed and fully understood by market participants. This seems impracticable, given that the likes of lawyers, accountants, ratings agency managers and bond traders have very different views of the same market, and differing attitudes to their employers, clients and so on.

So it's no real surprise that the narrative of the current financial crisis (e.g. "The Big Short") demonstrates the deficiencies in all these models and the manner in which they were deployed, as well as the (sometimes willful) lack of understanding of them amongst virtually all sub-prime debt market participants, regulators, intermediaries and advisers.

This poses an enormous challenge for the future development of markets for complex products. Better financial models, and better use of those models, won't avoid future financial crises. More rules and regulations cannot really be the answer, at least while they remain external to market participants and their transactions - and weakly enforced. Ultimately, we must either improve the knowledge of market participants relative to the complexity of products (through better education and training and/or by reducing the complexity of the products) or give regulators, or some independent creature - a more active role in transactions, if not as outright participants or potential participants.

Regulatory participation in transactions - or the threat of it - could be achieved partly through real-time transaction reporting from all significant financial markets, as is currently proposed in various initiatives around the globe. But that begs the question what the regulators will actually do with the transaction data.

As suggested in my previous post, perhaps adding short-selling to the regulatory repertoire would not only improve transparency and timeliness in dealing with market misconduct, but also provide regulators with a better feel for the limits in the models deployed in and around the financial markets.

What Is More Socially Important Than The Creation Of Wealth?

I've been reading article after article, and book after book about our financial crisis, and the really bad news is not the continuing poor risk management and regulatory failings despite decades of warnings in the form of scandals and mini-crises, or bank ram-raids on the Treasury to cover their losses while they retain their profits and keep paying giant bonuses, or £81bn in public sector spending cuts, higher unemployment, lower house prices or a decade of economic malaise.

The really bad news is that all this stems from a western cultural problem that is nowhere near resolution, so that we are doomed to repeat the whole, sorry saga.

Of all that I've read so far, perhaps John Lanchester's Whoops! has been most emphatic in elucidating what that cultural problem is - recently borne out by the ending to Money Never Sleeps (and, indeed, "The Other Guys"). Lanchester alerts us to the fact that John Maynard Keynes, the great god of economic thought, wistfully looked forward to a new world without greed and acquisitiveness:

"When the accumulation of wealth is no longer of high social importance, there will be great changes in the code of morals. We shall be able to rid ourselves of many of the pseudo-moral principles which have hag-ridden us for two hundred years, by which we have exalted some of the most distasteful of human qualities into the position of the highest virtues."

J.M. Keynes, "Economic Possibilities for our Grandchildren", 1930

In other words, the root cause of all this financial mayhem is that we have no higher, universally accepted social ambition(s) than the accumulation of wealth.

So when will the accumulation of wealth cease to be of high social importance?

When there is enough wealth? Surely not. There will never be 'enough wealth', because we seem to have no idea what 'enough' is as a society, nor how to figure that out. And there will always be greedy people, and people in great need, who will be compelled to find a way to accumulate wealth. So don't look to change people's desire to accumulate wealth as a solution. That will never happen. Especially when the financial crisis is putting everyone under pressure to make a penny to survive, although an Age of Conspicuous Thrift and a focus on sustainable capitalism may help.

No, if we are going reverse an ugly trend in our financial system, our society must agree on at least one higher ambition than the accumulation of wealth.

What's it to be?

Learning?