Greece and Dimon and Bernanke

Standard & Poor’s rating services have just given Greece sovereign debt the lowest rating it has.  The Greek leadership is upset.  “We have a very tight fiscal package coming” the leaders say.  Yet the downgrades continue. 

The timing of the reduction in the debt rating, according to some pundits, is not coming at a very good time.

But, these things never happen “at a very good time”.  Building up excessive amounts of debt reduce options (http://seekingalpha.com/article/271651-debt-ultimately-leaves-you-with-no-good-options) and they leave you in a state where there is no “good time” to deal with the debt. 

Yet, people and governments, over the past fifty years, acted as if the amount of debt outstanding did not matter to their economy and that any fiscal difficulty a country might find itself in could be overcome by increasing the spending of the government and increasing the amount of government debt.

The amount of debt a government issued did not matter because the economic models the governments used did not include government debt.  Thus, a government could increase debt as much as it wanted and their economic models would be unaffected.

One of the primary reasons that debt, both public and private, was not included in the models was because there was not sufficient historical evidence on the levels of debt outstanding before, during, and after a financial crisis to justify inclusion in the models.  Kenneth Rogoff and Carmen Reinhart have attempted to eliminate this reason with their study of eight centuries of financial data presented in their book, “This Time is Different.”

Another reason why it is hard to study the burden of debt on a country is that the analysis of the risk associated with any given amount of debt is to a large extent psychological.  There seems to be little if any “tight” relationship between when the market determines that the amount of debt being carried by a country is excessive.  There seems to be no unique “trigger” to determine a sovereign debt crisis.

The bottom line is that the role of debt in the precipitation of a debt crisis is very, very complicated and the quantitative tools that exist are just not sufficient to fully capture any one specific situation.

As a consequence, the amount of debt a country carries is a judgment call, but the more debt a country accumulates the more it limits its future options and the more it loses control over the timing of any “crisis” that might occur.    

There seems to be other cases currently in the news pertaining to governmental decisions in areas that are very complicated and cannot be modeled in any satisfactory way. 

This is brought out very clearly is the column by Andrew Ross Sorkin in the New York Times this morning, “Two Views on Bank Rules: Salvation and Job Killers.” (http://dealbook.nytimes.com/2011/06/13/two-views-on-the-value-of-tough-bank-rules/?ref=business)

In this article, Mr. Sorkin re-plays the recent verbal exchange between Jamie Dimon of JPMorgan, Chase, and Ben Bernanke of the Board of Governors of the Federal Reserve System.  Mr. Dimon, among other things, questioned the ability of the Federal Reserve (of regulators) to understand the consequences of their regulatory actions.

Sorkin remarks, “it’s an uncomfortable truth that Mr. Dimon should be taken seriously, at least his suggestion that policy makers can’t predict the full impact of the coming regulation.”

Sorkin reports that when Mr. Bernanke answered Mr. Dimon’s question, he said, “Has anybody done a comprehensive analysis of the impact on credit? I can’t pretend that anybody really has. You know, it’s just too complicated. We don’t really have the quantitative tools to do that.”

Mr. Bernanke’s answer captures something that the economist Friedrich Hayek stated many years ago, that a central organization or one individual body can never possess sufficient information to make decisions that are dependent upon information that is dispersed widely throughout the economy and is relevant for “local” decision making.

With this statement, Mr. Bernanke loses more of the credibility that he had been trying to hang onto over the past eighteen months. 

The economic models that people and governments have been using over the past fifty years are inadequate, at best, and misleading in practice.  They work best when the economy is smoothly growing.  They just do not have sufficient data to handle the very complex situations that happen when things are not going smoothly.

As Hayek taught us, there is just too much relevant information for us to collect, store, and process and even if we could store it all, most of the information pertains to “local” situations that are way beyond our ability to model. 

Hayek also taught us that one of the major roles of the economist is to demonstrate to decision makers how little they really know about what they imagine they can design. 

In this respect, governments need to create the processes though which decisions are made and should not focus on the outcomes.  Outcomes are a result of those things a decision maker thinks he/she can “design” and this applies to bank regulation, unemployment targets, and so forth. 

 

To me the process of openness and disclosure is still the most important thing that a government can require…of itself…or of the organizations it is regulating.  When the government begins to determine what decisions should be made and what outcomes are to be attained, it begins to exceed its ability to succeed. 

And, as the government fails to attain the outcomes it wants, it asks for more control to gain those outcomes…and then more control…and then more control…

Regulation Never Works As Planned

One constant seems to run through my whole professional career.  The regulators impose some new rules…and within a reasonable period of time, the private sector finds ways to get around the new rules.  Then the regulators impose further new rules…and within a reasonable period of time, the private sector finds ways to get around them.

Back in the 1960-1971 period, I was in the Federal Reserve System and one of the main new financial innovations that the Fed was dealing with at the time was the Eurodollar deposit.  The “time lag” then was about six months. 

That is, the Fed would see some activity it wanted to get greater control of and it would impose new rules or restrictions on the activity.  The banks would then respond to the new rules or regulations.  About six months later the Fed would discover what the banks were doing to get around these new rules or regulations.  Then, the Fed would move into action once again.

At that time, however, we did not refer to the commercial bankers as “greedy bastards.”

In fact, any void seemed to call forth the ingenuity of the financial community.

The credit inflation, begun in the early 1960s, provided the incentive for the financial community to engage in more financial innovation over the next fifty years than ever before in human history. 

Restrictions on the interest rates that financial institutions could pay on deposit—Regulation Q—could not stand up to the inflationary expectations that got built into interest rates.

The consequent volatility in interest rates made it worthwhile to develop interest rate futures and interest rate options.

The desire to drive more and more credit into the housing market resulted in the government creation of the mortgage-backed security and the validation of “slicing and dicing” of the cash flows generated by financial instruments.

This slicing and dicing spread to government issues and we got the Treasury “Strip” securities...and more.

And, the continued credit inflation resulted in greater and greater amounts of risk taking and things like credit default swaps to hedge against risk taking.  We got more and more financial leverage and this required new ways to “cut things up” or hide things “off-balance sheet” or make things “synthetic” or deal only in “nominal” values. 

And, the beat goes on.

To me, this comes out in the rant of JPMorgan’s Jamie Dimon the other day against Ben Bernanke.   His blast, I believe, was one of pure frustration.  We want to be bankers, Dimon said, but the Fed…and Congress…and the Administration…force us to be financial innovators, constantly creating ways to get around the ill-considered new rules and regulations that continuously flow out of the government. 

He could have said, “If you want us to stop the financial innovating do two things.  First, stop inflating credit as you have done for the last fifty years and are continuing to do at this very minute!  Second, let things settle down and stop trying to regulate the very things you are causing us to do because of your inflation of credit!”

Will the government do this?  Not likely, and that is why Dimon is so frustrated.

My prediction: the financial system, over the next five to ten years, will be different in major ways from what we now see in front of us. 

The reason is that bankers…and the public…will create a new and different financial system. 

For, example, what about the “shadow-banking system” that was created in the past twenty years or so?  Maybe this “system” will become the preferred lender to business.

It is still there, thank you, and it is “filling in the current void.”  See the front page New York Times article this morning: “Bank Said No? Hedge Funds Fill Loan Void.” (http://dealbook.nytimes.com/2011/06/08/bank-said-no-hedge-funds-fill-a-void-in-lending/?ref=business)  “With traditional lenders still avoiding risky borrowers in the wake of the financial crisis, hedge funds and other opportunistic investors are stepping into the void.  They are going after mid-size businesses that cannot easily raise money in the bond markets like their bigger brethren.”   No telling where hedge funds…and others…will be found these days.  

And, this doesn’t even include what might be done electronically.

What is money?  What is finance?

As I have argued many times in previous blog posts, money…finance…is just information…just 0’s and 1’s!

“Concerns about the integrity of money have also seen a fundamental shift…While fraud is still a concern, the financial collapse of 2008 has called into question the competence of the central banks that are supposed to manage national currencies.  In this week’s technology special we examine how the internet is allowing groups of people to set up means of exchange that are independent of both the banks and the state.”

Hold on there…

What about gold or silver?

“Private currencies are nothing new, but novel possibilities such as bitcoin now beckon.  Though bitcoins are magicked out of nothing, money is what money does, and many people are happy to accept bitcoins as payment for real goods and services.  The bitcoins in circulation are now worth around $50 million in conventional currency.”

“Governments may want to clamp down on what they see as a way to evade taxes…”

“But the future of money, as so much else, may be shaped by the internet’s ability to bring interested parties together outside the ambit of governments or big companies. “

“Under a scheme operating in the city of Macon, Georgia, special bonds are issued to residents—but each person receives only half a bond, and can only redeem it by locating the person with the matching half.  Participants must seek each other out through online social networks such as Twitter, then decide together how to spend the cash.  Attempts to set up such ‘local currencies’ have been tried many times before, but have usually proven too difficult to co-ordinate and organize.  Social media offer such schemes a new lease of life.” (New Scientist, June 4, 2011)

The point is that regulation never works as planned because humans are just too ingenious and improved information technology and the spread of information eventually winout over time.  As a consequence, regulators…and politicians…are always fighting the last war.  Another way to phrase this is that regulators…and politicians…are always out-of-date!

Follow the Dimon!

For months I have been arguing in my blog posts that the larger banks have already moved beyond the regulators although they have always been far in advance of the politicians. These latter two groups of people are attempting to create a regulatory system that will prevent the events of 2007 through 2009 from happening again.

Would somebody tell them that the big banks are somewhere else.

JPMorgan Chase announced some major changes in their top management structure yesterday. These changes, to me, are just the most visible sign that the banking of the future is going to be significantly different from the banking of the past. But, we’ll come back to this later on.

The management changes also confirm, to me, that Jamie Dimon is the pre-eminent banker in today’s world.

Why?

A long time ago I stopped looking at the “glow” of the person running things, the Chairman, President, or CEO, and I started concentrating on the people around the glorious leader. I found that the fact that the leader of an organization had very, very capable and experienced people around them was a better indicator of the quality of the person in charge than was his or her own sparkling image.

Top people have top people around them. In addition, winners help to make everyone around them perform better.

Jamie Dimon has these qualities.

I believe that Jack Welch also had them.

One person I had contacts with at one time who, I felt, didn’t have these qualities and was a disaster waiting to happen, was Donald Rumsfeld.

Jamie Dimon has a top notch team around him and is positioning them to take on the world. In my estimate, more than one of the individuals that are on this team will be a Chief Executive Officer of a major bank in the United States…or, the world.

Many people that Jack Welch had around him went on to lead major companies around the world.

But, back to the banking changes: JPMorgan is going off-shore!

The New York Times has it right, “JPMorgan Sets Sights Overseas,” (http://www.nytimes.com/2010/06/23/business/23bank.html?ref=business). Dimon has given out the mandate to his closest lieutenants “to start a global corporate banking business and scout out opportunities in Europe, Latin America and Asia.” Mr. Dimon, himself, has recently been in China, India, and Russia and wants to especially focus on these three BRIC countries as well as Brazil and also Vietnam, Indonesia, Malaysia, the Philippines and parts of Africa.

My suggestion: Watch what Mr. Dimon and JPMorgan do. My guess is that they will point the way to the future and will do a good job along the way!

But, what about American and Europe?

In terms of banking and finance, I am not sure the political and governmental leaders in these areas of the world know what they are doing. For one, as I have said over and over again, in terms of financial regulation…they are fighting the last war!

Politically, both areas are split and looking for direction. No one can tell at this time where “direction” will come from.

So, what better time than this to move to where the action is going to be!

If anything, the fiasco going on in Washington, D. C. is going to drive business and finance further off shore. The BRIC nations are becoming wealthier and more savvy in the world. They are also accumulating more power as will be in evidence in the upcoming G-20 meetings. But, as Mr. Dimon indicates, there is a lot more going on if one looks to the other countries he has highlighted in his recent statements.

Moving in this direction will involve acquisitions, something that JPMorgan has already started doing. To build itself into a larger presence in these markets in a timely fashion, the company will have to acquire significant other properties. JPMorgan Chase is going to get bigger.

And, Washington was concerned with the size of the banks in the United States that were “too big to fail” in 2008?

Furthermore, this doesn’t even get into one of my favorite subjects, the “quantification” of finance. What is going on with respect to the “quants” in JPMorgan? My guess is that there has been significant movement in this area as well over the past two years.

The future of banking?

Keep your eyes on the Dimon. I think you will find that it will be time well spent!