Distributed Economics

Today, May 9th, is is 39 days since the Federal Reserve Banks of the United states of America stopped buying Mortgage Backed Securities at the end of March 2010 with TARP funds.

Strictly, as Calculated Risk and others have pointed out, actual purchases won’t finish until mid year, since some payments won’t be settled for a few weeks after purchase. But to all intents and purposes, after a year where credit issuance was held fairly constant courtesy of the US taxpayer, approximately $100 billion dollars of credit is now being removed from the US credit economy each and every month.

This is the backdrop to the Greek crisis. All the time Mortgage Backed Securities are being sold by the Banking system, credit is effectively unlimited. As soon as it stops or slows down though, then credit begins to dry up. The large majority of today’s debtors, be they Governments, companies, or private citizens, don’t plan on repaying their debt, but on continuously renewing it. This works as a strategy while the total quantity of available debt is continuously expanding, as it has been for the last 2 decades, it fails very quickly once any credit contraction sets in. So as the withdrawal of Federal Reserve support for the credit suppliers starts to impact, debt renewal becomes a problem again, and the axe falls on the biggest, weakest, debtors first – in this case Greece.

Not that Greece has ever been a poster child for fiscal responsibility, even before Goldman Sachs decided to help them out with their Euro application, but that brings up a well known problem in engineering, avoiding single points of failure.  Greece has a population of a little over 11 million, and is a member of a currency union of something over 300 million people. If the underlying system regulating that currency union is so fragile that it can be endangered by one, rather small country misbehaving itself, then it’s reasonable to argue that the problem isn’t Greece per se, it’s the system itself.

The singular failure that the creators of the Euro committed,was the failure to completely standardize banking practices across all countries. Although mechanisms exist to regulate the creation of money by banks and countries, there was no separate regulation of debt. Presumably the creators thought that debt was implicitly regulated by the money supply, but unfortunately the introduction of securitized loans had broken that assumption. So within the Euro zone there are countries whose banking systems have issued large amounts of Mortgage Backed Securities such as Belgium and Ireland, and others who haven’t. The increased amount of private, bank originated debt, now competes with Government debt for renewal, and either the amount of total credit available  spirals increasingly out of control, or somewhere, somebody’s debt isn’t renewed. Failure of  debt to be repaid in this system isn’t a matter of borrower whim, it’s a mathematical inevitability.

The US and European  economies, and through them the rest of a highly interlinked global financial system, are now caught in the red queen’s securitization trap. The financial system can’t keep issuing Mortgage Backed Securities without buyers, but it can’t stop either. Stopping triggers the same credit crisis, and the same Fisher debt deflation cascade that was avoided by creating the TARP fund purchase scheme. But continuing, or to be more accurate, restarting federal MBS purchases, simply continues to transfer fractional reserve originated debt from the Banks to the federal government, and from there to the taxpayer.

And while there is no systemic control on the total amount of debt that Banks can originate, the runaway global debt spiral can only continue.

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In memorium: Paraskeui Zoulia, Aggeliki Papathanasopoulou,  and Epameinondas Tsakalis.

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Over in the land of the rising Volcano,  the first full report on a banking system collapse has just been released.

Interestingly, even with a report that goes into a fair amount of detail on the extraordinarily contrived web of lending and borrowing between a small circle of Icelandic  businessmen, the main Icelandic banks, and their overseas Creditors, there seems to have been relatively little attention paid to the problems in the underlying monetary mechanics that allowed it to happen. In particular, the  approximately ten times expansion in the money supply that accompanied the businessmen’s sleight of loan practices, appears to have been overlooked.

Money supply figures for Iceland are available from the Icelandic Central Bank. The following analysis is based on the “Monetary Aggregate” (Peningamagn og tengdir liðir) spreadsheet which is the only statistical series that appears to have been updated since the collapse in September 2008. It labels figures since Sept 2008 as ‘provisional’.

This series covers M1, M2 and M3 statistics up until 2009. As previously discussed, the M series monetary statistics are not an entirely pure measure of the total amount of money in any given monetary system, as they can include some forms of debt instruments. In the Icelandic case, two adjustments need to be made to get a quantitative estimate purely of Icelandic Krona: the removal of Money market accounts from M3 which eventually amount to about 10%, and also foreign currency accounts which are included as part of M2. Foreign currency savings accounts incidentally, as a percentage of krona denominated M2, vary between 15-43% of total M2 over this period – which suggests there are other potential stability issues, especially for small currencies, lurking in the background connected to the fractional reserve banking system.  Iceland’s banking and currency system has never been a haven of price stability.

The issue illustrated here is both scientifically fascinating, and utterly appalling in its eventual effects. Iceland deregulated its banking system in 2001. Two of the banks, Kaupthing [nee Búnaðarbanki] and Landesbanki, were sold to private businessmen, who in at least one case used money borrowed from one bank, to purchase shares in the other. Now let’s think about that for a moment, in the context of fractional reserve banking. You borrow money from one bank, and use it to buy control in another. How does that borrowed money get treated? If – and it seems to have been the case – that money is put into Equity Capital holdings at the second bank, then the total amount  the second bank  can lend, and thereby increase the overall money supply by, has just increased. As a result of a debt somewhere else in the banking system. It’s a feedback loop entirely within the commercial banking system, increasing the money and debt supply, independent of any control by the central bank.

The statistics are divided into two series, with considerably less detail available from the earlier period. We can see from the first series below, that quantitatively the currency was relatively stable up until 1997 when M3 began to diverge from the other measures. Unfortunately, there is no detail in the first series to suggest exactly why.

The second series is over a shorter time period, slightly over 6 years. Although the most dramatic behaviour of the currency is in 2007-8, what happens before then shouldn’t be overlooked. Between September and October 2003 for example, M1 and M2 double.

Iceland is a very small country, of approximately 300,000 people, which is why these effects are so obvious. M2 as shown here is the total amount of bank deposits in the country, aside from longer term time deposits which are counted as part of M3. Iceland, as elsewhere, stores its currency electronically – physical notes are printed as needed. But the size of the country, and the electronic nature of its storage, doesn’t change the quantitative nature of what happened in September 2003.

Looking rather closely at those two months, it looks like there was approximately an 100,000 M.Kr. increase in bank deposits. At a guess, and that’s all it is, the proximate cause of the increase was probably the first payments by the Icelandic banks of the money being lent for the Icelandic Power Companies then latest venture into Aluminium production, to the tune of  $20 million in locally sourced loans. This at some level just represents how fractional reserve banking works, and if nothing else, demonstrates the dangers of making big loans within a small currency base. In terms of nuts and bolts economics, the production of things, the support of livelihoods, and general improvements in living standards,  the loan certainly made sense, in increasing total electrical power available to the economy. It’s the monetary side effects, inflation as a result of a loan, and then presumably deflation as it’s repaid -  although it seems that’s an increasingly old fashioned concept these days  -  resulting purely from the mechanics of the underlying system where the loans are created, that don’t.

The money supply continues to increase over the next 3 years. It’s masked to some extent by the rather dramatic increases in 2007, but M1 doubles by the end of 2006, M2 increases by about 1.8 times, and M3 by a factor of 1.6. CPI Inflation rises from 2% in 2004, to 8% in 2006, and this causes other problems. Icelandic krona loans are index linked, something that was introduced to deal with a previous bout of severe inflation – in fact, i’d guarantee that historically Iceland got severe inflation anytime their power company decided to expand their electricity supply, and borrowed money to finance it. Fractional reserve banking is far from problem free even when it’s not being deliberately exploited.  The increase in the last decade though, had another cause.  In the background of the Icelandic economy, a small cabal of Icelandic businessmen had effectively turned their businesses, in conjunction with their relationships with the owner’s of the three main Icelandic banks, into what appears to have been a co-ordinated exploit of the Equity Capital loophole.

As a result of this, the Icelandic money supply measures double again in the year between January 2007 and September 2008, when the collapse of Lehman Brothers intervenes, and turns Iceland into, were anyone paying any attention to the actual systemic issues behind the credit crises of the early 21st century, the canary in the goldmine.

Doubling the money supply in slightly over a year, is by any standards extraordinary. As is having it increase by an order of magnitude in  7 years. It’s not Weimar levels of increase, but neither is it something that should just be occurring without any comment. It also makes any and all economic statistics for that period from Iceland highly suspect. Money is used as an economic measurement. If the quantity of money is changing, and this isn’t corrected for, it’s akin to trying to measure with an elastic band.

Quantitative changes in the ratio’s between currencies don’t necessarily play themselves out in immediate adjustments to currency trading, the relationships themselves seem to be quite sticky with sudden, abrupt changes. The Icelandic Krona’s exchange rate was relatively stable up until the crisis hit in 2008 in an 80-100 band. The high interest rates being paid because of central bank attempts to control the monetary expansion acted to attract foreign investment, and damp down the quantitative impacts of the increase.  In Iceland as elsewhere, a lot of the quantitative increase in the money supply is essentially getting trapped within the monetary system, which limits the impact on general inflation. Iceland did experience a severe housing bubble though, and there as elsewhere, the shells of uncompleted luxury condominium projects litter the countryside.  What is clear today, is that anybody holding Icelandic Krona at the 2008 rate of 90 to the Euro, has lost about half of their purchasing power with the current, capital control protected rate of 172.

The total quantity of Icelandic M1 and M2 in circulation over the 2003-2009 period in fact increased by about 10 times. Measurements of M2 can’t be compared exactly between countries, because they aren’t consistently defined, but driven by similar systemic factors, US M2 doubled in roughly the same time frame, and the Euro increases by about 50%. This would counterbalance the Icelandic increase to some extent, and any increased production would also have had a counterbalancing deflationary effect.  While it’s also certainly not the case that all currency is local, neither is all currency available for foreign currency trading.

Although the Icelandic Central Bank has been heavily and rightly criticised for its role in this, it has a  simple defense on the behaviour of the monetary mechanics. It followed the Economics textbook. It raised interest rates, to try and control the money supply expansion being created by a business culture that had devolved to simply making as many loans as possible, and extricating the proceeds abroad. All this achieved though, was to attract more foreign currency into the economy in pursuit of higher interest rates. Enabling increased expansion, and more loans, rather than the careful control and regulation suggested by Economics theory.  The Economics textbook is wrong at a very basic level, but since its false assumptions are so embedded and central to the discussion itself, it seems impossible to break its hold on the debate.

But perhaps we can start with a simple question.  In Economics’ textbooks, control of the money supply is consistently described as being solely the responsibility of the Central Bank, and for very good reason. Changes in the total supply of money effect everybody, double the money supply, halve the value of people’s savings. Weimar was just the extreme case.  So perhaps somebody could ask the Icelandic Central bank if they deliberately increased their money supply by ten times over the last 7 years?

And if they didn’t, who did?

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The latest Bank of International Settlement Figures are out for Asset Backed Security Issuance for September 2009. The total amount of outstanding international securitized loans  increased by approximately $1 trillion in the 3 months between June and September 2009. Based on the  USA’s stock market performance this last three months, I wouldn’t expect there to be a drop in issuance this quarter either, especialy since the Federal Reserve Banks are still the buyer of last resort. That puts the world on track for a total increase in issuance this year of around $3 trillion. There are some rather interesting questions hanging around relative valuation of financial instruments given that the unit is american dollars, and the dollar hasn’t being doing well of late, but that doesn’t effect the impact for the USA.

The Federal Reserve  expects to be able to stop buying Mortgage Backed Securities next March. It will certainly be quite entertaining if they try.

The gross figures are quite interesting. They do show that up to this point, securitization is predominantly a problem of developed countries, although issuance is starting to increase in the developing countries. The first credit crisis period also stands out clearly, and stands out as a drop in securitization. So a naive approach to the problem, would be to simply worry about that drop, and find ways to “restart the securitization pipeline”, which is pretty much the policy that has been both advocated and followed over the last year.

Consequently, the Federal Reserve Bank of America, wittingly or unwittingly, has put itself in an interesting situation. They can’t stop buying Mortgage Backed Securities, as soon as they do, the lending pipeline collapses again, and we get Credit Crisis II. Like all sequels, bigger and much worse than the first release. On the other hand, how long can they continue? Especially as the world’s financiers then turn around and just sell more of them. Thereby increasing the total amount outstanding by $1 trillion a quarter.

Any increase in the outstanding amount of Asset Backed Securities, increases the ratio of debt in the system, to money. Money is ultimately what has to be available to pay debt, so as the proportion of debt within the monetary system increases, there is less money to pay more debt. It’s a complex relationship, especially when variable rate interest payments start to get factored in, and it’s fair to say, one that the world’s financial authorities clearly don’t understand very well, if they think increasing the amount of securitized loans is a way out of this.

Outstanding securitization actually peaked in June 2008 at $25,300 trillion, and didn’t return to that peak until June 2009 this year, at $25,900 trillion. We’re now at $26,900 trillion.  However, trying to predict the next crisis point isn’t as simple as looking at the outstanding figures, and going gulp. In the background, the movement of debt instruments into equity capital is also wreaking its own share of havoc.

This is total liabilities and assets for the US Commercial Banks. It is not as simple as liabilities equals deposits, and assets equals loans, since for one thing the equity capital reserve is listed under assets (hence the excess over liabilities.) But it’s close enough for government work. These figures show the other side of the credit crisis, the debt failure induced contraction in the money supply – total deposits, and also the recovery this year, as the securitisation pipeline was restarted.

The contraction in the money supply as debt was removed from the system, either by foreclosure, or by loan repayment – is pure monetary mechanics – it’s a side effect of the other problems in the economy and a consequence of the linkage between money and debt created by the fractional reserve banking process. However, it has its own repercussions. In particular, it worsens the imbalance between money and debt being created by securitization. So in some sense, it’s just as well that didn’t continue too long.

But the price of an at most half trillion dollar increase in the US money supply, appears to have been over $1 trillion of securitized loans. And the money to buy those loans , was provided as a direct claim on the US tax payer. So it would seem, that ignorant of the underlying causes of the problem, the Federal Reserve is failing, to run the red queen’s race, as it tries to stop the housing market in the USA completely collapsing  from a fisher debt deflation.

Quite how long they can continue to sustain the banks with interest payments on their central bank reserves, presumably being funded from the proportion of securitized loans that they are receiving capital and interest repayments on is a very interesting question. What they’re doing to the rest of the economy in the process, even more so.

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Paul Krugman had an interesting article in the NYT at the weekend, that inadvertently highlights several problems with current economic analysis. He is essentially discussing the presumed evils of deflation.

“Whatever the specifics, however, falling wages are a symptom of a sick economy.”

Really? Why?

Here’s how the paradox works. Suppose that workers at the XYZ Corporation accept a pay cut. That lets XYZ management cut prices, making its products more competitive. Sales rise, and more workers can keep their jobs. So you might think that wage cuts raise employment — which they do at the level of the individual employer.

But if everyone takes a pay cut, nobody gains a competitive advantage. So there’s no benefit to the economy from lower wages.

However, as stated, “XYZ management cut prices” – this is a benefit to the economy. Individual access to goods is controlled by price. Let’s say, all the food manufactuers engaged in a competitive wage cut process, triggering a 10% pay cut, and this resulted in a 1% cut in everybody’s food bill. Krugman goes on to suggest that if wage cuts trigger an arms race across all manufacturers, then everybody is poorer. But this assumes that consumption is performed solely by wage earners. It ignores people on fixed incomes (pensioners), recipients of wages from tax (civil servants).

It seems impossible to predict the actual consequences of what Krugman is describing, outside of the distributed system context that he is implicitly ignoring. For example, tax payments on the reduced wages would fall, presumably triggering a drop in wages derived from tax. But this wouldn’t happen until the following year, since government budgets are typically calculated on the previous years receipts. This introduces a latency component to the problem as well.

The actual problem Krugman is worried about is further down:

In particular, falling wages, and hence falling incomes, worsen the problem of excessive debt: your monthly mortgage payments don’t go down with your paycheck.

Well the problem for most of the american indebted is a little worse than that since their house prices are dropping steadily as well. One might speculate that this problem is particularly acute for NYT journalists, given their location at one of the ground zero’s for the flow of funds out from the financial industry, but that would perhaps be a little discourteous. Quantitatively it seems this is because the artificially boosted loan supply from the securitization pipeline has dropped from approximately $3 trillion in 2007, to $1,300 trillion in 2008. I’ve yet to see any evidence of a Fisher debt cascade in the Federal Reserve statistics, but it could be being masked by the reserve’s rescue activities. It is interesting, to put it mildly, that there are still buyers out there for that amount, but perhaps not so surprising given the Federal Reserves willingness to swap them out for treasuries in the various TALF schemes.

I really need to build a computer model to understand this more thoroughly, but my feeling at the moment is that the tax payer is essentially pumping money through a leveraged loop, to try and sustain some degree of securitized lending, in order to prevent a complete Fisher debt cascade collapse. This puts the tax payer on the wrong side of the money multiplier, and consequently at a distinct disadvantage to Wall Street. But I think we already knew that.

It seems that there might be a need within economic analysis to separate out deflation caused by increased productivity – which is what the computer/datacommunications industries have been experiencing – from deflation caused by fluctuations in the reserve lending system’s loan and money supplies. The latter is really more of a mathematical abstraction, albeit one with very real consequences. Possibly the cause of the business cycle?

The other issue that this highlights is that this is very much an example of loans behaving exactly like money in the general economy. An increase in supply caused (Asset) inflation, a decrease in supply caused (Asset) deflation, with all sorts of side effects triggered by differential latency problems, as the different factors affect the real time economy over different periods of time. Which is support for the idea that stability of the loan supply, is just as critical as that of the money supply.

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