The Beveridge Model

William Beveridge

Want is only one of the five giants on the road of reconstruction and in some ways the easiest to attack. The others are Disease, Ignorance, Squalor, and Idleness. 

-Social Insurance and Allied Service, a.k.a. The Beveridge Report (1942)

In 1940, Great Britain tottered on the edge of extinction. Its armies badly mauled by the Wermacht in France, its cities absorbing a ferocious shellacking from the Luftwaffe, and the United States still over a year from entering World War II, the British government in an act of supreme optimism began making plans for post-war life on the assumption that it would prevail over both Nazi Germany and the Empire of Japan.

There was little doubt that the aftermath of two world wars and an economic depression would wrought profound changes on British life. The working- and middle-class men who had fought the wars would insist on taking charge, and the heretofore dominant patricians admitted that they had a point. Prime Minister Winston Churchill appointed noted economist and social reformer Sir William Beveridge to define a paradigm for the brave new world; Beveridge's effort changed the face of Europe.

Social Insurance and Allied Service, published in 1942 and also known as the Beveridge Report, became the blueprint for the postwar British welfare state. A bestseller in its day, the report was distributed to British troops despite an aborted attempt by Churchill to suppress it until after the war. Wildly popular across the political spectrum, the post-war implementation of the Beveridge Report became a foregone conclusion.

While it focused mainly on social insurance -- what Americans think of as Social Security -- the report also articulated the right of anyone to receive health care on the basis of clinical need regardless of ability to pay, and gave rise to a health care system known as the Beveridge Model. While the term "socialized medicine" is often used carelessly and inaccurately, the Beveridge Model is in fact socialized medicine: A health care system owned and operated by government.

Today, the Beveridge Model is applied by Cuba, Denmark, Finland, Great Britain, Hong Kong, Italy, Norway, Spain, and Sweden. With the exception of Cuba, all are capitalist democracies that have decided to remove the profit motive from health care on the grounds that it compromises equity and efficiency.

While the model is implemented differently in each country, it operates on the basis of a set of one or more common characteristics:

• Health care is a human right, not a privilege
• Government ownership and operation of health care
• National government responsibility for delivery of equitable and efficient health care
• Full access to all regardless of ability to pay
• Primary care physician as gatekeeper to the rest of the system

One misconception about the Beveridge countries is that the costs of providing expansive health care for all residents have been prohibitive and bankrupting. The following table shows that Beveridge Model countries deliver health care efficiently and with great effect:

As a whole, Beveridge Model countries spend a lower percentage of GDP on health care than any other nation. Why? Because the Beveridge Model is tax-based and not insurance-based, the governments of those countries have great incentive to emphasize the biggest bang for the health care buck, that being preventive care. As a result, Beveridge Model countries tend to have robust public health programs (Finland is one of two countries to reverse the obesity epidemic plaguing the developed world) and a strong emphasis on primary care. (Seventy per cent of British doctors are PCPs as opposed to 30% in the United States.) Primary care contributes to better outcomes, increased use of preventive services, fewer hospitalizations, reductions in overall costs, fewer hospitalizations, and less use of emergency departments.

All approaches to health care have tradeoffs, and the Beveridge Model is no exception. Welfare state values that call for a high level of social services also mean higher taxes. The emphasis on efficiency often results in less choice for patients, and broad service offerings tend to concentrate in urban areas. While doctors receive free education, have little administrative burden, and are almost never sued for malpractice, they are also salaried and earn less than their American counterparts. Equal access and the emphasis on primary care can translate into long wait times for non-acute secondary and tertiary care. Finally, the imperative to hold down costs means that the newest technologies are not easily available.

Converting the United States to the Beveridge Model -- and there's little reason to believe that the American people want this -- means eliminating the health insurance business, making virtually all physicians salaried government employees, tightening the regulatory screws on pharmaceutical companies, and establishing wholly new government bureaucracies at the federal, state, and local levels. In the absence of a complete societal breakdown, American history suggests that this degree of systemic change requires a sustained nationwide mass movement of at least 8-10 years. Given the undesirability of the former and the unlikelihood of the latter, it's most productive to think of the Beveridge Model in terms of what can be gained from it.

So while opponents of socialized medicine can rest easy, there are nonetheless lessons to be drawn from the Beveridge countries:

• The value of a national health policy to provide guidelines and direction for federal response to national health issues
• The importance of a strong public health program (at all levels of government) to preventive health and reduced costs
• The key role of primary care, again in prevention and efficient allocation of health care resources

Later, HealthMatters will look in detail at the health care systems of Beveridge Model countries.

Repost from 06/06/08: Reagan and Obama - Reforming the Welfare State

In Britain a national election lasts just three weeks and spending by each candidate is strictly capped. Campaigning between elections is not permitted. Accepting so much as a hotel stay from a lobbyist is a resigning offence. As a result, our news is full of the American campaigns to make up for the deficit in newsworthy political conflict locally. I follow the American election, as does most of the world given the potential for good and ill that proceeds from it. Please indulge me in ruminating on one aspect of the Obama candidacy that intrigues me.

Ronald Reagan came to power on a popular backlash against the welfare state. It appears that Barack Obama may come to power on a similar backlash against the welfare state. The difference is the identity of the welfare claimants.

Ronald Reagan inflamed the public’s righteous anger against a stereotyped ghetto “welfare queen” who raised a brood of illegitimate, proto-criminal children on public funds. Barack Obama will inflame the public’s righteous anger against the corporate welfare queens who have raised a brood of profiteering executives and lobbyists in the generation since. Under Reagan and succeeding presidents, including Clinton, the K Street lobbying machine transformed Washington DC into a government by the lobbyists, of the lobbyists and for the lobbyists. Subsidies, market distortions, tax breaks, earmarks, selective protectionism, regulatory forbearance, cost-plus government contracts, relaxed accounting oversight, criminal and civil immunity, war profiteering and other policy depredations promoted a corporate welfare state beyond the dreams of ghetto avarice.

Ronald Reagan partisans demonised citizens who paid no taxes but claimed public housing, medical care and food stamps as their right. Barack Obama appears prepared to challenge corporations who pay no or nominal taxes (worth clicking through just for the graph) but claim government subsidies, earmarks and tax breaks as their right. Corporations have further stripped the US tax base by outsourcing or relocating jobs abroad, leveraged speculation rather than productive capital investment, and transfer pricing to avoid US tax. If Obama does parallel Reagan, both campaigns will tap a deep well of public anger against the perceived injustice of those who degrade the nation’s future prosperity while claiming too much from its taxpayers.

The bankers of Wall Street now toasting the Fed’s recent largesse from their Hamptons beach houses and yachts are the latest in a long line of American corporate welfare queens who have lobbied for and secured generous federal contracts, subsidies and regulatory forbearance. As noted two weeks ago in Looting the Vaults, more has now been lent to banks by the Fed under opaque new facilities than has been appropriated for the war in Iraq. Both the Fed’s new facilities and the war appropriations arguably benefit corporate welfare queens rather than serve the public interest.

The contrast between McCain and Obama on lobbyists alone is striking. Obama has banned contributions from lobbyists to his presidential campaign, even returning $500 donated by Thurgood Marshall, Jr. Instead, Obama has built a novel fundraising machine that reaches out to millions of working class Americans. McCain’s campaign relies almost entirely on wealthy contributors and lobbyists for finance. He has recently suffered a series of staff purges as high-ranking campaign officials - all of them lobbyists - were linked to large corporations and dictatorial regimes. Obama has committed to opening his fundraising events to the press pool. McCain insists on holding his fundraisers behind closed doors, no press allowed.

Obama as the presumptive Democratic nominee and party leader is preparing to drive the contrast home. Yesterday Obama enforced his opposition to special interest money on the wider party. Obama announced that from now on the Democratic National Committee will return cheques from lobbyists and political action committees, mirroring the Obama presidential campaign. This is a significant initiative in positioning the Democrats as the party to reclaim government from the corporate welfare queens.

The media pundits will use the reliable rhetoric of identity politics, religious strife, class war, patriotism and national security, but they are merely masking the fundamental policy conflict that divides the presidential candidates: Should government serve the people or the corporate elite? When Obama invokes Reagan, as he does very effectively in his elegantly crafted speeches, he is tapping the same vein of public outrage against a government promoting the comfort of those who contribute too little to the nation’s wellbeing.

A recession would clarify the public policy choices. When the economic pie is shrinking, fairness becomes a surer focus. The eyes of the hungry are watchful as the slices served get smaller.

Can Obama successfully challenge the K Street machine? He encourages us to hope, but we should be realistic. The K Street machine will not sit idly by as their unfettered control of the corporate welfare state is threatened by the upstart junior senator from Illinois who would not “wait his turn”.

Ghetto welfare queens were powerless to forestall the legislative and regulatory reforms that cut their subsidies. Corporate welfare queens are very far from powerless. We see new evidence of their power to claim public funds and direct public policy every day as the credit crisis closes off private finance options and squeezes profits. Whether the American public can elect enough reform-minded representatives to successfully challenge the corporate welfare queens may be the political test of this generation and may well determine whether the American economy recovers its powerhouse status.

Also on Thursday, Obama introduced legislation on the floor of the Senate to expose the corporate welfare queens hiding in the federal budget: The Strengthening Transparency and Accountability in Federal Spending Act of 2008 (pdf).

Is JP Morgan a welfare queen for the Fed subsidised Bear Stearns buy-out? Discuss.

Next week I promise to stick to economic and regulatory policy.

__________________________

Post Script on 22/12/08: JPM's paltry $37 billion subsidy from the Fed back in the Spring seems like chicken feed compared to the over $5 trillion the corporate welfare queens have looted from the Fed and Treasury since then. Worse, I am now sceptical that Obama will be any different to Bush in terms of restraining taxpayer largesse to corporate elites. He seems to endorse every bailout and stimulus, regardless of merit. We shall just have to wait and see what happens, but so far Obama is looking only marginally more fiscally sound than Bush.

How Much Money Do You Spend On Health Care?

The per capita annual income of the United States is $44,070. Of that, $6,174 goes to health care expenses, meaning that the average American spends 14.3% of his or her income on health care. This can come in many forms: co-pays, Medicare withholding, deductibles, out-of-pocket expenses, and tax subsidies for employer-based health insurance.

As a point of comparison, consider the averages of six of the Beveridge Model nations. (I've excluded Cuba, Hong Kong, and Norway: Cuba has a command economy and so is not comparable; Hong Kong is an outlier; and Norway's nationalized petroleum helps fund its social services.) As a group, Denmark, Finland, Great Britain, Italy, Spain, and Sweden have an average per capita income of $37,222. Of that, $3,031 goes to health care, meaning that the residents of these countries spend 8.1% of their incomes on health care (including the tax burden).

Six Bismarck Model nations (Belgium, France, Germany, Japan, Netherlands, Switzerland) have an average annual per capita income of $35,067, with $3,379 going to health care (9.6%). (Keep in mind that there are more than six Bismarck model nations.)

So, if the average American per capita expense on health care was 8.1%, as it is in Beveridge model countries, he or she would spend $3,570 on health care for a savings of $2,604 person. For a family of four, that's over $10,000 a year. For the economy as a whole, that's about $786B per year that is arguably being spent unnecessarily and unproductively.

If the average American per capita health care expense was 9.6%, as with the Bismarck model countries cited here, he or she would spend $4,230 annually for a savings of $1,944, or nearly $8,000 annually for a family of four and $583B for the economy as a whole.

Another way of looking at it is to compare per capita incomes before and after health care expenses:

United States: $44,070/$37,896

Beveridge: $37,222/$34,191

Bismarck: $35,067/$31,688

None of this is intended as an endorsement of either model. But it illustrates the impact that reducing the per capita health care expense from 14.3% to 10% would have: A family of four would have an additional $7,000 a year to save, buy food and clothes, travel, or enjoy family activities. Moreover, 10% is a completely reasonable goal: It's still higher than almost every other country in the developed world. 

Robert Paterson's Boyd 2008 Summary - Hope!

From Robert Paterson's blog on Boyd 2008:

* The goal for us all to work to is clear - that we have to build back into the system Resiliency. This means that each region has to work to become largely energy, food and financially self sustaining and that each region needs to network into the others. In effect we shift from an efficient machine to a resilient network

* That the leadership model is no longer the dominant hero but the ego-less servant

* That we cannot wait to be saved. We have to all do our part to make our place "Home"

Many are desperate that somehow President Obama save us and importantly turn the clock back. Take us back to consumer heaven of 2006. Even if he could, would this be the right thing to do? To take us back to a world that is a fantasy?

What got us to this place?

The Dark Side of a Mindset. The Machine/Institutional/Newtonian/Engineering Mindset that created most of the wealth of the 19th and 20th century tipped over into the dark side. Where not only did we give up all our power to institutions but gave the few that ran them the license to use these institutions for their own benefit.

So we spend nearly a trillion on defense but not on what the troops really need. We spend billions of health and America is on a par with Cuba. We spend billions on education and more than 50% of Americans are functionally illiterate. We spend billions on food and we eat crap. We see that the leadership of these institutions live in a bubble. The gap between the rich and poor has never been greater. The middle class is being squeezed. We don't make anything anymore. We make no progress toward energy independence.

The Big Four

The nations of the world have coalesced around four approaches to delivering health care:

• The Beveridge Model, wherein the government owns and operates health care. Cuba, England, Hong Kong, Italy, Spain, and the four Scandinavian countries all provide health care via the this model, which is named for the British reformer who designed the parameters of Britain's welfare state. Beveridge Model systems are characterized by their commitment to public health and primary care, as well as efficiency. Also known as single payer, the Beveridge Model is the embodiment of socialized medicine
• The Bismarck Model, wherein all residents of a country are required to have health insurance and insurance companies are required to sell it to them. France, Germany, and Switzerland and most countries of western Europe operate under this model (as does Japan), named for the German chancellor who designed it in the 19th Century. Insurance can be profit, non-profit, or both (depending on the country); individual or employer driven. In any case, the insurance and health systems of Bismarck countries are tightly regulated. Bismarck Model nations often have advanced systems of health information technology.
• The National Health Insurance Model, wherein each resident pays into a government run insurance program that compensates private-sector providers. As the sole insurer, the government has a powerful negotiating role with providers and pharmaceuticals. Canada, Taiwan, and South Korea provide national health insurance.
• The Out-of-Pocket Model, wherein access to health care depends on the individual ability to pay. All undeveloped, non-industrialized countries must resort to this approach, as they have neither the resources nor the infrastructure to adopt the Beveridge, Bismarck, or NHI models.

As you can tell, the United States has a bit of all four. VA health care is government-owned and -operated (Beveridge); most Americans get insurance through employment and will soon have it mandated (Bismarck); most Americans pay into Medicare (NHI); and the uninsured and underinsured look to their own devices (Out-of-Pocket).

HealthMatters will examine each of the first three models, covering their implementations in different countries and pointing out the tradeoffs that each country makes.

One Man's Agenda 1, Honest Debate 0

In his column today, New York Times columnist David Brooks writes:

But it should be possible to strengthen the safety net while modernizing some of the Great Society structures. Paul Ryan, a Republican, and Alice Rivlin, a Democrat, have come up with a Medicare reform plan in which new enrollees would receive a fixed contribution from the government, growing a bit faster than inflation. They would apply that money against the cost of health insurance. This would make Medicare a defined contribution program and save hundreds of billions. If Obama said he was open to thinking about this sort of fundamental reform, he'd generate tremendous excitement on the right.

Medicare inflation is a Titanic burden on the health care system and on the overall economy. It must be addressed, and one way to start is with an honest presentation and not an ingenuous sales job. Unfortunately, Mr Brooks' remarks are closer to the latter.

You may well believe that the Ryan plan is the best way to curb Medicare costs: It would likely save billions of dollars, would offer the benefits of portability, would force greater consumer involvement in health care choices, and would limit the health care role of government to that of financier. If you do advocate Rep Ryan's approach, then you also know that the vouchers are scheduled to take effect in 2021 based on 2010 dollars. You are also aware that while they are indeed indexed to a rate above general inflation, they are also indexed at a rate below the higher rate of medical inflation. The idea is to provide momentum to reign in Medicare costs, but it requires elders to increasingly bear the risks of success or failure. That is the actual crux of the question about the Ryan plan: We can save billions of dollars, but who bears the cost and the risk? And is the answer to that question acceptable? What are the alternatives? Many advocates of the Ryan plan are prepared to discuss these questions honestly, but unfortunately one of the leading columnists in the country is not.

If we're to accomplish anything, we must debate health care proposals based on their actual content, not on what sounds most inviting. Mr Brooks has failed to contribute to that debate.

At What Cost Is The Right to Know?

Gina Kolata writes in the New York Times that new tests have raised an ethical dilemma for physicians: Should they notify patients who do not have Alzheimer's that they are at risk for the disease?


Ms Kolata's article implies another dilemma as well: Should the tests be performed at all?  Should we be spending hundreds of thousands of dollars on procedures and tests for a condition that has no cure, that can eventually be diagnosed without the tests, and when not everyone who receives them descends into Alzheimer's? Americans and their physicians have become addicted to the latest diagnostic technology, and yet our healthy quality of life is no better -- and in many cases worse -- than the citizens of other wealthy economies. Our costs, though, are staggering -- nearly double those of some of the same countries.


Moreover, whether by design or economic imperative, the United States has chosen to invest in secondary and tertiary care at the expense of primary care and public health. At some point, dollars spent on specialty care negatively impact the savings and improved health from the preventive medicine made possible by primary care and public health policy. Is the detection of a predisposition to early Alzheimer's worth that?

That patients should live with uncertainty is a frightening thing. But so are the crushing health and economic burdens of overtreatment and inadequate investments in primary care and public health.

More on the lunacy of the Basel Accords

I was looking at the preferred asset classes under the Basel Accords in my previous post on why central banks are so determined to stave off a government default, and realised that every single asset class that is given less than a 100 percent credit risk weighting is now tainted by widespread default, scandals or bailouts.

The credit risk weightings mean that instead of reserving the standard 8 percent of capital in respect of a debt, the bank can cut that by the weighting applied to the asset class. Effectively, the reduction in credit risk weighting operates as a powerful subsidy to the borrowers and equally powerful incentive to over-leveraging the lenders.

As a baseline, all financial, consumer and corporate debt must be reserved at a credit rating of 100 percent of 8 percent, unless explicitly discounted. A weighting of 50 percent, for example, means that instead of holding $8 reserves on a loan of $100, the bank only needs to hold $4 of reserves. A zero weighting means they lend $100, but hold no reserves at all.

Mortgages get a credit risk weighting of 50 percent, and we all know how well the mortgage market is performing. Mortgages and mortgage backed securities became the largest asset classes globally in a matter of years thanks to the credit weighting subsidy and securitisation. If I recall correctly, our present long crisis started with the collapse of the sub-prime market and now all categories of US mortgages are impaired by the ongoing mess with MERS and fraudulent or missing documentation. Borrowing short to lend long brought down Northern Rock in the UK and many other over-leveraged mortgage banks.

Interbank debt gets a credit risk weighting of 20 percent. We've seen from the collapse of interbank lending that banks do not trust each other. At the same time, inter-bank exposures and credit derivatives mean that financial institutions are massively dependent on each other, such that bailouts are justified as essential to prevent systemic collapse. If Too-Big-To-Fail is predicated on the systemic impact of a bank's failure on other banks, it would seem that the 20 percent inter-bank risk weighting was and is unsound.

Government agency debt gets a risk weighting of 10 percent. Looking at Fannie and Freddie, and the serial scandals and bailouts they have occasioned over the past decade, it is hard to see how such a subsidy can be justified.

Finally, sovereign debt of Zone A states is zero weighted - no reserves required at all. Zone A includes any country in the EEA, full members of the OECD, or states that have concluded special lending arrangements with the IMF except that any state that reschedules its debt is excluded from Zone A status for five years.

So the current financial crisis started with bad mortgage debt, spread to bad bank debt, carried over into bad agency debt, and now encompasses bad sovereign debt. Each of these categories was given preferential capital weighting under the Basel Accords, and now all are open sores on the financial system and the stability of excessively indebted governments.

Not only did the Basel weightings encourage poor risk assessment, they directly contributed to the inadequate capitalisation of banks for the risks they assumed.

And yet, have you heard any regulator take responsibility for regulatory failures yet? I haven't. In fact, I've seen no historic analysis of capital requirements, deregulation of credit markets, securitisation, derivatives, demutualisation, or any of the other regulatory policy innovations which should reasonably be matters for review in assessing the causes of the current crisis.

As the bankers and regulators do not seem keen to be reflective about their own policies and conduct, it's hard to imagine that they can craft constructive reforms to make the system safer or more efficient in future.

I've downloaded the draft Basel Accord III, released this week, for leisure reading. Sadly, I'm trending to the view that all harmonised regulation is likely to end in disaster as it precludes independent judgement and sensible challenge to orthodoxy. Once something has been agreed by a big enough committee, it becomes impossible to question whether it makes sense. Ultimately the unintended consequences of incentives and distortions mean it won't make sense, but by then it's far too late to change course and break from the herd.

Re-Post from 30/05/08: Famine Futures: Deregulated Markets and Food Insecurity

Originally published at RGE Monitor on 30 May 2008.

In a week when Hormel celebrates another surge in Spam sales, my preferred indicator of US food insecurity, it is appropriate to raise the market and regulatory failures that are driving global food insecurity.

Like so much that we have observed in the past eight years of the Bush administration, the origins of the current food crisis can be traced to the recycled policies of the Nixon White House. Henry Kissinger stated the premise succinctly in 1970: "Control oil and you control nations; control food and you control the people."

With credit, oil and food markets spiralling out of reach of the poor and straining the middle-class, it is worth exploring whether similar policies underpin similar problems. In each industry, a small handful of global companies control supply and a massive increase in ill-transparent speculation acting on pricing in exchange markets forces prices up regardless of the fundamentals of supply and demand. The risks for famine and political instability are huge. One doesn’t need to be a conspiracy theorist invoking the Trilateral Commission to feel that something is very wrong with policies leading to simultaneous crises in credit, oil and food that threaten not just the wealth but the wellbeing of most of the world’s population.

Two or three generations ago, most of us would have been directly involved in food production as a hedge against food insecurity. My parents’ generation kept a garden in the back yard, putting to me to work each summer to raise corn, tomatoes, cucumbers and other fresh foods for the table, sending me to pick berries and fruits in season from our own and the neighbours’ bushes and trees. My grandparents’ generation kept chickens as well as a garden behind their house in the middle of a large industrial city. The garden and chickens helped my mother survive the Great Depression at a time when my father suffered stunted growth from rickets. My great-grandparents’ generation were almost entirely farmers working the land.

Today global agriculture is dominated by eight multi-national corporations. The policies promoted by successive governments and international institutions including the IMF, World Bank and WTO have aimed at undermining local production, distributed commercial networks, and diverse local markets in favour of mass production, streamlined supply chains and concentrated global market pricing.

As with other areas of our lives, the policies of “free market fundamentalism”, as George Soros styles it, have not diminished risks but increased them. My children are hostages to food insecurity, as are yours and billions of others. A disruption in global food supplies or surge in prices that puts food staples beyond the reach of many low income or middle-class families cannot be offset from the back garden. The exposure of food to pricing in markets open to manipulation and excess speculation puts the lives of millions at risk.

Mack Frankfurter at Seeking Alpha has written a compelling review of how we got where we are.

The Commodity Conundrum: Securitization and Systemic Concerns (Part I)

The Commodity Conundrum: Securitization and Systemic Concerns (Part II)

The Commodity Conundrum: Securitization and Systemic Concerns (Part III)

Mr Frankfurter reviews the history of “securitized commodity products” and the development of commodities as speculative investments, distinct from their role in production and consumption within the economy. He suggests that something “systemic and possibly more insidious” has altered the benign role of speculators as providers of market liquidity and ties this change to the ill transparency of OTC derivatives arising from The Enron Loophole. I recommend reading the whole series.

We begin to see a pattern emerging. Free market policies and liberalised regulatory regimes promoted rapid concentration of a sector into a global oligopoly which could control supply. Free market doctrines and trade liberalisation enabled predatory targeting of markets to undercut domestic production and smaller producers, reinforcing the concentration of the market and the pricing control of the oligarchs. Free market ideologies and innovative financial derivatives promoted domination of market pricing mechanisms by speculative investors able to accelerate steep price gains regardless of supply and demand fundamentals.

Whether it is credit, oil or food, we are all going to suffer from bad policies which promoted free markets as risk reducing rather than risk enhancing. In the US and the UK we may hope that our food insecurity does not worsen to the point of riots, looting, political instability and the starvation of children, but many parts of the world will not be so fortunate. If there is a backlash against free trade, against free market doctrines, against the domination of big banks, big oil and big food, perhaps it will not be unenlightened but enlightened. Perhaps it is overdue.

We can live without credit. We can live without oil. We cannot live without food.

Credit and oil prices are also feeding the food price bubble. The Kansas City Fed highlighted risks confronting the agricutural sector from higher credit costs for infrastructure, fuel and margin calls on hedged exposures in its report Survey of Tenth District Agricultural Credit Conditions.

The role of market mechanisms and deregulation in fuelling the commodity price rises is coming under increasing scrutiny as the markets themselves now fail to meet their basic function of matching buyers and sellers of commodities.

Bloomberg News:

The divergence between CBOT futures and the underlying commodity is so great that some grain merchants have stopped bidding for new crops, said Niemeyer, a member of the National Corn Growers Association board. Others won't guarantee a price for more than 60 days. ''We have a fundamental problem with the markets,'' said Kevin McNew, president of researcher Cash Grain Bids Inc. in Bozeman, Mont., and a former Montana State University economist. ''It is very difficult to operate a grain business when the cash prices are below the futures'' by such a wide margin, he said. The price gap should converge when futures contracts expire and deliveries are settled. Instead, the average premium for CBOT wheat has quadrupled in two years to 40 cents a bushel, compared with 10 cents the prior five years, McNew said. For James McReynolds, who farms 2,000 acres of wheat outside Woodston, Kan., futures aren't worth the risk. ''The differential of what the market should be and what you can actually sell is so far out of line that you aren't willing to do it,'' McReynolds said. ''This is a tough situation. Agriculture is not as healthy as we'd like to think it is.''

One of the drivers of the Commodity Exchange Act of 1936 was a desire to have regulators responsible for ensuring that commodity markets serve the legitimate hedging needs of producers and consumers in the economy and not merely speculators. The Enron Loophole devastated regulation of commodity markets. Once again, legislators and regulators have failed to protect the public by discharging their mandate in favour of protecting the speculators who bid higher for influence.

Where It All Began

Justin Kimball

In 1929, Justin Kimball, then a vice president of the Baylor University medical extensions in Dallas, reflected on a pile on unpaid hospital bills, many of them from teachers. He proposed a prepaid plan wherein for $6 a year, Dallas teachers would receive up to 21 days of hospitalization. The idea proved popular, and soon 75% of Dallas teachers were enrolled. From this modest beginning, the American health insurance business took root.

Meanwhile, the ravages of the Great Depression influenced New Deal policy makers to urge President Franklin Roosevelt to propose a national policy of guaranteed health care. But Roosevelt's attention was preoccupied with other legislative priorities and with conducting World War II. Moreover, he shied away from battles with the American Medical Association and southern segregationists, who feared that a national plan would lead to integrated hospitals.

Harry Truman, Roosevelt's successor, felt a stronger commitment to guaranteed health care and made it a central platform of his remarkable reelection campaign in 1948. But after Congress rebuffed an initial effort, Truman set health care reform aside in favor of other priorities. Still, he had proven its resonance as a political issue, so much so that the next president, Dwight Eisenhower, searched for a public-private alternative to the federal program he feared was coming.

Eisenhower could never make a public-private plan pencil out, but he did articulate a conservative alternative for health care reform. More importantly, he signed the Revenue Act of 1954, which formalized a wartime regulation making employer-provided health care expenses tax deductible. Employer-provided insurance became a cornerstone of compensation, and by the end of the decade more than 50% of Americans had health insurance coverage.

Two groups, though, did not: the elderly and the very poor. In 1962, John Kennedy sought to change that, undertaking a national crusade for Medicare legislation that was unable to surmount Congressional opposition. Kennedy lacked the legislative skills necessary to pass Medicare, but Lyndon Johnson did not. With his able guidance, Medicare/Medicaid became law in 1965.

Liberals, led by Senator Edward Kennedy, continued to pursue a single national health program for all. Seeking to blunt their momentum, Richard Nixon advocated a public-private partnership based on the emerging concept of managed care. Watergate weakened Nixon politically, and Kennedy would later regret not having allied himself with Nixon on this issue.

Kennedy's primary defeat by Jimmy Carter and Ronald Reagan's subsequent election spelled the end of the liberal push for national health insurance or a single-payer system. Bill Clinton's complex effort, which collapsed under its own weight, contemplated neither. Republicans had prepared an alternative approach based on mandates, but pulled it once it became apparent that the Clinton plan would not succeed.

The presidency of George W. Bush saw passage of Medicare Part D, which offered prescription drug coverage through a public-private mechanism. Though complex and unfunded, Part D proved popular despite its inadvertent creation of a "doughnut hole," which left uncovered a middle tier of expenditures. Meanwhile, in 2006, Massachusetts Democrats teamed with Republican governor Mitt Romney to pass a law requiring all residents to obtain state-regulated minimum coverage.

In 2009, President Barack Obama proposed what in became 2010 public law 111-148, also known as the Patient Protection and Affordable Care Act. Health Matters will review the ACA in detail; for now, it is enough to say that it stems from the public-private values originally envisioned by President Eisenhower, that it tracks closely to the Massachusetts law, and that -- ironically -- it takes advantage of policy alternatives proposed by Republicans in the 1990s.

Unfortunately, opposition to ACA concentrated on defeating political adversaries; as the war of words escalated, the quality of the discourse degenerated and the country missed a chance to debate health care reform in meaningful terms. It is not true, for example, that the ACA funds death panels, nor is it socialist. (There is a such thing as socialized medicine; the ACA isn't it.) It is also not the case that the leading conservative alternative to the ACA amounts to "get sick and die."

America needs an honest debate about health care reform: The stakes are high and the issues are so complex that it makes no sense to discard tools and alienate each other on the basis of ideology. After all, we'll all need health care eventually, and we want the health care that we get to be both affordable and good. Unfortunately, today there is no guarantee of that despite the best efforts of dedicated, highly trained doctors and nurses with access to world-class health care technology.

That must change.

Re-Post from 15/05/08: Looting the Vaults of the Central Banks

Originally published on RGE Monitor.


When I was a young central banker, we often spent our lunchtimes debating how best to rob our employer. Tempted by the thought of great mounds of gold ingots far beneath us in the third sub-basement, nestling deep in bedrock, we would speculate on the viability of various plans for plundering our nation’s store of wealth. The presence of sufficient security forces to defend a medium size city and enough steel around the vault for a battle cruiser only spurred our youthful imaginations. After some months of fantasy gold robbery, I began to assert to my colleagues that stealing the gold would be foolish as it would be impossible to get away with enough gold in city traffic to make the attempt worthwhile, and selling it in any sizeable amount would lead to instant detection. I argued instead in favour of stealing the wheelie bins of cash conveniently lining the hallway to the loading ramp. Cash would be faster and easier to steal and more liquid to spend than gold.

I see now that I was a central banker of very little brain – and lacking ambition. The way to rob a central bank efficiently is to be a bank executive so skilled in financial engineering that I take my bank to the edge of extinction. I can then swap all my unpriceable, illiquid, engineered credit instruments for good central bank cash and Treasuries. That’s larceny without risk, making the central bank a complicit partner in the looting of its vaults, and earning gratitude and bonuses instead of audits and indictments.

Since the credit crisis was first diagnosed last fall, the Federal Reserve has advanced more cash and Treasuries than the entire five year cost of the Iraq war – over $400 billion. It has plundered more than half its holdings of US Treasuries, taking impaired asset-backed securities collateral in their place. It has overseen the devaluation of the dollar to third world levels of instability and inflation. And all of this debasement has as its objective the re-financing of those bank and shadow-bank executives who have so looted their own institutions that they hold the global financial system hostage to their incompetence, malpractice and greed. Without consultation or review, the Federal Reserve was able to chuck out decades of transparency and accountability in favour of secret facilities, secret loans favouring secret beneficiaries of secret largesse.

The Term Auction Facility (TAF), the Primary Dealer Credit Facility (PDCF) and the Treasury Securities Lending Facility (TSLF) are all ill-transparent conduits funnelling central bank cash to bankers in the private sector free of oversight, audit or scrutiny. The recent liberalisation of collateral by the Fed means that it is now officially the market maker of last resort for securities which are unmarketable in the private sector.

And the creepy thing is that most of the establishment thinks the Fed is doing a great job. Because there will never be an independent investigation or audit, we will never know whether they are policy geniuses or criminally complicit accomplices. Perhaps it makes no real difference to either motivation or outcome.

Now the Fed wants powers to enable it to create even more credit to finance failure. It is said to be seeking Congressional authority to pay interest on bank reserves (via Forbes with a hat tip to Steve Waldman). While this might sound benign, especially in a modern era when American banks hold no non-borrowed reserves, the expanded powers are potentially very dangerous. Paying interest on reserves would permit the central bank to extend hundreds of billions more in TAF, PDCF and TSLF credit without the inconvenience of having to sterilise the monetary expansion through further sales of its increasingly meagre inventory of Treasuries.

Spies and weapons, whether real or imaginary, are asserted by the military-intelligence complex as justifying more spies and weapons. If no attack occurs it is because they are so efficient at protecting us and pre-empting many unpublished threats. If an attack occurs, it was because they were under-funded or over-constrained. In the same way, financial excess and bad credit have been used by the banking system to justify more financial excess and bad credit in a self-reinforcing loop of financial and supervisory indulgence and forbearance. If no crisis occurs, it is because there is a new paradigm and risk management models are more reliable. If a crisis occurs, it is because banks lacked access to adequate liquidity and were over-regulated. For too long the cycle has reinforced monetary laxity, permissive deregulation and regulatory forbearance on accounting and capital adequacy, with all accountability and market discipline excused by the need to forestall contagion and systemic failure.

Any crisis now accelerates the trend toward greater public laxity, private excess and central bank secrecy. A crisis, real or manufactured, is most useful to increase the amount of public money clandestinely extended and diminish public oversight and administrative review of outcomes. This has been the pattern for at least 25 years, and may continue for some time to come before a taxpayer or creditor revolt ends the American spiral downwards towards bankruptcy and corporate tyranny.

It used to be the realm of conspiracy theorists to assert that policy makers in Washington were aligned with the military-intelligence complex in promoting international conflicts for profit or that the Federal Reserve was the tool of Wall Street banks in promoting irresponsible bubbles. Now it is accepted policy, defended openly in the media as right and inevitable, as providing an efficient means for America to meet the “threats” to security and financial stability in a changing world.

The danger of embracing the spin is that the productive economy shrinks from underinvestment and distortions as an increasing share of a slower growing pie gets diverted to government and the cronies who direct government policies.

The thrift failures in the 1980s were followed by financial deregulation and increased mortgage subsidies, enabling the massive misallocation of credit and leveraging of balance sheets on an even greater scale. Further deregulation, forbearance, subsidies and bailouts can only lead to more frightening misallocation of scarce capital in zero-savings America and more fragile over-leveraged banks, but now presenting a danger of contagion to the rest of the world. It is the savings of the world’s productive economies funding American misallocation and excess, and the world’s poor that suffer the contagion of inflation from a devalued dollar.

Already the ECB and Bank of England have followed the Fed in extending good central bank funds against questionable collateral under rapidly liberalising lending facilities. While they appear slightly more resolute on prudential supervision and inflation-fighting, they are nonetheless compromised and constrained by the policies and practices of bankers and central bankers across the Atlantic. As American banks receive forbearance and largesse, the European banks shout, “Me too!”

Globalisation of banking and regulatory “best practice” was once seen as raising standards, but may be at risk now of lowering them. Just as Japanese zero-interest rate policy flooded the world with cheap liquidity from the carry trade, fuelling speculative bubbles and providing cover for low rates elsewhere, Federal Reserve forbearance and credit accommodation may flood the world with warped management incentives and credit distortions which pervert the banking sector and financial markets, undermining rationales for savings and productive investment.

Without transparency of central bank facilities and policies, there can be no accountability for misuse of public resources and abuse of the public trust. Transparency provides an essential check on bank mismanagement, even for central bankers.

When Bloomberg revealed this week that Ben Bernanke lunched with [JPM's Matt] Dimon at the New York Fed on March 11 with key Wall Street bankers just three days before the emergency $14 billion financing for Bear Stearns and five days before the sweetheart $30 billion financing of JPMorgan’s acquisition of Bear (again, the acquired assets the Fed received for the cash are secret), it made me very uneasy. Suspicious minds might think the public interest and integrity of market mechanisms, including the corrective of the occasional failure, weren't foremost in their discussions.

Whether cock-up or conspiracy, recent reforms set the scene for looting of the central banks on a scale never imagined by my younger self.

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As some regulars to Professor Roubini’s blog will know already, I am a mere commenter on the blog who has been elevated to posting by invitation of the Professor. Having seen the list of new posters who will be joining us here, I can assure you that I am deeply honoured to be among them.

London Banker will continue to post anonymously. It permits me to be more forthright than I could be otherwise.

Despite being a poster, my commitment to this site is as a commenter, and I hope to see many comments from my blog buddies below so that we can continue the dialogue I have enjoyed on this site for so long.

Being new at this, I will also welcome ideas and guidance at londonbanker ( at ) btinternet.com.

Re-Post from 23/05/08: Capital-ist Economies to Capital-less Economies

I'm going to cross-post early RGE posts that weren't published here over the coming week so I'll have all my writing up here somewhere for the record.

It's an interesting exercise in reviewing my perceptions from earlier in the year for me, and I hope for you too.

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Originally posted on RGE Monitor.

A farmer who eats the seed corn over the winter must borrow to plant in the spring. He must repay the loan from the harvest, leaving him with even less to live on come the following winter if the crop does not yield a greater harvest. The misfortune of one bad harvest can start a cycle of decline that leads to permanent penury. Sharecropper plantation owners have exploited and impoverished sharecropper farmers on this principle for centuries.

Is it different for nations?

"It is the aim of good government to stimulate production, of bad government to encourage consumption." - Jean Baptiste Say

In the classical conception of economics, capital is the surplus of production over consumption. Only by consuming less than is produced can a person, or a company, or a nation accumulate capital for reinvestment, growth and continued prosperity. Capital cannot be borrowed, because borrowing implies repayment from the proceeds of the endeavour at a rate which – on the whole – precludes accumulated surplus.

A gambler might get lucky and make enough to both repay the debt and hold a surplus over his consumption, but gambling erodes investment discipline and prudence, and so over time proves a poor basis for economic management in the home, the boardroom or the Treasury.

A thief or con-artist might steal or defraud enough to repay the debt and hold a surplus over his consumption, but theft and fraud erode commerical confidence and invite retribution, and so over time prove a poor basis for economic management in the home, the boardroom or the Treasury.

A defaulter can simply refuse to repay the debt, and keep any surplus for himself, but defaulting erodes investors’ confidence and leads to bankruptcy, and so over time proves a poor basis for economic management of the home, the boardroom or the Treasury.

Borrowing implies risk, for both the lender and the borrower.

Somehow neo-classical economics was able to finesse this principle to convince a generation of consumers, bankers, regulators, legislators and investors that debt should be considered capital too, and that more debt than savings could be good for economic growth and prosperity.

For a time, the neo-classical economists appeared to have found a financial perpetual motion machine. As consumers, companies and governments borrowed more, they appeared to prosper more. Leveraging the accumulated equity in their homes, the consumers got bigger houses and bigger cars. Leveraging their fixed assets and future revenues, the companies got bigger balance sheets, bigger executive remuneration and bigger shareholder dividends. Leveraging their power of taxation and monetary creation, the governments got bigger militaries, bigger bureaucracies, bigger scope for patronage projects. The bankers intermediating all this debt got bigger too, with bigger bonuses for “loan origination”, bigger fees from M&A, bigger commissions and income from securities and derivatives dealing, and bigger influence with their supervisors to loosen any inconvenient accounting, reporting, audit, scope or expansion rules that might have impaired their freedom to keep the party going.

Free Market became the rallying cry of those who believed in perpetual motion. They passionately decried regulation as impairing the market’s freedom to allocate “capital” to the best likely return. They passionately decried taxes as diminishing the “capital” held by those who would reinvest it in growth. They passionately exhorted consumers, businesses and governments to borrow as much “capital” as they could possibly bear, and to err on the side of profligacy, so that more “capital” would be working to grow their revenues and balance sheets in the “free market”.

But the problem with this perpetual motion machine was that it was all the time grinding the seed corn. The “capital” it was pumping out was not the surplus of production over consumption, but the borrowed surplus of greater fools who believed in the hawkers’ pitch of perpetual motion and laid their meagre savings and accumulated assets on the barrelhead in faith the machine would return them multiplied.

The reality of the American, UK and other heavily leveraged economies is that we have eaten our seed corn and eaten the seed corn of those who have financed our profligacy. Over the past twenty-five years there has been a quiet conspiracy among those bankers profiting from the process to promote gambling, stealing, fraud and default as solutions to disguise the implications of a failure of perpetual motion.

Financial markets have morphed over this time from mechanisms for efficient allocation of scarce investment capital to promote greater production through rewarding foresight and diligence into casinos that reward those with a system that beats the unwary and beats the house. Leverage has been used to overcome bad judgement, rewarding those willing to risk more at the expense of the prudent. Modern markets have arguably never been less transparent, with fragmentation, off-exchange dealing, derivatives, structured finance, hedge funds and other ill-transparent innovations making it all but impossible for the average Joe Investor to assess activity and prospects with any confidence.

Companies were urged to borrow for sprees of mergers and acquisitions, and then either declare bankruptcy to shed their inconvenient pension liabilities or move production offshore to reduce expenditure on labour or both, emerging from these contortions as desirable prospects for more mergers and acquisitions. Any setback resulted in the generous retirement of one incompetent executive and the more generous appointment of another that would borrow the company into future prosperity.

Consumers and consumer finance companies were urged alike to feed the machine by overstating house values, overstating incomes, understating debts, juggling credit cards, and continually recycling any proceeds from the mania’s inflation of asset prices back into more accumulated debt through regular refinancing. Workers were forced to give any surplus savings from labour to the machine as mandatory pension contributions or cajoled into it through tax breaks on 401Ks and other ruses funnelling seed corn to the machine.

Governments were urged to finance wars, social welfare spending, police state intelligence technologies, infrastructure and excess, defaulting through loose monetary policy, defrauding through massaged official statistics, and deregulating the financial sector and capital markets when credit constraint threatened to stem the tide. A government that got into trouble was urged to "privatise" by leveraging or selling government assets, the seed corn of past accumulations, or to put services out to tender in the private sector so that they could pay more to receive less through the miraculous efficiencies of free market fulfillment of social needs. Any difficulty or disruption was overcome with tax breaks, subsidies and public underwriting of yet more debt creation - with mortgage interest deductions, corporate debt interest deductions, FNMA, FHLC and other ploys all feeding more seed corn to the machine.

All of this will someday unwind. It may be this year. It may be next year. It may be several years hence if central bankers can scrape together more seed corn from ever greater fools to keep the perpetual motion machine turning over. At some point, indebted societies must revert to the discipline of consuming less than they produce to repay their debts, or these societies will suffer the even worse consequences of the social dislocation and commercial disruption that follows gambling, theft, fraud and default.

Globalisation has allowed the bankers to hawk their perpetual motion wares to a wider pool of greater fools. This is a dangerous policy. Warren Buffett has long warned that as long as the US has major foreign trade deficits, it has to "give away a little part of the country" each year. He warned America was becoming a "sharecropper economy," where Americans largely work for foreign-owned firms – or governments. The profusion of sovereign wealth funds represents the rational diversification of states with surplus production over consumption – capital – to preserve that wealth through equity investment that unlike debt will be secure from the debtor’s attempt to inflate away his obligation through the expedient of monetary laxity. Owning equity means a permanent claim on American production. Like the sharecropper, foreign equity ownership implies permanent want and decline to penury for the borrower nation.

Worryingly, globalisation has increased the likelihood that debt will lead to political instability and international conflict. The wars for resource, long a “Great Game” but now increasingly a violent and expensive gamble, are only one outcome. Food riots and inflation encourage governments to resort to intervention and oppression. Internal economic decline and dissent reinforces calls to patriotism, theocracy and militarism over reason. Lately I find myself wondering if the “beggar thy neighbour” policies of the 1930s weren’t a result of a similar dynamic, following, as they did, a similar era of massively irresponsible bank-fuelled credit growth and deflation.

When I was young and in debt, an old mentor of mine enjoined me to pay off my loans and my credit cards and to never again “borrow for consumption”. Investment that would confidently yield a good return, such as buying an education in a profession or purchasing a home for the long term, could be financed, but a new TV or a holiday must always be earned and paid for from present income.

Strange to say, but his advice shocked me. I had grown up with debt. My parents were always in debt. My earliest memory of economics is my father explaining to me that he loved inflation because his salary would get bigger and his debts would get smaller.

Nonetheless, I took my mentor’s advice and have lived within my income, whether large or modest, ever since. Perhaps I have missed out on having a grander house, or a flashier car, or the trendiest gadgets, but I have slept remarkably well for over twenty years and feel confident of withstanding the challenges and profiting from the opportunities that the future may bring.

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Hat tip to Capone (the blogger formerly known as JMa) for suggesting the title in his comment on Professor Roubini's blog on2015-05-13 14:39:49.

I've been given a regular Friday slot here on Finance & Markets Monitor. This allows us to carry on the chitter chatter over the weekend when the Professor's blog is quiet for the most part. There may be some weeks when I don't post, but the team at RGE now has enough depth that there will always be something worth reading here.

Basel Faulty: Sovereign Defaults and Bank Capital*

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. - Ralph Waldo Emerson

When historians of the future look objectively at the era preceeding this long financial crisis, they might well conclude that failure of the globalised capital system is traceable to the Basel Accords.** The unreasonable assumptions and myriad distortions introduced in this one-size-fits-all paradigm of bank capital adequacy fatally undermined the practice of independent judgement in assessing credit risk and prudential supervision of banks.

Bankers of the past had to assess the creditworthiness of a debtor or counterparty based on balance sheet, revenue potential and management reputation for competence. They husbanded their scarce capital, aware that each dollar lent remained at risk until repaid, with cash reserves proportional to the bank's assets usually 8 to 10 percent.

A primary fallacy of the Basel Accord is that OECD government debt is risk free and requires no bank reserves. Better yet, the banks can count the government debt they hold as Tier 1 capital, reserving against other debt assets. The Basel Accords assume all OECD government debt is a cash proxy, being liquid in all market conditions.

Walter Wriston's 1970s dictum that "sovereigns can't default" was disproved in the Third World Debt Crisis of the 1980s, but somehow the BIS Committee on Bank Supervision still embraced it when applied to OECD state debts.

Roughly, the risk weights of the main asset classes under Basel I were:
- zero for Zone A (EEA and OECD) government debt of all maturities and Zone B (non-OECD) government debt of less than one year;
- 20 percent for Zone A inter-bank obligations and public sector entity debt (e.g. Fannie Mae, Freddie Mac, et al.);
- 50 percent for fully secured mortgage debt;
- 100 percent for all corporate debt.

The post-Basel bank supervisors applied their prudential supervision models unthinkingly, to rubberstamp the bankers' leveraging of their balance sheets toward ever greater excess. No one bothered to ask whether Basel Accord assumptions made sense. They were the harmonised norm for prudential supervision and too deeply embedded in the fabric of international finance to adjust, except to allow more and greater leverage in Basel II through liberal recognition of derivatives. Basel II allowed the banks to offset even more risk exposure with even less capital through collateral, securitisation, credit default swaps, and recognition of the validity of internal asset valuation models.

Global harmonisation of prudential supervision around the Basel Accord meant that the hobgoblin of excess leverage became systemically entrenched in all markets, in all nations. The foolish consistency of harmonised capital adequacy was adored by little minds of global bankers and central bankers worldwide.

The zero weight for OECD government debt must have appeared a harmless subsidy to OECD governments in 1988, promoting liquid government debt markets and enhancing the competitive positioning of OECD-based global banks who stood to gain most from the harmonisation of global bank regulation and capital rules.

Leveraging their balance sheets to work every dollar of capital harder became the obsessive preoccupation of two generations of bank executives once the Basel Accords were adopted. Risk management departments were less about controlling exposure to adverse credit events than about identifying deal structures which would minimise the amount of regulatory capital allocated to any exposure.

Fannie Mae, Freddie Mac, and their ilk were an early mechanism to reduce the reserves required from 50 percent on an individual mortgage to twenty percent or even zero, allowing the banks to write more and more mortgages with less and less capital. When these entities proved inadequate in the go-go 1990s, asset back securities allowed banks to get sub-prime mortgages - and thereby the capital requirement - off their books entirely, passing the risks to yield-hungry investors. With Basel II they could reduce capital even further by writing each other a daisy chain of credit default swaps for all categories of exposure. Who could have known that it would end badly?

OECD government debt is zero risk weighted and accounts for a disproportionate bulk of Tier 1 capital of major banks. A default by any EEA or OECD government will force banks and central banks to recognise that government debt has inherent risk like all other debt. This would force recognition of a positive risk weighting, and bring into question the assumption that government debt can be counted as a cash-proxy in Tier 1 reserves. The illiquidity of impaired or defaulted government debt would undermine its role as a Tier 1 reserve asset in bank capital models.

At this writing the OECD governments at risk of default are Greece, Portugal, Spain and Ireland, with other states queuing up in the wings. Already the ECB is the only buyer in the market for much of the impaired government debt.

If any OECD state were to default there would be very serious implications:
- The Basel Accord zero risk weight of government debt would be proved fanciful;
- The assumption of government debt as a liquid asset suitable for bank Tier 1 reserves to meet unanticipated and sudden cash demands will become unsustainable;
- Banks would be forced to recapitalise at much higher levels, forcing even sharper deleveraging and contraction of lending;
- Governments would lose the captive, uncritical investor base they have relied on to finance excess public expenditure for the past 30 years;
- Central banks could be forced to suddenly monetise even more government debt if required to meet the cash demands of a run on their undercapitalised banks.

Looked at this way, you should be able to understand why the ECB keeps repeating that there can be no Eurozone sovereign default, and why the UK and US are staunchly behind them in preserving the illusion of state solvency for all Eurozone states.

It will likely prove impossible to reform the bankers and central bankers dependent on the Basel Accords for their business models and careers. Harmonisation of global standards was supposed to make the world safer. A foolish consistency on bad policy and bad practice led instead to a world on the edge of financial implosion.

This hobgoblin haunts us all.
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* Hat tip to Tracy Alloway at FTAlphaville for suggesting a revision to the title for this post.
** Several commenters questioned my spelling of Basle Accords in the original post. I prefer the British/French Basle which was standard in my youth on Basle Accord documents, to the German/American Basel more common and current today. Nonetheless, I yield to the customs and usage current today in changing the spelling to Basel.

Banks are lawless dictators? Whose side are the police on?

First, hat tip to Barry Ritholtz for the articles linked here. I read two of the articles, written on opposite sides of the planet, one after another, and suddenly the dangers confronting us in political instability were much clearer.

Back in June I wrote:

It used to be that the role of the state in financial market regulation was to ensure efficient market operations, promote transparency of prices and liquidity, protect consumers from abusive practices, and to resolve failed companies according to principles of equitable distribution of assets among like classes of creditors. If the role of the state now is to shield HFT, dark pool and OTC markets from transparency, provide liquidity where the market fails, oversee the orderly fleecing of consumers, and to ensure that some creditors of failing firms always win while others always lose, then we no longer have a market economy. And as virtually all these regulatory policies have evolved in the absence of public debate and legislative scrutiny, we also no longer have democratic governance of markets.

The deficit that worries me most in terms of the future of our civilisation is the legal accountability deficit - or anomie as I use it here. This deficit is huge and still growing rapidly as decisions are taken behind closed doors to shield lawless bankers from taxes or criminal sanctions and dedicate more and more public funds and/or monetary expansion to the same lawless bankers with too little public accounting, scrutiny or recourse.

This morning a commentary by Robert Fisk crystalised this concern as a political crisis in the offing: Bankers are the dictators of the West.

Let's kick off with the "Arab Spring" – in itself a grotesque verbal distortion of the great Arab/Muslim awakening which is shaking the Middle East – and the trashy parallels with the social protests in Western capitals. We've been deluged with reports of how the poor or the disadvantaged in the West have "taken a leaf" out of the "Arab spring" book, how demonstrators in America, Canada, Britain, Spain and Greece have been "inspired" by the huge demonstrations that brought down the regimes in Egypt, Tunisia and – up to a point – Libya. But this is nonsense.

The real comparison, needless to say, has been dodged by Western reporters, so keen to extol the anti-dictator rebellions of the Arabs, so anxious to ignore protests against "democratic" Western governments, so desperate to disparage these demonstrations, to suggest that they are merely picking up on the latest fad in the Arab world. The truth is somewhat different. What drove the Arabs in their tens of thousands and then their millions on to the streets of Middle East capitals was a demand for dignity and a refusal to accept that the local family-ruled dictators actually owned their countries. The Mubaraks and the Ben Alis and the Gaddafis and the kings and emirs of the Gulf (and Jordan) and the Assads all believed that they had property rights to their entire nations. Egypt belonged to Mubarak Inc, Tunisia to Ben Ali Inc (and the Traboulsi family), Libya to Gaddafi Inc. And so on. The Arab martyrs against dictatorship died to prove that their countries belonged to their own people.

And that is the true parallel in the West. The protest movements are indeed against Big Business – a perfectly justified cause – and against "governments". What they have really divined, however, albeit a bit late in the day, is that they have for decades bought into a fraudulent democracy: they dutifully vote for political parties – which then hand their democratic mandate and people's power to the banks and the derivative traders and the rating agencies, all three backed up by the slovenly and dishonest coterie of "experts" from America's top universities and "think tanks", who maintain the fiction that this is a crisis of globalisation rather than a massive financial con trick foisted on the voters.

The banks and the rating agencies have become the dictators of the West.

The banks as dictators makes sense to me. In thinking about my dissatisfaction with financial regulation for much of the past decade, I see that a great deal of it is attributable to who the regulators see as their polity. Their idea of consultation on regulations is to ask the bankers, traders and rating agencies whether they approve. The idea of making public policy in the public interest if the bankers disapprove is unimaginable to them. And so the banks get the regulations they prefer - or at least did so until the crisis.

And my queasiness about David Cameron's behaviour in Brussels on Friday stems from the same concern. He threw his toys out of the pram and turned his back on the EU because they wouldn't guarantee to preserve the City from further taxation, regulation and scrutiny. It's very clear that the polity he was serving was not the United Kingdom's 62,300,000 people - but the one per cent that make their living in the City of London.

Immediately after reading the Fisk piece, I read the moving statement of Patrick Meighan, My Occupy LA Arrest.

My name is Patrick Meighan, and I’m a husband, a father, a writer on the Fox animated sitcom “Family Guy”, and a member of the Unitarian Universalist Community Church of Santa Monica.

I was arrested at about 1 a.m. Wednesday morning with 291 other people at Occupy LA. I was sitting in City Hall Park with a pillow, a blanket, and a copy of Thich Nhat Hanh’s “Being Peace” when 1,400 heavily-armed LAPD officers in paramilitary SWAT gear streamed in. I was in a group of about 50 peaceful protestors who sat Indian-style, arms interlocked, around a tent (the symbolic image of the Occupy movement). The LAPD officers encircled us, weapons drawn, while we chanted “We Are Peaceful” and “We Are Nonviolent” and “Join Us.”

As we sat there, encircled, a separate team of LAPD officers used knives to slice open every personal tent in the park. They forcibly removed anyone sleeping inside, and then yanked out and destroyed any personal property inside those tents, scattering the contents across the park. They then did the same with the communal property of the Occupy LA movement. For example, I watched as the LAPD destroyed a pop-up canopy tent that, until that moment, had been serving as Occupy LA’s First Aid and Wellness tent, in which volunteer health professionals gave free medical care to absolutely anyone who requested it. As it happens, my family had personally contributed that exact canopy tent to Occupy LA, at a cost of several hundred of my family’s dollars. As I watched, the LAPD sliced that canopy tent to shreds, broke the telescoping poles into pieces and scattered the detritus across the park. Note that these were the objects described in subsequent mainstream press reports as “30 tons of garbage” that was “abandoned” by Occupy LA: personal property forcibly stolen from us, destroyed in front of our eyes and then left for maintenance workers to dispose of while we were sent to prison.

When the LAPD finally began arresting those of us interlocked around the symbolic tent, we were all ordered by the LAPD to unlink from each other (in order to facilitate the arrests). Each seated, nonviolent protester beside me who refused to cooperate by unlinking his arms had the following done to him: an LAPD officer would forcibly extend the protestor’s legs, grab his left foot, twist it all the way around and then stomp his boot on the insole, pinning the protestor’s left foot to the pavement, twisted backwards. Then the LAPD officer would grab the protestor’s right foot and twist it all the way the other direction until the non-violent protestor, in incredible agony, would shriek in pain and unlink from his neighbor.

It was horrible to watch, and apparently designed to terrorize the rest of us. At least I was sufficiently terrorized. I unlinked my arms voluntarily and informed the LAPD officers that I would go peacefully and cooperatively. I stood as instructed, and then I had my arms wrenched behind my back, and an officer hyperextended my wrists into my inner arms. It was super violent, it hurt really really bad, and he was doing it on purpose. When I involuntarily recoiled from the pain, the LAPD officer threw me face-first to the pavement. He had my hands behind my back, so I landed right on my face. The officer dropped with his knee on my back and ground my face into the pavement. It really, really hurt and my face started bleeding and I was very scared. I begged for mercy and I promised that I was honestly not resisting and would not resist.

My hands were then zipcuffed very tightly behind my back, where they turned blue. I am now suffering nerve damage in my right thumb and palm.

I was put on a paddywagon with other nonviolent protestors and taken to a parking garage in Parker Center. They forced us to kneel (and sit--SEE UPDATE) on the hard pavement of that parking garage for seven straight hours with our hands still tightly zipcuffed behind our backs. Some began to pass out. One man rolled to the ground and vomited for a long, long time before falling unconscious. The LAPD officers watched and did nothing.

This account turned my stomach, as it demonstrates all too clearly that the sympathies of the state are with lawbreaking bankers and not the victimised masses bailing them out.

So that’s what happened to the 292 women and men were arrested last Wednesday. Now let’s talk about a man who was not arrested last Wednesday. He is former Citigroup CEO Charles Prince. Under Charles Prince, Citigroup was guilty of massive, coordinated securities fraud.

Citigroup spent years intentionally buying up every bad mortgage loan it could find, creating bad securities out of those bad loans and then selling shares in those bad securities to duped investors. And then they sometimes secretly bet *against* their *own* bad securities to make even more money. For one such bad Citigroup security, Citigroup executives were internally calling it, quote, “a collection of dogshit”. To investors, however, they called it, quote, “an attractive investment rigorously selected by an independent investment adviser”.

This is fraud, and it’s a felony, and the Charles Princes of the world spent several years doing it again and again: knowingly writing bad mortgages, and then packaging them into fraudulent securities which they then sold to suckers and then repeating the process. This is a big part of why your property values went up so fast. But then the bubble burst, and that’s why our economy is now shattered for a generation, and it’s also why your home is now underwater. Or at least mine is.

Anyway, if your retirement fund lost a decade’s-worth of gains overnight, this is why.

If your son’s middle school has added furlough days because the school district can’t afford to keep its doors open for a full school year, this is why.

If your daughter has come out of college with a degree only to discover that there are no jobs for her, this is why.

But back to Charles Prince. For his four years of in charge of massive, repeated fraud at Citigroup, he received fifty-three million dollars in salary and also received another ninety-four million dollars in stock holdings. What Charles Prince has *not* received is a pair of zipcuffs. The nerves in his thumb are fine. No cop has thrown Charles Prince into the pavement, face-first. Each and every peaceful, nonviolent Occupy LA protester arrested last week has has spent more time sleeping on a jail floor than every single Charles Prince on Wall Street, combined.

A deflationary collapse will lead to political instability. It always does, because deflation destroys the value of paper assets which are mostly held by the most wealthy - the 1 per cent. And when deflation destroys their assets, it destroys their power and creates a vacuum. We need to be very clear in such a case that the enemy of the people is not the state, because if the state uses its police powers to protect the guilty and punish the innocent, then popular resistance and revolt become all too probable.

In Europe, the politicians know this. Even the police know this. No matter what I think of any British government, the conduct of the LA Police would be inconceivable here. The police killing just one career criminal this summer sparked nationwide riots. Brutalising non-violent protestors would have all of us on the streets.

There are values which are independent of financial assets. Those of us concerned to retain those values as a legacy for our children need to be vigilant as the bankers are only concerned with the values they can cash short term.

Thomas Jefferson wrote, "When the people fear their government, there is tyranny; when the government fears the people, there is liberty."

Fisk and Meighan remind us that the people are sovereign. The protests are because our sovereignty is undermined when it is disrespected by bankers buying lawlessness or by the police or financial regulators using state powers against the public interest. We have a right as a free people to self-governance under the rule of law. We as a free people have a right to regulate financial services to ensure that it serves a socially constructive function in the economy. Applying the rule of law to bankers reinforces the principles of justice essential to capitalism and the preservation of private property. The banks are not sovereign, and do not have a right to laws, regulators and police that protect them and them alone. There's some work to do here, of course, but having the issue crystallised helps a lot.

Deflation has become inevitable

For a while now I have been on the fence on the inflation/deflation issue – whether the massive monetisation of bad debts by central banks and governments will lead to rapidly escalating inflation as currencies are debased or, alternatively, lead to deflation as bad debts and illiquidity undermine all commercial and financial activity in the economy. I’m now coming down on the side of deflation for a very simple reason: there is no longer any incentive to save or invest, and so debt and investment cannot increase much beyond current bloated levels.

In Lombard Street, Bagehot’s seminal tome on fractional reserve central banking, Bagehot advises any central bank facing a simultaneous credit crisis and currency crisis to raise interest rates. By raising rates they will ensure that foreign creditors remain incentivised to maintain the general level of credit available while the central bank resolves the local liquidity crisis through liquidation of failed banks and temporary liquidity support of stressed banks.

The very opposite policies have been pursued by central banks in the US, Europe and UK since the beginning of the sub-prime crisis in August 2007. They have cut policy rates drastically, and as the crisis escalated and spread, the yield on government debt has dropped to negative territory. Meanwhile they have shielded those responsible for the creation of record levels of bad debt from any regulatory accountability, relaxed transparency of accounts, and provided massive taxpayer-funded financial infusions to prevent failure and liquidation.

While in the short term these policies have expediency and the maintenance of market “confidence” on their side, in the longer term these policies must undermine any confidence a rational and objective saver or investor might have that savings or investment in the US, EU or UK will be fairly remunerated at an above-inflation rate, or that savings and investments will be protected by effective oversight and regulation from the sorts of executive debasement and outright misappropriation and fraud that are beginning to colour our perceptions of the past decade.

Anyone sitting on a pile of cash now is unlikely to want to either (a) place it in a bank, or (b) invest it in the stock market. As a result, the implosion of the financial and real economy must continue no matter how big the central bank’s aspirations for its balance sheet or the treasury’s aspirations for its deficit.

If US, EU and UK had substantial domestic savings to fund their banks (as in Japan in 1990), then perhaps the consequences would not be so imminently disastrous. Lacking sufficient domestic savings, however, their actions will likely make foreign creditors in Japan, China, the Gulf and elsewhere question whether it is worthwhile to keep pumping scarce savings into such flawed and reckless economies.

During the reckless boom years, savings collapsed in bubble economies as retail and commercial and financial actors alike chased speculative yields with greater and greater leverage. During the reckless bust years, savings will collapse further as retail and commercial and financial actors chase safety by hoarding their meagre remaining assets from further erosion by refusing to lend at negative returns and refusing to finance failed corporate and investment models that only enrich poltically-connected management and intermediaries.

The determination to avoid any accountability for failed banks, failed business models, failed regulatory systems and failed academic rationales for all the above invites anyone with spare cash – an increasingly select crowd – to withhold it from further depredations. It is this instinct, more than confidence in the government, which is driving so many to seek the temporary safety of short-dated government securities.

The result of discouraging domestic and foreign creditors and investors must be inevitable deflation as debt levels become increasingly hard to finance and ultimately contract. Irresponsible central banks and governments can try to bail out the failed banks, businesses and municipalities at the centre of every popped bubble, but the bubble economies are ever more certain to deflate with each bailout. Each bailout further undermines the market discipline which is bedrock to a saver or investor’s decision to part with hard-earned cash by trusting it to the intermediation of the management of a bank or business.

It’s this simple: I won’t invest in a country that bails out failure and punishes savers. I won’t invest in the US or UK until they change course and protect savers and investors, ensuring a reasonably predictable positive return. In the EU, I will be very selective, preferring those conservative states like Germany that never embraced the worst excesses, although sadly still have fall out from individual banks' stupidity in buying into foreign excess. I will know when it is safe to reinvest when policy interest rates, bank/intermediary oversight and accounting standards give me confidence I am better protected than the corporate or financial elite.

While it may take the Asian and the Gulf State investors longer to embrace my analysis, I have no doubt that they too will eventually conclude that parting with their savings under the terms now on offer will only deepen their losses. They would be better off keeping the money at home, investing locally under local laws and vigilance, and letting the US and UK implode.

The argument against this has always been that with trillions already invested in the US during the deficit years, the Chinese and Gulf States would suffer even more horrible losses from a collapse of the western economies. This is accurate, but not complete, as it ignores the relative value of cash investment at the top and bottom of a bursting bubble. Once the collapse has bottomed out, so long as a globalised economy survives, there will be even better opportunities for those with savings to invest selectively in businesses with clearer prospects and more certain profitability under regulatory frameworks which have been restored to a proper balance of investor protection and intermediary oversight.

Right now survival of businesses in the West depends largely on political pull and access to regulatory forbearance and central bank or treasury finance. The market has failed, and officialdom is collaborating in perpetuating that failure.

Should the western economies implode in deflation, however, there will be new opportunities to return to market-based policies that reward effective, efficient management and punish corrupt, debased management. Until that happens, those that invest will continue to lose money. Once deflation is exhausted, then those that invest can expect to make and retain profits again.

I think it took me so long to feel confident about predicting deflation because the floating currency system under dollar hegemony and Bretton Woods II distorts the workings of both inflation and deflation. Despite the US being the epicentre of all the failed debts, failed securitisations, failed credit derivatives, failed rating agencies, failed banking businesses, failed corporate governance, failed accounting standards, failed capital adequacy models, and failed regulatory forbearance, the US dollar has recently strengthened as deflation globalised. The US exported inflation in the boom years, and now exports deflation in the bust years.

Since spring 2008, as US investment banks sold off assets, imposed margin calls, and used access to unsegregated wholesale assets in custody in the rest of the world to upstream liquidity to their US-based parents and affiliates, the dollar has strengthened relative to other currencies. The media reports this as a “flight to quality”, but it is more like a last looting of the surrounding countryside before dangerous brigands hole up in their hilltop fortress. The brigands appear temporarily wealthy compared to the peons left stripped and penniless and facing winter. When the brigands have eaten all the stolen grain and livestock, however, they will have no means to replenish except to use force to raid the countryside again. The peons can always hunt, forage, farm and carefully husband a surplus to gradually increase their wealth. If the brigands raid too thoroughly or too regularly, the peons have no incentive to grow crops or keep herds (negative savings returns) and everyone starves (deflation).

In the meanwhile, the peons just might wise up, hide any surplus more securely and organise mutual defense against further attacks to ensure that their peon children prosper and the brigands die off. That would be the end of Bretton Woods II, and the rise of China, India, the Gulf and other productive and/or resource rich states which invest surplus in domestic productivity and regional growth.

I reread my piece on Fisher’s Theory of Debt Deflation in Great Depressions the other day. One of the more confusing aspects is his assertion that the dollar “swells” as debt deflation takes hold. What he meant, of course, is that deflation increases the quantity of assets and the likely investment return each dollar purchases as deflation wrings debt and misallocation of capital out of the economy.

It is now clear to me that policy makers in the West are determined to apply every available resource to underpinning failure, misallocation and executive excess. As this discourages the honest saver from parting with cash, policy makers are ensuring that deflation will wreak its havoc on the financial and real economies of the world. Only when that deflation has played out and rational policies that reward market-based management and returns are restored will it be worthwhile to invest again. In the meanwhile, any wealth saved securely from state seizure will "swell" to buy more assets in future - a key aspect of deflation and a key means of restoring the control of the economy into the hands of more farsighted savers and investors.

I have quoted Mr John Mill before, but it bears repeating: ““Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.” The extent to which capital has been betrayed in the past quarter century under Bretton Woods II, bank deregulation and the Basle Capital Adequacy Accords is unrivalled in the history of fiat banking. The bankers, lawmakers, regulators and academics who collaborated in the betrayal still hold power, like the well-armed brigands in the fortress, and their continued collaboration to prevent accountability must inevitably discourage honest savers from risking further loss. Even so, it is the savers/peons who hold the ultimate power as they can starve the brigands.

Some day soon savers will revolt at financing further depredations. They will refuse to buy even government securities, gagging at the quantities of issue forced upon them under terms of only negative return. When that final massive bubble bursts, deflation will follow its harsh corrective course and clean out deficit-financed “unproductive works”.

When that happens, if reason is restored in markets with effective oversight, I might consider investing again, very selectively, in whatever productive works might then be on offer and only when secure in realising - and retaining - a positive yield.

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Apologies for not posting last Friday.

Writing for this blog has been a great experience, forcing me to refine my views about current events and the principles which should underpin financial market interactions and supervision. In parallel, I have been forced to re-evaluate whether I should commit to sorting out some of the practical aspects of the future of banking in the global economy. Writing takes a lot of time and passion, and these are limited commodities for any of us.

I have accepted a full time executive position which will take all of my time and passion going forward in 2009, so the blogging has to be suspended at year end. The job will enable me to put into practice the principles I’ve illuminated here, hopefully mitigating some of the impacts of financial instability. I’ll still lurk, and maybe comment on Professor Roubini’s thread from time to time.

Wish me luck!