Gordon the Firefighter

Whilst listening to Gordon Brown during the 2010 General Election campaign it is difficult to escape an impression that he behaves like a firefighter in dealing with the current financial crisis. He gets into a combative rhetoric and posture and lambastes his opponents as threats to economic recovery. In 2008 Gordon was "the world saviour". Now he got into even a hotter role.

However one must not forget that the current economic crisis was caused by the government and regulators responsible for the probity of the financial world, at best by monumental incompetence that let the financial institutions behave fraudulently, at worst by a criminal conspiracy to defraud the taxpayers.

Indeed Gordon is a firefighter. But either a stupid one or, worse, one with a hero syndrome. All in all, "the world saviour" in the current firefighting role comes across as a bit of a Walter Mitty.

Since writing this article, the author found that Lord Lamont also compared Gordon Brown to an arsonist posing as a firefighter in his article over a year ago (albeit in a different context). It seems it is not only an unbridled imagination.

FSA is coming back to their senses

The UK regulator, FSA, appears to be coming back to their senses. Today an actuarial professional who works for a retail bank, has written to the author of this blog:

"I attended a presentation on liquidity from a senior figure in my banks Treasury department - the FSA are proposing a ratio which would in effect mean LTD < 100%."

On one side it is good news, but on the other it is worrying: even if FSA do something right they do not really understand what they are doing. But it is a progress from much-celebrated "Turner Review".

Election 2010 - short of ideas or lack of guts

All three major parties, Conservative, (New) Labour and Liberal-Democrats, talk the same about the impact of the financial crisis. "We are all in it together" say their leaders. The discussion is on the issues how we are made to pay for that: a combination of public expenditure cuts and raise in taxes. In the last few days, the media brought a story of Goldman Sachs facing fraud charges in the US and the Financial Services Authority investigating the same in the UK. This accompanies the stories of banks' (again) bumper profits and huge bonuses paid to individual bankers.

In contrast, yesterday during the three parties leaders debate an elderly lady, who worked hard all her life, asked a question whether it was fair for her, at the age of 84 years, to live on £59 a week pension.

"We are all in it together.": retired folk on £59 a week pensions and individuals from financial institutions that, allegedly, committed serious fraud and who are responsible for the current crisis and, thanks to the mechanism that caused the current crisis, collect hundreds of thousands or even millions of pounds in bonuses. And if it were not enough, in her article in yesterday's FT, Gillian Tett clearly suggested that individuals in these institutions, or at least in one of them, operate like mafia under a code of silence.

"Irrespective of what Goldman’s clients and service providers have really thought about the bank, most have been reluctant to antagonise the bank, since they feared that Goldman was so powerful that any critic would face some backlash. Hence the fact that so few law firms, consultants – or even bankers – have ever testified in public against the firm, on CDOs or anything else."

Thus far the only action that politicians proposed to curb excessive, if not dishonest, bonuses was to tax banks and bankers on their future income, forcing banks to pay more in shares than in cash. Any effective action was frustrated by those who argued, rather irrationally, that such actions would lead to bankers leave the country. Hence not only would very little be collected but the industry would be damaged as it would relocate abroad, away from the City. This is not only nonsensical. This is also looking through the wrong end of the telescope.

In 1997 when New Labour came to power they imposed a retrospective "windfall tax" on "the excess profits of the privatised utilities".

Leaving aside arguments about legality of the bankers profits, there is a uniform agreement amongst three parties, Conservative, (New) Labour and Liberal-Democrats, that bankers pay has been excessive for some years. Therefore all three parties should have proposed a similar windfall, retrospective tax on the individuals working in the City (including any source of future income like pension pots). The tax should go at least as far back as 1997, when the change to financial regulations was introduced and, to avoid any accusation of unfairness, it should tax net income above a reasonable threshold.

For example, as a reasonable guide (i.e. a template for the politicians), for any tax year since 1997/1998, an individual must pay a 90% tax on any net income received above £200,000. Not only would this recoup billions of pounds for the Exchequer, but it would also go some way in resolving such disgraceful cases like Sir Fred Goodwin's pension as his pot would have been reduced accordingly.

No one can question that £200,000 a year net income is generous especially if it comes from the industry that has been proved to be such a financial disaster and massive liability to the taxpayers. If the politicians are really concerned about the bankers leaving the UK as a result of such measure, they can give an incentive for the bankers to stay. For example, they can allow a 1% tax refund for every year that an individual stays in UK and pays taxes up to maximum 10%. I.e. if an individual stayed and paid taxes for the next 10 years he would have paid 80% tax on all his net income above £200,000 for every year between tax year 1997/1998 and 2009/2010.

As this would be basic tax legislation, like windfall tax in 1997 on "the excess profits of the privatised utilities", all other options against the financial institutions and individuals working for them would still remain open. In 1997 some opponents of the windfall tax argued then that it would damage utilities industry. It did not. By the same token, such tax will not damage banking. This would not be a tax on banks, that might be struggling now as institutions. This would be a tax on individual bankers who collected massive payments whilst they were driving the industry into a disaster. This measure would not be about justice but recouping billions of pounds that the Exchequer needs so badly.

So are our leaders short of ideas or they do not have guts?

Communism (for the rich) is alive (and well)

In yesterday's Financial Times Martin Wolf published an article "The challenge of halting the financial doomsday machine". It appears that the mainstream analysts are slowly reaching the correct diagnosis albeit in a descriptive manner and in a roundabout way.

What Martin Wolf describes as the financial system has all classic hallmarks of a pyramid scheme (for example, of an Albanian type). However, being clearly out of his depth, he simply still does not realise that banks continue to lend with loan to deposit ratio (LTD) greater than 100% which perpetuates this doomsday machine. (Whilst writing about "leverage" could be interpreted in that way, it is far too imprecise as lending with LTD less than 100% is also leveraging).

Banning lending with LTD greater than 100% would not automatically have made financial system safe. However it would have removed a single mechanism that guarantees that financial system is a doomsday machine. (i.e. you can do whatever but if you do not remove this mechanism the system will continue operating like a classic Albanian pyramid that is guaranteed to fail).

Surprisingly (or maybe not) Martin Wolf appears to be an adversary of a free market competitive economy. He clearly does not like an idea of not bailing out failing banks. Alongside a pyramid scheme operated by the banks, they are classic anti-competitive oligopolies. For centuries, until the current crisis, banks had been allowed to fail and indeed sometimes they had. In that respect there is no reason to consider banks any different than other companies (like oil and gas). Indeed the chief issue is that "banks are too big to fail". If the banks are broken up into much smaller businesses (in a similar way as Standard Oil was broken up nearly 100 years ago) with a clear and transparent ownership (that provides reserve capital, in cash of course) and accountability, then banks can be let go bust. And if this happens individual owners will lose their investment, so they will ensure the safety ofthe system. And even if they fail, as the number of the banks will be very large, a collapse of one or two (or three) banks will be easily absorbed by the system. The kind of communist thinking ("communism for the rich") that Martin Wolf presents will ensure that the problems will not go away any time soon. Lenin is dead, long live... Martin Wolf.

Just a start?...

Surely the recent news that US' Securities and Exchange Commission accused Goldman Sachs of fraud did not come to this blog readers as a surprise. The author of this blog argued for a long time that the financial industry is the hotbed of pathological behaviour: both in professional substance and in style.

At a time when the western world has been in deep in recession, banks were making "profits". Where could this "profit" come possibly from? Banks themselves are not creating directly any economic wealth. They are a service industry: if their clients, businesses and individuals, are not making money, how possibly banking industry keeps on making money. The only rational answer is that the financial system is in a pathological state: it is designed and set up to fleece the mainstream economy. The actual service provided is nothing more than a cover-up of thieving practices.

There still exists a myth of intellectual sophistication and professional complexity in finance. But, in fact, the industry strategies that amount to, by example, insuring a house before deliberately burning it down are not particularly sophisticated or complex. Rather primitive, dishonest and criminal. Incidentally whilst such strategies in the world of insurance are almost impossible (a role of insurance excess is to prevent that, i.e. that an insurance owner does not have a commercial interest in causing a damage), in the world of financial engineering it is possible to insure a prospective "loss" many times over (i.e. a perverse arrangement whereby a policy holder may have an interest in causing a damage in order to claim insurance exceeding the actual loss).

The SEC's move is good news and hopefully the start of the process of holding financial industry to account. There is no doubt that Goldman Sachs case is not even a tiny bit of the tip of the iceberg, measured in quadrillions of dollars, of what is happening in the world of high finance. It is promising that historically the US' authorities have a pretty good record on trying to root out the pathology from the economic free market. Hopefully Goldman Sachs case is just a good start that will lead to unravelling real causes and mechanics of the current financial crisis, the largest heist in history. As Brad Hintz of the US brokerage Bernstein said: "There is rising public appetite for punishment of the guilty parties that caused the credit crisis."

From rags to riches

Recently a post (see below this short article) can be found on numerous blogs: a "from rags to riches" recipe. If it worked, we could all make, on average, $11,390,625 ($1 x 15⁶). The whole world would become rich! (Just rich, not fabulously rich.) The financial crisis would be irrelevant. Wouldn't it be great?

But for the same (technical) reasons as the credit crunch happened, the "from rags to riches" recipe will not make us rich. It will fail miserably. Like the causes of the current financial crisis, it is yet another example of a pyramid scheme.

You've been warned.

====

Hi guys/gals,

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THE PAYPAL $6 DOLLAR MONEY-MAKING METHOD:
This is all you need:

1) An email address
2) A Pay Pal account
3) Then POST, POST, POST..........

THIS IS A 2009, CURRENT EMAIL LIST
Ever since the internet became popular, the word "scam" has become a daily term. I have never once tried any moneymaking "system" outside of this because of that very reason. However, after reading reports on the validity and reputation of this money making system (seen on Oprah, CNN, and other media forums) I gave it a try. Only hours after implementing this exact system I just about fell out of my chair as money ACTUALLY started rolling in. I couldn't believe it and for that reason, I became a believer in this system.

HERE IS HOW IT WORKS...
There is a list of 6 email addresses (you'll see it as you read further). Each of these people has already taken part in this system. When someone new comes along (such as yourself) he/she removes #1 off of the list, moves the other five email addresses up one position (i.e. #6 goes to #5, #5 to #4, etc.), and adds their Pay Pal email address in the 6 position. This process is what develops the power of compounding. The bottom line is this... Honesty and Integrity creates Profitability. Following this EXACT process is what creates the money, and that is why this system has been raved about. Altering the system creates weak results. The legality of this system comes from the idea that you are of course creating a mailing list, and a "service" is being provided (more on that later.)

INSTRUCTIONS:

STEP 1:
The first thing to do COPY, PASTE and SAVE this entire post in word or notepad on your computer so you can come back to it later. After that, if you are not already a Pay Pal user you need to go to the Pay Pal website at https://www.paypal.com/ and SIGN UP. To receive credit card payments from other people you must sign up for a PREMIER or BUSINESS account (not just a PERSONAL account). This is highly recommended to allow others easy payment options. To place the initial $6 into your account, you will have to verify your bank account with PAYPAL (which may take a few days). PAYPAL is 100% secure and is used by millions of people worldwide.

STEP 2:
Here is where the action occurs. Next send a $1.00 payment to each of the 6 email addresses on the current list from your Pay Pal account. To do this quickly and successfully, follow these simple steps:

1. Login to Pay Pal and click the "Send Money" tab near top of screen
2. In the "Recipient's Email" field type: the email address
3. In the "Amount" field type: "1" (your $1.00 payment)
4. In the "Category" field select: "Service" (Keeping it legal)
5. In the "subject" field type: "EMAIL LIST",
6. In the "message" field type: "PLEASE PUT ME ON YOUR EMAIL LIST". (By doing this, you are creating a service and maintaining the legality of the system by "paying" for the service.)
7. Finally, click on the "Continue" button to complete the payment.
8. Repeat these steps for each of the 6 email addresses.

That's it! (By sending the $1.00 payment to each address, you are implementing the compounding POWER of the system. You will reap what you sow!)


Here is the current e-mail list:
*************************************************
The email list:

1) [1]@gmail.com
2) [2]@gmail.com
3) [3]@gmail.com
4) [4]@gmail.com
5) [5]@gmail.com
6) [6]@gmail.com

*************************************************


STEP 3:
Now take the 1 email off of the list that you see above (from your saved file), move the other addresses up (6 becomes 5, 5 becomes 4, etc.) and add YOUR email address (the one used for your Pay Pal account) as number 6 on the list. This is the only part of the document that should be changed. **Make sure to use the email address you registered with Pay Pal**

STEP 4:
now post new file created in STEP 3 to at least 200 newsgroups or message boards. Keep in mind that there are tens of thousands of groups online! All you need is 200, but remember the more you post the more money you make as well as everyone else on the list!
Use Netscape, Internet Explorer, Fire fox, Safari, or whatever your internet browser is to search for various news groups, on-line forums, message boards, bulletin boards, chat sites, discussions, discussion groups, on-line communities, etc.

For example? Log on to any search engine like Yahoo.com or Google.com and type in a subject like 'MILLIONAIRE MESSAGE BOARD', MONEY MAKING DISCUSSIONS', 'MONEY MAKING FORUMS', or 'BUSINESS MESSAGE BOARD', etc. You will find thousands and thousands of message boards. Click them one by one and you will find the option to post a new message. Fill in the subject, which will be the header that everyone sees as they scroll through the list of postings in a particular group, and post the article with the NEW list of email addresses included. THAT'S IT!!! All you have to do is jump to different newsgroups and post away. After you get the hang of it, it will take about 60 seconds for each newsgroup.

HOW THE MONEY WORKS:
When you post 200 messages in various forums, it is estimated that at LEAST 15 people will respond and send you a $1.00 ($15.00). Those 15 will Post 200 Posts each and 225 people send you $1.00 ($225.00), etc. through 6 levels of email addresses. For comprehension purposes, here is an easy viewing chart:

1) 15(1) = 15 people ($1) = $15
2) 15(15) = 225 people ($1) = $225
3) 15(225) = 3375 people ($1) = $3,375
4) 15(3375) = 50625 people ($1) = $50,625
5) 15(50625) = 759375 people ($1) = $759,375

Within a few WEEKS you begin to see results, thanks to the speed of the internet! When your name is no longer on the list, take the latest posting in the newsgroups and begin the process again. Simply amazing...Follow the system as described, and enjoy your PROFITS!!!


REMEMBER... HONESTY AND INTEGRITY = PROFITABILITY
YOUR NAME COULD CYCLE FOR A LONG TIME!
THIS MAKES IT THE GIFT THAT KEEPS ON GIVING.
REMEMBER, THE MORE NEWSGROUPS YOU POST IN, THE MORE MONEY YOU WILL MAKE!! GOOD LUCK!!

Remember that most news servers will leave the posted messages on there servers for about 2 weeks. If you will post your message again, it WILL again start from the beginning. So you can repeat this over and over again. There are tons of new honest users and new honest people who are joining the Internet and newsgroups everyday and are willing to give it a try. Estimates are at 20,000 to 50,000 new users of the Internet, every day.
!!!!! REMEMBER!!!!! Follow every step, and IT WILL WORK!!!

Make Today A Great Day. Wish U Well...

Computational complexity analysis of Credit Creation

This article presents a rigorous analysis of many issues discussed on this blog already sometimes in a less formal manner. Especially a banking practice of lending with Loan to Deposit Ratio above 100% that has been shown to constitute a sufficient condition of causing liquidity shortage in the banking system (i.e. it was a sufficient condition that caused the current financial crisis).

It is estimated that Cash (narrow money) constitutes around 2% of money circulation in the economy. The reminder 98%, sometimes referred to as broad money, is created by banks through Deposit – Loan Cycles. It is called Credit Creation. When money is paid into a Bank it is

either:

• a disbursement (cost) that a Bank has to pay out (but even, in this case, unless it is stored privately, it will end up in a Bank as someone else’s Deposit); a dividend to be paid by a Bank to its shareholders is also considered as a disbursement

or

• a Deposit; any other money than disbursement is considered as a Deposit paid into a Bank (e.g. if it is a Bank’s retained profit, Bank’s own money is a Bank’s Deposit on its own books; if a Bank uses its own money to buy an investment product, from Deposit – Loan Cycle perspective, in this model it is considered as if a Bank was lending money to itself).

A Bank can lend out Cash that is paid in as a Deposit: this is Credit Creation.

A liquidity risk is a risk of a situation when a demand made by a Depositor to withdraw Cash (narrow money) cannot be met by a Bank. If Money Multiplier is 1 (or less) liquidity risk is 0%: $1 (or more) Cash Reserves covers every $1 Deposits on a Bank’s Loan/Deposit Balance Sheet. If Money Multiplier tends to infinity liquidity risk is 100% in a finite time: at the limit, $1 Cash would have to cover infinite amount of dollars of Deposits on a Bank’s Loan/Deposit Balance Sheet.

Liquidity risk is directly associated with a phenomenon called “bank run”, when depositors, in large numbers, would like to withdraw money from a Bank to either pay it to another bank or worse, from liquidity point of view, keep it privately. As some depositors cannot withdraw their money it results in destruction of a Bank’s credibility. Then even more depositors follow suit leading to a Bank’s collapse.

1. Full Reserve Banking

When a Bank retains all Deposits paid in, a Bank is not lending. It acts as a Product/Service Supplier of storing cash. This is also called 100% Reserve Banking.

For every $1 paid as Cash Deposit, Bank’s Loan/Deposit Balance Sheet shows Loan = $0, Deposit = $1, Cash Reserves = $1. Money Multiplier is 1 (i.e. in every day’s language money is multiplied by 1, i.e. it is not multiplied, no Credit is created).

Conclusion: Full Reserve Banking is a case of complexity of no growth (O(1)). Ignoring theft and fraud, the liquidity risk of Full Reserve Banking is 0% (i.e. 100% Deposits paid in are always in a Bank and can be withdrawn on demand at any time.)

2. Fractional Reserve Banking

When a Bank lends part of Deposits paid in, a Bank is Creating Credit. A proportion of a Loan to a Deposit from which a Loan is given is called Loan to Deposit Ratio (which may also be expressed in percentage terms: for example, LTD = 0.9 is equivalent to 90%.).

For example, for initial $1 paid in if the Loan to Deposit Ratio is LTD, a Loan given is $1 x LTD. Generally in the money-based economy it can be assumed that, on the whole, this Loan, $1 x LTD, will end up in a Bank as a Deposit and then it is re-lent again. Assuming the same Loan to Deposit Ratio, the next Loan is $1 x LTD². Generally after n iterations from the initial $1, the Loan given is $1 x LTDⁿ. Since LTD is less 1 (100%) then it is a regressive geometric series with limit 0 and the total Credit Created from the initial $1 Cash is $1 x 1/(1-LTD).

Money Multiplier is a ratio of Deposits on a Bank’s Loan/Deposit Balance Sheet to Cash Reserves accumulated. It tells us how many times Cash (narrow money) was multiplied by Credit Creation process (into broad money). Therefore based Loan to Deposit Ratio, LTD, we can calculate a Money Multiplier, MM. It is: MM = 1/(1-LTD). Money Multiplier tells us how many Deposited dollars on a Bank’s Loan/Deposit Balance Sheet are covered by $1 Cash.

For example, let LTD = 0.9 (i.e. 90%), i.e. MM = 10, then for every $1 of initial Cash Deposit (narrow money), the first loan is $0.9, the second $0.81, the n^th $1 x 0.9ⁿ, the total value of Deposits on a Bank’s Loan/Deposit Balance Sheet is $10 and there are $9 of Credit Created (circulated in money-based economy) and Cash Reserves are $1.

Conclusion: Fractional Reserve Banking, with Loan to Deposit Ratio above 0 and below 1, is a complexity case of no growth (O(MM)) of a Bank’s Loan/Deposit Balance Sheets to underlying Cash Reserves as Money Multiplier is a constant number in relation to Loan to Deposit Ratio. We observe that it entails liquidity risk below 100%, since it is always possible that demand for withdrawals, at one time, exceeds Cash Reserves.

It is not a purpose of this paper to argue what level of liquidity risk is acceptable or beneficial for money-based economy and what factors ultimately determine this risk in reality. This may depend on many phenomena that affect human decision making process.

3. No Reserve Banking

We also observe that as Loan to Deposit Ratio is less than 1 and approaching it, the Money Multiplier tends to infinity, and nearly no Cash Reserves are created, the liquidity risk keeps increasing up to 100% at the limit. Nearly all the money paid in as Deposits are turned into Credits. Loans and Deposits tend to infinity on a Bank’s Loan/Deposit Balance Sheets, whilst Cash Reserves tend to remain finite and constant.

If Loan to Deposit Ratio is 1, at the limit, it is a linear growth of Loans and Deposits on a Bank Loan/Deposit Balance Sheet, Money Multiplier is infinity, Cash Reserves’ growth is 0 (i.e. they stay on the level which was when Loan to Deposit Ratio of 1 was started) and liquidity risk (in a finite time) tends to 100%. It is a case of trivial geometric series with common ratio 1 (which is also an arithmetic series).

Conclusion: No Reserve Banking is a complexity case of linear growth (O(n)) to infinity of both Loans and Deposits on a Bank’s Loan/Deposit Balance Sheet. A Money Multiplier is infinity resulting in liquidity risk of 100% in a finite time. No Reserve Banking is also called 0% Reserve Banking.

4. Depleting Reserve Banking

Depleting Reserve Banking, lending with Loan to Deposit Ratio above 1, is not possible, unless there are already Cash Reserves. It is, effectively, a Credit Creation with a “top up” from already existing reserves (this top up may come as a Loan from another bank’s reserves and a lending bank may consider borrowing bank’s debt papers as good as Cash). A Bank is Creating Credit by lending Deposits paid in and topping up from existing Cash Reserves (or a Loan from another bank’s reserves). A proportion of a Loan to an underlying Deposit is called Loan to Deposit Ratio.

For example, for initial $1 paid in if the Loan to Deposit Ratio is LTD, a Loan given is $1 x LTD. Generally in the money-based economy it can be assumed that, on the whole, this Loan, $1 x LTD, will end up in a Bank as a Deposit and then it is re-lent again. Assuming the same Loan to Deposit Ratio, the next Loan is $1 x LTD². Therefore after n iterations starting with the initial $1, the Loan given is $1 x LTDⁿ. Since LTD is above 1 (100%) then it is a progressive geometric series with exponential growth to infinity. The total Credit Created from the initial $1 Cash tends exponentially to infinity: $1 x ((LTDⁿ – 1)/(LTD – 1))

As Loan to Deposit is above 1, and the geometric series is diverging, it is impossible to calculate Money Multiplier based on a ratio of Loans to Deposits on a Bank’s Loan/Deposit Balance Sheet at any one time. We also must know how many times a Deposit – Loan Cycle was executed at what Loan to Deposit Ratio. The general formula to calculate Money Multiplier (when Loan to Deposit Ratio is above 1) is:




i = 1, …. , n

LTD_i is a Loan to Deposit Ratio

ki is a number of Deposit - Loan Cycles with a Loan to Deposit Ratio LTD_i (LTD_i+1 is a Loan to Deposit Ratio that follows LTD_i).

It is a side note but we observe that it looks unlikely that Deposit – Loan Cycles (Credit Creation) starting with initial $1 Cash are uniform processes in money-based economy. Therefore it may be practically impossible to calculate accurate and reliable Money Multiplier when Loan to Deposit Ratio is above 1.

For example, let LTD = 1.17 (i.e. 117%) then for every $1 of initial Cash Deposit (narrow money), the first loan is $1.17, the second $1.3689, the n^th $1 x 1.17ⁿ, i.e. for n equal 220 the 220^th Loan value is over $1 x 10¹⁵. The total value of Deposits on a Bank’s Loan/Deposit Balance Sheet is over $5.8 x 10¹⁵ and there is also over $5.8 x 10¹⁵ Credit Created and circulated in money-based economy. Cash Reserves are initial Cash Reserves minus $5.8 x 10¹⁵. Money Multiplier is over 5.8 x 10¹⁵. In other words, whatever the initial Cash Reserves had been at the start of Credit Creation with Loan to Deposit Ratio of 1.17 (117%), after 220 Deposit – Loan Cycles executions, starting with initial $1 Deposit, the Cash Reserves were depleted by over $5.8 x 10¹⁵.

It is a side note but in practice banks’ Cash Reserves, on a Bank’s books, may be replaced with credit collaterals or other non-Cash financial instruments, being considered as good as Cash. This may result in, nominally, retaining any required reserve ratio, but this reserve would not be in Cash. These financial instruments are a part of Products/Services Supply and their market value/price (in Cash) depends on Products/Services Demand (Money Supply), see the graph on page 2.

Conclusion: Depleting Reserve Banking, with a Loan to Deposit Ratio above 1, LTD > 1, is a complexity case of exponential growth (O(LTDⁿ)) of a Bank’s Loan/Deposit Balance Sheets to underlying Cash Reserves. As Money Multiplier tends to infinity the liquidity risk is 100% in a finite time.

5. Brief computational complexity analysis summary

Let us consider Credit Creation as an algorithm that we would like to implement on a computer. (It is actually a very basic algorithm.)

The cases of Full Reserve Banking and Fractional Reserve Banking, of O(k) where k is a constant equal 1/(1 - LTD), are tractable algorithms. They can be considered as contained algorithms: the requirement on resources is a constant multiple of an underlying parameter of Credit Creation (i.e. Cash).

No Reserve Banking (of O(n)) is also a tractable algorithm but it takes more resources than Full Reserve Banking or Fractional Reserve Banking. In fact it would be a case of concern that at some point, in linear time depending on a number of executions of Deposit – Loan Cycles, the demand on resources will eventually exceed availability threshold. This is non-containable case as there is no upper limit of demand on resources in relation to underlying parameter of Credit Creation (i.e. Cash).

Depleting Reserve Banking, of O(LTDⁿ), is an intractable algorithm. The growth of demand on resources is exponential. This type of algorithms is considered impractical for implementation on computers. (In general, in computer science algorithms with complexity above polynomial are not accepted as general solutions to underlying problems.)

In the cases considered above, containable algorithms of Credit Creation present liquidity risk below 100%. They are of manageable risk as a part of a risk portfolio. Non-containable algorithms present liquidity risk of 100% in a finite time, i.e. it is unmanageable risk as liquidity shortage is a matter of a finite time. In the case of Depleting Reserve Banking, due to exponential growth of a Bank of Loan/Deposit Balance Sheet and Money Multiplier (and also exponential depletion of Cash Reserves) such finite time is assumed to be very short: short enough, in practice, for the liquidity shortage to occur. By computational complexity standards, Credit Creation using Depleting Reserve Banking is intractable, i.e. non-practical for implementation.

6. Depleting Reserve Banking and loss of control of Money Multiplier

Essential to managing liquidity risk is the knowledge of Money Multiplier (MM), i.e. how many dollars of Deposits on banks’ Loan/Deposit Balance Sheets are covered by $1 Cash. As already showed in the preceding sections of this article, if a Loan to Deposit Ratio is always below 1 then the total value of Deposits and total value of Loans on banks’ Loan/Deposit Balance Sheets are the basis for calculation of Money Multiplier: MM = Total Deposits/(Total Deposits – Total Loans).

If Loan to Deposit Ratio is above 1 then the above equation does not hold. In order to calculate Money Multiplier we need more information about each Deposit – Loan Cycle (which may be impractical or even impossible to gather). This is even more complicated: it is possible to execute any number of Loan – Deposit Cycles with Loan to Deposit Ratio above 1 (achieving any arbitrary high Money Multiplier in this process) and then with one cycle only reduce a ratio of total value of Loans to total value of Deposits below 1 on a Bank’s Deposit – Loan Balance Sheets. This may look like an “average” Loan to Deposit Ratio below 1. However this value used in the formula presented above, MM = Total Deposits/(Total Deposits – Total Loans), will not produce a true value of Money Multiplier (most likely, in practice, a real Money Multiplier will be much higher).

Therefore, concluding this computational complexity analysis, Credit Creation with Loan to Deposit Ratio above 1 must not be practiced since:

• exponential growth of banks’ Loan/Deposit Balance Sheets is intractable

• liquidity risk, in a finite time, is 100%

• practical macro control of growth of Money Multiplier is lost

It is a side note but due to exponential growth of a Bank’s Loan/Deposit Balance Sheet and exponential depletion of reserves, Depleting Reserve Banking is a classic example of a pyramid scheme.

It is also a side note but the present liquidity crisis and resulting economic crisis was preceded by a prolonged period of Credit Creation with Loan to Deposit Ratio above 1.

7. Consequences of Depleting Reserve Banking on Mark-to-market and Value-at-risk (VaR)

Depleting Reserve Banking results in Money Multiplier growing at exponential pace without any upper bound (i.e. infinity is the limit) such that each unit of cash has to satisfy ever growing demand on banks balance sheet. In a finite time (in practice, due to exponential growth, very short time), banks run out of cash to service their payment obligations like deposit withdrawals: all cash becomes tied to servicing such obligations and the shortage keeps growing presenting liquidity shortage. Consequently there is a decreasing volume of money (cash) to pay of any non-cash financial (and other) products. This volume decreases at exponential pace (i.e. practically very fast) to zero [as Money Multiplier grows at exponential pace to infinity, cash available to service non-cash obligations decreases to zero]. Hence a Mark-to-market price of any non-cash financial products also decreases to zero, as there is a decreasing volume of cash available to complete a transaction. In such scenario a probability of a non-cash asset losing 100% of its value in a finite time tends to 100%. In other words, as a result of Depleting Reserve Banking, for any arbitrary high loss less than 100% of a non-cash asset, there is always a finite time horizon (in practice, due to exponential characteristics, very short) such that probability of such loss is 100% (it is a certainty).

Conclusion: The effect of Depleting Reserve Banking is such that, if continued, it turns all non-cash financial products into worthless assets (so-called “toxic waste”): Value-at-risk (VaR) as a loss of 100% of a value of non-cash financial products is practically 100% in a finite time.

8. Financial perpetuum mobile

Depleting Reserve Banking (i.e. Credit Creation with Loan to Deposit Ratio above 1) can lead to unusual, unintuitive effects. As noted above a Bank, as a Credit Creator, makes profit, on the whole, by paying out less for taking Deposits than charging Creditors for Loans. It is not typical for a Bank’s customer to expect to be paid more in interest on a Deposit put in a Bank than to pay for a Credit taken out. It is even less typical to expect a Bank to make a profit in such a scenario. It would be a perfect business model, “win – win “, for a customer and a Bank: financial perpetuum mobile.

Let L be a Loan taken by a Bank customer which she immediately deposits in a Bank. Let I₁ be an Interest Rate paid on a Loan by a customer to a Bank and I₂ be an Interest Rate paid on a Deposit by a Bank to a customer. I₁ <>2. Let D be a total Deposits accepted by a Bank from which it Creates Credits, C = D x LTD. Let LTD > I₂/I₁. (A customer’s Deposit and Loan, both equal L, are, in practice, much smaller than D.)

Customer’s perspective:
L x I₂ - L x I₁ = L x (I₂ – I₁) > 0: since I₂ > I₁ a customer makes profit.

Bank’s perspective:
C x I₁ - D x I₂ = D x LTD x I₁ - D x I₂ = D x (LTD x I₁ – I₂) > 0: since LTD > I₂/I₁ a Bank makes profit too.

A Bank is making profit since it is lending out more than is taking in Deposits with LTD > I₂/ I₁. But such lending is unsustainable: it can only last as long as Cash Reserves are sufficient to top up Loans. However Cash Reserves are depleting at exponential pace. Hence this financial perpetuum mobile will have to come to a halt.

From bail-in to bail-out: letter to The Economist

On 28 January 2010 The Economist published a guest article authored by Messrs Paul Calello, the head of Credit Suisse' investment bank, and Wilson Ervin, its former chief risk officer, who proposed a new process for resolving failing banks, "From bail-in to bail-out".

On 3 February 2010 the author of this blog sent the following letter to the Editor of The Economist. The reader are invited to draw their own conclusions why it was not published.

===

To the Editor of The Economist

Sir

The "bail-in" proposed by Paul Calello and Wilson Ervin "bail-in" "From bail-out to bail-in" fails to address the real reason for the banks' liquidity crunch: that the loan to deposit ratio was greater than 100%, creating rapid growth via the money multiplier (which every economics student studies as the process of "deposit creation"). This makes a liquidity risk a certainty, a probabilistic inevitability. When the banking system's exploding liabilities outstripped their ability to get hold of cash, central banks stepped in, in effect printing money to restore banks' liquidity through quantitative easing.

The Calello-Ervin proposal does not deal with this. It does not state at what level the money multiplier would be sustainable and how to keep it below that limit. Instead, it spreads the liquidity risk among shareholders and creditors of different financial institutions, meaning that the next (and inevitable) credit crunch will be more severe and still more widespread than the one at the end of 2008.

An analogy would be a tank in which gas pressure is growing at an uncontrolled rate. Making the tank stronger only delays the inevitable (and much larger) explosion.

In short, "innovative" risk management mechanisms such as the Calello-Ervin proposal cause more harm than good, rather as credit-default swaps have done.

Yours sincerely

Greg Pytel

Nothing happened

In his article "Against All Odds", Daniel Gross is trying to prove that, very likely, "AIG might just pay the Fed back" the costs of the bailout. He concludes: "Nobody at Treasury or the Fed is bold enough to predict that taxpayers will ultimately be made whole. Some rough math suggests that final cost to the taxpayers for the AIG debacle could be between $12 billion and $20 billion. Yes, that’s a bitter pill to swallow. But it’s a much smaller pill than we have imagined even a few months ago."

Mr Gross' analysis and arguments are supported by pretty detailed calculations. Yet his "rough math" has the major flaw. It does not take into account the costs of the downturn of the economy caused by the financial crisis in which AIG played a key role. The financial crisis is not really a crisis but, as shown in the seminal article on this blog, a collapse of the pyramid scheme engineered in order to funnel cash from the economy into individuals' hands. The costs of the economic downturn go into trillions of dollars in national budgets’ deficits and far more if we were to add losses of individuals and families that lost their jobs and homes.

The enormity of the current global financial mayhem that will be paid for by generations to come brings a question about a true motivation of publishing articles painting a rather rosy picture as if nothing really has happened.

Money creation and circulation in the economy

(This is a draft version of an article. Therefore any comments, corrections and suggestions for improvement are welcome as they will be used to improve it.)

1. Money in economic universe

Economy universe consists of two sets of processes:

• Products/Services Creation, Trading and Consumption /Destruction


• Money Creation, Multiplication and Destruction

They interact in the following way:

- all Products/Services (including financial) are Supplied onto the Marketplace

- Cash (narrow money) is as the medium of exchange and store of value

- through Market Transactions such as producing goods, selling/buying goods, destroying (consuming) goods, selling/buying services, consumer banks operations (depositing money in a bank, lending money by a bank, withdrawing deposits, paying back loans)

- Credit Creation by circulating Cash through Deposit – Loan Cycle: by accepting Deposits and Lending them out, money is circulated in the economy multiplied in the process (also sometimes referred to as broad money), this is reflected on Loan/Deposit Balance Sheets and Cash Reserves; Loan to Deposit Ratio defines Money Multiplier (an underlying attribute of Credit Creation)

- Central Bank operations such as Creating or Destroying Cash, setting up Interest Rates, Open Market Operations, lending as the Lender of Last Resort

The graph below shows the structure and flow of money in the economy:

Economic universe has the following characteristics:

- ownership/supply of Product/Service

- value/price of Product/Service

- Cash Reserves and Loan/Deposit Balance Sheets

- Credit Creation (Deposit – Loan Cycles) information

2. Economic activities

An economic activity is a Market Transaction which is a transfer of ownership/supply for a price or Depositing or Lending money through as a Deposit – Loan Cycle (Credit Creation).

The model presented on the graph above separates and abstracts a Service of depositing and lending money from a process of Multiplying Money, i.e. Credit Creation, which is a result of lending deposits out. The former is modelled on the graph by a Market Transactions process (of Supplying a Product/Service) while the latter is modelled by Credit Creation. This a dual role of a bank as a Credit Creator and, possibly through it, as Product/Service Supplier is central to money creation and circulation in the economy.

2.1 Products and Services Demand and Supply

Products and services are created and they are ready for sale on the market in exchange for money. This constitutes Supply and Demand characteristics whose balance may be described, for example, by a Fisher’s “Equation of Exchange”, MV = PT. As an example we can observe that if we do not control the growth of Supply of Products and Services (due to its complex structure, natural and unpredictable phenomena, etc.) and we control growth of Money Supply (for example by setting Interest Rates or controlling Loan to Deposit Ratio) then additional Money Supply, through Credit Creation, will result in inevitable Inflation to balance Supply with Demand. A gradual increase of Demand results in gradual increased economic activities to satisfy it on a Supply end.

It is not a purpose of this model to argue the correctness of any theory or equation of Supply and Demand but to show that the model presented in this paper can accommodate any Supply and Demand theory.

2.2 Market Transactions

Money received for provision of Products/Services is either held outside of a Bank e.g. by a Product/Service Supplier), spent on Products/Services (Direct Cash Exchange, No Credit Creation) or is Deposited in a bank (in a form of Deposit or repayment of a Loan previously obtained).

2.3 Credit Creation (Deposit – Loan Cycle)

Banks (modelled as Bank on the graph above) provide Deposits back to the market (to depositors: Deposits paid out) or give loans (to creditors: Loans given), which is Credit Creation. Loans are given using Fractional Reserve Banking method. In extreme cases:

- if Loan to Deposit Ratio is 0% then effectively no loans are provided only deposits paid in are paid out to depositors (Cash Reserves equals liabilities on Loan/Deposit Balance Sheet); in such case a Bank is a store of Cash (in other words Cash Reserves are 100%). This is called Full Reserve Banking (or 100% Reserve Banking).

- if Loan to Deposit Ratio is 100% then all Deposits are turned to Loans and no Cash Reserves are created. This is called No Reserve Banking.

In the first instance, banks do not play a role as a (re)-lender but are a store for money. In the second instance (no Cash Reserves are accumulated to secure demands of depositors to pay out), if loans were 100% secure repayable on demand then such a model could have practically functioned. Typically banks lend with Loan to Deposit Ratio between 0% - 100%. For example, if Loan to Deposit Ratio were 90% than for every $10 on the Loan/Deposit Balance Sheet of liabilities banks accumulated $1 Cash Reserves, i.e. Money Multiplier is 10.

Such a model is possible to function in practice, since money is circulated through banks and not all depositors demand money at the same time, only a fraction of liabilities (on Loan/Deposit Balance Sheet) need to be satisfied at any one time. However, since there are demands on Deposits to be paid out and some creditors may default (not pay back a Loan) Cash Reserves are necessary. Inter-bank lending makes the system function as one big bank balancing supply and demand of liquidity by different banks. Furthermore a role of Central Bank is to act as a Lender of Last Resort in the event that banks’ Cash Reserves are not sufficient to satisfy demand for Deposits withdrawal (State guarantees of Deposits play an ultimate role in a credibility of such system, which works as a statistical machine).

It is not a purpose of this paper to argue a safe or practical level of Loan to Deposit Ratio which determines Money Multiplier and Cash Reserves level (or that Fractional Reserve Banking with Loan to Deposit Ratio above 0% should be accepted as a model). We observe that it is a philosophical debate what level of risk the society should accept, similar to safety of road, train or air travel, or nuclear power stations. We observe that the higher the Loan to Deposit Ratio the larger the Money Supply in economy, however at the same time, the greater the risk of liquidity shortage as the size of Cash Reserves are relatively smaller to overall banks’ liabilities on Loan/Deposit Balance Sheet.

2.4 Central Bank’s role

Apart from acting as the Lender of Last Resort, a role of Central Bank¸ as a creator of Cash (narrow money), is to set control on Money Supply (through Credit Creation) by setting an Interest Rate and acting through Open Market Operations. For example, a higher Interest Rate encourages saving and discourages borrowing thereby reducing Money Supply by reducing volume of Credit Creation, i.e. amount of broad money in circulation. This, in turn, reduces Products/ Services Demand which reduces pressure on Supply, typically resulting in reduction of Inflation. This, in turn, usually results in reduction of Interest Rates by Central Bank. This is a balancing act that a Central Bank plays (in practice, typically using principles behind MV = PT equation as a guide).

3. Additional comments

3.1 Financial Products/Services

Financial (banking) Products/Services are considered like any other Product/Services in the economy. There is no reason to consider them differently: they are simply Products/Services sold as a part of Market Transactions. The importance of banks’ role as Credit Creators (by executing Deposit – Loan Cycles) suggests that if banks collapse the economy will collapse too. Whilst this may be reasonably assumed as a correct hypothesis, this does not make banks unique suppliers of Products/Services in the economy. For example a collapse of electricity producers/suppliers or water producers/suppliers would bring economy to a collapse too. Therefore whilst banks role may be seen as vital, it is not unique.

In this context we separated and abstracted banks’ role as Credit Creators (through Deposit – Loan Cycles) and a role of Product/Services Suppliers.

- when a bank issues a Loan out of a Deposit, on one side it Creates Credit AND, at the same time, it is selling a Product/Service (provision of a Loan) for which a Creditor pays;

- when a bank accepts a Deposit (which may be later issued as a Loan), on one side it makes the first step in Credit Creation AND, at the same time, it is buying a Product/Service for which it pays a Depositor. We consider a Depositor as a Lender to a bank (i.e. a bank is a Creditor to a Depositor).

As noted before, this approach separates and abstracts a mathematical process of Money Multiplication (resulting from Loan to Deposit Ratio above 0%) from a Products/Services Supply of lending money (and other financial Products/Services). A Bank, as a Credit Creator, makes profit, on the whole, by paying out less for taking Deposits than charging Creditors for Loans. Pensions, endowments, savings, wholesale funding, insurance policies, derivatives and so on are financial Products/Services.

3.2 A role of a State in the model

In this description there is no reason to separate a State impact on economy from other providers of Products/Services. For example, taxation is a Market Transaction whereby taxpayers pay for Products/Services delivered by a State. (Whether efficiently or not is another matter and this question also applies to privately sold Products/Services.) Government bonds are financial products sold on the market. For avoidance of doubt, this model does not imply or support any argument whether a “larger State” is better than a “smaller” one, the State sector is as efficient as private sector etc. It also does not imply that such Market Transactions are voluntary (in some case like payment of taxes or law enforcement services, clearly they are not).

4. Economy dynamics

At any point in time a state of the economy is characterised by a set of information about it. This would include all the information at every level of economic activity: all information about every single Product/Service, its price/value, amount of money in circulation and its allocation, Loan/Deposit Balance Sheet, Cash Reserves, Interest Rate and so on. Any economic activity in such a system is a transition from the existing state to a new one. Examples of transitions to a new state:

- a Product or Service is sold at a certain price

- a new product is offered on the market at a certain price

- a prospective buyer of a service agrees a reduction of a price

- such a buyer (as above) completes a transaction

- a bank lends money to a borrower

- a borrower repays (a part) of a loan

- a deposit is made money in a bank

- Central Bank changes an Interest Rate

- … and so on

In general a transition from one state to another, changes the information defining ownership/supply of Product/Service or value/price of Product/Service or Creating Credit or other attributes in the model.

We can consider any economic activity as a transition from one state of economy to a new one. Some economic activities may be null transitions, i.e. result in no change to information about the state of the economy. For example, a re-evaluation of the price of a Product/Service resulting in the same price is an example of a null transition.

The presented model does not imply whether deposits create loans or vice versa. This is akin to “chicken and egg” dilemma. Money circulation is of cyclical nature with iterative or recursive characteristics and description has to start somewhere which may possibly give a wrong impression of any assumed starting point of a cycle. In the context of this model it is a purely philosophical issue of no practical consequence.

Putin says US no better than Greece in handling debt

For once, Vladimir Vladimirovich Putin has nailed it. The author of this blog would not venture to suggest that Vladimir Vladimirovich is its posts reader, in particulat "Default: Greece first then US?" However the world should pay attention and consider "a US way out" as a real possibility.

Comment to ”The largest heist in history”

The sheer power to blow up the banking system of lending with Loan to Deposit Ratio greater than 100% is all too obvious. If we look at this mechanism ("The largest heist in history", or more rigorously in "Loan to deposit ratio and banks liquidity") which is an exponential growth of balance sheets (credit expansion), we easily realise that even if just one small bank in the financial system started doing that, it would still blow up the banking system by causing systemic liquidity shortage (credit crunch). It does not matter at all what exactly this bank would be doing: borrowing on the wholesale money market, issuing bonds, collateralising and selling its loans, etc, as long as it kept on lending with Loan to Deposit Ratio greater than 100%. The reason being, that if the financial system were not to be blown up, i.e. not suffer the liquidity crunch, the Money Multiplier could have grown to infinity in a very fast, exponential pace as a result of growth to infinity of the balance sheet of this bank. I.e. a single dollar of cash would be sufficient to ensure liquidity of any number (up to infinity) of dollars of this bank’s obligations on its balance sheet.

It is somewhat incredible that almost all analysts, commentators and, most importantly, those responsible for the financial system still ignore that. It is obvious that many are unable to comprehend it: "difficult maths and all that". But this process is simply too trivial. Therefore it is impossible that almost ALL decision makers in the financial industry are genuinely so incompetent that nearly none of them can understand it. Therefore it is very likely that they deliberately engineered such lending with Loan to Deposit Ratio greater than 100% in order to construct a giant global pyramid scheme designed to fleece the system of cash, like Albanian gangsters in 1996 – 1997.

Additional note:

Of course it seems rather implausible that, in practice, if only one small bank started lending with Loan to Deposit Ratio greater than 100% it would have been allowed to do so for long by its competitors. Basically such bank would have grown very fast from a small bank to a very large one and, ultimately, to the largest bank in the world many times over (technically up to infinity) its nearest competitor. And this would not have gone unnoticed. Other financial institutions, which in such system are necessary to co-operate in this process, for example, through wholesale money market, would most likely have stopped it.

(Incidentally, during the time leading to the current crisis, we saw such massive growth of small or medium size banks: Northern Rock, Royal Bank of Scotland.)

We saw prior to the current financial crisis, which was the sufficient cause of it, other banks simply joining in and also starting lending with Loan to Deposit Ratio greater than 100%. As such process became acceptable and widespread it turned the financial system into a giant global pyramid scheme. Before its collapse in the second half of 2008, it looked like an unprecedented growth of the financial sector: but it was nearly all bogus and was bound to collapse spectacularly like pyramid schemes in Albania in 1996 – 1997. Inevitable and easily predictable: no benefit of hindsight needed.

(Please note that lending with Loan to Deposit Ratio greater than 100% was the sufficient, on its own, cause of the current financial crisis, i.e. it guaranteed it. However it is possible that it is not the only problem of the financial industry.)

"Financial risk" - The Economist video

After a year and a half since the financial crisis errupted The Economist published the video on their web site titled "Financial risk" that touches upon the causes of the crisis.

It is pretty good, but still some way short of being adequately informative. Two key points are missing:

1. The author of the video does not explain why in the crisis the spread between the prices of Treasury bills and LIBOR grew to "unimaginable" levels and all, what he called, "assets" slumped together in a correlated way. It is obvious and it was easily predictable: in multiple deposit creation process with Loan to Deposit Ratio greater than 100%, the Money Multiplier keeps growing to infinity at exponential pace (very fast) and the risk of liquidity shortage (i.e. "credit crunch") becomes 100% in a finite time: in practice it means that in the presence of cash shortage banks cannot be lent money as the risk of not getting them back is very high and all assets dramatically lose value as there is not sufficient money going around to pay for them. What appears on the video to be discoveries were, in fact, trivial to predict prior to the crisis by any competent financier, i.e. with rudimentary knowledge of mathematics.

2. Considering the above the author of this video should have clearly stated that banks should accumulate cash to restore their capital reserves rather than strictly non-cash instruments/products. Otherwise the banks and the video author may get a nasty surprise that their capital might become little worth toxic junk if another liquidity shortage happens again. And it will happen again if banks continue to generate credit with Loan to Deposit Ratio greater (or equal) 100%.

Bearing these two points in mind, the video is worth watching. It clearly justifies the pyramid model of the current crisis presented on this blog.

Default: Greece first then US?

Yesterday Professor Joseph Stiglitz stated on BBC Newsnight, in response to a suggestion resulting from "speculators" (i.e. money markets) behaviour that Greece might default on its debt:

"The absurdity of these speculators is illustrated by what's happening in the United States: the spread, the CDS', the bets on a default in the US government are going up. Does anybody believe that US government is going to default?

The fact that US government can print money, you can bet [on it], or whether there is inflation. But to bet on a default in the US is utterly absurd." [Starts at around 13:25 into the programme.]

With the greatest respect to Professor Stiglitz, I would not dismiss the "speculators" behaviour that easily as "absurd". They are not poor people working in an irrational way. In the past their behaviour was a really good sign of the forthcoming events (including governments' intentions). Do we remember how the Bank of England was building the "firewall" in September 1992 to protect the pound and how it eventually ended? And who made and who lost the money? That what the Germans appear to be doing now. Good luck to them! To answer Professor Stiglitz' question directly: "Does anybody believe that US government is going to default?". The author of this blog believes that there is a realistic risk of this happening, growing with every dollar borrowed by the US government. For more read "A US way out?"

New Labour: could it have been worse?

In today's Daily Mail Mrs Margaret Cook, the wife of late Robin Cook, the Leader of the British Parliament House of Commons who resigned in protest against Iraq War in 2003, wrote a tribute to her late husband for taking such stance. Anyone who follows British politics knows how hard, for personal reasons, it must have been for her to do so. And how sincere and reflective must it be. Be in no doubt, despite having been in a shadow of her late husband, Mrs Cook is an intellectual in her own right.

Mrs Cook expressed her take on the ongoing Chilcot Inquiry into the circumstances of the Iraq War in 2003. She wrote:

"Wriggle and obfuscate as they have done at the inquiry, those former ministers and aides who have given evidence have only been able to cover their backs partially.

For we now know that they either followed blindly and willingly into the conflagration or they saw the folly, but failed to speak out.

Some have pleaded that, in retrospect, they made 'honest mistakes'. For people in high and responsible places, there is no such thing."

Many believe, including all eminent international lawyers including Mr Philippe Sands QC, that starting the Iraq War was not only a "folly" (which has been obvious without any benefit of hindsight) but also a crime. Mr Jeremy Paxman remarked on BBC Newsnight, that – apart from "Tony's mates" like Lord Falconer - he could not find any lawyer prepared to argue for legality of the Iraq War. By lawyers' standards there are almost always arguments "for" and "against" in any case. Therefore this amounts to quite a conclusive judgement.

The author of this blog has argued since its inception nearly a year ago, that the current financial crisis was also caused by the crimes of financiers (and quite likely regulators and some politicians) who engineered and operated, or allowed to do so, a giant global pyramid scheme. This financial scam is designed to rob middle classes off their savings and investments and distribute it amongst individuals who effectively (not notionally like, for example, pension funds or unit trust and endowment client-investors) control the financial industry. This has already been dubbed "socialism for the rich", a somewhat natural progression for Islington and Notting Hill New Labour’s "Bollinger bolsheviks".

Calling criminals in high places criminals is a taboo. The mainstream media did not come round to a conclusion that both individuals who decided to start Iraq War as well as individuals who are responsible for the global financial crisis (through a pyramid scheme) must be held accountable for their actions in a Court of law. "Not only must Justice be done; it must also be seen to be done." Accepting "honest mistakes" of politicians who dragged the country into the Iraq War is as foolish as blaming the financiers' greed and stupidity for the current crisis. These are all not acceptable, and to some abhorrent, but at the end they are legal. Therefore this attitude of ostensible criticism by the mainstream media is designed to vent the public anger at the same time allowing war criminals and fraudsters to escape justice (and, of course, preserve their ill-gotten wealth). We should not be surprised if we even see effigies of politicians and bankers being hanged or burnt if it all helps them escaping being brought to book. Financiers will be happy to organise such events (no doubt, they will even make money on them).

Here we are now. But hopefully politicians, our democratically elected representatives, especially a new intake in the British Parliament and there will be quite a lot of them after the forthcoming elections, will take more robust view on both issues.

Spectacularly started New Labour's era of British history appears to be coming to even more spectacular end. Taking a long term perspective, 100 - 200 years after we are all long gone, and our children and grandchildren too, a New Labour period is likely to be judged as a time of crime and stupidity: Britain run by war criminals and financial fraudsters. We shall be in no doubt that future generations, who will have to pay trillions of pounds for New Labour’s rule and maintain memorials of those who fell pointlessly in the illegal Iraq War, will be too benevolent or naïve in looking for excuses.

On the election night on the 1st of May 1997, at a dawn of New Labour era many of us sang "things can only get better". And even those who did not (like this blog's author), had genuine hopes and were well-wishers. But, still going through the Iraq mess and the financial destruction, could it actually have been worse?


PS. Since this article was published, on 7 February 2010 Alistair Campbell, Tony Blair's media guru gave interview on Andrew Marr Show. Compare this interview (especially after 4:20 of the recording) with an interview he gave on 27 June 2003 on Channel 4 News (especially after 3:20 of the recording). It is quite clear there is something he is worried about. What is it? Any clues please post in the Comments section below.

Davos 2010: a "cunning" plan how we will all pay for "the largest heist in history"

According to Wall Street Journal, "top bankers and senior government officials from major economies held informal private talks on regulation that participants called 'constructive' but which produced little concrete result. (…) [The] only one concrete proposal was discussed in depth, according to a European CEO who took part: the idea of converting some of banks' debts into equity if their capital reserves are insufficient to cover writedowns, a proposal aimed at increasing banks' ability to absorb heavy losses.". Conspiracy? Of course not, just "a working meeting", but nevertheless let us forensically examine what this is likely to mean in practice.

The current financial crisis was caused by the banks engineering and operating a massive, global pyramid scheme. As a results the banks debt and potential liabilities became too large for underlying cash reserves. Or, more technically, the Money Multiplier became too high. Effectively, banks lost liquidity.

To save such pyramid from collapse governments injected trillions of dollars to improve banks liquidity, or, more technically, to reduce the Money Multiplier. This was done in two ways: by injecting cash (and giving governments' guarantees which are as good as cash) and taking banks’ equity for that and by quantitative easing, i.e. generating additional liquidity by printing money. The former risks putting governments' debt onto unsustainable level, whilst the latter carries high risk of backfiring with hyperinflation. Despite the massive amounts injected, testing the public financing and markets to the limits, those actions did not bring about the desired results. The banks' liquidity remains dire. This is a testimony to a massive scale of the pyramid (i.e. a level of Money Multiplier) engineered and operated by the financial industry.

Nearly a year ago, Professor Nouriel Roubini suggested converting banks debt and liabilities to equity. This idea reappeared at the meeting in Davos. Banks will be allowed to issue their own shares and settle their debt with them. Whilst it may not apply to individual depositors who have government guarantees (although this is also far from being certain as it is not known how the system may be developed in the future), in practice it would mean that a depositor or a creditor may receive in return a bunch of bank's shares having demanded a payment in cash. The practicality is that such solution will not cost governments directly (i.e. it will not be reflected as a part of governments’ debt) and will not carry a risk of high inflation as no new cash will be printed.

So what are the pitfalls? Issuing new shares will dilute their value. As the size of the pyramid is massive, we really talk about massive dilution. Therefore the depositors and creditors will be paid with practically worthless shares and, on top of that, existing shareholders will lose the value of their holding. It is likely to be very similar to Zimbabwe-style hyperinflation but not of cash currency but of share value of a bank being diluted (i.e. hyperdevaluation of the share value). It is not really a concern for short-term speculative investors as they always find a way to make money on the margins of fluctuations. Apart from affecting depositors and creditors of a bank, it will affect long-term investors, cumulatively large-scale through pension funds, endowments and unit trust investments. They are mainly middle class, responsible people who took care about their financial planning, their children education and pension. They have been the pillars of the free market economy for a century. They cannot do much to escape a beating if "banks' debt to equity plan" goes ahead: their funds' shareholding of banks is substantial so even if they try to escape by selling it out, they will be punished. This appears to be another way of making taxpayers pay for the largest heist in history. This time round, rather than through governments' finances or inflation, the toxic waste will be unloaded on depositors and creditors with additional diluted worthless shares. Clever, eh?

This kind of shareholding dilution strategy has been associated with companies regarded as rather dodgy, trading on OTC or AIM in London. (No doubt other countries have their equivalents.) Some City lawyers joke that "a criminal record" is a mandatory entry on their Board Directors' CV's. Now this kind of "unorthodox" financial practices looks destined for mainstream markets with governments' blessing. Similarly to governments' stimuli and quantitative easing it will make ordinary folk who worked, saved and paid for his/her pension poorer.

One way or another, the outcome of this crisis is not going to be any different than when pyramids collapsed in Albania in 1997 impoverishing the entire nation. The difference is that at least some of the perpetrators there languish in jail and some of the wealth gained was confiscated.

UK bogus growth?

Today UK has been reported to have 0.1% growth in the last quarter of 2009.

The UK GDP in 2009 was, circa, £1,460 billion. 0.1% of it (i.e. growth) is £1.46 billion.

Now, let us take the quantitative easing, i.e. printing money, into account. It does not represent any growth at all. It has totalled £200 billion. Therefore, in reality unless this 0.1% growth is adjusted for the effect of quantitative easing and the reports do not mention that, there was economy contraction of £198.54 billion, i.e. shocking 13.6% of GDP. This does not take into account when money printing took place but is a good estimate nevertheless.

I hope the ministers and mainstream financial commentators explain this.

PLEASE READ EXCHANGE OF COMMENTS BELOW THAT GIVES FULL PERSPECTIVE ON THIS SHOCKING FIGURE.

Stiglitz: ”US does not have capitalism now”

One is tempted to say: has it not been obvious, Professor Stiglitz for at least a year? You can say it again. However the fact that such a well-known and respected economist says it, confirming that the current crisis is not a failure of capitalism as we do not have capitalism, leads to conclusion that basic rules of free market were broken. A breach of such rules is at best a wrongdoing at worst a crime.

Professor Stiglitz makes also, implicitly, a very important point. Many, including top experts, pointed out to the Author of this blog, that the banks have not been operating a pyramid scheme since in a pyramid scheme the beneficiaries would normally be its originators high up its chain. Whilst this is only an intuitive argument, generally it makes sense. However the banks suffered heavy loses and were not beneficiaries at all. Therefore banks were not operating such a scheme.

Professor Stiglitz, implicitly, points out a difference, even a separation and conflict, between bankers and banks. So whilst the banks (or rather their shareholders) suffered heavy losses, bankers who run the banks and were up the pyramid chain, extracted and are still extracting their profits through remuneration and also by being "sophisticated" investors in a pyramid themselves. Banks, as institutions, were not originators of a pyramid scheme. Bankers were such originators turning the banks into their tools of running a pyramid scheme.

Financial terrorism

Traditionally terrorism has been based on asymmetry and disproportion between terrorists' demands and consequences of their actions, which were inevitable or extremely difficult to prevent, in case their demands were not met. A demand could be of a financial nature or a request for freeing of already convicted terrorists' comrades, or some political or social demands. A threatened action was typically disproportionate either by its sheer scale, or by an outrage it was designed to cause.

During the current financial crisis banks and other financial institution started playing "the terrorists' game" with the taxpayers. It all seems to have started by accident. At first, by engineering a massive global pyramid scheme, the banks were robbed of cash and were on the verge of collapse. This threat of collapse, with unimaginable consequences, pressured governments to come up with rescue packages. Effectively taxpayers started subsiding the financial industry. This is not to say that shareholders or owners benefited from this. This was not the game of the financial establishment. The beneficiaries have been the individuals, quite a large number of them, running the financial institutions: the industry "captains" and other "top financial talent". As mentioned, they engineered pyramid schemes paying themselves massive amounts of money in the process, not surprisingly almost exclusively in cash, not some kind of innovative financial instruments. It questions whether they believed in the first instance that they were legitimate financial products or they were just designed to funnel out the cash. This led to liquidity shortage resulting in near-collapse of the banking system. The erstwhile shareholders of these institutions lost some of their holdings as governments and other investors stepped in.

The financial industry "captains" continue to play this simple game with governments. They have learnt that they are considered as "too big to fail" and governments will rescue them. Now they also terrorise governments that if they do not pay themselves generously enough the so-called "talent" might leave the financial sector. Some governments seem to accept this nonsense as they feel terrorised by a thought of a prospect of the collapse of the financial system. Sometimes it even looks like a case of a Stockholm syndrome.

The truth of the matter is that the financial system appears to be operated in an illegal way. Firstly, a situation of allowing any institution of any kind (apart from rare exceptions like an army) to grow and be considered as "too big to fail" is in breach of any competition principles. Institutions that are "too big to fail" have monopolist grip on the market as they have a free insurance against failure, underwritten by taxpayers. This stifles smaller competitors, which are not "too big to fail" and creates insurmountable costs of market entry for any prospective new players. As a result productivity decreases and the industry becomes a hotbed of business pathology. It is an absolute contradiction to any free market principles and capitalism. The anti-trust case of Standard Oil looks like a child's play. The financial system resembles the communist world from its dying days.

Secondly, the financial industry became a classic form of a pyramid scheme. As a result it is impossible to ascertain whether the recently reported banks' profits are real ones or they are bogus and are the signs of yet another pyramid collapse similar to what we observed in September 2008, January 2009 and summer 2009.

Thirdly, receiving subsidies from taxpayers, to such a massive degree as the financial system got, is considered illegal under the European Union legislation. If in the US it is technically legal, one can assume that it is only the case because such taxpayers' subsidies were unthinkable in the past. Above all, public subsidies are anticompetitive and discriminatory to businesses that do not receive them on the same scale.

It is clear that taxpayers and governments must wake up to the fact that they are being terrorised by the financial establishment. The banks must be broken into much smaller businesses. The test is that each of them must be well below the mark of being "too big to fail". Each of the banks must be capitalised by holding cash reserves belonging to individual shareholders risking their loss in cash in case their bank collapses.

The financiers, with regulators and possibly some politicians, must face justice for causing the current crisis by engineering a global pyramid scheme. The prospect of having them languishing in jail and the wealth gained confiscated must be real. This would not be an act of revenge but of elementary justice. This would also be a deterrent for the "surviving" and future financiers making them less inclined to defraud the owners of smaller banks that should emerge from this crisis. As such smaller banks would not be "too big to fail", the balance will be on the owners to employ the management honest and competent enough that would not ruin a bank. If they do not, they, as the owners, may be held at ransom, terrorised. But the taxpayers will not be.

A letter to Vice-Chairman of the US' Financial Crisis Inquiry Commission, Mr Bill Thomas

24 January 2010

To: Bill Thomas - billthomas@fcic.gov

Dear Sir

In response to your invitation to the member of the public to send questions that witnesses to the inquiry should answer, please find my questions below. The Background to these questions has been explained in detail in the evidence sent to the British Parliament House of Commons Treasury Committee that investigated the causes of the current Banking Crisis:

http://www.publications.parliament.uk/pa/cm200809/cmselect/cmtreasy/144/144w254.htm

Further more detailed justification is on my blog:

"Financial crisis? It's a pyramid, stupid." - http://gregpytel.blogspot.com/

I trust my questions will be helpful with the Commission's work.

Yours sincerely

Greg Pytel

Background:

The current financial crisis began as a banking crisis called "credit crunch". Credit crunch was a shortage of liquidity, namely cash, i.e. one dollar real cash had to cover too many dollars of financial liabilities and there was insufficient volume of cash. A ratio how many dollars of liabilities on banks’ books one dollar cash has to cover is called Money Multiplier (MM).

With loan to deposit ratio (LTD) less than 100% Money Multiplier is constant for a constant LTD, and always finite (at the limit). I.e. if LTD = 0% then MM = 1, if LTD = 20% then MM = 1.25, if LTD = 50% then MM = 2, if LTD = 80% then MM = 5, if LTD = 90% then MM = 10, if LTD = 99% then MM = 100, if LTD = 99.9% then MM = 1000, and so on.

If LTD equals 100% then MM equals infinity at the limit, i.e. MM keeps growing without a limit linearly as a result of every multiple deposit creation cycle.

If LTD is greater than 100% then MM equals infinity at the limit, i.e. MM keeps growing without a limit exponentially (very fast) as a result of every multiple deposit creation cycle.

Therefore if LTD ratio is greater than (or equal) 100% in multiple deposit creation cycle then one dollar cash is expected to cover ever growing (technically infinite at the limit) number of dollars of liabilities on banks' balance sheets. In other words, Money Multiplier grows to infinity. In case of LTD ratio greater than 100%, it is an exponential, i.e. very fast, growth guaranteeing liquidity shortage in a finite time, i.e. the risk of credit crunch is 100%.

The exponential growth of Money Multiplier, MM, to infinity can be graphically represented and it looks like a pyramid.

Furthermore, if LTD ratio is less than 100%, the overall ratio of total loans to total deposits, on bank(s) balance sheets, gives an average LTD ratio and can be used as the reliable basis for calculating MM (for a banks, or a number of banks, or the financial system). If LTD is greater than (or equal) 100%, it is impossible to calculate a MM based on a ratio of total loans to total deposit.

The banks were using LTD ratio greater than 100% in the multiple deposit creation process (lending).

Questions to the financial executives (each of them):

Since lending with LTD ratio greater than 100% has been a standard banking practice:

1. Do you expect MM to be arbitrary high (potentially infinite) without causing a liquidity shortage (credit crunch)? The answer must be: "yes" or "no".

2. Two alternatives

2.1 If the answer is "yes", how do you expect one dollar cash to cover potentially infinite number of dollars of liabilities on the bank's balance sheets without causing liquidity shortage (credit crunch)?

2.2 If the answer is "no":

- can you advice on the maximum MM, what it should be (the answer must be a concrete figure: e.g. 5, 8, 10, 15, 20, 50, 100, etc)

- how do you expect the financial institutions to practically control and ensure that MM is never greater than that maximum.