Why banks might need further support

In 2006, and more so in 2007 (until "the bubble burst") houses were being bought and sold at unprecedented prices. Many other assets were similarly "overvalued", simultaneously. How is this possible?

Firstly, let's start with the money supply. It has formed a bit-part of political vocabulary since the days of Reagan and Thatcher, and in Economics a little longer. Many laymen would first think of the money supply as what exists in coins and notes.

In reality this amounts to a tiny proportion of total money. To this can be added all money that is instantly accesible, in the form of current account deposits, and overdraft allowances (you have this money, since you can spend it instantly at no great cost to yourself). A precise definition of what should and shouldn't be counted as money isn't available, instead we have several measures, which reflect things you can trade with differing degrees of ease.

Ultimately, lots of money can be created through leveraging. A bank receives a £10000 deposit, and is permitted by law to lend £9000 out. This £9000 is spent, and the recipients then deposit it. £8100 of this £9000 is lent out in the same manner as the £9000 originally. This process repeats until £100k has been deposited. This is how much can be created with leverage ratios of 10%.

In a boom, it is essential for banks (from a competitive sense) to lend as much as possible, and so they extend their leverage, keeping, say 5% in house, so that £10k can become £200k instead of £100k. As leverage increases, so does the money supply.

A similar procedure occurs with houses. Where a minimum deposit of 20% prevails, prices are low, because fewer people can afford the house, reducing demand. When this requirement is reduced to 5%, people with only a quarter of the means can suddenly afford the house. This naturally increases the price, and so encourages banks to reduce their requirements (if prices are rising, defaults are rare, so deposits are less necessary).

However, when "the bubble bursts" or faith is lost, the required deposit surges cutting the number of people who can afford a house, and therefore house's value. Now the owner can't sell, even if they wanted to, simply because the leverage requirement/limit changed.

As banks deleverage, it is important to increase their "capital base" artificially, since moving from 5-20% whilst maintaining the same money supply (important to keep the economy going) requires a QUADRUPLING of the banks stocks. And a 20% holding is required in crisis periods, because people are more likely than usual to withdraw their money at short notice.

That is why the banks needed the support they've had so far, and will possibly continue needing more. I don't have their balance sheets, and am uncertain as to how "de-levereaged" they want to become, so I can't be sure HOW MUCH money they'll need. It is also why we use the credit crunch term to describe the cause, rahter than just the nature, of the crisis.

Economics for beginners #1

http://www.youtube.com/watch?v=VVp8UGjECt4

Also available on Greg Mankiw's blog, which is appropriate, since it his his "10 principles of Economics" which are being translated into non-specialist-ese.

Psychology of a crisis

An article in yesterday's New York Times gives a very interesting account of the importance of understanding mood and psychology, and particularly their role in creating crises such as this one.

Robert Schiller writes about a paper delivered by Larry Summers in 1989 about a fictional crisis set in 1991, where a stock market boom had led people to believe that recessions would never return.

Euphoria gripped the investors of his fictional universe. “The notion that
recessions were a thing of the past took hold,” Mr. Summers said. He added that
over a 15-year period through 1990 — a time that included the 1987 crash —
investors earned an average real return of 11 percent. The popular view was that
“with a reduced cyclical element, the future would be even brighter.”

Much of the story mirrors what has happened in the past 2 years in reality. Handily, the paper's author is now director of the White House's National Economic Council, so is well placed to treat the patient, but, of course, that requires the agreement of many politicians, with differing worldviews and motives.

Here's hoping.

The markets this week

Whilst daily updates on the state of the stock markets, and currency and commodity markets can be useful, they can often mask trends.

Therefore, every week (when I remember) I will publish here the change from Friday close to Friday close of the following: FTSE, DOW, $/£ rate, €/£ rate, Oil price, Gold price (using offical $ rates and unofficial translations into £ and €).

FTSE: up 56 points or 1.46%
DOW: up 497.8 points or 6.84%
£: down 1.39 US cents or 0.96%
£: up 1.19 Euro cents or 1.12%
Oil: up 11 US cents, 42 pence or 88 Euro cents
Gold: down $30, £14.55 or €7.81

My view: FTSE flat, DOW up (mostly thakns to $1.2tn toxic asset purchase scheme) are both news of increased optimism on the markets. The falling £ is a bad sign (as I think economic recovery globally would lead to a recovery of the £) - but having said that, the € fell by more, which might imply great market confidence in the US recovery plans.

Oil rising and gold falling are both signs of increased optimism.

Dominic on bonuses

Another imported Facebook note, also written in early February. I only wrote two of the planned "mini-blog" notes, which augurs badly for this actual blog, but hey, here it is.

Sorry, another note that fails to include 25 things about me. I'm sure you're all/both devastated. Anyhoo, I'm now going to unleash the second of my "a few" notes in this series. Topic, as in the title is bonuses.

Why bonuses?
Simple, they've been in the news lately.
Bonuses, in my view are a valid tool for persuading people to do their job properly. Not in all situations, but certainly in some. Ultimately, in many jobs, once you're in there's little making you work hard, except the hope of promotion or the desire for a good reference. From an employer's point of view, neither is a great way of making a large workforce work hard. Promotion can only be offered to so many people, and references are what you give to employees who have just left. This is why they offer performance-related pay.

How should they be?
Well, in a situation where your job has a very simple "success" measure (sport: winning trophies, most businesses: making money) then a logical pay scheme would offer you enough money to get by, plus a (hopefully) generous bonus for the profits you bring into the company. So far, so good. The trouble is, that company profits aren't straightforwardly £1 per transaction or £1m per transaction. They take into account costs for which an individual employee isn't responsible. Also, some work is more profitable than others and so forth. Also, not all companies make profits, even if some of their departments do. How do you even define the profits generated by the accounts department?
Therefore, some companies offer bonuses based on the firms performance, whilst others do so more on the basis of individual results. The first case is barely an improvement on basic pay (it has the advantage of being cheaper when times are tough). The latter case will encourage departments to be as profitable as possible (but perhaps at the expense of others). This is where the current situation comes in.

Current situation:
About a month ago, Northern Rock hit the headlines (again) when it offered staff approximately £9m in bonuses. This caused outrage, given the huge debt the bank owes to HM Treasury. It amounted, however, to about 10% of annual earnings for most staff, well down on the 60% that might have been available, according to documents in the public domain 4 months ago. The bonuses were paid because staff were exceding expectations in repaying the debt (allegedly by foreclosing on record numbers of houses, more on that in a minute) and so were rewarded for doing their job well.
Northern Rock famously had a bad set of loans on its books when it was nationalised, so it is only natural that many properties were due for foreclosure. I'm willing to believe that the bank was foreclosing on a lower proportion than usual of "underperforming" loans. Even in the current crisis, debt is debt, and must be paid. Eventually, and to someone.RBS has now raised further ire by offering its (much larger) staff up to £1bn in bonuses. In some cases, its staff are contracted to "minimum 100% bonus" - this I don't understand (why not just increase basic pay?) In other cases, its staff work in highly profitable departments (RBS is a VERY large firm) and in some cases, well, expectations must be met.
Basically, I feel that only some of these can be justified, but even those that can, shouldn't receive their bonus. Ultimately, if the best footballer played for a poor team, they wouldn't win, he wouldn't get his bonus. The team (RBS now, metaphor almost over) is failing, don't give the stars their bonuses.
Having said that, about 100,000 to 150,000 of the 177,000 staff son't actually earn all that much, and who am I to begrudge them an extra £1000 to £3000. An unemployed person, dammit, so begrudge them I shall.

Moral of the story:
Signing contracts you can't fulfill is idiotic. Gettting paid to lose money sounds like a nice job, if you can get it. And, if you get it - won't you tell me how?

Dominic on Economics

Another note imported from Facebook. Written in early February.

I'll probably be writing a few of these over the next week or two, and they'll probably be about as interesting as each other (ie yes to me, and maybe to some of you). In other words, a blog-lite.

Anyhoo, what with economic crisis affecting much of the world (and providing my first retort to "why are you unemployed") the profession/science/study/field of economics has come under some criticism.

1) Why wasn't the crisis predicted?
Well, it was. There's an old line, that economists have predicted 87 out of the last 5 recessions. This is inevitable in any field of prediction: I personally like to compare it to meteorology. After all, we've had snow predicted for us many times and it doesn't always end up happening. Also, the 1- or 2- day forecasts are usually accurate, whilst the 10-day forecast is only a little better than saying it'll be the same as today's weather forever. In economics, the predictions go slightly longer, but are just as reliable. Not long ago, the predictions for 2009 indicated solid growth. Now they predict a long recession. 2008 was worse than predicted, some years end up better.

2) Internecine fighting.
Forgive me, I wanted to use a long word. Many economists have been suggesting a large "stimulus" package to boost demand across the economy. Others say that the resulting debt will cause more uncertainty and undermine the effort, rendering the stimulus impotent. Unfortunately, media organisations feel the need to report both sides of disagreements (global warming, anyone?) so those advocating little action, or criticising actions are given much media spotlight, regardless of the merits of their case.
Of course, that is not to say that I am in complete support of every action undertaken by the UK (and US, German, French, Japanese, etc.) government(s). However, the question: "was this the right thing to do?" is a tough one to answer. Firstly, as time goes by, more information is uncovered about quite how bad the situation is. Secondly, the counterfactual "what if we hadn't done it?" can never be shown. Imagine, if you choose, that the government had (as suggested by Vince Cable of the Liberal Democrats) nationalised Northern Rock at the first sign of customers queuing outside the building. This would have shown decisiveness, and might have helped. But ultimately, that can never be proven.

3) Economics is not a proper science.
This last point is important to consider when evaluating economics' claim to be a science. No double blind test can responsibly be run on any macroeconomic question*. Microeconomic questions can be studied, using techniques from psychology and so called "natural experiments". Policies can be partially implemented, trialled in certain regions, and the effects of the policy can be controlled against the area or group who felt none of the effects of the policy.
For how to deal with an economic crisis worse than anything in the past 75 years (at latest estimate) how can anyone expect a double-blind proven response? The study of rare medical conditions is probably an appropriate simile here. There are only so many countries, and so many recessions. In all cases, the causes of recession are different (even if similar - high commodity prices, collapse of an industry, war, famine, hyperinflation can happen too).
Ultimately, nobody knows what will happen next, nor do they know the consequences of certain policies in a situation where most banks are crippled by bad debts and Knightian uncertainty (Donald Runsfeld's unknown unknowns). However, some people are in a better positon than others to make "best guesses". These are the experts, the Nobel-prize winners, the professors of economics at the top universities and the chief economists/economic advisors of major organisations (OECD, governments, UN, World Bank, IMF, etc).
Their opinion should be given a stronger weight than that of generic backbench opposition MP. Not the other way around.

4. Study it at university?
I did. Which is why this note reads as it does (I've tried to avoid jargon, and probably failed) and probably why it is being written at all.
I thoroughly recommend it to anyone with the vaguest interest. The current crisis doesn't render all that has ever been learned before meaningless. It does, however offer a chance for more to be learned (and revisited - Keynes et al).
However, having studied it hasn't helped me as much as some other subjects might. Such is life. Given the information I had at the time, I made the right decision. However, I won't† study a Masters. This is because I think a specific professional qualification would be more useful to me now.

Final thoughts:
Like I said, the subject has come under attack of late. That is to be expected (Biology would come under similar attack if millions were mutating, instead of becoming unemployed). Bringers of bad news are seldom welcome, so those predicting disaster aren't usually welcomed (the phrase "don't shoot the messenger" exists for a reason). Discussion and debate are common in any field of study (especially in those so immature as economcs) but these facts do not render the answers brought forth worthless.

As I said at the beginning, there will probably be several of these, addressing fields vaguely related to my "expertise". Read at own risk, no responsibility is claimed for your wasted time, if you so feel. Correspondence will, however, be entered into, so feel free to comment.

* That I can think of, off the top of my head.
†Probably

My favourite sites/blogs

As a follower of the credit crunch and a Bachelor of the Science of Economics I have a few opinions of my own. In this blog I will sometimes expound these views. However, in this post, I will tell you where I acquire my information, and which ideas I see. Firstly, I would like to recommend Baseline Scenario http://www.baselinescenario.com/ as a source of analysis on the credit crunch. It has an explanation of the situation's causes (as they see it) and several daily posts on policy proposals and economic data.I would also recommend http://krugman.blogs.nytimes.com/ and Paul Krugman's twice weekly Op-Ed articles in the New York Times. Various other contributors on http://www.nytimes.com/ also have interesting views.The Economist http://www.economist.com/ always has interesting views on current affairs (not just Economics) but here I will recommend their columnist blogs, available here:http://www.economist.com/blogs/ I particularly like Bagehot, Charlemagne, Free Exchange and Democracy in America, but the others are also worth reading.I'll also mention Greg Mankiw: http://gregmankiw.blogspot.com/ and the New York Review of Books: http://www.nybooks.com/ which has some interesting articles (updated approximately fortnightly, in line with their print copy).
For Formula 1, I will recommend http://www.itv-f1.com/ and http://www.formula1.com/ but if you want lots of information http://f1junkie.com/ provides links to many of the main news sources for the sport. Former commentator James Allen has a blog available at http://www.jamesallenonf1.com/
Assorted other sites draw in my daily attention - http://www.bbc.com/, http://www.doonesbury.com/, http://www.marca.com/, http://www.elpais.com/ and http://www.guardian.co.uk/ for news and cartoons.
Finally, I would like to promote my very first attempt at a website: http://www.funinthesunglasses.co.uk/ and its newer version: http://www.fitsunglasses.com/ which sells good quality sunglasses at low prices. Prescription sunglasses are available, as are designer names (including Porsche!)