Next Crisis: The ECB-induced Sovereign Debt Bubble

By Sam Vaknin
Author of “Malignant Self-love: Narcissism Revisited”

As 2011 came to a close and in the first months of 2012, the European Central Bank (ECB) initiated a massive injection of liquidity into Europe’s embattled banking system. The ECB provided 3-year loans amounting to half a trillion euros at nominal and minimal interest rates. At first, the risk-averse banks re-deposited the funds with the ECB. Later, however, they embarked on an arbitrage operation of unprecedented proportions using the cheap money to purchase sovereign bonds with historically high coupons issued by the likes of Italy and Spain. Thus, the ECB ended up fostering yet another unsustainable bubble in sovereign obligations and threatening the balance sheets of the very institutions it seeks to prop up when the bubble inevitably bursts.

The global credit crunch induced by the subprime mortgage crisis in the United States, in the second half of 2007, engendered a tectonic and paradigmatic shift in the way central banks perceive themselves and their role in the banking and financial systems.

On December 12, 2007, America’s Federal Reserve, the Bank of England, the European Central Bank (ECB), the Bank of Canada and the Swiss National Bank, as well as Japan’s and Sweden’s central banks joined forces in a plan to ease the worldwide liquidity squeeze.

This collusion was a direct reaction to the fact that more conventional instruments have failed. Despite soaring spreads between the federal funds rate and the LIBOR (charged in interbank lending), banks barely touched money provided via the Fed’s discount window. Repeated and steep cuts in interest rates and the establishment of reciprocal currency-swap lines fared no better.

The Fed then proceeded to establish a “Term Auction Facility (TAF)”, doling out one-month loans to eligible banks. The Bank of England multiplied fivefold its regular term auctions for three months maturities. On December 18, the ECB lent 350 million euros to 390 banks at below market rates.

In March 2008, the Fed lent 29 billion USD to JP Morgan Chase to purchase the ailing broker-dealer Bear Stearns and hundreds of billions of dollars to investment banks through its discount window, hitherto reserved for commercial banks. The Fed agreed to accept as collateral securities tied to “prime” mortgages (by then in as much trouble as their subprime brethren).

The Fed doled the funds out through anonymous auctions, allowing borrowers to avoid the stigma attached to accepting money from a lender of last resort. Interest rates for most lines of credit, though, were set by the markets in (sometimes anonymous) auctions, rather than directly by the central banks, thus removing the central banks’ ability to penalize financial institutions whose lax credit policies were, to use a mild understatement, negligent.

Moreover, central banks broadened their range of acceptable collateral to include prime mortgages and commercial paper. This shift completed their transformation from lenders of last resort. Central banks now became the equivalents of financial marketplaces, and akin to many retail banks. Fighting inflation – their erstwhile raison d’etre – has been relegated to the back burner in the face of looming risks of recession and protectionism. In September 2008, the Fed even borrowed money from the Treasury when its own resources were depleted.

As The Economist neatly summed it up (in an article titled “A dirty job, but Someone has to do it”, dated December 13, 2007):

“(C)entral banks will now be more intricately involved in the unwinding of the credit mess. Since more banks have access to the liquidity auction, the central banks are implicitly subsidising weaker banks relative to stronger ones. By broadening the range of acceptable collateral, the central banks are taking more risks onto their balance sheets.”

Regulatory upheaval is sure to follow. Investment banks are likely to be subjected to the same strictures, reserve requirements, and prohibitions that have applied to commercial banks since 1934. Supervisory agencies and functions will be consolidated and streamlined.

Ultimately, the state is the mother of all insurers, the master policy, the supreme underwriter. When markets fail, insurance firm recoil, and financial instruments disappoint – the government is called in to pick up the pieces, restore trust and order and, hopefully, retreat more gracefully than it was forced to enter.

The state would, therefore, do well to regulate all financial instruments: deposits, derivatives, contracts, loans, mortgages, and all other deeds that are exchanged or traded, whether publicly (in an exchange) or privately. Trading in a new financial instrument should be allowed only after it was submitted for review to the appropriate regulatory authority; a specific risk model was constructed; and reserve requirements were established and applied to all the players in the financial services industry, whether they are banks or other types of intermediaries.

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Reclaiming Time

By Sam Vaknin
Author of “Malignant Self-love: Narcissism Revisited”

The commoditization and commercialization of Time are recent phenomena. Until the advent of the Industrial Revolution, man’s time was at the mercy of Nature and the seasons or surrendered to superiors and masters to be allocated at their will. Serfs and servants, vassals, and clergy were mere cogs in social machines which dictated what they did and, as importantly, when they did it, in accordance with strict long-predetermined schedules.

With the abolition of feudalism and the emergence of modern manufacturing, workers reassumed control over and ownership of Time. They began to sell time units (in the form of labour), bartering them for money, lodgings, clothing, and food. Yet, even so, labourers remained slaves to the rhythms of production lines and markets. Technology merely took over from Nature and substituted for erstwhile landlords: machines and clocks now set the pace and rationed time.

The last third of the twentieth century heralded a true revolution in Man’s relationship with Time. Trends such as self-employment, telecommuting, the mobile or virtual office, flextime, and multiple careers mean that workers are the ones who decide on the timing of work and leisure activities and hobbies as well as the amount of time to allocate to them. Technologies such as the Internet and smartphones while atomizing society also render us more self-sufficient, more mobile and less dependent on decisions made by others in many fields: from banking to entertainment.

We are reclaiming Time and, in the process, for the first time in history, we have become our true and only masters.

In his book, “A Farewell to Alms” (Princeton University Press, 2007), Gregory Clark, an economic historian at the University of California, Davis, suggests that downward social mobility in England caused the Industrial Revolution in the early years of the 19th century. As the offspring of peasants died off of hunger and disease, the numerous and cosseted descendants of the British upper middle classes took over their jobs.

These newcomers infused their work and family life with the values that made their luckier forefathers wealthy and prominent. Above all, they introduced into their new environment Max Weber’s Protestant work ethic: leisure is idleness, toil is good, workaholism is the best. As Clark put it:

“Thrift, prudence, negotiation and hard work were becoming values for communities that previously had been spendthrift, impulsive, violent and leisure loving.”

Such religious veneration of hard labor resulted in a remarkable increase in productivity that allowed Britain (and, later, its emulators the world over) to escape the Malthusian Trap. Production began to outstrip population growth.

But the pendulum seems to have swung back. Leisure is again both fashionable and desirable.

The official working week in France has being reduced to 35 hours a week (though the French are now tinkering with it). In most countries in the world, it is limited to 45 hours a week. The trend during the last century seems to be unequivocal: less work, more play.

Yet, what may be true for blue collar workers or state employees – is not necessarily so for white collar members of the liberal professions. It is not rare for these people – lawyers, accountants, consultants, managers, academics – to put in 80 hour weeks.

The phenomenon is so widespread and its social consequences so damaging that it has acquired the unflattering nickname workaholism, a combination of the words “work” and “alcoholism”. Family life is disrupted, intellectual horizons narrow, the consequences to the workaholic’s health are severe: fat, lack of exercise, stress – all take their lethal toll. Classified as “alpha” types, workaholics suffer three times as many heart attacks as their peers.

But what are the social and economic roots of this phenomenon?

Put succinctly, it is the outcome of the blurring of boundaries between work and leisure. This distinction between time dedicated to labour and time spent in the pursuit of one’s hobbies – was so clear for thousands of years that its gradual disappearance is one of the most important and profound social changes in human history.

A host of other shifts in the character of work and domestic environments of humans converged to produce this momentous change. Arguably the most important was the increase in labour mobility and the fluid nature of the very concept of work and the workplace.

The transitions from agriculture to industry, then to services, and now to the knowledge society, increased the mobility of the workforce. A farmer is the least mobile. His means of production are fixed, his produce mostly consumed locally – especially in places which lack proper refrigeration, food preservation, and transportation.

A marginal group of people became nomad-traders. This group exploded in size with the advent of the industrial revolution. True, the bulk of the workforce was still immobile and affixed to the production floor. But raw materials and finished products travelled long distances to faraway markets. Professional services were needed and the professional manager, the lawyer, the accountant, the consultant, the trader, the broker – all emerged as both parasites feeding off the production processes and the indispensable oil on its cogs.

The protagonists of the services society were no longer geographically dependent. They rendered their services to a host of geographically distributed “employers” in a variety of ways. This trend accelerated today, with the advent of the information and knowledge revolution.

Knowledge is not geography-dependent. It is easily transferable across boundaries. It is cheaply reproduced. Its ephemeral quality gives it non-temporal and non-spatial qualities. The locations of the participants in the economic interactions of this new age are transparent and immaterial.

These trends converged with increased mobility of people, goods and data (voice, visual, textual and other). The twin revolutions of transportation and telecommunications really reduced the world to a global village. Phenomena like commuting to work and multinationals were first made possible.

Facsimile messages, electronic mail, other forms of digital data, the Internet – broke not only physical barriers but also temporal ones. Today, virtual offices are not only spatially virtual – but also temporally so. This means that workers can collaborate not only across continents but also across time zones. They can leave their work for someone else to continue in an electronic mailbox, for instance.

These technological advances precipitated the transmutation of the very concepts of “work” and “workplace”. The three Aristotelian dramatic unities no longer applied. Work could be performed in different places, not simultaneously, by workers who worked part time whenever it suited them best.

Flextime and work from home replaced commuting (much more so in the Anglo-Saxon countries, but they have always been the harbingers of change). This fitted squarely into the social fragmentation which characterizes today’s world: the disintegration of previously cohesive social structures, such as the nuclear (not to mention the extended) family.

All this was neatly wrapped in the ideology of individualism, presented as a private case of capitalism and liberalism. People were encouraged to feel and behave as distinct, autonomous units. The perception of individuals as islands replaced the former perception of humans as cells in an organism.

This trend was coupled with – and enhanced by – unprecedented successive multi-annual rises in productivity and increases in world trade. New management techniques, improved production technologies, innovative inventory control methods, automatization, robotization, plant modernization, telecommunications (which facilitates more efficient transfers of information), even new design concepts – all helped bring this about.

But productivity gains made humans redundant. No amount of retraining could cope with the incredible rate of technological change. The more technologically advanced the country – the higher its structural unemployment (i.e., the level of unemployment attributable to changes in the very structure of the market).

In Western Europe, it shot up from 5-6% of the workforce to 9% in one decade. One way to manage this flood of ejected humans was to cut the workweek. Another was to support a large population of unemployed. The third, more tacit, way was to legitimize leisure time. Whereas the Jewish and Protestant work ethics condemned idleness in the past – the current ethos encouraged people to contribute to the economy through “self realization”, to pursue their hobbies and non-work related interests, and to express the entire range of their personality and potential.

This served to blur the historical differences between work and leisure. They are both commended now. Work, like leisure, became less and less structured and rigid. It is often pursued from home. The territorial separation between “work-place” and “home turf” was essentially eliminated.

The emotional leap was only a question of time. Historically, people went to work because they had to. What they did after work was designated as “pleasure”. Now, both work and leisure were pleasurable – or torturous – or both. Some people began to enjoy their work so much that it fulfilled the functions normally reserved to leisure time. They are the workaholics. Others continued to hate work – but felt disorientated in the new, leisure-like environment. They were not taught to deal with too much free time, a lack of framework, no clear instructions what to do, when, with whom and to what end.

Socialization processes and socialization agents (the State, parents, educators, employers) were not geared – nor did they regard it as their responsibility – to train the population to cope with free time and with the baffling and dazzling variety of options on offer.

We can classify economies and markets using the work-leisure axis. Those that maintain the old distinction between (hated) work and (liberating) leisure – are doomed to perish or, at best, radically lag behind. This is because they will not have developed a class of workaholics big enough to move the economy ahead.

It takes workaholics to create, maintain and expand capitalism. As opposed to common opinion, people, mostly, do not do business because they are interested in money (the classic profit motive). They do what they do because they like the Game of Business, its twists and turns, the brainstorming, the battle of brains, subjugating markets, the ups and downs, the excitement. All this has nothing to do with money. It has everything to do with psychology. True, money serves to measure success – but it is an abstract meter, akin to monopoly money. It is proof shrewdness, wit, foresight, stamina, and insight.

Workaholics identify business with pleasure. They are hedonistic and narcissistic. They are entrepreneurial. They are the managers and the businessmen and the scientists and the journalists. They are the movers, the shakers, the pushers, the energy.

Without workaholics, we would have ended up with “social” economies, with strong disincentives to work. In these economies of “collective ownership” people go to work because they have to. Their main preoccupation is how to avoid it and to sabotage the workplace. They harbour negative feelings. Slowly, they wither and die (professionally) – because no one can live long in hatred and deceit. Joy is an essential ingredient of survival.

And this is the true meaning of capitalism: the abolition of the artificial distinction between work and leisure and the pursuit of both with the same zeal and satisfaction. Above all, the (increasing) liberty to do it whenever, wherever, with whomever you choose.

Unless and until Homo East Europeansis changes his state of mind – there will be no real transition. Because transition happens in the human mind much before it takes form in reality. It is no use to dictate, to legislate, to finance, to cajole, or to bribe. It was Marx (a devout non-capitalist) who noted the causative connexion between reality (being) and consciousness. How right was he. Witness the prosperous USA and compare it to the miserable failure that was communism.

From an Interview I Granted

Question: In your article, Workaholism, Leisure and Pleasure, you describe how the line between leisure and work has blurred over time. What has allowed this to happen? What effect does this blurring have on the struggle to achieve a work-life balance?

Answer: The distinction between work and leisure times is a novelty. Even 70 years ago, people still worked 16 hours a day and, many of them, put in 7 days a week. More than 80% of the world’s population still live this way. To the majority of people in the developing countries, work was and is life. They would perceive the contrast between “work” and “life” to be both artificial and perplexing. Sure, they dedicate time to their families and communities. But there is little leisure left to read, nurture one’s hobbies, introspect, or attend classes.

Leisure time emerged as a social phenomenon in the twentieth century and mainly in the industrialized, rich, countries.

Workaholism – the blurring of boundaries between leisure time and time dedicated to work – is, therefore, simply harking back to the recent past. It is the inevitable outcome of a confluence of a few developments:

(1) Labour mobility increased. A farmer is attached to his land. His means of production are fixed. His markets are largely local. An industrial worker is attached to his factory. His means of production are fixed. Workers in the services or, more so, in the knowledge industries are attached only to their laptops. They are much more itinerant. They render their services to a host of geographically distributed “employers” in a variety of ways.

(2) The advent of the information and knowledge revolutions lessened the worker’s dependence on a “brick and mortar” workplace and a “flesh and blood” employer. Cyberspace replaces real space and temporary or contractual work are preferred to tenure and corporate “loyalty”.

Knowledge is not geography-dependent. It is portable and cheaply reproduced. The geographical locations of the participants in the economic interactions of this new age are transparent and immaterial.

(3) The mobility of goods and data (voice, visual, textual and other) increased exponentially. The twin revolutions of transportation and telecommunications reduced the world to a global village. Phenomena like commuting to work and globe-straddling multinationals were first made possible. The car, the airplane, facsimile messages, electronic mail, other forms of digital data, the Internet – demolished many physical and temporal barriers. Workers today often collaborate in virtual offices across continents and time zones. Flextime and work from home replaced commuting. The very concepts of “workplace” and “work” were rendered fluid, if not obsolete.

(4) The dissolution of the classic workplace is part of a larger and all-pervasive disintegration of other social structures, such as the nuclear family. Thus, while the choice of work-related venues and pursuits increased – the number of social alternatives to work declined.

The extended and nuclear family was denuded of most of its traditional functions. Most communities are tenuous and in constant flux. Work is the only refuge from an incoherent, fractious, and dysfunctional world. Society is anomic and work has become a route of escapism.

(5) The ideology of individualism is increasingly presented as a private case of capitalism and liberalism. People are encouraged to feel and behave as distinct, autonomous units. The metaphor of individuals as islands substituted for the perception of humans as cells in an organism. Malignant individualism replaced communitarianism. Pathological narcissismreplaced self-love and empathy.

(6) The last few decades witnessed unprecedented successive rises in productivity and an expansion of world trade. New management techniques, improved production technologies, innovative inventory control methods, automatization, robotization, plant modernization, telecommunications (which facilitates more efficient transfers of information), even new design concepts – all helped bring workaholism about by placing economic values in the forefront. The Protestant work ethic ran amok. Instead of working in order to live – people began living in order to work.

Workaholics are rewarded with faster promotion and higher income. Workaholism is often – mistakenly – identified with entrepreneurship, ambition, and efficiency. Yet, really it is merely an addiction.

The absurd is that workaholism is a direct result of the culture of leisure.

As workers are made redundant by technology-driven productivity gains – they are encouraged to engage in leisure activities. Leisure substitutes for work. The historical demarcation between work and leisure is lost. Both are commended for their contribution to the economy. Work, like leisure, is less and less structured and rigid. Both work and leisure are often pursued from home and are often experienced as pleasurable.

The territorial separation between “work-place” and “home turf” is essentially eliminated.

Some people enjoy their work so much that it fulfils the functions normally reserved to leisure time. They are the workaholics. Others continue to hate work – but feel disorientated in the new leisure-rich environment. They are not taught to deal with too much free and unstructured time, with a lack of clearly delineated framework, without clear instructions as to what to do, when, with whom, and to what end.

The state, parents, educators, employers – all failed to train the population to cope with free time and with choice. Both types – the workaholic and the “normal” person baffled by too much leisure – end up sacrificing their leisure time to their work-related activities.

Alas, it takes workaholics to create, maintain and expand capitalism. People don’t work or conduct business only because they are after the money. They enjoy their work or their business. They find pleasure in it. And this is the true meaning of capitalism: the abolition of the artificial distinction between work and leisure and the pursuit of both with the same zeal and satisfaction. Above all, the (increasing) liberty to do so whenever, wherever, with whomever you choose.

Fixed and Flexible Exchange Rate Regimes and Policies: Pros and Cons

By Sam Vaknin
Author of “Malignant Self-love: Narcissism Revisited”

1. What is your opinion about fixed exchange rate regimes?

A. Fixed exchange rate regimes are useful in crisis circumstances, when the restoration of stability and the trust of citizens, investors, and speculators is essential. Such harsh measures, usually coupled with capital controls, should be short-term and lifted immediately when the economy had picked up and expectations have settled.
Maintaining a fixed-rate regime in the long-term has nefarious and dangerous consequences as the exchange rate diverges further and further from the real value of the currency, adjusted to inflation. This erodes the competitiveness of exporters, renders imports relatively cheap, distorts the price signal throughout the economy (in other words: people don’t know what the real value of their currency is abroad). It also leads to speculative attacks on the currency from the outside (if the currency is convertible and traded in free foreign exchange markets) – or from the inside (in the form of a thriving black foreign exchange market.)

2. What is the connection between exchange rate policies and better economic results?

A. This depends on how open the country is to the global capital markets and what percentage of its GDP is made up of international trade and various transfers from abroad (such as remittances.) As a rule, the more exposed a country is to the ups and downs of the global market, the more it should have a flexible and adaptable exchange rate policy. A country that exports and imports a lot needs to have competitive manufacturing, services (e.g., tourism), and agricultural sectors. An important part of such competitiveness is having the correct exchange rate which reflects inflation differentials, purchasing power disparities, relative advantages, and structural elements. Such constant adjustment (up AND down, for instance within a band) is excluded by a fixed rate regime. By adopting a fixed exchange rate, the country is giving up on one of its most important automatic economic stabilizers and policy tools, as Greece is discovering now to its great cost.

3. Is a fixed exchange rate good for controlling inflation? Is there a possibility to control the prices and make a correction of the value of the currency?

Inflation reflects expectations of the population regarding the future level of prices. These expectations are affected by the level of stability inside the country – but also by factors outside it. In a country that is open to international trade, foreign capital flows, and foreign direct investment, external instability is far more important than internal stability. Indeed, in countries like Macedonia, Israel, and Brazil, most of the inflation comes from the outside via the soaring prices of imports such as energy products, foodstuffs, and raw materials. There is little the monetary authorities can do to affect such imported inflation.
Still, it is true that a string of unannounced, arbitrary, unscripted, incomprehensible, and large devaluations will create inflation. The exchange rate policy has to be transparent, predictable, rational, and adaptable. There are dozens of countries around the world with various modesl of flexible exchange rates and, yet, with stable prices: these two are not mutually exclusive. Flexible exchange rates mean that the currency can do down (devaluation) – but also up (appreciation or revaluation.)
4. What happens to an economy if people from abroad stop sending money?
Depends on: (1) What is the share of remittances in the GDP; and (2) What are the remittances used for. In most poor countries remittances constitute 10-15% of GDP and they are used by the recipients mostly for consumption. When remittances decline, consumption and GDP are adversely affected, the level of foreign exchange reserves declines, and outlays on social welfare increase.

5. Can a country defeat the trade deficit with a fixed exchange rate?

The exchange rate is only one component in the overall competitiveness of the economy. Structural reforms in the public sector and various institutions; infusion of management and marketing skills; innovation; a functioning financial system; new inputs (equipment, information technology, intellectual property under license); focused and up-to- date training and re-skilling; better access to core export markets; the economic conditions in these export markets; level and relevance of the workforce’s education; mentality and ethos – all these are as important as the exchange rate alone. Germany and Japan had overvalued currencies for decades and still were able to achieve prosperity and dominate international trade.

Crisis of Growth, Crisis of Measuring Growth

By Sam Vaknin
Author of “Malignant Self-love: Narcissism Revisited”

The sovereign debt crisis of 2010-2 emanated from the realization that lower growth rates throughout the industrialized West were insufficient to guarantee the repayment of debts accumulated by governments. The proceeds of the credits and loans assumed by public sectors throughout Europe and in the USA were ploughed into successive futile attempts to stimulate ailing economies and avert banking crises and panics.

But this second leg of the global Great Recession is less about stalling growth than about the perception and measurement of growth. As labour-intensive industries increasingly adopted information- and automation-driven manufacturing, outsourcing and offshoring, the anemic recovery that attended the 2008-9 conflagration in the industrialized West was rendered jobless. Corporations sit on hoarded cash piles, driven by enhanced profitability and productivity even as workers languish in unemployment lines. Globalizeed labor and skills markets coupled with technological substitution for human employment dented consumption and this, in turn, adversely affected investments. The classical twin engines of every recovery since the Second World War have thus been somewhat decommissioned. Bouts of fiscal and monetary profligacy failed to resuscitate moribund financial transmission mechanisms.

But this is also a crisis of national accounting. The traditional ways of measuring growth simply fail to capture technological progress; the massive increase in purchasing power as it applies to consumer goods and products; and a discernible improvement in externalities such as the environment. Critical factors such as vastly improved health, an increased life expectancy (and, therefore, an extended economic horizon), public goods, or even changes in the quality of life remain unreflected in the way that countries measure their output and adjust it.

Indeed, current methodologies of quantifying GDP and GNP (NDP) take a dim view of the precipitous and predictable drop in the prices of consumer goods, for instance. The same computing power costs now one fifth what it used to cost only three years ago. But this means that its contribution to the country’s GDP is down by c. 81% over the same period of time (assuming 6% inflation in these three years)! In other words: technological (and productivity) improvements translate into economic contraction in the way we currently gauge our economies.

Moreover: it is a maxim of current economic orthodoxy that governments compete with the private sector on a limited pool of savings. It is considered equally self-evident that the private sector is better, more competent, and more efficient at allocating scarce economic resources and thus at preventing waste. It is therefore thought economically sound to reduce the size of government – i.e., minimize its tax intake and its public borrowing – in order to free resources for the private sector to allocate productively and efficiently.

Yet, both dogmas are far from being universally applicable.

The assumption underlying the first conjecture is that government obligations and corporate lending are perfect substitutes. In other words, once deprived of treasury notes, bills, and bonds – a rational investor is expected to divert her savings to buying stocks or corporate bonds.

It is further anticipated that financial intermediaries – pension funds, banks, mutual funds – will tread similarly. If unable to invest the savings of their depositors in scarce risk-free – i.e., government – securities – they will likely alter their investment preferences and buy equity and debt issued by firms.

Yet, this is expressly untrue. Bond buyers and stock investors are two distinct crowds. Their risk aversion is different. Their investment preferences are disparate. Some of them – e.g., pension funds – are constrained by law as to the composition of their investment portfolios. Once government debt has turned scarce or expensive, bond investors tend to resort to cash. That cash – not equity or corporate debt – is the veritable substitute for risk-free securities is a basic tenet of modern investment portfolio theory.

Moreover, the “perfect substitute” hypothesis assumes the existence of efficient markets and frictionless transmission mechanisms. But this is a conveniently idealized picture which has little to do with grubby reality. Switching from one kind of investment to another incurs – often prohibitive – transaction costs. In many countries, financial intermediaries are dysfunctional or corrupt or both. They are unable to efficiently convert savings to investments – or are wary of doing so.

Furthermore, very few capital and financial markets are closed, self-contained, or self-sufficient units. Governments can and do borrow from foreigners. Most rich world countries – with the exception of Japan – tap “foreign people’s money” for their public borrowing needs. When the US government borrows more, it crowds out the private sector in Japan – not in the USA.

It is universally agreed that governments have at least two critical economic roles. The first is to provide a “level playing field” for all economic players. It is supposed to foster competition, enforce the rule of law and, in particular, property rights, encourage free trade, avoid distorting fiscal incentives and disincentives, and so on. Its second role is to cope with market failures and the provision of public goods. It is expected to step in when markets fail to deliver goods and services, when asset bubbles inflate, or when economic resources are blatantly misallocated.

Yet, there is a third role. In our post-Keynesian world, it is a heresy. It flies in the face of the “Washington Consensus” propagated by the Bretton-Woods institutions and by development banks the world over. It is the government’s obligation to foster growth.

In most countries of the world – definitely in Africa, the Middle East, the bulk of Latin America, central and eastern Europe, and central and east Asia – savings do not translate to investments, either in the form of corporate debt or in the form of corporate equity.

In most countries of the world, institutions do not function, the rule of law and properly rights are not upheld, the banking system is dysfunctional and clogged by bad debts. Rusty monetary transmission mechanisms render monetary policy impotent.

In most countries of the world, there is no entrepreneurial and thriving private sector and the economy is at the mercy of external shocks and fickle business cycles. Only the state can counter these economically detrimental vicissitudes. Often, the sole engine of growth and the exclusive automatic stabilizer is public spending. Not all types of public expenditures have the desired effect. Witness Japan’s pork barrel spending on “infrastructure projects”. But development-related and consumption-enhancing spending is usually beneficial.

To say, in most countries of the world, that “public borrowing is crowding out the private sector” is wrong. It assumes the existence of a formal private sector which can tap the credit and capital markets through functioning financial intermediaries, notably banks and stock exchanges.

Yet, this mental picture is a figment of economic imagination. The bulk of the private sector in these countries is informal. In many of them, there are no credit or capital markets to speak of. The government doesn’t borrow from savers through the marketplace – but internationally, often from multilaterals.

Outlandish default rates result in vertiginously high real interest rates. Inter-corporate lending, barter, and cash transactions substitute for bank credit, corporate bonds, or equity flotations. As a result, the private sector’s financial leverage is minuscule. In the rich West $1 in equity generates $3-5 in debt for a total investment of $4-6. In the developing world, $1 of tax-evaded equity generates nothing. The state has to pick up the slack.

Growth and employment are public goods and developing countries are in a perpetual state of systemic and multiple market failures. Rather than lend to businesses or households – banks thrive on arbitrage. Investment horizons are limited. Should the state refrain from stepping in to fill up the gap – these countries are doomed to inexorable decline.

In times of global crisis, these observations pertain to rich and developed countries as well. Market failures signify corruption and inefficiency in the private sector. Such misconduct and misallocation of economic resources is usually thought to be the domain of the public sector, but actually it goes on eveywhere in the economy.

Wealth destruction by privately-owned firms is typical of economies with absent, lenient, or lax regulation and often exceeds anything the public administration does. Corruption, driven by avarice and fear, is common among entrepreneurs as much as among civil servants. It is a myth to believe otherwise. Wherever there is money, human psychology is in operation and with it economic malaise. Hence the need for governmental micromamangement of the private sector at all times. Self-regulation is a costly and self-deceiving urban legend.

Another engine of state involvement is provided by the thrift paradox. When the economy goes sour, rational individuals and households save more and spend less. The aggregate outcome of their newfound thrift is recessionary: decreasing consumption translates into declining corporate profitability and rising unemployment. These effects are especially pronounced when financial transmission mechanisms (banks and other financial institutions) are gummed up: frozen in fear and distrust, they do not lend money, even though deposits (and their own capital base) are ever growing.

It is true that, by diversifying risk away, via the use of derivatives and other financial instruments, asset markets no longer affect the real economy as they used to. They have become, in a sense, “gated communities”, separated from Main Street by “risk barriers”. But, these developments do not pertain to retail banks and when markets are illiquid and counterparty risk rampant, options and swaps are pretty useless.

The only way to effectively cancel out the this demonetization of the national economy (this “bleeding”) is through enhanced government spending. Where fearful citizens save, their government should spend on infrastructure, health, education, and information technology. The state’s negative savings should offset multiplying private savings. In extremis, the state should nationalize the financial sector for a limited period of times (as Israel has done in 1983 and Sweden, a decade later).

A Note on GDP (Gross Domestic Product)

GDP figures are not an exact science. All over the world, GDP numbers are politicized and subject to heavy manipulation. There are at least 3 known methodologies to calculate GDP and, for each of these methodologies, there are two alternative formulas which take into account completely different economic sets of data.

 

Still: there are good proxies to GDP. For instance: the consumption of electricity in the residential (household) sector and in the industrial sector, adjusted for the size of the informal economy, for the change in personal incomes (including private credit), and for shifts in weather patterns (as measured by a multiannual time series of average temperatures). Macedonia’s energy consumption has been growing by almost 4% annually for a few years now. This means that the economy is either stagnant or slightly contracting – but definitely not growing, as the government would have us believe.

 

Other proxies: money velocity; wage statistics (especially the wages of urban unskilled workers); crude death rate; infant mortality; and even the amount of mail sent per capita. Fluctuations in purchasing power (PPP) reflect the relative strengths of currencies, but also changes in GDP. All these measures indicate that Macedonia’s economy is experiencing either weak growth or no growth at all.

The formula to calculate GDP is this:

GDP (Gross Domestic Product) =

Consumption + investment + government expenditure + net exports (exports minus imports) =

Wages + rents + interest + profits + non-income charges + net foreign factor income earned

But the GDP figure is vulnerable to “creative accounting”:

1. The weight of certain items, sectors, or activities is reduced or increased in order to influence GDP components, such as industrial production. Developing countries often alter the way critical components of GDP like industrial production are tallied.

2. Goods in inventory are included in GDP although not yet sold. Thus, rising inventories, a telltale sign of economic ill-health, actually increases the GDP!

3. If goods produced are financed with credits and loans, GDP will be artificially HIGH (inflated).

4. In some countries, PLANS and INTENTIONS to invest are counted, recorded, and booked as actual investments. This practice is frowned upon (and landed quite a few corporate managers in the gaol), but is still widespread in the shoddier and shadier corners of the globe.

5. GDP figures should be adjusted for inflation (real GDP as opposed to nominal GDP). To achieve that, the calculation of the GDP deflator is critical. But the GDP deflator is a highly subjective figure, prone, in developing countries, to reflecting the government’s political needs and predilections.

6. What currency exchange rates were used? By selecting the right “points in time”, GDP figures can go up and down by up to 2%!

7. Healthcare expenditures, agricultural subsidies, government aid to catastrophe-stricken areas form a part of the GDP. Thus, for instance, by increasing healthcare costs, the government can manipulate GDP figures.

8. Net exports in many developing countries are negative (in other words, they maintain a trade deficit). How can the GDP grow at all in these places? Even if consumption and investment are strongly up – government expenditures are usually down (at the behest of multilateral financial institutions) and net exports are down. It is not possible for GDP to grow vigorously in a country with a sizable and ballooning trade deficit.

9. The projections of most international, objective analysts and international economic organizations usually tend to converge on a GDP growth figure that is often lower than the government’s but in line with the long-term trend. These figures are far better indicators of the true state of the economy. Statistics Bureaus in developing countries are often under the government’s thumb and run by political appointees.

Note: Why Recessions Happen and How to Counter Them

The fate of modern economies is determined by four types of demand: the demand for consumer goods; the demand for investment goods; the demand for money; and the demand for assets, which represent the expected utility of money (deferred money).

Periods of economic boom are characterized by a heightened demand for goods, both consumer and investment; a rising demand for assets; and low demand for actual money (low savings, low capitalization, high leverage).

Investment booms foster excesses (for instance: excess capacity) that, invariably lead to investment busts. But, economy-wide recessions are not triggered exclusively and merely by investment busts. They are the outcomes of a shift in sentiment: a rising demand for money at the expense of the demand for goods and assets.

In other words, a recession is brought about when people start to rid themselves of assets (and, in the process, deleverage); when they consume and lend less and save more; and when they invest less and hire fewer workers. A newfound predilection for cash and cash-equivalents is a surefire sign of impending and imminent economic collapse.

This etiology indicates the cure: reflation. Printing money and increasing the money supply are bound to have inflationary effects. Inflation ought to reduce the public’s appetite for a depreciating currency and push individuals, firms, and banks to invest in goods and assets and reboot the economy. Government funds can also be used directly to consume and invest, although the impact of such interventions is far from certain.

Economies revolve around and are determined by “anchors”: stores of value that assume pivotal roles and lend character to transactions and economic players alike. Well into the 19 century, tangible assets such as real estate and commodities constituted the bulk of the exchanges that occurred in marketplaces, both national and global. People bought and sold land, buildings, minerals, edibles, and capital goods. These were regarded not merely as means of production but also as forms of wealth.

Inevitably, human society organized itself to facilitate such exchanges. The legal and political systems sought to support, encourage, and catalyze transactions by enhancing and enforcing property rights, by providing public goods, and by rectifying market failures.

Later on and well into the 1980s, symbolic representations of ownership of real goods and property (e.g, shares, commercial paper, collateralized bonds, forward contracts) were all the rage. By the end of this period, these surpassed the size of markets in underlying assets. Thus, the daily turnover in stocks, bonds, and currencies dwarfed the annual value added in all industries combined.

Again, Mankind adapted to this new environment. Technology catered to the needs of traders and speculators, businessmen and middlemen. Advances in telecommunications and transportation followed inexorably. The concept of intellectual property rights was introduced. A financial infrastructure emerged, replete with highly specialized institutions (e.g., central banks) and businesses (for instance, investment banks, jobbers, and private equity funds).

We are in the throes of a third wave. Instead of buying and selling assets one way (as tangibles) or the other (as symbols) – we increasingly trade in expectations (in other words, we transfer risks). The markets in derivatives (options, futures, indices, swaps, collateralized instruments, and so on) are flourishing.

Society is never far behind. Even the most conservative economic structures and institutions now strive to manage expectations. Thus, for example, rather than tackle inflation directly, central banks currently seek to subdue it by issuing inflation targets (in other words, they aim to influence public expectations regarding future inflation).

The more abstract the item traded, the less cumbersome it is and the more frictionless the exchanges in which it is swapped. The smooth transmission of information gives rise to both positive and negative outcomes: more efficient markets, on the one hand – and contagion on the other hand; less volatility on the one hand – and swifter reactions to bad news on the other hand (hence the need for market breakers); the immediate incorporation of new data in prices on the one hand – and asset bubbles on the other hand.

Hitherto, even the most arcane and abstract contract traded was somehow attached to and derived from an underlying tangible asset, no matter how remotely. But this linkage may soon be dispensed with. The future may witness the bartering of agreements that have nothing to do with real world objects or values.

In days to come, traders and speculators will be able to generate on the fly their own, custom-made, one-time, investment vehicles for each and every specific transaction. They will do so by combining “off-the-shelf”, publicly traded components. Gains and losses will be determined by arbitrary rules or by reference to extraneous events. Real estate, commodities, and capital goods will revert to their original forms and functions: bare necessities to be utilized and consumed, not speculated on.

It’s the Same Banking Crisis, Stupid!

The crisis that started in 2008 is a banking crisis and it is still going strong. Banks all over the world over-leveraged their capital and extended loans unwisely to the undeserving. American financial institutions lent money to homeowners who could not pay back, buried as they were under a mountain of debt. European banks lavished funds on countries such as Greece and Italy which were technically insolvent or illiquid owing to low economic growth rates and bloated public sectors. Chinese “banks” were coerced into bankrolling near-bankrupt state-owned (SOEs) enterprises and municipalities. Consequently, China’s financial crsis is imminent as is the collapse of the municipal bond markets in the West.
Thus, what appear to be disjointed economic crises are actually manifestations of a single cancerous phenomenon: the avarice, recklessness, and inanity of banks. The solution? To Nationalize all the major banks, starting this coming November 2011.

The “sovereign debt” phase of the banking crisis (2010-2) emanated from the realization that lower growth rates throughout the industrialized West were insufficient to guarantee the repayment of debts accumulated by governments. The proceeds of the credits and loans assumed by public sectors throughout Europe and in the USA were ploughed into successive futile attempts to stimulate ailing economies and avert banking crises and panics.

Banks are the most unsafe institutions in the world. Worldwide, hundreds of them crash every few years. Two decades ago, the US Government was forced to invest hundreds of billions of Dollars in the Savings and Loans industry. Multi-billion dollar embezzlement schemes were unearthed in the much feted BCCI – wiping both equity capital and deposits. Barings bank – having weathered 330 years of tumultuous European history – succumbed to a bout of untrammeled speculation by a rogue trader. In 1890 it faced the very same predicament only to be salvaged by other British banks, including the Bank of England. The list is interminable. There were more than 30 major banking crises this century alone.

That banks are very risky – is proven by the inordinate number of regulatory institutions which supervise banks and their activities. The USA sports a few organizations which insure depositors against the seemingly inevitable vicissitudes of the banking system. The FDIC (Federal Deposit Insurance Corporations) insures against the loss of every deposit up to a certain amount. The HLSIC insures depositors in saving houses in a similar manner. Other regulatory agencies supervise banks, audit them, or regulate them. It seems that you cannot be too cautious where banks are concerned.

The word “BANK” is derived from the old Italian word “BANCA” – bench or counter. Italian bankers used to conduct their business on benches. Nothing much changed ever since – maybe with the exception of the scenery. Banks hide their fragility and vulnerability – or worse – behinds marble walls. The American President, Andrew Jackson, was so set against banks – that he dismantled the nascent central bank – the Second Bank of the United States.

Banks are institutions where miracles happen regularly. We rarely entrust our money to anyone but ourselves – and our banks. Despite a very chequered history of mismanagement, corruption, false promises and representations, delusions and behavioural inconsistency – banks still succeed to motivate us to give them our money. Partly it is the feeling that there is safety in numbers. The fashionable term today is “moral hazard”. The implicit guarantees of the state and of other financial institutions move us to take risks which we would, otherwise, have avoided. Partly it is the sophistication of the banks in marketing and promoting themselves and their products. Glossy brochures, professional computer and video presentations and vast, shrine-like, real estate complexes all serve to enhance the image of the banks as the temples of the new religion of money.

 

Banks operate through credit multipliers. When Depositor A places 100,000 USD with Bank A, the Bank puts aside about 20% of the money. This is labelled a reserve and is intended to serve as an insurance policy cum a liquidity cushion. The implicit assumption is that no more than 20% of the total number of depositors will claim their money at any given moment.

In times of panic, when ALL the depositors want their money back – the bank is rendered illiquid having locked away in its reserves only 20% of the funds. Commercial banks hold their reserves with the Central Bank or with a third party institution, explicitly and exclusively set up for this purpose.

What does the bank do with the other 80% of Depositor A’s money ($80,000)? It lends it to Borrower B. The Borrower pays Bank A interest on the loan. The difference between the interest that Bank A pays to Depositor A on his deposit – and the interest that he charges Borrower B – is the bank’s income from these operations.

In the meantime, Borrower B deposits the money that he received from Bank A (as a loan) in his own bank, Bank B. Bank B puts aside, as a reserve, 20% of this money – and lends 80% (=$64,000) to Borrower C, who promptly deposits it in Bank C.

At this stage, Depositor A’s money ($100,000) has multiplied and become $244,000. Depositor A has $100,000 in his account with Bank A, Borrower B has $80,000 in his account in Bank B, and Borrower C has $64,000 in his account in Bank C. This process is called credit multiplication. The Western Credit multiplier is 9. This means that every $100,000 deposited with Bank A could, theoretically, become $900,000: $400,000 in credits and $500,000 in deposits.

For every $900,000 in the banks’ books – there are only 100,000 in physical dollars. Banks are the most heavily leveraged businesses in the world.

But this is only part of the problem. Another part is that the profit margins of banks are limited. The hemorrhaging consumers of bank services would probably beg to differ – but banking profits are mostly optical illusions. We can safely say that banks are losing money throughout most of their existence.

The SPREAD is the difference between interest paid to depositors and interest collected on credits. The spread in Macedonia is 8 to 10%. This spread is supposed to cover all the bank’s expenses and leave its shareholders with a profit. But this is a shakey proposition. To understand why, we have to analyse the very concept of interest rates.

Virtually every major religion forbids the charging of interest on credits and loans. To charge interest is considered to be part usury and part blackmail. People who lent money and charged interest for it were ill-regarded – remember Shakespeare’s “The Merchant of Venice”?

Originally, interest was charged on money lent was meant to compensate for the risks associated with the provision of credit in a specific market. There were four such hazards:

First, there are the operational costs of money lending itself. Money lenders are engaged in arbitrage and the brokering of funds. In other words, they borrow the money that they then lend on. There are costs of transportation and communications as well as business overhead.

The second risk is that of inflation. It erodes the value of money used to repay credits. In quotidian terms: as time passes, the Lender can buy progressively less with the money repaid by the Borrower. The purchasing power of the money diminishes. The measure of this erosion is called inflation.

And there is a risk of scarcity. Money is a rare and valued object. Once lent it is out of the Lender’s hands, exchanged for mere promises and oft-illiquid collateral. If, for instance, a Bank lends money at a fixed interest rate – it gives up the opportunity to lend it anew, at higher rates.

The last – and most obvious risk is default: when the Borrower cannot or would not pay back the credit that he has taken.

All these risks have to be offset by the bank’s relatively minor profit margin. Hence the bank’s much decried propensity to pay their depositors as symbolically as they can – and charge their borrowers the highest interest rates they can get away with.

But banks face a few problems in adopting this seemingly straightforward business strategy.

Interest rates are an instrument of monetary policy. As such, they are centrally dictated. They are used to control the money supply and the monetary aggregates and through them to fine tune economic activity.

Governors of Central Banks (where central banks are autonomous) and Ministers of Finance (where central banks are more subservient) raise interest rates in order to contain economic activity and its inflationary effects. They cut interest rates to prevent an economic slowdown and to facilitate the soft landing of a booming economy. Despite the fact that banks (and credit card companies, which are really banks) print their own money (remember the multiplier) – they do not control the money supply or the interest rates that they charge their clients.

This creates paradoxes.

The higher the interest rates – the higher the costs of financing payable by businesses and households. They, in turn, increase the prices of their products and services to reflect the new cost of money. We can say that, to some extent, rather than prevent it, higher interest rates contribute to inflation – i.e., to the readjustment of the general price level.

Also, the higher the interest rates, the more money earned by the banks. They lend this extra money to Borrowers and multiply it through the credit multiplier.

High interest rates encourage inflation from another angle altogether:

They sustain an unrealistic exchange rate between the domestic and foreign currencies. People would rather hold the currency which yields higher interest (=the domestic one). They buy it and sell all other currencies.

Conversions of foreign exchange into local currency are net contributors to inflation. On the other hand, a high exchange rate also increases the prices of imported products. Still, all in all, higher interest rates contribute to the very inflation that are intended to suppress.

Another interesting phenomenon:

High interest rates are supposed to ameliorate the effects of soaring default rates. In a country like Macedonia – where the payments morale is low and default rates are stratospheric – the banks charge incredibly high interest rates to compensate for this specific risk.

But high interest rates make it difficult to repay one’s loans and may tip certain obligations from performing to non-performing. Even debtors who pay small amounts of interest in a timely fashion – often find it impossible to defray larger interest charges.

Thus, high interest rates increase the risk of default rather than reduce it. Not only are interest rates a blunt and inefficient instrument – but they are also not set by the banks, nor do they reflect the micro-economic realities with which they are forced to cope.

Should interest rates be determined by each bank separately (perhaps according to the composition and risk profile of its portfolio)? Should banks have the authority to print money notes (as they did throughout the 18th and 19th centuries)? The advent of virtual cash and electronic banking may bring about these outcomes even without the complicity of the state.

But what is behind all this? How can we judge the soundness of our banks? In other words, how can we tell if our money is safely tucked away in a safe haven?

The reflex is to go to the bank’s balance sheets. Banks and balance sheets have been both invented in their modern form in the 15th century. A balance sheet, coupled with other financial statements is supposed to provide us with a true and full picture of the health of the bank, its past and its long-term prospects. The surprising thing is that – despite common opinion – it does.

But it is rather useless unless you know how to read it.

 

Financial statements (Income – or Profit and Loss – Statement, Cash Flow Statement and Balance Sheet) come in many forms. Sometimes they conform to Western accounting standards (the Generally Accepted Accounting Principles, GAAP, or the less rigorous and more fuzzily worded International Accounting Standards, IAS). Otherwise, they conform to local accounting standards, which often leave a lot to be desired. Still, you should look for banks, which make their updated financial reports available to you. The best choice would be a bank that is audited by one of the Big Four Western accounting firms and makes its audit reports publicly available. Such audited financial statements should consolidate the financial results of the bank with the financial results of its subsidiaries or associated companies. A lot often hides in those corners of corporate holdings.

 

Banks are rated by independent agencies. The most famous and most reliable of the lot is Fitch Ratings. Another one is Moody’s. These agencies assign letter and number combinations to the banks that reflect their stability. Most agencies differentiate the short term from the long term prospects of the banking institution rated. Some of them even study (and rate) issues, such as the legality of the operations of the bank (legal rating). Ostensibly, all a concerned person has to do, therefore, is to step up to the bank manager, muster courage and ask for the bank’s rating. Unfortunately, life is more complicated than rating agencies would have us believe.

 

They base themselves mostly on the financial results of the bank rated as a reliable gauge of its financial strength or financial profile. Nothing is further from the truth.

 

Admittedly, the financial results do contain a few important facts. But one has to look beyond the naked figures to get the real – often much less encouraging – picture.

 

Consider the thorny issue of exchange rates. Financial statements are calculated (sometimes stated in USD in addition to the local currency) using the exchange rate prevailing on the 31st of December of the fiscal year (to which the statements refer). In a country with a volatile domestic currency this would tend to completely distort the true picture. This is especially true if a big chunk of the activity preceded this arbitrary date. The same applies to financial statements, which were not inflation-adjusted in high inflation countries. The statements will look inflated and even reflect profits where heavy losses were incurred. “Average amounts” accounting (which makes use of average exchange rates throughout the year) is even more misleading. The only way to truly reflect reality is if the bank were to keep two sets of accounts: one in the local currency and one in USD (or in some other currency of reference). Otherwise, fictitious growth in the asset base (due to inflation or currency fluctuations) could result.

 

Another example: in many countries, changes in regulations can greatly effect the financial statements of a bank. In 1996, in Russia, for example, the Bank of Russia changed the algorithm for calculating an important banking ratio (the capital to risk weighted assets ratio). Unless a Russian bank restated its previous financial statements accordingly, a sharp change in profitability appeared from nowhere.

 

The net assets themselves are always misstated: the figure refers to the situation on 31/12. A 48-hour loan given to a collaborating client can inflate the asset base on the crucial date. This misrepresentation is only mildly ameliorated by the introduction of an “average assets” calculus. Moreover, some of the assets can be interest earning and performing – others, non-performing. The maturity distribution of the assets is also of prime importance. If most of the bank’s assets can be withdrawn by its clients on a very short notice (on demand) – it can swiftly find itself in trouble with a run on its assets leading to insolvency.

 

Another oft-used figure is the net income of the bank. It is important to distinguish interest income from non-interest income. In an open, sophisticated credit market, the income from interest differentials should be minimal and reflect the risk plus a reasonable component of income to the bank. But in many countries (Japan, Russia) the government subsidizes banks by lending to them money cheaply (through the Central Bank or through bonds). The banks then proceed to lend the cheap funds at exorbitant rates to their customers, thus reaping enormous interest income. In many countries the income from government securities is tax free, which represents another form of subsidy. A high income from interest is a sign of weakness, not of health, here today, gone tomorrow. The preferred indicator should be income from operations (fees, commissions and other charges).

 

There are a few key ratios to observe. A relevant question is whether the bank is accredited with international banking agencies. These issue regulatory capital requirements and other mandatory ratios. Compliance with these demands is a minimum in the absence of which, the bank should be regarded as positively dangerous.

 

The return on the bank’s equity (ROE) is the net income divided by its average equity. The return on the bank’s assets (ROA) is its net income divided by its average assets. The (tier 1 or total) capital divided by the bank’s risk weighted assets – a measure of the bank’s capital adequacy. Most banks follow the provisions of the Basel Accord as set by the Basel Committee of Bank Supervision (also known as the G10). This could be misleading because the Accord is ill equipped to deal with risks associated with emerging markets, where default rates of 33% and more are the norm. Finally, there is the common stock to total assets ratio. But ratios are not cure-alls. Inasmuch as the quantities that comprise them can be toyed with – they can be subject to manipulation and distortion. It is true that it is better to have high ratios than low ones. High ratios are indicative of a bank’s underlying strength, reserves, and provisions and, therefore, of its ability to expand its business. A strong bank can also participate in various programs, offerings and auctions of the Central Bank or of the Ministry of Finance. The larger the share of the bank’s earnings that is retained in the bank and not distributed as profits to its shareholders – the better these ratios and the bank’s resilience to credit risks.

 

Still, these ratios should be taken with more than a grain of salt. Not even the bank’s profit margin (the ratio of net income to total income) or its asset utilization coefficient (the ratio of income to average assets) should be relied upon. They could be the result of hidden subsidies by the government and management misjudgement or understatement of credit risks.

 

To elaborate on the last two points:

 

A bank can borrow cheap money from the Central Bank (or pay low interest to its depositors and savers) and invest it in secure government bonds, earning a much higher interest income from the bonds’ coupon payments. The end result: a rise in the bank’s income and profitability due to a non-productive, non-lasting arbitrage operation. Otherwise, the bank’s management can understate the amounts of bad loans carried on the bank’s books, thus decreasing the necessary set-asides and increasing profitability. The financial statements of banks largely reflect the management’s appraisal of the business. This has proven to be a poor guide.

 

In the main financial results page of a bank’s books, special attention should be paid to provisions for the devaluation of securities and to the unrealized difference in the currency position. This is especially true if the bank is holding a major part of the assets (in the form of financial investments or of loans) and the equity is invested in securities or in foreign exchange denominated instruments.

 

Separately, a bank can be trading for its own position (the Nostro), either as a market maker or as a trader. The profit (or loss) on securities trading has to be discounted because it is conjectural and incidental to the bank’s main activities: deposit taking and loan making.

 

Most banks deposit some of their assets with other banks. This is normally considered to be a way of spreading the risk. But in highly volatile economies with sickly, underdeveloped financial sectors, all the institutions in the sector are likely to move in tandem (a highly correlated market). Cross deposits among banks only serve to increase the risk of the depositing bank (as the recent affair with Toko Bank in Russia and the banking crisis in South Korea have demonstrated).

 

Further closer to the bottom line are the bank’s operating expenses: salaries, depreciation, fixed or capital assets (real estate and equipment) and administrative expenses. The rule of thumb is: the higher these expenses, the weaker the bank. The great historian Toynbee once said that great civilizations collapse immediately after they bequeath to us the most impressive buildings. This is doubly true with banks. If you see a bank fervently engaged in the construction of palatial branches – stay away from it.

 

Banks are risk arbitrageurs. They live off the mismatch between assets and liabilities. To the best of their ability, they try to second guess the markets and reduce such a mismatch by assuming part of the risks and by engaging in portfolio management. For this they charge fees and commissions, interest and profits – which constitute their sources of income.

 

If any expertise is imputed to the banking system, it is risk management. Banks are supposed to adequately assess, control and minimize credit risks. They are required to implement credit rating mechanisms (credit analysis and value at risk – VAR – models), efficient and exclusive information-gathering systems, and to put in place the right lending policies and procedures.

 

Just in case they misread the market risks and these turned into credit risks (which happens only too often), banks are supposed to put aside amounts of money which could realistically offset loans gone sour or future non-performing assets. These are the loan loss reserves and provisions. Loans are supposed to be constantly monitored, reclassified and charges made against them as applicable. If you see a bank with zero reclassifications, charge offs and recoveries – either the bank is lying through its teeth, or it is not taking the business of banking too seriously, or its management is no less than divine in its prescience. What is important to look at is the rate of provision for loan losses as a percentage of the loans outstanding. Then it should be compared to the percentage of non-performing loans out of the loans outstanding. If the two figures are out of kilter, either someone is pulling your leg – or the management is incompetent or lying to you. The first thing new owners of a bank do is, usually, improve the placed asset quality (a polite way of saying that they get rid of bad, non-performing loans, whether declared as such or not). They do this by classifying the loans. Most central banks in the world have in place regulations for loan classification and if acted upon, these yield rather more reliable results than any management’s “appraisal”, no matter how well intentioned.

 

In some countries the Central Bank (or the Supervision of the Banks) forces banks to set aside provisions against loans at the highest risk categories, even if they are performing. This, by far, should be the preferable method.

 

Of the two sides of the balance sheet, the assets side is the more critical. Within it, the interest earning assets deserve the greatest attention. What percentage of the loans is commercial and what percentage given to individuals? How many borrowers are there (risk diversification is inversely proportional to exposure to single or large borrowers)? How many of the transactions are with “related parties”? How much is in local currency and how much in foreign currencies (and in which)? A large exposure to foreign currency lending is not necessarily healthy. A sharp, unexpected devaluation could move a lot of the borrowers into non-performance and default and, thus, adversely affect the quality of the asset base. In which financial vehicles and instruments is the bank invested? How risky are they? And so on.

 

No less important is the maturity structure of the assets. It is an integral part of the liquidity (risk) management of the bank. The crucial question is: what are the cash flows projected from the maturity dates of the different assets and liabilities – and how likely are they to materialize. A rough matching has to exist between the various maturities of the assets and the liabilities. The cash flows generated by the assets of the bank must be used to finance the cash flows resulting from the banks’ liabilities. A distinction has to be made between stable and hot funds (the latter in constant pursuit of higher yields). Liquidity indicators and alerts have to be set in place and calculated a few times daily.

 

Gaps (especially in the short term category) between the bank’s assets and its liabilities are a very worrisome sign. But the bank’s macroeconomic environment is as important to the determination of its financial health and of its creditworthiness as any ratio or micro-analysis. The state of the financial markets sometimes has a larger bearing on the bank’s soundness than other factors. A fine example is the effect that interest rates or a devaluation have on a bank’s profitability and capitalization. The implied (not to mention the explicit) support of the authorities, of other banks and of investors (domestic as well as international) sets the psychological background to any future developments. This is only too logical. In an unstable financial environment, knock-on effects are more likely. Banks deposit money with other banks on a security basis. Still, the value of securities and collaterals is as good as their liquidity and as the market itself. The very ability to do business (for instance, in the syndicated loan market) is influenced by the larger picture. Falling equity markets herald trading losses and loss of income from trading operations and so on.

 

Perhaps the single most important factor is the general level of interest rates in the economy. It determines the present value of foreign exchange and local currency denominated government debt. It influences the balance between realized and unrealized losses on longer-term (commercial or other) paper. One of the most important liquidity generation instruments is the repurchase agreement (repo). Banks sell their portfolios of government debt with an obligation to buy it back at a later date. If interest rates shoot up – the losses on these repos can trigger margin calls (demands to immediately pay the losses or else materialize them by buying the securities back).

 

Margin calls are a drain on liquidity. Thus, in an environment of rising interest rates, repos could absorb liquidity from the banks, deflate rather than inflate. The same principle applies to leverage investment vehicles used by the bank to improve the returns of its securities trading operations. High interest rates here can have an even more painful outcome. As liquidity is crunched, the banks are forced to materialize their trading losses. This is bound to put added pressure on the prices of financial assets, trigger more margin calls and squeeze liquidity further. It is a vicious circle of a monstrous momentum once commenced.

 

But high interest rates, as we mentioned, also strain the asset side of the balance sheet by applying pressure to borrowers. The same goes for a devaluation. Liabilities connected to foreign exchange grow with a devaluation with no (immediate) corresponding increase in local prices to compensate the borrower. Market risk is thus rapidly transformed to credit risk. Borrowers default on their obligations. Loan loss provisions need to be increased, eating into the bank’s liquidity (and profitability) even further. Banks are then tempted to play with their reserve coverage levels in order to increase their reported profits and this, in turn, raises a real concern regarding the adequacy of the levels of loan loss reserves. Only an increase in the equity base can then assuage the (justified) fears of the market but such an increase can come only through foreign investment, in most cases. And foreign investment is usually a last resort, pariah, solution (see Southeast Asia and the Czech Republic for fresh examples in an endless supply of them. Japan and China are, probably, next).

 

In the past, the thinking was that some of the risk could be ameliorated by hedging in forward markets (=by selling it to willing risk buyers). But a hedge is only as good as the counterparty that provides it and in a market besieged by knock-on insolvencies, the comfort is dubious. In most emerging markets, for instance, there are no natural sellers of foreign exchange (companies prefer to hoard the stuff). So forwards are considered to be a variety of gambling with a default in case of substantial losses a very plausible way out.

 

Banks depend on lending for their survival. The lending base, in turn, depends on the quality of lending opportunities. In high-risk markets, this depends on the possibility of connected lending and on the quality of the collaterals offered by the borrowers. Whether the borrowers have qualitative collaterals to offer is a direct outcome of the liquidity of the market and on how they use the proceeds of the lending. These two elements are intimately linked with the banking system. Hence the penultimate vicious circle: where no functioning and professional banking system exists – no good borrowers will emerge.

 

Basel III

 

In the wake of the Great Recession (2007-8) – a crisis largely of the financial system – the multinational Basel Committee and the Group of Central Bank Governors and Heads of Supervision, comprised of central bankers, banking supervisors, and regulators more than doubled the amount of equity (Tier 1) capital banks must have to 4.5%.

 

Another 2.5% of their assets must be held as an equity “conservation buffer” to be amortized and deployed in case of emergency. Banks which resort to the buffer must, however augment their capital by any (legal) means possible (for instance, by not distributing dividends, by divesting non-core assets, or by issuing new stock). Yet another 1.5% of the balance sheet must be held in “less-than-equity” quality investment vehicles and the total leverage ratio must never go below 3% in equity (admittedly, a liberal number).

 

Moreover: regulators can impose the equivalent of yet another 2.5% in risk-weighted assets (including off-balance-sheet assets, such as derivatives) in the form of a “countercyclical buffer”. This is intended to counter the pro-cyclical nature of most capital requirements and reserves regimes: the more assets’ prices rise (and commensurate risks increase), the less the capital set aside as loans are deemed “safer” by greedy bankers whose compensation is often tied to their institution’s short-term performance.

 

The Basel III regime has to be fully implemented by 2019, a concession to under-capitalized banking sectors in various EU members (notably Germany). Ironically, the Basel Committee was created in 1974, following the failure of a German bank and an ensuing near-collapse of the currency markets. Indeed, the Basel regime is as strong as its weakest link: multilateralism has its price. This in-built frailty forces the Committee to remain vague on what constitutes capital; on disclosure regarding derivatives; and on the loaded issue of subordinated debt vs. corporate bonds (subordinated debt would force banks to become a lot more transparent and is likely to foster shareholder activism).

 

What Will Happen to My Euros?

By Sam Vaknin
Author of “Malignant Self-love: Narcissism Revisited”
Investors have lost confidence in the political leadership of the Eurozone: in their commitment to the project, their solidarity, their willingness and ability to adopt unpopular measures, and their managerial competence.
So, are the days of the euro numbered? is it on its way to the garbage heap of history?
No. The euro is here to stay. Current Eurozone members like Greece and Portugal may be forced to leave the club – but the inner core: Germany, France, Austria, Belgium, Netherlands, Finland and even some new members such as Slovakia and Estonia – will remain. The composition of the Eurozone membership is immaterial. The euro can actually benefit from such developments.
But, if the membership changes, if countries abandon the project, would it still be the same currency?
Yes, it will. The US dollar was legal tender in the 19th century when the US was comprised of only 20 states (and had no central bank, by the way) as it is today with 50 states. The ruble served the USSR and now is Russia’s currency. The Yugoslav dinar survived economic crises and wars as did the German mark.
Still, what if the euro is cancelled? What will happen to my money?
The answer depends on the form in which you hold your money: cash, deposits, or savings. Cash, deposits, and savings will all be exchanged for reinstated local currencies, probably at the original rates at which these currencies were converted to euros a decade ago. So, if you have euros in Germany and the euro goes belly up, you will receive newly-minted Deutschmarks at a rate of 1.95 times the amount of euros you possess.
New interest rates will apply, of course. Quotas will be imposed on cash conversions in the first 6-12 months of transition and savings and deposits are likely to be involuntarily “extended” (read: frozen). Withdrawals from savings accounts and deposits will possibly be limited to a certain percentage of the principal per month.
What if I live in a non-euro country but have a deposit or savings account denominated in euros?
In all probability, the same rules will apply: your euros will be converted to the local currency at the last known rate published by the domestic central bank or by the European Central Bank. You will be able to convert only a certain percentage of your money per month and access to your deposits and savings will be limited and rationed, at least initially.
What happens if my bank goes bankrupt?
If you have a deposit or savings account with a prime (major) European bank, the governments of the Eurozone will likely nationalize it at the first sign of trouble. Deposits up to 100,000 euros are anyhow guaranteed by the state throughout the European Union. Only small, regional and obscure banks in non-Eurozone members represent a real risk.
So, should I stick to euros or should I sell the euros and buy US dollars, or, better still, Swiss francs?
Swiss francs are likely to be a bad investment this coming year. The currency is heavily overvalued and the Swiss National Bank (SNB) often intervenes in the currency markets to bring it back to equilibrium with other major currencies. The US dollar is a “refuge currency” (safe haven): it appreciates only in times of severe crises. Otherwise, it has been drifting downwards ever since the 1980s. Still, its prospects are good this year. My advice is: if you are not a professional currency speculator, stick with the euro. As a currency the euro represents true vale and is reasonably priced. You may wish to divide your money to 3 or 5 parts and invest it in several currencies to hedge your bets via diversification.

Make War and Money: Innovate!

By Sam Vaknin
Author of “Malignant Self-love: Narcissism Revisited”

War and money confer an evolutionary advantage on Mankind by spurring innovation: hence their ubiquity. Attempts to foster creativity and genius via state largesse, the education system, and bolstering entrepreneurship pale in comparison to the accomplishments wrought on by belligerence and cupidity.

On 18 June, 2002 business people across the UK took part in Living Innovation 2002. The extravaganza included a national broadcast linkup from the Eden Project in Cornwall and satellite-televised interviews with successful innovators.

Innovation occurs even in the most backward societies and in the hardest of times. It is thus, too often, taken for granted. But the intensity, extent, and practicality of innovation can be fine-tuned. Appropriate policies, the right environment, incentives, functional and risk seeking capital markets, or a skillful and committed Diaspora – can all enhance and channel innovation.

The wrong cultural context, discouraging social mores, xenophobia, a paranoid set of mind, isolation from international trade and FDI, lack of fiscal incentives, a small domestic or regional market, a conservative ethos, risk aversion, or a well-ingrained fear of disgracing failure – all tend to stifle innovation.

Product Development Units in banks, insurers, brokerage houses, and other financial intermediaries churn out groundbreaking financial instruments regularly. Governments – from the United Kingdom to New Zealand – set up “innovation teams or units” to foster innovation and support it. Canada’s is more than two decades old.

In the first decade of the 21st century, the European Commission has floated a new program dubbed INNOVATION and aimed at the promotion of innovation and encouragement of SME participation. Its goals are:

  • “(The) promotion of an environment favourable to innovation and the absorption of new technologies by enterprises;
  • Stimulation of a European open area for the diffusion of technologies and knowledge;
  • Supply of this area with appropriate technologies.”

But all these worthy efforts ignore what James O’Toole called in “Leading Change” – “the ideology of comfort and the tyranny of custom.” The much quoted Austrian economist, Joseph Schumpeter coined the phrase “creative destruction”. Together with its twin – “disruptive technologies” – it came to be the mantra of the now defunct “New Economy”.

Schumpeter seemed to have captured the unsettling nature of innovation – unpredictable, unknown, unruly, troublesome, and ominous. Innovation often changes the inner dynamics of organizations and their internal power structure. It poses new demands on scarce resources. It provokes resistance and unrest. If mismanaged – it can spell doom rather than boom.

Satkar Gidda, Sales and Marketing Director for SiebertHead, a large UK packaging design house, was quoted in “The Financial Times” as saying:

“Every new product or pack concept is researched to death nowadays – and many great ideas are thrown out simply because a group of consumers is suspicious of anything that sounds new … Conservatism among the buying public, twinned with a generation of marketing directors who won’t take a chance on something that breaks new ground, is leading to super-markets and car showrooms full of me-too products, line extensions and minor product tweaks.”

Yet, the truth is that no one knows why people innovate. The process of innovation has never been studied thoroughly – nor are the effects of innovation fully understood.

In a new tome titled “The Free-Market Innovation Machine”, William Baumol of Princeton University claims that only capitalism guarantees growth through a steady flow of innovation:

“… Innovative activity-which in other types of economy is fortuitous and optional-becomes mandatory, a life-and-death matter for the firm.”

Capitalism makes sure that innovators are rewarded for their time and skills. Property rights are enshrined in enforceable contracts. In non-capitalist societies, people are busy inventing ways to survive or circumvent the system, create monopolies, or engage in crime.

But Baumol fails to sufficiently account for the different levels of innovation in capitalistic countries. Why are inventors in America more productive than their French or British counterparts – at least judging by the number of patents they get issued? And why did innovation blossom in the USSR throughout its existence?

Perhaps because oligopolies are more common in the US than they are elsewhere. Baumol suggests that oligopolies use their excess rent – i.e., profits which exceed perfect competition takings – to innovate and thus to differentiate their products. Still, oligopolistic behavior does not sit well with another of Baumol’s observations: that innovators tend to maximize their returns by sharing their technology and licensing it to more efficient and profitable manufacturers. Nor can one square this propensity to share with the ever more stringent and expansive intellectual property laws that afflict many rich countries nowadays.

Very few inventions have forced “established companies from their dominant market positions” as the “The Economist” put it recently. Moreover, most novelties are spawned by established companies. The single, tortured, and misunderstood inventor working on a shoestring budget in his garage – is a mythical relic of 18th century Romanticism.

More often, innovation is systematically and methodically pursued by teams of scientists and researchers in the labs of mega-corporations and endowed academic institutions. Governments – and, more particularly the defense establishment – finance most of this brainstorming. the Internet was invented by DARPA – a Department of Defense agency – and not by libertarian intellectuals.

A report compiled by PricewaterhouseCoopers from interviews with 800 CEO’s in the UK, France, Germany, Spain, Australia, Japan and the US and titled “Innovation and Growth: A Global Perspective” included the following findings:

“High-performing companies – those that generate annual total shareholder returns in excess of 37 percent and have seen consistent revenue growth over the last five years – average 61 percent of their turnover from new products and services. For low performers, only 26 percent of turnover comes from new products and services.”

Most of the respondents attributed the need to innovate to increasing pressures to brand and differentiate exerted by the advent of e-business and globalization. Yet a full three quarters admitted to being entirely unprepared for the new challenges.

Two good places to study routine innovation are the design studio and the financial markets.

Tom Kelly, brother of founder David Kelly, studies, in “The Art of Innovation”, the history of some of the greater inventions to have been incubated in IDEO, a prominent California-based design firm dubbed “Innovation U.” by Fortune Magazine. These include the computer mouse, the instant camera, and the PDA. The secret of success seems to consist of keenly observing what people miss most when they work and play.

Robert Morris, an Amazon reviewer, sums up IDEO’s creative process:

  • Understand the market, the client, the technology, and the perceived constraints on the given problem;
  • Observe real people in real-life situations;
  • Literally visualize new-to-the- world concepts AND the customers who will use them;
  • Evaluate and refine the prototypes in a series of quick iterations;
  • And finally, implement the new concept for commercialization.

This methodology is a hybrid between the lone-inventor and the faceless corporate R&D team. An entirely different process of innovation characterizes the financial markets. Jacob Goldenberg and David Mazursky postulated the existence of Creativity Templates. Once systematically applied to existing products, these lead to innovation.

Financial innovation is methodical and product-centric. The resulting trade in pioneering products, such as all manner of derivatives, has expanded 20-fold between 1986 and 1999, when annual trading volume exceeded 13 trillion dollar.

Swiss Re Economic Research and Consulting had this to say in its study, Sigma 3/2001:

“Three types of factors drive financial innovation: demand, supply, and taxes and regulation. Demand driven innovation occurs in response to the desire of companies to protect themselves from market risks … Supply side factors … include improvements in technology and heightened competition among financial service firms. Other financial innovation occurs as a rational response to taxes and regulation, as firms seek to minimize the cost that these impose.”

Financial innovation is closely related to breakthroughs in information technology. Both markets are founded on the manipulation of symbols and coded concepts. The dynamic of these markets is self-reinforcing. Faster computers with more massive storage, speedier data transfer (“pipeline”), and networking capabilities – give rise to all forms of advances – from math-rich derivatives contracts to distributed computing. These, in turn, drive software companies, creators of content, financial engineers, scientists, and inventors to a heightened complexity of thinking. It is a virtuous cycle in which innovation generates the very tools that facilitate further innovation.

The eminent American economist Robert Merton – quoted in Sigma 3/2001 – described in the Winter 1992 issue of the “Journal of Applied Corporate Finance” the various phases of the market-buttressed spiral of financial innovation thus:

  1. “In the first stage … there is a proliferation of standardised securities such as futures. These securities make possible the creation of custom-designed financial products …
  2. In the second stage, volume in the new market expands as financial intermediaries trade to hedge their market exposures.
  3. The increased trading volume in turn reduces financial transaction costs and thereby makes further implementation of new products and trading strategies possible, which leads to still more volume.
  4. The success of these trading markets then encourages investments in creating additional markets, and the financial system spirals towards the theoretical limit of zero transaction costs and dynamically complete markets.”

Financial innovation is not adjuvant. Innovation is useless without finance – whether in the form of equity or debt. Schumpeter himself gave equal weight to new forms of “credit creation” which invariably accompanied each technological “paradigm shift”. In the absence of stock options and venture capital – there would have been no Microsoft or Intel.

It would seem that both management gurus and ivory tower academics agree that innovation – technological and financial – is an inseparable part of competition. Tom Peters put it succinctly in “The Circle of Innovation” when he wrote: “Innovate or die”. James Morse, a management consultant, rendered, in the same tome, the same lesson more verbosely: “The only sustainable competitive advantage comes from out-innovating the competition.”

The OECD published a study titled “Productivity and Innovation”. It summarizes the orthodoxy, first formulated by Nobel prizewinner Robert Solow from MIT almost five decades ago:

“A substantial part of economic growth cannot be explained by increased utilisation of capital and labour. This part of growth, commonly labelled ‘multi-factor productivity’, represents improvements in the efficiency of production. It is usually seen as the result of innovation by best-practice firms, technological catch-up by other firms, and reallocation of resources across firms and industries.”

The study analyzed the entire OECD area. It concluded, unsurprisingly, that easing regulatory restrictions enhances productivity and that policies that favor competition spur innovation. They do so by making it easier to adjust the factors of production and by facilitating the entrance of new firms – mainly in rapidly evolving industries.

Pro-competition policies stimulate increases in efficiency and product diversification. They help shift output to innovative industries. More unconventionally, as the report diplomatically put it: “The effects on innovation of easing job protection are complex” and “Excessive intellectual property rights protection may hinder the development of new processes and products.”

As expected, the study found that productivity performance varies across countries reflecting their ability to reach and then shift the technological frontier – a direct outcome of aggregate innovative effort.

Yet, innovation may be curbed by even more all-pervasive and pernicious problems. “The Economist” posed a question to its readers in the December 2001 issue of its Technology Quarterly:

Was “technology losing its knack of being able to invent a host of solutions for any given problem … (and) as a corollary, (was) innovation … running out of new ideas to exploit.”

These worrying trends were attributed to “the soaring cost of developing high-tech products … as only one of the reasons why technological choice is on the wane, as one or two firms emerge as the sole suppliers. The trend towards globalisation-of markets as much as manufacturing-was seen as another cause of this loss of engineering diversity … (as was the) the widespread use of safety standards that emphasise detailed design specifications instead of setting minimum performance requirements for designers to achieve any way they wish.

Then there was the commoditisation of technology brought on largely by the cross-licensing and patent-trading between rival firms, which more or less guarantees that many of their products are essentially the same … (Another innovation-inhibiting problem is that) increasing knowledge was leading to increasing specialisation – with little or no cross- communication between experts in different fields …

… Maturing technology can quickly become de-skilled as automated tools get developed so designers can harness the technology’s power without having to understand its inner workings. The more that happens, the more engineers closest to the technology become incapable of contributing improvements to it. And without such user input, a technology can quickly ossify.”

The readers overwhelmingly rejected these contentions. The rate of innovation, they asserted, has actually accelerated with wider spread education and more efficient weeding-out of unfit solutions by the marketplace. “… Technology in the 21st century is going to be less about discovering new phenomena and more about putting known things together with greater imagination and efficiency.”

Many cited the S-curve to illuminate the current respite. Innovation is followed by selection, improvement of the surviving models, shake-out among competing suppliers, and convergence on a single solution. Information technology has matured – but new S-curves are nascent: nanotechnology, quantum computing, proteomics, neuro-silicates, and machine intelligence.

Recent innovations have spawned two crucial ethical debates, though with accentuated pragmatic aspects. The first is “open source-free access” versus proprietary technology and the second revolves around the role of technological progress in re-defining relationships between stakeholders.

Both issues are related to the inadvertent re-engineering of the corporation. Modern technology helped streamline firms by removing layers of paper-shuffling management. It placed great power in the hands of the end-user, be it an executive, a household, or an individual. It reversed the trends of centralization and hierarchical stratification wrought by the Industrial Revolution. From microprocessor to micropower – an enormous centrifugal shift is underway. Power percolates back to the people.

Thus, the relationships between user and supplier, customer and company, shareholder and manager, medium and consumer – are being radically reshaped. In an intriguing spin on this theme, Michael Cox and Richard Alm argue in their book “Myths of Rich and Poor – Why We are Better off than We Think” that income inequality actually engenders innovation. The rich and corporate clients pay exorbitant prices for prototypes and new products, thus cross-subsidising development costs for the poorer majority.

Yet the poor are malcontent. They want equal access to new products. One way of securing it is by having the poor develop the products and then disseminate them free of charge. The development effort is done collectively, by volunteers. Open source software, such as the Linux operating system is an example as is the Open Directory Project which competed with the commercial Yahoo! Directory.

The UNDP’s Human Development Report 2001 titled “Making new technologies work for human development” is unequivocal. Innovation and access to technologies are the keys to poverty-reduction through sustained growth. Technology helps reduce mortality rates, disease, and hunger among the destitute.

“The Economist” carried last December the story of the agricultural technologist Richard Jefferson who helps “local plant breeders and growers develop the foods they think best … CAMBIA (the institute he founded) has resisted the lure of exclusive licences and shareholder investment, because it wants its work to be freely available and widely used”. This may well foretell the shape of things to come.