Yeah, What HE Said: Limited Government

Quote shamelessly borrowed from the Cato Institute's blog today:

"Limited government is one of the greatest accomplishments of humanity.
It is imperfectly enjoyed by only a portion of the human race, and, where
it is enjoyed, its tenure is ever precarious. The experience of the last
century is surely witness to the insecurity of constitutional government
and to the need for courage in achieving it and vigilance in maintaining it."
- Tom G. Palmer, Cato Institute Fellow and Humanitarian

Nik's Laws: Profit

If profit is outlawed, only outlaws will profit.

What Will Tomorrow Bring: Financial Utilities

The story of the financial industry is a breathless one. With all that money sloshing around, smart people know that there is profit to be made. Unfortunately, due to that same money (=liquidity) and profit potential, financial products and services get commoditized very quickly. Competitive advantage is fleeting. It's textbook hyper-competition. Constant, hostile, explosive innovation is necessary to survive.

Unfortunately, that also leads smart, sensible people to do horrifically stupid, risky, nonsensical things which relieve immediate (financial or political) pressures but which have been entirely "un-thunk" in terms of their end-state consequences.

Hyper-competition also intrinsically conflicts with hyper-regulation.

Last year I predicted that the weight of new regulations (written and unwritten), political instability, and economic realities would force financial institutions to give up their for-profit status to become utilities:

Financial Institutions will once again be lobotomized. Divided into two classes:
- Utilities (aka retail banking)
- Casinos (aka everything else)

"Utilities" are done for as a for-profit enterprise. Just like Amtrack and Con Ed, they will require permanent and heavy subsidy verging on nationalization to survive the tonnage of regulations which will be piled on.

Evidence continues to pour in to support this including:

• More than 8,000 entries in the OCC's list of sanctions here. They are just one of a half-dozen governmental agencies which take enforcement actions against banks
• 111 bank collapses in the past 12 months per the FDIC's Bank Failure website. Twenty-six banks collapsed between 2000 and the end of 2007
  
• Voluntary closure of a regional bank this week "in an extreme example of the frustration felt by many bankers as regulators toughen their oversight of the nation's financial institutions"
• According to a Marakon report (source of the chart above), "only four US banks, or 10% of banking equity capital, are expected to generate returns above the cost of equity; a staggering 90% of banking capital is not performing"

But you ain't seen nothing yet. The above are mostly smaller institutions. The financial titans (Titanics?) are better at fighting and delaying, but trust me they are also bending under the weight. Their stock prices are beginning to reflect it.

UCSD professor Frank Partnoy yesterday published his opinion in the Financial Times with a piece titled "The coming world of smaller banks." He highlights not only the unavoidable reductions in share prices and headcounts, but more damningly, the unavoidable extinction (or drastic evolution) of the standard banking business model:

If all of the world’s major banks had failed during 2007-08, and regulators had permitted Apple, Facebook, Google and Microsoft to take over the economy’s capital allocation function, how would employment numbers have changed? Surely any neo-bank would hire smart lenders, traders, analysts and advisers, the people who have the strongest relationships with, and knowledge of, the institutions that demand or supply capital. But would they have hired all of them? Half? How many people would a new bank really need? Hedge funds take on traditional bank functions with a fraction of the employees.

He concludes:

[Banks] will occupy a smaller place in the economy and they will be less profitable. In a decade, there will be fewer professionals working on Wall Street than there are today.

If I map his comments onto my own, it becomes clear where the job losses will be. The "Financial Utilities" will be characterized by a low-skill, low-innovation, low-margin, high-volume business model. Since capital and information are almost entirely digital these days, there is nary a barrier to massive automation. The remaining jobs will be the folks keeping the computers humming and the 'relationship' people in high-touch areas like customer complaints and regulatory relations.

Yeah! What HE Said: Smart is as Smart Says ... Hopefully History Repeats

Allow me to quote myself quoting someone who has every right to give Uncle Sam a big ole "told ya so" right now.

"Experience hath shewn, that even under the best forms of government those entrusted with power have, in time, and by slow operations, perverted it into tyranny." - Thomas Jefferson

"And to preserve their independence, we must not let our rulers load us with perpetual debt. We must make our election between economy and liberty, or profusion and servitude." - Thomas Jefferson

"That government is best which governs least." - Thomas Jefferson

Time for Timmy to Take a Page from the Dick Nixon Book

Three months ago, on April 19, Timmy G flashed that charming nose-flair and scowl as he proclaimed "no risk" of credit rating downgrade. With a Treasury Secretary like that, who needs enemies?




That incredible foresight has created quite a bank of political capital and immense credibility for Timmy. Knowing that his fatherly tone alone can instill confidence in the most dubious heart, he decided today to leverage a bit of his capital, saying, in effect, 'trust me - China will continue to support borrowing habit.' No need to get our fiscal houses in order. That's just too hard. Too confusing. Too complicated for the average dumb voter. Better to just distract everyone by attacking the ratings agencies ... for ... um ... our fiscal mess?


Also based on his incredible Volcker-like, Lula-like track record of securing our country's fiscal future, he shared some friendly advice with his colleagues in Europe, admonishing those pre-pubescent countries to make sure they don't spend more than they make. If only they were as fiscally responsible as we are. If only they were lead by such world-class minds as we.


Investors are expressing their immense appreciation for Timmy's FDR fireside chat moment by voting with their feet ... from equities, debt, swaps, and even energy straight into gold.

Risk Free?

S&P's downgrade of US debt is not the first domino, nor will it be the last.

Traders and Brokers: wear rubber underwear Monday.

Thousands of funds are contractually required to hold a specified percentage of AAA debt. They ALL have a significant position in US Treasuries. Monday they will have to decide whether they go to their investors hat in hand requesting permission to hold non-AAA US debt or whether to dump their holdings. Furthermore, risk algorithms and valuation models used by nearly all financial institutions and investors are based on the US treasuries as the "risk free" rate of return. These models will have to be re-assessed ... and the consequence will be a shift in investments.

The charters of many countries and sovereign wealth funds require their central banks to hold AAA notes (or the currencies of those countries) for their national reserves. Thus, the US's reserve currency status may also be reviewed next week. FX markets, interest rate markets, swap markets ... wow - hold your hats, kiddos.

(update) Don't take my word for it. Mohammed el-Elrian echoed my comments in the Financial Times over the weekend.

The fact that yields on US debt have fallen all week speaks more to our ability to manipulate markets (in the short and medium term) than it does to confidence level. So don't go there.

This could have been avoided. Go ahead and fiddle, Congress. Washington is burning.

Stupid is as Stupid Does

Switzerland has spent over a century building a safe, predictable, stable currency. Sadly, as one of the last bastions of sovereign stability, the nation is now feeling the unintended consequences of their scotch ways. It is teetering on the verge of recession because their currency is too expensive. As a consequence, Europeans are cancelling trips to the Swiss Alps because everything is too expensive there. Swiss are driving across the (0pen) border to buy TVs and food in Italy where their francs go much further.

Thus, the central bank intervened in currency markets today to knock down the franc. Tonight, the franc is trading above where it started the day.

Ditto Japan.

Consequently, the Swiss and Japanese central banks' wallets are a few billion dollars lighter tonight ... and currency traders' wallets are a few billion dollars heavier.

When will central banks learn??

Nik's Laws: Croaking Canaries

The states are the canaries in the mine of our economy.

A better set of incentives to maximize economic efficiency by focusing directly on maximizing economic "intensity"?

Various economic systems have tried to determine the best allocation of goods, services, and capital (which includes labor, money, natural resources, land, etc). Capitalism allocates capital based on who can think of the most profitable use for that capital. This encourages risk-taking and discourages equality. In this system, people who grow wealthy by taking smart risks with their capital "deserve" the resulting profits. People who go bankrupt by taking dumb risks "deserve" that too.

One unfortunate side effect of wealth-creation under this system is that some people stop making smart capital-allocation decisions and become capital hoarders. They don't care that they are creating little value out of the capital, either because they expect the value to go up, or because they have sufficient personal wealth to meet their own needs and wants without squeezing the maximum value out of each asset.

In this case, capital becomes inefficiently allocated to the detriment of the "have nots." Second homes sit empty while homeless people sit on the street. Farmers in developed countries are paid to NOT grow crops while whole villages in developing countries starve. In other words, the usage of that capital (the "intensity") is lower than it could be.

So my challenge to my fellow readers is: could we revise the incentive mechanisms to encourage maximum capital "intensity" while preserving those components of the system which encourage the necessary innovation, risk-taking, and reward-reaping?

Talk Amongst Yourselves: US Government Spending as a Percentage of GDP