Sometimes the Truth Really Hurts

I have just managed to spend some time reading through the IMF’s recent Global Financial Stability Report. And yes it’s tedious at over 200 pages in length. Suffice to say that this is not the stuff young children should be allowed to read: the numbers are staggering.

Martin Wolf at the Financial Times offers a great summary of the report so I won’t repeat it. You all should add him to your regular list of reading: I think he is one of the best analysts on world affairs out there.

But, for those of you who want a sample here are some numbers to get your arms around:

• $4.4 trillion. That’s the total of all global banking write-offs expected at the moment.
• $2.7 trillion. That’s the write-offs in the US alone. Just to show how fluid the situation is: this level of write-offs compares with the last IMF estimate back in October of only $1.4 trillion.
• 37 years. These write-offs represent 37 years worth of foreign development aid at 2008 levels.
• 13%. The write-offs represent about 13% of the GDP of the countries involved.
• $8.9 trillion. This is how much governments worldwide have spent so far in providing aid to the financial system. And that looks like just a beginning.
• $500 billion. The amount of new capital US banks need to get back to a 17 to 1 capital ratio, which is barely adequate.
• $25.6 trillion. The amount of bank assets that will mature and need to be replaced between now and 2011. Yes that’s $25.6 trillion!

As you can see these numbers are simply breathtaking. They tell a story of an industry not just run amok, but totally beyond control. Insane and totally self regarding the banking industry has brought the world to its knees.

Banking became a world unto itself. It created products and services that had no bearing to the ‘real’ economy, but represented fluff that trading desks could churn at lightening speed to earn fees that supported short term bonus structures. The actual contribution of banking to economic activity was hidden behind a veil of self gratification and greed that ended up destroying the world economy. The numbers do not lie: the business models providing the basis for banking over the past thirty years are a disaster.

The truth is that banking became a cancer. It is an illusion based upon a series of false premises and demonstratively incorrect economic theories. It is no accident that the derivatives business exploded right after the publication of the Black-Scholes-Merton financial economic theory. That theory is wrong at its core, but it gave legitimacy to what had previously been viewed as gambling. It took a phone call from Milton Friedman to the SEC to force them to allow the Chicago Exchange to trade derivatives. The rest is history. Finance became totally separate from all other economic activity. A world unto itself it has now ruined lives right across the globe.

There was no underlying purpose to most of what the big banks trading floors did other than to generate fees. It was perhaps the world’s most utterly pointless and useless utilization of resources ever.

And the IMF’s data highlight the incredible damage.

What the IMF also points out is that recessions following financial crises are particularly severe. So are recessions that spread out across the entire globe.

Presumably recessions like this one that are both global and originating within the financial sector are the worst possible kind.

Sorry folks, but this recovery may have to be long and slow in order to eliminate the excesses that the banks wrought.

In fact that’s a very good bet.

Which is why I beat the drum of banking reform. Never again must they do this to us.

Addendum:

For those of you who have no clue what the ‘Black-Scholes-Merton’ theory is: have no fear! It is one of the most significant economic theories of the last fifty years. It won the authors Nobel prizes and huge acclaim. It is taught at the most elite economics departments around the world – MIT seems to be at the fore. It anchored the whole explosion in derivatives trading. It gave intellectual plausibility to options trading.

And it is wrong. Totally.

It relies on core assumptions that collapse in the face of empirical analysis and, frankly, should be tossed aside along with stuff like the ‘efficient markets hypothesis’ and all the other equipment of the extreme neo-classical school of economics. Hiding behind all those Nobel prizes doesn’t make up for the damage their ideas have wrought.

One of my beefs with the economics profession is that it simply doesn’t want to admit its role in the current debacle. I suppose $4.4 trillion in write-offs isn’t enough to get their attention. This was their model. Their theory. They are just as culpable as the idiots on the trading desks, and the politicians of all political stripes who pressed for deregulation.

When I hear academic economists decrying their colleagues for teaching this rubbish I will start to listen to what else they have to say. Meanwhile I consider them more than a little ethically challenged.