The Longest Now


frightmotif: deleveraging and the veil of illusion
Thursday September 18th 2008, 3:50 am
Filed under: chain-gang,fly-by-wire,international,metrics,poetic justice,Uncategorized

Our interconnected global economy is built on the illusion of trust.  Gautama himself would be impressed by how far we have advanced the texture of societal illusion.  While there are certainly many non-illusory sources of trust, the trust most modern men have in our financial instruments and currencies is based on a blind association of “interest rates”, “inflation”, “market valuation” and similar concepts with a hazy set of economic laws, as though they were fundamental laws in the sense that one discoveres Mathematical or Physical Laws.   Not social norms that could change on short notice; not starting rules of nomic games of risk and manipulation; not Massively Multilayered Online Resource-Permuting Guidelines, hundreds of indirections removed from the original social norm of personal credit and unenforcable on any large scale.  They are perceived instead as Laws, discoverable and immutableNot quite.

For better or worse, we live in fascinating times.  Thanks to this motif of fright, many once-in-a-lifetime financial decisions are being made every day.  A few recent moves by the US Federal Reserve Bank, striving to maintain order:

  • Sunday: an unprecedented 4-hour Sunday afternoon org-to-org trading session, part of “last-ditch efforts to prevent toxic assets from ailing Lehman Brothers spilling into global markets and rupturing investor faith in the international financial system”.   The result: only $1B in trades, slightly less panic the following day, and a loosening of the shared global trust in unwavering financial regulation.
  • Sunday night?: Banks are told they may use deposits to fund their investment bank subsidiaries, flaunting Federal Reserve Act Section 23A. potentially stabilizing failing banks at the cost of risk to individual investors.
  • Monday: a ‘dramatic loosening’ of the standard for federal loans to banks, potentially stabilizing them at the cost of dramatically increased risk of government losses.  Meanwhile, the US Treasury’s S&P AAA rating is vulnerable. Shared global trust in regulation dips.
  • Tuesday: The Fed lends $85B to AIG, after refusing them $20B over the weekend.  True, AIG isn’t a bank, but see FRA Section 13(3).  AIG uses ‘all of its assets’ as collateral, giving the Fed an 80% stake.
  • Tuesday: the FDIC feels the crunch, says it’s ok for a while, but makes a medium-term request for a $500B line of credit.  Why?  Well, while there are over $6,000B in bank deposits in the US, more than half of them FDIC insured, banks report less than $300B cash on hand. And the FDIC reserve is down to $45B, only enough to cover ~15% of the difference in case of a widespread bank run.
  • Wednesday: Banks may count goodwill as capital when meeting regulatory requirements for capital onhand.  This allows a deepening of the leveraging of assets of troubled banks, which only caused trouble during the S&L crisis; what’s different now?
  • Thursday: After three Reserve Fund money market accounts drop below $1 a share, Putnam‘s Prime Money Market Fund shuts down to avoid losses.  It’s been a while.
  • Friday: The Treasury pulls out a few more stops and assigns the $50B in the Exchange Stabilization Fund to current money market funds.

Updates as the week progresses.  The large market swings are reminiscent of the month before Black Monday… so stay tuned, relax, stick to insured banks, and (remind your loved ones to) stay out of the stock market.

Liquidity pyramid diagrams, fractional reserves, and other comments below the fold.

Before we continue, you may want to revisit the origins of the modern fractional-reserve banking system.  The international banking scene includes an additional layer of derivatives (“Not Your Father’s Financial Calculus” ), leading to a world with over 15x as many financial tokens as could ever be redeemed for underlying assets.  Here is the liquidity ‘pyramid’ from a few years go; it is twice as top-heavy now :

Global liquidity pyramid

Bear in mind in the weeks to come : what scares the central parts of global banking systems is the knowledge that their empires are built on air… not just a cushion of air, for a single country, but clouds all the way down, for everyone.  People may talk about 10:1 or even 60:1 leveraging of assets, but even  the 1 in those equations relies on shared standards of value and basic trust.

Other comments:

Wednesday: Kenneth Rogoff suggests a $2T bailout may be needed to ‘contain the contagion’.

Wednesday night: The UK Telegraph reports on the day’s global credit freeze and the ongoing hit to the Moscow bourse, where trading was suspended after the Micex dropped 24% in 2 days.

On this motif : compounding the fear of having no fundamental support : our urban centers have in theory no hard backstop preventing total financial collapse, with a loss of faith in any institution to protect and safeguard value over time, and a loss of any shared sense of abstract value or usable currency.  In contrast, the closer one gets to self-sufficient communities with their own natural resources and balanced sets of local skills, the more superfluous these abstractions, and the less deadly their dissipation.

There is something to be said here about the stabilizing value of multiple competing (or even not entirely substitutable) currencies in a community, in comparison with a strong central bank, but I don’t know how to formulate it.


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