Monday, October 17, 2011

Revisiting The Limits to Complexity

A little more than a year ago I wrote an article generally sketching out The Limits to Complexity that our global society faced back then and continues to face now. The speed at which some of these limits have materialized for the average consumer, business, investor, employee, taxpayer, politician and central banker in the developed world, while expected by many, has still been nothing short of flabbergasting. Before revisiting the complex "solutions" formulated by governments and central banks to address the problem of over-complexity, we should briefly recap what has happened over the last decade and a half, more or less.

During and after the implosion of the "tech bubble" and the brief financial recession of the late 1990s, major banks and corporations around the world realized they needed a new "asset" which could be leveraged by consumers and businesses to support aggregate demand and, therefore, their revenues and profits. With the help of aggressive fiscal policy, new government statutes (i.e. "Community Reinvestment Act"), the repeal of pesky "firewalls" ("Gramm-Leech-Bliley Act" repealing the "Glass-Steagall Act") and accommodating (low-interest) monetary policy, private banks pushed unfathomable amounts of debts onto people and businesses who could not afford them by any stretch of the collective imagination.

These same banks were also allowed to securitize many of the underlying loans, sell them off to various institutional investors and market derivative instruments to those clients who wished to gain exposure to the global sub-prime mortgage bonanza. When the greatest financial ponzi scheme known to man eventually collapsed in 2007-08 and it was clear that the global economy faced an imminent depression, governments worldwide decided to "respond". What this response amounted to was an attempt to maintain economic and financial complexity by adding on layer after layer of ever-more complex structures, and suspending/manipulating any measure of reality that was in the least bit accurate.

Those layers, in part, took the form of unprecedented fiscal and monetary policy, which funneled trillions worth of taxpayer-guaranteed funds to banks that were deemed too complex too fail. So how did this big dose of complexity fare after the flames died down and the smoke cleared? Focusing on the U.S., here's what I wrote last year about Obama's $820B "American Reinvestment Recovery Act" (ARRA):

The Limits to Complexity

"The [ARRA] allocated about $820 billion to various local governments and companies in an effort to create jobs. What they don’t tell you about the ARRA is how much of that money, as a matter of necessity, is wasted in bureaucratic institutions that distribute and keep track of the money as it is funneled down to economic actors. Much of the money also goes to funding extremely misguided projects, such as tax credits for homebuyers that incentivized the construction of new homes when there is already a year’s worth of excess supply.

Sometimes the money goes to fund the repair of roads that don’t even need any repair, as I have personally witnessed in my own community. New estimates have made clear that it is unlikely more than 1 million jobs were created by the ARRA stimulus, which amounts to $820,000 per job, some of which were not even productive for the general economy."

Despite the [misleading] BLS unemployment rate falling to 9.1% in 2011 (signifying more people who have given up looking for work), the employment situation has significantly deteriorated since last year. On Friday, the non-farm payroll numbers came in at +103K for the month of September, with about 40K of that coming from Verizon workers who ended their strike. The more accurate U-6 unemployment measure increased to 16.5%, its highest since December of 2010. Zero Hedge has calculated that at least ~261K jobs must be created for the next five years for the unemployment rate to return to pre-2008 levels, and this number has been consistently increasing every time it performs the calculation. [1]

The numbers for August were revised upwards for ZERO jobs created to 54K, which is still an overall dismal print. Manufacturing jobs declined by 13K in the month of September, while average duration of unemployment hit an all time high of 40.5 weeks. [2]. Initial claims have continued to hover around 400k per week for at least the last six months (and have been consistently revised upwards), which essentially implies no jobs are being created. [3].

It is quite clear, then, that Obama's stimulus did very little to spur job growth, and now he is facing an even bigger limit to complexity – a dearth of political capital to pass any new "jobs bills" through Congress. On the monetary front, policy mainly took the form of slashing the federal funds rate to near zero and launching asset purchase programs which targeted more than $2T in mortgage-backed securities and Treasury notes/bonds over the last two years. As the principal on the MBS was paid down, that money was reinvested back into Treasuries (and now more MBS) to maintain the value of securities on the Fed's balance sheet.

The Limits to Complexity

"The above policies serve to keep a floor on mortgage rates and finance our government’s deficits at low interest (what used to be stealth monetization is now just monetization), while also providing cash to banks with the alleged hope that they will lend it out into the economy, where consumers and businesses will spend/invest the loaned money. Out there in the real world, no such lending has happened, as the banks are sitting on $1+ trillion in cash and the Fed is caught in a liquidity trap.

...Private markets are currently saturated with debt and therefore very few people want to borrow money, and very few lenders want to make loans at affordable rates since debtors can barely pay back what they owe now. As mentioned before, interest rates have bottomed out and there is minimal economic activity to show for it. The velocity of money in the economy has collapsed, and the Fed’s policies merely transfer large sums of taxpayer money to major banks that use it to blow more speculative bubbles in stocks, bonds, commodities, and derivative bets on the price movements of those assets."

Since the time that was written, we have seen numerous destructive consequences derived from this monetary policy. The speculative bubbles mentioned above have led to soaring inflation in the Middle East, which, in turn, has been partly responsible for the ensuing sociopolitical unrest and violence. At the same time, global markets are largely back to the same valuations they were at a year ago when QE2 was implemented. Banks are now sitting on at least $600B of additional cash (excess reserves deposited at the Fed). [4]. Back then, I also mentioned that "equity outflows from institutional investing firms have continued for months unabated and have totaled over $50 billion year-to-date". Well, let's go ahead and make that a four-fold increase to $200B in the last two years. [5].

And since the Fall of 2010 is so out of style and the Fed does not currently have enough credibility to launch a similar asset purchase program, it has decided to merely shift the duration of Treasuries on its portfolio (swapping $400B in short-term bills/notes for $400B in longer-term bonds). This "twist" operation has done absolutely nothing to spark appetite for risk and is actually perceived as being net negative for financial markets, since long-term rates will compress and the yield curve will be flattened even further, thereby limiting the ability of banks to generate profits from interest spreads. Another limit to complexity, perhaps?

Ben Bernanke has consistently punted the responsibility for supporting "confidence" in markets and the economy to the Administration and Congress in recent months, and they consistently prove to us that they are both politically and financially unable and unwilling to do anything meaningful for neither one nor the other. Central authorities in the West have exhausted almost all of their tools for supporting financial markets, except for increasingly short-term liquidity measures. In addition, the policies they have enacted in the comfort of 2010 are now coming back to haunt them, as the publicly-sponsored complexity has made the system even more inflexible than it was before.

This layered complexity also took the form of Western governments placing an item misleadingly known as "financial reform" on their political agendas. In the U.S., "financial reform" amounted to federal politicians attempting to somehow regulate systemic financial stability into existence by creating a few new government agencies or sub-agency departments, which possessed a few more monitoring and enforcement mechanisms, and A LOT more bureaucracy. These agencies were essentially tasked with monitoring "systemic developments" in the financial sector whenever they felt up to the task. I wrote the following about this issue soon after the Dodd-Frank bill had been passed into law:

The Limits to Complexity

"...and the “finreg” bill failed to break up the TBTF banks, audit the Fed or create transparency for risky derivative products. More importantly, these new top-down regulations have the inherent feature of creating unintended consequences in our complex society, despite the alleged best intentions of their creators, and can even make the targeted problem worse.

The financial reform bill created new restrictions on “angel investors” which will inadvertently stymie the creation/expansion of small businesses, while the behemoth investment banks will continue to exploit financial markets by hiring teams of lawyers to easily bypass the new regulations that affect them (as they are currently doing with the “Volcker Rule”) or by simply buying off the regulators."

Fast forward to today and we can clearly see that not a single soul on Earth, let alone those moving the markets, believe the Dodd-Frank Bill did anything to mitigate systemic risk or even make sure it could be adequately identified before developing into another full-blown crisis (which has already begun). And then, of course, we have the unintended consequences of complexity. One major unintended consequence of the Dodd-Frank Bill that has recently asserted itself stems from the "Durbin Amendment" (introduced by Congressman Dick Durbin-D-Ill). What analysts are now labeling the "Durbin Tax" provides us with the quintessential example of diminishing returns to complexity. Forbes Magazine reports:

"Bank of America Debit Card Fees Slammed as "Durbin Tax"

"The law applies to those big banks – the ones over $10 billion in assets – and was ostensibly passed as an effort to increase competition. It was supposed to be pro-consumer.

But here’s the kicker: the Amendment gave the Federal Reserve the power to regulate debit card interchange fees and other bits of banking admin, which they’ve done. Over the summer, the Fed released the final rule on the matter. The combination of fees, restrictions and caps is thought to cost banks subject to the amendment nearly $14 billion annually.

The banks could try to recoup this money from somewhere else – like merchants. But merchants now have the ability to shop around a bit more and of course, they could refuse to accept cards altogether. It was quicker, cheaper and easier for banks to go straight to the customer."

Forbes Magazine is simply a shill for the big banksters, but the underlying point remains true. When politicians attempt to regulate "financial consumer protection" into existence by layering on increasingly complex regulations, they are bound to create unintended situations such as this one. They are also bound to not even recognize that these consequences have occurred. That is why Congressman Durbin can create legislation that has forced banks to impose fees on their customers, and then stand in the Capitol building a year later and tell those same customers to “get the heck out of” Bank of America, because it had the nerve to impose a debit card usage fee!

It's not just Bank of America either, but Citigroup, Wells Fargo and JP Morgan who are also proposing to institute similar debit card usage fees on their customers. For the time being, people will put up with this extortion because they see no other convenient places to park their cash or ways to make their purchases and pay their bills.

Rest assured, though, that these measures are a sign of desperation by the major banks, and will eventually lead to much fewer commercial transactions by consumers, which will dampen economic growth and decimate the profit margins of banks even further. Of course, the limits to complexity are not only present in the U.S. financial system, but the entire global economy, as Europe, China, Japan, Canada, Australia and many other "emerging economies" can attest to. Just last year, many of these regions were being hailed by mainstream analysts as survivors of the "Great Recession" and the future drivers of global economic growth. Now, their FIRE sectors are imploding and they are all following the U.S. and Europe down the swirling contours of the collective toilet bowl.

The financial topic du jour is, and has been for many months, the critical situation in the EMU. At this point, there is very little need to even point out the limits to the EMU’s complexity. One clear example, though, is the most recent discussions about the size and nature of the European Financial Stability Fund (EFSF). It was only a few weeks ago that the European leaders were discussing possibilities of expanding and/or “leveraging” the fund to adequately backstop the public financing needs of Italy and Spain, and prevent contagion from a Greek default. Today, some pundits and politicians are discussing whether the fund should instead be used to directly recapitalize Euro-area banks that are struggling to stay solvent. Stephen Castle reports for the New York Times:

Europe Calls for Infusion of Capital for Banks
”If Europe did adopt a regionwide approach to recapitalizing the banks, the question is whether that money would come from the bailout fund agreed to in July, which must still be voted on by a handful of member nations. If adopted, as expected, that bailout fund — the European Financial Stability Facility — would gain an effective lending capacity of 440 billion euros ($595.4 billion).

That might be enough to provide the necessary capital cushion to the region’s banks. But it would leave little cash to lend to any national governments that might require aid to protect themselves from a Greek contagion. Spain and Italy are seen most vulnerable on that count. “

Needless to say, there is bitter political disagreement on both of those issues and it is looking very unlikely that either will be done anytime soon, when the countries and banks need it the most to survive in their current form. [6]. Financially speaking, it is simply impossible for France and Germany to backstop the entire Euro periphery OR major Euro-area banks, let alone both of them. That fact becomes even more poignant when we consider another brutal limit to complexity in the form of France being downgraded by ratings agencies if it decides to bail out all of these other institutions. That would place enormous pressures on its own sovereign financing situation and effectively make it a non-factor in the bailout mechanisms.
From the NYT piece linked above:
”France’s caution over recapitalization illustrates how each potential solution to the euro zone crisis tends to become entangled in member nations’ domestic politics. A downgrade of France’s debt rating would be damaging to the French president, Nicolas Sarkozy, ahead of presidential elections next year.

The problem is that if you recapitalize the banks, then you have a problem with sovereign debt,” said one European official not authorized to speak publicly. “That is Paris’s big issue.”
Sarkozy and Merkel are hashing it today (Sunday) to see if they can agree on just how badly the Western taxpayers will be shafted yet again. Paris has suggested to use the very recently expanded "stabilization fund", created to backstop sovereign bonds, and redirect much of it towards recapitalizing banks directly. Berlin has said so far that this is a ridiculous proposal and the fund is only to be used as a "last resort" for the banks. [7]. Although Dexia, the Belgian bank that scored highest on the EU "stress test" earlier in the year and was the first to implode, has once again reminded us that the banks' first resort is the same as their second resort and every other resort up until their last resort - taxpayer funded bailouts.

The problem for the panhandling elites is that these bailouts are not as simple and as much of a given as they used to be, which was evident in the decision over whether to bail out Dexia and to what extent. The bailout issue was finally “resolved” today as France and Belgium agreed to nationalize 100% of Dexia’s operations, which is 100% against the interests of Belgian and French taxpayers. The plan must still be submitted to Dexia’s Board of Directors, who are sure to approve of any public bailout they can get their greedy hands on. Reuters reports:
France, Belgium, Luxembourg agree Dexia Rescue
" The burden of bailing out Dexia led ratings agency Moody's to warn Belgium late on Friday that its Aa1 government bond ratings may fall.
The negotiations to dismantle Dexia, which has global credit risk exposure of $700 billion -- more than twice Greece's GDP -- are being watched closely for signs that Europe might be capable of decisive action to resolve its banking crisis.

"I am convinced that it is possible ... by tomorrow morning to have an agreement in which Belgium resolves the issue without pushing up the debt level of our country too high," Leterme told Belgian television before the talks began on Sunday.”

It’s not that Belgium may be downgraded, but that it will be downgraded if the deal goes through, and France’s ratings may come under some pressure as well. No matter what happens, Dexia is just the first of many European banks to pass the faux “stress tests” with flying colors that will shortly implode, including major French banks. When that happens, there is no way France will come out of that with their AAA bond rating intact, and a French downgrade will feed into the need for even more bailouts. Since the implosion of Bear Stearns and Lehman Brothers nearly three years ago, nothing has changed. The limits to complexity have been stretched out a bit, but now they are well poised to snap back even harder.

It turns out that everyone who participated in the mainstream dialogue for the last few years had bought into the narrative of a global economic "recovery" and had conditioned their policies and attitudes accordingly. Now, they are all left reeling from the strict, unflinching evolution of complex systems. The subject of "bailing out banks", which was too taboo to even discuss last year, is now priority #1 on the policy agenda in Europe (and will soon be in the U.S.), but there is simply not enough political or financial capital left to do the job. Soon, the global financial system will be forced to revisit the limits to complexity, just as we have done today, and this time it will not be so easy for our leaders to avoid their implications.

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