Thursday, January 3, 2013

A Freaky Economy

I'm no economist by trade, but I do have common sense.  Here's my understanding of something I think everyone needs to think about. 

Most people have heard that Chinese curse "May you live in interesting times" at one point or another.  History has had some very interesting times, but it's important to look at the present and truly appreciate how interesting things are right now.

To anyone with a modicum of common sense, where we are right now is no surprise.  Despite the well documented pitfalls that arise out of debts, we have an economy that is now built on the concept of debt, and nothing is being done to curtail it.  There used to be a phrase "Never a borrower or a lender be" that was an axiom, yet now debt comprises most of the world's finances.  Most people also know, though they probably don't want to acknowledge it, but these debts aren't exactly getting paid down.  Just look at the US spending - it's going up faster than ever and the solution is always to increase the ceiling, rather than paying down the debts.  

Everyone knows this can't continue indefinitely without something really, really, bad happening at some future point.

The good news is some people know that this status quo shouldn't continue, and these people said something about it.  These people are the members at the BIS - or the Bank of International Settlements.  

In layman's terms (not 100% accurate, but for the purposes of this article, good enough), the BIS was a bank that was setup to deal with Germany's reparation debts after WWI.  It was a central bank to a number of nations that made sure payments went where they needed to go, and because of Switzerland's neutrality in most international affairs, it was located there in a place called Basel.  As time went by, it superseded that initial role and now it has more member countries and it tries to keep everyone's money in check - not just the original members money.  This groups largely keeps quiet, but on occasion it will notice that the banking systems in the world are getting a bit screwy, and it makes a recommendation.  These recommendations are not law - they're just advice to banks on how to avoid trouble.

The first recommendation was after the 1974 liquidation of the Herstatt Bank in Cologne, and it was known as the Basel Accord.  It basically stipulated that in the same way you need to keep money in your account to cover your mortgage whilst your latest pay check clears, banks need to keep a certain amount to cover time differences like when dealing with New York as the counterparty banks still need to be paid on time during the settlement processes if the money hasn't arrived at it's destination yet.

The second recommendation was in 2004.  The BIS knew what was coming with this reckless lending, and basically told banks to shore up reserves to make sure they didn't go under.  This was known as Basel II.  The banks basically had troubles meeting this goal, then the crash of 2008 put the wind up them so fast that they quickly locked down all lending and "found" the money.  The money was so locked up, governments had to print new money to get liquidity going again.

The third recommendation was in 2010-11 as a response to what had happened with the deficiencies found in the financial crisis.  Known as Basel III, the timeline to implement this starts in January 2013.  It's purpose is to increase how much the banks need to hold onto, and to make sure they stand up to a stress-test.

Hopefully, that layman's version of history has kept you with me so far.  It's got holes and glosses over vast tracts of detail, but the general gist is what you should know if you don't already.

As part of Basel III, one small aspect was to reclassify what the banks could hold as collateral that held no risk.  In the old days, banks could use gold.  During the 80s this went a bit haywire and after a massive spike followed by a crash, gold lost it's status as "zero risk".  Banks therefore offloaded it and moved over to debts.  

Something screwy then happened - much like that "find the pea under the three shells" game.  A bank has assets and liabilities just like any other person or corporation.  However, if you put your savings money in the bank, this is actually a liability to the bank as they have to pay this back to you when you want access to it.  To stop it being a liability, they "move" the money to the lending arm, and give it out, and now it's it's an "asset" as it's generating cash for the bank and they can call it in (or repossess your home for hopefully an equal value) should they want the money back.  

So your money is now both an asset and a liability.  Can you see how stress testing a bank is going to get a little complicated?  This is before they start packaging up the liability side and selling it off as Credit Default Swaps and other financial products that basically make a mockery of the classification of "who has what?".

Can you see where the real money is?  No?  Neither could anyone else…

So, over the past 30 years, gold has been slowly building up value and now it's back at the point where they're reclassifying it as "zero risk", meaning a bank can hold gold as part of it's "tier 1" assets.

The problem is the whole system is still largely gummed up with debts because everyone owes everyone else something.  Countries are having issues (countries like South Africa excepted) implementing the Basel III framework according to the Jan 2013 schedule.  The USA has postponed it "indefinitely", meanwhile it continues to face another "solution" of raising the debt ceiling further.

This is starting to sound like Basel II all over again, right?

The big issue is we know that there is only so much gold above the ground, ballooning debts and an ever expanding supply of "fiat" money (printed money) being created to service this.  The problem is this printed money is being accounted for in weird ways that eventually have to be "unwound" and settled between parties.  During this process, the money that was an asset moves back to being a liability and is payable somewhere to someone.  

So what does this mean for non-cash assets such as gold?  Does it's price skyrocket as it becomes apparent that it's one of the few actual assets these banks have to settle debts?  After skyrocketing, does it crash again, just like in the 80s bubble?

More importantly, what happens to those countries banks who have postponed putting in the Basel III safety net?

As I said, I'm no economist, but this situation freaks me out from a common sense point of view, and I don't see a good ending to it.  

I just can't work out why other people aren't freaking out too.