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Value(s) by Mark Carney: Chapter 11 The Climate Crisis: Key Takeaways / Analysis / Citations

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Chapter 11 The Climate Crisis

Key Takeaways

For 11,000 years, the stable Holocene era has afforded humanity the playground to thrive. Now we have created the Anthropocene which is driven by human impacts on the planet. Carney does not go into any counter-arguments to say that the impact of human activity on the planet is correlated 1% with climate change or 99%…for him the data is conclusive. In the 1850s, the Industrial Revolution drove up global temperature averages by 0.07 degrees Celsius per decade. The planet’s average temperature is up by 1 degree Celsius  since the 19th century.

Other climate changes noted

  • The oceans are 30% more acidic since the Industrial Revolution;
  • Sea levels have risen 20 centimeters in the last 100 years;
  • The 5th mass extinction has shifted to the 6th with extinctions at a rate that is a hundred times higher than an average from millions of years; 
  • There has been a 70% drop in mammals, fish, birds, amphibians and reptiles since 1965, assuming evolution is not at play, although how do you define evolution?; 

Now, market prices of assets are being impacted. Climate change is likely creating: 

  • a.            a feedback loop of rising sea levels, 
  • b.            massive human migration away from rising coastal sea levels, 
  • c.             extreme weather events that are damaging insured property, 
  • d.            More impaired assets on the balance sheets of companies, 
  • e.            A reduction work productivity with the lethal heatwaves,
  • f.              Global conflict over scares resources,
  • g.            collapse of coral reefs destroying the livelihood of 500 Million people and ¼ of all biodiversity,
  • h.            Increased regime change,
  • i.              Increased citizen unrest,
  • j.              Increased spread of disease
In Kiribati, an island republic in the Central Pacific, large parts of the village Eita (above) have succumbed to flooding from the sea.

What is the cause? 

Causes: Emissions

The UN’s Intergovernmental Panel on Climate Change (IPCC) has argued that there is a 95% chance that human activity is CAUSING the global warming / climate change. The release of GhGs (Greenhouse Gases) with the most problematic being CO2 which, during rapid industrialization and growth has meant that over 250 years, humans have burned ½ trillion tons of carbon. Trends suggest another ½ trillion could be released in the next 40 years…¾ of the warming impact of emissions is CO2, with the remainder being methane, nitrous oxide and fluorinated gases. Trees cannot carbon capture to rebalance. Temperature and CO2 emission move roughly together, therefore we know what the carbon budget  ie. the amount of carbon dioxide that be released into the atmosphere before temperature thresholds are surpassed. 

The planet as a system would accelerate into a dangerous feedback loop if average global temperatures go past 1.5 degrees Celsius. The IPCC predicts that if temperatures reach 2 degrees Celsius above pre-industrial levels then 1) sea levels could risk 10 centimeters, 2) ¼ of all people could experience severe heat waves, 3) coral reefs will die off almost completely… 4) permafrost could further unlock CO2 and methane accelerating the trends would blow the budget wide open.

622-02757722 © Masterfile Royalty Free Model Release: No Property Release: No Green Number 0 on White Background

Net Zero

Carney advocates a stabilization of temperatures at 1.5 degrees Celsius. above pre-industrial levels. To do that: 

  1. Emissions have to fall by a minimum of 8 percent for the next 2 decades….
  2. We release about 42 +/- GigaTons of CO2 per year, 
  3. Planetary budget is 420 GigaTons of CO2 remaining before we hit 1.5 degrees Celsius and 1500 GigaTons of CO2 before we hit 2 degrees Celsius..

Children born in 2021 will have to generate ⅛ the amount of CO2 emissions compared to baby boomers into order stay on carbon budget of 420 GigaTons of CO2 remaining before we hit 2 degrees Celcisu. We need to reduce excess carbon from:

  1. Industrial processes are 30%
  2. Buildings 18%
  3. Cars 17%
  4. Energy generation 17%
  5. Agriculture 10% 

To reduce GhG, the solutions must

  1. Change how we create energy (fossil fuels must shift to renewables);
  2. Change energy usage (decarbonizing industrial processes, increased energy efficiency for buildings);
  3. Increase the carbon capture, use and storage (and maybe terra forming, although Carney doesn’t mention this)….

Basically, we need to convert the creation of all industrial process to electric and then shift the source of electric from fossil fuels to renewables. The first step may appear impossible considering the amount of energy needed to manufacturer most items in our homes, however that’s what has to happen. Bill Gates details the technologies needed in his book “How to Solve the Climate Crisis.” 

Geography of Emissions

most pollution is from cities. By region its:

  1. China 28%,
  2. Asia – Other 16%
  3. USA 15%
  4. EU-28 10%
  5. India 7%,
  6. Russia 5%,
  7. Japan 4%,
  8. Europe – Other 3%, 
  9. Africa 3%, Canada 2%, Australia 1%

The Consequence of Climate Change

How much do we value the future? The estimates of the costs of climate change and value of the sustainability contain many uncertainties that enable doubters. The GDP, employment and wage impacts are one way (a 25% reduction in GDP at the tipping point of 3 degree Celsius), the net present value of all future cashflows. What we really value such as the lives of species, livelihood adaptation, birth rate drop aren’t easily monetized. 

How central bankers view climate change? There are two types of risk

  • physical risks
  • transition risks

Risk Type 1: Physical risks =

increased rate of climate and weather related events (storms, fires, floods). The underwriting risk shows that the entire livelihoods buckle as inflation adjusted losses have increased over 8x over the last few years. 

  • Insurers are in the front line of climate change, beach houses aren’t getting insured at the prices they were 10 years ago. 
  • The insurance sector is adjusting and pricing-in some climate change using various projected models, subject to re-writes like any other model…Carney feels that coupling “sophisticated forecasting, forward-looking capital regime and business models built around short-term coverage has left insurers relatively well placed to manage physical risks” (277, Value(s)). 
  • Carney argues that there areas of the economy that will need a public backstop because insurance companies will not insure those areas between $250 Billion and $500 Billion on the US coastal property by 2100. 
  • Insurers and reinsurers are expecting trouble, Lloyd’s of London has a 20cm assumption which coupled with a hurricane would cause Manhattan damage that is 30% more severe than Hurricane Sandy.
  • Coastal flooding is projected to rise by 50% by the end of this century. 
  • Lethal heatwaves are projected to effect 1.2 billion people annually by 2050;
  • The Network for Greening the Financial System (NGFS) is an 80 central bank strong group that have created representative scenarios to show climate risks may evolve affecting the real and financial economies:
  • Hothouse earth shows that at 3 degrees Celsius, sea levels rise x cm and extreme weather events result in a 25% GDP loss by the end of the century. 

Risk Type 2: Transitional Risk 

The second category of costs of risk. The costs and opportunities are more apparent as the crsis worsens and impositions become more overarching:

There will be stranded assets

  • Tropical deforestation of palm oil, soy, cattle and timber is for commercial use 70% of the time.
  • Automotive industry that will, in Carney’s mind, be disrupted by electric vehicles, driverless vehicles and car-sharing services.
  • Coal producers have gone bankrupt in the US. 
  • Demand and Supply Shocks: demand shocks affect consumption, investment, government spending and net exports in the GDP = C + I + G +(X – M). Demand shocks are short-term usually and therefore don’t effect the productivity of the economy. Supply shocks effect growth, the growth of labour supply, physical capital, human capital and natural capital and the degree of innovation in the economy. So the impact of climate change on GDP is very tough because the sample of prior shocks also contained policy adjustments …

 Calculating the Impact of Climate Change on GDP

  • Feedback loops amplify quickly and suddenly (ice melting off of the antartica rapidly) and the north pole, it’s dynamic and not inherently predictable even if there is no human variable in the atmosphere itself (all chemistry, geology and hard sciences):
  • The relationship between GDP and temperature is not linear; 
  • Do physical climate events actually have a negative effect or simply impact growth (feedback loops and bad social impacts);
  • The degree of adaptation and innovation to mitigate the impact of climate change could be much more significant (i.e humans turn a disaster into a strength leading to more prosperity due to new opportunities that are created). 
  • Factors like the mass climate refugees which could be over 200 million people, the poorest being dislocated.
  • The 6th Mass Extinction: the biodiversity that provides natural capital from the Amazon to the coral reefs will be effected.

For Carney, it is a big deal that the CEO of Shell (Sir Mark Moody-Stuart) says that the probabilities of climate change’s negative impact on humanity is 75% and acknowledges that despite that uncertainty in predicting climate change, Moody-Stuart through the course of his career made larger strategic bets with much lower probabilities…

Causes Incentives

For Carney, climate change is a ‘tragedy of the horizon.’ The worst impacts are beyond the life-span of the decision-makers of today. The horizon is beyond: the business cycle, political cycle and central bank cycles.

  • The horizon of central banks is 2 to 3 years.
  • The horizon of financial stability is about 10 years.  
  • The horizon of political decision-making is about 4 years.

The benefits of mitigating greenhouse gases which stay in the atmosphere for centuries is massive, but for the people who don’t vote today, because they don’t exist yet. “Halving emissions over 30 years is easier than halving them in a decade.” (285, Value(s)) The welfare of future generations should not be discounted as heavily as the financial calculations typically demand.

S-Curve:

The rate of adoption of new technology has three phases; 1) research and development, 2) mass adoption, 3) maturity. The rate of S-Curve over the years has been accelerating. James Watt who invested the stem and in 1769 did not see coal over take peatmoss until 120 years later in the 1900s (technically, Watt died before see that development). So, technology to tackle climate change is emerging at quicker paces. The S-Curve needs a nudge from the market as well as the public sources of capital investment.

Tragedy of the Commons

The original example is the unregulated grazing rights on the common lands of Ireland and England in the 19th century there was a negative externality in which a decision is taken which then effects others who aren’t party or even benefit from that decision, is taken. We, the consumer, and we the producer don’t pay for the CO2 emitted to produce most goods. Other examples:

  • 1)    Overfishing to the point at which that stock of fish is depleted (Cod on East Coast of Canada);
  • 2)    Deforestation to the point where the forest is spoiled (Easter Island…);
  • 3)    Commons grazing to the point where the land was destroyed…

Three solutions to the Tragedy of the Commons:

  1. Pricing the externality: putting a price on carbon. This has only worked well in theory. There is a price of $15 per ton but you would need $50 to $100 per ton to meet the Paris Accord target…
  2. Privatization of the public spheres:  Public grazing lands in the UK to privatization however this created a wealth transfer to those who had the right to charge a fee.
  3. Supply management by the community to cooperate or regulate the scarce resources there in. Popularized by Elinor Ostrom (1933 – 2012) as economic governance. Get political consensus with shared management.

Carney goes on to draw the analogy that COVID is like climate change, it is a global problem. But climate change has no boundaries at all. Now, there are echoes of Bretton Woods style nationalist self-interest, huge debts and new institutions to tackle climate change:

  • 1992 – Rio Earth Summit; a good start..
  • 1997 – COP (conference of the parties) 1 and 3 the Kyoto Protocol: Kyoto was flawed, didn’t have teeth, a more serious call to action;
  • 2009 – COP15 the Copenhagen Accord flawed, advanced countries pledge financial flows to reduce emission in poorer countries;
  • 2015 – COP21 the Paris Accord, more stakeholders, financial firms, turning the agreement into legislative objectives as the UK did (already a low emitter, but limited recycle programs and lots of trash in the streets)

 Our political systems don’t overcome these items. True leaders are stewards of the system. Leadership is about being custodians.

Current Financial Sector

Financial markets aren’t really pricing in a carbon price transaction. There is a low urgency effort that will lead to hot house earth, according to Carney. Most financial energy numbers don’t use a price test for their carbon stress test of capital investment They usually use a static price. Their prices are well below the medium to get to zero. BP has $100 per ton in its internals. Only 4% of banks and insurers think these climate risks are being priced accurately. Only 16% used a dynamic price.

Transition Pathway Initiative (TPI) is a consortium of thirteen + five asset owners/managers that are trying to better understand the transition to low-carbon impacts investment strategies. They also launched the FTSE TPI (Climate Transition Index) to articulate who is on the right side of history in Carney’s mind. Investors are shifting capital away from hydrocarbon investments incrementally suggesting that they are pricing in a transition. In other words, the markets are responding to something akin to inevitability about a low-carbon economy. But these are strategic bets, it doesn’t mean they are certain. Moody’s “recently identified sixteen sectors with $3.7 trillion in debt with the greatest exposure to transition risk” (297, Value(s)).

  • §  For the Goldman Sachs, capital expenditure in oil and gas is being hindered by this transition of asset manager value in oil and gas. Major projects have been mitigated by 60% over the last five years, big oil is moving to big energy. 
  • §  Portfolio managers are engaging and pulling down their oil and gas investment incrementally. Also, in part due to the collapse of prices.
  • §  Transition bonds. In the fullness of time, climate change will incentivize brown companies to raise capital for green innovation.
  • §  Carney argues we cannot diversify away from climate change.
  • §  For Carney he argues that we need financial markets to build a virtuous cycle, better pricing for investors and smoother transition.
  • §  Sustainable financial systems are being built and the next chapter discusses this in more detail. 
Previous Chapter
Next Chapter
Introduction: Humanity Distilled Chapter 1 Objective Value
 Chapter 2 Subjective Value Chapter 3 Money & Gold
 Chapter 4 Magna Carta  Chapter 5 Future of Money
 Chapter 6 Market Society Chapter 7 Financial Crisis
 Chapter 8 Safer FinanceChapter 9 Covid Crisis
 Chapter 10 Covid Recovery Chapter 11 Climate Crisis
 Chapter 12 Climate Horizon Chapter 13 Your Values
 Chapter 14 Values in Companies Chapter 15 ESG
  

Analysis of Part 2 Chapter 11:

  • Sea level a big deal? Just how bad is this going over 2 degrees Celsius? It’s a prediction that seems likely and would result in actually cooking-up Earth, with accelerated feedback loop, to the point where the Antarctic ice sheet completely melts and we’d all have to learn to swim…We might even develop gills…..okay, that’s a stretch…how much of this is probable? The emotional crescendo of Al Gore’s An Inconvenient Truth was, in my view, showing major cities around the world being flooded by rising sea levels. This was the easiest and therefore, best way to illustrate the problem(s) which are myriad as Carney has tabulated in Chapter 11. But…..
  • Sea level estimates are being re-evaluated: There is one issue with this description of coastal flooding…it is not so probable as once thought. Carney seems to have ignored the claim that water levels would rise 20 feet i.e. 6 meters for that reason….I wasn’t sure why his book doesn’t mention this often quoted climate catastrophe? He doesn’t address it. I mean, 6-meters-of-water! was probably the most obvious and emotionally powerful visualization as to why climate change should be a concern…. Well, it turns out that it is not as probable in the next 100 years as once thought. Read this page to get the down-low: https://en.wikipedia.org/wiki/Sea_level_rise. According to latest projections from the IPCC 6th Assessment Report (2021); the sea level is predicted to rise by 2 – 3 meters if global warming is limited to 1.5 degrees Celsius, 2 – 6 meters at 2 degree Celsius and 19 – 22 meters at 5 degrees Celsius and that’s over the next 2000 years…..Hmm…confused yet? 2000 years as in 4021?…yes….So by 2050, there “will” be 50 million people under the water line using 2010 populations as a benchmark….The prediction of mass migration (1/2 billion people) is slightly overstated….
  • New research suggests that sea levels substantially lag Earth temperature changes, so the probability that sea level rising is a massive problem is much less the central / easy-to-understand threat of climate than originally thought.
  • We don’t trust our audience to get a concept quickly enough therefore we skirt the concept: science is a process of contestation, not an absolute truth system. New information changes old scientific models. The mass migration narrative we thought 15 years ago is not quite the consensus view in 2021. Of course, scientific consensus can change with new research, why is that a problem? I’ve noticed that the default assumption is that the general public is incapable of understanding that nuance….and or the threat that an opponent will exploit “changing” scientific consensus to suggest “X is a hoax!”, X being whatever a partisan wants to discredit for the time being, is greater than the benefit of being honest with people. Carney talks about this with regard to Bank of Canada forecasts being both a ‘certainty’ and obviously ‘not a certainty’….
  • Trust but verify | Calculate the sea level rise yourself: If you do your own calculation of the how much ice needs to melt off of land masses such as land glaciers on North America etc, Greenland and Antarctica, then doing so will help strengthen your understanding. In the case of the total ocean, there is an area of 361 million square kilometers that the new water would have to be evenly distributed on top of. There is 1.338 billion cubic kilometers of total water in the ocean that has to occupy 361 million square kilometers of Earth’s surface. The Antarctic Ice Sheet is 30 million cubic kilometers of ice, which could be added for a total of 1.368 billion kilometers. Depth = volume / length x width i.e. 30 million cubic kilometers / 361 million square kilometers is 0.083 km or 83 meters of additional water across the 361 sq km of ocean. Add 2.9 million cubic kilometers from Greenland and about 170,000 cubic km from mountain and other glacier formations…if you like but that would be a modest increase.
  • 83 meters = 100% of Antarctica’s ice sheet has to melt: So take the 83 meter increase described above…that describes ALL the ice in the Antarctic melting which is more likely if human beings are idiotic (nuclear war, smog everywhere etc) or an extraterrestrial species from a Venus like home world invades and terra forms Earth to a warmer clime…. Even so, there is no where near enough ice on land to get to Waterworld levels, 83 meters = 272 feet….so don’t believe Hollywood, folks.
The level of flooding depicted above is not supported by the math behind how much land-based ice is presently on glaciers, Greenland and Antarctica,. So, yes emotionally, Water World (1996) made you care about the environment, but there is not enough ice on earth to flood as above…unless more water is introduced to Earth.
  • Sense checking the 6 meters concept: So anyway, there are a bunch of assumptions that are required to get that original 6 meters prediction that Al Gore was shocking us with….And here is an example calculation. Basically, a small portion of Antarctic needs to melt for the 6 meter increase to occur, ie 83 meters = 100% therefore 6 meters = 13.8% of the ice sheet to drop into the ocean…but again, IPCC believes that 13.8% of 30 million cubic kms which is 4.14 million cubic kms will take a really long time to melt, the point is it will with our current policies but we’re also talking beyond 2100. So that’s assuming we do nothing which is obviously not the case. Humanity will reach a goal of carbon reduction because current companies will find a way to cost save and there are trillion dollar companies yet to be founded that charge a fee for solving climate change….probably.
  • Bottom line on sea level right now: So if the IPCC report suggests that 1) ice melting will take a lot longer to have an effect than original thought, and 2) the planet has to warm by 5 degrees Celsius over a longer period of time, then the 6 meters isn’t probable (in our lifetimes or the lifetimes of most children born in the 2020s…). And by 2100, there will be multiple generations worrying about climate change so (gov’t & private) solutions will emerge ($$$$$$$).
  • Magicians pivot your attention: So anyway, scientists don’t know for sure but it’s safe to say that the sea level story is no longer the central concern, hence Mark Carney does not lay into it at all in Value(s). Now, it seems plausible that he doesn’t discuss sea level much because he doesn’t want to admit that science is not static or that governor of central bank can’t accurately predict the future because then you won’t trust him or the institution to generally do what’s right… Instead of admitting the truth that science is a journey, in order to persuade us to make personal sacrifices, Carney and others have put more emphasis has been put on the fact that there will be more flooding as humans demand more single-dwelling homes in flood plains….which takes us back to the problem of personal preferences and how the consequences of those preferences are distributed.
  • Smart money / market argument: Over the decade after An Inconvenient Truth (2006), most of the emphasis was on awareness coupled with government intervention. Stephane Dion in Canada led the Liberal Party to massive defeat in 2009, a campaign built on a Green Shift. Of course a myriad of variables determined that election which is why blaming the Green Shift is a political statement that Canadians “don’t really care about climate change” which obviously varies as an opinion per Canadian. Such is our complex voter preferences… However, the lesson taken there is that the idea that government and by extension the civil service and regulation are primary means of driving punitive costs to polluters has consistently been deemed suspect by a significant portion of smart-money folks.
  • Obama was hands off for example because of the coalition he had backing him and the legislative strategy he needed to implement. And in his biography, his mother knew that jobs were more important then environment for poor Indonesians that she worked with for years. Now, financial institutions, which enable the allocation of scarce capital, in as optimal a manner as possible, are being marshalled (by the general investment customer base) to more seriously address climate change + the general investment. Carney does not put the most devastating case forward because it gets harder and harder to know how that would play out in a complex eco-system such as our planet. But basically, after the sea levels rise 10 cm….10 cm or 20cm? So what? We were talking about 20 feet in 2006. Some of the claim by Al Gore on ocean level has since been reevaluated (as mentioned above)….websites are disappearing that used to contain claims of 6 meter sea level rises “guarantee”. So he has to combine weather with flooding to say Hurricane Sandy would have been 30% worse than it was from an insurance perspective. I feel so bad for insurance companies having increase their rates….not! 
  • Reparations: Another point is that the Alberta conversation needs a better answer around some support system, although historically when a sector struggles we do not necessarily intervene, but with climate change, government is intervening to accelerate the transition. There are no easy answers there because living in minus 40 conditions in Edmonton becomes hard to fathom if the human capital with a green tech breakthrough can migrate to Silicon Valley with no dis-incentives.
  • Another question is: what if the scientists are wrong, again? How much punishment should allocated to their grandchildren for the oil & gas careers that are hindered unjustly in this hypothetical? That would be absurd of course but the climate physics is rock solid until new research uncovers better techniques and models as part of the scientific method. It’s an important philosophical question: what is the consequence of getting it wrong? What commitment can Carney truly make if he is wrong? And if / when climate change is mitigated through a combination of human ingenuity and sacrifice, there will be naysayers who point of that it was never real in the first place because all the bad things that were suggested did not transpire! Such is the elephant in the room of all data science: there is not parallel version of Earth where we can control for different approaches to climate change.
  • The Yeah But…a lot of the public still can’t connect this slow moving crisis to their lives, most people see this is a transitionary problem over decades and decades, predictions have been wrong and continue to be wrong, if saving humanity was so lucrative then why haven’t we paid to terra form the planet to prevent sea level rising: there is a funding problem: no one wants to pick up the cheque, where is the global fund to pay for these changes, you are asking people to suffer for an abstraction that isn’t flawlessly defined…
  • Carney fails to address the command economy advocacy imbedded in prescribing with science what every person’s carbon footprint ought to be. Here, there is no invisible hand, the government of the world is most equipped with providing each citizen with their responsibility. The counter by Carney is of course, seatbelts wouldn’t have been imposed without political and regulatory force. It is the use of that force that can spur innovation in concentrated points throughout the economy. 
  • Putting a price on pollution is like putting a price on negative social media comments, the state is imposing a costs for doing something that perceived as bad but has some positive value and making the recipient hopefully tougher for criticism of their instagram post of a really delicious meal.
  • A general rule in life is to identify that if someone is claiming that there is a single cause to a problem, they are trying to convince you of something or sell you something. You are being persuaded into conformity of some kind, like you need to buy X to resolve the Y. A lot of people don’t actually like being talked down to…I’ve found…. The language problem of inexactness of human communication system (language) is slowly being overcome with PowerPoint, Film etc. This problem of debating cause versus correlation is best exemplified with climate change discussions. Human activity has caused climate change immediately sounds misleading because the “climate is always changing” and how does one know to what degree “human activity” is causing climate change. Humans could be contributing 1% or 99% of the factors driving climate change, but some goof will point out that volcano contribution to disrupt the argument. For example, the counter argument that human activity is not causing climate change conflates causing with contributing. If someone says human activity is not contributing to climate change then that’s a sniff test for an intellectual dilettante. To prove that humanity is contributing to changes in the environment simply apply the counterfactual of the no-humans version of Earth. In that version of Earth, on this day, you would now be outside rather than in your home or office where you are reading this article. There would be no roads, etc etc. The very fact that this is obvious, proves that humans impact Earth in a significant way. And secondly, all those human tools and technology that we have been using requires heat energy to produce. That heat energy generates CO2 amongst other gases. So if any one says that humans do not contribute to climate change, they necessarily have to deny that absent humans there would be roads, houses mysteriously populating this no-humans version of Earth. In other words, it’s absurd.
  • Carney neglects to acknowledge that the research cited is subject to grants. If someone is obsessed with derivatives, then they will likely think derivatives are really important. They will have biases that warp their world to the point where their own brain notices patterns elsewhere that relate back to derivatives: this is selection bias. To not acknowledge that any human being, regardless of credentials is subject to the same confirmation and selection bias should they study climate change, is intellectually controlling. I suspect Carney knows there should be some doubt but he may not trust readers with this nuance. 
  • Another interesting sense from this chapter is that Carney doesn’t have an entrepreneurial spirit really, if he did he would understand that extinction is a necessarily part of evolution. If the cause is human habitat encroachments which by definition is going to continue to happen, then we should be sympathetic. However, extinction is not by definition bad. Does anyone miss Pan-American Airlines? Does anyone miss the Dodo Bird? Of course, we all miss these things or would like to see them in the wild but such is life…Dodo Birds were definitely eaten to extinction but they also did not produce enough offspring. Life is cruel and unfair.
  • Measuring the acidity of the oceans: a 30% increase in acidity is significant if the acidity of the acid content is 1 -> 1.3 part per 100 but not if it is 1 0> 1.3 part per 1M….
  • Carney does not mention that there is an increase in human habitats such that extreme weather events like flash flooding are on the rise…in geographies where the events are newsworthy. An analogy might be that coverage of gun violence is only newsworthy when a random citizen is the victim rather than a gang related victim.  
  • Carney does not address terra forming solutions accept for the socially accepted one: carbon capture which involves sucking carbon out of the air or releasing CO2 into the ground.
  • Carney basically tells readers to read Bill Gate’s How to Avoid A Climate Disaster. In other words, friends help friends.
  • Anyway, here are some of my wacky but fun ideas to address the most extreme consequences (such as the 6 meters ocean rise) which as I mentioned above is not that likely in the next 100 years:
  • Notice how any terra forming suggestions are met with derision as they are not a complete solution, not costed and/or seemingly enable current practices? People forget that things do take a long time to implement. People also tend to want a single causal variable to solve all the underlying problems because our brains organized to address single cause circumstances…..there is rarely a single bullet, and change is incremental (we can’t cram for solutions). We tend to need a business case as well.
  • If the 6 meters sea level rise is increasingly less likely, then we will continue to put off any wacky terra-forming ideas, and that’s less fun for me, but definitely not a major loss.

Citations Worth Noting for Part 2: Chapter 11:

  • ‘What is Ocean Acidification’, PMEL Carbon Program.
  • IPCC, Special Report: Global Warming of 1.5 degree Celsius (2018).
  • Saul Griffith, Rewiring America, e-book (2020).
  • Stockholm Environment Institute, ‘Framing stranded asset risks in an age of disruption’ (March 2018). 
  • Norman Myers, ‘Environmental Refugees: An Emergent Security Issue’, Oxford University (May 2005). 
  • Sandra Batten, ‘Climate Change and the Macro-Economy – A Critical Review’, Bank of England Staff Working Paper No. 706 (January 2018). 
  • IMF, ‘The Economics of Climate’ (December 2019). 
  • Ryan Avent, ‘Greed is good isn’t it?’, American Spirit, 18 April 2020.
https://www.transitionpathwayinitiative.org/
Business, Politics, Science

Value(s) by Mark Carney: Chapter 10 Covid Crisis: Fallout, Recovery and Renaissance: Key Takeaways / Analysis / Citations

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Chapter 10: Covid Crisis: Fallout, Recovery and Renaissance

Key Takeaways

The reality is that mobility did decline as people accepted the lockdowns. State legitimacy is ensured by containing the virus. A lot of what Carney is saying here is a summary of what is relatively uncontroversial. He discusses the framework for the common good. Is that it is possible to calculate that value of a given person? The solidarity of citizens is important to note here, because the view was that no one should die in this pandemic regardless of age (or rather that folks did not want to contract this virus). 

Other topics: 

  • Perceived fairness of healthcare: you cannot have one set of rules for the rich and another for general citizens.
  • Value of a senior versus other citizens. 
  • The young will have to pay twice in increased taxes and the depression of the moment.
  • Kids with internet had an advantage in home schooling. 
  • Value creation and destruction increased under Covid.
  • R0 as the metric is a useful anchor just as the 1.5 degree Celsius  increase to evade the most harmful effects of climate change. 
  • Managing R0 was the core activity of this pandemic as far as governments were concerned.
  • Carney rationally described how the government that is presented ought to appear competent. 
  • Local businesses will be emphasized over global for years to come.
  • There will be future black swans, no kidding. 
  • We have continued to move towards market society however, in this Covid crisis, we have “acted like Rawlsians and communitarian rather than utilitarians and libertarians.” (260, Value(s)).

Covid and Climate Change

  • Carney predicts that the pandemic’s post active phase will see an increase the societal confidence in science, demands for stakeholder capitalism
  • Carney then draws a parallel between Covid and climate change. Using science to inform decision making for example. Having targets. How no country can isolate for each other in a pandemic or a climate crisis. 
Previous Chapter
Next Chapter
Introduction: Humanity Distilled Chapter 1 Objective Value
 Chapter 2 Subjective Value Chapter 3 Money & Gold
 Chapter 4 Magna Carta  Chapter 5 Future of Money
 Chapter 6 Market Society Chapter 7 Financial Crisis
 Chapter 8 Safer FinanceChapter 9 Covid Crisis
 Chapter 10 Covid Recovery Chapter 11 Climate Crisis
 Chapter 12 Climate Horizon Chapter 13 Your Values
 Chapter 14 Values in Companies Chapter 15 ESG
  

Analysis of Part 2 Chapter 10:

  • Leadership means being a custodian to the long-term. It’s not about you, says Carney.
  • There is a so what to this chapter….it falls short of saying anything about how the issuance of debt what appropriate or not. He didn’t talk about work from home or how the virus works which is a missed opportunity.
  • Carney seems to downplay the fact that the biggest failing of the pandemic is actually that government are operated by people who are focused inwardly in their own self interest within the architecture they have inherited. And such there is a lack of real time data to respond to the real society as it is occurring. There is a high lack information between citizen and government. The government should get out of the way for those who want that and step in for those who need help. Being able to distinguish between complex contradictory people as we all are is critical. It’s a credit card for UBI, it’s an interface to detail ones preferences voluntarily, it’s a relationship that is not simply a marketing blast….
  • Carney makes sweeping claims here that are sufficiently inoffensive to warrant much comment. There are no innovative sliders that he trials in this chapter, there was a lot of spicy behaviour in Covid but Carney manages to keep it very potatoe. 
  • Surprised he doesn’t go after thie no mask wearers and other violators of lockDown. We tend to forget that these regulations were ignored by millions of people as they were ill enforced… 

Citations Worth Noting for Part 1: Chapter 10

  • World Health Organization, ‘Coronavirus disease 2019 (COVID-19) Situation Report – 11’, 31 January 2020.
  • Christian von Soest and Julia Grauvogel, ‘Identity, procedures and performance: how authoritarian regimes legitimize their rule’, Contemporary Politics 23 (3) (2017), pp. 287 – 305.
  • Stephanie Hegarty, ‘The Chinese doctor who tried to warn others about coronavirus’, BBC, 6 February 2020.
  • Ruth Igielnik, ‘Most Americans say they regularly wore a mask in stores in the past month; fewer see oher doing it’, Pew Research Center, 23 June 2020.
  • Timothy Besley, ‘State Capacity, Reciprocity, and the Social Contract’, Econometrica 88(4) (July 2020), p. 1309 – 10.
  • Allan Freeman, ‘The unequal toll of Canada’s pandemic’, iPolitics, 29 May 2020.
  • Daniel Kahneman, Thinking, Fast and Slow (London: Allan Lane, 2011).
  • Timothy Besley and Nicholas Stern, ‘The Economics of Lockdown’, Fiscal Studies 41(3) October 2020), pp. 493 – 513.
Business, Finance, Politics, Science, Strategy

Value(s) by Mark Carney: Chapter 9 The Covid Crisis: How We Got Here: Key Takeaways / Analysis / Citations

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Chapter 9 The Covid Crisis: How We Got Here

Key Takeaway

This chapter discusses the discovering of COVID and all the other asks of this pandemic that we are all very familiar with. Carney was the governor of the Bank of England until February 2020. Economic and family priorities. 

The Covid crisis emphasized:

  1. Solidarity: companies, bank, society
  2. Responsibility: for each other, employees, supplies, customers.
  3. Sustainability: where the health consequences skew towards seniors while the economics consequences skew towards millennials and Gen Z.
  4. Fairness: sharing the burden, providing access to care.
  5. Dynamism: restoring the economy with massive government intervention and private sector resurgences…..

Duty of the State:

Carney goes through a review of political philosophy from Thomas Hobbes (1588 – 1679) to John Locke (1632 – 1704) to Rousseau (1712 – 1778) to suggest that in exchange for giving up certain freedoms, the state promises to deliver protection to its citizens. Much the same with central banks; that the public gives up the detailed nuanced control of the money supply in exchange the financial system delivers prosperity. 

Capacity of the State must have: 

1) legal capacity: ability to create regulations, enforce contracts and protect property rights: these include social distancing regulations that aimed to reduce transmission of COVID 19; 

2) collective capacity delivering services;

3) fiscal capacity: power to tax and spend: state capacity has moved from 10% of GDP to 25% to 50% of GDP with corresponding services to protect citizens from COVID 19.

Other Points:

  • Poor compliance in democratic societies;
  • Stock piles were not restocked;
  • Bill Gates Ted Talk from 2015 was not actioned by any one actor;
  • Many countries didn’t have PPE and depended on China’s production initially; 
  • No country is really prepared for this particular kind of pandemic;
  • South Korea had a pandemic in 2015 and Carney repeats the often mentioned success of South Korea through contact tracing and geo-targeting of users;
  • Governments need to be better at coordinating: there were departmental territoriality;
  • In simulations for pandemics this was very evident.

Cost-Benefit Analysis for Hard Choices:

  • There was a weighting of variables to decide whether to lockdown or otherwise.
  • The effects of lockdown: domestic abuse were hard to do that. 

Calculating the value of a human life: is hard to do. But there is actuaries to put the intrinsic versus investment value of a life or the net present value of all future cashflows that person is predicted to generate. Life is priceless. Sometimes the calculation is about the productivity of the person in life…..

Schelling’s “The Life You Save May Be Your Own” points out that the value of a life principally the concern of the person living it. Value of a Statistical Life (VSL) became the industry standard. The example Carney provides is the a risk of death in a high-risk job might be 1 in 10,000 and employees receive $300 of danger pay, therefore the VSL is $3,000,000. There are several other methods: 1) stated-preference, 2)hedonic-wage, 3) contingent etc. And different countries use different metrics in similar circumstances. In Canada, the estimated range of a human life is $3.4M to $9.9M CAD meanwhile in the US, the estimated range of a human life is $1M to $10M USD. Healthcare looks at quality-adjusted life year (QALY) and cost-utility versus cost-benefit analysis. Schelling’s assumption about how a person can evaluate the value of their life. VSL usage is a moral choice. Wealthcare many not be measured properly according to Carney. Another model is the VSLY Value of a Statistical Life Year. The question remains: do all lives have an equal value or is it the number of life years should be treated as equal? 

Previous Chapter
Next Chapter
Introduction: Humanity Distilled Chapter 1 Objective Value
 Chapter 2 Subjective Value Chapter 3 Money & Gold
 Chapter 4 Magna Carta  Chapter 5 Future of Money
 Chapter 6 Market Society Chapter 7 Financial Crisis
 Chapter 8 Safer FinanceChapter 9 Covid Crisis
 Chapter 10 Covid Recovery Chapter 11 Climate Crisis
 Chapter 12 Climate Horizon Chapter 13 Your Values
 Chapter 14 Values in Companies Chapter 15 ESG
  

Analysis of Value(s) Part 2 Chapter 9 

  • While it is complicated, I would have liked Carney to have explained the system of money creation in simple terms as it pertains to the pandemic. The level of government issuance of support has been massive. It is imperative folks understand how stimulus money is created.
  • The perception that money is created out of thin air, subject to political pressures is not true. Zeitgeist and other explanations of the money system are warped thinking. There friends and family going around saying that central banks ‘just print money’ whenever it suits them…
  • Here is a good explanation of how the central bank enables money creation:   To support small businesses and citizens out of work: Is the government increasing tax or are they printing money during the pandemic? The stimulus money was not coming from new taxes so here the government raises through borrowing. The government issues treasury bills to three groups of savers: 

(1) public sector (other parts of the government, 

(2) the private sector (people and companies), 

(3) foreign entities.

The government agrees to pay those savers back with interest at a future date. In the short-term the government uses that cash sucked out of the economy in exchange for the treasury bills to issue stimulus cheques back into the economy. Keynesian economics says that the more stimulus there is, the more economic activity which enables more private savings which then fuels more transactions for bonds. The government can borrow, unlike an individual, through this system as long as the economy is growing at the same or greater rate then that of the debt. The economy is growing at the same rate as debt then the debt to GDP ratio will be stable. If the debt to GDP ratio is stable, then the government can argue for continued investment in its debt securities (ie. bonds).

An additional layer of complexity is that: (4) the source which is the Mint in Canada and the Federal Reserve in the US does not print actual paper money much any more but does indeed ‘print out of thin air’: electronic money, that is credited in the treasury department’s account. In exchange, the Fed then holds treasury bills. The key consequence of issuing too much money with this source (4) is inflation whereby more money in circulation is chasing the same limited number of goods available thus driving the price upward of the individual goods. The 10 year Treasury Note then starts to go up and inflation creeps in. In this case, the Fed needs to increase interest rates to counteract/dampen the purchasing of the demand side….. 

  • The fines for violating COVID rules have an earned media dynamic: we know that the virus is spread through gatherings where one ore more participants has the virus. When someone gets an ‘arbitrary fine’ it effectively markets better than other forms of advertising such as digital. The injustice of the fine is earned media.
  • There are Canadians under the false impression that government at the federal, provincial and municipal level are not allowed to make rules that ‘violate’ the Charter of Rights and Freedoms. Well, a constitution has to be enforced, my friend… 
  • This time will be different which was Carney’s number one lie in finance seems to be fillable here to say, why would you think that in a future pandemic in say 2055, that our children will be able to respond better then this time?
  • Just are Carney fails to explain how the central bank manages the money supply, he too here fails to give a basic description of the “obvious’ nature of the COVID 19 virus. Its unique gestation period in which it sheds without the host having any symptoms for T+7 days is very novel unlike other viruses that are initially extremely aggressive, for example, ebola or SARS.
  • The threat of future pandemics is very real until it isn’t at all. If COVID had the immune effects of HIV then the response would have been more severe in North America. However COVID can be contracted and the likelihood of death is 1 – 5% based on comorbidities. We’ve literally spent the last year talking about this virus. The next virus if it were HIV but airborne, the human race would be in full black plaque mode. Freedom loving + scientific illiteracy are a potent weapon.
  • Lack of understanding the characteristics of the virus.
  • In ability to connect barriers that create friction such as laws, walls and masks have the underlying same logic; they do not prevent all the negatives from happening but laws, walls and masks make the unwanted thing from happening, obviously.

Citations Worth Noting for Part 1: Chapter 9:

  • John Locke, A Third Concerning Toleration, in Ian Shapiro (ed.), Two Treaties of Government and A Letter Concerning Toleration, 1689.
  • Jean-Jacques Rousseau, The Social Contract.
  • Thomas Piketty, Capital in the Twenty-First Century (Cambridge, Mass.: Harvard University Press, 2014).
  • Derek Thompson, ‘What’s Behind South Korea’s COVID-19 Exceptionalism?’, Atlantic, 6 May 2020.
  • A.E. Hofflander, ‘The Human Life Value: An Historical Perspective’, Journal of Risk and Insurance 33(1) (1966).
  • Cass Sunstein, The Cost-Benefit Revolution (Cambridge, Mass.: MIT Press, 2018): OECD (2012).
Business, Finance, Politics, Science, Strategy

Value(s) by Mark Carney: Chapter 8 Creating a Simpler, Safer, Fairer Financial System: Key Takeaways / Analysis / Citations

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Chapter 8 Creating a Simpler, Safer, Fairer Financial System

Key Takeaway

The Problem with Humans versus Objects – Determinism:

Carney makes the classic case that value measurement losses sight of intrinsic or objective reality and then there is a burst of the bubble and wealthy people lose their shirts. This touches on the central thesis of Random Walk Down Wall Street. Many economists have this instinct to try to explain reality by convincing themselves and then others that people are perfectly rational actors. Carney points out that this rational actors theory is wacky: adding that economists envy physicists and engineers, economists love neat equations and want a deterministic model of reality but that’s just too bad, economist! Determinism, meaning that any input will have a predetermined outcome in the model, doesn’t work when the subject of your experiment has agency/choice. Try telling a toddler that they are rational! Lol.

Sir Isaac Newton said it best: “I can calculate the motions of celestial bodies, but not the madness of people. ” Now, fun fact, Newton wrote that having lost a huge investment by speculating in the famous South Sea Company which basically involved misleading investors into thinking that the British empire had opened up South America to trade when in reality, they were actually capped at 1 ship per port per year in South America….But of course, human being aren’t going to let facts get in the way of investment momentum that drives prices up! Get on the train, folks! And again, because humans are awesome, we will #$ck with you’re predictions whether you like it or not.

Case in point, not everything that is going up is a bubble. Value that is disconnected from fundamentals of accounting are more likely to be a bubble says Carney but there are no guarantees. The investment could be a castle in the sky or just a really good investment…

2008 – 2016 UK:

The lost decade in the UK where there was political fragmentation of the economy is from 2008 to 2016, according to Carney. The real household income did not grow in the UK for that decade (technically 8 years…but whatever). There was a decline of trust in experts. Finance lost its integrity, prudence and became more protectionist. It came crashing down on the poorest in the financial crisis as discussed in the previous chapter. The G20 had to make radical adjustments and reforms. Value was disconnected on the way up and re-calibrated on the way down. 

No, I’m not gonna put Thug Life shades (sunglasses) on Queen Elizabeth II. I have some modicum of decency left in me. I thought about though…

When Queen Elizabeth II asked:

“Why did no one notice the credit crisis?” The answer: signed by 33 distinguished economists said ‘it was the failure of the collective imagination of many bright people in the UK and internationally to understand the risk of the system as a whole.’

So another factor is certainly, the lack of systems thinking! What I do may not have a positive / negative impact on me, but it could have a positive / negative impact on others. 

The decline in the trust for experts comes from experts being: 

  1. too academic and therefore disconnected to practical reality… 
  2. simply creating bearers for others to understand their view point and choosing to capture value instead of communicating valuably. 
  3. Unable to see the credit crisis coming…
  4. Lack of systems thinking / solidarity / or, in other words, the reliance on the invisible hand / free market as infinitely wise. 

The fault lines were:

  1. too much debt;
  2. excessive reliance on markets for liquidity;
  3. Complexity in derivative markets;
  4. Huge regulatory risk,
  5. Misaligned banks and imitators. 

Getting Global Support for Reforms: G20 finance ministers backstopped the entire system. 

G8 treasury leaders. They didn’t think that the system would self equilibrate as a solution. As such, they created a new plan with the FSB (financial stability board). It is the United Nations for finance. Mario Draghi had an immediate impact on the financial system as the chair. The FSB developed over 100 reforms. And Mark Carney succeeded Draghi as chair of the G20.

Chairing the G20 Finance Stability Board comes with several important lessons:

  1. You must have a clear vision; you need political backing. FSB has the power to recommend reforms, however the national legislatures must put these reforms in place…
  2. You must get the best people you can around the table. Bureaucracy is not helpful here. The group is composed of central bankers, regulators, finance ministers….
  3. You must build consensus that entrenches ownership. Dany Rodrik sees an intractable problem here: a trilema of economics, democracy and sovereignty…We have a seeding or pooling influence. No country is obligated to implement these reforms however it is in everyone, globally that these reforms be implemented at the national level. Commercial banks were happy that “heads they win tails we lose” with the bail out but there were positive reforms made via FSB. 

Mark Carney’s Three Lies of Finance:

Financial crises happen frequently, if you hear someone say any of these lies, then take note: 

  1. “This time, it’s different”
  2. “Markets always clear”
  3. “Markets are always moral”
  1. “This time, it’s different”: what’s happening today is fundamentally different from all prior human history….Nope, don’t believe this lie. Usually, a new innovation is compelling because of its initial success, complexity and opacity. Solving the stagflation of the 1979s and 80s with new monetary stability that were democratic, effective, evident remits, strong governance….The Great Moderation from the 1990s to 2008s also paralleled, technological growth, non-financial consumption, such that it was easy to become complacent. And people assumed housing prices can only go up. This optimism is known at the business cycle. Carney refers to this as the Minsky moment: where lending is abruptly pulled back when financial experts realize there is a correct brewing and thus causes the economic downturn to more severe. In 2008, “Minsky went mainstream.” (186, Value(s)). 
  1. “Markets always clear”: at the right price, excess supply and demand will clear (ie. the supply will meet demand). Labour markets are efficient and clear? Sorry, nope they are rigid and sticky. If money is efficient, then they will reach equilibrium? Sorry, nope markets are incredibly ineffective in reality. Markets do not always clear because life is not a textbook. You can’t describe the real world because people are too complex for any mental or predictive model. Synthetic credit risk; the risk was spread all up. Panic ensues with risk being pooled. The real world is far more complex, we cannot anticipate all of human activity at any given time. Calculating every scenario is impossible, Newtonian physics doesn’t quite work in every scenario and physics doesn’t even involve tricky human beings.
    1. Keynes in General Theory shows that when having his students rank the prettiness of faces in exchange for a prize, it’s more important to calculate what the average opinion believes the average opinion is. Keynes noted that this is what happens in markets where everyone else was thinking, the derivative of the derivative of what other people will do matters more (subjective utility). Keynesian saw the instability is on spontaneous preferences, the full consequences are only based on animal spirits. The belief that markets are always right was what enabled the last bubble and the next bubble. Markets are populated by people however, fickle people.
    2. Cass Sunstein argues that 1) preferences in public differ to what is in our heads, 2) social obligations impact our acceptance of new things. For example, if 1000 people protest something, then we will be more amenable to that something as well. Read: Robert Schiller’s Narrative Economics. Critical mass opinion happens in finance as well. The Minsky cycle works on average and average opinion. How do markets become more differentiated? There is a spontaneous urge to make a decision rather than a complex weighted calculation of the mathematical benefits x the probabilities of a given consequence of the decision…
  1. “Markets are moral”: FICC (fixed income, currencies and commodities markets) have a lot of fraud in them even though they determine the cost of resources, food, housing, government debt prices etc. The commodity squeezes in rye in 1868, cocoa in 2010, and ‘wash trades’ in Manhattan Electrical Supply on 1930 and the Tera Exchange in 2014 show a recurring phenomenon. There have been a lot of squeezes. Planted rumours to drive up a cost happens frequently wherever traders are bored or desperate. Tweaking LIBOR and FX involved manipulating these foreign exchange benchmarks rates for the interest across firms at the expense of retail and corporate clients in the billions. Technology evolves and laws are passed. Engineers of the subprime crisis were clubby and colluded online, globe bank misconduct costs were $320 Billion for $5Trillion of assets. People were colluding online and few were held to account. And there was no rush to take the blame. Trust in the UK went from 90% (1980) of UK citizens thinking banks were well run versus 20% (in 2008). Financial firms help the real economy. The FICC markets, markets are ever more important to people. FICC markets can go wrong with poor regulation. Carney argues you need Hard infrastructure (regulations, foreign exchange benchmark objectivity) and Soft infrastructure like corporate culture, informal codes and policy handbooks. Light banks. Central banks participate in fire insurance. Mistrust between companies and hesitate to invest in firms. FICC infrastructure is key, soft codes of infrastructure, weak banks. Relies on informality. 

Carney argues that the solutions are the following: 

  1. Trust: G20’s Financial Stability Board helps by acknowledging that the market is amoral and will not always clear  by instilling greater trust, less complexity.
  2. Smarter: Ensure traders remain pro-market (shouldn’t be a problem) but support smarter regulation. 
  3. Avoid Lies: Ensure financial professionals avoid the attractiveness of the 3 lies. 
  4. Realistic: Recognize that regulation will not bust the cycles since innovation is always happening but ensure that  regulators be understanding. Implement policy that make real markets more robust with market infrastructure that creates the best markets for innovation.
  5. Transparency: In 2008, Over the Counter derivative trades were largely unregulated, bilaterally settled (closed door) and unreported, but now 90% of new single currency interest rate derivatives are centrally cleared in the US i.e there is transparency. 
  6. Systems Thinking: Ensure financial professionals recognize the importance of protecting the system as a whole.

Risks in Emerging Markets are a danger for another financial crisis where the lie that markets always clear continues. China’s economic success contains a lot of shadow banking (SIVs, mortgage brokers, finance companies, hedge funds and private asset pools), there are lots of repo financing, major borrowers and banks with significant opacity. There is now a worrying amount of debt in China that could leave Ray Dalio reevaluating his career choices once again. There could be a major margin call / run on Chinese assets, with first mover. There will be mismatches of markets. There could be a rush to get out of the Chinese market: this is the risk of being trapped when the assumption that markets will always clear (buyers and sellers will find each other) is exposed as wrong. Cyber to crypto crises could also trigger another financial crisis.

Risks in Illiquid Assets treated as if They Are Liquid:

New risk is the global assets under management of $50 trillion in 2010 to $90 trillion in 2021. But $30 trillion is promised to be liquid when it is illiquid assets. Carney’s addressed this problem of not having consistency between liquidity of funds’ asset versus their redemption terms while he was governor of the Bank of England with the help of the FCA (Financial Conduct Authority):

1) liquidity of funds’ assets should be valued as either a) the price discount needed to do a quick sale of a vertical slice of those assets OR b) a time period needed to sell the asset without a price discount. 

2) Investors who redeem get a price for their investment that mirrors the discount required to sell a proportion of a funds’ within the special redemption notice period;

3) the “redemption notice period mirror the time needed to sell the required proportion of a funds’ assets without discounts beyond those caputed in the price received by redeeming investors.” (196, Value(s)). 

During the 2008 crisis: 

  1. Liquidity disappeared with cash-powered banks refusing to lend;
  2. There was a ‘run on repo’ which increased the haircuts on collateral to de-risk counterparties which were shadow banks that then collapsed;
  3. In Europe, the debt crisis compounded these problems driving up nationalist sentiments…

There is now the liquidity coverage ratio and net stable funding ratios…but there are weaknesses with US repo market troubles in 2019- 2020. The Fed’s open market operates calmed down…Carney doesn’t know where the next bubble will burst but he has a few ideas.

Bagegot’s principal of being the lender of last resort thus preventing short-term liquidity shortages from causing wide spread insolvency.

Bank of England presentation by Mark Carney…

Central banks have challenges:

  • Figuring out if the firm is solvent when the market is against that firm’s assets and the market can be wrong longer than that firm can stay liquid;
  • What constitutes good collateral, can always lend government bonds and in the 2008 crisis, it didn’t appear to have an impact on the functioning of the system, banks horde
  • The penalty rate means the firms come late because it convey weakness.

Central banks have now moved to doing transparent auctions of liquidity to many counter-parties which includes banks, broker-dealers, an central counterparties in the derivatives market. Bank of England has a contingent term repo facility….

An Anti-Fragile System – This Time is Different – What Was Done to Banks:

  • Public trust was harmed most by the mantra of too-big-to-fail banks. 
  • Banks didn’t pass lending out enough which amplified inequality. 
  • Privatization of profits while socializing the losses harmed trust.
  • Public paid $15 trillion in bailouts, government guarantees against bank debts and special central bank liquidity projects….. 

G20 FSB brought in standards to create an anti-fragile system:

  • Banks are less complex. 
  • Banks have a ‘living will’ and are reorganized so they have a firewall between the banking that continues to serve families and business even if their investment banking division is imploding. 
  • Trading is less between banks thus shifting to lending to customers.
  • Public funding has dropped by 90% post-crisis with market discipline…
  • Senior leadership can be expected to bare the cost of failure.
  • Can’t legislate virtue but can legislate incentives around how senior leaders train staff.
  • Improving cyber penetration attack resilience. 
  • Looking for risks across the economy, thinking system level about where the next crisis is least likely to be and make sure that is focused. 
  • Macroprudential policy: addressing systematic risks….cyclical risk when the financial system loosens up, debt grows and complacency sets in, the Minsky effect is severe…
  • Macroprudential policy: addressing systematic risks…structural risks when there is a wbe of exposures to derivatives risk, which means the need to have liquidity buffers, restrictions on mortgage lending, shutting down the shadow banking approach.

Bank of England serves the purposes “To promote the people of the United Kingdom”

Restoring Morality to Markets:

Oscillating regulation, light touch versus total regulation. 

  • Aligning compensation with values;
  • Increasing senior management accountability;
  • Renewing the vocation of finance.

Longer-Term Horizons Focus the Mind: Bonuses in the UK are now managed with compensation by delayed by 7 years. If there is misconduct then bonuses can be clawed back, according to Carney. Business mission statements tend.

FICC Markets now have new guidelines:

  1. have clear, proportionate and consistently applied standards of market practice;
  2. are transparent enough to allow users to verify that those standards are consistently applied;
  3. provide open access (either directly or through an open competitive and well-regulated system of intermediation);
  1. Allow market participants to compete on the basis of merit; and
  2. Provide confidence that participants will behave with integrity.

Effective markets are those which also:

  1. Allow en users to undertake investment, funding, risk transfer and other transactions in a predictable way;
  2. Are underpinned by robust trading and post-trade infrastructure enabling participants to source available liquidity;
  3. Enable market participants to form, discover and trade at competitive prices; and
  4. Ensure proper allocation of capital and risk.

Drawing on the Magna Carta:

Having the right principles is essential. Keep pace with the innovation. Senior Managers Regime (SMR) individual accountability. Values need to be exercised like a muscle. SMR makes sure senior leadership is accountable even if many of them were involves in the 2008 financial crisis. Employees must be connected to their communities. 

Previous Chapter
Next Chapter
Introduction: Humanity Distilled Chapter 1 Objective Value
 Chapter 2 Subjective Value Chapter 3 Money & Gold
 Chapter 4 Magna Carta  Chapter 5 Future of Money
 Chapter 6 Market Society Chapter 7 Financial Crisis
 Chapter 8 Safer FinanceChapter 9 Covid Crisis
 Chapter 10 Covid Recovery Chapter 11 Climate Crisis
 Chapter 12 Climate Horizon Chapter 13 Your Values
 Chapter 14 Values in Companies Chapter 15 ESG
  

Analysis of Part 1 and Chapter 8

  • Mark Carney can look to Mario Draghi for inspiration since, Draghi is now the Prime Minister of Italy (as of 2021). Central Bankers can cross into the political sphere. Currently Draghi is trying to get bank mergers to happen in order to clean themselves up. So like Carney, using the power of politics to effect change is sometimes valuable where as a central banker, you cannot effect change. Analogies, and history does not have predictive power, Italy is very different from Canada, however it is instructive that getting into a position of power may not be a high hurdle for Carney. Finance catteacts people with no socience training, because they are looking for absolutes. These folks lean deterministic. 
  • A bit odd that the Senior Managers Regime (SMR) doesn’t really connect because the people who self-select to work in banking are frequently math. The problem is that the people with the experience made decisions in the financial crisis that seem to benefit themselves disproportionately company to the general public. It is similar to having doctors make decisions for hospitals, there is a conflict of interest in being in control and regulating oneself. 
  • Perhaps the bad behaviour is in Crypto…
  • Great economic shocks cause institutions to recalibrate and reform. It isn’t the individual actors that drive such change but rather macro externalities where no one internally can be blamed that cause reform. 

Citations Worth Noting for Part 1: Chapter 8:

  • Carmen M. Reinhart and Kenneth S. Rogoff, This Time is Different: Either Centuries of Financial Folly (Princeton: Princeton University Press, 2009)
  • Raghuram Rajan, Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton: Princeton University Press, 2010). 
  • Hyman P. Minsky, ‘The Financial Instability Hypothesis’, Levy Economics Institute Working Paper No. 74 (May 1992). 
  • https://www.youtube.com/watch?v=PIRHM_Dz_fQ Adair Turner
  • Kenneth J. Arrow and Gerard Debreu, ‘Existence of an equilibrium for a competitive economy’, Econometrica 22(3) (1954). 
  • Gilian Tet, Fool’s Gold (London: Little, Brown, 2009) which shows that derivatives were distributed throughout 100s of balance sheets through the pooling and distribution of that risk. Similar in essence to a decentralized ledger.
  • John Maynard Keynes, The General Theory of Employment, Interest and Money (London: Palgrave Macmillan, 1936).
  • Wlater Bagehot, Lombard Street: A Description of the Money Market (Cambridge: Cambridge University Press, 2011). 
  • Financial Stability Board, ‘Strengthening Governance Frameworks to Mitigate Misconduct Risk: A Toolkit for Firms and Supervisors’ (April 2018).
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Value(s) by Mark Carney: Chapter 7 The Global Financial Crisis: Key Takeaways / Analysis / Citations

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Part II Three Crises of Value(s)

Chapter 7 The Global Financial Crisis: A World Unmoored

Key Takeaways

Re-Litigating the Credit Crisis:

The US was leading global growth as the G1 and centre of financial reliability. The UK had 14 years (56 straight quarters) of growth. Inflation was stable. The early 2000s were an age of terrorism-wary prosperity. It was a time of great expansion, technological progress, countries clamouring to join the EU, China joined the WTO but there were other signs of trouble, for example Al Gore’s An Inconvenient Truth was shifting public opinion, according to Carney. Nevertheless, faith in markets rather than the underlying assets reigned supreme. Risk was by-passed using masked pools. Although Carney didn’t see it coming (he was obsessed with the US dollar’s health), he notes that the 2008 – 2009 financial crisis nearly imploded the US financial system (Argentina-style 2002) with collateralized debt obligations (packages of risky subprime mortgages) and credit default swaps (insurance deals on those risky mortgages). Carney notes that there is a pattern, before the credit crisis there was the dot.com bubble where profitless firms listed themselves at immense valuations…Russian 1998 financial crisis, September 16th, 1992 Black Wednesday UK exits the Exchange Rate Mechanism…Black Monday: 1987, 1929…not everything that is labelled a bubble is a bubble however…but the big pop was the 2008 – 2009 global (US-centred) financial crisis and it’s not exactly just about CDOs….

The world was about to become G0 i.e. no longer US-led, according to Carney.

To understand consider the Bob Hirst Doctrine:

Bob Hirst was a partner at Goldman Sachs who told Carney years prior that: 

  1. if someone explains a concept or new innovation in finance the first time to you and it doesn’t make sense and then you ask for them to re-explain it and a second time it still doesn’t make sense, then you should run and or pick up your note pad in that meeting and just leave.
  2. The sales person is likely describing some financial alchemy or new version of the four most dangerous words in the English language: “this time it’s different” (page 155, Value(s)). Or possibly, the sales person doesn’t actually understand the alchemy in question themselves and they are too embarrassed to admit it. 
  3. The only dumb questions in finance are the ones that are never asked….which is a problem. 
  4. Carney recognizes that some financial pros do get lucky once in a while. Banks can sometimes copy and paste another bank’s strategy without understanding how that product actually works. But in a bear market, heads will roll or at minimum those responsible will run for the exits before the collapse….

Up in Canada, in August of 2007 the then deputy governor of the Bank of Canada Mark Carney got a panicked call from the President of Goldman Sachs Canada named James T Kiernan. The call was surprising,Carney knew Kiernan to not be a friendly chitchatter type. Kiernan was in fear that a crisis was brewing, the Canadian ABCP (asset backed commercial paper) market was in trouble: there were margin calls (a kind of run on the bank such that investors are demanding their capital to be withdrawn to safer havens) and liquidity back up lines were needed to be activated (capital injections from the central bank for example)….As the deputy governor, Carney’s first thought was ‘this was supposed to be a chill government post!’ In fact, Carney started out in commercial paper which is corporate debt that is short-term, matures in three to six months and is issued by successful large corporations. 

CP helps with raising short-term capital for new projects for that associated corporation. It’s a sleepy space in finance and few people “got rich doing CP” (page 153, Value(s)). But there was now a $32 billion corner on Canadian ABCP…..which is minor compared to the $500 Billion government (provies, munies etc) debt and $1.5 Trillion in equities on the TSX at the time. Canadian ABCP was being abused by cowboys. Unlike Banker Acceptance (BA) which is issued by financial arms of various successful corporates with a stamp for a Dealer/Commercial bank and Banker Discount Notes (BDN) which are backed by Dealers/Banks like TD, BMO, CIBC, Scotia, RBC and NB, Canadian Asset Backed Commercial Paper were created by Bay Street cowboys who pooled credit card debt from the likes of Canadian Tire and then mixed that in with other risky debt ie subprime mortgages…It worked because it was opaque and the assumption with ABCP was that it would continue to be rolled forward and not redeemed at maturity which was typical as Carney says, 3 months to 6 months. But August 2007, Canadian Asset Backed Commercial Paper was about to stop making sense the Bob Hirst sense.

How this Canadian ABCP snowballed into a serious problem in Canada: 

  • There was this reformed approach / alchemy that pools of diversified assets were better, easier to sell than a single commercial paper from a single company such that large pools of credit card receivables could be packaged and then sold into a SIV (off-balance sheet structured investment vehicle) which are small shell companies that can disappear easily.
  • That SIV (structured investment vehicles) would then issue commercial paper (short-term debt)…
  • As long as the total interest paid on the credit cards (including the defaulting credit cards) was greater than the cost of the commercial paper, money was being made.
  • The bank sells credit card receivables, gets cash and then issues new loans. 
  • The SIV owners make money on the spread (the bid-ask bargaining zone) between payments of credit cards and the interest on the commercial paper. 
  • Meanwhile investors would get returns on their capital allocations that were better than the interest from commercial paper of similar credit quality;
  • They get paid to monitor and analyze the underlying assets to ensure “this all made sense.” (page 156, Value(s)). However, for Carney, a good idea that makes sense today ought to be re-evaluated regularly. In the case of these CP pools, there were sub-prime mortgages that wouldn’t come due in the 3 and 6 months intervals of the credit-card debt. This became murky and was why Kiernan needed to freeze margin calls.

Three Types of Risk Involved: 

  • 1st, the first type of risk to consider with Canadian ABCP is liquidity risk. Liquidity risk deals with the ability to sell an asset or borrow against its value. When the market is deep, taking cash out from individual investors is easy and doesn’t impact the overall price in the market. But when markets are thin, taking cash out can be much harder since there is less liquidity (thin) to have a two-sided transaction. The market can turn shallow quickly.
  •  2nd, the second type of risk to consider with Canadian ABCP is credit risk where the underlying assets in the liquidity come due but there is widespread defaults (ie. the payments on the Canadian Tire credit cards aren’t being made). This can create a cascading impact on the inter-connected balance sheets of banks and trigger a financial crisis. 
  • 3rd, the third type of risk is disintermediation risk: Since ABCP was sleepy, the investors relied on the reputation of the SIV (off-balance sheet structured investment vehicle). But the problem was the SIVs relied on the credit track record of the bank managing the credit cards. While the credit rating agencies did their due diligence, there wasn’t a serious consideration around the quality of the underlying assets since the banks would issue loans and then put them in the market to be packaged away. The SIVs were far removed (ie. disintermediated) from the borrowers (ie credit card holders). There was a reliance on others in the system to ask the tough questions in good and bad times, and only when things went badly did true due diligence start. There was outsourcing of the moral hazard scenario. For Carney, the SIVS were acting like banks and the banks wanted the market to buy up their loans….

What Are Commercial Banks For: Carney details the function of commercial banks which is:

  1. To facilitate payments, the dumb pipes that make transactions possible…which is somewhat underthreat by new solutions…Stripe etc.
  2. To transform short-term liability (ie. deposits from customers which command interest payments) into long-term assets like (picking winners and losers) a loan to a small business or a mortgage which allows the homeowner to have a short-term asset and long term liability. This provides liquidity to customers by transacting at various maturities to provide efficiency in financial markets such that borrowers can obtain the lowest rate of interest based on their risk profile. The bank must necessarily mitigate the risk should depositors will all ask for their money at the same time which causes a run on the bank. The banks have deposit insurance which is calibrated to avoid moral hazard at the bank and there is the fail safe of the central bank can step in to be the lender of last resort;
  3. To connect savers with borrowers with good ideas to create economic growth: in other words, to allocate scarce resources to maximize profits by attracting savers seeking returns and giving to borrowers that can increase real value in the real economy.  

The Great Disintermediation:

Carney argues that there was disintermediation between what banks are meant to provide and what they were providing. They forgot that they aren’t an end in and of themselves, although it seems a tall order for any individual to accept their role as servant in this context. The reality however is that many innovations were created to boost the financial bets between dealer to dealer transactions which were zero sum propositions dueling as “masters of the universe.”

Markets and Banks in a Collision Course:

Banks (relationship based specialized solutions) versus markets (transactional based standardized solutions): Banks manage relationships with the customers. Markets require standardization (low touch, limit orders) while banks love specialization (high touch and bespoke). Markets are transactional and connect savers and borrowers but markets aren’t relationship based.

For Carney, there were several issues at play in the crisis.

  • First, banks were over levered as they moved towards short-term markets to fund their activities such as Repo, Commercial Paper and Money Markets. 
  • Second, banks used securitization markets again like Asset Backed Commercial Paper (ABCP) to do both the relationship side and the transactional side. Banks were taking specialized loans and packaging them as transactional pools/packages. 
  • Third, they moved into investment bank and proprietary trading which increased conflicts of interest with their client base. 
  • Fourth, Banks broke the system by taking the originate-to-distribute business model where specialization/relationships were packaged into standardized products that could be transacted as AAA rated because no one knew what was in them. 

Northern Rock business model was this originate-to-distribute business model. Beginning as a building society, which issues mortgages fueled by payments from other mortgage lenders, Northern Rock pivoted into a regular bank in 1997. And their values effected value.

Rise of Shadow Banking and How Subprime Mortgages Impacted Canadian ABCP:

At the same time, markets moved into bank principally maturity transformation and credit intermediation through investment vehicles called the Shadow Banking system: SIVs, mortgage brokers, finance companies, hedge funds and private asset pools. Complacency drove a herd-like mentality that is common in finance generally. Then there was greed that began to bubble up as the bankers sought better returns. SIVs crammed into subprime mortgages into these ABCPs. ABCP made sense for a long time before it didn’t. As is well documented, packaging securities such as credit card debt, mortgage debt and other debt into new entities became commonplace and it became so murky you couldn’t tell what was in the underlying asset. The original idea made sense but then the bankers started to package subprime mortgage into these stable asset classes such as credit cards which are paid monthly while mortgaged take a lot longer to come due…. Creditworthiness relied on math that calculated the overall pools ability to reduce risk by having diversified pooling ie. the CAPM! BUT subprime was particularly screwed up in a downturn because strippers could buy 5 houses with Ninja Mortgages. The managers of the SIV’s balance sheets would put the assets to work by mimicking London and New York explosion of synthetic derivatives. The key was that these Canadian ABCP managers were selling synthetic derivatives to the London and New York firms and back this up with collateral from their ABCPs which meant that $32Billion in assets could balloon to be $200Billion in leverage. 

Thoughts on Derivatives:

Carney wants to make clear that traditionally derivatives are considered an effective way of shifting risk as it is a bet on the underlying asset that is independent of that underlying asset. It allows the transfer of risk from one entity to another that is better able to handle that risk. Mesopotamia farmers were using derivatives on clay tablets to ensure that a farmer can agree to sell their crop in the spring to be sold in the fall for a set price. The farmer is protected by an uncertain outcome but the other side of that transaction could be harmed or benefited depending on how that season goes.  

In Mesopotamia 5000 years ago (modern day Iraq) farmers were doing derivatives contracts on clay tablets to lock in the sale of their crop in the spring for that coming fall at a set price regardless of how the market price for that corp changed between the spring and fall. With interest rates, it is the same principle but with interest rates rather than the price of a corp being the risk that fluctuates.  

Carney notes that by the mid-2000s, banks were no longer providing home loans based on their balance sheet of liquidity and capital constraints but rather on how quickly they could get that loan into the market by selling it into a securitized pool. By 2007, it wasn’t clear who you might call about the mortgages in question as they were pooled haphazardly regardless of the specialization and catering to the end customer. Since banks were keen to engage in risk averse trading, they locked in a derivative to protect against defaults on these potential pools should the mortgage default rate rise. But that only works if the supplier of the derivative can pay out the mortgage if it goes bad. Bankers became increasingly dependent on stacking more and more risk on top of itself. If the derivative supplier defaulted well then there was also as for collateral known as margin (Credit Default Swaps). More risky the position, the more collateral was required.

For Carney, the problem is that few people looked at the whole system. This is what happens when you have overconfidence in markets to solve these problems. Markets built upon Markets. Trying to solve market problems with more markets doesn’t always work. Or was it a crisis of moral hazard? Shareholders didn’t do the hard work. No one calculated the risks. The risks they thought they had off the balance sheet…The problem was that no single actor knew this was actually happening, really. And this was also widespread….. 

Disintermediation between Finance and the Real Economy:

Significant GDP growth in the era was through these activities which were predominantly between banks and other institutions rather than between banks and the real economy…The regulators didn’t understand what was going on. The total value of the commercial paper market increased by more than 60% and the ABCP market increased by 80% in the three years prior to collapse…

Things Fall Apart:

Back to Carney’s personal story, in August 2007, the Canadian ABCP market was going to collapse even though the underlying assets were relatively balanced to the liabilities. The Commercial Paper investors wanted their assets out as there was a subprime crisis brewing in the US and the SIVs had pooled subprime mortgage into these ABCP. Unfortunately, it turns out that these assets had been pledged as collateral for credit insurance. The credit insured was able to collateralize up to 10 times the actual assets. London firms were holding $200 billion in Canadian credit exposures on underlying assets that were only $32 billion in value. The wider screwup was about $600 billion which was more than half of Canada’s GDP in 2007….These folks were just the start of a global crisis across the US, UK Europe….The market value of the subprime mortgages was under pressure and credit funds were now suddenly talking about pricing based on the underlying assets (objective value) rather then the market price / value of the assets (subjective value). 

Therefore, those holding credit insurance from Canadian ABCP asked for more collateral, but the only way the ABCP could provide more collateral was if they issued more commercial paper and sold additional assets…this was precisely what the Canadian market didn’t want to do….

London banks knew if their margin calls weren’t met, they would immediately have massive exposures to credit on their balance sheet that they thought they had insured away. This explosion in the size of their balance sheet would be happening just as the investors and creditors started demanding answers about subprime mortgages. So a deal was possible merely because self-interest aligned not because of value(s)…..

The European Central Bank, the Governor of the Bank of Canada David Dodge, the Canadian department of finance, Henri-Paul Rousseau from Caisse de Depot et Placement du Quebec (Caisse) were able to convince the London and New York firms to stop their margin calls and prevent new issues of commercial paper. There was a freeze and the crisis was averted that summer. Carney hired Purdy Crawford to help prevent a catastrophe triggered by Commercial Paper. Investors eventually receive 90% of their investment rather than the 20% that was expected. 

Global Financial Crisis:

In light of the Commercial Paper market near collapse in Canada there was a more well known crisis brewing with shell companies insuring enormous exposures. There was spiral as the markets were built on markets that assumed an upward future no matter what: leverage was more significant similar to the Canadian ABCP example. UK and US banks balance sheets went from 15x to 40x (169, Value(s)). Shadow banking had masked huge leverage and large contingent exposures. When margin calls couldn’t be met, the banks turned to money markets to support their cash needs but they were also major purchasers of ABCP….There was no sensitivity analysis in place. The opacity, complexity caused even more panic than was properly required according to Carney. The damage in the end was 5x larger than the original subprime mortgage crisis. $200 Billion became $1Trillion. 

The Disembodied Grows Faster than the Underlying Asset:

There was a clear disintermediation between the general economy in the banking system. Overtime the banking system was no longer serving in the interest of connecting borrowers with lendersMid-level Traders would hedge out, so they would stretch out risk to the future. This was disembodied work. When bankers become disconnected, the LIBOR setter became obsessed with the number and not the underlying system. 

Short-Termism:

The value of the short-term was everything, the future didn’t exist. The ethical foundations of finance are weak. The financial community cannot see the consequences of their actions the way a teacher or nurse does with student and patients respectively. 

Investors were seeking to sell the risk on, until there were several layers of disconnection. On the way up value was disembodied, on the way down value was further warped. 

They turned to the state and self interest was manifested. The crisis was painful because we didn’t have the chance to fix it. 

Five lesson of crisis management during a financial crisis:

  1. The market can be wrong longer than you can stay solvent: no one agrees with objective value doesn’t work in a crisis. When markets collapsed, and the underlying assets were only worth 25% of what they were labeled then the banks holding those securities would be insolvent. So what was a liquidity problem became an insolvency problem over night. 
  2. Hope is not a strategy: a plan beats no plan. Searching endlessly for the best is not realistic. When Carney was the head of the Bank of England, he expected “Remain” to win the Brexit vote however his contingencies building a play book for what could go wrong but not every possible scenario. It was better to have a bill insurance policy. This included ensuring the commercial banks preposition conlaterall with the Bank of England in order to underwrite the whole contingency. This enable the BoE to lend at least $250B to the banks, and it was the 4 times the size of the entire lending market to UK house holds the previous year. During the Brexit crisis, Carney was able to say “we are well prepared for this”
  3. Communicate clearly and honestly. You can’t spin your way out of this. Canadians know that the Fed and the Bank of Canada communicate regularly and Ben Bernake would be informing the BoC.
  4. There are no libertarians in financial crises, or no atheists in a fox hole: crises reveal the markets fail points. There was a call to shut the hedge funds down! According to the CEO, Lehman brothers was crazy. AIG was saved. Carney focused on the Canadian banks, they were the last stop before a barter economy. However much like a smoker Smoking in bed causes a fire, you would be worse off if you actually let the house burn down because adjacent properties might also catch fire and burn. The failure of one bank caused another bank. It had to be done quickly.
  5. Importance is Massive Action: resilience, reassurance is essential and the public need to be calmed by overwhelming force. What if the Bank of Canada didn’t act because the Harper government was not willing to act as they were in an election campaign? Carney needed to show that we would react overwhelming, and in coordination with the BoE, the Fed on an interest rate 50 basis point cut off. We needed a plan. In the case of letting the person who smokes in bed die, you bring on the risk that other houses might burn down in your effort to provide him that useless lesson since he is now dead. Better to let him live and teach him the dangers of smoking in bed. 

Closure on the Canadian ABCP Story:

When investors asked what’s in these pools of Canadian ABCP, the bankers( who were one step up from branch level) explained that they couldn’t disclose the source. When the crisis erupted, those same bankers who sold the cowboy products to those same investors had to provide “no opinion on the matter” and explain this was tough luck burning relationships permanently.  

The Washington consensus was flawed: Alan Greenspan had seen irrational arguments based on the fact that what he done had worked for the last 40 years and he did think he could lean into a bubble. Greenspan’s was partially wrong that some oversight. He was shocked that his expectations were dumbfounded. He didn’t address the expectations of a global market. Greenspan did rely on the self interest of markets. Greenspan felt that he had 40 years of experience that suggested too much government intervention is suboptimal. 

Emergency G20 Meeting:

At the meeting Brazilian Finance Minister Mantega complained about the stupidity of Lehman Brothers….Bush showed up and admitted he was wrong, and asked that central banks and finance ministers back and support the US in solidarity. Bush won the room. Mario Draghi told Carney after the meeting was over, that in 1990, Mikhail Gorbachev was asking Mario Draghi for advice, which Drahi took to be a very bad sign at the time. Bush was desperate like Gorbachev. The world had moved from G1 to G0. Could the US restore faith in its financial systems? According to Carney, only if they rediscover their values…..

Previous Chapter
Next Chapter
Introduction: Humanity Distilled Chapter 1 Objective Value
 Chapter 2 Subjective Value Chapter 3 Money & Gold
 Chapter 4 Magna Carta  Chapter 5 Future of Money
 Chapter 6 Market Society Chapter 7 Financial Crisis
 Chapter 8 Safer FinanceChapter 9 Covid Crisis
 Chapter 10 Covid Recovery Chapter 11 Climate Crisis
 Chapter 12 Climate Horizon Chapter 13 Your Values
 Chapter 14 Values in Companies Chapter 15 ESG
  

Before closing this chapter, I’ve added my notes from the Rotman Macroeconomics course attributed to Professor Dungan at UofT. 

“

Post-Lehman:  What Happened and How the Monetary Mechanism Has Changed

What Happened in the US – Very Simplified 

  • Highly risky mortgage debt was issued in US (also some European countries) 
  • Mortgage approval was split off from mortgage holding – a major incentive to approve excessively risky mortgages for the commission while not having to face the risks (Not having ‘skin in the game’)
  • Moreover, the mortgages were ‘securitized’ – packaged into securities that were supposedly highly diversified and which got credit ratings far in excess of their true riskiness
  • Banks in the US were eager to acquire these apparently safe but high-yielding assets in a scramble for returns when otherwise the long-short rate differential was very low
  • The US has thousands of small banks at the local level that are difficult to regulate closely and that find it difficult to diversify widely.
  • When Lehman failed, the market for the mortgage-backed assets dried up – the value of these assets was clearly diminished but there was no way to unload them or to value them accurately.
    • Moreover – banks were required to ‘mark to market’ their asset values
  • As a result, many US banks were potentially insolvent – they stopped lending to virtually everyone.  (“Credit rationing”)
  • This, and rates hitting zero, have changed US monetary policy instruments in a major way – see FRBSF ‘Economics Education
  • For decades, the relative stability of the ‘money multiplier’ was taken for granted;  it changed over time with the technology of finance and monetary operations, but the changes were generally smooth.
  • With the post-Lehman meltdown in the US, commercial banks began to hoard reserves – fearing for the soundness of their assets and the risks of any further lending.
  • In addition, the Fed could now pay interest on excess reserves – a source of risk-free return further helping soundness. 
  • The US Federal Reserve has supplied billions of new reserves to the system but, multiplied by a much reduced money multiplier, there has been relatively little growth in the true ‘money supply’.  While reserves have exploded, the money multiplier has imploded.
  • Much of the ‘inflation fear’ stemming from the Fed’s ‘adding hundreds of billions of dollars to the money supply’ does not recognize how the money multiplier has also shifted down.  Most of the Fed’s supposed money creation has gone to excess reserves.
  • Much of the ‘inflation fear’ stemming from the Fed’s ‘adding hundreds of billions of dollars to the money supply’ does not recognize how the money multiplier has also shifted down.
  • The Fed’s job will be to take back the extraordinary reserves as the subprime toxic debt slowly unwinds and a more normal money multiplier is gradually re-established.  (See (Optional) ‘Supersize Fed…’)

Why was Canada largely spared?

Canadian mortgage mechanisms generated relatively few excessively risky mortgages.

Canadian banks are large, diversified and more heavily regulated; they took on relatively little ‘toxic’ debt

Canadian banks have higher ‘capital’ ratios – the share of assets against deposits that must be the bank’s (shareholders) own equity.  They were not as ‘leveraged’.

The Bank of Canada has therefore had to intervene little to assist the banks, and the money multiplier, base money and the money supply are all much more ‘normal’

See KrugmanFeb012010 on Canadian banks

What is Quantitative Easing? 

  • With short-term interest rates at zero, how can the US Fed further stimulate the US economy?  
    • (When rates are zero and inflation only 1%, real rates are -1%;  Given the unemployment rate, the historical norm for the US would be real rates of -3% or -4%, but that is only possible when inflation is much higher and nominal rates do not hit the ‘zero bound’.)
  • The response was ‘Quantitative Easing’ – in essence, trying to increase the money supply further even though there will be no additional effect on short-term rates.
  • Under ‘Quantitative Easing’ the Fed bought a large amount of longer-term bonds (mostly gov’t); this should reduce longer-term rates, which affect longer-term Investment decisions.
  • It also increases the reserves of the banks, making it more likely they will do more lending (increasing the money multiplier) because they have more ‘safe’ assets (their reserves at the Fed).
  • Finally, it may increase expectations of inflation – but that works too, because it reduces the real rate of interest, both short and long.
  • See ‘Economics Education’ (FRBSF)

New Monetary Tools:

  • The other new tool of monetary policy is ‘forward guidance’ – letting the market know more concretely what the central bank intends to do; this can also help influence longer rates as they should respond to plans for future short rates.
  • Now that the Fed has massive assets, and there are huge ‘excess reserves’ in the banking system, the mechanism for changing the key Fed rate changes (although the underlying principle is the same).  The Fed has announced it will only sell off the assets acquired under QE when monetary conditions and interest rates become more normal.
    • See Fed Interest Rate Mechanism after the Crisis – Journal of Economic Perspectives (JEPFall2015…(Optional))

Should Central Banks Target Asset Bubbles?

  • After 2008 (and even before that) some analysts have accused central banks of not doing enough to deflate asset bubbles – even if tighter money would not otherwise be warranted by the level of inflation or the state of the overall economy.
  • But an emerging current of thought is that other tools exist that can be used to attack asset bubbles without forcing restrictive monetary policy on the non-financial side of the economy – these are usually called ‘macro-prudential’ policies and include regulations limiting risk taking, forcing higher equity ratios, reducing margins, etc.
  • See:  Narrow Path – Monetary Policy & Asset Bubbles ECJun212014 and  Low Rates vs. Financial Risks   ECSep262015

Negative Rates and Helicopter Money? 

  • Very recently (Japan & Europe) some official rates and some market rates have gone negative.  If inflation is negative, or expected to be so, this can still mean a positive real rate – so Japan is no surprise; but the negative rates have a bigger effect in Europe.
  • Effectively, banks and other financial institutions are paying a ‘fee’ to work in electronic balances, rather than in literal ‘currency’ (which has a zero nominal rate);  But there are limits to how far the negative rates can be pushed:  See ‘Limits to Negative Rates’ ECFeb062016
  • Discussion is emerging about ‘helicopter money’ – literally giving people more money; Effectively this also involves fiscal policy (taxing and spending by governments) and how it is financed.

See ‘Money from Heaven’  ECApr232016

  • The most recent issue is whether central banks should increase their inflation targets (say to 4%) or move to a different target altogether (the most popular is ‘nominal GDP’).  The reason for 4% is that then basic interest rates could be 5+% in ‘normal’ times and there would be room to drop rates a lot to counter a recession – given the zero interest rate limit.  

See ‘When 2% is not Enough’  ECAug272016

”

End of Rotman MBA Notes

Analysis of Part 1 and Chapter 7

  • Notice that the person who clued Carney into the Canadian ABCP crisis is someone he had worked with at Goldman Sachs, Jamie Kiernan. Networks matter. Networks shape how decisions are made. Hence the desire to take human decision-making out of central banking through first effort BitCoin-type solutions…which have their own problems etc.
  • Carney is definitely hitting the nail on the head when it comes to system’s thinking versus individual thinking. We, as animals, aren’t very good at thinking about systems at all. And even if you give people a bird’s eye view of a system, they lose interest if there isn’t anything shareworthy, shocking or otherwise entertaining about that system. We talk about a single issue at a time in isolation. Our brains are unable to model the entire set of policy options. People who really dig board games are slightly better at this because they are exercising their systems thinking. Traders aren’t incentivized to think at the system level, neither are nurses, doctors, police, teachers etc we only address the breakdown in a system not when it is at risk of breakdown. And when it is at risk, there are strategic bets being made that it won’t breakdown versus something else that should be prioritized.
  • This chapter is a nice re-examination of the oft Monday-morning quarter-backed Financial crisis which features prominently in film, television and academia. 
  • Good ideas make sense but then get abused and stop making sense, at that point self-interest sets in to running away while Carney fails to detail what should a banker do when something stops making sense?
  • The Ben Bernanke analogy that it is better to wake the smoker in their bed and put out the fire before it engulfs the house and the neighbourhood is an illustrative analogy but it does not have predictive power in how might the financial crisis play out absent the government bailouts. This is particularly evident in the clue Carney leaves that the overall size of the subprime mortgage crisis with more like $200 Billion and not the $1 Trillion that it ended up being. If the crisis had an its course with the network of bankers saving themselves from total disaster then it is possible that the $200 Billion would have been self-containing and correcting or much less than the $1 Trillion price tag….we will never know whether a depression was truly avoided because it didn’t materialize partly due to the interventions of the government…the ultimately political discussions centre around known-unknowns. We know that there are alternative courses of action, we don’t know how those options would play out because we only have one version of events.
  • The amount of regulatory oversight has always been limited by the fact that you can’t attract the best people to work in regulation because the best people are typically attracted by returns from hard work in the market. 
  • What happened with Canadian ABCP could have been used to warn other global actors about a heavily over-leveraged derivatives market.
  • How has the Canadian GDP gone from 1.2 Trillion to 1.7Trillion in the last 10 years? If that is real, then who is getting all that benefit of the additional $500Billion?
  • Wouldn’t it seem evident that people who have the least amount to lose in the medium term are those who expect to retire in the short term? If so, how do we ensure against, undue risks taken by those in the senior leadership who are typically command the resources of the firms they have risen up within? Bankers change jobs, get promoted, the decisions they make may not have material consequences until after they have left their role or even retired. How is asking for morality going to have a material change? The bankers didn’t even know what was going on, they were fixed on price in many cases. The mortgage lenders gave the stripper with the 5 houses because they were able to….where is the Big Short story in Carney’s narrative. Interesting to hear this CP story as it wasn’t the focus in my MBA which was well after the crisis….
  • Citations Worth Noting for Part 1: Chapter 7:
  • Mark Carney, “What are Banks Really For?”, Bank of Canada speech at the University of Alberta School of Business, 30 March 2009.
  • Larry Summers, “Beware Moral Hazard Fundamentalists”, Financial Times, 23 September 2007.