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

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. 
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.

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

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? 

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).

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

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. 

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).

Value(s) by Mark Carney: Chapter 7 The Global Financial Crisis: Key Takeaways / Analysis / Citations

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…..

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.

Value(s) by Mark Carney: Chapter 6 The Market Society and the Value of Nothing: Key Takeaways / Analysis / Citations

Chapter 6 The Market Society and the Value of Nothing

Key Takeaways

The way we value the market has bled into how we value everything in society and that is harmful to public policy, society and quality of life. 

Gift giving is an emotional value that cash cannot measure. Economic value is commodification these days. The reality is market value is taken to mean intrinsic value (the net present value of all future cashflows). And so in the market society, they know the price of everything and (try) to calculate the value of everything. 

There is another way to view reality. Relative equality is better for society, more opportunity distributed to as many people as possible is better for GDP and for happiness within society. Inequality has a negative impact on economic growth. 1% Gini-point increase in inequality leads to a 6% increased chance that economic growth will fall in the coming year. Carney pulls out some social science research (warning: difficult to base conclusions on data science that involves human subjects as we aren’t always rational and will defy expectation because we are awesome creatures!). Carney shows that inequality is bad based on the IMF research etc…over the long term. In the short-term, inequality is shown to be positively correlated to GDP growth. 

Carney believes that happiness is the key to life, not just money. He lists the keys to happiness:

  1. Mental and physical health;
  2. Quality of relationships;
  3. Sense of community;
  4. Job satisfaction;
  5. Income/money;
  6. Society status (freedom, government performance, peace)

A little bit of money to the less well off can truly boost GDP. For example, after about $75K USD a person’s happiness is not necessarily improved with that much more money according to Milanovic’s Capitalism Alone. Happiness does not equal just prosperity. John Rawls veil of ignorance as in, if you were born again but didn’t know under what circumstances you were to be born, what kind of societal arrangement would you want….is the marker that Carney supports. 

Carney argues that Freakeonomics is incorrect when their authors argued that economics is morally neutral. Carney believes that economics is moral. He’s in good company. Adam Smith and Socrates also believed that economics is a moral science. Whether economists realize it or not, they typically are trading in a utilitarian approach of some variation: “to maximize the greatest benefit to the most people”. Utilitarianism is about the happiness of the most number of people according to Bentham. Carney’s point here is that economic growth maximization is not necessarily going to lead to the best welfare outcomes in society. There is a risk as Milanovic argues that the endpoint might be “utopia of wealth and a dystopia of personal relations.” page 137, Value(s).

Carney asks, what about:

  1. Distribution of the gains and losses or
  2. Unpriced benefits and costs related to the dignity of life…..

Carney believes the social capital (altruism, supporting each other, sharing) has been crowded out by economic capital, selfishness. John Kay’s approach is useful here. That the pluralism of capitalism enables a) creative trial and error testing of ideas where the bad ones disappear, b) entrepreneurial energy is focused on wealth creation rather than value capture/rent-seeking. 

Capitalism is the best way to organize society. China and Russia are have capitalism without democracy. A political capitalist society has 1) an efficient technocratic bureaucracy, 2) rule of law, 3) autonomy of the state. 

What was needed to build on the capitalist foundation is: 

  1. A competitive nation state in the form of Thomas Hobbes’ Leviathan. A state could ease these fears;
  2. The rise of the liberal state with a professional class of bureaucrats/civil servants;
  3. The welfare state from Bismarck to LBJ’s Great Society;
  4. Thatcher and Reagan’s revolution unlocked dynamism at the time. For Carney, red-tape, state ownership of commercial businesses, extensive regulations and the states interference in the markets needed to be shaken up. Pro-market ideas shifted the overton window such that the market society became conventional wisdom for Carney as he started out his career. Inequality rose and economic dynamism did as well. The right thinks the state gives too much where teacher unions are prioritized over students and the left thinks the state gives too little with small state arguments to push special interest groups. It’s a false framework.

The Tommaso Padoa-Schioppa Doctrine:

Carney worked with Tommaso Pado-Schioppa as the Italian Minister of Finance at the IMG/World Bank Annual Meeting in Dubai in 2003. His argument was that if the market is deep and liquid it will move towards equilibrium or that the market is ‘always correct”. Tommaso said that this ideal had gone too far. He argues that ”when we grant an entity infinite wisdom, we enter the realm of faith.” page 135, Value(s). In short, policymakers should not simply take their orders from the masters of the universe, the market is not infinitely wise. His major contribution is that:

  • Separation of linked spheres is healthy: The church and state should be separated because these two aspects of life ought not to contaminate one another because when they do it is depravity.
  • Political and economic activity is also linked but also separated. They may determine the fate of the other power and wealth and…..

The Social Contract is Breaking Down:

As Michael Lewis explains to the Princeton graduating class “Success is always rationalized. People don’t like to hear success explained away as luck – especially successful people. But you are lucky to live in the richest society the world has ever seen, in a time when no one actually expects you to sacrifice your interest to anything.” (page 138,Value(s))

Equality of opportunity has fallen as well. Social mobility: 

Gatsby curve. People who get rich generation by generation versus nouveau rich.

Why It Matters:

Carney argues for creating a foundation of inclusive capitalism: 

  • Dynamism: The dynamism is essential;
  • Sustainable: To align incentives between generations, there needs to be sustainability;
  • Trusted: Markets need to be fair in order to be effective and trusted;
  • Accountable: Individuals must be responsible or accountable for their choices. 
  • Solidarity: Citizens must recognize their obligation to each other, there is a need for solidarity.

The Financial Crisis revealed: 

  • Major banks were treated as too big to fail with a “heads I win, tails you lose” mentality;
  • Market benchmarks were manipulated for personal gains;
  • Equity markets support the technologically empowered over the retail investor.

Commodification or Hyper-Capitalist Society that Carney would like to Fix:

  • Erosion of the trust.
  • Money is not that glorious. 
  • Cheating in sports. 
  • Companies typically create shell companies. 
  • There are forced sellers. 
  • Traders only care about money, a crisis of culture. 
  • Voluntary system: payments take away the moral system. Money doesn’t solve all problems:Israeli day-care fines story: the lateness fee actually gave parents the license to be lade. 
  • Paying a child to read makes the act of reading work..

The thesis of the book remains: “How do we learn to be moral again?” – Rabbi Jonathan Sacks with a sprinkling of:

  • We need to grow our civic virtue: Civic virtues are grown, not drawn down. Nicomachean Ethics by Aristotle talks about cultivating virtue with practice…like a muscle that needs to be exercised regularly.
  • We need a scorecard of value: Cass Sunstein’s scorecard competition for all the values that are beyond capital but aren’t calculated in economics or aren’t valued.
  • We’re measuring value incorrectly: The idea that value is measured by the sum of all market prices it’s just wrong. 
  • Pragmatic centrism: Joe Biden says “don’t tell me your values show me your budget” Carney’s solutions are readily presented in this section but you have to expect that involves money being redistributed while presenting his investment banker credibility as amenable to incremental rather then radical and ineffective revolutionary change.
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 6

  • The citations are extensive because the claims are more normative (what ought to be the case). We have to wonder, finishing off this section, we should appreciate the analysis but where are the solutions; Woodrow Wilson might have stayed vague about the League of Nations but the hope is that Carney will delineate how you get a trader to “be more moral….”
  • Just as Carney takes us on a winding and fascinating journey to show that ‘money is a proxy for value’ so too does he inch by inch explain that ‘more money tends to lead to more problems after a certain individual threshold’ in this chapter.
  • While the claim that inequality in Ireland went down and the economic growth went up is obviously a data science play. There is no way to know for certain with statistically expressions which cannot reflect the complexity of reality, that inequality declines lead to increased GDP. The thesis is political which by definition means that because it was applied across the entire sample (a country) we cannot validate that inequality is the independent variable (decline in inequality) that drove the dependent variable (rise in GDP). So it is in the realm of “I don’t know if for a fact but I know it’s true.”
  • He has not read the Subtle Art of Not Giving A @$ck and others who view happiness as highly overrated. There is a strong conservative (perhaps) streak that says that the kind of thinking that focuses on making life easier, happier truly ignores the importance of cruelty, fear and unhappiness which can also serve to drive GDP or meaning in one’s life…in the proper dosage per person. 
  • How fair is a financial system that allows for people to put cash that they have saved up or inherited or otherwise to put that cash into the market and then get more money in exchange for risking that capital? 
  • “Greed, for a lack of a better word, is good.” Michael Douglas in Wall Street
  • Cue Matthew McConaughey in The Wolf of Wall Street
  • Carney worked at Goldman Sachs…where is the long list of transgression of that firm?

Citations Worth Noting for Part 1: Chapter 6:

  • John Maynard Keynes, The Economic Consequences of the Peace (London: Macmillan, 1920).
  • Joel Waldfogel, Scroogenomics: Why You Shouldn’t Buy Presents for the Holidays (Princeton: Princeton’s University Press, 2009) and the “The Deadweight Loss of Christmas”, American Economic Review 83(5) (1993).
  • Michael Sandel, What Money Can’t Buy: The Moral Limits of Markets (London: Penguin, 2012). 
  • Johnathan D. Ostry, Andrew Berg and Charalambos G. Tsangaride, “Redistribution, Inequality and Growth” IMF Staff Discussion Note (April 2014).
  • Abhijit Banerjee ad Esther Duflo, “Inequality and Growth: What Can the Data Say?”, Journal of Economic Growth 8(3) 2003. Growth and inequality are non-linear.
  • Shekhar Aiya and Chistian Ebeke, “Inequality of Opportunity, Inequality of Income, and Economic Growth’ IMF Working Paper No 19/34 (15 February 2019)
  • Albrto Alesian, Rafael DiTella and Robert MacCulloch, “Inequality and Happiness: Are Europeans and Americans Different?” Journal of PUblic Economics 88 (2004).
  • Richard Layard, Can We Be Happier? Evidence and Ethic (London: Pelican Books, 2020).
  • Brank Milanovic, Capitalism Alone: The Future of the System that Rules the World (Cambridge, Mass.: Belknap Press, 2019).
  • Steven Levitt and Stephen J. Dubnet, Freakonomics (William Morrow and Company, 2005).
  • A. B. Atkinson, “Economics as a Moral Science”, Economica 76 (2009) (issue Supplement S1).
  • Cass R. Sunstein, The Cost-Benefit Revolution (Cambridge, Mass.: MIT Press, 2018). 
  • Tommaso Padoa-Schioppa, Markets and Government Before, During and After the 2007-20XX Crissi, Per Jakobson Foundation lecture, Basel, 27 June 2010.

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