Friday, November 25, 2011

On the Enslavement of Debtors: Pros and Cons

Cultures and peoples have long been plagued with the problem of what to do with a man who is either incapable or unwilling to pay his bills.  In the old days, there was a rather widespread solution which was also a rather simple one, if also rather crude.  If a man sold off all his property and still could not pay his debts, he was forced to sell the only thing left which he 'possessed' -- himself.  He was sold into slavery to his creditors.  This practice was imminently logical and folded in nicely with the widespread institution of slavery as it existed for most of human history.

Now, there were certainly many other ways in which one might find himself enslaved which would in no way impugne his character, to say nothing of the abuses which were prolific in this system, and to be sure I would seriously doubt that there was any forethought given to the aspect of the situation which I am presently interest in.  Nevertheless, there was a certain 'upside' of this way of doing things that bears reflection giving our present circumstance.  Namely, an economically productive outlet was created to deal with those sorts of people who simply could not be trusted to manage their own finances or to pay their bills.  By the action of this practice, their activities were largely placed under the stewardship of those that could and would keep them mostly out of trouble.  Unless, of course, they happened to be shiftless and feckless enough that they became good, honest outlaws.  At any rate, there was a very strong incentive to stay out of debt and to carefully mind one's obligations.  Thus, the financial systems of the ancient world had at least one built-in mechanism to address a serious threat -- the activities of people who would outherwise have created havoc in the marketplace by rampantly stiffing creditors. 

Fast-forward a few thousand years.  By processes of which I do not pretend to know all the details, the West has decided that this practice should be abolished -- presumably because it violates basic human dignities.  Legal institutions governing bankruptcy now generally allow a debtor to discharge his debts by agreeing to give up all his assets to his creditors while retaining his own freedom, the creditors absorbing whatever residual loss remains.  Unless, of course, it is student loan debt, which may not be discharged through bankruptcy --  it is with the borrower 'till death or repayment do them part.  I suppose that even respect for human dignity has its limits.

But as the reader must by now suspect, there has also been a number of rather perverse outcomes in the financial world as a result of these changes.  Nowadays, rather than reducing the financially irresponsible to a position in society that will keep them from harming others and mostly out of trouble, or else truly exposing them for the ruthless brigands they are, the modern practice is to either put them on welfare and/or make them powerful statesmen and financial magnates. 

The Problem of Moral Hazard

The Problem of Moral Hazard in finance can be succintly stated as a situation with privatized gains coupled to socialized loss.  Heads, I win, tails, you lose.  There are a myriad of manifestations of this phenomenon --

  • Inflation, which benefits the inflating banks and their borrowers while harming savers and other holders of cash, besides creating the business cycle
  • Too-big-to-fail bailouts, which subsidize the risk- taking of large institutions by allowing them to reap whatever profits emerge from their activities, while pushing losses onto taxpayers when they fail
  • And, of course, government subsidy and other forms of welfarism which are self-explananatory

Modern bankruptcy is a major source of moral hazard.  It places a limit on the losses a defaulting borrower can sustain, as well as leaving him free to enter into further borrowing arrangements after he has defaulted.  Theoretically, market participants should refrain from lending to a borrower with a history of default.  Practically, they don't.  Ask the lenders to the governent of Argentina.  Credit markets are an 'aggregating phenomenon' -- which often means a 'lowest common denominator phenomenon' -- in that a giant pool of creditors is competing for borrowers.  What one party knows about a borrower won't necessarily be known by all parties, and with inflating money, there are typically plenty of fish to fleece.

Never mind the moral hazard that governs the mechanics of most lending -- a lending broker, with limited interest in repayment beyond the initial transaction, doling out somebody else's money, to God-only-knows-who.  Given the natural limits of the flow of information and the ingenuity of the human rationalizing organ, it should not surprise anyone that credit can usually be had by practically any narethewell in a 'good' market, and pretty much only by Government In Whom We Trust in a 'bad' one.  Except, of course, when it's really bad.

Most entrepreneurs know this.  Most go bankrupt several times before they hit it big.  If they ever hit it big.  Some find that careful bankruptcy can be a lucrative enough trade in itself.  In the process of creating wealth and jobs and all the other wonderful things rightly attributed to them, they also commonly leave a flotsam of bankruptcies, financial havoc, broken promises and unpaid bills in their wake.  Naturally, in a competitive environment with subsidized risk, it pays dividends to knuckle under the competition with ruthless doubling-down.  Hey, it ain't your money, and if you blink, you might lose.  (But then, so what if you did?)  The process of bankruptcy tends to intimidate and deter those who retain notions of decency and shame, archaic and vestigial as they may be to the modern economy.  These days, the cautious and prudent need not apply, which is all well and good for those who are neither -- better pickings for them.  Thus it is that the scum so readily rises to the top.

In case the reader hasn't heard, such soulless entrepreneurship has hit a new low in recent weeks with the bankruptcy of MF Global.  It appears that under the watchful eye of that stalwart euntrepreneurial soul John Corzine, MF Global 'invested' the margin holdings of its clients and somehow lost them.  They are gone.  In case the reader is not quite sure how that works, these holdings are supposed to be held with the financial institution in the event the investor sustains a large loss on a leveraged position.  Which means, the investor has chosen to borrow money from someone else to invest, and the borrower has asked that he set some fund aside to prove he will be protected by a cushion.

In the event that such a large loss is sustained, these funds allow the institution to unwind the position and ensure that the investor's lenders get paid back.  MF Global, however, in a fit of entrepreneurial genius, simply took these funds and did 'something' with them.  After all, like gold, uninvested funds earn no interest.  Such a holding is financially inefficient, and in keeping with modern investing philosophy, MF Global decided it was better to be all-in all the time.  Prudence is, after all, for middle-class, wage-earning losers.

Now that they are bankrupt, it has been revealed that they were operating a bank with an empty vault. Many people who were legally supposed to be paid back won't be.  This is very unsettling to markets, as it undermines faith in the ability of counterparties to meet their obligations, and at least one broker has decided that it simply does not make sense for her clients to invest in markets with such obvious breaches of good-faith.  At all.

It is by such practices and others that the West has come to be ruled by the class that otherwise would have been fetching water and avoiding the lash in previous generations.  Or raping and pillaging on the highways, I suppose.  Since being entrusted with the reins of the system, they have been systematically picking it apart it to suit their interests to the point of today's destruction.  But I have told that story many times before.  Today, a particularly interesting situation is been brewing in the Old World.

The Problem of Europe

I think most people understand the basic Problem of Europe.  Several governments on that continent owe more money than they are able or willing to pay.  That much is pretty simple.  But there is a very interesting interplay of forces going on there that is somewhat more complex and worthy of more attention than it gets.

Governments love banks, and banks love governments.  Perhaps, to be somewhat more accurate, politicians love bankers and vice versa.  As I have shown, in the modern world, both groups are largely populated by reckless and financially irresponsible people.

Politicians love bankers because bankers have the power to lend them large sums of money with which to buy votes and engage in pyramid building -- usually to the benefit of politicians and the bankers' mutual cronies.  Bankers love politicians because they have the authority to borrow enormous sums of money and the power to collect payments on that debt from taxpayers on threat of imprisonment.  Thus the relationship is naturally highly mutualistic with respect to one another -- and parasitic towards the taxpayer.

But like all such matches, there comes a time when the love affair must end and reality intervenes.  The host runs dry, or at least out of patience.  For despite protestations coming from Athens, Brussels, and other such dens of iniquity, it remains that sovereignty is ultimately an issue decided by force.  The taxpayer of Athens has decided that he does not wish to pay for the expenses his politicians have seen fit to saddle him with, his own enjoyment of the benefits from such government spending notwithstanding.  But the money is largely owed to the banks, who have in effect lent the governments their peoples' own deposits for them to spend on themselves.  If the people do not pay the banks back...who will pay the people back? 

But never mind that for now.  As I have discussed, the banks have a seat very near the governments' ear.  They would very much like to be paid back, whether the people like it or not, and have taken steps to see to it that they do.  In other words, they are attempting to revoke the assumed sovereignty of the government of Greece to declare bankruptcy and discharge its debts on behalf of the Greek people, calling to mind the ancient issue of the enslavement of the debtor.  That is what 'austerity' means.  If it weren't so, it would be called 'prudence,' but as it is well known that there is no residue of that involved anywhere, and hasn't been a hint of it for ages, 'austerity' it must be.  The banks are contending with national governments as peers in the geopolitical state-of-nature.  I suspect they will eventually lose, but that remains to be seen. They perhaps should have considered investment in tanks and troops along with all that sovereign debt, had they seen this day coming. 

Or perhaps they did see this day coming, and thought that their investment in sovereign debt was an investment in troops and tanks?

The issue of sovereignty looms.  The people are theoretically sovereign in democratic Athens.  They can choose not to repay, to drop the Euro and leave the EU, to do as they please.  Immunity and irresponsibility is the ultimate expression of sovereignty.  So far, the banks have blinked.  The ECB has inflated, and offered a 50% haircut to boot if the Greeks will just keep putting their checks in the mail.  The fact that this deal fell through shows that some powerful sovereign entity isn't satisfied -- namely, the people of Greece.  But for aligning itself with the populace and attempting a popular referendum, the seated government was tossed out.  Which means that the banks still have great leverage.  They have also managed to prod the other governments of Europe to lend to Greece several times -- against the will of the respective populaces.  Their power and influence is manifestly widespread, but the resolution of this struggle remains to be seen.

If the banks get away with 'austerity,' we will know with whom the final measure of sovereignty rests in Europe -- the banks.   At least for now, until Italy, Spain, Ireland, Portugal, and, realistically, the rest of the European continent meets the same end.  Then it will be plain to all what shifting sand the European banking empire was built upon.

As for America' can only wait and see...

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