Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

23 October 2011

Dexia = AIG Redux, or Einstein’s Definition of Insanity


[For my recent post on the Arab Spring, click here. But this one is probably just as important, that is, if you think Western economies are important.]

I don’t want to upstage my post on the Arab Spring, which is a key development in human history in its own right. But I can’t refrain from commenting on the Dexia debacle now taking place in Europe. It is proof positive that, if Europe continues on the disastrous path broken (and I do mean “broken”) by Hank Paulson and Tim Geithner, it will do nothing but flush the economies of the EU and US, and probably Japan by association, further down the drain.

The essential facts appear in a good and succinct report in the New York Times today. The report summarizes a bunch of dry banking details, but it’s only two online pages. Everyone who wonders why Western economies are in such bad shape should read it, maybe three times.

Dexia is a European bank unknown to most Americans. It is insolvent, and it owes a lot of money to American banks like Goldman Sachs and Morgan Stanley. The EU is now deciding how much its governments and taxpayers, especially those of France and Belgium, will pay Dexia and (indirectly) its creditors to bail it out.

If you’ve followed the 2008 crisis with any interest and attention, what immediately strikes you is how exact an analogue is Dexia in 2011 to the failed American insurance company AIG in 2008. And I mean exact.

Dexia was once a sleepy bank helping finance municipalities in Europe. It did what every bank has done from time immemorial. It lent them money at a certain interest rate. It tried to borrow at a lower interest rate, to make money on the spread. But the Crash of 2008 and its aftermath made interest rates volatile and uncertain.

So what did Dexia do? Did it reduce its business, seek more capital, and batten down the hatches for a coming storm, as every other capitalist in the world did (outside finance)?

Hell, no. It went straight to the casino. It bought a number of “innovative” financial-gambling vehicles, many from American companies, to “hedge” the risk of unpredictable interest rates.

Dexia’s bets weren’t very smart. It gambled that interest rates would go up. Unfortunately, as the global economy tanked and central banks began printing money furiously to prevent a global collapse, they went down. So Dexia lost big.

That, of course, was exactly what AIG had done here in the US. The only difference was that AIG had bet on ever-rising housing prices and mortgage-backed securities, and Dexia bet on ever-rising interest rates.

But that’s not all. When you gamble, the house always has an advantage. Just so with the interest-rate hedges that Goldman Sachs and other American casinos sold Dexia. Their creative financial instruments held a big trick in favor of the house: collateral. When things even began to turn against the gambler, the house could demand more collateral―as much as twice the amount of any putative loss.

That is exactly what happened, both to AIG and to Dexia. As interest rates turned south and Dexia’s balance sheet turned red, the American casinos demanded collateral, according to the fine print they themselves had written into their instruments of gambling, in order to stay safe.

And guess who was in the forefront of the demand for collateral? Goldman Sachs, the very firm whose early demand for collateral had, according to crack reporter Matt Taibbi in his now-famous book Griftopia, sunk the State of Texas and AIG, leading to the Crash of 2008.

One last thing. European governments are on the hook for much of this nonsense because they guaranteed it. That’s a bit more than on our side of the pond. Our government only made implicit guarantees of banks “too big to fail.” Europe’s guarantees were explicit and in writing. But that’s a distinction without a difference. Whether implicit or explicit, paying private bankers on all these guarantees without radical structural changes will just make another round of 2008 virtually inevitable. Crash of 2014, anyone?

Einstein’s definition of insanity is doing the same thing over and over again and expecting different results. The Russians have a similar proverb. If you step on the short end (the tines) of a rake, and the handle comes up and bonks you in the head, you should learn. That should only happen once. If it happens more than once, you’re either careless or pretty stupid. If it happens three times, no one is going to hire you for anything other than menial labor.

Well, after watching the US do it, all of Europe is about to step on the rake’s tines a second time. All we here across the pond can do is watch in utter horror. And China, which has all its banks under pretty firm control, is smiling and waiting to pick up the pieces.

The bankers say there is no alternative. They would, wouldn’t they? Bail us out and let us keep all our power and our perks and continue gambling with your money, they say, or the whole system will collapse.

No, it won’t. Not if we bail out the innocent parties and let the gamblers and swindlers, or at least the casinos, fail.

The solution is radical but simple. The global financial system―not capitalism itself―is badly and plainly broken, So bail out its innocent victims but let it die.

That’s precisely what we did during the Great Depression. We bailed out depositors and other innocent creditors and let government take over the failed banks. That’s what the FDIC still does with failed retail banks. But the really big banks, which are now also investment banks and casinos (thanks to repeal of Glass-Steagall), have managed to win themselves immunity by infiltrating every level of government from here to Brussels.

The banking system is much more complicated now that it has become a nexus of interlocked casinos. But the principle is still the same. Bail out individual depositors (but not traders!), no matter how rich, and any firm with a legitimate non-financial business, but only to the extent of that business. Then let the whole global financial casino go through an extended, specially structured bankruptcy proceeding to see which croupier gets to feast on what’s left of the collective rotten carcass.

In the meantime, instead of having central banks printing money to support the casinos, let them lend to worthy individuals and real businesses. Let them support, take over or re-create the commercial-paper market to keep real business alive. In other words, let central bankers take over the essential non-casino functions of the financial sector to sustain real global businesses, including America’s excellent ABC companies.

I suspect we will find that the essential functions comprise a surprisingly small subset of the things so-called “banks” now do. Every gambler thinks that the next bet is the one that will make him whole. That why we have Gamblers Anonymous. It’s time for our global gamblers, who have tanked economies worldwide and now threaten to do so a second time, to begin their twelve-step healing program.

Is this a radical solution? You bet! Are there any better ones? I’m listening. To continue stepping on the short end of the rake with the wild abandon of a battered and half-crazed gardener would epitomize Einstein’s definition of insanity. Unfortunately, that looks like precisely what the EU is about to do, beginning with Dexia.

So the Western world may be about to hit the canvas a second time. The third time, and we’ll be down for the count.

Me? I've got my money nearly all in cash and safe investments until I can foresee how many times we’ll step on the short end of the rake, before we learn that gambling is neither finance nor legitimate business, and bailing out casinos and gamblers is not capitalism.

P.S. For all you day traders out there, I just wanted to note that I’m aware of how the “markets” view these bailouts. They are salivating over them. They are just waiting for European governments to bail out the likes of Dexia, and through them the likes of Goldman Sachs and Morgan Stanley. Then they’ll surge.

But that irrational exuberance won’t last for long. It may last months, maybe even a whole year. It might last about as long as it takes a drinking binge to turn into a terrible hangover.

The writing is on the wall. We Yanks are broke―as broke as we’ve even been since the world’s greatest war. Europeans are broke and about to get broker, the more so the more they bail out the casinos and gamblers.

Who’s next? The Chinese? I don’t think so. They’re far too smart. They didn’t work like dogs and bear insufferable pollution and authoritarian government for several decades just to throw it all away on the likes of Goldman Sachs. They’ll say some nice words and make a token contribution for the sake of international good will. They they’ll politely bow out. Ditto for Brazil, India, Russia and whoever else the broke gamblers pass their empty hats to.

The fact is, bailing out casinos and gamblers is simply unsustainable, as every housewife with a gambling husband knows. You either stop gambling, or you lose big.

If you personally want to gamble on being comfortably seated when the music stops, be my guest. But don’t delude yourself that you’re investing. You’re not; you’re gambling. You might win in the short term. But in the medium term, let alone the long term, investors will beat you every time.

That’s one reason why this century promises to be the Asian Century. Asians gamble as individuals. They don’t gamble with their governments or big institutions. So if the West persists in gambling away all its riches, they’ll win. And they’ll win much quicker than they would if the West offered serious, disciplined competition.


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