Two Twerps and Silly Milliband

On the morning of January 6 I heard an embarrassing interview between David Cameron, the British Prime Minister, and Evan Davies, a particularly drippy favourite of the current regime at the BBC who is often presented as an Economics expert. Davies's style is that of an insouciant fifth former from some long-vanished County Grammar School; including a tendency to ride hobby horses.

Today's spat was about the old chestnut of bankers' bonuses. The Prime Minister may not be as ill-informed on this issue as he routinely appears to be, but again today he spoke as if the core of the issue was bonuses paid to Directors - and particularly chief executives - and to senior managers of conglomerates that include banking divisions. In the USA and the UK, in particular, in banking as in businesses in many other sectors of the economy bonuses exceeding the nominal salary have been paid to such individuals, and many bonuses reached extreme levels during the bubble years before 2008. In retrospect it is clear that a significant minority of chief executives led their companies down routes that eventually proved to be disastrous: shareholder value was reduced - sometimes obliterated - yet it was palpable that the shareholders had not acted to curb the excess when the time was right. What Americans call "compensation" and Brits call "remuneration" has been determined [in most cases] by sub-committees of the board of directors who pay expensively for advice from specialist consultancies that compare top salaries over companies and sectors, looking at factors like the number of staff on the payroll as much as on the quality of thinking [which is almost impossible to assess] and profitability where the present strategy will  only produce results in a few years time [so that present profits owe more to past managers and policies rather than to the present lot]. Shareholders [which includes investment trusts and pensions funds, with highly specialist and well-paid managers] let themselves be led by the consultancy reports; with the result that the gap between top salaries and "ordinary" employees' remuneration increased to a degree that most people thought was obscene.

There is now a battery of propaganda urging shareholders to recapture control of compensation [or remuneration] and to narrow the gap between top and bottom salaries. Governments have been put under pressure to use taxation and regulation to diminish the purchasing-power of top people's pay packages. An additional measure that has been used widely for more than ten years requires companies to pay a proportion of the bonuses in shares in the company rather than in cash, and to put restrictions on when the shares may be sold so that the recipients cannot just cash-in quickly. For those employees who are continuing to work for the company and who have already accumulated such a heap of shares there is a huge incentive to work effectively and so increase the value of the shares; and this fact is adduced to argue that bonuses positively help to drive progress and profitability for the business. Against it is ranged the fact that the average tenure of chief executives gets shorter and shorter so that it is rare for a boss to be in post to reap what he has sown.

Control of relatively 'transparent' remuneration packages for directors and top managers never was the biggest problem, and it is now obvious that that range of stipends will be brought under control: and may even gain public acceptability.

The bigger and more scandalous problem has been accidentally and partially addressed by the imposition of temporary taxes on bonuses, and it has been mitigated massively by the recession in the world economy which has cut back the trades for which the biggest bonuses were paid during and after the bubble. I was emphasising this problem by 2005; while most commentators - even many of those who predicted the crash - appear still to be as oblivious to it as David Cameron and Evan Davies appeared to be today.

The biggest bonuses, ranging to thousands of per cent of notional base salary in the most extreme cases, were available in what has - quite rightly - come to be called casino banking. But even those who coined the phrase do not seem to have grasped fully what it means, as I tried to express the matter in my Fellows Lecture to the Insurance Institute of Ireland early in 2007. Very able people, mostly graduates in mathematics, pure science or sophisticated engineering, and often with doctorates in those disciplines, were taken into the proprietary trading subsidiaries [or sections] of companies that had taken on a complex of traditional 'financial' transactions: stockbroking, jobbing [holding stocks and shares for brokers to buy from them], corporate analysis, financial advice to businesses, assistance in issuing new shares or raising loans, facilitating mergers and takeovers, and a series of specialist services. Having brought them together, as was permitted by the relaxation of market regulations in the nineteen 'eighties [the British 'big bang' was in 1986], their bosses were greedy for growth: to be achieved by the conglomerates competing with each other for established classes of business and by developing wholly new products and the markets in which to place them. The latter area was where the brilliant scientific minds could most profitably be brought to bear. People grounded in the old skills worked in close collaboration with lawyers who could draft the terms of new contract types, and auditors who could find ways of validating the reported outcomes, and rating agencies that claimed to be able to evaluate the contracts, they developed new ways of securitising loans that had been made to 'real world' people and firms; and ways of gambling against possible outcomes in 'real' markets without ever actually buying or selling commodities or company bonds or shares or insurance policies.

Futures had been available for centuries: for example, a biscuit manufacturer could enter into a contract to get grain next year at a determined price from a merchant who bought and sold grain and believed that [to some modest extent, but better than others] they could guess probable future prices. If the merchant guessed wrong, and had to pay more to get the grain that was needed to fulfill the contract price that he had promised to sell it for, he took the loss: but if he had guessed right and the open market price for the crop on the day when he had to buy to meet the contract [the spot price] was below the level at which he would sell the grain to the contracted buyer, he made a gain.

Copying the 'real' futures market, the new wave invented financial futures. These were betting slips by which a punter [often a trader working for another conglomerate] would place his bet as to what movement would take place in the price of some share or bond with another trader who had a slightly different expectation. No shares or bonds were involved between the parties: they simply had a bet on how much the price of the bonds or shares [that were being held and traded by participants in the 'real' market] would rise or fall in a set period. If the seller of the betting slip was proved more accurate in his guesswork, he had nothing to pay out and he kept the fee for which the slip had  been sold. If the issuer of the share or bond was a worse forecaster, in this case at this time, than was the holder the issuer had to pay to the  holder whatever sum had been specified in the contract. This principle was extended to a vast range of derivatives and other instruments or products that were progressively dreamed -up. These creations existed only in cyberspace, as promises between firms, which had notional values when the contracts came to maturity. Many did not run their full course, where get-out clauses were exercised as external conditions and the internal needs of client firms changed.

Settlement had to be made periodically between the conglomerates and this was done by transfers of cyberspace credit: and trades between firms largely evened-out over the years. Nothing of value to the material world was generated as a result of trade in the more esoteric 'products': but the immense scale of the leading firms' balance sheets that resulted from totting-up the notional value of all the contracts they had bought was accepted to have justified them in increasing their securitisation of loans to people and firms in the 'real economy'. The success of the imaginary trade sanctioned an increasing use of securitisation to expand credit to 'real' householders and factory owners, and hence the credit bubble was fuelled despite minimal [or even negative] growth in the productivity of the material economy.

Massive imaginery profits were made from the imaginative trades: so the traders and product designers and lawyers - and, above all, the inventors who constantly created new species and variants of the contract types, were paid huge 'bonuses' which were volumetric commissions on turnover achieved by the skill and imagination of the team leaders and their clever supporters. The amounts that the best such people earned took the bulk of the real-world cash that was earned by the banking and advisory sections of the conglomerates. As the bubble grew in 2003-7 the banks did not have enough basic cash to pay the bonuses in full; but their directors were keen to go on expanding their cyberspace balances, for which they had to encourage the deal-makers and the secondary traders who backed-up the markets in the transferable slips. Pro-rata bonuses were paid to the creators of, and traders in, more spectacularly imaginative 'products' that were traded with ever-greater  notional values. The conglomerates paid an increasing proportion of bonuses in shares: because the cybertrades delivered no significant cash earnings to the firms whose brightest and best were dealing in them. Until bonuses became a source of mass public concern the dealers could cash their shares by seling them on the open market. But the shares were becoming relatively less attractive because the comglomerates were using most of their net cash [real world] income to encourage their dealers to expand the   scope and size of the unreal universe. The conglomerates didn't have sufficient cash left over to pay higher dividends: so firms like Barclays - which changed from being primarily bankers to being phenomenally bigger proprietary traders - did not significantly increase dividends and consequently their share prices did not grow significantly through the bubble period.

When the crash came, trillions of dollarsworth of the notional value of cyberspace contracts ceased to have calculable prices. The aftermath is still being felt, and many situations are unresolved; but it seemed obvious to the boards of the conglomerates that they had to earn what they could where they could: so they retained their dealers in the market segments that survived, encouraging them to maximise their turnover; and thus they had to continue to reward them in the way that had been evolved in the good times. The 'banks' had an intractible image problem that sat uncomfortably alongside their systemic business problem. The remuneration of the cybertraders was competing for cash earned by 'bog standard' banking with the regulators' demand that they had to keep more cash in their reserves [proportionally to their retail banking business].

To the public- including [apparently] the Prime Minister - bonuses are the income supplements paid to top directors, which have in some cases been stigmatised as 'rewards for failure'. On that assumption it seems obvious to put a cap on bonus payments in 'banks': but as has been shown above the bulk of 'bonus payments' have really been turnover commissions to dealers who are far removed from the sort of banking that involves the voting citizenry.

The simple solution to this dilemma [and a large part of the answer to the Merkel-Sarkozy nonsense of the Tobin Tax] is to classify all the problematic businesses as what they are - gambling. Take them out of the 'financial services' arena and stick them under the regulation of the Gambling Commission, with the appropriate regime of taxation. The banks can still own such firms, if they want to take the reputational and financial risk of doing so; but the true nature of the business and the proper explanation for its remuneration system would be apparent. One cannot expect Evan Davies to get the point, but there might be somebody in Whitehall who can coach the Prime Minister into an element of common sense.

UPDATE
On February 3 the Leader of the Labour party joined in the display of ignorance. He too berated "bankers'" remuneration packages withour recognising the differential between traders' commissions for turnover and directors' pay that is loosely related to the general level of 'compensation' in the business. This is another display of the fact that a well-chosen comprehensive school and Oxbridge can produce a result similar to a product of Eton and Oxbridge in becoming a clot who can join in the yaa-hoo 'debate' that is a natural development from the example set by the minority who have passed through the Bullindgon Club.  

The EU and the Eurozone. What Should be Done Next?

Superficially, the easiest thing that could have been done by the EU in the last 24 hours would be to force Germany to open its coffers to 'save' the euro by buying all the bonds that may be issued or guaranteed by the puppet governments that have been installed in Greece and Italy, and may be installed in other economically failed countries. The spokespersons for the 'markets' - and representatives of the Obama Administration - will continue to press for a 'solution' on these lines whenever it appears that the new solution to the euro crisis is open to question.

In the 'markets' so-called hedge funds and other speculative investors have been stockpiling at-risk bonds when they could buy them cheaply, in the expectation that Germany would eventually be forced to 'support' them at higher prices. Germany has declared its commitment to the European Union, and to the euro, for decades and the marketeers think that pride and stubbornness will not let them back off from supporting the new dispensation. The Obama team of died-in-the-wool pre-2008 bankers have done pretty well to consolidate the position of their former employers since the big bail-out of the rationalised banks that were cobbled together in 2007-9.But they are well aware that the ramshackle result could begin to crack if the euro was disrupted, causing the US banks' holdings of euro debt to loose value. The US has been calling-in the moral obligation that is supposedly owed by Europe for US investment in defence during the cold war of 1947 to 1991. Time has moved on. The sensibly selfish basis for US policy, past and present, is clearly recognised and contemporary Europeans do not recognise a continuing obligation.

Germany in 2011-12 does not recognise an ongoing obligation specially to assist European countries that suffered occupation or destruction during the second world war. Huge reparations have been paid, the balance sheet has been cleared, and the anti-German current within Greek protest against financial stringency is self-defeating.

Germany should in no way feel obliged to assist a bankrupt state that got itself into the mess that its proconsular ruler is trying to resolve. Greece is uniquely in that perilous situation at this moment. The Greek people will suffer dramatically lower living standards for an indefinite future because Greek governments doled out more resources than the country had generated continuously for the past three decades. Though different parties won elections from time to time, each government had a popular mandate; and it is the misfortune of modern citizens in any state that they collectively carry responsibility for the accumulation of debts that the elctorate consented to being accumulated.Any Greek could have discovered that their huge salaries, early retirement ages and evasion of taxation were not only exceptional but also blatantly unaffordable when set against national economic data. The typical citizen may have chosen not to take cognisance of the facts: that dereliction alone stimulates fair-minded aliens to inhibit any sypathy for the unfortunate elderly who now have dramatically reduced living standards and no prospect of mitigation in their lifetime.

Economists have been allowed to dominate economic policy with the assertion that 'markets' are efficient. They have handed it down as 'scientific fact' that governments should so arrange affairs that markets are the drivers of the economy. This is utterly ludicrous. Markets are creations of human beings, and only have any life to the extent that human beings take part in them. The people exist under the protection of the state, they can make contracts because the state and its courts-of-law recognise them as legal persons. The companies that exist in markets are licensed to exist by the state. The contracts that people and companies make are only enforcible if the state's courts recognise them to be valid. The state has an unqualified precedence over any business structure and this is an inescapable fact: for Economists and their dupes to presume otherwise is profoundly dangerous.

People have an infinite capacity for cheating, crookery, and fraud; as much as they have the capacity to be creative in the arts and sciences. A few hundred people - mostly science graduates, many with PhDs - have become adepts in black arts that enable them to create derivatives and credit default swaps. They can - and some of them do - set up deals that are designed deliberately to exploit other market participants. They invent and trade in fantastic 'instruments' such as 'shadow shares' that enable a pension fund to put its money into bonds but in parallel with that to buy notional shares, with a promise that if the 'real' bonds fail and the notional shares retain value, then the firm that has sold the shadow share package is contractually obliged to give the pension fund value equivalent to the gap between the value of the bonds that they hold in comparison to the then value of the notional shares. The idea that any financial firm would be able to deliver on such a promise in the event of systemic market failure, without the sort of government support that the banks were given in 2008, is absurd. The contract - and the pension fund with it - would most probably be wiped out. But while the contract is operational [and untested] fees are paid to the conjurers, the pension fund managers get their salaries and the Trustees draw their fees or allowances: only the fund members stand to lose.  The financial services providers have become even more blatant than they were before 2008 in the absurdity of the 'products' that they have offered; and the gullibility of their clientèle seems to be undiminished. The providers made Greek and Irish state debt appear to be sounder investments than they were, by enabling the holders of the bonds to 'hedge' those purchases with derivatives or ghost shares.

Markets that include such cajolery and sheer brass cheek among their trading methods, selling 'products' on which millions of peoples' future incomes depend which have no substance, are profoundly 'imperfect'. It is blatant that knowledge and understanding of the products and of the risks that are inherent in them are not equally understood by purchasers and the people who unknowingly depend on the outcome of the contracts. Essential rules of the system must be defined by the state, the traders must continue to be licensed by the state and the products must be subject to classification by the state. The infantile version of the Tobin Tax that has been proposed in the EU would have no significant impact in regulating the markets as they have evolved in London and New York. It would primarily be a regressive imposition on the day-to-day bank and insurance transactions of the mass of the population. If 'complex products' are to continue to be regulated as financial assets, much more intrusive regulation - more comprehensive than what is currently being proposed by the EU financial regulator - is needed.

But a completely different approach would be more sensible. At the very least, derivatives and most 'swaps'.and many futures and other 'asset classes' should be classified as betting slips; which is the simple truth. As bets, they should be regulated in the UK by the Gambling Commission, not the Financial Services Authorities. They should be subject to gambling tax and not susceptible to regulation by the EU Financial Services Commissioner and his empowering legislation. By trying to exempt Britain - specifically the 'City' - from any new restrictive EU financial services regulation David Cameron has had a Pyrrhic victory. He has not got any significant exemption for British financial services [which he repeatedly points out is 10% of the economy] and he does not have any inkling of the basic fact that much of the 'industry' that he is trying to protect is not finance, but gaming. The appropriate regulatory change should speedily be implemented: then the EU system of financial regulation would not apply.

It would make an amazing positive change to the continentals' perception of Britain and of the activities of the City if the suggested reclassification were to be carried out. If the British Treasury and Cabinet Office will ever be capable of taking this point, they can frame a regulatory regime that will be seen by the rest of the EU as exemplary. Britain's detractors would be wrong-footed and the rehabilitation of the UK would be facilitated. The City need not suffer any great loss of business, insofar as the players can convince their clients that the betting slips that they have been buying to hedge their investments will still serve the same purposes under a more appropriate and honest regulatory regime. I have only a scintilla of doubt that the City lobbies will oppose any reclassification of their 'proprietary' activities because their pride will be offended by their being classified as bookmakers and their greed will baulk at paying higher taxes on a different basis and possibly experiencing some loss of business. But the City and the government have a golden opportunity to escape the very real threat that the new Europe will much more massively deflate the City's income under its tightening and uncomprehending regulatory regime.

Away to the west Dublin has developed huge 'financial services' expertise that is currently underemployed. A swift-footed Irish government - safe within the carapace of the revamped eurozone - can go a significant way to develop a high-level bulk betting regime that could capture a great deal of the market that the City of London stands to loose. That threat [and the possibility that the Swiss may dabble in these markets]  may help to persuade the City that here is a way forward.