17 November 2008

GSUL

Back in the office and just cleaned up the inbox. I'm sure all 52 present at GSUL 5 would agree that it was very productive. All the formal presenters had valuable insights: Professor Antal E. Fekete, Darryl Robert Schoon, Tom Szabo and Nathan Narusis; but just as much was learnt from the insightful questions of the attendees. This is not surprising, as they were, as Nathan so aptly described, "self made wealth, independent thinking" people. I sensed early on that the presenters were initially a bit taken aback at the directness of the questioning, but maybe that is just the Australian way and commendations to the organisers for going with the flow. Also productive were the after session sessions down at the bar. The internet is a valuable technology for communication, but so much more seems to get done face to face - we are social creatures after all.

A few ideas/things I thought needed work on from the session:

1. AUD basis - does this really exist (eg we need to use aussie cash rates and aussie spot price) or since USD trading dominates the gold market, should we really study USD basis and trade/interpret that, only converting profits back into AUD?
2. Confiscation - my speculations on this and the application of Part IV of the Banking Act 1959 (see my August blog for background) seemed to be of interest and I will finish my blog on this shortly.
3. Warehousing of precious metals - what is the real warehousing cost, and particularly the correct relative storage charge between gold and silver? Also consider that where gold can be lent, or stored "free" as with the Mint's unallocated, there is no warehousing cost so how does this affect the basis, particularly the AUD basis?

I look forward to the continuing discussions.

1 comment:

Anonymous said...

In my mind, the biggest problem with the current financial/economic system is that loan contracts including an interest component (ie. most loan contracts) are enforceable by the lender on the borrower even in the situation where the borrower doesn't have the means to pay the interest, effectively sending the borrower bankrupt in that situation. This combined with the fact that all money is created as a loan ultimately leads to the current situation in the economy where the world is facing a major economic bust. How exactly one leads to the other takes a bit of explaining, so I'll attempt to outline that here.

As all money is created as a loan either by a normal bank or by a central bank, upon the day of issue of money to a community the total money issued to the community on that day (M0) will equal the total increase in debt associated with that money issue within the community on that day (D0). If we call the increase in the indebtedness of the community due to the issue of money to the community on the day of issue "the principal amount of the loan" (P), then on the day of issue we have M0 = D0 = P. The following day, the debt will accrue interest at the daily rate of interest (I). Thus, one day after the day of issue, the total debt of the community associated with the money issue will be D1 = D0 + I = P + I > M0. In other words, the debt exceeds the available money and can never be repaid.

In my mind it is a major problem to have an entire financial/economic system founded on the premise that debt can never be repaid. But let's see how this plays out...

At first, when the interest bills fall due, some of the money (M0) in the community is used to pay down the interest bill. If we assume the extreme scenario where the whole interest bill is paid off so that only the principal remains, the result is the new situation where D2 = D1 - I = P = D0 > M0 - I = M1. Essentially, this is similar to the situation that existed on the day the money was issued in that the total debt equals the principal, the difference now being that the total money available is less than the total money originally issued. Repeating this cycle ad infinitum, the asymptotic condition is that the money in the community will tend to zero while the total indebtedness of the community will remain constant: ie. the community becomes a slave community serving the money lenders. Another way the figures can play out is that the debt (D) continues to increase, but the amount of available money (M) as a proportion of the debt continues to decrease (M/D -> 0), resulting in the same conclusion.

In the real world, it takes a bit of time for this scenario to play itself out because new money is issued to the community on a regular basis to make up for the shortfall, and there's a lag between the issuance of money and the time when its interest bill falls due. This works for a while as new money is issued as loans to entrepreneurs, and other nation builders, who use the money to create new things. If new things could constantly be created and incorporated into the economy forever, then perhaps this system might never result in a bust. However, the reality is that we live in a finite world with finite resources, with various fluctuations in productivity affected by the seasons plus numerous other factors. It is impossible to sustain infinite growth! Consequently, eventually there are not enough good projects to lend money to, economic growth slows, the rate of increase of available money slows, while the interest bill continues to accrue. In this situation, leaving the interest rate constant would quickly lead to economic depression as the interest bill swallows up all the available money.

Again, to slow the onset of this situation, the central banks generally lower the interest rate as economic acivity slows, such that a major depression is temporarily avoided. I mentioned above that the asymptotic condition in this system is that available money tends to zero while total indebtedness remains constant. This condition is only asymptotic if interest rates also tend to zero. If interest rates do not tend to zero, then at a constant level of debt, the total available money will go to zero if the scenario is allowed to play out to its end. Another way of putting it is that the ratio of available money (M) to the debt associated with that money (D) tends to zero: ie. M/D -> 0. As in our present system political and economic pressure prevents interest rates going to zero, then the ratio M/D approaches zero in a finite amount of time. But what are the consequences of that?

In a nutshell, in the current system before the ratio M/D ever reaches zero, people and businesses in the community begin to go bankrupt as there just isn't the money available to pay the interest bill, eventually resulting in an economic recession or depression (ie. what's happening in the world today). This acts as a safety valve on the system, reducing D as bad debts are written off. Ultimately this increases the ratio M/D back to a value that allows the economy to recover and continue churning as it did before the bust.

But what a safety valve! Actually, "safety valve" is a misnomer as it begs the question, who is it saving? In the current system, it certainly doesn't save the majority of the population who lose their investments, their retirement savings, their businesses, jobs, and livelihood! This leads me to my main point with which I started above: the reason these major economic busts occur is because loan contracts are enforceable by lenders onto borrowers to the extent of forcing them into bankruptsy if they cannot make their interest payments. But before elaborating on this, I want to just recap on what I've stated thus far.

Basically, our capitalist financial/economic system creates a situation where it is guaranteed that at some point someone will default on a loan, and this situation becomes ever more likely to the point that it becomes a certainty as the ratio M/D decreases over time. Once enough defaults occur, D is reduced, and the ratio M/D increases again, and thus the system resets itself for another round of boom and bust. It is agreed that booms are good and busts are bad, so in a way the bust can be seen as the cost of having a system that creates such great booms. We've certainly all benefited from the products of the capitalist system, so that shouldn't be lost sight of. I think on balance people would agree that they'd rather have our capitalist economic system than any other alternative because even factoring the costs of the busts, overall we're much better off because of the booms it also creates, and I agree with that. ie. I don't want to change the fundamental workings of our economic system as I think we derive a lot of benefits from it.

However, what I do want to examine is the way in which losses are distributed amongst the community when a bust occurs, the justice of the way in which it is currently done, and how that leads to larger and more costly busts than are warranted. All of this hinges on who carries the responsibility for a loan contract. Currently, the vast majority of loan contracts place the entire burden of the responsibility for the loan on the borrower, such that if the borrower can't make a payment, then the lender can force the borrower into bankruptsy. What if the situation were modified and the lender was responsible for the quality of his investment decision, such that he continued to receive his interest if he had made a wise investment decision in lending the money to a productive borrower, but couldn't force the borrower into bankruptsy if he defaulted on the interest (failure to repay the principal when required is a different kettle of fish, and I don't propose removing any of the existing penalties associated with that, as that would essentially condone a kind of theft). I'll canvas both the current situation and the situation with my proposed change here...

In the current situation, we have an financial/economic system that guarantees somebody will default on a loan at some point. But in the same system we penalise people who default on their loans by sending them bankrupt. There is a question of justice surrounding this situation. If an individual is born into and is living in a system not of his making, that guarantees somebody at some point must default on a loan, how just is it for that individual to be penalised if it happens to be he who defaults on the loan? And when I say "penalised," I really mean "penalised" in that bankruptsy is far more than just living on the poverty line: there are consequences in terms of reputation, ability to trade, and many other things - in a lot of ways it's like doing time, but without a gaol. So how just is it to penalise someone for something that was guaranteed to happen to someone anyway? I would suggest that it is not just, and that the worst that should happen to someone who can't pay an interest bill should be that they are reduced to the poverty line while repaying principal amounts as they fall due, and as much as possible of the interest while still having enough means to survive and carry on whatever productive activity they were pursuing. ie. People should only be penalised with bankruptsy if they cannot repay their principal as agreed, as this is somebody else's capital that they have borrowed and have taken responsibility for.

Besides the question of the justice of the current system, there is also the issue that by placing the burden of responsibility for a loan on the borrower, it to a degree lessens the responsibility of the lender, as the lender always has recourse to penalise the borrower if there is a default. This lessened responsibility of the lender tends to make lenders far more reckless than they would be if they would have to carry the losses of poor invesment (lending) decisions, as has been seen with the subprime lending practices. This in turn leads to greater and more freequent boom and bust cycles. Maintaining the responsibility of repayment of the principal with the borrower while shifting the risk of investment for an interest return to the lender would lead to more prudent lending practices, and overall stabilise the economy, with less frequent booms and busts, and far less extreme ones when they do happen. Besides which, this is also a more just way to appropriate the responsibility: the borrower should be responsible for the capital he borrowed, while the lender should be responsible for assessing the borrower's ability to produce enough to pay a reasonable rate of interest.

Another aspect to consider is the amount of damage done to the community in the event of a bust. If busts are destined to occur when the ratio M/D approaches zero, and the only way to reset the system is to write off bad debts, decreasing D, and increasing M/D to a reasonable level again, then the question arises, how best to decrease D (write off bad debts) with minimum disruption to the community.

Taking the example of a mortgage, currently what happens is that once someone defaults on an interest payment, the bank reposesses the property and sells it to pay off the total debt owing (principal and interest). As this happens more and more frequently in an economic bust, the prices of properties fall, and the banks are less and less able to cover the outstanding debt from the proceeds of sale. Eventually they are forced to write off bad debts while simultaneously forcing people into bankruptsy, D decreases, M/D increases, and the economy returns to normal. The resulting fallout of all that is the banks have written off some bad debts to reduce D, while a lot of people have ended up homeless and bankrupt. Analogous examples could be drawn up for business loans, etc.

On the other hand, what I'm proposing is that once someone defaults on an interest payment on their mortgage, the bank doesn't reposess the property (so long as the agreed principal repayment is still made). Rather, the bank can investigate to see whether the person is really in economic hardship and unable to pay the interest, in which case it immediately writes off the missing interest payment as a bad debt. If on the other hand the bank ascertains that the person was able to pay but just decided not to, then there should be more severe penalties (I understand that there may be a fine line between these two situations and may require some judgement and perhaps arbitration or court involvement if complicated). In this scenario, as M/D approaches zero and the economy heads towards a bust, banks would immediately begin writing off as bad debts all the interest payments that aren't able to be met by the borrowers, thus reducing D, increasing M/D, and restoring the economy to a workable state. In this scenario, banks would still have to write off bad debts as they have to do in the current system, as this is the only way to lower D and increase M/D. The difference is that in this scenario an economic bust has a far lesser effect on communities as far less people lose their houses, businesses, livelihoods, and go bankrupt as the economy resets itself through its normal cycle.

Anyway, that's the best improvement I can come up with for now. I'm looking forward to seeing other people's comments on this.