Thursday, January 5, 2012

Leveraging/Deleveraging: “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world”

“Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.”
- Archimedes

In this post, we will refer to a "technical term" that constantly keep appearing on TV, newpapers and in all kinds of political and economic discussion, but very few people really understand exactly what it means: Leveraging (and de-leveraging).

Through this "technical term" we can increase our understanding of how the monetary and banking system works, as leveraging plays an important role in our daily lives, even we don't fully realize it..

To better understand what leveraging is, we will use a simple example from everyday life: The health care system.

In order to have maximum protection, a health care system should privide "one doctor per person" (ratio 1:1). If we could achieve this ratio, then the population would be very secured in case of disease, even in "extreme" cases of an epidemic, as there would be enough medical staff to treat the sick and fight the epidemic.

But if we do apply a ratio of 1:1 ("one doctor per person"), then half of the world's population would have to be doctors (!). That only leaves the remaining 50% of the population to actually produce wealth. For this, and for a number of other reasons, the option of having one doctor per person was rejected.

So what we do have is a health care system where there is one doctor per 10, 20 or even 100 people (i do not know the exact numbers - and of course the exact numbers vary from one country to another, depending on the state of each country's economy, or how "humanitarian" each society is (how much people view life as "the most important thing in the world"), etc.).

Thus, the health care system is based on a ratio much greater than 1:1. For simplicity reasons, suppose that the ratio is 1:100 ("one doctor per 100 people"). Such a ratio does not privide us with as much protection as to have "one doctor per person" (eg in case of an epidemic or some other major medical emergency). However, such a ratio provides a "good enough" coverage, and it does so without converting 50% of the population into doctors.

A doctor simply treats the "worker-drones" that have been "damaged" so that they can return to production, just like the parts of a machine need repair or maintenance every now and again. Therefore, the doctor provides an important but secondary (auxiliary) service. He does not directly produce wealth, he is however necessaryin order to "keep the machine going" for as long as possible and as efficiently as possible. And of course he also treats the capitalists, who own the machine.

This basic principle that "one doctor can treat many people" (for example one doctor can treat up to 100 people, if the ratio is 1:100), is an example of leveraging.

The same principle is used in the banking system: If the bank has 10$ in its vault, it can give out loans of up to 100$ (leverage 1:10). This is why if all depositors simultaneously go to the bank and withdraw their deposits, the bank will go bankrupt. This is called "fractional reserve banking", and many people think of it as "the source of all evil". Here's wikipedia on how the system works:

Fractional reserve banking
Fractional-reserve banking is a form of banking where banks maintain reserves (of cash and coin or deposits at the central bank) that are only a fraction of the customer's deposits. Funds deposited into a bank are mostly lent out, and a bank keeps only a fraction (called the reserve ratio) of the quantity of deposits as reserves. Some of the funds lent out are subsequently deposited with another bank, increasing deposits at that second bank and allowing further lending. As most bank deposits are treated as money in their own right, fractional reserve banking increases the money supply, and banks are said to create money. Due to the prevalence of fractional reserve banking, the broad money supply of most countries is a multiple larger than the amount of base money created by the country's central bank... 
Criticism of fractional-reserve banking
One criticism posits that since debt and the interest on the debt can only be paid in the same form of money, the total debt (principal plus interest) can never be paid in a debt-based monetary system unless more money is created through the same process. For example: if 100 credits are created and loaned into the economy at 10% per year, at the end of the year 110 credits will be needed to pay the loan and extinguish the debt. However, since the additional 10 credits does not yet exist, it too must be borrowed. This implies that debt must grow exponentially in order for the monetary system to remain solvent....
Leveraging is also used today in the monetary system: When the gold standard was in place, each state was forced to issue currency that corresponded to the amount of gold it owned (ratio 1:1). Now that the gold standard is gone, states can print as much much surrency as they want (the ratio of currency:gold has been rising for years).

But is leveraging really that bad? Moreover, is it really "the source of all evil"?

Here is Marx's take on it - from wikipedia:
Fictitious capital is a concept used by Karl Marx in his critique of political economy. It is introduced in chapter 29 of the third volume of Capital. Fictitious capital contrasts with what Marx calls "real capital" which is capital actually invested in physical means of production and workers, and "money capital" (actual cash held). The market value of fictitious capital assets (such as stocks and securities) varies according to the expected return or yield of those assets in the future, which is at best only indirectly related to the growth of real production. Effectively, fictitious capital represents "accumulated claims, legal titles, to future production" and more specifically claims to the income generated by that production.
The formation of fictitious capital is, for Marx, linked to the wider contradiction between the financial system in capitalism and its monetary basis. Marx writes: "With the development of interest-bearing capital and the credit system, all capital seems to double itself, and sometimes treble itself, by the various modes in which the same capital, or perhaps even the same claim on a debt, appears in different forms in different hands. The greater portion of this 'money-capital' is purely fictitious. All the deposits, with the exception of the reserve fund, are merely claims on the banker, which, however, never exist as deposits." The expansion of the credit system can, in periods of capitalist expansion, be beneficial for the system; but in periods of economic crisis and uncertainty, capitalists tend, Marx argues, to look to the security of the "money-commodity" (gold) as the ultimate measure of value. Marx tends to assume the convertibility of paper money into gold. However, the modern system of inconvertible paper money, backed by the authority of states, poses greater problems. Here, in periods of crisis, "the capitalist class appears to have a choice between devaluing money or commodities, between inflation or depression. In the event that monetary policy is dedicated to avoiding both, it will merely end up incurring both"
As Marx correctly pointed out, "The expansion of the credit system can, in periods of capitalist expansion, be beneficial for the system". So, those who support capitalism should in fact thank the bankers and the politicians who make all this leveraging possible. Leveraging allows the capitalist system to grow - and bank loans or other forms of leveraging have always existed. In fact, there are many capitalists that will tell us, and they would be right, that they got a business loan from a bank, they started a business, and now factory workers are working, goods are being produced, etc. That's not that bad, is it?

Leveraging can help capitalism achieve growth. If it wasn't for leveraging, then banks wouldn't have been able to give out all these loans, and there would have been no growth. This is why most people liked this system, until they realized that they can no long pay all these loans. But we will get to that in a minute. 

First, let's go back to the example of the health care system: If there was no leveraging, then we should have "one doctor per person", and half the population would have to be doctors! This would obviously inhibit production and growth. In today's "leveraged" health care system, we need less doctors, so that the majority of people can be mobilized in production. To have half the world's population practicing medicine is absurd, because it actually prevents the production of new wealth.

Here is a contradiction of capitalism:

If the ratio of leveraging is "low" (eg, 1:1 in the most extreme case where there is no leveraging), then it inhibits growth. There would be little growth if half the population are doctors, or if banks do not give out business loans. Leveraging is a good way for banks to utilize their capitals more efficiently, as they can give out a lot more loans that they could if their only utilize their capital at a ratio of 1:1 (= if they only give out a few loans, using only the moeny they actually have in their vaults).

If the ratio of leveraging is "high", then although there is growth, the system becomes unstable and collapses. For example, if there is only one doctor per 1.000.000 people, then even an "ordinary" case of flu can become really serious. If there are no doctors in a society, then this society will have the greatest possible number of workers producing goods, but who will "fix" all these workers if they "brake down"? The same goes for the "excessive leveraging" of today's banking system.

Some might get the impression that the best solution would be to "restrain the banks", and to use "moderate" leveraging (ie a "social-democratic" approach). In fact, there are many Keynesian -and other- economists who -rightly- accuse the banking system for being "out of control", asking essentially a status of "moderate leveraging".

This approach was in fact tried during the Great Despession of 1929 - the big banks were broken up, and the ratio of leveraging was somewhat reduced, in order to prevent the system from crashing again. This approach worked for a few decades, but as always, it didn't last long.

This is because, as we said before, greater leveraging leads to greater growth, even if it makes the system more unstable in the long run. The capitalists, blinded by their greed, always end up applying more and more leverage. If for example a bank has 10$, then deep down inside it prefers to give out loans totaling 1000$ instead of "just" 100$, because that will increase its profits, at least in the short term. But this makes the system more unstable. Here lies the problem with capitalism as a system based on accumulation of personal wealth.

Today we are being told that there is "too much leveraging": For example, financial derivatives that circulate globally are worth 700 trillion $ (!) - W. Buffett called derivatives "financial weapons of mass destruction", as their value far exceeds the world's GDP.

The system has being growing for many years through accumulating debt - this is why it needed increased leveraging, so that the banks could create this debt and "compesate" for the flight of industrial capital from the West to Asia.

Now that these loans can not be repaid, the system collapses, and this is why even a "small" country like Greece is causing such large shocks in the world's financial market: Leveraging is so great that even if one borrower can't pay what the bank expects, then the bank will collapse. This is called "de-leveraging", as the banks are forced to accept major losses. This is not something that the banks like of course, so in order to avoid bankruptcy, the banks are looting theworkers, constantly asking for "sacrifices".And will not stop until they get trillions more.

EFSF, the fund that the European capitalists set up in order to save "the PIIGS nations" (=in order to save the banks), is a good example of how the world does not accept any more leveraging: EFSF was only given a few billions at best, and the Germans wanted to use a high ratio of leveraging those billions, so that the EFSF could lend out 1 trillion euros (even though its actual funds were nowhere near that number). The world rejected it, as everyone is starting to reralize that the PIIGS nations will require a lot of money, and the EFSF does not actually have this money. So, nobody really liked the EFSF - here's a great comic illustration of it as a box that is shinny on the outside, but...empty on the inside:

We are going to see a lot more of these "rejections" over the next few years. In the mean time, here's a famous quote by JP Morgan - something for everyone to think about:

"Gold is Money. Everything Else is Credit".

What happens when an "era of leveraging" ends? Maybe "credit" will not do so well from now on...