DABERIAM XXXIX

May 2008

Since March, visits to both the East and West coasts of the US and Asia, including Ulaan Baatar, have highlighted to me the divergence in the Western and Asian economies. My theme last year that inflation was going to be the major problem is playing out with a vengeance. Central Bankers now have a dilemma, they cannot continue to push interest rates down to deal with the West’s financial crisis as convention requires them to push interest rates up to deal with inflation. The single lever of interest rates is, however, unlikely to have much impact on inflation as it is being imported from Asia. The same trade mechanism that enabled the Governments of Western countries to claim credit for the benign inflation as consumer goods rolled off the new and modern production lines of Asia at low prices, is turning as those product prices along with commodity prices rise rapidly, as discussed in my March comments. 

The interest rate dilemma is going to make the Western economy very uncomfortable, with the worst consequences in Britain and Europe. The more pragmatic Federal Reserve Bank and the far less rigid economy of the US means that probably the slow down will be less and the recovery quicker. The rigidity of the Euro area and the overarching bureaucracy stifles enterprise and makes economic change slow, but at least enterprise can evolve albeit slowly within this environment. Britain, however, has in the last eighteen months developed a whole new paradigm of Government incompetence of Third World proportions. The Government, under the Brown leadership, a rabid Socialist Scot with minimal knowledge of commerce and industry, has managed to create fiscal and legal uncertainty of monumental proportions. The tax system is in chaos, both for the poorest in the land and right up to the huge numbers of wealthy non-British who reside here. Rafts of changes are announced and then withdrawn or amended, leaving total uncertainty in both the personal and corporate tax areas. 

Global Economic Indicators

World Economic Growth	2007 (IMF Estimate)	4.90%	2006 (World Bank)	4.00%	2005 (World Bank)	3.60%
Base rates: 30 April 2008	USD	2.00%	EUR	4.00%	GBP	5.00%
MSCI World Equity Index	30/04/2008	309.223	31/12/2007	299.916	YTD %	3.10%
Gold (PM London Fix $ per ounce)	30/04/2008	971.00	28/12/2007	833.75	YTD %	16.46%
Oil (WTI Crude $ per barrel)	30/04/2008	113.46	28/12/2007	96.01	YTD %	18.18%

Added to the tax and fiscal chaos, the announcements of rafts of legislation destabilising the rules for employing people, are hugely discouraging business and industry from taking on employees. A depressing picture that is going to greatly exacerbate the economic difficulties over the next year or so in Britain. 

This rather depressing view has been triggered by a lot of travel over the last few months which over-rode my intention to confine my comments to a more backward looking view of some of the causes of the Western financial crisis, which follows:- 

As we look back over the financial turmoil of the last six months it is worth thinking about some of the causes of these man-made disasters. Most industries are self-regulatory and where monopolies start to appear they are easily identifiable. If they are not being encouraged by the Government, then they are relatively easily curtailed. In other words, market forces in most areas tend to stop excesses, but this does not apply to the financial sector. 

The finance industry, a vital part of modern economics is highly regulated as well as being the product of Government’s delegation to the sector of the responsibility of creating “money”. The finance industry like any other needs to be looked at from an evolutionary point of view. Humans, like any other life form, will take advantage of any nook or cranny that will sustain life or make money. 

Conceptually, human ingenuity therefore will evolve strategies to take advantage of any profitable activity. In a regulated environment where legislation is inevitably put in place as a reaction to the latest crisis, the legislative process will be confused and of itself create inconsistencies that can be exploited. 

Looking back, it is interesting that the crisis of the 1930s created the Glass Steagall Act of 1933 separating conventional banks from Merchant or Investment Banks and Brokers. Two regulatory environments developed as a consequence, the Federal Reserve to deal with Bankers and the Securities and Exchange Commission to deal with stock broking and investment banking. 

The separate evolution of these two different regulatory authorities enabled a great deal of banking activity to be taken over by broking houses which for example led to the growth and collapse of Enron, and many other institutions. The legislative consequence here was the creation of the Sarbanes-Oxley Act, the bizarre consequence of which was to create an explosion in off-balance sheet finance. The commonly called Structured Investment Vehicles (SIVs) - this is paper that distances the Finance Vehicle from the Company issuing, was encouraged by the Act. It is these instruments that the Finance Industry created over the last few years in abundance that are, as Warren Buffet called them, instruments of mass financial destruction. 

Created to get between the cracks of legislation they encouraged companies to parcel up debt and sell it. The buyers of the paper in its various forms are banks, insurance companies, pension funds, mutual funds, etc. To give purchasers comfort with the strange instruments, the rating agencies, Moody’s etc., extended their mathematically systematic method of evaluation, which typically gives great weight to the historic record of defaults for any particular type of paper and categorising it Triple A down through the alphabet. This method of rating encouraged buyers to forget to look at the underlying structure of the instrument and familiarity bred complacency. 

More recently, the banking regulators implemented, with effect from January ’08, a regime called Basle 2, which uses part of the same rating system to categorise bank liquidity to the simplistic rating of paper between being Prime, i.e., A rated, and Sub-Prime - B rated; ignoring the possibility that the rating agencies will change the ratings as experience evolves with the consequence that the banks’ reserve assets can be wiped out by a change in rating category without looking and taking into account the real underlying asset value of the paper. This uncertainty has led to the breakdown of trust between banks, investment banks and brokers in large parts of the financial system, and it is going to take some time for managements to work through the ‘books’ to figure out what they are really holding! These dislocations will not be fully cleared up until we get through the next year-end ’09. 

Still shocks to come. 

Damon de Laszlo 
May 2008