Friday, 9 September 2011

The Pharaoh Takes Interest

Ali had made so much money that he felt it was time to build himself a palace. Because Ali was not a fool, he made it a small palace. It attracted the envy of the greedy and stupid, who assumed that if he had money he must have stolen it from them, instead of the truth, that his clever ideas had moved them out of mud huts into comfortable stone houses, but it was not large enough to attract the envy of the Pharaoh.

On the Nile was a man who provided many of the oxen that ran the pumps. This was a very big business, the fourth largest on the Nile it seemed. He lacked all humility, and build an enormous palace filled with marble - so extravagant was it that Ali wondered how anyone could afford it. When the Pharaoh heard, he wondered the same thing. And when the Pharaoh's agents came to inquire, they found the man was a thief. The accounts he had written were false. The money the shareholders had given him to buy more oxen had been spent on his palace.

The mob were furious, and would have put him in prison if he had not died anyway.

Many people lost money, and it was a bad year. But all Ali's schemes worked as they should. Credit Default Swaps were paid out and protected the creditors. All the parts of the enterprise that actually existed and worked were sold to new shareholders who made them operate again, honestly this time. Although the price of corn fell, the farmers were protected by futures. Although shares fell, most funds had some money hedged, so pensions did not fail.

All these were effectively insurances, and the people paying out were the banks, although by now they were more "financial institutions", Thanks to derivatives, the costs were spread amongst all the banks in all the world, so even though the sums involved were huge, colossal, mind blowing, they were simply paid without difficulty (although many people did a lot complaining, as people do).

All these financial systems, Ali explained to the Pharaoh as they walked by the river, acted like the built up embankments along the Nile. When the waters rose higher than they should, the farms and the people were protected. "But what," asked the Pharaoh "Will happen if the flood is so high it overwhelms the banks?" "Does that not mean the floods will be more sudden and do even more damage?"
"Yes majesty, that is why we must always keep an eye on the waters."

The Pharaoh looked thoughtful, spent the rest of the day with Ali, and then invited him to stay in his palace for a while. And Ali, while flattered, suspected the attention of kings would not prove to be a good thing.

One night, the Pharoah's teenage twin sons were allowed to join them for dinner. At nine, as darkness fell, they excused themselves, saying they had to be up for lessons the next day and would be beaten if they were late. With the children out of the room, the Pharoah explained his plans for the banks. He felt, he said, that what the banks were doing was so important that they must be protected from themselves. For that reason, he proposed to give each bank a letter to pin on the wall, promising that it could borrow from the Pharaoh himself if it had to, at a price, or interest rate, that the Pharaoh would set for all of them. The Pharoh would thus be The Lender Of Last Resort. Further, the Pharaoh intended to set rules on what proportion of the money the bank took would have to be held in cash, gold, or other assets that could be acessed imemdiately. A liquidity ratio.

"Very well" said Ali, "If we must agree to this, may I ask two things of you?"

"Speak on" said the Pharaoh.

"Firstly, I want you to double the wages of your tax inspectors, and secondly I wish you to make it the rule that your twins always go to bed at nine of a night".

After a year, the Pharaoh called Ali to the palace to discuss how the banking reforms were going. Before the Pharaoh could ask about the bank, Ali aked him how his children's bedtimes were doing. The ruler groaned. "Before your stupid rule, the children were always in bed by nine, but now that is the rule, they are always late, always making excuses, always finding ways round it, and I have to send the servants to beat them all the time to get them to obey!"

"And, majesty, how are your tax inspectors doing?"

Here the Pharoh brightened "Ah, clearly you are far better with tax inspectors than children!" "Tax revenues are up fifty percent - it seems now the wages are high I have tax inspectors who are as clever as the people I want to pay taxes, whereas before they were just bamboozled where they were not corrupt."

"Quite, Majesty." "Before our new rules, I decided to whom it was safe to lend, and how much of our money we should lend, and at what rate, and my shareholders fussed constantly over my shoulder and wondered if loans were safe, or if I was being wise, or if such and such was secure and if our loan to so and so was too cheap." "Now you have set the rate at which I can borrow, so that rate, plus a cut for me and an allowance for risk, is how much I can lend for." "And you decide what proportion of our money we can lend, so that is the proportion we lend, hence my shareholders no longer worry about the risks I take, because they assume that that which you allow is safe - instead they grumble all day that I should find ways to fit things that make money into your regulations, because just like your children and their bedtime, they no longer have to think for themselves." "So, majesty, you had better pay your bank inspectors well, because it is my job to get away with as much as I can, and you had better think carefully about interest rates and liquidity ratios because now you, not I, decide what my bank does."

The Pharaoh stroked his beard. "Let me see if I have this right... because I removed the responsibility from my twins to set their own bedtime, they now assume the bedtime I have chosen for them is something they can safely try to subvert, and I must constantly supervise them; because I have removed the responsibility from the banks to choose their own interest rates and liquidity ratios they will constantly try to thwart me and I must constantly supervise them, and I must not pay the supervisors less than the banks pay their own staff or the supervisors will be failed bankers constantly trying to suck up to the banks in the hope of getting a proper job?"

"Your majesty has it exactly!"

Monday, 5 September 2011

On The Banks Of The Nile

Once upon a time, long ago, there were ten farmers on the banks of the Nile, each using an irrigation pump, the last word in high technology at the time. Every year, on average, one pump would break, the farmer would lose his crop before it could be repaired, and he and his family would be destitute.

So the farmers agreed that each would hand over 1/10th of their own crop to whichever of them was unlucky. This led to endless disputes however, because not all the farms were the same, and the local wise man, Ali, was forever being pressed to mediate. In the end Ali said "Look, each of you can pay me a little money every month, and I shall decide who would be entitled to what and when, and I will insist that your pump is maintained, and I shall not be involved in your endless argument about who is marrying whose son to whoever's daughter or who stole whose ox, and I shall simply see that the scheme is fair - and I shall take a small cut."

The farmers agreed. And now they no longer had to keep funds back in case their pump failed and destroyed their crop, they all grew their farms, and the people of the Nile ate better, and the farmers grew richer, and Ali made money.

So well did this new idea of insurance work that Ali's two cousins, also called Ali, started similar schemes for the fishermen of the delta and the cattle farmers in the hills.

And Ali went to his farmers and said "Ok, now you no longer worry about your pump bankrupting you, how come you are still keeping money under your beds, and not putting more land under cultivation?"

The farmers shook their heads and explained that every generation or so the Nile would burst its banks and flood their fields, destroying the crop. And of course Ali's fund could not insure against that, because it would not have the money, since everyone would need it at once.

When Ali asked his cousins, he found that they had the same prblem - the fishermen could not be insured against storms, not the hill farmers against cattle diesease. So Ali suggested they each define and price the risk, and then sell it to each other. That way, if the cattle all died, the fishermen and corn farmers would back them up. After all, it was unlikley the Nile would flood and there would be a storm that sank the ships and the cattle would all die in the same year. So the Alis insured all their clients, and sold the risk to each other, creating derivitives.

Once again, because the farmers and fishermen had monetised their risks, they bought more boats, supported more cattle, and put more land under cultivation, and the people of the land were better fed, and richer, and happier.

So rich had the farmers become that they came to Ali and asked if he could build a vault and look after their money for them. So Ali built a bank. But he noticed that sometimes the farmers took out, and sometimes they put in, but there was always a large sum sat in the vault, because they all needed money at different times, and it averaged out. So he suggested they lend out half of the money for interest, and split the profits. The farmers agreed, and now they too could borrow money and expand their farms. And again more crops were grown, and everyone was happier and richer, the population expanded, less people starved, and the beggars found the townsfolk more generous.

But the farmers tended to take out their money in the Spring and bank it in the Autumn, whereas the other two Alis had quite different patterns. So the Alis started lending to each other, and that way all of them could lend more money to their customers. And once again, now retail banking and interbank lending had been created, the farms expanded, more boats were built, everyone ate better and grew richer.

Once again Ali went to the farmers and said, "OK, you have credit facilities, you are insured against natural disasters, but even now you have huge tracts of land not in use, and there are people who would love to work for you begging in the streets - what holds you back?"

The farmers explained that some years corn was expensive and they made money, and some years it was cheap and they did not. They needed to keep money back. So once again the three Alis got together. They agreed to buy part of the farmer's and the fishermen's output at the most likely price months in advance - at a discount of course. And then they sold those futures to each other, so that no one of them was exposed to a bad year in one product.

Yet again the Alis grew richer, the farmers and fishermen expanded their industries, the land was better used, and everyone ate better and was happier.

Ali went to one of the best and richest farmers and asked him "If your farm was triple the size, would you make triple the money?" The farmer laughed and explained much of the time his capital equipment was idle - if his farm was triple the size he'd make five times the money, but he simply could not afford to borrow the money to do it. So Ali suggested he divide his business into shares, explain how he planned to grow it three times over, and invited the rich merchants in the town to buy some of the shares. So he did. And the farm grew hugely, and became much more efficient, and made much more money. And although not all of the money was farmer's, he was still richer. As were the merchants. And, of course, Ali, who had handled the floatation. Because the land was now better used, the people ate better too. Soon all the farmers were at it, and people began to trade the shares in the stock exchange. Thus people who had no desire to farm or fish could invest in corn and fish.

Abdi was not a very good farmer, although he was a clever and energetic man, because he prefered to hang around the town gossiping in taverns. The value of the shares in his farm did not rise, but those of his neighbour did. Eventually his neighbour was able to buy the shares by selling only some of his own, and took to running Abdi's farm himself much better, causing the shares to rise again. So the land was better used, everyone ate better, everyone became richer, and everyone was happy.

The next time Ali saw Abdi, Abdi was, far from impoverished, looking very affluent indeed. He asked Ali if he remembered a man who had come to the bank with a new design of water pump, wanting to borrow money to make it. Ali knew nothing of water pumps, so could not tell if it was better or worse, and had sent him away. Abdi though had spent twenty years cursing water pumps, and could see that this was a far superior device. So he had loaned the young man the money he needed in return for half the profits, and now every farmer was buying their pumps. Abdi had switched from being a farmer to being a venture capitalist, and once again more food was being produced and everyone was better fed, richer, and happier. Soon, thanks to Abdi's support of promising ideas, carts would be getting better, threshing machines improving, and resource use improving by leaps and bounds.

Abdi was making money faster than he could invest it. Fortunately, he knew all about the farms, and he knew all the individual farmers and their flaws, so when he invested it in shares he made money faster than anyone else. Soon Ali came to him with a proposal. He would ask Abdi to invest his money for him in the right shares, and pay Abdi to do it. So well did this work that many of Ali's friends did the same. So now Abdi was a fund manager. Of course, Abdi's specialist knowledge was pushing money in the diretion of the best and most efficient farms, which then had the capital to grow. So one again the crop expanded.

For a few years, each Summer, Abdi gave Ali a big bag of coins. One year however he arrived crestfallen and explained that, thanks to a war in Numidia, it had been a bad year for farming and, even though he had picked all the shares that did best, they had still all lost value. Ali was sympathetic - he expected to win some years, lose others. Abdi was upset to find though that many of his investors wanted safety, and had withdrawn their funds. Then Ali had an idea. If Abdi had bought shares in a good farm, but agreed to sell shares he did not yet own in a bad farm, then he would still have made money. If the market overall had stayed flat, his "good shares" would have gone up, so he would have made money. But his "bad shares" would have gone down, so he could now buy them for less than he contracted to sell them for, so he would make money there too. If the market had gone up, then we would have made lots of money on the "good shares", and lost not as much on the "bad shares". And if the market had gone down he would have lost money on the "good shares" but made more on the "bad shares".
"Look at it This way Abdi - you want to bet on your specialist knowledge of the individual farms, not on how farms will do generally. "Hedge your bets - bet on how farms do against each other, not overall, and offer that fund to people who want to play safe."

And thus Abdi and Ali invented the hedge fund, once again bringing out money into the world, where it could be used to direct resources, instead of lying idle under a mattress.

Then Ali asked Abdi about his water pumps - how come the factory was still quite small, and the pumps hence so expensive? Abdi sighed. The trouble was that the farmers were now such big companies they could demand a year or more of credit. And, locally, they were now really just three giant farms, each buying hundreds of pumps a year. Abdi dare not let his business partner expand the company further, because if even one of those farms went bust it would send them bust in turn.

Once again the three Alis got together and found they all had the same problems. So they created, and traded, Credit Default Swaps, effectively an insurance against a specific company, with which they had nothing to do, going bust. Once the pump maker, and the shipwright, and the animal feed merchant could buy those, they were happy to ramp up production of pumps, boats and animal feed.

So, again, resources were used better, more food was grown, more people were employed, and the people were better fed, employed, richer, and happier. Happiest, best fed, and richest of all was Ali, and the fact that a small number of badly dressed, underachieving ignorant people failed to understand that they lived off the taxes he paid and wanted to burn down his bank bothered him very little.


If you live by a lake with a river flowing in and out, and sometimes the lake floods your house, you might well build an embankment round it to keep you dry. But if there are dams up river, and some idiot opens all the gates at the same time, not only will your embankment burst, but it will have stored up more water with which to wash away your house. If that happens, whom do you blame? The people who built the embankments, or the idiots who opened the gates of the dams?

The embankments are of course the derivatives, futures, CDSs, insurance, and all the other financial instruments that should have protected us all. The water is the credit, the dams are liquidity ratios and central bank interest rates. And the idiots who opened them are our political masters.

Next week I'll show you how the Pharaoh started to use the three Alis for his own purposes and, in the end, bankrupted them, along with the people of the Nile.