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!"

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