A WEEK IN ECONOMICS (04/02/13 – 11/02/13) MONEY, MONEY, EVERYWHERE BUT NOT A PENNY TO SPARE ANYWHERE

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Week-in-Economics

This has been a tough week for the Royal Bank of Scotland. The bank has become a pariah for its involvement in the Libor scandal incurring a £390 million fine from UK and US authorities although it is not the only bank currently being investigated; neither is it the only bank to have been fined. Barclays and UBS have this ignominious honour too. Japanese banks are also under fire especially following revelations by a former trader that there was widespread manipulation of Tibor rates.   Here, Japanese banks would borrow using Libor and lend using Tibor. By artificially increasing the Tibor rates, the spread widens bringing in more profits for the Japanese bank in an economy suffering from persistently low interest rates.

From the evidence available, Libor manipulation was common amongst the banking fraternity,  even encouraged by superiors, and judging by the insouciance by which traders conducted these transactions, very few felt that there was anything wrong.  Even the practice of determining Libor rates is highly ambiguous. Banks quoting a rate theyexpect to pay other banks leverages off some sort of gentlemen agreement between banks to be honourable in their estimation. In a world dedicated to increasing profits, providing such a leeway is bound to be exploited especially when the money returns from interest rate transactions can be astronomical. The banking culture is driven by optimising the risk-return dynamic; traders are especially motivated by generating more revenue. If this is the raison d’etre of the banking world, then should it come as a surprise that bankers will try to find ways of producing exponential returns by exploiting ambiguity?

The culture of money making is one that most individuals subscribe to, and banks, in general, do a very good job at making money. Manipulating Libor rates were to serve the bank’s bottom line of generating more financial assets. However, with creative financial engineering and improvements in technology, banks are earning (and creating) more financial assets that is delinked from the real economy.  In a recent report by the consultancy Bain & Company, in 2010 there was approximately $63 trillion in total output compared to $600 trillion of financial assets.  The report states “real economic activity is the engine that makes possible the accumulation and replenishment of capital  assets.  The economy’s productive capacity, in turn, spins off ?nancial  assets the owners  of capital  aim to invest in, creating  new forms of wealth. When supplemented by leverage and creative  ?nancial  engineering by banks  and  other ?nancial intermediaries, the crown of the capital  pyramid  encompasses all ?nancial assets.” Yet, the build up of financial assets post Bretton Woods has masked slow global economic growth, so while bankers can celebrate in bonuses and profitable balance sheets, countries and corporates are scratching their heads wondering how to generate income in a recessionary environment.

The report states that the markets are awash with capital, with too few investment opportunities, and of those that are preferred by investment managers, there is the potential of creating asset bubbles. The problem that arises is that banks wish to use their liquidity in investing in assets that can provide a guaranteed return as part of a balanced portfolio. The real economy is too risky and preference is to keep money in markets where money is flowing. Financial institutions, throughout the world, share this kind of thinking. For instance,  Saudi Arabian domiciled investment funds’ overall assets reached SR 88 billion at the end of December 2012 with assets growing by 7.15 percent from the preceding year’s value of SR 82.2 billion. These funds are likely to be parked in the money market or bond funds where the level of capital protection is high.

Diverting capital away from the real economy has widespread (and long term)ramifications for the global economy. Many countries are suffering from a budget deficit and are looking for ways to increase their productivity.  Greece comes to mind immediately. There are others. India has revised its growth forecast to 5% as it suffers from a slowdown in exports and subdued domestic demand affecting the manufacturing and services sectors. Opening the markets to foreign investors will boost economic activity and highlights the importance of a flow of income.  The EU has had to reduce its budget even through countries such as Spain are suffering from declining output.  More investment into entrepreneurial ideas, infrastructure, businesses will undoubtedly benefit economies – it was the whole purpose of quantitative easing, yet the new money was  going to bond investors and banks, i.e, increasing financial assets.

There is a natural assumption that giving money to banks dedicated to increasing financial assets will have a trickle-down effect in the form of loans and other types of investments. This is not always the case, especially as the banker is not driven by the potential of the invested to bring long term benefits for society; a banker’s horizon is usually short term.

And herein lays the problem: how does society allocate resources when insitutions have varying perspectives between immediate and long term returns. Self interest is all good and well but at the expense of society it becomes a concern. When money is only seen as numbers on a screen, then the potential of long term benefits dimishes. It is the misfortune that is affecting the global economy. Economists such as Robert Gordon have, possibly prematurely, predicted that we are living in a world where global economic growth rates will be much less than years previous as technology as potentially hit a plateau. However, this ignores the economic growth that emerging markets will undoubtedly experience provided investment in the real economy is consistent and sustained. Countries in the GCC, worrying about the growing unemployment rates in the country are investing in developing entrepreneurship that will not only increase innovation but will move away from dependence on oil.  One thing that cannot be ignored is that capital is available and it sits in the coffers of financial institutions. To gain access to it, the bankers need to have longer horizons, or they should not be surprised with more fines and societal ire.

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