Cypress and Policy Laundering

Now that a member of modern, responsible banking system, Cypress, has gone the way of taking depositor's money to save itself, the cat is out of the bag, the precedent is set.

Under conditions expected to be announced on Saturday, depositors in Bank of Cyprus will get shares in the bank worth 37.5 percent of their deposits over 100,000 euros, the source told Reuters, while the rest of their deposits may never be paid back.

 

The toughening of the terms will send a clear signal that the bailout means the end of Cyprus as a hub for offshore finance and could accelerate economic decline on the island and bring steeper job losses.

1.  No one can ever claim they did not understand how the game works.  Legally, you do not own the money you deposit in the bank.  Your claim is secondary to the needs of the bank, and the banks owners, and the system in which it operates.

2. Now that it worked, with zero repercussions (so far) Cypress which was once trending toward freedom will join Sicily in centuries of poverty.  But since it worked so well, the policy will be tried again and again.  The proposition is pitch perfect: "We are taking YOUR money because OFFSHORE investors have put theirs in with your accounts.  If you object to this, we'll have to reduce the free $#!t you get from us."  Like squirrels in the parks, people organize around the freebies.

The funny thing is, the freebies will end anyway.

The game is always the same.  Lend money at interest.  Fractionally reserve money, and create currency to lend at interest.  Lend credit at interest.  Crash.  those who can print indefinitely buy up assets from distressed buyers.  Those who control the means of production then fund the armies that enforce the rules.  Poverty as far as the eye can see.

The only defense is never take that first loan at interest.

The winds blow on the edges first, and then sweep into the center of civilization.  The idea that you can escape this in any way is delusional.  Here is a very successful computer programmer who based himself in pleasant Cypress, hired many locals, and had his assets seized.  Check out his online statement.  This is YOUR future:

A computer programmers business depends on money coming in, money going out, constantly.  Money comes in for a coding project, money goes out to the coders.  Figure this guy works on 10% margin, see how much he is constrained, well, he is out of business. Stop the money, the business dies.  Lay off his workers.  It's a downward spiral.

History shows people go to gold and silver at these points, but this poor world trader in coding will have a heck of a time coming up with a viable alternative payment system.

A free market would solve this, so step #1 is deregulate banking and get the state out of it.  All the Government backed banks would fail, and we'd have as great and economic renaissance as we had when we deregulated telephony back in 1980.

On the other hand, this fellow could move deeper inside the system, say Berlin, and do his work more locally, where the banks still function.  But he'll find the influx heavy, competition heavy.

Gold and silver won't help,  because there will be nothing to buy, no where to go.  All countries will be affected, and USCitizens blamed the most.  Those who are depending on pension, paycheck or property (and bank accounts are property) will be hit the hardest.

When gale force winds blow, you head into harbor, pull down the sales, and hunker down to ride out the storm.  Get a business going that actually provides a value.  There is hope.

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Supreme Court John Wiley Case

I've always understood the rule to be once you buy something from Disney (or it's retailers)  in USA it is yours to resell as you wish.  If you buy something from Disney overseas, you can import it and do with it as you wish, even resale.  What you cannot do in USA is buy from a factory in USA not authorized to make by Disney.  Nor can you in USA is buy from a factory in overseas not authorized to make by Disney.

So buy 100 Mickey Mouse watches from DisneyLand in Japan and bring them home?  No problem.  Buy 100 Mickey Mouse watches from a unauthorized dealer in Tsim Sha Tsui.  problem with US Customs.

So when an enterprising Thai student attending USA Community college noted the USA overpriced John Wiley Co (no relation) textbooks were the same but far cheaper in Thailand, and this student could arbitrage the difference between The thai price and selling cheap online in USA, this student made millions buying retail through authorized dealers in Thailand and reselling in USA.

They took it to the USA Supreme court.  The Supreme Court got this on right:

In rebutting the dissent and Wiley and in support of its decision adopting a non-geographical interpretation of §109(a), the Court had this to say about markets:

Wiley and the dissent claim that a nongeographical interpretation will make it difficult, perhaps impossible, for publishers (and other copyright holders) to divide foreign and domestic markets. We concede that is so. A publisher may find it more difficult to charge different prices for the same book in different geographic markets. But we do not see how these facts help Wiley, for we can find no basic principle of copyright law that suggests that publishers are especially entitled to such rights.

The right to sell onward something you legitimately bought is in common law.  John Wiley wanted to overturn common law with some serious sophistry:

Justice Ginsberg argued that the majority opinion embraces “international exhaustion” and does not adhere to Congress’ goal of protecting copyright owners “against the unauthorized importation of low-priced, foreign made copies of their copyrighted works.”  (Opinion pdf page 42).

See what's missing? Foreign John Wiley-made copies of John Wiley made books.

Had this gone the other way, John Wiley would have picked up yet another huge big business subsidy for enforcement of copyright law plus restrictions on sales that would further enrich Wiley by choking some competition.

There is much more here...

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Traditional Chinese Medicine

Comes now something I longed to see, science brought to Traditional Chinese Medicine (TCM):

"TCM is a well-established medical science based on thousands of years of clinical practices. It shows great promise treating complicated conditions that the single-target Western medicine has failed to handle," said Zang Jingwu, senior vice-president and head of GlaxoSmithKline's R&D in China.

"Our priority is to transform TCM from an experience-based practice to evidence-based medicines through innovation and differentiation," he said.

Currently, a 10-person team in Shanghai is in charge of the program, with a medication candidate for skin disease in the works.

Zang, a US-trained neurologist, said TCM is more of a multi-target therapeutical approach, which might work to treat complex conditions.

Big Pharmacy has not been interested in this since you cannot patent any of these medicines.  At he same time the FDA has clamped down on health claims.  In any event, medicine should be science based.  If the big boys want to bring science to medicine, then great.  If they plan to win through marketing, then great.  If they plan as usual, such as with taxol, to win through legalism, "embrace and strangle,"  then "here we go again."

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Pettis Vs Corrigan

Now there economic analyst China watcher named Sean Corrigan.  As far as I can tell, Pettis is of the Keynesian school.  Corrigan is of the Austrian school.  Here is Corrigan on the same topic as Pettis essayed.  Corrigan, even with his over-stuffed prose, gets it clearer and quicker than a Keynesian.  For my part, I cannot critique Corrigan's essay, here in part:

It is therefore not Keynes or Kuznets to whom should be looking, much less the ineffable Krugman, but the shining example of Sir John Cowperthwaite whose enlightened strategy of what he called ‘positive non-interventionism’ in 1960s Hong Kong—coupled with a near blanket ban on the collation of official statistics for fear their provision would tempt men into meddling (“If I let them compute those statistics, they’ll want to use them for planning.’’)—allowed the entrepot to more than quadruple its GDP per capita (it really is a hard habit to break, isn’t it?) in comparison with its colonial masters in dour, socialist Britain, in the space of single generation. 

A man who eschewed tariffs in an era of protection; who abstained from government borrowing at a time when his peers were fast becoming ’all Keynesians now’; who capped income taxes at a modest 15% in an age when the rich were being ‘squeezed until their pips squeaked’; and who resolutely refused all blandishments to shower corporate welfare upon the taipans, Cowperthwaite’s assessment of his own role was nonetheless characteristically modest, once declaring that, as regards his contribution to Hong Kong’s success,

I did very little. All I did was to try to prevent some of the things that might undo it.

Today, when we are plagued with the grossest of governmental interventions, the maddest of monetary manipulations, and the most invidious of attacks on individual wealth, it might serve to reflect upon some of Sir John’s expressed principles. 

On capital controls:

… money comes here and stays here because it can go if it wants to. Try to hedge it around with prohibitions and it would go and we could not stop it and no more would come. 

Re the role of the state vis-à-vis the private sector in production:

…when government gets into a business it tends to make it uneconomic for anyone else.

On what we Austrians would call the great ‘knowledge’ problem—so routinely overlooked by the meddlers in office:

In the long run, the aggregate of decisions of individual businessmen, exercising individual judgment in a free economy, even if often mistaken, is less likely to do harm than the centralized decisions of a government, and certainly the harm is likely to be counteracted faster.

Or this:

For us, a multiplicity of individual decisions by businessmen and industrialists will still, I am convinced, produce a better and wiser result than a single decision by a Government or by a board with its inevitably limited knowledge of the myriad factors involved, and its inflexibility.

And again:

I must confess my distaste for any proposal to use public funds for the support of selected, and thereby, privileged, industrialists, the more particularly if this is to be based on bureaucratic views of what is good and what is bad by way of industrial development. An infant industry, if coddled, tends to remain an infant industry and never grows up or expands. 

Are you listening, Mr Cameron; écoutez-vous, M. Hollande?

 But, setting aside the political philosophy for now, let’s return to the humdrum business of commenting upon that laboratory of central bankers, that Petri dish of those armed with the printing press, that we touchingly refer to as the ‘market’.

Much of the week has been an exercise in Google-translated rune-reading from China’s ongoing ‘Two Meetings’ at which the formal handover of power will be undertaken. Largely monopolized so far by the outgoing crew, we have to wonder whether Wen Jibao’s effusiveness reflects policy as it will be or whether it is simply a wistful, legacy-minded expression of policy as it should have been.

For what it’s worth, there has been plenty of open criticism of the GDP-at-all-costs model and some frank recognition of the scale of the malinvestment already in place. For example, NDRC chairman Zhang Ping candidly admitted that ‘a rising number’ of heavy industries were making losses and ‘lamented’ the overcapacity in steel, aluminium, cement, glass making and coking coal. Plants in these sectors, he said, were running at just 70-75% of capacity, while the once booming solar industry was operating at just 60%. To address their ‘huge difficulties’, Zhang said he was pushing to increase the pace of mergers in these sectors, but also confessed that such an approach has had ‘little success’ in recent years.

The financial flipside to this was made plain by Li Yining, professor at Beijing University, who warned a CPPCC press conference of nothing less than ‘a possible financial collapse caused by over-investment amid the country’s new urbanization wave.’ – you know, the same ’wave’ on which all the CCP’s hopes are being pinned for the coming years. 

In the midst of this, we were treated to the release of the Chinese trade numbers for February which, for reasons of LNY calendar variability, are best combined with those for January when we attempt to gauge the state of play. Intriguingly, imports—not the least imports for number of key commodities, such as copper, iron ore, and oil—were relatively subdued and hence,  in keeping with anaemic showing of neighbouring Korea and Taiwan. But, despite this, exports took a major jump, rising by almost a quarter on the same two months of 2012.

How did that happen? Had China suddenly and dramatically reduced the erstwhile heavy contribution of foreign inputs to its output? Was this a staggered liquidation of product built up in QIV’s hothoused burst of activity? Or was it perhaps an exercise in good, old fashioned, tax and subsidy arbitrage and/or chicanery aimed at evading the current account restrictions?

We ask this because, although they, too, rose in absolute terms, exports bound for the United States—after all, the fastest growing of all the large, net-deficit economies and hence there most likely destination—fell to a modern-era record low share while those to round-trip Hong Kong soared 60% to a new outright and relative share high. At the same time, the country saw record foreign exchange inflows of more than $100 billion—a marked contrast to last year’s hefty drain of hot money. Not coincidentally, this was a period in which the traditional speculative vehicles, the markets for stock and property, both, were on a violent upward tear.

So, were exports—possibly greatly overinvoiced—again being used to wash funds through the somewhat porous capital account barrier, picking up tax rebates along the way? Was this a means to exploit the yen’s twice-in-a-lifetime rate of decline by clandestinely borrowing some of that excess valuation in Abe-san’s fast depreciating currency? We have no way of knowing, of course, but we remain duly suspicious. 

There is a difference between the regnant Keynesians and the marginal Austrians.  The Austrians know how to spot the problems and how to fix them.  But, if no problems, and no fixes necessary, then who needs government?  No one, but people want government.  But as Hong Kong shows better than anywhere else, if left alone business will self-govern, and the government can sleep easily at night.

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Where to Start?

This comes form a past seminar participant:

Hi John, Thanks for the emails you have sent. I enjoyed your class and I want to start but I have cold feet. I just don't have a good grasp of this. I am still reading and for a time I just put it down. I have recently picked it up again so can you give a few words of encouragement and where to start first?

"Where?" is the question indeed.  Where are you right now, in the sense of "your life so far"?

That is the place to start.  Where you are. As you reflect on yourself, consider what in your life causes you to suffer.  Trust me, for a minute, and think about that.  What causes you to suffer.  Forget about what and who you know, forget about what everyone else thinks.  You are about to face an existential crisis.  What really matters to you?

So, what causes you to suffer?  This is that critical passion question, for passion comes from the Greek (the Romans took it from the Greek) word "to suffer."

But passion is not enough.  We suffer over a lot of things.  The winning combination is when you find JOY working on the solution to the problem that causes you to suffer.

Now, this is very specific, and the two parts narrow this down, but it also applies to anything.  Goods. Services. Agriculture.  You name it.  But what you find is by immersing yourself in what causes you to suffer, the only pain relief is the joy in working on the solution.

Your work is you and your lifestyle, you solve problems for yourself, but you find you are not the only one who suffers the way you do.  There are others.  They too will benefit from your work.  They are called customers.  Bill Boeing built his first airplane for himself.  Steve Jobs built his first computer for himself.  Gregor Mendel developed the first pink peas for himself.  Og, the caveman, made the first wheel for himself.  Shakespeare wrote his first story for himself.  You'll develop it for yourself, and then out of love of neighbor you'll offer it to others.  For a price.  Of course.  You are not running a charity, and they do not want to be obliged to you.  They want to cancel any obligation to you by purchasing your product.  If my friend gives me a cup of coffee, I owe him.  If I give Starbuck's $4 for a cup of coffee, I owe them nothing.  To make real sure we owe Starbucks nothing, we even tip the help.  People feel overwhelmed by obligations.  Money discharges obligations.  People would rather buy it also to make sure it keeps coming.  if you make something they want again and again, they know if you do not charge, it will stop at some point.  They are happy to pay.

We know some things.  No customers, no business.  So you test your solution on customers.  This assumes you are pursuing Plan A.  Test your idea with retailers, as a customer of theirs.  (Plan B, selling something off the shelf, is not for you.)

Test your idea, your solution to the problem, and then listen.

Get that far, and then let me know how it goes.  Feedback on your idea will be so specific, there is no point speculating right now what you should do after feedback.  But respond to the feedback you must, so achieve that important milestone, and report back.

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Pettis on China, Part Six

Part five in a series reflecting on a Michael Pettis essay...

Comparing development models

1.       In the US case this seems to have been brutal domestic competition. If China wants to benefit from its own protection of infant industry, it is important that there be similar domestic drivers of innovation and efficiency. Note that access to cheap capital cannot be such a driver, even though it is one of the main sources of Chinese competitiveness. Access to cheap capital is just another way to protect infant industries from foreign competition. 

***I agree 100% with this.  I do wonder at the world “brutal domestic competition.”   Competition means to “strive with” not fight with.  How can competition ever be brutal.  When did we get the idea that life without subsidies or preferences is “brutal?”***

2.      Every country that has become sustainably rich has had significant government investment in infrastructure, but not every country that has had significant government investment in infrastructure has become sustainably rich.On the contrary there are many cases of countries with extraordinarily high levels of infrastructure investment that have grown for a period and then faltered. 

***Except Hong Kong, and if you look more than 200 years, government is irrelevant, and if you calculate government investment and return on investment, you’ll find in the last 200 years, including government investment in war, “government” has been a disaster on every single metric.***

I would argue that the difference is almost certainly the extent of capital misallocation. In some countries it has been much easier for policymakers to drive capital expenditures, and in those countries it seems to have been relatively easy to waste investment. If this is the case in China, as I believe it is, the key issue for China is to rein in its spending and develop an alternative and better way to allocate capital. 

***Yes, in free markets.  Of all the places in the world, China today has less government pound for pound than any other place, and it also has the best government in the world under the aegis of the Communist Party.  Go figure.  But the point is yes, experiment in even less government ...  “protect the borders and deliver the mail, let the people handle everything else."***

The point is that there is a natural limit to infrastructure spending, and this limit is often imposed by institutional distortions in the market economy. When this natural limit is reached, more investment in infrastructure can be wealth destroying, not wealth enhancing, in which case it is far better to cut back on investment and to focus on reducing the institutional constraints to more productive use of capital, such as weak corporate governance and a weak legal framework. The pace of infrastructure investment cannot exceed the pace of institutional reform for very long without itself becoming a problem. 

***Exactly.  Here again LaDany’s book on law might be helpful.  Lex Mercatoria and common law would be a good start. The UCP of the ICC... all private law.***

3.      Any economy looking to achieve sustainable long-term growth must have a “good” financial system that allocates capital efficiently and rewards the correct level of risk-taking. It is hard to determine what the characteristics of a “good” financial system are, but we shouldn’t be too quick to assume that this has to do with stability.

***And certainly it is beyond the ability of government to define characteristics and correct levels. ***

What’s more, while obviously the capital allocation process is vitally important, I would also suggest that the liquidation of bad loans is just as important. Bad loans, as Japan showed us in the past two decades, can become a serious impediment to growth in part because financial distress distorts management incentives in the way widely understood and described in corporate finance theory and in part because they retard the process by which bad investment is absorbed by the economy.

***Yes, as we see in the cases of Cypress and USA, that refuse to liquidate zombie banks, and places like Iceland and Estonia that have already bounced back after repudiating the debts.***

4.      One thing I have not discussed above is the role of wages. The American System was developed in opposition to the then-dominant economic theories of Adam Smith and David Ricardo, in part because classic British economic theory seemed to imply that reductions in wages were positive for economic growth by making manufacturing more competitive in the international markets. A main focus of the American System, however, was to explain what policies the United States, with its much higher wages than in Europe at the time, had to engineer to generate rapid growth Sustaining high wages, in fact, became one of the key aspects of the American System.

***This presumes there was some government policy on wages.  The highest wages in medieval Europe were after the Black Death wiped out 1/4 of the population.  Spanish wages skyrocketed after the gold began pouring in, and Spain has never recovered.  Be careful what you wish for, or what you think you see with only a 200 year view.***

The Japanese version of this development model, as well as many of the various versions implemented in other countries throughout the 20th Century, shared its view of wages not with the American System but rather with classic British economic theory. Rather than take steps to force up wages and keep them high – thereby both driving productivity growth and creating a large domestic consumption market for American producers – many of the later versions of the American System sought to repress growth in household income relative to total production as a way of improving international competitiveness. This is perhaps the main reason why the United Sates, unlike many other countries that have implemented similar development strategies in the 20th Century, tended to run large current account deficits for much of the 19th Century

***Aside form a tendentioous reading of history, Pettis seems ot believe the state should have a wage policy.    There is nothing to show that this is a good idea.***

This different focus on whether high wages are to be encouraged or discouraged is, I believe – although very little discussed in the theoretical literature as far as I know – nonetheless perhaps the most important difference between the American development model and its many descendants in the 20th and 21st centuries. I would even argue, although I cannot prove it, that one consequence of this difference is that growth in demand tends to be more sustainable when it is balanced between growth in both consumption and investment.

***Mr. Pettis would do well to acquaint himself with the Austrian school literature.***

In analyzing China’s growth in the past three decades we seem to forget that there have been many growth “miracles” in the past two hundred years. Some have been sustainable and have led to developed country status but many, if not most, were ultimately unsustainable. Nearly all of the various versions have had some similar characteristics – most obviously infant industry protection, state-led investment in infrastructure, and a financial system that disproportionately favored producers at the expense of savers – but the way these characteristics played out were very different, in large part because the institutional structure of the economy and the financial sector created a very different set of incentives.

***I think it is an error to think we are so advanced and those before the industrial revolution so backward that taking any longer view is unnecessary.  Capitalism will be gone in less than decades, and maybe within the year.  Will we adapt as easily as the communists have as their system folded, that is without violence?  Not unless we know of working alternatives that we can move to...***

I would argue that in understanding China’s growth and its sustainability we need to have a clear understanding of why these characteristics worked in some cases and not in others. Most economists who focus on China seem to know little about economic history, and when they do, their knowledge tends to be limited to a very superficial understanding of US economic history. 

***Wow.  Ummm... pot... kettle... Never mind...***

But there are many precedents for what is happening in China and not all suggest that further Chinese growth is inevitable.

On the contrary, the historical precedents should worry us. In most cases they suggest that China has a very difficult adjustment ahead of it and the closest parallels to its decades of miracle growth suggest unfavorable outcomes. Understanding why the growth model has succeeded in some few cases and failed in most will help us enormously in understanding China’s prospects.

***When our system goes down, or once we realize the game is over, then every country will have it hands full.  The question is do we in the capitalist countries understand what works and what does not?***
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A Reader Inquires

Colloquy via Sweden:

To achieve surplus profits participants need to innovate and as a result we are offered better products for the same price.

***How are you defining profits?  I follow Drucker: profits are just another business expense.

Innovation brings us new, and therefore price blind.  It is after improving iterations that at some point yield enough market to invite a conservator in, that is when they apply economies of scale and bring down the price on what is now a commodity.***

But my question is; is this the same as to say that we can buy same for less?

***When the innovator yields enough market to invite a conservator in, that is when the consevator applies economies of scale and brings down the price on what is now a commodity.***

I would say no. Same product for less, yes, but not necessarily same utility for less (utility being determined by its ability to generate future cash-flows)

***If it is the same product, how can it not be the same utility, whether less or not?  And utility to whom?  The fish I am having for dinner has a utility that has nothing to do with cash flow...***

This varies with the elasticity of demand for different products.

***Elasticity is effected in innovative products by means of design, in conservator products by means of price.***

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Cypress Madness

Expect assassinations if this Cypress deal happens.  Specific people made decisions that take billions from people who will be hard to identify.  The targets are too easy and the suspects will be too many.

Cyprus government spokesman Christos Stylianides said: "We averted a disorderly bankruptcy which would have led to an exit of Cyprus from theeuro zone with unforeseeable consequences."

Asked about the level of losses on uninsured depositors in Bank of Cyprus, he told state radio: "The assessment is that it will be under or around 30 percent."

The bankruptcy will come anyway.  Leaving the Eurozone has consequences that can be seen, all good.  These consequences just cannot be seen by Stylianides.

IMF chief Christine Lagarde said the agreement was "a comprehensive and credible plan" that addresses the core problem of the banking system.

The core problem is the central bank.  The central bank lives.  The core problem as not been addressed.

The tottering banks held 68 billion euros in deposits, including 38 billion in accounts of more than 100,000 euros - enormous sums for an island of 1.1 million people that could never sustain such a big financial system on its own.

It is all the depositors fault.  Blame the victim.   Cypress is not on its own.  It is part of the EU banking system.  Don't tell anyone in Hong Kong, where they manage far more money per capita.  These explanations are sheer nonsense.

The point of the central bank is to avoid chaos, we are told.  We have a central bank.  It brings chaos.

It is no secret that the big money is Russian.  The seizure will get to specific Russians, probably shady characters among them.  They have money elsewhere too. This sets a precedent. If the Cypress heist works, then where next? This action will bring a response.

One nice thing about being a central banker is all the limousines and caviar with no real responsibility for their actions.  I think that will change very soon.

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Pettis On China - Part Five

A continuing critique of a Michael Pettis Essay.

A sound system of national finance

The third pillar of the American System was the creation of an appropriate financial system. But what does that mean? It is hard to describe the American financial system in the 19th Century as stable and well-functioning. In fact the American banking system was chaotic, prone to crises, mismanaged, and often fraudulent, and yet the US grew very rapidly during that time.

***It is good to call this the “American system” because everyone knows it’s been around a mere 200 years.  If we say the “British system” or the German system we might be misled since Germany is about 100 years younger than the USA and the British system only slightly older.

Americans like to think the USA is unique.    The fact is all banking systems around the world were chaotic, prone to crises, mismanaged, and often fraudulent, and yet these countries grew very rapidly during that time.***

China’s banking system, on the other hand, is far more stable – in fact the favorite cliché of Chinese bankers is that while the system may not be efficient, it is very stable. What makes the Chinese banking system stable, of course, is that it is widely believed that the government stands fully behind the banks. It makes no difference, in other words, how weak the credit allocation decision is, because by controlling credit and the deposit rate, and by limiting alternatives for Chinese savers, the government guarantees both the liquidity and solvency of the banking system. As long as government credibility is intact, the banking system is unlikely to fail.

In that sense you can easily make the case the Chinese banks today are sounder than American banks in the 19th century. This might bode well for the future of the financial system in the short term, but in the long term it is not clear to me that monetary soundness and financial stability are necessarily correlated with more rapid growth.

***The Chinese banks today mimic the USA banks today.  Why would they mimic 19th century banks?  The Chinese would no more institute 19th century banking than install trolley cars instead of an airport at Pudong.***

I say this because I have seen no evidence that countries with sound and conservative financial systems grow faster than countries with looser and riskier financial systems (although they do seem to have fewer financial crises). In fact I have more than once made reference to Belgian bank historian Raymond de Roover’s provocative and profound comment that “perhaps one could say that reckless banking, while causing many losses to creditors, speeded up the economic development of the United States, while sound banking may have retarded the economic development of Canada.”  Canada was blessed (or cursed, according to de Roover) in the 19thCentury with being part of the Britain, and so inheriting England’s much better managed financial system.

***  Boy, here again definitions and time frames cream out for specificity.  What do we mean by development, reckless and when?  Whatever the thesis here might be, the fact is all world banks today are so similar that any crash will mean that all crashes.

The idea that China’s banks or USA’s or the EU might go down independently is to miss that all great upheavals happen worldwide.  Think of 1968 and China, France, Rome, Berlin, Chicago, etc.

Or the 1860s and the civil wars in USA, India, China, Japan.  And back through history.  Whatever relative merits of the banks that matter, when one goes down, all the ones that matter will go down,***

“Reckless” banking is hard to define, and certainly it is easy to make the case the Chinese banking has been reckless, especially in recent years, but it is a very different type of recklessness. Once again I cannot say with complete confidence how China’s version of its development model differs meaningfully with the American System on the subject of banking, but I would suggest there are at least two very important differences.

First, the American financial system then (and now) has been very good at providing money to risky new ventures. It provides capital on the basis not only of asset value but, more importantly, on future growth expectations, and risk-taking has been actively rewarded In China it isn’t clear that this is the case at all. Chinese banks favor large, well-connected, and often inefficient giants at the expense of risk-takers.

*** He speaks as if there is no WAMU. Enron, Worldcom, and for that matter Goldman Sachs?  Whatever benefit Mr. Pettis is ascribing to USA, China is actually much better at it.***

Second, although both systems were prone to bad lending, the American banking system tended to correct very quickly – in the form of a crisis – and bad loans were written down and liquidated almost immediately. This was certainly painful in the sort term – especially if you were a depositor in the affected bank – but by writing down loans and liquidating assets three important objectives were achieved. Financial distress costs were quickly eliminated (writing down debt does that in ways I won’t get into because they are well-known and much discussed in corporate finance theory), capital allocation was driven by profitability, not by implicit guarantees, and assets were returned to economic usefulness quickly.

A classic example of the last of these objectives may be the response to the railway bubble of the 1860s. During and after the 1873 crisis, a number of railroads went bankrupt, including major lines like the Union Pacific and the Northern Pacific, the latter of which even brought down Jay Cooke & Company, the leading financier of the US government during the Civil War. After the crisis some major railway bonds traded as low as 15-20% of their original face value, and so they were purchased and reorganized at huge discounts. The new buyers were consequently able to cut freight and passenger costs dramatically, in some cases by over 50%, while still earning more than enough to cover the costs of buying the railroads, and this led to a collapse in transportation costs in the US.

Liquidation, in other words, provides an important economic value to the economy. It allows assets to be re-priced, which creates a boost to the economy and prevents those assets from acting as a deadweight loss. If the railroads hadn’t been liquidated, in other words, any reduction in costs was likely to be minimal and the railroads would have been far less useful to the development of the US economy.

*** The “national greatness” provided money for wasteful projects.  When the projects failed, they were cleaned up quickly.  Ye, this is far superior than what we have today with, 5 years in, we are still bailing out zombie banks daily.  But If the state was not allowed to get involved in banking, we would not have had the bankrupt rail lines to begin with.

And one subsidy for the railroads was the cost of murdering hundreds of thousand of Indians was socialized.***

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