Of Real and Financial Economies

I thought that it would be appropriate to comment on how the “real” and “financial” economies seem to be working these days, as their movements are tracked throughout this week’s market updates. By financial economy I mean banks, by real economy I mean manufacturing, mining, farming and other activities that create the bulk of jobs.

 

The September 2008 market crisis was one of financial economy in the first instance, not real economy. The spiral of bank collapse precipitated by Lehman Brothers was almost unreal, the financial economy had become unreal and prone to collapse. Banks had lost their way in the heady world of complicated financial trade, where the market swapped things far divorced from the real economy. We all know that there is no free lunch, you cannot make something from nothing, and yet this is precisely how many of the investment banks operated. A bank is supposed to oil the wheels of the real economy, make it possible for someone who has a bright idea but no money to loan it from a bank who has a depositor with no idea and money to spare. Both sides of the equation benefit as the idea bears fruit, the loan-holder can make his dreams reality and the depositor earns interest.

 

A new breed of bank emerged over time, the investment bank, whose ambition was less to oil the real economy but to oil a financial economy. Rather invest money themselves and earn, don’t wait for depositors to pony up savings. In time they became fiercely competitive, creating a dog eat dog world where to be second was to be last and innovating means of making money from a financial economy was their sole purpose.

 

Investment banks saw their dreams come true with the boom of complicated “assets”, called derivatives. A derivative is what it says on the tin: a derived thing based on some underlying real thing. Take for example a futures contract. Here the buyer promises to buy something from the seller at a future date, but for a price that is agreed now. An example would be a futures contract between wheat farmers and a wholesaler, where the wholesaler guarantees that he will buy the farmer’s crop at harvest for an agreed price, before the farmer sows his fields. The farmer then knows how much to sow: as much plus some margin to ensure he delivers what the wholesaler wants. The wholesaler is happy because he knows he will definitely be in for a quantity of wheat at a set price, and he can negotiate with the market or store upfront as well.

 

The problem is that investment banks have become very creative with derivatives in recent history. The 2008 financial crisis was caused by a collapse in the US housing market. Why? Well some very clever fellow creative a derivative called the mortgage backed security or MBS. Here a bank loans out money to anyone it can, then buckets 1,000 loans into a single derivative and sells that bucket of debt to another investment bank (who in turn sells it on and on and on).  Now you can imagine how things might and did go wrong:

i)                    The bank who originally loaned the money isn’t that concerned with the prospect of repayment, because it will have sold the debt on before long;

ii)                   The investment bank trading MBS cannot with all the computers in the world figure out how much an MBS is worth. How will a crack team of bankers in New York know whether 1,000 homeowners in Florida will pay their mortgages this month?

iii)                 The big assumption was that house prices will increase tomorrow so it doesn’t really matter because underneath the MBS derivative somewhere is a house worth more than it was bought for.

 

The collapse was set up by all three of the points above, (i) meant that banks were lending 120% of the mortgage value to new buyers, (ii) meant the hot potato was spreading all over the place and it didn’t take long for (iii) to stop occurring. At some point even 120% didn’t buy many new homeowners a house, and suddenly everyone saw how far removed the financial economy of MBS had departed from the real economy of bricks and mortar. Everything that has happened since is the popping of a big balloon so that the financial economy drops to the real economy of what a house is worth, which is as it always was: what someone is willing and can pay for it.

 

The real and financial economies are still trying to find one another. The financial economy was nuked in September 2008 and radiated its poison to the real economy. Good businesses went bust just because their banks clenched up, not because they were in any way inefficient or unprofitable. McDonald’s almost missed payroll because its bank suddenly decided that it wasn’t credit worthy! Small businesses have closed in their thousands because they cannot get a $1,000 overdraft to see them through a slow week. Instead of oil the financial economy became glue, as each small business went under, its suppliers lost another payment and also collapsed. The housing sector simply buckled after the first deck of cards was down, the real economy now in dire straits with people losing work just because their employer cannot find $1,000 more to keep going.

 

The solution by world governments lay in melting the financial glue, to do this meant shoveling as much money as it took to fill the bomb site at the banks until they had stopped the cycle of shock and horror. In today’s market update, for the first time in over a year, it looks like governments might at last be done filling the hole but the jury is definitely not out yet.

 

My advice is to stick with the “real” economy news; this is where the jobs and the road to recovery lie. If data from the US, Europe and South Africa is anything to go by, we appear to be recovering, albeit slowly.