Spinor Info

I know, I know. Hindsight is 20-20, and here I am, the Monday morning armchair quarterback, making sense of what happened to the US banking system this past weekend.

Then again, my excuse is that I am no expert (not even close) so what is hindsight in my case should have been foresight on behalf of those who do this stuff for a living. The fact that it wasn’t…

How do banks work? Say, you deposit $100,000, and the bank pays you 2% interest. So far so good. But the bank doesn’t just sit on your money. If they did, they’d be losing money by paying you interest. No, they lend that money to me, say, in the form of a mortgage at 5% interest. The difference, that 3%, is the bank’s profit.

Suppose one day unexpectedly you show up and tell the bank that you want to withdraw your money. The bank doesn’t have $100,000 cash. Nor can they call on the money they lent to me, since it is in the form of a long-term mortgage. What they can do, however, is sell my mortgage to another lender. For me, that mortgage is debt; for the bank, it’s an asset, worth good money. So they sell it to another bank, get the $100,000 cash and now they can honor your request to withdraw your funds.

So far so good… but what happens if the county’s central bank raises interest rates rapidly? Say, in a short amount of time the central bank’s rate goes from a fraction of a percent to over 5%? When you come to our bank to withdraw your money, the bank tries to sell my 5% mortgage to another lender, but finds no buyers. Why would these other banks buy my 5% mortgage from our bank when they can invest their money in government bonds that have a 100% guarantee and now a yield better than 5%? Oops. You try to withdraw your money, but our bank is unable to oblige. When a bank cannot pay a depositor, it is big trouble. It basically means that the bank is going under.

When interest rates change slowly, gradually, this does not happen. Mortgages expire and need to be renewed at revised rates. The market adjusts. But when interest rates rise rapidly, the system cannot adjust. There is not enough time.

Central banks throughout the Western world have raised interest rates at a historically unprecedented pace in recent months, to fight inflation. Did they really not anticipate the consequences?

And now the reaction: some financial news sources suggest that, never mind further rate increases, the US Federal Reserve’s interest rate may actually come down next month. Now that worries me as it may be an overreaction. Overcompensating a controlled system can actually lead to even larger swings or oscillations.

What bothers me about this is that what I am describing here is not exactly ground-breaking revelation. Beyond the financial specifics, it is basic operations research, its modern roots dating back a century or so. Seriously, when they were raising interest rates as recklessly as they did, what were the central banks thinking? Were they truly not aware of these possible consequences? Or was fighting inflation so important that they opted to ignore the advice of their own knowledgeable experts?

A few months ago, after a miserable half decade during which Greece lost one quarter of its economy, fed-up Greeks elected a far-left government that promised no more austerity, no more giving in to heartless European demands.

To bolster its legitimacy, the government held a nationwide referendum, in which Greeks voted in large numbers against accepting a (by then defunct) austerity package that was a precondition for more European bailouts and assistance.

And now… the Greek government agreed to an even worse austerity package than the one Greek voters just rejected?

What exactly happened here while I blinked?

If you thought that the scary news from yesterday was the mass murder of 145 people at a Pakistani school, think again. Tragic as that event was, it has zero effect on your security or well-being unless you happen to live in northern Pakistan.

But what happened in Russia yesterday may threaten the security of us all. The Russian central bank’s decision to hike rates by a whopping 6.5% overnight is a sign that the Russian economy is in deep trouble. Worse yet, it is unlikely that Putin will change course, since his popularity is based mainly on his newfound nationalism, not his economic performance.

Which raises the possibility that Putin will lash out and do something stupid. Not just in the Ukraine but, perhaps in a fatal miscalculation, in the Baltic region. If he has any reason to think that NATO would not respond to Russian aggression in places like Estonia, we are all in deep trouble, because I cannot see how NATO would not respond… and that, of course, is a nightmare scenario.

Meanwhile, Obama made the bombshell announcement of restoring diplomatic ties with Cuba. Long, long, long overdue. (To those who think this amounts to appeasing a communist regime, all I can say is, look how well the policy of isolation worked in the last 50+ years.) I also wonder what the Kremlin’s masters think about this. Cuba was one reliable ally in America’s backdoor that they could always count on… what is going to happen now?

We seem to be living in interesting times.

I consider myself a fiscal conservative. I like the idea of small governments, balanced budgets, low taxes. But… not at all costs.

Austerity is the worst possible response to an economic crisis. The world should have learned this during the Great Depression. But it didn’t.

Or rather, North America did, as it chose stimulus spending over austerity despite the fact that America was led by a conservative president and Canada, by a conservative prime minister at the time. Giving credit where credit is due, I think we should thank Messrs. Bush and Harper for their willingness to put aside ideology and implement pragmatic policies, even if they might have done so kicking and screaming.

Not so in Europe, where austerity prevailed in the countries worst affected by the recession. And the result speaks for itself, most loudly perhaps in Greece. After years of austerity, the Greek economy is in shambles; Athens is crippled by smog because of all the wood burning as a result of drastic tax increases on natural gas and fuel oil; and instead of going down, the country’s debt-to-GDP ratio continues to increase relentlessly, as tax revenues dropped more rapidly than government expenditures as a result of the cutbacks.

Courtesy of a Google+ friend, I stumbled across this graph, originally from The Atlantic:

What this graph demonstrates is quite simple. Take any random collection of nations. Former member states of the Soviet Union. All the countries along the 5th parallel. Members of a reconstituted Ottoman Empire. Or even countries beginning with the letter “M”. In all cases, the countries you pick turn out to be socioeconomically less diverse (i.e., they have more in common) than the major member states of the European Monetary Union.

I don’t know if it really makes the Eurozone doomed, but it certainly shows that holding it together will be quite a challenge.