Tuesday, May 15, 2007

Financial and Economic Cycles: A Short Story


A lighthearted note today... speculating on a hypothetical situation in a hypothetical world... where asset prices are going up-up and the perceived risks are going down down since its beginning. Let's call this hypothetical world: Omicron Ceti III (OC for short--star trek nerds will appreciate this), where a certain two groups of people interact in an imaginary economy, and establish economic exchange involving money. There were two clans in this world: The Klings and the Fergies.

The Klings were a nomadic hunter-warrior tribe before coming to OC. Honorable, proud, and sticklers for tradition, they are a hardworking people who have left their birthplace due to climatic changes and other acts of nature which forced them to find new sources of subsistence. The Klings were a very numerous people as women bore many children and men were prolific fathers. This eventually put strains on the environment when all their game were extinct. They had to move somewhere as many people were starving and had no food to eat.

The Fergies were in early stages of establishing agricultural surplus and an elementary economy before their coming to the OC. They have pride in their abilities to think beyond what's given in nature, and were superior to the Klings in education, intellect, and organization. They were also very resource minded and frugal, mainly because they were greedy. They established a very sophisticated system of social organization, and did not breed much and deliberately controlled breeding with complex systems of religion that promoted chasity. They wanted to conserve nutrients in their farmland and be frugal with what they know to be limited economic resources. They lived a rich life with a high standard of living per capita. Unfortunately, their military strengths were no match for a neighboring clan who has decided to invade them, and thus their trek to OC to find a new place where they can be left alone.

When the Klings and the Fergies met up in OC when both tried to settle in the land, the two chieftains who led the people at the time agreed to establish a democracy of equals, with the rule of law and property. The Klings were very impressed with Fergian knowledge of agriculture and political economy, and the Fergies needed badly the Kling dedication and experience with the "grunt work" and not to mention war-like activities to acquire and defend territory. Thus, generations have passed, and eventually both the Klings and the Fergies settled down and both called OC home. But of course, due to the Fergies previous intellect and experience with economic activities, and also due to their shrewdness and greed, they soon acquired significantly more wealth than the Klings. After a period of two generations, the Fergies were only 5% of the population, but controlled most of OC's vast amount of wealth and property. By then the economy has gotten relatively advanced. Not only were there a basic food and services industry that the people originally needed to survive, but tastes for consumer discretionary, finance, real estate, luxury goods, and the likes have also popped up on the backs of high population growth and a healthy labor market. Of course, it was mostly Fergies who had the bulk of the wealth to enjoy these amenities. Naturally, the Klings were unhappy with this, as their people were working very hard, but none could ever make as much as the Fergies. As the economy developed, up went the prices of assets such as land, shelter, and raw materials used to create the goods and services, and this meant it was very difficult for Klings to get in on the action with seemingly very meager wages. One day, a whole lot of Klings gathered and signed an official petition for a fairer distribution of wealth, and they protested and complained during a democratic council that the Fergies were guilty of manipulation and conspiracy to undermine the Kling people. This was the first time that the two groups of population had such problems since their founding.

Sensing danger of popular unrest, the democratic council tried very hard to figure out a solution. Around the same time, a secret committee of business and financial industry titans of the Fergie race convened in a secret meeting to try and figure out what to do to keep the Klings happy. The Fergies knew that the Klings were generally a proud and stubborn bunch who could in no way compare to the Fergie intellect and instinct for wealth accumulation, but they also did not think that this was a crime. These Fergies didn't look down upon the Klings, for they also needed the vast number of labor resources that the Klings provide for their civilization. They also realize that a Kling could kick a Fergie's butt any day in a physical match, which makes them dangerous if the Klings ever became politicized. The Fergie committee thought long and hard about what to do, and how to make the Klings feel richer without having to give up their own property and wealth that they've worked so long and hard to accumulate. But they just couldn’t figure it out, would they really have to give away their hard earned money and property in order to keep the social fabric from tearing apart?

Just then, a deus ex machina came and saved the day. A peaceful people known as the Chins sailed to OC from afar, with a caravan full of goods. They were very interested in opening up trade with OC, and the best part of it is that all they asked for in return for the ship full of goods were common shiny pebbles that were plenty to be found on a beach nearby. Apparently, where the Chins came from, these pebbles are very valuable.

The Fergies quickly capitalized on this opportunity and called in an emergency session with the democratic council on the island. The Fergies promised to fix the problem of income inequality by changing the money supply from the current rare gemstones to pebbles, and make available many assets in due time that Klings could purchase with these pebbles. The community built a 10 ft, heavily guarded wall outside of the beach, and established the first central bank in the OC. Of course, none of the Klings were smart enough to figure out what was going on, and the Fergies funneled enough pebbles into the pockets of Kling politicians to keep them happy enough to allow the Fergies to be the ones that controlled this seemingly endless beach full of pebble money. When the bank opened, all was welcomed to exchange their gemstones for these pebbles at a set rate of 50 pebbles per gemstone. The population quickly did so.

Trade with the Chins quickly heated up, and a vast surplus of goods and services were soon imported from the distant homelands of the Chins. A complex system of banking and finance sprang up as a result, where paper representing ownership of pebbles soon began circulating in the two-world economy. The Chins soon also incorporated bank-notes from the Fergies as a part of their currency back home, though they’ve always kept it tucked away as the Fergies didn’t export what they didn’t already have back home. The only thing that the Chins ever really wanted from the OC were the seemingly ubiquitous shiny pebbles and notes representing claims to these pebbles.

Soon, the food of goods from the Chins created a disinflationary effect on the economy of the OC, and the Klings, whereas before they could not afford the luxuries that the Fergies have enjoyed, quickly snatched up goods at cheap prices. The opening to foreign trade had allowed Fergie business owners to shift their production to low-cost foreign countries, outsourcing jobs once held by Klings. There were some complaints regarding job-loss, but in general, society in a very content state-of-being, everyone could purchase price-deflated consumer goods for cheap, and no one was hungry.

Of course, the Fergies who have outsourced labor overseas to the land of the Chins quickly found themselves able to earn very handsome margins on the products they shipped back home. Branded goods and services soon appeared, and an entire fashion and glamour industry sprang up on the backs of high selling prices. Voluptuous females, Kling and Fergie, paraded the catwalks and appeared in newly printed media advertising the new crowning consumerism, and urging the nouveau riche to splurge pebbles on luxury goods made widely available and affordable.

This worked pretty well for a while. The Klings were happy consumers, and could purchase more than they ever thought imaginable. And due to the flexibility of the Fergie dominated central bank, which has increasingly injected more and more pebbles and claims to pebbles into the money supply to pay for goods imported from the Chins, the Klings were able to enjoy very beneficial financing terms. They soon bought their own homes with very little down payment and mortgage debt with very little money down, low interest rates, and a terms of twenty-plus years. Despite the fact that more and more jobs were being shifted to the land of the Chins, in aggregate this was no problem because enough jobs were being created in the real estate, finance, and consumer retail industries in the OC to off-set job losses in hard-asset businesses. Nobody really worried about “real wages”, because inflation didn’t exist in this world of endless cheap Chin goods. Of course, all this prosperity have kick-started asset prices even more, and prices in the local stock exchange—once very illiquid and with only Fergie participation—has become very trendy among the new middle class Klings. Everyone was happy to see their home prices appreciate, and everyone was ecstatic when the value of their portfolios went up steadily day by day. This has created even more confidence in consumer spending, and the Klings were enjoying the seemingly unlimited wealth that the new banking/financial system created. Meanwhile, behind the scenes, the Fergie central bankers and central bank chairman Ulan Bluespan made sure that the system created enough pebbles and pebble denominated debt to sustain this asset inflation and the consumption binge.

And meanwhile, the Chins were increasingly worried that the pebbles and notes claiming pebbles would soon depreciate in value. After all, their economy is now flooded with pebbles, and they have been recently suffering a serious bout of deflation with more and more manufacturing capacity coming online with the easy pebbles available. However, the seemingly insatiable demand of the OCs were simply too profitable to ignore (at least in terms of what they thought was profit… more and more pebbles and pebbles denominated notes). Plus, the OCs were seen by the Chins as an economically and politically superior group of people. The Fergies, on the backs of a prosperous economy, had encouraged out-of-work young Klings to join in a new military expansion program—in the name of all that is good and just: freedom, liberty, and the pursuit of happyness. Over time, this military expansion program had lead to overseas expeditions known as freedom fights, and this showed off the OC economic and military might to the rest of the world, which significantly helped in the credit ratings of the OC central bank in the eyes of Chins and an increasing number of other societies.

All this has served to greatly increase the Klings satisfaction with the Fergie banking administration. Although the Fergies did not necessarily create real income equality, there was a standard-of-living equality that greatly satisfied the large Kling population, whom can now be largely considered “middle class”. At the same time, however, nominal income disparity widened further, as the original many Fergie asset owners, and a few Nouveau riche Klings accumulated an ever-increasing share of society’s wealth, so much that they had no idea what to do with it except to invest further into more assets and/or use them to flip stocks.

Abstract artists, once considered economically despicable in both the proud warrior-like Kling species and the practical Fergie race were soon making a good living tapping paint on a canvas and making random stories of feelings and heartbreaks. A canvas with three red dots were fetching on the market for as high as five hundred million pebbles. This mirrored the increases in securities markets and maybe even more.

However, the Fergies soon realized that this economic miracle would not be forever, and they soon started thinking about the downside to all this. The more they thought, the more they began to hedge themselves. The consumption binge and the seemingly endless asset inflation would grind to a halt if any trouble with the belief in the value of the pebble would come into question… but so long as the Chins and other nations impressed with the OC’s economic and military might were willing to take these pebbles and finance whatever account deficits and a growing national debt, and keep these in their foreign reserves and treat them as legal tender for possible future purchases, then the OC would be fine, and this binge would continue on and on. But all good things must end, and the fact remains that these pebbles were once just pebbles on a beach, and they hold no real value what-so-ever, and that sooner or later, there would be doubts to the real value of the OC pebble, and what goods and services that it might bring to the holder. The Fergies know this, and they are devising methods to try and shift the risk away from themselves.

Finally, the greediest among the Fergies would devise a method to enrich themselves one last time and still guarantee they would still come out alright. So, with a natural instinct for profit, and ever at a loss in finding ways to make money and keep money to themselves, the Fergies have devised very intricate financial innovations. The first of these innovations was asset securitization. The Fergies geniously devised a plan to extend even more credit to households that were not living the OC dream yet (they call this subprime pebble loans), and packaging these loans into fixed income securities called Mortgage Backed Securities. They also extended numerous loans to new start-up companies created by young, educated, and optimistic Kling entrepreneurs, and packaged the cash-flows to those and sold them off as Asset Backed Securities and Collateralized Debt Obligations. The Fergies loaned to whoever they could, and transferred the risk of default and asset depreciation to the investing public (whom by now are in a frenzy of asset purchases and speculation), and pocketed billions of pebbles worth of transaction fees and brokerage fees. Second, they began marketing various derivative instruments and packaged fixed income instruments to foreigners—in particular, the Chins, who were not as sophisticated as the Fergies in coming up with financial innovations, but were nevertheless eager to invest due to the strength of the OC pebble on the international currency exchanges. Third, the Fergies began to encourage leveraged products, as diminishing investment returns and low risk-return spreads plagued the rabidly greedy investors. This leverage allowed Fergies to pocket even more fees as they package ever increasing debt and sell them off to the public. As long as asset prices appreciated more than the interest on any of these loans that the Fergies made, then the investors were golden. Fourth, the Fergies began to create even more fervor among markets by organizing Private Equity funds, where they garner billions and billions of pebbles from investors, and take public assets private on the bank of billions of dollars in bank loans often at 20 – 30% premiums, and then IPOing these private equity funds back to the public at and even more mark-up.

Among all the frenzy in the markets, and everyone buying into the belief that the new financial innovations that the Fergies devised making investments permanently safer and more liquid, asset prices kept going up for a while. The Fergies have long gotten out of the game, while the Klings keep flipping and the Chins keep hoarding assets.

One day, out of the blue, the Chins decided that they now had enough pebbles and pebbles denominated debt to last them ad infinitum, so they started buying OC hard assets themselves (much like the Japanese did during their market bubble). The Klings also started selling these assets, and pretty soon, there was a rush of Klings wanting to sell and pocket their gains. Asset prices went down a bit, and margins on loans were called, and securitized products began losing some of their collateral. In other words, minor events and tremors in the system, and the subsequent asset price declines soon triggered several critical states in the economy. Those that had houses on subprime pebble loans began receiving rates that were beyond their payment capability, and they defaulted. Loans made on the backs of company products and equity securities were increasingly being called in. Klings and Foreigners across the board began losing money, and buying interest was taken out of the system by quite a bit.

And the Fergies central bank, in attempt to fix the problem, pondered two possible scenarios: lower borrowing costs, which will inject excess liquidity even more and support asset prices, but nevertheless will induce foreigners to sell pebbles, and will probably resulted in a run by the Chins on the existing pebble currency, where inflation hidden in years of disinflationary consumer products will finally kick in. Or, do nothing, which will create total illiquidity, where asset prices continue to tumble and across the board losses will occur with much of the value of pebble denominated assets wiped out—not to mention all the derivative products that were written to the public. Either way, however, the Fergies come out fine, due to their shrewd transfer of risk to the public, and their ability to buy back cheap assets when the markets tank.

Fergies 1, the rest 0. By now, the gems that were originally the money supply replaced by pebbles are now worth 600 pebbles per 1 gem. And the economy of OC is being plagued with an extended period of stagflation.

What will the Fergies think up next?

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