Financial Stability

Fraud, Confidence and the Wealth of Nations

Frederick L. Feldkamp, R. Christopher Whalen

• Publisher: Wiley
• Year: 2014
• ISBN:
  9781118935804
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Applying the Lessons of History to Understanding Fraud Today and Tomorrow

Financial Stability provides a roadmap by which the world can anticipate and avoid future financial disruptions. This unique discussion of past and present financial events offers new insights that explain economic, political, and legal antecedents of financial crises in Western markets. With a detailed discussion of the history of finance, this book shows modern investors and finance professionals how to learn from past successes and failures to gauge future market threats.

Readers will gain new insight into the antecedents of todays financial markets and the political economy that surrounds them. Armed with this knowledge, they will be able to craft a strategy that steers away from financial disorder and toward maximum stability. Coverage includes discussion of capital, forecasting, and political reaction, and past, present, and future applications within all realms of business. The companion website offers additional data and research, providing a complete resource for those seeking a better understanding of the risk at hand.

As the world struggles to emerge from the latest financial crisis, professionals in finance, the law and other disciplines, and the people they advise, are searching for understanding to avoid future crises. Financial Stability argues that the best lessons are learned from our own mistakes, and that the ability to look ahead depends upon our willingness to look back. Readers will:

• Review the historical laws, practices, and outcomes that shaped the modern day financial markets of the great western economies
• Understand the theory of financial stability, the roles of law and transparency, and the importance of action to punish fraud in order to prevent future contagion
• Work through the theoretical proofs in terms of math, law, accounting, economics, philosophy, and international trade
• Build a strategy for the future with consideration toward needs, sources, balance, and learning from past mistakes

Everywhere around the globe, at all points in history, financial crises have always been rooted in the confluence of politics, finance, and law. Financial Stability puts the latest global financial crisis in perspective, highlighting the lessons we have already learned, and those we need to internalize today.

PART One
A Flight through Financial Market History—Freedom and Fraud

CHAPTER 1
The First Few Millennia

The first five books of the Bible are common to the religious heritage of three monotheistic faiths: Judaism, Christianity, and Islam. For believers, these five books record history from Earth’s beginning to the death of Moses. With reliance on one god, monotheism overcame the duplicity of polytheistic faiths where strife was accepted as deceptions of man caused by differences among the various gods.

Deuteronomy is the fifth book of the Bible. Scholars have different theories on the timing and purpose of Deuteronomy. It was written after the Jews escaped slavery in Egypt and before they reached the Promised Land. By the time the book was composed, settlements of anatomically modern humans existed on every continent.

Coming from slavery and having wandered the desert for a considerable time, one can imagine the level of strife and debate within the Jewish tribes over how to treat each other in the face of competition for scarce resources. Deuteronomy seems to be a kind of treaty that lists specific behaviors that followers of Moses required of each other. It let them live in peace while seeking the greater society that was yet to come.

The book is an early statement of the rule of law. Some admonitions (e.g., one requiring that a woman’s hand be cut off if she defends her husband by grabbing the genitals of an enemy) seem unique to a tribal community with a need to procreate. The book’s definition and preclusion of fraud, however, is enduring.

Deuteronomy mandates that followers apply only one measure in their homes and trade. That precludes the use of two measures—that is, duplicity, the core of all fraud. It equally prohibits use of a small measure when a large one is proper (e.g., when selling bread) and use of a large measure when a small one is proper (e.g., when buying wheat).

Deuteronomy dates to somewhere between the twentieth and seventh centuries before the common era denoted by the Gregorian calendar. Precluding the use of two measures is recognition that society has an interest in preventing the threat that fraud poses to peace and prosperity. This side of the rule of law is summed up in the Silver Rule of earliest theology and philosophy: “Do not do to others what you do not want others to do to you.”

The Golden Rule, which emerged around the world near the start of the common era, inverts that proposition. It calls for affirmative individual action: “Do to others as you want others to do to you.”

The Golden Rule creates an individual obligation to step forward and make peace. The Silver Rule creates a collective obligation to preserve peace by avoiding specific behavior. All financial crises are founded in fraud. Precluding fraud will not end duplicity, so the law in Deuteronomy cannot assure financial stability. Precluding fraud is essential to financial stability, however, since it provides a standard toward which we can aspire and measure actions. It is only by disclosure and affirmative support for good transactions (explained later) that society can identify and undo fraud in a manner that sustains stability.

Punishing fraud is necessary to minimize the gotcha effect, or the sudden ebbing of confidence that surprises markets and triggers financial crises when unsuspected fraud is exposed. Instability begins when confident investors lend money to (or otherwise entrust) intermediaries that prove unworthy of trust. Fraud breaks that trust. It hides speculation until the duplicitous activity generates losses or inquiries that lead to discovery, but that generally occurs only after the entrusted money is gone.

When significant or systemic fraud is discovered, trust is shattered (along with fortunes) and is very hard to regain. Revelations of fraud trigger the spikes in credit spread that create crises. When confidence returns, spreads fall. When the cost of Adam Smith’s great wheel falls substantially, however, financial intermediaries perceive a need to hide speculation so that smaller margins can be collected on a larger base.

To do this, it is inevitable that some institutions will stoop to using two measures for investment. Speculation will determine that firm’s actual investments but will not be disclosed. The duplicity of secret speculation benefits managers at the later expense of investors. The use of off-balance sheet finance, discussed later in this book, is a prime example of this behavior. That is what makes such practices a moral hazard problem.

When the fraud fails, investors have no apparent source for repayment, as illustrated by the tiny recoveries in the $7 billion fraud committed by Allen Stanford. As investors rush for the exit, they drag good institutions down because investors lose trust in all institutions and markets contract in synchronicity.

Financial institutions, moreover, can be expected to lose customers when a competitor invades their territory and uses duplicity to permit managers an edge. When fraudulent savings and loans (S&Ls) used accounting gimmicks to hide speculation and undercut the practices of responsible commercial bankers in Texas during the 1980s, the biggest casualties were honest Texas banks that faced the choice of match or die. It is in good times, therefore, that regulators must insist on one measure for all.

Along with preventing fraud, vibrant private markets are also essential to assuring financial stability.

Ancient Rome certainly understood the power of controlling money in the first century. Cicero labeled the unlimited financing of coinage and taxation by a state monopoly “the sinews of war.” From ancient Rome to today, governments have used banking schemes (often supported by armies) to create and force acceptance of their currency. The government that exercised this power most carefully, in turn, was the winner of almost all wars in history.

Rome controlled the Mediterranean world by dominating money, through its ability to create currency and collect taxes for its support. Temple priests in Jerusalem used the conversion of Roman money and their control of Temple money to fund their work free of Roman interference. To them it was obvious that their currency exchange and pricing practices would not survive in an open market outside the Temple.

In the United States, disputes over banking started in part because Thomas Jefferson despised central banks as much as he despised the priests and kings who controlled them. The history of money and its control, however, links to just about everything evil and good in every society, because banking is the mirror image of the rest of society. The assets of banks (loans) are the liabilities of the rest of society and the liabilities of banks (deposits) are the assets of the rest of society. Because production and finance are intertwined in this manner, banking is both supremely important and utterly frustrating. As we discuss later, the world of finance can be explained using the image of a large water balloon. Whenever the balloon is pushed from one or more sides, an equal and opposite reaction must occur somewhere else. The key to financial stability is understanding the precise places where each push will generate a response.

In the four millennia between Deuteronomy and the eighteenth century, death was a likely end for anyone who dared to challenge those who controlled people by controlling money. Chinese emperors, the Incas of Peru, European despots, and religious tyrants all monopolized the processes of finance to control the money and thoughts of their subjects.

There is little evidence that these despots had much regard for the well-being of individual subjects. It is only as independent central banks emerged after the Dark Ages that we begin to see free and open debate between the critics and proponents of banking. Only then do we begin to see suggestions for how to use money and banking for the general welfare of citizens.

CHAPTER 2
The Bank of England and the Scottish Enlightenment

Under the rule of English monarchs, before the seventeenth century British civil war, anyone who sought to open finance and interfere with the ability of the crown to fund its whims faced the possibility of horrific punishment and death. It was treason to undermine supreme rulers. In England, treason could be punished by public hanging, disembowelment, decapitation, and just about every other torture conceived by man.

Then came the Glorious Revolution and the Scottish Enlightenment.

By a confluence of unusual events, as the middle of the eighteenth century approached, a small group of gifted thinkers in the Scottish capital of Edinburgh (theretofore a rather dreary regional capital dominated by a hilltop castle) was suddenly allowed to say just about anything that was well-reasoned in regard to the rule of recently crowned Hanoverian kings in London.

In the seventeenth century, Charles I, a Stuart and a Scot, became the king of England. His assassination led to a civil war. After the dictatorial rule of Oliver Cromwell, Charles II was for a time the king of England, Scotland, and Ireland. Then came the Glorious Revolution. In 1688, William of Orange and his wife, Mary (both Stuarts, descended from Charles I), came to England from Holland. William deposed James II and became King William III of England.

Parliament refused to tax citizens to allow William to make war with France. In 1694, however, it borrowed a concept from Sweden and Holland. Parliament created the Bank of England. The BOE allowed William to take in deposits, which were borrowed by the government to make war with France. This was rather like the United States using war bonds to finance World Wars I and II and the later deficit funding of wars in Vietnam, Afghanistan, and Iraq.

In Holland, having a central bank enabled the government to control lending and lower the cost of long-term government borrowing. That allowed Holland to build dikes and fund the land recovery needed to convert the bottom of the North Sea to farmland.

The process of turning salty sea beds into arable land can take decades or even a century. Using a central bank allowed for development of a farm infrastructure with limited risk (aside from a tulip mania) of disrupting the means of funding normal commerce. The same process, in the hands of militarist rulers, permits high-risk gambles on the success of war.

In England’s case, William’s war with France and a series of conflicts with Spain proved economically imprudent (as is usually the case). The lesson of history is that no nation can afford war. William died in 1702 and was succeeded by Anne, the last of the Stuarts. When she died in 1714 with no surviving offspring, the Stuart reign ended as its other potential successors were barred from ascending to the throne as Roman Catholics.

George I, the elector of Hanover, Germany, succeeded to the British throne in 1714. The Hanover family (who later changed their name to Windsor when Germans became notably unpopular) has reigned in England since 1714.

Rather than tax their subjects to pay for past errors, Parliament embarked on a series of schemes by which they sought to hide incurred losses. These gambles backfired.

One idea created the infamous South Sea Bubble. In 1711, Parliament approved the creation of a company with a monopoly on British trade with South America. It was capitalized with British government liabilities, and shares were sold to citizens based on expected returns from the bonds and prospects for favorable trading. It was a Ponzi scheme.

Investors, lured in by the promise of quick returns, rarely stopped to ponder the problem Spanish and Portuguese control of South America posed to the firm’s trading prospects. England was often at war with Spain. The company failed, of course, and a decimating financial crisis followed.

In addition to destroying firms in London by its perceived need to increase revenues, the Bank of England felt compelled to charge high rates on advances made to Scottish banks that used the money for investments in and around Edinburgh. At least one of the Scottish banks was owned by friends of Adam Smith. With no means to collect more interest from customers, the Scottish banks and their owners went broke.

In short, the first 50 years of British central banking were grim for English and Scottish investors alike. One benefit of this debacle, however, was the thinking generated in the mind of Adam Smith by his friends’ losses. The result was an analysis of how banking should be conducted that remains as relevant today as when Smith wrote it in 1776.

In 1745, despite financial losses and the city’s capture by an army supporting a Scottish claimant to the throne of England (Bonnie Prince Charles), Smith and other intellectuals in Edinburgh remained loyal to the Hanoverian King of England, then George II. These intellectuals did not challenge the Scottish Highland clans that joined forces with Prince Charles to seize Edinburgh and fight the English army (which soundly defeated them) but neither did they join the clans.

Perhaps the English saw a need to encourage loyal Scots who could serve as a buffer while they resolved issues with the clans that fought to enthrone Charles. The intellectuals of Edinburgh, in any event, became a loyal opposition recognized for enlightened thought, even in dissent.

The Scottish Highlands suffered as British ...