(Executive Review) Tower of Basel by Adam LeBor

Synopsis:

LeBor, an ardent anti-banker, presents a strong historical case for the questioning of the role of central bankers in the modern financial system.  Using historical case data dating back to 1920’s Germany, LeBor paints the picture of the Bank for International Settlements (“BIS”) as the caricature of an unaccountable elusive organization serves as a stand-in for central bankers of all stripes.

Summary: 

LeBor begins with an account of the BIS as having been founded following the implementation of the Dawes Plan, the treaty through which German reparations were to be paid out following WWI.  Out of this, the BIS was born.  As Keynes summarized at the time:

“The United States lends money to Germany, Germany transfers its equivalent to the Allies, the Allies pay it back to the United States Government.  Nothing real passes – no one is a penny the worse.  The engravers’ dies, the printers’ forms are busier.  But no one eats less, no one works more” (p. 10).

Under the auspices of settling the accounts of the various countries in the merry-go-round of payments systems involved in WWI reparations, the BIS took shape.  The BIS was chartered under Swiss Law, in Basel, with the following functions:

  • buying, selling, and holding gold
  • buying and selling securities other than shares
  • accepting deposits from central banks
  • opening and maintaining deposits for central banks
  • acting as an agent of or correspondent for central banks
  • entering agreements to act as a trustee or agent in connection with international settlements (p. 21)

From its earliest days, however, the Bank was quickly transformed into a machine for the advancement of German interests, particularly those of the Nazi party.  Names like Hjalmar SchachtHermann Schmitz, and Kurt Baron von Schröder were some of the earliest involved in running the BIS, and all were later tried for war crimes following WWII (p. 35).  These names, and the German-American business connections behind them, feature prominently throughout the book and serve a central role in the operation of the BIS throughout the 20th century.

LeBor then highlights, in a prelude to WWII, how economic warfare had become a component rivaling that of the battlefield.  During the Spanish Civil War, the German-backed nationalist government set up its own national bank which by war’s end produced a rival currency worth three times the Republic’s currency despite a lack of gold reserves (p. 55).  As LeBor points out:

This, as much as the Blitzkrieg, was the real lesson of the Spanish Civil War: the nationalists’ sophisticated fusion of financial and military power.  The Nazis would hone this model, using the BIS to underpin their economic empire.

The BIS, which housed the gold reserves of the various constituent banks, including France, Germany, Austria, and others (notably absent was the U.S. because at the time, U.S. leaders were wary of involvement in oversees commitments), functioned as an international clearinghouse for central banks.  Worth quoting in its entirety is the parallel drawn by LeBor of the BIS method of transaction to that of the islanders of Yap, in Micronesia:

The BIS managers and directors were immensely proud of the bank’s innovative, new mechanisms for gold and foreign currency trades.  But the principle behind earmarked accounts was not nearly as new as they believed.  Few, if any, of the BIS directors had ever heard of the island of Yap, in Micronesia.  But centuries ago its inhabitants had invented a similar system, one based on large limestone discs.  The discs, known as fei, were quarried on a neighboring island and brought back to Yap by boat.  The discs, the islanders decided, represented substantial wealth-enough, for example, to pay for a daughter’s dowry.  But the “currency” was extremely heavy and almost unmovable.  So it stayed in its place, and only the ownership changed with the agreement of the buyer and seller.  In fact the stone did not even need to be present on the island.  The locals’ oral tradition tells of one disc that fell off the boat into the sea.  Rather like the gold deposits of the BIS accounts in London or New York-or indeed any bank nowadays-the physical existence of the submerged fei was taken as a matter of faith.  The islanders simply passed the ownership of the submerged disc back and forth-until 1899 when the Germans arrived and colonized the island of Yap (p. 61).

Like the stone quarry of the Yap, the BIS simply earmarked the appropriate gold reserves for each country’s account as they were held in the United States and Britain.

Despite the U.S. not using its allotted shares of its BIS stake, many prominent Americans stood alongside the Germans in shaping BIS policy.  The well-connected John Foster Dulles, along with his younger brother Allen Dulles, stood at the heart of BIS affairs in its early years.  These two, with Thomas McKittrick, largely shaped the German-American connection which kept the bank running during WWII.

In another aside, the author explains how several of these prominent figures were involved in what became known as the “Swedish match scandal” (p. 75).  Here again it is worth quoting the passage:

Wall Street had welcomed [Ivar] Kreuger [the head of the ‘scandal’] with open arms and checkbooks.  Thanks to McKittrick and his colleagues, Kreuger’s reputation had preceded him.  The London Higginson partners told their American colleagues that Kreuger had already made them a fortune.  But it was a fortune built on fraud.  Kreuger had constructed a massive ponzi scheme that demanded a never-ending stream of new investors to pay their predecessors.  In 1931, one of the brokers at Lee, Higginson wrote to Kreuger that some of his bank creditors would like more information about the company and how it worked.  The broker asked Kreuger to explain what he meant by “loans secured by real-estate mortgages,” which was an eerie precursor of the bundled mortgages that triggered the subprime meltdown in 2007 [emphasis added].

A recurring theme that runs through the book, beside the obvious main point driven home by LeBor that the BIS has numerously served as a tool for German advancement, is that history has shown a failure on the part of the U.S. financial and political elite to forecast the consequences of decisions made on their behalf.  Driven by the decisions of appeasers such as Norman Montagu, U.S. and other Allied financiers allowed Axis powers to advance their interests during the wartime, particularly those of Germany.

McKittrick remained head of the BIS even after the U.S. signed the Lend-Lease program, effectively ending their neutrality.  Despite this, he was allowed to remain head of the BIS, a sure sign that Germany found his acquiescence suitable to their needs, as they could have opted to have a neutral country’s banker serve at the helm.  However, as LeBor points out, the Nazi’s used the BIS to shuttle stolen gold and other means of payment to the rest of the world.  Gold shipments from Bern to Bulgaria, as well as gold exchanges with Turkey (neutral, but traded heavily with Germany), and gold smuggled from Germany to the Swiss National Bank (SNB) constitute some of the transactions the BIS took in accordance with German military and economic interests during the wartime era (p. 87).

Chapter 8, “Arrangement with the Enemy,” goes on to detail how, utilizing the strong wartime connection between Stockholm and Berlin, the U.S. implemented the “Harvard Plan.”  The plan’s primary objective was to win over the German financial and political elite by appealing to the profit motive which could be realized after the war (p. 119).  This arrangement, which played itself out just a few years later, manifest itself in the International Bank for Reconstruction and Development (IBRD) and the International Monetary Fund (IMF), both of which operate today.

Chapter 9, “United States to Europe: Unite or Else,” describes the structures set up in post-war Europe to facilitate reunification.  Beginning with the Marshall Plan, the U.S. began a path of greater involvement with Europe.  Although the BIS did not directly distribute the Marshall Plan funds (as the U.S. still was not technically a member), it did “advise” on many of the mechanisms of distribution.  During this time the OECD and World Bank were also constructed, both of which the BIS was at least tangentially related to in some form or another.

Chapter 10, “All is Forgiven,” repeats the theme set forth by the Harvard Plan.  Indeed, German bankers who would otherwise have been charged with war crimes, and whose involvement in the war effort was substantial, were allowed to participate in the new economic order of Europe.  The Reichsbank was abolished, replaced with the Bank deutscher Länder (BdL).  Most of those who had served in some capacity during the war were given positions with the new bank, which itself was the precursor to the Deutsche Bundesbank prior to the ECB’s creation.  Germany’s plans for a postwar European economic order were laid out in the Red House Report (p. 155).  Below is the author’s summary of the events:

As the Allies advanced on Germany, the Nazis stepped up their plans for the postwar era. On August 10, 1944, an elite group of industrialists gathered at the Maison Rouge Hotel in Strasbourg, including representatives of Krupp, Messerschmitt, Volkswagen, and officials from several ministries.  Also in attendance was a French spy, whose report reached headquarters of the Allied invasion force, from where it was forwarded to the State Department and the Treasury.  The account of the meeting is known as the Red House Report.

Germany had lost the war, the Nazi industrialists agreed, but the struggle would continue along new lines.  The Fourth Reich would be a financial, rather than a military imperium.  The industrialists were to plan for a “postwar commercial campaign.”  They should make “contacts and alliances” with foreign firms but ensure that this was done without “attracting any suspicion.”  Large sums would have to be borrowed from foreign countries.  Just as in the prewar era, the US connection and links to chemical firms, such as the American Chemical Foundation, were essential to expanding German interests.  The Zeiss lens company, the Leica camera firm, and the Hamburg-American line had been “especially effective at protecting German interests abroad.”  The firms’ New York addresses were passed around the meeting.

This continues on page 156:

US Treasury officials were closely watching this massive export of German capital, much of which was going to South America…Harry Dexter White told a meeting of Treasury officials in July 1944 during the Bretton Woods conference. …’They bought estates and industries and corporations, and there is evidence that German corporations have been buying into South American corporations in the expectation of being able to re-establish themselves there after the war.’ …The Treasury officials also discussed the BIS at the same meeting, noting that out of twenty-one board members and senior officials, sixteen were ‘representatives of countries that are either now our enemies, or are occupied,’ including Walther Funk and Hermann Schmitz [emphasis added].

It is at this point that LeBor begins outlining the many German connections to the postwar European economic order.

Chapter 11, “The German Phoenix Arises,” begins with the establishment of the European Payments Union (EPU) in 1950, which was ultimately the precursor to the EMU.  The BIS was the “agent” of the EPU, managing banking, controlling funds, and keeping accounts.  This represents the other point central to LeBor’s premise: that the BIS has morphed over time as its responsibilities have dried up, finding a way to make itself useful after its stated purpose has been outlived.

During the Bretton-Woods era, the U.S. was having difficulties keeping the USD pegged to gold at $35/oz.  In order to keep the system afloat, the BIS was used as the staging ground for the London Gold Pool (p. 188).  Despite the fact that there was no written agreement, the central banks of numerous countries colluded to keep the price of gold stable in order to preserve the currency system established decades earlier.  This meeting took place in what is now known as the BIS Markets Committee, which to this day does not post an agenda, take notes, or publish minutes of its meetings.

Included in these affairs are:

  • Price stabilizing measures enacted immediately following the Kennedy assassination, where the U.S. (on order of Charles Coombs) borrowed millions in foreign credit without any prior consultation of the foreign states to ensure international credit markets would remain sound (p. 190).
  • Financial aid to Hungary, allowing it to meet the financial obligation necessary to join the IMF (p. 203).
  • Coordination with Paul Volcker to extend credit to Mexico in 1982 during the “Tequila Crisis” (p. 207).

Bringing the story to the present day, LeBor tells of how the BIS oversaw the transition of the EPU to the European Monetary Agreement, as well as the agent for the European Monetary Cooperation Fund, which was ultimately parlayed into the European Union.  Largely a product of central bankers, the decisions of the Delors Committee laid the groundwork for the current economic framework in Europe.  Of course, these mechanisms were what the German political and economic elite had had in mind all along, as LeBor goes on to point out:

[Walther] Funk was released from Spandau Prison in Berlin the same year and died in 1960, but his pan-European plan for a continent free of trade and currency restrictions lived on and flourished. …In 1992 twelve European countries signed the Maastrict Treaty, which brought the European Union into existence (p. 219).

…To point out the any similarities between the Nazis’ postwar economic plans for Europe and today’s European Union is to risk ridicule and invective.  The European integration project has, for many, become and untouchable truth, an article of faith in the world’s inexorable progress toward a brighter and more secure future (p. 220).

…The uncomfortable, unspoken truth is that the parallels between the plans of the Nazi leadership for the postwar European economy and the subsequent process of European monetary and economic integration are real.  The BIS runs like a thread through both (p. 220).

…Funk’s deputy Emil Puhl described the BIS as the “only real foreign branch” of the Riechsbank (p.220).

…As early as 1940, Arthur Seyss-Inquart, the ruler of the Nazi-occupied Netherlands, called for a new European community, “above and beyond the concept of the nation-state,” which would “transform the living space given us by history into a new spiritual realm.” …The Reichsbank president [Funk] laid out his thoughts in a detailed, eight-page memo called ‘Economic Reorganization of Europe,’ a copy of which is stored in the BIS archive in Basel.

Given the supporting evidence of Nazi-BIS ties, it comes as little surprise to readers by books’ end that many of the German aims were near-universally realized.  LeBor continues:

The Reichsmark would be the dominant currency [according to Funk], but the currency basis of postwar Europe was of secondary importance to economic leadership.  “Given a healthy European economy and a sensible division of labor between the European economies, the currency problem will solve itself because it will then be merely a question of suitable monetary technique.”  Here Funk seems to anticipate the arguments of Euro enthusiasts who, fifty years later, claimed that a common currency, if properly constructed in the right economic conditions, could not fail.

Funk’s analysis and prediction are unsettlingly prescient of the subsequent course of postwar European economic and political history.

…Bilateral payments must be transformed into multilateral economic transactions and clearing arrangements, “so that the various countries may enter into properly regulated economic relations with one another through the intermediary of clearing arrangements of this kind” -just as happened with the 1947 Paris agreement on multilateral payments and its successor mechanisms, such as the European Payments Union (EPU).

It is in this chapter (chapter 14, “The Second Tower”), that LeBor makes his case for the BIS as the instrument that projected German control on the postwar European economy.  Of course, with such strong ties to both the Nazi party and the alphabet soup of European economic arrangements in the 1950’s and onward, the BIS was centrally located to serve this purpose.  LeBor continues on page 222:

An actual monetary union was more complicated, Funk presciently argued, as it demanded “a gradually assimilated standard of living, and even in the future the standard cannot be the same in all the countries participating in the European clearing” -a statement that neatly anticipated the modern disequilibrium between Germany and Greece. But once the European central clearing system was operating, foreign exchange restrictions would be abolished, first for travelers crossing frontiers and then for import trade.  There would be a bonfire of regulations that slowed down trade and commerce; Funk wrote, “Meticulous surveillance and all the regulations, which weigh down on the individual business enterprise with a mass of forms, will no longer be necessary” [emphasis added].

As accurate as Funk’s assessment seems to be, LeBor makes the case that it is a damning indictment of the BIS, and the technocratic leaders of postwar Europe.  Despite the war raging in Europe on the battlefield, German leaders were already planning ahead to a postwar Europe where Germany would secure a place as an economic hegemon.  As he writes on page 223:

The Nazi leadership welcomed Funk’s plans.  In 1942, The German Foreign Ministry created a “Europe Committee,” whose members drafted plans for a German-dominated European confederation.  That same year the Berlin Union of Businessmen and Industrialists held a conference at the city’s Economic University, entitled “European Economic Community.”  As the writer John Laughland notes, the titles of the speeches delivered at the conference are “eerily reminiscent of modern pro-European discourse.”  They include “The Economic Face of the New Europe,” “The Development Towards the European Economic Community,” “European Currency Matters,” and the hardy perennial, still much discussed today: “The Fundamental Question: Is Europe a Geographical Concept or a Political Fact.” In June a German official drafted the “Basic Elements of a Plan for the New Europe,” which outlined how the new confederation would work.

LeBor finishes by taking the book up to the present day, complete with the BIS’s role in modern affairs.  Although these stand out, they warrant a discussion all their own.  Germany has long had a history of manipulating the Eurozone to its own advantage, and indeed many scholars foresee an end of the ill-fated attempt at European economic unity.  However, an equally compelling story exists where the BIS plays only a periphery role, but sinister motives and German economic dominance feature heavily in the narrative…

Economics of the Euro (part 2) – Flaws

In part one of our story, we touched upon some of the theoretic foundations underlying the Eurozone.  Optimal Currency Area Theory and the notion that currency areas lead to positive political ties that prevent war combined to create the winds of change driving the sails that swept along European intellectuals in the latest great experiment in post-nationalism.  Although the discussion of a unified Europe predated the eurozone by decades, the main drivers behind the change were public intellectuals like Delors and Mundell, who saw a way to bridge the divides of nationhood and overcome some inherent functions of psychology (ex. in-groups and out-groups) and economics (ex. bond spreads between Eurozone countries).

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Graph of the Eurozone with countries adopting the euro in light blue.

“Europe exemplifies a situation unfavorable to a common currency. It is composed of separate nations, speaking different languages, with different customs, and having citizens feeling far greater loyalty and attachment to their own country than to a common market or to the idea of Europe.”

-Milton Friedman, 1997

The theory underpinning the creation of the Eurozone was built on the belief that nations could come together as could the various united states within the American Union.  Of course, at the root, members of the United States see themselves as Americans, while Europeans rarely identify as such.  This lack of a supra-national identity has distinct ramifications for the Eurozone, as well as all areas that try to overcome the limits of banking.  Even the United States, which uses a common currency courtesy of the 1913 Federal Reserve Act, is hardly a bastion of unity.  In fact, Michael Kouparitsas of the Chicago Fed argues that the United States is not one OCA but rather eight.  This analysis comes courtesy of a 2001 paper on the topic, which highlights the economic differences between various regions of the United States.

The main flaw, of course, need not even be thought of as the failures of assumption in creating the framework, but the active forces pulling at the Eurozone today.

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European Central Bank

Economists agree that two primary forces are at work in the macroeconomy – monetary policy and fiscal policy.  Generally, monetary policy is the application of controls to various aspects of the financial system, such as regulating bond prices or controlling the amount of money in circulation (who does this, as with many aspects of economics, varies according to who you ask).  The ability to regulate monetary policy has generally come under the purview of central banks in the last 100 years.  Markets keep a close watch on what central banks plan on doing with regards to monetary policy, and as such there has been a general push to separate central banks (the Federal Reserve, for example) from government (Congress, for example), in hopes of avoiding a political business cycle driven by partisan economics.

On the flip side of this coin is fiscal policy, which in the simplest terms is the way about which government chooses to tax and spend.  But for a brief period during the Clinton administration, but United States has nearly continuously run budget deficits for the last century.  Of course, the United States can do this primarily because of its ownership of a central bank that can print money to bail out any loans that might have accrued over time.  Contrary to the alarmism present in the popular press, the United States is not “in debt to China” and cannot default on its debt unless congress willfully defaults on its own.

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U.S. deficit charted by year since 1946, from The Atlantic piece cited above.

In the Eurozone, however, such a case is not so cut and dry.  Imagine, for a moment, that the Eurozone is simply the United States.  Kansas is France, and le Gouverneur Sam Brownback has decided to spend significantly more euros than the French state brings in through taxation.  This is a problem for La République.  In order to cover the cost incurred by the state, bonds must be sold in order to pay off the current debt brought about by this year’s shortfall.  This can happen for a few years without suspicion, but eventually financial markets begin to question the solvency of the French state.  This of course, is precisely what happens in the eurozone, where some states post significantly greater default risk than their counterparts.

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Spreads on Euro-area bonds prior to the inception of the Eurozone through 2011.

This point can clearly be seen in bond spreads, where certain countries in the Eurozone have significantly higher yields in order to compensate for the added default risk.  The United States, unlike the Eurozone, can bail itself out by printing its own money.  If creditors come calling, bills can be printed and debts paid off.  In the Eurozone, however, individual countries do not have the option to print their own euros.  Rather, the European Central Bank (ECB) prints euros that are then distributed.  This creates adverse incentives for individual member states, however.  States that overspend might expect to be bailed out by the ECB in the event of default, as the Germans accused Greece and Cyprus of expecting during the turbulence of the post-Great Recession crisis.  This tension between fiscal policy and monetary policy is a recurring theme in macroeconomics today and one that we will regularly revisit as this series continues.  The graph above on bond spreads warrants a discussion all its own, and misaligned incentives will make a reprising role in future parts.  Stay tuned.

Excel Applications: Naive Bayes AI (Text Classification) – part 1 of 2

Excel Applications: Naive Bayes AI (Text Classification) – part 1 of 2

Artificial intelligence is pervasive in our world today.  From the cars we drive to the food we eat, our world is increasingly defined by the algorithms and the formulas of which they are composed.  Because of the diversity of possible applications of artificial intelligence, cottage industries have cropped up attempting to apply AI models to virtually every facet of modern life.  Although the applications of these techniques are quite modern, the underlying techniques themselves predate modernity by generations.

The workhorse of artificial intelligence algorithms is derived, interestingly enough, from the work of an ecclesiastical 18th century academic and statistician, Thomas Bayes.  After his death, his notes would be published, laying out the foundations of Bayes’ Theorem, which would find new purpose in the world of machine learning.  Concurrently, Bayes’ Theorem experienced a renaissance in the aftermath of the post-2008 financial crisis world, where “fat tails” and “black swans” gained notoriety as common parlance in mainstream academia.  The simple premise underlying the statistical jargon is that previous observation (or “Bayesian priors”) should be accounted for when making predictions about the future.

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Platykurtic, or “Fat tail,” distribution, which in finance refers to greater price volatility

Think about recent flooding.  Climatologists often proclaim to much fanfare that once-in-a-hundred year hurricanes, earthquakes, and other natural phenomena are occurring at rates that far exceed their likelihood, and thus their policy recommendations should be considered above their more muted peers.  Bayesian thinking, including the incorporation of “priors”, might indicate that the likelihood of the inaccuracy of the model is greater than the likelihood of two massive wildfires occurring in subsequent years being a virtual impossibility.  Of course, this thinking pervades many spheres.  The financial meltdown of 2008 was caused in part (how many parts there actually were is the subject of a whole subset of literature) on the erroneous notion that risk in the sub-prime housing market was not systemic.  Of course, observation of prior banking crises indicates that in fact systemic risk is an endemic part of the banking sector.  Nonetheless, we will see that Bayesian thinking has become centrally featured in the world of statistics.

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Bayes’ Theorem in living color

Probability theory undergirds Bayes’ theorem and the naive Bayes AI applications used in Excel.  John Foreman’s Data Smart gives an excellent primer on probability theory, and is worth a look for anyone wanting a quick refresher in reference to AI models.  For our sake, it’s worth remembering that p(A|B) is the probability of A given B.  This is known as a conditional probability, because it is the probability that A occurs on condition of B occurring.  In the case of independent events, we can apply conditional probability.  If p(A)=.5 and p(C)=.5, the chance that both A and B occurs is .5 x .5 = .25.  Understanding probability theory will help in working through Naive Bayes models, particularly with regard to sentiment analysis application in Excel.

The model used for our purposes will allow us to perform text classification.  Text classification in the modern sense allows us to rapidly and effectively make judgments about the class of text that we are attempting to understand.  Sentiment analysis, a subset of text classification, is often used by advertisers to gauge twitter reactions and customer reviews.  Text classification spans a broad range of applications, however, from military intelligence to targeted advertising to data mining.

Continue reading Excel Applications: Naive Bayes AI (Text Classification) – part 1 of 2

Economics of the Euro (part 1) – Foundations

Economics of the Euro (part 1) – Foundations:

Genesis

The foundations of the euro have their roots in war.  Although sovereignty, war, and currency are intertwined in ways beyond the scope of this series, the chain of causality in our story nonetheless beings following the second world war.  Following the reunification of Germany, the drumbeat of a unified Europe became a refrain that required response.  Germans, beginning with the Third Reich, developed a plan for a unified Europe that transcended the war-torn map they themselves had developed.  By the 1990’s, though, this plan had materialized as a way to prevent the future possibility of war.  If countries were intertwined in both economic and societal terms, so the thinking went, war would be an impossibility.  The first, and most significant, step was unification through trade liberalization and currency use.  Rather than separate countries, the goal of the eurozone would be create a new sovereignty on the basis of federalism.  Like the United States, the states within the eurozone would ultimately be superseded by a decision-making body that held sway over the decisions of its constituent members.  Although most every thinker will admit this goal has not been achieved, whether or not it is even possible remains largely a function of who you ask.

Optimal Currency Area (OCA), or: The Theory That Started It All

The idea underpinning the unification of the European area into a single currency union was born out of the work of Robert Mundell, who developed the theory of an Optimal Currency Area (OCA).  The OCA, roughly likened to an area like the United States (although this is a point of contention that we will return to later), is one in which certain criteria are met that allow for the frictionless adoption of a single currency.  Sovereign nations of course issue their own currencies, and this is roughly a layman’s approximation of an OCA.  More formally, areas that experience symmetric shocks in their economies should peg (fix) their currencies to one another.

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Asymmetric shock of a preference change in goods between two countries – this response, common in eurozone countries, defies OCA theory

The theory of shocks and the reality of asymmetric shocks in times of crisis (like, for instance, a multi-trillion-dollar asset bubble in an ill-regulated market) is one we will return to, but these ideas have since helped to explain the problems that arise from a system of pegged currencies (see also: the Euro, Argentine peso to USD, the Tequila Crisis, Bretton Woods).  In order to qualify as an optimal currency area, four primary conditions must be satisfied:

  1. Perfect labor mobility: The first criterion for an OCA assumes that workers are interchangeable across the extent of the area.  For this assumption to hold, workers’ preferences do not vary across regions.  Language barriers must not exist, skills requirements must be satisfied by workers, and prejudice has no place in the market.  Under this scheme, no barriers to the freedom of movement have been erected and costs are negligible (think of 401K’s and switching driver’s licenses-or passports).
  2. Capital mobility and wage/price flexibility: The second criterion assumes that supply and demand dictate the flow of capital throughout the region.  This assumes that wages and prices are freely able to adjust according to the flow of workers (such as an absence of a minimum wage).  Implicit in this assumption is the notion of a non-artificially restricted labor supply, tying back to the notion of labor mobility.
  3. Risk sharing that mitigates adverse impacts of conditions (1) and (2): The third criterion states that a system of fiscal transfers takes place that reduces the economic burden brought on by shifts in the flow of wages and workers across an OCA.  In the United States, for instance, redistribution of wealth takes place at the federal level and the state level, where certain states are net beneficiaries of federal dollars and others are net payers.
  4. Similarity of business cycles: The fourth criterion assumes that areas within the OCA have similar business cycles.  When the cycle trends upward in one area, that effect is similarly felt in all other parts of the optimal currency area.  This is also true in the reverse, whereby all areas affected by an adverse economic shock are affected equally.  This is closely related to the notion of asymmetric shocks, which we will later see disqualify certain areas from being truly optimal currency areas.

The list above constitutes the main four conditions that must be satisfied in order to be considered an OCA as originally set forth by Mundell.  Other potential criteria include product diversification, homogenous preferences, and solidarity.  If the list above sounds to you more like textbook theory than the eurozone, you aren’t alone.  However, the reasoning was sufficient to give proper context to the Maastricht Treaty, which started the domino effect of unification.

Humble Beginnings

The Maastricht Treaty provided the backbone of what would eventually become the EU.  In order to consolidate the various forces pushing for union, the Maastricht Treaty (along with the Delors Commission) created the three pillars of what would become the European Union:

  1. The European Communities (such as the ECSC)
  2. The Common Foreign and Security Policy
  3. The Police and Judicial Co-operation in Criminal Matters

 

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‘Three Pillars’ of the Maastricht Treaty, which eventually spawned the EU of today

The three pillars can still be seen today, in some ways in greater detail.  The ECSC in many ways acted as the precursor to the eurozone, while the third pillar foreshadowed Interpol.  Despite these beginnings, Europe remains somewhat distant from the ideals laid out by the three pillars.  For instance, many scholars have waxed poetic about the failure of Europe to enact a comprehensive foreign policy in the face of the global winds of change (despite the second pillar).

The Ghost of Maastricht

In order for states to enter the eurozone, however, price stability was needed.  Achieving it, according to the Maastricht treaty, required five criteria to be met.  The convergence criteria, or Maastricht criteria, were thought to constitute the necessary conditions for an optimal currency area’s creation.  The five criteria were:

  1. HICP inflation: Inflation levels for the countries entering the eurozone were supposed to stay within an ill-defined range which was counted as the unweighted arithmetic average of the similar HICP inflation rates in the 3 EU member states with the lowest HICP inflation plus 1.5 percentage points.  If, however, states had significantly lower interest rates than the average, they were not to be included in the measure of the lowest three.  How this was determined was through a test as to whether they had suffered from “exceptional factors.”  What seems more exceptional was that this rule was implemented at all.
  2. Government budget deficit: The ratio of the domestic government deficit was not to exceed 3% of GDP of the previous fiscal year.  This rule, although used as convergence criteria, was supposed to have been a strict, binding rule, although as we will see this has largely been violated by virtually every eurozone country at any given point in time.
  3. Government debt-to-GDP ratio: The government debt to GDP ratio was not to exceed 60% of the GDP at any time.  While the budget deficit is a flow, the debt ratio was a stock that, again, was supposed to be inviolable.  As time has progressed, however, most eurozone countries have gone well beyond the 60% mark, calling into question the ECB’s commitment to honoring the ground rules and the extent to which it seems willing to stamp out “moral hazard.”
  4. Exchange rate stability: Devaluation of the applying country’s currency was not to have happened in the prior two years to convergence.  Unlike the previous two rules, this rule (for obvious reasons) does not carry forward to the present day.  However, the inability of countries like Cyprus and Greece to devalue their currencies while Germany amasses a large trade surplus features centrally in the problems of the eurozone at the present time.
  5. Long-term interest rates: Long term interest rates were not to exceed 2% greater than the average of applicant countries, with wording similar to the first criterion.  The foundational notion behind both the first and fifth criteria was that post-convergence, inflation and interest rates for all eurozone countries would be exactly equal, as the market would view these countries’ bonds as perfect substitutes. As we will see, this erroneous line of thinking nearly caused Grexit and the eventual collapse of the EU.  Although that problem was staved off temporarily, the chief lesson from the 2008 financial crisis was that without fiscal controls available to the member nations, the assumptions behind the first and fifth criteria are fallacious enough to potentially end the eurozone experiment.

maastricht comic
Live look-in at current EU talks – c.21st century

The EU, founded upon the notion that unification would prevent war, has struggled since its inception to build a stable economic policy framework.  Between the assumptions made in equating the eurozone to an optimal currency area (four) and the assumptions implicitly behind the convergence criteria (five), the great unification experiment was founded upon a set of notions that have been in want of a solution in the decades since.  In the coming parts of the series we will examine these assumptions, the tensions behind solving them, and the outcomes if they go unsolved.  The experiment to end war through economics may ultimately rest on these very outcomes.

Principal Component Analysis with Python (Intro)

Principal Component Analysis (PCA) is a statistical remedy that allows data science practitioners to pare down numerous variables in a dataset to a predefined number of ‘principal components.’ Essentially, this method allows statisticians to visualize and manipulate unwieldy data.

For a moment, take a look at the graph below, which comes from Jose Portilla’s Udemy course on machine learning.  On the upper left graph, you see what would be considered a normal data with two features, or ‘components.’  This graph is the eventual output of a PCA transformation.  Looking at the bottom left graph, you see all of the data points graphed on a single axis, with the y value (‘Feature 2’) dropped so as to only display the values on a single x axis.  The bottom right graph functions in a similar way, but using the other ‘principal component’ (‘Feature 2’) as the axis.

PCA.png

At its root, PCA requires understanding the theory behind the X and Y axes that normally goes unnoticed when looking at plotted data.  Below, you see a traditional number line like the one that gets presented to primary school students across the country.  Normally, any value is plotted as a one-to-one relationship to a point on the graph.  For instance, take stock returns.  If in year one returns for the S&P 500 were 6%, that number would be dotted at the six.  If in the following year returns for the S&P 500 were -2%, that number would be represented with a dot at the -2.  Simply, all graphs that we see in everyday life are representations in 2-dimensional space as the intersection between two variables.

number line
Number line as shown to students learning mathematics fundamentals

In finance, statistics, epidemiology, and elsewhere, we typically see this referred to as an ‘axis.’  So, plotting any two of these at a 90 degree angle typically yields the scatterplots, bar charts, or trendlines typically seen in the professional and academic worlds.  PCA is principally no different from this, except that we take dimensions to the nth number and pare them down until we can visualize them on a two-dimensional graph.

When datasets get complex and more than two variables are used to capture the essence of the data, PCA can be used as a tool to visualize and capture information about the data structure.  In the following example, using Python, we will move through Principal Component Analysis on a built-in Python dataset: Continue reading Principal Component Analysis with Python (Intro)

(Content Review) Tower of Basel by Adam LeBor

Synopsis:

LeBor, an ardent anti-banker, presents a strong historical case for the questioning of the role of central bankers in the modern financial system.  Using historical case data dating back to 1920’s Germany, LeBor paints the picture of the Bank for International Settlements (“BIS”) as the caricature of an unaccountable elusive organization serves as a stand-in for central bankers of all stripes.

Summary: 

LeBor begins with an account of the BIS as having been founded following the implementation of the Dawes Plan, the treaty through which German reparations were to be paid out following WWI.  Out of this, the BIS was born.  As Keynes summarized at the time:

“The United States lends money to Germany, Germany transfers its equivalent to the Allies, the Allies pay it back to the United States Government.  Nothing real passes – no one is a penny the worse.  The engravers’ dies, the printers’ forms are busier.  But no one eats less, no one works more” (p. 10).

Under the auspices of settling the accounts of the various countries in the merry-go-round of payments systems involved in WWI reparations, the BIS took shape.  The BIS was chartered under Swiss Law, in Basel, with the following functions:

  • buying, selling, and holding gold
  • buying and selling securities other than shares
  • accepting deposits from central banks
  • opening and maintaining deposits for central banks
  • acting as an agent of or correspondent for central banks
  • entering agreements to act as a trustee or agent in connection with international settlements (p. 21)

From its earliest days, however, the Bank was quickly transformed into a machine for the advancement of German interests, particularly those of the Nazi party.  Names like Hjalmar SchachtHermann Schmitz, and Kurt Baron von Schröder were some of the earliest involved in running the BIS, and all were later tried for war crimes following WWII (p. 35).  These names, and the German-American business connections behind them, feature prominently throughout the book and serve a central role in the operation of the BIS throughout the 20th century.

LeBor then highlights, in a prelude to WWII, how economic warfare had become a component rivaling that of the battlefield.  During the Spanish Civil War, the German-backed nationalist government set up its own national bank which by war’s end produced a rival currency worth three times the Republic’s currency despite a lack of gold reserves (p. 55).  As LeBor points out:

This, as much as the Blitzkrieg, was the real lesson of the Spanish Civil War: the nationalists’ sophisticated fusion of financial and military power.  The Nazis would hone this model, using the BIS to underpin their economic empire.

The BIS, which housed the gold reserves of the various constituent banks, including France, Germany, Austria, and others (notably absent was the U.S. because at the time, U.S. leaders were wary of involvement in oversees commitments), functioned as an international clearinghouse for central banks.  Worth quoting in its entirety is the parallel drawn by LeBor of the BIS method of transaction to that of the islanders of Yap, in Micronesia:

The BIS managers and directors were immensely proud of the bank’s innovative, new mechanisms for gold and foreign currency trades.  But the principle behind earmarked accounts was not nearly as new as they believed.  Few, if any, of the BIS directors had ever heard of the island of Yap, in Micronesia.  But centuries ago its inhabitants had invented a similar system, one based on large limestone discs.  The discs, known as fei, were quarried on a neighboring island and brought back to Yap by boat.  The discs, the islanders decided, represented substantial wealth-enough, for example, to pay for a daughter’s dowry.  But the “currency” was extremely heavy and almost unmovable.  So it stayed in its place, and only the ownership changed with the agreement of the buyer and seller.  In fact the stone did not even need to be present on the island.  The locals’ oral tradition tells of one disc that fell off the boat into the sea.  Rather like the gold deposits of the BIS accounts in London or New York-or indeed any bank nowadays-the physical existence of the submerged fei was taken as a matter of faith.  The islanders simply passed the ownership of the submerged disc back and forth-until 1899 when the Germans arrived and colonized the island of Yap (p. 61).

Like the stone quarry of the Yap, the BIS simply earmarked the appropriate gold reserves for each country’s account as they were held in the United States and Britain.

Despite the U.S. not using its allotted shares of its BIS stake, many prominent Americans stood alongside the Germans in shaping BIS policy.  The well-connected John Foster Dulles, along with his younger brother Allen Dulles, stood at the heart of BIS affairs in its early years.  These two, with Thomas McKittrick, largely shaped the German-American connection which kept the bank running during WWII.

In another aside, the author explains how several of these prominent figures were involved in what became known as the “Swedish match scandal” (p. 75).  Here again it is worth quoting the passage:

Wall Street had welcomed [Ivar] Kreuger [the head of the ‘scandal’] with open arms and checkbooks.  Thanks to McKittrick and his colleagues, Kreuger’s reputation had preceded him.  The London Higginson partners told their American colleagues that Kreuger had already made them a fortune.  But it was a fortune built on fraud.  Kreuger had constructed a massive ponzi scheme that demanded a never-ending stream of new investors to pay their predecessors.  In 1931, one of the brokers at Lee, Higginson wrote to Kreuger that some of his bank creditors would like more information about the company and how it worked.  The broker asked Kreuger to explain what he meant by “loans secured by real-estate mortgages,” which was an eerie precursor of the bundled mortgages that triggered the subprime meltdown in 2007 [emphasis added].

A recurring theme that runs through the book, beside the obvious main point driven home by LeBor that the BIS has numerously served as a tool for German advancement, is that history has shown a failure on the part of the U.S. financial and political elite to forecast the consequences of decisions made on their behalf.  Driven by the decisions of appeasers such as Norman Montagu, U.S. and other Allied financiers allowed Axis powers to advance their interests during the wartime, particularly those of Germany.

McKittrick remained head of the BIS even after the U.S. signed the Lend-Lease program, effectively ending their neutrality.  Despite this, he was allowed to remain head of the BIS, a sure sign that Germany found his acquiescence suitable to their needs, as they could have opted to have a neutral country’s banker serve at the helm.  However, as LeBor points out, the Nazi’s used the BIS to shuttle stolen gold and other means of payment to the rest of the world.  Gold shipments from Bern to Bulgaria, as well as gold exchanges with Turkey (neutral, but traded heavily with Germany), and gold smuggled from Germany to the Swiss National Bank (SNB) constitute some of the transactions the BIS took in accordance with German military and economic interests during the wartime era (p. 87).

Chapter 8, “Arrangement with the Enemy,” goes on to detail how, utilizing the strong wartime connection between Stockholm and Berlin, the U.S. implemented the “Harvard Plan.”  The plan’s primary objective was to win over the German financial and political elite by appealing to the profit motive which could be realized after the war (p. 119).  This arrangement, which played itself out just a few years later, manifest itself in the International Bank for Reconstruction and Development (IBRD) and the International Monetary Fund (IMF), both of which operate today.

Chapter 9, “United States to Europe: Unite or Else,” describes the structures set up in post-war Europe to facilitate reunification.  Beginning with the Marshall Plan, the U.S. began a path of greater involvement with Europe.  Although the BIS did not directly distribute the Marshall Plan funds (as the U.S. still was not technically a member), it did “advise” on many of the mechanisms of distribution.  During this time the OECD and World Bank were also constructed, both of which the BIS was at least tangentially related to in some form or another.

Chapter 10, “All is Forgiven,” repeats the theme set forth by the Harvard Plan.  Indeed, German bankers who would otherwise have been charged with war crimes, and whose involvement in the war effort was substantial, were allowed to participate in the new economic order of Europe.  The Reichsbank was abolished, replaced with the Bank deutscher Länder (BdL).  Most of those who had served in some capacity during the war were given positions with the new bank, which itself was the precursor to the Deutsche Bundesbank prior to the ECB’s creation.  Germany’s plans for a postwar European economic order were laid out in the Red House Report (p. 155).  Below is the author’s summary of the events:

As the Allies advanced on Germany, the Nazis stepped up their plans for the postwar era. On August 10, 1944, an elite group of industrialists gathered at the Maison Rouge Hotel in Strasbourg, including representatives of Krupp, Messerschmitt, Volkswagen, and officials from several ministries.  Also in attendance was a French spy, whose report reached headquarters of the Allied invasion force, from where it was forwarded to the State Department and the Treasury.  The account of the meeting is known as the Red House Report.

Germany had lost the war, the Nazi industrialists agreed, but the struggle would continue along new lines.  The Fourth Reich would be a financial, rather than a military imperium.  The industrialists were to plan for a “postwar commercial campaign.”  They should make “contacts and alliances” with foreign firms but ensure that this was done without “attracting any suspicion.”  Large sums would have to be borrowed from foreign countries.  Just as in the prewar era, the US connection and links to chemical firms, such as the American Chemical Foundation, were essential to expanding German interests.  The Zeiss lens company, the Leica camera firm, and the Hamburg-American line had been “especially effective at protecting German interests abroad.”  The firms’ New York addresses were passed around the meeting.

This continues on page 156:

US Treasury officials were closely watching this massive export of German capital, much of which was going to South America…Harry Dexter White told a meeting of Treasury officials in July 1944 during the Bretton Woods conference. …’They bought estates and industries and corporations, and there is evidence that German corporations have been buying into South American corporations in the expectation of being able to re-establish themselves there after the war.’ …The Treasury officials also discussed the BIS at the same meeting, noting that out of twenty-one board members and senior officials, sixteen were ‘representatives of countries that are either now our enemies, or are occupied,’ including Walther Funk and Hermann Schmitz [emphasis added].

It is at this point that LeBor begins outlining the many German connections to the postwar European economic order.

Chapter 11, “The German Phoenix Arises,” begins with the establishment of the European Payments Union (EPU) in 1950, which was ultimately the precursor to the EMU.  The BIS was the “agent” of the EPU, managing banking, controlling funds, and keeping accounts.  This represents the other point central to LeBor’s premise: that the BIS has morphed over time as its responsibilities have dried up, finding a way to make itself useful after its stated purpose has been outlived.

During the Bretton-Woods era, the U.S. was having difficulties keeping the USD pegged to gold at $35/oz.  In order to keep the system afloat, the BIS was used as the staging ground for the London Gold Pool (p. 188).  Despite the fact that there was no written agreement, the central banks of numerous countries colluded to keep the price of gold stable in order to preserve the currency system established decades earlier.  This meeting took place in what is now known as the BIS Markets Committee, which to this day does not post an agenda, take notes, or publish minutes of its meetings.

Included in these affairs are:

  • Price stabilizing measures enacted immediately following the Kennedy assassination, where the U.S. (on order of Charles Coombs) borrowed millions in foreign credit without any prior consultation of the foreign states to ensure international credit markets would remain sound (p. 190).
  • Financial aid to Hungary, allowing it to meet the financial obligation necessary to join the IMF (p. 203).
  • Coordination with Paul Volcker to extend credit to Mexico in 1982 during the “Tequila Crisis” (p. 207).

Bringing the story to the present day, LeBor tells of how the BIS oversaw the transition of the EPU to the European Monetary Agreement, as well as the agent for the European Monetary Cooperation Fund, which was ultimately parlayed into the European Union.  Largely a product of central bankers, the decisions of the Delors Committee laid the groundwork for the current economic framework in Europe.  Of course, these mechanisms were what the German political and economic elite had had in mind all along, as LeBor goes on to point out:

[Walther] Funk was released from Spandau Prison in Berlin the same year and died in 1960, but his pan-European plan for a continent free of trade and currency restrictions lived on and flourished. …In 1992 twelve European countries signed the Maastrict Treaty, which brought the European Union into existence (p. 219).

…To point out the any similarities between the Nazis’ postwar economic plans for Europe and today’s European Union is to risk ridicule and invective.  The European integration project has, for many, become and untouchable truth, an article of faith in the world’s inexorable progress toward a brighter and more secure future (p. 220).

…The uncomfortable, unspoken truth is that the parallels between the plans of the Nazi leadership for the postwar European economy and the subsequent process of European monetary and economic integration are real.  The BIS runs like a thread through both (p. 220).

…Funk’s deputy Emil Puhl described the BIS as the “only real foreign branch” of the Riechsbank (p.220).

…As early as 1940, Arthur Seyss-Inquart, the ruler of the Nazi-occupied Netherlands, called for a new European community, “above and beyond the concept of the nation-state,” which would “transform the living space given us by history into a new spiritual realm.” …The Reichsbank president [Funk] laid out his thoughts in a detailed, eight-page memo called ‘Economic Reorganization of Europe,’ a copy of which is stored in the BIS archive in Basel.

Given the supporting evidence of Nazi-BIS ties, it comes as little surprise to readers by books’ end that many of the German aims were near-universally realized.  LeBor continues:

The Reichsmark would be the dominant currency [according to Funk], but the currency basis of postwar Europe was of secondary importance to economic leadership.  “Given a healthy European economy and a sensible division of labor between the European economies, the currency problem will solve itself because it will then be merely a question of suitable monetary technique.”  Here Funk seems to anticipate the arguments of Euro enthusiasts who, fifty years later, claimed that a common currency, if properly constructed in the right economic conditions, could not fail.

Funk’s analysis and prediction are unsettlingly prescient of the subsequent course of postwar European economic and political history.

…Bilateral payments must be transformed into multilateral economic transactions and clearing arrangements, “so that the various countries may enter into properly regulated economic relations with one another through the intermediary of clearing arrangements of this kind” -just as happened with the 1947 Paris agreement on multilateral payments and its successor mechanisms, such as the European Payments Union (EPU).

It is in this chapter (chapter 14, “The Second Tower”), that LeBor makes his case for the BIS as the instrument that projected German control on the postwar European economy.  Of course, with such strong ties to both the Nazi party and the alphabet soup of European economic arrangements in the 1950’s and onward, the BIS was centrally located to serve this purpose.  LeBor continues on page 222:

An actual monetary union was more complicated, Funk presciently argued, as it demanded “a gradually assimilated standard of living, and even in the future the standard cannot be the same in all the countries participating in the European clearing” -a statement that neatly anticipated the modern disequilibrium between Germany and Greece. But once the European central clearing system was operating, foreign exchange restrictions would be abolished, first for travelers crossing frontiers and then for import trade.  There would be a bonfire of regulations that slowed down trade and commerce; Funk wrote, “Meticulous surveillance and all the regulations, which weigh down on the individual business enterprise with a mass of forms, will no longer be necessary” [emphasis added].

As accurate as Funk’s assessment seems to be, LeBor makes the case that it is a damning indictment of the BIS, and the technocratic leaders of postwar Europe.  Despite the war raging in Europe on the battlefield, German leaders were already planning ahead to a postwar Europe where Germany would secure a place as an economic hegemon.  As he writes on page 223:

The Nazi leadership welcomed Funk’s plans.  In 1942, The German Foreign Ministry created a “Europe Committee,” whose members drafted plans for a German-dominated European confederation.  That same year the Berlin Union of Businessmen and Industrialists held a conference at the city’s Economic University, entitled “European Economic Community.”  As the writer John Laughland notes, the titles of the speeches delivered at the conference are “eerily reminiscent of modern pro-European discourse.”  They include “The Economic Face of the New Europe,” “The Development Towards the European Economic Community,” “European Currency Matters,” and the hardy perennial, still much discussed today: “The Fundamental Question: Is Europe a Geographical Concept or a Political Fact.” In June a German official drafted the “Basic Elements of a Plan for the New Europe,” which outlined how the new confederation would work.

LeBor finishes by taking the book up to the present day, complete with the BIS’s role in modern affairs.  Although these stand out, they warrant a discussion all their own.  Germany has long had a history of manipulating the Eurozone to its own advantage, and indeed many scholars foresee an end of the ill-fated attempt at European economic unity.  However, an equally compelling story exists where the BIS plays only a periphery role, but sinister motives and German economic dominance feature heavily in the narrative…

Overview of Dowsing Alpha

Dowsing Alpha is a blog about the effects of critical thinking on our lives.  Critical thinking comes in many forms.  From p-hacking¹ to a replication crisis² in the sciences to the under-performance of mutual funds³, critical thinking today is more relevant than ever (and sorely needed).  For every generation save the last three, it has been possible to get away with an unseemly amount of fudging, deceit, and editorializing without the awareness of the public.  These measures served their purpose in a bygone era, but they now fail to hold up to the scrutiny that characterizes the modern age of over-information.

Blogs, like the one you’re reading, are one symptom of the overarching theme of history’s progress toward openness of information.  If knowledge was once considered power, it is now considered a mixed bag.  How did this come to be?

¹http://journals.plos.org/plosbiology/article?id=10.1371/journal.pbio.1002106

²https://www.washingtonpost.com/news/monkey-cage/wp/2016/03/09/does-social-science-have-a-replication-crisis/?utm_term=.aefd10bb0440

³http://www.cbsnews.com/news/its-getting-crowded-in-the-mutual-fund-graveyard/

Continue reading Overview of Dowsing Alpha

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