TECTONIC SHIFTS IN FINANCIAL MARKETS

Henry Kaufman

Subtitle: People, Policies, and Institutions, Palgrave, Macmillan, 2016, 180 pgs., index, bibliography

Reviewer's comment

This is a more important book than it may appear to be, from its size. It is a very personal memoir by an author who was for critical years inside and a commentator of the transformation (tectonic shift) that he describes. One could apply Niall Ferguson's networking methods to see the extent of Kaufman's network throughout the financial world. And by extension one could also construct a meaningful picture of the international financial- political world as well. Dr. Kaufman well knows the individuals about whom he writes here and he shows to the reader the significant roles they plaid in this transformation. The individuals created or changed financial institutions and developed new financial tools and products, based on new theories, which expanded the role of finance itself in the markets. One can observe this, for instance, in the relative size of the financial industry category in the various categories in the S&P 500 used by mutual funds and ETF's when constructing portfolios. While the author describes the changes in financial markets and methods over the extended period in which he was a central actor, his focus is on what happened in the financial crisis of 2008 and why the changes he describes played a central role. His organization of chapters is partially chronological and partially topical.
I placed some links below to other authors who have discussed the same issues.
Here is a biography of Henry Kaufman. There is another at Bloomburg. There is an excellent review by John Authers in the Financial Times, June 25, 2017.

Preface by Paul Volcker -

He writes a very personal account based on years of friendship and professional interaction. He writes that Henry Kaufman knows so much about what is wrong with financial policy and activity and about economics in general because he has lived his life in the financial world. He writes; "One of the important lessons of Henry's books is the degree to which those in financial markets have lost their way."

Chapter 1 - How It Began as Salomon Brothers

Dr. Kaufman begins by noting that the financial world was very much different in the 1960's from it today. He provides some of the specific differences - among them that non-financial debt has increased from $1.1 trillion to $6 trillion and that U.S. Government debt has increased from $320 billion to $17 trillion. (that is 17 thousand billion). The list is lengthy and of fundamental factors. He begins with Salomon Brothers because it was in the 1960's that this organization began its rapid and steep expansion toward becoming a "major force in the money and capital markets." He writes that he will comment on these changes that created such a new financial world. He believes that these major changes were not the result of a planned policy-driven effort by government or leaders but the culmination of smaller actions taken by specific individuals.

He recounts how he joined Salomon Brothers in 1962. Then he describes his role in the transformative activities of the company until he left it in 1988. Among the key individuals he mentions in this chapter are Walt Wriston, Charlie Sanford, Michael Miliken, Sidney Homer, Bill Salomon, and John Reed.

Chapter 2 - The Art and Science of Forecasting

In this chapter Kaufman discusses the expansion in demand for forecasting that took place and some of the major problems forecasting faces. One of his conclusions: "As for long-term forecasting, there is simply no scientific methodology that can produce accurate predictions." Among the key individuals he mentions in this chapter are Walter Friedman, Ronald Reagan, Jimmy Carter, and Charlie Simon. The chapter should be studied along with Philip Tetlock's "Superforecasting: The Art and Science of Prediction" and study of Bayes' Theorem and its use in prediction.

Chapter 3 - Presidents versus Fed Chairmen

Dr. Kaufman points out that the FED is considered to be independent of the government and in particular of the executive office of the President. Yet the two often have conflicting opinions and objectives. He cites various specific examples of the results of these differences, naming the actors involved. The key individuals he mentions in this chapter are William McChesney Martin, Thomas B. McCabe, Harry Truman, Lyndon Johnson, Arthur Burns, Richard Nixon, G. William Miller, Paul Volcker and Alan Greenspan.

Chapter 4 - Paul Volcker, Perennial Public Servant

Kaufman jumps back in years to 1957, when he joined the Federal Reserve Bank of New York and met Paul Volcker. He devotes the chapter to comment about Volcker and also to the significant issues on which he played a part. He includes his own comments and responses to events and decisions of that time. The main issue was inflation, what to do about it and in that connection what to do about interest rates. He specifically notes the important financial issues on which he differed from Volcker. The key individuals he mentions in this chapter are Paul Volcker, Robert Rosa, Al Wojnilower, Leonard Santow, Aubrey Lanston, Jimmy Carter, Milton Friedman, and Walter Wriston.

Chapter 5 - The Fed and Financial Markets: Greenspan, Bernanke, and Yellen

He begins by noting that these three Federal Reserve Chair persons have received more public and political attention than any previous central bankers in U.S. history. And, of course, with good reason considering the central role they have played and the increasing influence of monetary policy in politics. He pens a polite understatement when commenting that they 'remained rather tone deaf to structural changes in financial markets and how those affected monetary policy'. Kaufman describes the events and changes in the financial world during this critical period. A critical issue was financial risk evaluation and 'taking'. He quotes Greenspan's testimony that the economic model which had determined his view of the financial world and hence his monetary policy decisions was faulty. Specifically, he notes Greenspan's role in canceling the important Glass-Steagall Act and its replacement by the Gramm-Leach-Bliley Act.

Kaufman's evaluation: "Alan Greenspan therefore left his biggest imprint more through what he failed to do - rein in credit and investment bubbles, regulate derivatives, control financial concentration, and later (under president George W. Bush) speak out against burgeoning deficits - that what he did."

FED governor Bernanke also comes in for criticism. Kaufman mentions Bernanke's famous book "Essays on the Great Depression" which, I also, consider contained 'strong clues as to how he would steer monetary policy during the crisis' (2008), and in my opinion not for the good.
Kaufman's summary: " Bernanke's record regarding 2008 and its aftermath was decidedly mixed." And, "One reason for the lack of foresight about the crisis was that, like his predecessor at the helm of the Fed. Mr. Bernanke didn't understand the interrelationships between monetary policy and financial markets and institutions." Kaufman provides his own analysis of the 2008 financial crisis and quotes Peter Conti-Brown (see below). Among other evaluations, Kaufman writes: 'The decision by key government officials to let Lehman fail was heavily influenced by politics." He considers Treasury Secretary Paulson an important player in this. The principle individuals he mentions in this chapter are Greenspan, Bernanke. Christopher Cox, Hank Paulson, Robert Rubin, Larry Summers, President Bush, and briefly Janet Yellen. and President Trump

Chapter 6 - Charles Sanford and the Rise of Quantitative Risk Management

Dr. Kaufman considers Charles Sanford to be "one of the most innovative, entrepreneurial, and philosophical commercial bankers in the post- World War II Era.' In this chapter Kaufman reverts back to the period beginning in 1961 when Sanford joined Bankers Trust. He credits Sanford with a major restructuring the bank by 1997. And he devotes the chapter to describing the significant developments in the banking and whole financial world during this 30 + years. He quotes several of Sanford's lectures on the changes and future of financial markets. He also notes the legal problems that Bankers Trust faced. He notes that the financial community did not learn from these lessons.

Chapter 7 - The Dominance of Walter Wriston

Walter Wriston was CEO of Citibank from 1967 to 1984, and Kaufman's comment is: that Wriston was the most dominant banker during that period during which he "pushed the boundaries of American banking." Among other important innovations, Wriston created the ATM machine. Kaufman cites other policies: to push aggressive risk taking in order to increase earnings, and reduce capital requirements versus liabilities, and negotiable certificates of deposit, These policies were then copied by other banks in order to remain competitive. But, Kaufman, believes, "No other commercial banker of the era was more outspoken, aggressive, or influential." Among the early disasters was Citi loans in South America. Kaufman quotes from his contemporary warnings about these dangers. He also faults the government regulators for enabling the expanded financial policies that led to greater risk. His assessment is that the "financial meltdown was propelled by reckless lending,." Among the individuals he mentions are Wriston, Edward Palmer, John Reed, Charles Prince and William Spenser who all fought his analysis.

Chapter 8 - The Bigness Crisis

Dr. Kaufman sees two major problems that took place together in 2008. One was the publicly observed systemic collapse itself. Another was the collapse of many of the institutions that intermediate between lenders and borrowers into a few remaining giant players in a process promoted by official policymakers. Thus was created the well known "too-big-to-fail' condition in the financial institutions. Government officials required these giant institutions, then, to accept partial government ownership. This spread the damage from the financial system into the national economy as a whole. He notes that consolidation and creation of oligopolities has been spreading throughout the business world. He notes further that while government officials have been focused on the variety of new financial instruments they have not paid enough attention to the structure of the 'dominant' financial institutions' themselves. He describes the gradual process that took place from the 1960's on. And he provides some telling data. For instance, as recently as 1990 the ten largest financial companies had about 10% of the U.S. Financial assets. Now they hold 80%. "Of the fifteen largest U.S. financial institutions in 1991, all but five have lost their independence." Of investment banks only two important entities remain - Goldman and Morgan Stanley. He includes a long list of famous companies that no longer exist.

He provides some specific conclusions. 1. the financial industry has 'not been an anchor of stability in our financial system'.
2. The leading firms' drove the credit creation process with great ingenuity and force. They also played a central role in popularizing quantitative risk analysis... which as encouraged risk taking."
3. "leading financial conglomerates played a central role in shifting the concept of liquidity to one that was asset-based to the liability side of the balance sheet."
4. "There is a clear correlation between institutional bigness and rule breaking."
He continues for several pages describing and analyzing the adverse results of all this. Here is one key example; "Yet another damaging effect of financial consolidation, the most important of all, is its role in pushing our political economy away from economic democracy, whatever its imperfections. In an economy with a highly concentrated financial sector, the government will remain a powerful force in the allocation of credit, as shown by the 2008 crisis."

Dr. Kaufman has fingered the most important result. But he refrains from further consideration and analysis. Financial industry is one of the 'commanding heights' of any economy, along with education, health, and energy. It is a key goal of revolutionaries at all times to gain control of the financial industry. It has been a central political struggle in the U.S. since Hamilton and Jefferson. Since the beginning of the 'progressive movement' now the radical leftist elite control of the financial system has been recognized as critical. The creation of the FED and its support by a national income tax was a major and fundamental 'progressive' achievement.

Chapter 9 - A Meeting with Margaret Thatcher

Dr. Kaufman notes an unfortunate habit of leading politicians, neglect of or even understanding of economic issues. He mentions that he met all the U.S. Presidents from LBJ to Clinton. And then also he met Israeli Prime Minister Shimon Peres and British Prime Minister Margaret Thatcher. His point is to comment that these two possessed an exceptional breadth of knowledge and understanding, Mrs. Thatcher, in particular, was unusually knowledgeable about monetary policy. He quotes at length from her memoir and then remarks. "It is, unfortunately, difficult to imagine a U.S. President discussing economic matters with such sophistication and clarity." He descries his own views that he offered the Prime Minister. Among them was the greatly increasing role of credit in the money supply making it difficult to define the money supply, hence to conduct monetary policy as a control over the economy.

He continues, "In the new world of finance, I suggested to Mrs. Thatcher, the very concept of liquidity was changing rapidly, and with it the possibility of money supply targeting."

Exactly.

He continues, "yet another obstacle to an effective money supply target, I continued, was the rapid globalization of financial markets, with London itself playing a key role in the process." For this book, he adds further conclusions. Then he turns to the question of government bonds and the creation of a new type - inflation indexed bonds. He gives excellent reasons for his opposition to these, but notes that Great Britian, then the U.S. and many other countries did create them. He is correct, that government indexing financial instruments to inflation itself assures the increase of inflation.

Chapter 10 - Michael Milken: Moving Junk Bonds to Prominence

As the title indicates, this brief chapter is all about the role of Michael Miliken on expanding the use of less that prime credit instruments to accomplish such projects as using debt to take over target companies. As Kaufman indicates, this put 'junk' bonds into major play in credit markets which encouraged general expansion of using risky credit. His base was the brokerage, Drexel Burnham Lamert, they encouraged corporate raders to use high leverage to pursue corporate takeovers. Frequently the purpose was to then extract value and unload the shell of the company. The stated rationale was to enable small firms to use credit to expand and improve their corporate operations. In the process, of course, Miliken and Drexel made billions of dollars of profits through their fees. Kaufman relates his exposure to this game, in which he declined to participate. He cites a book by W. Braddock Hickman, which Miliken read, in which Hickman claimed that 'junk' bonds were underrated and not as risky as the agencies claimed. If they were really underpriced then using them could generate large profits at low risk. Kaufman states that the junk bond market totaled $6 billion in 1970 and reached $210 billion by 1989. The process was one of those involving acceptance (even courting) greater financial risk that soon permeated the markets.

Kaufman concludes, "Mike Miliken's impact on financial markets has been underrated. He influenced its participants to become much more entrepreneurial - to take more risks as borrowers and as money managers.".

Chapter 11 - Financial Crises and Regulatory Reform

In this chapter Kaufman opens another broad topic. He concedes that efforts at 'financial reform' have been triggered by financial crises which seem to come in waves or as some contend, cycles. He also contends that the larger problems that need addressing in reform efforts are frequently seen long before the related crisis. He refers back to 1912 - 1913 and the House hearings ()Pujo hearings) about the 'money trusts'. They were about the perceived influence of the very large New York banks and Trust companies to control the investment banking industry. In that era control was achieved by having a few key individuals be members of the boards of several corporations in various industries and then able to manipulate policies. The Pujo committee did not find actual evidence or proof of conspiracies, but still made many recommendations for significant changes (reforms) But Congress refused to expand federal government control into widespread private markets. But it did create the Federal Reserve ansd the Clayton Antitrust Act. Then, during the Depression The Roosevelt Administration created more major banking and securities laws. Kaufman describes the function of each. As he notes, the new regulatory system remained (with amendments) since then. He notes that the Savings and Loan 'debacle' in the 1980's generated more changes. He continues to discuss more such regulatory efforts. Then came the financial collapse in 2008, which resulted (among other things) in the Dodd-Frank legislation with its Financial Stability Oversight Council and Office of Financial Research. Kaufman expresses his 'concern' about this. He finds other 'problems' throughout the legislative responses to the 2008 crisis.
His conclusion: "In the immediate wake of the shattering events of 2007 and 2008 the Obama Administration squandered a rate opportunity to fundamentally revamp the financial sector". And his question: "Where will the second great financial crisis take American capitalism?"

Chapter 12 - The Present Value of Financial History

Kaufman turns to a critique of the common failure to learn from history. He notes the significant difference between simply remembering something and systematically analyzing it.
"Ignorance of history has two main dimensions. One is refusing to believe it matters. The other is believing it matters but learning the wrong historical lessons." His appraisal of not only the public's but also business, financial and political leaders' knowledge of history is very negative. "Any kind of historical perspective is painfully lacking.".. in short, our financial leaders need broad horizons."... " Financial crises are rife with valuable lessons." He suggests some lessons from financial history. Many of these focus on the malignant activities of leading individuals such as Ivan Kreuger, Kenneth Lay, Jeffrey Skilling and Charles Ponzi - and the whole gang at LTCM. He mentions the false ideas of james Glassman and Alan Greenspan.

Chapter 13 - The Politicization of the Fed

Dr. Kaufman opens with this appraisal: "The U.S. Federal Reserve record since the end of World War II has been checkered at best." He describes successes and failures. His view: "As a starting hypothesis, it seems uncontroversial that our complex, advanced economy requires a robust and well-integrated financial sector to intermediae the savings and investment process."
He focuses on the allocation of credit. "A shift in attitudes over the last few decades has caused the differences between money and credit to become blurred."

In my opinion credit has always played a significant role as a component of the real money supply. That there has been a 'shift in attitudes' is due to the greatly increasing role credit now plays as the largest component of actual money - although many officials continue to ignore that. We continue to read about 'money AND credit' as if they are different, when we should read 'currency and credit' ARE money.

But Kaufman also cites the Fed as it "has failed to recognize on a timely basis changes in the financial structure and the implication of these changes for monetary policy." He lists some of the changes.
1 -"Spread banking" - result rising interest rates, expansion of debt, freedom from restraint and deterioration of credit quality.
2. - FED "failure to appreciate the significance for monetary policy of the rapid increase in securitizaton of obligations."
3. - FED "adhered to the notion that liquidity was heavily based on the amount of short-term assets on the balance sheets."
4. - Questionable ability of the FED to calculate the extension which financial institutions and markets are much more international now.
5. - the perceived relation between reward and risk that encourages taking risks including illegal activities.
6. - "the impact on monetary policy of the concentration of financial assets in the hands of a few institutions."

He relates all this to the 'independence' of the FED from political considerations. The result, he believes, is that the failure of the FED to prevent these changes (and indeed to encourage them) as resulted in this development of the concentration of financial resources in a few giant institutions and the increase in FED regulation over them. FED officials now are permanently assigned within banks. Among the other problems he cites is the new concept of 'forward guidance' - that is FED pronouncements about its assessment of the economy and its plans for future interest rates. Now, he notes, everyone are 'mesmerized' by these words. Unprecedented and also usually wrong. He comments: 'Governance of today's Fed is distorted."

Well, my observation, as with many other sectors of the economy the occurrence of mishaps leads to demands for expanded regulation and control, which then enables further mishaps which increase the demand for more expansion of control.

Chapter 14 - Tectonic Shifts

Dr. Kaufman sees the various results of the explosion in computers, communications and 'big data' as a tectonic shift. He questions whether the inundation with masses of data is entirely positive when so much of it is doubtful. The frequent revision of the basic GDP number he cites as an example. He has many concerns. Such as: "More broadly, the prevailing analytical approach to cycles fails to capture key structural changes in business and finance and their significance." .. "Relying solely on cyclical economic analysis can lead to false expectations." He lists more.

Chapter 15 - You Can't Go Home Again

In other words, what is done is done. The changes described in prior chapters cannot be undone. but we do have to not only deal with them but also be proactive in creating new institutions and policies. The bulk of the chapter includes a detailed description and analysis of a central concern - the massive expansion of credit-debt both private and government.

He writes: "In U.S. financial markets, tectonic shifts have been breathtaking, their consequences only beginning to unfold, debt has been growing at a very rapid clip, not only in absolute terms but, more importantly, relative to GDP." And, "The relative and absolute volume of debt are not the only issues. Equally important is the dramatically deteriorating quality of debt in recent decades." He believes the long term secular decline in interest rates is over. He wonders if we will see another increase in rates similar to that of 1946 - 1981. He questions such terms and concepts as a "new normal." He lists several major problems the financial system will face when the next crisis occurs.

Some related references

James Rickards - The Road to Ruin

James Rickards - Currency Wars

Niall Ferguson - The Square and the Tower

Niall Ferguson - The Ascent of Money

Charles Calomiris & Stephen Haber - Fragile by Design

Anat Admati & Martin Hellwig - The Bankers' New Clothes

George Melloan - The Great Money Binge

Peter J. Wallison - Hidden in Plain Sight

Peter Conti-Brown - The Power and Independence of the Federal Reserve

Danielle DiMartino Booth - FED UP