The MSME Credit Black Hole: Failure of the Magna Carta

 

The end cannot justify the means for the simple and obvious reason that the means employed determine the nature of the ends produced—Aldous Huxley 

In this issue:

The MSME Credit Black Hole: Failure of the Magna Carta

I. The Magna Carta: The Policy and Its Promise

II. The Empirical Test

III. Why MSME Lending Became Relatively Less Attractive

IV. When The State Makes The Intended Borrower Less Bankable

V. Where Did the Bank’s Capacity Go?

VI. Why The Architecture Keeps Reproducing Itself

VII. Where The 2026 BSP Relief Cascade Fits

VIII. Conclusion: Three Symptoms, One Structure

The MSME Credit Black Hole: Failure of the Magna Carta 

How a Credit Quota Failed to Change the Architecture of Financial Concentration 

I. The Magna Carta: The Policy and Its Promise 

Enacted in 1991 through Republic Act 6977, the Magna Carta for Small Enterprises was built around a simple structural diagnosis: banks naturally preferred larger, more established borrowers, leaving smaller businesses chronically short of formal credit. Congress tried to override that bias by mandating that banks devote a share of their lending to small enterprises. 

The framework was strengthened in 1997 and expanded again through RA 9501 in 2008, which established the familiar 8% allocation for micro and small enterprises and 2% for medium enterprises, for a combined 10% mandate, backed by penalties for noncompliance. 

The law is the anchor. Whether it worked is an empirical question. 

The data has been answering it for sixteen years. 

II. The Empirical Test

Figure 1

MSMEs account for roughly 99.6% of businesses and about 67% of employment, yet bank lending to the sector has remained stubbornly below the share Congress intended to force into the system. (Figure 1)

Figure 2

MSME lending's share of the banking system's loan portfolio peaked near 8.4% in Q1 2010. It then fell in an almost uninterrupted decline. It kept falling after the quota expired in 2018 and MSME lending ceased to be subject to a mandatory allocation. (Figure 2) 

By Q2 2026, lending to the MSMEs stood at 4.48% of the banking system's portfolio — the second-lowest share on record for the combined micro-small segment — while the medium-enterprise share was at its lowest recorded level. 

The law was intended to redirect bank credit toward the productive base. 

Instead, the banking system progressively moved away from the mandate. 

That matters because it eliminates the easiest explanation for the failure: enforcement. 

Two different enforcement regimes, spanning four presidential administrations, produced essentially the same underlying trajectory. The quota was mandatory and backed by penalties; then the quota expired and compliance became voluntary. Neither regime reversed the decline. 

That consistency is the tell. 

A law that produces the same disappointing outcome under both a penalty-backed mandate and a voluntary regime is not primarily failing because regulators forgot to enforce it. It is failing because the policy is asking legislation to override an incentive structure that keeps making the targeted lending relatively unattractive. 

There is a Goodhart's Law problem here: once the state turns a desired outcome into a compliance target, the target can become the object of the exercise rather than the underlying objective. The Magna Carta could measure whether banks allocated a prescribed share of their portfolio to MSMEs. It could penalize them when they did not. What it could not do was make MSME lending economically as attractive as the alternatives competing for the same balance sheet. 

It measured the allocation. It never changed the incentives producing the allocation. 

And once the quota became the policy instrument, compliance could substitute for reform. The system could satisfy, evade, minimize or eventually abandon the target without resolving the underlying reason banks preferred other borrowers. 

That is why the sixteen-year trajectory matters more than any individual compliance rate. The quota was aimed at the symptom — the share of credit going to MSMEs — while the incentive structure determining that share remained largely intact. 

The question, then, is not why banks ignored the Magna Carta. 

It is why lending to MSMEs kept becoming a worse proposition. 

III. Why MSME Lending Became Relatively Less Attractive 

The banking system's bias against MSMEs did not happen in a vacuum. The risk-adjusted cost of serving them has been shaped by several forces operating simultaneously, and the direction of travel has been remarkably consistent. 

The first is monetary — and inflation is central to it. 

Sustained periods of easy money expand the nominal pool of money and credit moving through the banking system. But nominal credit growth is not the same thing as an expansion of real productive capacity capable of absorbing higher-risk lending. 

For MSMEs, the more immediate problem is volatility. 

Inflation does not simply raise prices. It makes the relationship between costs, revenues and cash flow less predictable. Input costs can move faster than a small business can adjust prices. Working-capital requirements rise. Real purchasing power falls. Customers become more price-sensitive. Margins that were already thin become harder to forecast. 

Large corporations can absorb some of this through scale, purchasing power, pricing power, diversified revenue streams and easier access to financing. 

The typical MSME cannot. 

A bank does not lend against an entrepreneur's intentions. It lends against the probability that future cash flow will be sufficient to service the debt. When inflation makes that cash flow more volatile, the borrower becomes harder to underwrite even if the business remains viable in the long run. 

So what looks like a growing credit system in peso terms can coexist with a shrinking pool of borrowers whose real cash flows are stable enough to absorb bank debt. 

This is particularly damaging to MSMEs because they are already cash-flow-thin, collateral-poor and less able to hedge against purchasing-power shocks. Inflation therefore does not merely increase their costs. It increases the uncertainty surrounding their ability to repay. 

That uncertainty has a price. 

The second force is the structure of bank pricing itself. 

Large corporations with established balance sheets, collateral, audited accounts and long credit histories can borrow more cheaply than smaller firms. That cheap financing is not merely a passive advantage. It can become a competitive moat: the largest firms can finance expansion, acquire competitors and consolidate market share at a cost of capital that smaller firms cannot match. 

I wrote about one version of this in 2019, when Jollibee's expansion strategy illustrated the Pac-Man financing logic: use financial capacity to swallow competitors and reinforce an already dominant position. 

This is what preferential access to cheap credit looks like when it meets market concentration. 

The third force is regulatory and sits in the banking system's plumbing rather than in any single law or circular. 

Risk-based capital rules and provisioning requirements make the characteristics of the borrower matter to the bank's economics. An opaque, thinly capitalized, informally collateralized and poorly documented small enterprise is a fundamentally different credit exposure from a sovereign security or a large investment-grade corporation with a long financial history. 

A peso lent to a top-tier corporate borrower or placed in sovereign paper does not impose the same capital, monitoring and information costs as a peso lent to an unlisted small enterprise.

That distinction matters enormously when a bank is deciding where to put scarce balance-sheet capacity. 

Then there is the compliance burden. 

AMLC and KYC requirements, licensing, registration, reporting, taxation, labor rules, inspections and the ordinary friction of operating formally all impose fixed or semi-fixed costs. 

For a large corporation, those costs can be distributed across enormous revenues and dedicated administrative departments. For a small business, they consume a much larger share of the resources available to keep the business operating. 

Even wage increases can have asymmetric effects. A higher minimum wage raises labor costs immediately; a small enterprise with thin margins has far less room to absorb that increase than a large corporation with scale, pricing power and easier access to financing. 

None of these regulations individually targets MSMEs. 

That is precisely the point. 

Their combined effect is to make the typical MSME a more expensive and more difficult credit proposition while the alternative available to banks — paying the Magna Carta penalty — remained relatively cheap and predictable. 

Put the channels together and the sixteen-year decline stops looking like simple negligence. It looks increasingly like a rational response to a system in which MSME lending carries higher volatility, higher underwriting costs, higher capital costs and greater uncertainty than lending to the borrowers with the strongest balance sheets. 

IV. When The State Makes The Intended Borrower Less Bankable 

This creates a feedback loop that the Magna Carta itself could not solve. 

But the loop is larger than compliance alone: 

inflation and input-cost volatility → weaker and less predictable cash flow → higher perceived credit risk 

plus 

more compliance costs → higher fixed operating costs → thinner margins → weaker cash flow 

together producing

higher risk and underwriting costs → less attractive MSME borrowers → weaker bank lending → greater dependence on informal or more expensive financing. 

This is the policy contradiction. 

The state mandates banks to lend to MSMEs while simultaneously maintaining conditions that can make those same enterprises more volatile, less liquid and more expensive to underwrite. 

Inflation is particularly important because it can amplify the entire loop. A business operating with thin margins has little room between revenue and costs. When prices, wages, inventory and working-capital requirements become more volatile, that margin becomes harder to defend. A borrower that was marginally bankable in a stable environment can become unbankable when the same business is subjected to repeated cost and cash-flow shocks. 

The bank sees the final balance sheet. 

It does not care that the original policy objective was noble. 

And this is where the Magna Carta's basic design runs into reality. It treats the shortage of MSME credit as if the problem were primarily a bank's willingness to lend. But willingness is downstream of risk, return, capital requirements, transaction costs and the quality and stability of the borrower being presented to the bank. 

This is the old Bastiat problem of the seen and the unseen. 

The quota makes the seen effect obvious: a mandated peso of MSME lending can be counted, reported and celebrated as evidence that the policy is working. What disappears from view is the unseen opportunity cost — what that peso would otherwise have financed, and whether forcing it into a higher-risk borrower actually creates more productive capacity than the alternative use of the bank's balance sheet. 

The same logic sits behind Bastiat's broken-window fallacy. The broken window creates visible spending for the glazier; what remains unseen is what the shopkeeper would have done with the money had he not been forced to replace the glass. 

The Magna Carta creates its own version of the fallacy. 

It counts the credit it forces into MSMEs. It does not count the allocation it displaces.

That does not mean MSME lending is unproductive. It means that mandating an allocation is not the same thing as demonstrating that the allocation is economically efficient. 

Legislation can change the first-order incentive. 

It cannot repeal the balance sheet. 

V. Where Did the Bank’s Capacity Go? 

The failure becomes more interesting when we stop looking only at what banks did not lend to MSMEs and ask what they did with the capacity instead. 

The answer is visible in the structure of the financial system.

Figure 3

Universal and commercial banks held roughly 93% of the Php 31.3 trillion in total bank resources as of May 2026, while banks themselves accounted for about 83% of the Php 37.64 trillion financial-system total. (Figure 3, upper graph) 

The most recent comparable international measure, the World Bank's five-bank asset concentration ratio, put the top five Philippine banks at 67.3% of total banking assets (as of 2021—this should be larger today). (Figure 3, lower chart) 

This is not a decentralized credit market searching for deserving small borrowers. 

It is a highly concentrated financial system deciding where scarce balance-sheet capacity earns the best risk-adjusted return. 

And a substantial portion has gone into government and large corporate balance sheets.

Figure 4 

Banks' claims on the public sector sit near 30% of M2 and M3 and have grown faster than private credit, while large conglomerates — many operating within ownership structures intertwined with the financial system — absorb another substantial share of bank financing. (Figure 4, upper diagram) 

That produces a sovereign-financial feedback loop: 

government borrowing expands → banks absorb more sovereign exposure → financial institutions become more exposed to fiscal conditions → preserving liquidity and refinancing capacity becomes more important → financial stability and sovereign-market functioning become increasingly important to the system itself. 

This is the sovereign doom loop in domestic form. 

The BSP's 2025 Financial Stability Report puts a number on the other side of this concentration: roughly Php 1.6 trillion, or 22.7% of total conglomerate debt, comes due between 2027 and 2029, while dollar-denominated debt averages 37.6% of that load over the following five years. That is a wall of maturities approaching the same financial system that holds much of the exposure. (Figure 4, lower image) 

Read in isolation, it is a refinancing-risk warning. Read alongside the MSME data, it shows why the system has a powerful institutional preference for preserving the liquidity and refinancing capacity of the large borrowers already embedded in it. 

And it competes for the same financial resources that the Magna Carta was supposed to direct toward smaller productive enterprises. 

The important point is that MSMEs are not simply being denied a fixed quantity of credit. 

They are being denied relative access to a financial system in which other borrowers have structural advantages: greater scale, better collateral, more predictable cash flows, lower transaction costs and, in many cases, greater access to cheap financing. 

Inflation worsens that relative disadvantage because it magnifies the very cash-flow uncertainty that already makes MSMEs harder to lend to. 

That is why the issue is not merely whether banks have enough liquidity. 

It is where the system finds that liquidity easiest and safest to deploy. 

VI. Why The Architecture Keeps Reproducing Itself 

A framework this consistently biased against MSME lending, across four administrations and two enforcement regimes, does not persist by accident. It persists because the institutions responsible for revising it are embedded in the financial system it regulates. 

The BSP Monetary Board's seven seats have been populated by appointees whose careers include senior positions at banks, multinational lenders and major conglomerates. None of this is evidence of wrongdoing; many were appointed precisely for the expertise those careers provide. 

But expertise is not institutionally neutral. 

A regulator whose personnel move between private finance and public regulation brings with them professional networks, assumptions and risk frameworks formed inside the financial system. From a public-choice perspective, those experiences can shape not only what policymakers know, but which problems they perceive as requiring intervention. 

That matters when the same system has spent sixteen years directing capital toward sovereign and large corporate borrowers while MSME lending steadily loses ground. 

This is regulatory capture in its least conspiratorial form. No corruption is required. A revolving door dynamic can reproduce a policy bias simply because the people designing the rules share much of the same institutional worldview as the institutions operating under them. 

And that is before accounting for the influence of the executive branch and broader political incentives. 

VII. Where The 2026 BSP Relief Cascade Fits 

The BSP's five relief measures since April — NPL grace periods, the intragroup credit-risk reform, the pre-positioned CCyB release, the salary-loan maturity extension and the mark-to-market waiver — did not create this problem. (See our Stagflation Part 11 for details) 

They reinforce it. 

The MSME credit decline predates all five measures by more than a decade. What the cascade does is free additional balance-sheet capacity without attaching an MSME condition to it, inside a financial system already structured to favor sovereign and large corporate exposure. 

The measures are therefore an aggravating factor, not the cause. 

That distinction matters because blaming the latest relief package would turn a sixteen-year structural failure into a story about five recent policy decisions. The evidence says otherwise: the same allocation bias was operating long before the current relief cycle existed. 

VIII. Conclusion: Three Symptoms, One Structure 

Declining MSME lending, banking-system concentration and rising financial fragility are not separate failures. 

They are symptoms of the same architecture. 

The Magna Carta tried to force banks to allocate more credit toward the country's 1.24 million MSMEs. But the monetary, regulatory and institutional structure surrounding the banking system kept making sovereign and large-corporate lending more attractive. 

The law could impose a quota. 

It could not repeal the incentives determining where banks wanted to put their balance sheets. 

For sixteen years, those incentives won. 

That is why the Magna Carta did not merely fail to achieve its target. 

It created the appearance of a financial system deliberately making room for the small productive economy while leaving the underlying allocation of capital largely untouched. 

The quota could be measured. Compliance has been reported. The policy could point to a statutory commitment to MSMEs. 

But underneath the paperwork, the balance sheet kept moving in the other direction. 

The result was not a redistribution of financial power toward the many. It was a regulatory façade over an increasingly concentrated allocation of credit. 

And that is the deeper failure of the Magna Carta: It did not change the architecture that favored the few. It gave that architecture a quota, and called it reform.

In India, Child Labor Ban Leads to More Child Labor

Just one of the many examples of how noble-sounding statutes backfire when faced with economic reality. 

From the Wall Street Journal Real Times Economic Blog

A ban on child labor sounds like a policy move that would yield nothing but favorable results. But a new paper on the fallout from such a measure in India finds that isn’t the case.

The title — “Perverse Consequences of Well Intentioned Regulation: Evidence from India’s Child Labor Ban” — captures the conclusion that families’ welfare diminished rather than improved after India’s 1986 prohibition against labor by children under age 14.

The authors focused on particular jobs that the ban prohibited children from doing, such as working in mines, handling toxic substances, making cigarettes or providing food at rail stations. The ban didn’t extend to agriculture or family businesses, but the legislation set forth limits on how many and which hours children could work. Penalties for flouting the law included fines or prison time.

After the ban, the authors found, child labor actually increased — while wages for children, relative to those of adults, decreased. In addition, since fewer children were being paid, families became poorer, consumed and spent less and all told, found themselves struggling more financially than they had before the ban.

The abstract of the NBER paper by Prashant Bharadwaj, Leah K. Lakdawala and Nicholas Li (bold mine)

While bans against child labor are a common policy tool, there is very little empirical evidence validating their effectiveness. In this paper, we examine the consequences of India’s landmark legislation against child labor, the Child Labor (Prohibition and Regulation) Act of 1986. Using data from employment surveys conducted before and after the ban, and using age restrictions that determined who the ban applied to, we show that child wages decrease and child labor increases after the ban. These results are consistent with a theoretical model building on the seminal work of Basu and Van (1998) and Basu (2005), where families use child labor to reach subsistence constraints and where child wages decrease in response to bans, leading poor families to utilize more child labor. The increase in child labor comes at the expense of reduced school enrollment. We also examine the effects of the ban at the household level. Using linked consumption and expenditure data, we find that along various margins of household expenditure, consumption, calorie intake and asset holdings, households are worse off after the ban

At the end of the day, arbitrary edicts intended to safeguard certain constituents end up going on the opposite direction. Such is the law of unintended consequences

In Beijing, Property Curbs Fail to Stop Bubbles

When authorities say that regulations would do the wonders of effecting price controls, they are mostly propagandizing. That's because markets will prove them utterly wrong. 

One great example, the stiff property curbs in Beijing has failed to stem the locality’s ballooning property bubble.

From Bloomberg: (bold mine)

Beijing, which already has China’s strictest real estate curbs, is being forced to take additional steps to contain surging home prices as demands for record-high down payments fail to deter buyers.

The city has enforced citywide price caps since March by withholding presale permits for any new project asking selling prices authorities deem too high, according to developer Sunac China Holdings Ltd. (1918) and realtor Centaline Group. Local officials will need further tightening as they struggle to meet this year’s target of keeping prices unchanged from last year, said Bacic & 5i5j Group, the city’s second-biggest property broker.

The failure of official curbs to stem price increases in the nation’s capital highlights the government’s struggle to keep housing affordable as urbanization sends waves of rural workers into China’s largest cities. New-home prices in Beijing rose by 3.1 percent in April from the previous month, the biggest gain among the nation’s four so-called first-tier cities, and climbed by the most after Guangzhou in May, according to SouFun Holdings Ltd. (SFUN) They rose in each of the first five months of this year…

Beijing, the nation’s third-most populous city, is the only city that enforces price caps in earnest, according to Bacic & 5i5j. Guangzhou and Shenzhen in the southern province of Guangdong are rejecting presale permits for some projects seen as too expensive, CEBM’s Luo said. The three cities, along with Shanghai, are considered first-tier.

In one of his last policies, Wen, replaced by Li Keqiang less than a month later, on Feb. 20 called on city governments to “decisively” curb real estate speculation after home prices surged the most in two years in January.

Beijing followed with the toughest curbs among the 35 provincial-level cities that responded with price-control targets, becoming the only region to raise the minimum down payment on second homes from 60 percent and to enforce a 20 percent capital-gains tax on existing homes, according to Centaline Property Agency Ltd., China’s biggest property agency.

Still, new-home prices in the city of 19.6 million, jumped 10.3 percent in April from a year earlier, the biggest rise after Guangzhou and Shenzhen, the National Bureau of Statistics said May 18. Prices of existing homes jumped 10.9 percent, the most since they reversed declines in December, and the greatest gain among all the 70 cities tracked by the government.

Given China’s underdeveloped capital markets, the ongoing consolidation of their stock markets, the artificially low rates designed to attain negative real rates or via the "inflation tax" (I doubt the accuracy of official statistics suggesting otherwise) and the massive credit expansion channeled mostly through State Owned Enterprises, where do you think the average Chinese will put their savings?

Bubble policies motivates people to go into wild (yield chasing) speculative activities. Thus, property bubbles and property sector backed shadow banking system are merely symptoms of bubble policies. 

For as long as the Chinese government promotes credit inflation, bubbles will be the economic and financial order.

The failure of property curbs only exhibits of the flagrant myopia of politics—where authorities see their constituents as unthinking subjects or automatons who will merely surrender to their whims.

In reality, many Chinese look for loopholes such as resorting to “divorce” in order to circumvent property regulations.

Moreover, additional regulations only complicates a fragmented and diverse system which only encourages corruption and other unethical behavior.

Yet aside from property bubbles and the shadow banking system, the more cautious Chinese protect their savings through accumulations of gold. 

The recent flash crash has only prompted many of the the Chinese to a gold buying spree. Premiums on physical gold in China has “jumped four-fold in the last six weeks” according to the the Zero Hedge.

In the illusory world of the fiat based monetary political economy, people have been incentivized to either indulge in wanton speculation or to hedge on real assets rather than to engage in productive activities. Thus bubbles everywhere.

And price controls only worsens such imbalances.

World Competitiveness: Philippines Jumps to 65th Place

The World Economic Forum (WEF) recently released, The Global Competitiveness Report for 2012-2013 which attempts to measure relative competitiveness among 144 nations that provides “insight into the drivers of their productivity and prosperity”

It is important to highlight that the competitive ranking have been defined by the WEF as

as the set of institutions, policies, and factors that determine the level of productivity of a country. The level of productivity, in turn, sets the level of prosperity that can be earned by an economy. The productivity level also determines the rates of return obtained by investments in an economy, which in turn are the fundamental drivers of its growth rates. In other words, a more competitive economy is one that is likely to sustain growth.

Here is the roster of the top 30 most competitive nations.

Notice that the WEF says the ranking is about productivity, and not about “cheap labor”.

If competitiveness is about the “cheap labor” then the Philippines and Africa will be on top of the list. Unfortunately mainstream demagoguery has obstinately been focused on this, so as to justify the inflationist-interventionists doctrines.

Also notice that the most competitive nations have been developed economies. The GCI rankings have been closely aligned with the list of most economically free nations (Heritage Foundation: 2012 Index of Economic Freedom).

It is important to note that the above rankings are comparative or relatively based. This implies that changes in standings may not necessarily translate to advancement or deterioration in domestic policies but about quantified comparative measures.

First the good news.

According to the report, the Philippines leapt from 75^th to 65^th

Yet despite the huge gains, which obviously will be construed and used by the mainstream and political forces to grab credit as “achievement” for the administration, the Philippines trails vastly behind the ASEAN peers.

Curiously Africa’s Rwanda has even been ahead.

The bad news is that despite the remarkable gains, the gap in the per capita GDP figures has been widening relative to our developing Asian peers.

This means that yes the Philippines has shown material progress but such gains has not been enough to cope up with the scale of advancement in the region.

Lastly, the reason for the lag in productivity has been about over politicization of the domestic economy which has been manifested through a bloated bureaucracy, lack of infrastructure (which has been politically determined—see below), tax and labor regulations and high tax rates.

Of course corruption has still been the biggest deterrent to business. But, in truth, corruption signifies as symptoms of interventionism expressed through arbitrary policies and regulations, the bureaucracy, welfare-warfare state and state determined allocation of resources.

The informal economy, which is also a symptom of interventionism, takes up a huge chunk of economic activities. This is a clear manifestation of the failures of interventionism and of the incumbent political institutions.

Ironically the salutary conditions of the shadow economy could be suggestive of the alternative positive aspects of corruption, where people pay bribe money to authorities in order to do productive endeavors. This in spite of the major negative attribution on the survey.

The burgeoning informal gold mining sector, which comes mostly in response to recently imposed higher taxes should serve as a wonderful anecdotal example.

Yet the media and the social desirability bias afflicted pop culture cheers about the Php 407 billion proposed infrastructure or so-called “investment” spending without the realization that productive money will be diverted to the pockets of cronies (who will get the contracts), bureaucrats (who will pick the winners) and politicians (which most likely will be the source of electoral finance for the upcoming 2013 national elections).

chart from US Global Investors

All these supposed stimulus will only translate to greater inequality (enrichment of the political class and of the politically connected enterprises), more debts, higher taxes (for the middle class and the politically unconnected), more PRICE inflation (which will be blamed on the private sector) and importantly adds to the ballooning bubble dynamics driven by current easy money policies.

These so-called public work policies are a chimera, as the great Professor Ludwig von Mises explained.

The fundamental error of the interventionists consists in the fact that they ignore the shortage of capital goods. In their eyes the depression is merely caused by a mysterious lack of the people's propensity both to consume and to invest. While the only real problem is to produce more and to consume less in order to increase the stock of capital goods available, the interventionists want to increase both consumption and investment. They want the government to embark upon projects which are unprofitable precisely because the factors of production needed for their execution must be withdrawn from other lines of employment in which they would fulfill wants the satisfaction of which the consumers consider more urgent. They do not realize that such public works must considerably intensify the real evil, the shortage of capital goods.

For media and the dumb downed (“madlang people”) electorate which sees this as good news hardly understands that effects of so-called government stimulus would be based on the illusions of statistics [mainstream economic statistics are based on Keynesian formula constructs] and not from real growth.

Thus, temporary good news will eventually become long term bad news.

However, despite such realities, the relatively better competitive standings today will likely continue to improve. Again, this is hardly because of internal ‘business friendly’ improvements but because of positional standings which will mostly be determined by the political responses to the unfolding crisis abroad.

Again the WEF’s GCI

The global economy faces a number of significant and interrelated challenges that could hamper a genuine upturn after an economic crisis half a decade long in much of the world, especially in the most advanced economies. The persisting financial difficulties in the periphery of the euro zone have led to a long-lasting and unresolved sovereign debt crisis that has now reached the boiling point. The possibility of Greece and perhaps other countries leaving the euro is now a distinct prospect, with potentially devastating consequences for the region and beyond. This development is coupled with the risk of a weak recovery in several other advanced economies outside of Europe—notably in the United States, where political gridlock on fiscal tightening could dampen the growth outlook. Furthermore, given the expected slowdown in economic growth in China, India, and other emerging markets, reinforced by a potential decline in global trade and volatile capital flows, it is not clear which regions can drive growth and employment creation in the short to medium term

The big picture gives us an objective dimension of the real developments rather than fall for trap to political demagoguery

Updated to add:

I was unaware when I wrote a few hours back that the competitiveness issue accounts for today's main headline story.

How Government Policies Contributed to JP Morgan’s Blunder

Author and derivatives manager Satyajit Das, ironically a neoliberal, has a superb article at the Minyanville, which elaborates on how regulations and government policies, which I earlier posted, has shaped the incentives of Too Big to Fail institutions to take excessive risks and the failure of regulators to prevent them (all bold emphasis mine)

The large investment portfolio is the result of banks needing to maintain high levels of liquidity, dictated by both volatile market conditions and also regulatory pressures to maintain larger cash buffers against contingencies. Broader monetary policies, such as quantitative easing, have also increased cash held by banks, which must be deployed profitably. Regulatory moves to prevent banks from trading on their own account -- the Volcker Rule -- have encouraged the migration of trading to other areas of the bank, such as liquidity management and portfolio risk management hedging.

Faced with weak revenues in its core operations and low interest rates on cash or secure short term investment, JPMorgan may have been under pressure to increase returns on this portfolio. The bank appears to have invested in a variety of securities, including mortgage backed securities and corporate debt, to generate returns above the firm’s cost of capital.

Again, the failure of models…

Given JPMorgan vaunted risk management credentials and boasts of a “fortress like” balance sheet, it is surprising that the problems of the hedge were not identified earlier. In general, most banks stress test hedges to ensure their efficacy prior to implementation and monitor them closely.

While the $2 billion loss is grievous, the bank’s restatement of its VaR risk from $67 million to $129 million (an increase of 93%) and reinstatement of an older risk model is also significant, suggesting a failure of risk modeling.

The knowledge problem…

Banks are now obliged to report positions and trades, especially certain credit derivatives. This information is available to regulators in considerable detail. Given that the hedge appears to have been large in size (estimates range from ten to hundreds of billions), regulators should have been aware of the positions. It is not clear whether they knew and what discussions if any ensued with the bank.

External auditors and equity analysts who cover the bank also did not pick up the potential problems. Like regulators, they perhaps relied on assurances from the bank’s management, without performing the required independent analysis.

Hayek’s “Fatal Conceit” or the pretentions of knowledge by regulators to apply controls over society or the marketplace…

Legislators and regulators now argue that the rules for portfolio hedging are too wide and impossible to police effectively. In addition, the statutory basis may not support the rule. The legislative intent was intended only to exempt risk-mitigating hedging activity, specifically hedging positions that reduce a bank’s risk. Interestingly, drafters of the portfolio hedging exemption recognized the potential problems, seeking comment on whether portfolio hedging created “the potential for abuse of the hedging exemption” or made it difficult to distinguish between hedging or prohibited trading.

In a recent Congressional hearing, Former Fed Chairman Paul Volcker, who helped shape the eponymous provision, questioned whether the volume of derivatives traded was “all directed toward some explicit protection against some explicit risk.”

The pundits have been quick to suggest that the losses point to the need for more stringent regulations. But it is not clear that a prohibition on proprietary trading would have prevented the losses.

In practice, without deep and intimate knowledge of the institution and its activities, it is difficult to differentiate between legitimate investment and trading of a firm’s surplus cash resources or investment capital.

It is also difficult sometimes to distinguish between hedging and speculation. The JPMorgan positions that caused the problems were predicated on certain market movements -- a flattening of the credit margin term structure -- which did not occur.

Hedging individual positions is impractical and would be expensive. It would push up the cost of credit to borrowers significantly. All hedging also entails risk. At a minimum, it assumes that the counterparty performs on its hedge. But inability to legitimately hedge also escalates risk of financial institutions. Ultimately no hedging is perfect. or as author Frank Partnoy told Bloomberg: “The only perfect hedge is in a Japanese garden.”

Additional regulation assumes that the appropriate rules can be drafted and policed. Experience suggests that it will not prevent future problems.

Bankers and regulators have always been seduced by an elegant vision of a scientific and mathematically precise vision of risk. As the English author G.K. Chesterton wrote: “The real trouble with this world [is that]…. It looks just a little more mathematical and regular than it is; its exactitude is obvious but its inexactitude is hidden; its wildness lies in wait.”

In reality it is not just “without deep and intimate knowledge of the institution and its activities” but about having the prior knowledge of the choices of the individuals behind these institutions. This is virtually unknowable.

Finally, the monumental government failure…

How do regulatory initiatives and monetary policy action affect bank risk taking? Central bank policies are adding to the problem of banks in terms of large cash balances which must be then invested at a profit. The implementation of the Volcker Rule may have had unintended consequences. It encouraged moving risk-taking activities from trading desks where the apparatus of risk management may be marginally better established to other parts of banks where there is less scrutiny.

The most important question remains whether any specific action short of banning specific instruments and activities can prevent such episodes in the future. It seems as Lord Voldemort observed in Harry Potter and the Deathly Hallows Part 2: “They never learn. Such a pity.”

People who are blinded by power and or the thought of power never really learn.

A Map Of The World’s Drinking Habits

Interesting article from the Economist

THE world drank the equivalent of 6.1 litres of pure alcohol per person in 2005, according to a report from the World Health Organisation published on February 11th. The biggest boozers are found in Europe and in the former Soviet states. Moldovans are the most bibulous, getting through 18.2 litres each, nearly 2 litres more than the Czechs in second place. Over 10 litres of a Moldovan's annual intake is reckoned to be 'unrecorded' home-brewed liquor, making it particularly harmful to health. Such moonshine accounts for almost 30% of the world's drinking. The WHO estimates that alcohol results in 2.5m deaths a year, more than AIDS or tuberculosis. In Russia and its former satellite states one in five male deaths is caused by drink.

I’d like to add that institutions like the WHO, whom has called for stronger “alcohol control policies” appears to have forgotten about the epic regulatory failure in the “Volstead Act” or the US alcohol prohibition law of the 1920s.

Such prohibition, also known as ‘the Noble experiment’, according to wikipedia.org, “stimulated the proliferation of rampant underground, organized and widespread criminal activity” which eventually led to its repeal.

Noble intentions will never rescind the laws of demand and supply.

Doug Casey On Corruption: Laws Create Corruption And Corruption Engenders Laws

Investment guru Doug Casey in this conversation gives a trenchant insight of the mechanics of corruption

On his definition of corruption: (all bold highlights mine)

a betrayal of a trust for personal gain

On the difference between private and public corruption

One can find corruption within corporations, as when directors betray their duty to the shareholders for personal gain. Or churches, as when priests, for pleasure, betray the trust of the young people under their guidance. Even a parent can be corrupt, if he fritters away on high living money intended to be left to his kid. But those types of corruption stem from personal weakness and personal vices. They're horrible – but corruption in government is much worse.

Only government can impose its will on you by law, and back it up with a gun. And with other sources of corruption you can – theoretically at least – go to the government for redress. But when the government is corrupt, it's hard to get the state's right hand to cut off its left. Not only that, but government – partly because its essence is force – concentrates corruption, and incubates it. If a company or church is corrupt, one can quit them. But citizens are stuck with their government – and they'll probably keep paying taxes to it regardless of their feelings toward it. A discussion about corruption is necessarily a discussion about government as an institution.

On the roots of public corruption:

As Tacitus said in the second century A.D., "The more corrupt the state, the more numerous the laws." It's absolutely predictable that as all these governments around the world – and I mean all of them – respond to the ongoing crisis with an ever-accelerating onslaught of new laws, there will be more and more corruption – and frustration with that corruption.

Tacitus was right. But he could just as accurately have said, "The more numerous the laws, the more corrupt the state," because lots of laws engender lots of corruption. In other words, corruption isn't the problem. The state and its laws are the problem, to which corruption is an unsavory and unaesthetic – but necessary – solution. Laws create corruption, and corruption engenders laws.

Every time a legislature convenes, they pass more and more laws. That's all they do, all day long. So the body of laws and the accompanying volumes of administrative regulations and procedures to implement them is constantly growing – the whole world over. Legislatures are horrible and dangerous things that bring out the absolute worst in the people who inhabit them.

Laws and regulations are like barnacles on a ship. They keep growing and growing, weighing the ship down, slowing it down. If they aren't scraped off from time to time, they will threaten the ship's structural integrity.

On the efficacy of anti-corruption laws:

Those laws necessarily have the opposite effect of what's intended. By raising the stakes, they just raise the level of bribery required, resulting in even more severe corruption. Like everything governments do, it' not just the wrong thing to do, but the exact opposite of the right thing to do....

The only way to fight official corruption is to reduce the amount of legal control of officials, particularly their regulatory power over the economy. If there were no government regulators, inspectors, assessors, auditors, and so forth ad nauseam, there'd be no reason for businesses and consumers to bribe them to get the hell out of the way.

On how free markets are self regulated:

There are many market forces that regulate business activity – and more broadly, cultural forces that regulate interactions between people. In the marketplace, reputation is a very powerful force. So is competition. And so is liability – it's a powerful negative incentive. More broadly, culture is a very powerful regulatory force, which is to say, peer pressure, moral opprobrium, and social approbation restrain people from being naughty far more than fear of police does. And there are also private institutions that have powerful regulatory influences, such as churches, Rotary, Lions Clubs, and the like.

On the public’s wrong impression on the significance of government:

People somehow imagine that because government regulations are backed with the iron fist of the law, they work better, especially when the matter is considered vital. This is simply incorrect. It shows an ignorance of both history and of the state of the world today. Regulation usually becomes so corrupt that it ends up doing the opposite of its intended effect. A business that pays officials to look the other way can do even worse things than they would do if there were no officials, because the official seal of approval falsely tells the people that all is well. That's why the SEC should be called the "Swindler's Encouragement Commission" – because it lulls investors, especially the novices, into feeling they're protected.

On the roots of regulatory corruption:

Strict regulation leads naïve people to think, "Everything is under control." That has two important effects. One, it makes them irresponsible – a belief that they don't have to concern themselves. That general attitude then permeates the society. Two, regulation always creates distortions in the market. It's like a lid on a pressure cooker. Everything looks under control until the whole thing blows up.

That's what lies at the root of the concept of "black swan" type unexpected events. The black swan lands when the amount of corruption necessary to evade laws becomes as onerous as the laws themselves.

On why corruption is a good thing:

There's good news and bad news in this.

In itself, corruption is a bad thing – it shouldn't have to be necessary. As I touched on earlier, insofar as it's necessary, it's also a good thing. If we can't eliminate the laws that give rise to corruption, it's a good thing that it's possible to circumvent these laws. The worst of all situations is to have a mass of strict, stultifying, economically suicidal laws – and also have strict, effective enforcement of those laws. If a culture doesn't allow people to work around stupid laws, that culture's doom is further sealed with every stupid law passed – which is pretty much all of them.

Read the rest here