Friday, 26 September 2008

Avoiding Armageddon

26th September 2008
The Malta Independent - Friday Wisdom

The guide indicated to us the spot where the Jews believe there will be Armageddon the promised site for the last Judgement at the end of the world. I never thought that soon after my return to the office I would find the world financial system on the brink of its own Armageddon.

I apologise to my readers that this week again I feel compelled to write about the financial turmoil that has rendered the financial markets practically dysfunctional. It might be tempting to think that it should be of no concern to us if banks in America run into trouble because they have made bad loans and irresponsible investments in the US property markets which were in a speculative bubble that has burst.

This is wrong and it should concern us because our well-being, the value of our assets, the security of our jobs and the strength of our own financial institutions depend on it. This is an inter-connected world and if problems in the US send more Lehman type banks to the wall the loss of confidence would grow so much that the international financial system would seize up altogether.

This would mean that credit would stop, the plumbing of the world financial system gets jammed and good corporations will have to go to the wall with their bankers, jobs would be lost and the world would fall into a depression, not merely a recession, which would bring memories of the 1930s. This scenario would wreak havoc in government finances with falling revenues and growing expenditures which could well force governments to do the unthinkable and cut back on social programmes.

So the current financial turmoil is everybody’s concern no matter how unpalatable reading about it may be.

We are witnessing a classic failure of the free market. We are living strange days where in the motherland of capitalism, legislators, at the symbolic gunpoint of an Armageddon alternative pointed to their brains, are being asked to appropriate the astronomical sum of seven hundred billion dollars so that the executive can use this money to clean up the financial system from its bad loans and unblock the credit plumbing in the hope that we are still in time to avoid a deep recession if not a depression.

How much taxpayers would recover from this huge crisis appropriation is anybody’s guess. I heard views that if this bold measure of last resort succeeds the taxpayer could make a windfall by re-selling assets into an orderly market after having bought them from troubled banks at a deep discount. Others argue that it is difficult to estimate the correct value of these troubled assets and the government could well be overpaying and involving taxpayers in substantial losses purely to save the fat cats on Wall Street.

Why is capitalism not being allowed to work as it supposed to work and let the market sort things out choosing the wheat from the chaff and cleaning the system through normal mechanisms as is the professed religion of free capitalism? Why in this case the god of the market is not being trusted?

The simple answer is that banks are a special species indispensable for the proper working of the economy and cannot be allowed to fail as loss making businesses normally do. If banks are allowed to default in a systemic failure as we are presently witnessing, there will be too many innocent victims who pay too high a price in the form of lost jobs, devalued savings and general impoverishment. And most of these victims are the general mainstream of voters who would fault the politicians both if they use taxpayers’ funds to save the fat cats and much more if they let the market to wipe out the banks and much else along with them.

We have built an economic system built on credit. Economic growth depends on credit both to finance the necessary investments in productive assets as well as to stimulate consumption. Without abundant supply of credit consumer demand would fall in tandem with their standard of living and producers will curtail investment, cutting back production and discharging labour causing a downward spiral where unemployment feeds insecurity, fall in consumption and more unemployment.

Banks are the main medium for the supply of credit and hence why their good health is indispensable for orderly economic growth. And in acknowledgement of their importance not just for their own fortunes but, more importantly, for the good health of the overall economy, financial markets are supposed to be strictly regulated.

It is obvious that in the US regulation has not kept pace with developments in the financial markets and it had become ineffective to the point where regulators, particularly their prime cheer-leader the former Federal Reserve chairman Alan Greenspan, often professed their blind faith in the financial system to regulate itself. Regulated banks abandoned their traditional deposit intermediation role which requires abundant supply of capital, and developed risky investment banking activities generating smart alternative revenues from origination and distribution of very complex financial products wrapped in financial derivatives. Greenspan used to eulogise this distribution of risk beyond the traditional regulated markets saying that it made the system more resilient to external shocks.

Time has proved otherwise. When the shock came, thankfully for Greenspan not under his watch, the opacity of who was carrying this risk made the system more fragile with banks unwilling to lend freely to their counter-parts due to lack of transparency as to who was carrying the risk resulting from the housing shock.

The regulators were also caught napping at the wheel when they allowed traditional banking credit intermediation to be performed by hedge funds and private equity funds which operate largely unregulated with high leverage at the fringes of the financial system.

This over-confidence of regulators, whose fractionalised structured allowed too many cracks to be exploited by those who wanted to avoid regulation to take more risks than can be justified in such crucially important sectors, is by far the main reason why we are where we are today. It is incomprehensible how regulators could tolerate, even condone, crazy executive compensation policies adopted by regulated institutions to reward those who were taking excessive risks which produce a stream of paper profits for a few years which profits are then completely wiped out in a short time when the risks turn sours.

The regulators are as much at fault as greedy bankers. They probably don’t deserve to be bailed out. But there will be too many innocent victims if they are not. For the sake of the latter, including the poorest in the world, let’s hope that US legislators will swallow their pride and approve the bailout before they leave on their campaign trail next week. Being part of the world we depend on it too. But that is only a crisis averting solution. A more permanent solution depends on re-inventing a more effective system of regulation through transparency.

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