Financial crisis of 2008 – Jury is still out

The worst financial crisis since the great depression of 1930s touched the life of every single citizen of the globe. Collapse of the financial giants, mega scale bail out efforts by the governments, collapse of asset prices specially housing and the resultant foreclosures, evictions and wiping out the employment in the sector and substantial decline in economic activities characterized this. The Financial Crisis Inquiry Commission of USA, appointed by President to examine the causes, concluded in its Jan 2011 report that “The record is replete with evidence of failures. None of what happened was an act of God”. The report mentioned that Goldman Sachs collected $2.9 billion from the American International Group as payout on a speculative trade for its own account after AIG received bulk of it out of taxpayer’s money. The major findings related to ignoring the warning signs, failures in financial regulations and supervision, less capital with investment bankers compared to their risk profile, inadequate supervision of mortgage securitization train by the regulators, failure of corporate governance and risk management, short termism taking control of compensation system, key agencies like The Treasury Department & The Federal Reserve Board, remaining behind the curve, main actors in toxic mortgages not having enough skin of theirs in the game and failure of credit rating agencies etc.

The commission did not give any recommendation to fix the system for its mandate was limited but even in terms of diagnosis of the problem; its findings were a mix of causes and symptoms. Proximate apparent causes (which are in essence symptoms) were highlighted with lesser effort to reach at the epicenter(s) of the problem. Treatment of symptoms cannot be a lasting cure. It is futile to ask economic entities about their organization being full of opportunistic wolfs for every other organization also employed (and rewarded liberally) similar trait animals. This is best illustrated in the words of Citigroup‘s chief executive, Charles O. Prince who used an interesting metaphor to describe his company’s situation as a major provider of financing for leveraged buyouts -  “As long as the music is playing, you’ve got to get up and dance and we are still dancing”. The partying banks were overseen by indulgent fellow party animals (regulators) which explained their blurred vision failing to notice deployment of leverage ratio of more than 35:1 by some failed banks.

Here is an attempt to examine some of the problems at the epicenter(s) of the crisis.

1.   Currency pegging by China:

China’s boarding of manufacturing bus in 90’s, saw huge number of low income workers becoming available for manufacturing. The manufactured goods became very cheap which resulted into low and stable inflation numbers. The “maestro” Greenspan kept interest rates very low without being bothered for the risk of high inflation. This resulted into series of global asset bubbles. To make the problem more complex, china pegged the currency to USD which implied benign inflation scenario because of absence of appreciation in Chinese currency. The profitability of the corporates increased and people got paid more which made their housing dream reachable. The banks were quick to extend loans and shift their risk through financial engineering in the form of securitization.

Simultaneously, with some lag, US manufacturing became uncompetitive and jobs got lost. This also caused inflation in China- as their export to US gave them more of local currency because of exchange rates being pegged. The absence of free floating of Chinese currency led to disequilibrium – recession in US and low standard of living in China because of low wages and inflation. The correct policy response on the part of US should have been to nullify the effect of artificial pegging of Chinese currency by levying higher import duty.

2.   Capitulation of constitution and the government by corporates:

The right of electing governments lies with voting public. This right, though legally intact, has been diluted with the advent of multi-national giant corporations. The constitution is generally expected to serve two entities – public and the government and it had largely remained so in earlier times. In the post multi-national era, the corporates got enormous clout to enforce and (even extend) their sphere of rights – many times at the cost of reduced well-being of the public. The recognition of corporates as citizens diluted the accountability of the government solely to public. The elections are now effectively fought only by those who get campaign contributions by the corporates and public gets to elect only one of those corporate nominees. Since there is no free lunch, the elected government pays back the industry. US defense industry in the last decade got paid back in the form of two wars and enormous amount on defense expenditure. Financial industry was paid back in the form of de-regulation which became a contributory factor to financial crisis whose grand opening was showcased in 2008. Further, it got super dividend in the form of socialization of the liabilities of the rescued banks as they all enjoyed tax payer’s money to keep them afloat. Out-of-the-box thinking is required to grant legal superiority to general public rights over the rights of corporates. The exact modus operandi to implement this is a matter of enormous intellectual and social debate which calls for a separate discussion.

3.   Skewed orientation of cultural and educational value systems:

The proliferation of ultra-consumerism and flourishing of consumptive society was the result of the exploits of World War II. The elevated standard of living of the Americans since late 40’s has wrongly been attributed only to the American super efforts and achievements. In reality, to a large extent, it was made possible by fall of Europe and therefore forced disentitlement on a large block of humanity. Instead of sober realization, this created army of snobs who dreamt of upper class standard without even having college education. This was fertile ground for imbibing deep sense of entitlements, unbounded irrational optimism and narcissism. The education system was skewed and drenched in false concepts of wealth, economics and entrepreneurship. Money was confused with wealth. Money is merely a convenience (to replace barter trade). An economy based on swapping stocks or real estate back and forth at successively higher prices creates money but no wealth. The house which priced earlier at X and re-priced now at 2X creates money but no wealth. Real wealth gives rise to comfort. The house remained the same irrespective of the increased price tag going with this. Ask a wrecked sailor sitting with a fat wallet about its use – obviously nothing. He needs food, direction map, a rod to fish and possibly a female company to keep him in good spirit till he finds his ways to shore. Americans created money through financial engineering which was mistaken as wealth and splurged. When the bill finally came, there was nothing to fall back upon.

Instead of creating real wealth, their education system taught creating wealth on paper through financial engineering. Finance became the queen of the subjects. The corporates started being run by those who did not understand the technical aspects of their business. MBAs started having supremacy in the organization. The logical extension of this was preference towards inorganic growth. Organic growth through innovation in products and extension of product-lines became casualty. To make the matter worse, press abdicated its role of educating the public. It became propaganda machine of the corporates. All of these led to ballooning into mega-sized entitlements leaning on paper wealth to fructify. The disaster has been the logical consequence.

4.   Breach of social contract:

Ronald Reagan unfolded a deal under which rich and ultra-rich were given the benefit of lowered taxes. The implicit understanding was that lowering of tax would result into higher savings and higher re-investment by rich which would create more quality jobs and increased prosperity for all. They went back on their promise. The extra money available with them was used as play-money. Rather than investing their tax largesse in productive investment, they invested these in high stake risky games and tried to create more wealth by selling risky assets to each other at successively higher prices which in no case can be an endless gain. It did not matter if they lost as it was merely play-money for them and their skin was not really into the game. Progressive taxation requires to be strengthened so that drift towards undesirable risky ventures are not encouraged by government policies. Excessive inequality leading to natural tilt towards risky investment is a demon which requires to be dealt deftly by the governments. 

5.   Conscious inaction by regulators:

The story unfolded over a decade and it did not happen suddenly in 2008. It beats the logic as to how US Fed allowed (through their active internal decision) the banks to use credit default swaps to lower their capital without assessing the counter-party risk of the credit-default issuers. Similarly Fed watched approvingly the big three credit rating agencies doing both the designing of structured products and assigning ratings to them which is such an obvious conflict of interest. Though Fed did not pull the trigger, it did participate in loading the gun. What was the reason behind its deliberate in-action? Is it the case that US Fed, rather than being a truly independent agency, was unduly influenced by Wall Street covertly or overtly? After all it is not uncommon for people from Fed to take up high paying jobs in Wall Street after their stint in Fed.

6.  Inappropriate incentive structure of bankers based upon fake Alpha arising out of tail risk:

Average bonus of the employees of Wall Street banks in the year 2007 was four times the average household American income. Wow!!!! Surely they would have been the creamiest intellectuals and professionals. Unfortunately the subsequent events of 2008 and thereafter points to the contrary. In reality, they were paid obnoxiously for the excessive risks taken. 

Managers of financial assets generally generate return on the systemic risks (Beta risk) for which they do not deserve any incentive. Generation of Alpha by the managers entitles them for extra bonus but Alpha generators are practically non-existent. Wall Street managers generated fake Alpha arising out of tail risks assumed. Deployment of tail risk generates additional returns in the short run which is however counter balanced by heavy negative returns over distant future. A manager who invested in AAA-rated tranches of collateralized debt obligations (CDO) generated many basis points higher return than a similar AAA rated bonds. “Excess” return was in fact compensation for the “tail” risk that the CDO would default. True Alpha is captured when one analyses the return over long periods. Unfortunately managers were rewarded for their short term Alpha generation which encouraged them to deploy excessive tail risks.

The incentive structure should be based upon mechanism to calculate earnings over long horizons. Claw back mechanism is a welcome development in this direction. 

7.   Alan Greenspan

The maestro jumped ship just before the unfolding of the financial meltdown. In his memoir “The Age of Turbulence: Adventures in a New World”, he bared his love for the market (distorted one of course) in the words “……authorities should not interfere with the pollinating bees of Wall Street”. He had massive misguided faith in unregulated markets. He overly celebrated the “rationality of free market” and totally ignored the flaws of humanity which are nevertheless real and common place.

Pursuit of happiness under capitalism

My intellectual limitations do not permit me to define happiness. However I would like to differentiate happiness from pleasure. Pleasure is enjoyment of external stimuli. Pleasure can be found by having good food, buying Armani fashion stuffs or going on exotic vacations. One may be doing pleasurable things but still remain unhappy. Happiness comes from internal workings of our own minds.

For the benefit of readers who want to understand the real meaning of happiness, I quote Mahatma Gandhi: “Happiness is essentially a state of going somewhere, wholeheartedly, one-directionally, without regret or reservation”. Another perspective comes from Ayn Rand who considers happiness as a state of non-contradictory joy without penalty or guilt which comes only to a rational man desiring rational goals through rational values and rational acts.

Leaving aside the above finer distinction for the time being, let us dwell on as to whether we are happy today under capitalist system. Adam Smith placed total reliance on “invisible hands” of market to achieve both individual and collective prosperity. Would market mechanism provide remedy for the suffering of relatively in-efficient people or ensure fair reward in un-distorted fashion (beyond the narrow confinement of legalities)? Capitalism creates social inequality in wealth which trickles down, because children of unsuccessful parents will become disadvantaged to start with. This contradicts with capitalism slogan of “Equal opportunity”. High inequality can generate further higher inequality and eventually poor economic growth, social imbalance and formation of oligopolies which will take away the spirit of free competition so ardently advocated by capitalists. The business personnel whose profitable ventures result into emergence of inequality and oligopolies should be responsible to rectify the imbalance. This is not happening as the recent financial crisis has demonstrated.

Happiest countries tend to be Scandinavian socialist democracies. High per-capita GDP certainly plays a role, but even social democratic New Zealand, with per-capita GDP significantly lower, ranks well above US in the happiness index. Let us dig beyond the surface. What factors lead to diminished happiness under capitalism? Some loud thinking throws the following:

1.    Higher incentive to steal:

Capitalism as contrasted with socialism, gives full right to private property. The act of stealing (in its widest sense) is punishable under capitalism and socialism alike but undetected theft under socialism is likely to be limited as acquisition arising out of theft cannot be stored and passed over to future generations. Under socialism, theft will only give rise to undeserved current dubious consumption. As opposed to this, under capitalism the bounty acquired through stealing can not only be used for current consumption but also passed over to successive generations through money laundering techniques of layering and changing the color and label of the acquisition through theft. This distorts the social balance leading to diminished happiness.

2.    Crony capitalism:

If the capitalism system is purged from the menace of stealing, the crony capitalism does pretty much the same albeit at a higher scale. Under this, people with good connections to the center of power - the "cronies" of the government - manage to place themselves in positions of undue influence over economic policy, thus deriving great personal gains. Examples are dime a dozen. Just take issues arising out Nira Radia’s phone tape or 2G cellular spectrum auction. One industrialist is reported to have bragged that Government of India was “apni dukan”. The capitalism gets robbed of its true beauty under this kind of   systematic misuse – often garbed as legal acts. This dampens the spirit of entrepreneurship and fair reward.

3.    Unfair distribution of rewards and widening rich-poor gap:

The current “OCCUPY MOVEMENT” explains this so well. This is directed against economic and social equality. Professor Ravi Batra links rise in "the share of wealth held by the richest 1 percent" to speculative manias and depressions which are close cousins of capitalism. The top 1% of Americans control 38% of the wealth. Joseph Stiglitz, Nobel laureate in his article "Of the 1%, by the 1%, for the 1%" expressed great concern on this. The increased public focus on the growing income brought by “OCCUPY MOVEMENT” will impact the political process. The role of corporate cash in election process is being debated. U.S. Congressman Ted Deutch, introduced the "Outlawing Corporate Cash Undermining the Public Interest in our Elections and Democracy (OCCUPIED) Constitutional Amendment," which seeks to ban corporate money from the electoral process. The systemic amoral opportunistic decision in favor of capitalists at the cost of labor seems to be inherent in the capitalist system as currently practiced.

4. Free ride to pleasure for “HAVES” and uncompensated infliction of pain on “HAVENOTS”

For the sake of argument, let us assume that those who are poor are not so because of the wicked acts of others but simply because of their inferior abilities. Their state of inferiority in materialistic terms becomes a source of joy (though none of the “HAVEs” will admit this) for others as happiness is a relative consent. Various standards of comparison may be possible. Comparison with others is the most talked about. People compare themselves to others in terms of material possessions and social standing. The differences vis-à-vis others make people happy or sad depending upon difference being positive or   negative. Happiness of one is at the cost of other as positive difference for one implies negative difference for the other person. The free ride to pleasure by “HAVES” by simply viewing the plights of “LESSER HAVES” or “HAVENOTS” needs to be priced and organized. The collective happiness of the society can be optimized by distribution of social rewards in such a way that comparison is favorable for most people.

5. Ignoring the negative externalities in allocations of investment:

Under capitalism, the defining theme of production process is maximization of the profits of the capital providers. Profit is ordinarily taken as revenue minus cost. The perspective of capital providers is given in interpreting the term “cost”. Apart from the cost born by capital providers, there are some additional elements of cost born by externals (society) which is ignored. One such obvious cost is pollution and its effect on society. There are many other negative externalities like impact on pricing of other assets in the area before and after a factory having been set up. The list goes on. There are positive externalities also but these externalities are not random in the sense that positive and negative externalities balance out. This is so because of inherent bias on the part of capital providers to ignore negative externalities unless forced by regulations. There is a need to price-in the net negative externalities into the cost born by the capital providers. In the absence of price being linked to true total cost of production, efficient allocation of capital goes for a toss.

6. Ignoring the well-being of future generations:

Investors prefer quick returns. Beneficial projects for future generations likely to be taking multi-decades are ignored. Lack of concern for future generations is also well reflected in ruthless exploitation of oil as energy source despite full knowledge about its scarcity and capitalists remaining clueless about how the future generation would face the prospect of depletion of oil as source of energy. The alternative sources of oil may cost a lot in future but its impact on well-being on the society is not at all considered by present day capitalists.

How can the above problems be addressed? Back to socialism is not an answer. As the citizens of the twenty-first century are well-informed about the life-style offered by socialism; it seems more plausible for capitalism to survive the test of economic turbulence with some modifications.

I advocate the concept of “Inclusive capitalism” under which the inherent deficiencies of capitalism as discussed above are addressed to the extent found feasible. Thinking of utopia is wasteful. We need to respect and reward the individual superiority of human beings so long as it did not diminish the welfare of others and ensured minimum standards of welfare for entire humanity. I am therefore tempted to advocate curb on the absolute right to Passover the deceased property to his/ her progenies. An individual should enjoy and amass whatever he is capable of. Passing this over to successive generations creates economic imbalance, hardening and exacerbating the layered structure of already stratified society, diminishing the enthusiasm of children of HAVENOTS, creation of oligarchies and many other associated evils. An absolute ban on inheriting the property will serve as serious dis-incentive and frontal assault on the concept of libertarianism. A controlled inheritance prescribing cap on amount which can be inherited and heavy estate duty would temper the ill-effects of absolute right to private property. Any income arising out of estate duty should not be vested with government as increasing the domain of government in economic affairs reduces the efficiency drastically. The money thus available may be redistributed equally to all citizens of the country preferably in the form of financial instruments. Additionally negative externalities in the business process should be priced and factored into the cost of production. This is easier said than done because pricing of many externalities is difficult but trend towards pricing of environmental externalities in power sector, carbon emission trading, carbon allowance for consumers, marketable pollution permit etc. are welcome efforts in this direction. Pricing of externalities will however always remain works-in-progress.