COWBOY CAPITALISM AND HOW THE WEST WAS LOST
It is about time that people in power start being honest for a change – infact its to late now! The people in power have betrayed the American people – the World, and now we ordinary people, JOE THE PLUMBERS, are paying for it. Yes we are paying for it, and still going to pay dearly. Everybody is clinging on to some news article, some new headline of a turnaround, looking for a glimpse of hope, light in the tunnel of our economic future. And, all of this, because of bad management, bad judgement, and bad corporate governance.
THE MASSIVE BANK BAIL-OUTS in the United States and Europe won’t stave off recession in the rich countries fo the world. This will drag down emerging markets – which will all remain mired in low growth for some time to come. The fallout for the real economy is bound to be significant. It’s likely that countries in the developed world will go into recession – with few exceptions. “Ireland is already in recession; Britian, Germany, Italy, Spain, Switzerland and Japan are at the brink and it’s difficult to see how the US can avoid recession. Global trade will suffer and economic activity in the emerging world will also slow down considerably, even if outright contraction is avoided. Policy-makers will have to put inflation fears asside and try to protect their real economies by relaxing monetary and fiscal policy.
Growth forecasts are likely to be lowered further, especially for 2009, with some global growth falling to below 3% for some time to come in most countries. That could be regarded as a “growth recession” and will cause global uncertainty about the extent to which cmmodity prices could still decline in the world.
The political wrangling over the US Congress’s passing US Treasury Secretary Henry Paulson’s US$700bn bail-out plan for banks caught up in a credit crisis has highlighted the fact that taxpayers are loath to bail out bankers. Many politicians felt that it was wrong for taxpayers to bailout “fat cat” bankers who had taken excessive risks while earning stratospheric salaries.
In playing the blame game those bankers and other financial services executives are the first who come to mind. But to find the root cause of the problem you must dig deeper. You have to look at the conditions created by policymakers that enabled those executives to become cowboy capatalists.
The trigger for the credit crisis was the bursting of the US housing bubble. The question that needs to be asked is whether policymakers were in any way responsible for creating that bubble. Also, once it was created wasn’t it the responsibility of policymakers to prick that bubble so it could defalte gently rather than burst as messily as it’s done?
In answering that question, one name comes into the frame: Alan Greenspan, the former Federal Reserve chairman. It was Greenspan who slashed the Federal funds rate to a record low of 1% by 2003 and allowed the rate to stay at that level for a year, thereby creating easy money conditions that advantaged bankers who wanted to take on a lot of risk. It was also Greenspan who spoke out against tighter regulation of banks and financial services, calling instead for self-regulation.
Greenspan actually praised the sub-prime mortgage industry in a speech in April 2005. Sub-prime mortgages are loans extended to clients with tarnished credit records who would otherwise not have access to credit. Greenspan said in his speech in 2005: “Innovation has brought about a multitude of new products, such as sub-prime loans and niche credit programmes for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country… With those advances in technology lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers… Where once more marginal applicants would simply have been denied, credit lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in sub-prime mortgage lending; indeed, today sub-prime mortgages account for roughly 10% of the number of all mortgages outstanding, up from just 1% to 2% in the early Nineties.”
Against the backdrop of easy credit the housing market boomed and even early on some commentators were talking of a bubble. They asked the questions whether the Fed was responsible for the bubble and whether it should prick it. Given what’s happened to the US housing market and mortgage-backed securities, a report in The New York Times of 31 May 2005 is eerily prescient and quotes some analysts putting the responsibility firmly on the Fed.
“If the housing market has become a bubble, as increasing numbers of economists warn, would the Federal Reserve try to deflate it?” the report asks. It notes the idea runs counter to the deep-seated view at the US’s central bank, which refuded to puncture the stock market bubble of the Nineties and continues to view its main job as preventing inflation rather than influencing the prices of stocks, bonds or real estate.
“But many economists say the housing market poses a different challenge from the stock market. For one thing, they say, the Federal Reserve’s policies have played a much more direct role in the housing boom than they did in the technology fuelled stock bubble,” the report says.
It quotes Nigel Gault, a senior economist at Global Insight, as saying: “This time around the Fed’s policies have played a part. Its policy has been to boost the housing market and the consumer through very low interest rates.”
The report adds: “Others worry that the Federal Reserve has tacitly encouraged risky speculation through its role as chief regulator of the banking industry, which has steadily relaxed lending standards and allowed homebuyers to borrow more money through higher-risk loans.”
It quotes Edward Yardeni, chief economist at Oak Associates, as saying: “The Fed chairman cleaned up the mess caused by the bursting of the technology and telecom bubbles by by creating another bubble. Now he’s failed to stop the alarming deterioration of mortgage lending standards to stop the housing bubble.”
Those comments – made a full two years before any sign of trouble in the sub-prime market – show that analysts were ahead of the Fed in recognising that trouble was brewing.
The question as to whether the Fed should try to prick asset price bubbles gently is a controversial one and the housing bubble isn’t the first time the issue has been raised. Greenspan also stands accused of failing to act when the stock market was frothy in the late Nineties.
Fed Governor Frederic Mishkin, in a speech on asset price bubbles earlier in the year, argued that pre-emptive bubble pricking rested on three assumptions, none of them likely to be met. The three conditions are: First, the central bank must be able to spot a bubble in the making. But that means the banks knows better than the market. Mishkan says the Fed doesn’t know better than the market; if it knows for certain a bubble has developed then so will the market and the bubble will pop anayway.
Second, monetary policy must be unable to deal after the fact with the consequences of a bubble bursting for it to make sense to act pre-emptively.
Third, central banks must know the right monetary policy action to deflate a bubble ahead of time. That also seems improbable. By definition, bubbles are abnormal times. The effects of an interest rate rise in such times may be vary difficult to predict. It might do more harm than good.
However, in the process of creating the housing bubble the Fed thought it was doing good. Now that the bubble has burst the taxpayer is picking up the tab – and faith in the free market system has been dealt a severe blow.
Nowhere is the blow that’s been dealt to the free market system clearer than in th eglee socialists have expressed in the big bail-outs by taxpayers. An editorial in The Socialist, the weekly paper of the Socialist Party in England and Wales, was particularly gleeful about the nationalisation by the US government of mortgage companies Fannie Mae and Freddie MAc.
Free market purists would argue the fortunes of the banks and financial institutions that behavedrecklessly should have been left to the market. The argumet is that those companies had priced risk incorrectly and that the market would find its own new equilibrium risks premium. Trouble is ,the path towards a new, correctly priced risk premium isn’t a smooth one. Just as risk premiums overshot in the go-go years, they’re overshooting now the bubble has burst. That requires some intervention by governments to prevent a global economic meltdown of epic proportions. The price to be paid is greater government intervention in the economy that – if not handled carefully – could lead to distortions down the line and a heavy bill for the taxpayer.
One question that arises is whether the free market isn’t to blame for the crisis. The answer is no: the crisis isn’t evidence that financial institutions are better managed by the public sector. But it is evidence that cowboy capitalism – a free market in which rules are discarded, referees abscond and a free-for-all is created by the central bank – is a recipe for disaster.
Regulation has been to lax. An example is the $62 trillion market for credit default swaps (CDS), created to protect banks from loan losses. Bloomberg reports trading in those derivatives accelerated the collapse of Lehman Brothers and the takeover of AIG. Now there’s talk regulators want to bring oversight to that part of the credit market.
A crucial question that arises is whether, like Greenspan before, the seed of the next crisis isn’t being sown in the policy response to the current one. True, in the immediate future the US and many other rich nations face recession, which will hit emerging market countries. But the massive bail-outs by the US taxpayer are sending a message that if a financial institution is too big to fail, government will step in. Years into the future – when the current risk aversion has dissipated – that message will still stand.
It’s true the US administration had no choice but to undertake the current bail-outs, but in doing so it created the risk of moral hazard years down the line. Moral hazard exists when people or companies take on more risk than they would have done if they didn’t believe they’d be bailed out.
Another point is the easy money conditions and slack regulation of the past shouldn’t be repeated. It’s right the Fed slashed interest rates – from 5,25% to 2% – but once conditions have improved strongly the Fed must be careful not to let rates stay too low for too long again, for that could create fertile conditions for a future bubble.
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