A “convincing explanation”

Jacob Weisberg of Slate writes (link through Antidote)-

A source of mild entertainment amid the financial carnage has been watching libertarians scurrying to explain how the global financial crisis is the result of too much government intervention rather than too little. One line of argument casts as villain the Community Reinvestment Act, which prevents banks from “redlining” minority neighborhoods as not creditworthy. Another theory blames Fannie Mae and Freddie Mac for causing the trouble by subsidizing and securitizing mortgages with an implicit government guarantee. An alternative thesis is that past bailouts encouraged investors to behave recklessly in anticipation of a taxpayer rescue.

There are rebuttals to these claims and rejoinders to the rebuttals. But to summarize, the libertarian apologetics fall wildly short of providing any convincing explanation for what went wrong. The argument as a whole is reminiscent of wearying dorm-room debates that took place circa 1989 about whether the fall of the Soviet bloc demonstrated the failure of communism. Academic Marxists were never going to be convinced that anything that happened in the real world could invalidate their belief system. Utopians of the right, libertarians are just as convinced that their ideas have yet to be tried, and that they would work beautifully if we could only just have a do-over of human history. Like all true ideologues, they find a way to interpret mounting evidence of error as proof that they were right all along.

First, any intellectually honest person will note that libertarians are simply saying “I told you so”. They are agitated and angry, but they are not “scurrying around” because they don’t need to – they are not in power and they didn’t run the economy into the ground. Its the likes of Bush, Brown, Sarkozy, Chidambaram, and (surprise surprise) Putin who are scurrying around, and Chavez and Co. are a bit uncomfortable because falling oil prices might derail his slick socialism. Second, libertarianism’s biggest flaw is its broad definition – the situation is comic, adjust a couple of definitions and Hitler might probably qualify. The libertarianism I believe in is – limited government, zero regulation, and an absolute right to life, property, speech and expression. To my knowledge most libertarian philosophies are in agreement with this; other flavors, I don’t care. As for Greenspan calling himself a libertarian – there is a huge difference between actions and words; Bush supposedly stands for freedom. Concentrate on the actions, and you will know the man.

I dislike (hate is a better word) utilitarianism and utilitarian defenses of liberty. Since a lot of liberals and weak kneed capitalists defended capitalism on utilitarian grounds and went on about how capitalism and free markets were good because they raised standards of living, brought about competition, etc, instead of saying that free markets are right because they are free, because freedom is right, because freedom is moral, these “defenders” find themselves unable to answer criticisms regarding “market failure”. Blaming bad laws and excessive regulation, though these are to blame, does not cut it. And the backlash led by some sections of the illiterate public and a “too literate” media has successfully convinced people that the”free market” is to blame.

Unlike dodo-nomics, the predominant economic theory of our age – pushed to the forefront by the greatest dodo of them all – John Maynard Keynes, and new dodo-nomics, something his worshipers adhere to (ad hominem? guilty), libertarianism believes that government intervention in the market is bad – unconscionable. And unlike some people who can only slot men into two categories – conservative or liberal, without recognizing other forces at play such as communism / socialism and fascism/ corporatism, libertarians understand both, and hence oppose both. Its a nice trick Weisberg plays – saying that Marxism and libertarianism are on the opposite sides and are stricken by the same illness – dogma.

Communism, the purest form of socialism, will never work without a despotic government and without force – the philosophy places society above man, and only an idiot will work watching others eat while others eat watching him work – “from each according to his ability, to each according to his need.” Its bound to fail, and it will kill many in the process. And Marxists cry that it failed because people are not good enough.

Libertarianism, on the other hand, places the individual above society. It derives individual rights and freedom from natural rights, not out of some fuzzy concepts like democracy (rule of the mob). It does not claim that it will lead to some kind of Utopia – such an event depends on how individuals interact with each other in a free society. And libertarianism does not claim that it can somehow control human behavior – it does not recommend selective lobotomy on people’s brains to meet its ends. So, if companies and employees gave out loans without checking the credentials of the borrowers, they were doing it either because they were stupid, or greedy or scared. And libertarianism does not have a cure for this behavior. The punishment, a harsh one, is provided by an “unfettered” (TRULY FREE) market where such companies will sink, such employees will lose their jobs and won’t get new ones (how did you sanction a loan to someone who does not have a regular income, Mr. X? No answer? Good bye.) and governments won’t have the power to bail them out. But the pragmatist that Weisberg is, he is not willing to let this happen, or give ordinary people who took bad decisions “a wonderful lesson in personal responsibility”, or tolerate the creation of “thousands of new jobs in the soup-kitchen and food-pantry industries,” a reference to a massive systemic collapse, depression, joblessness – 1929 redux. The difference between Marxism and libertarianism should be apparent – clear as daylight, at least to those who have not shut their eyes purposely.

Weisberg writes further, “any competent forensic work has to put the libertarian theory of self-regulating financial markets at the scene of the crime.” But of course – you let the murderer go and catch hold of the one that called the cops while the murder was in progress – plot of Bollywood film #362 of 1986. Worse, the murderer is judge, jury and executioner. I say, go right ahead. It makes no difference. Tighten the screws as much as you want. When the most feared regulator in the world – the Soviet Union – couldn’t stop its economy from collapsing – what makes people think that more regulation will somehow prevent the next disaster? In Book II of Aristotle’s Politics, the greatest philosopher in the history of mankind defends the institution of private property from Plato’s totalitarian republic and its communal laws. And while his defense talks of “censure” (modern day regulation), and he feels that ethics and politics belong together, he points out a very important problem with human nature-

It is clearly better that property should be private, but the use of it common; and the special business of the legislator is to create in men this benevolent disposition. Again, how immeasurably greater is the pleasure, when a man feels a thing to be his own; for the love of self is a feeling implanted by nature and not given in vain, although selfishness is rightly censured; this, however, is not the mere love of self, but the love of self in excess, like the miser’s love of money; for all, or almost all, men love money, and other such objects in a measure. And further, there is the greatest pleasure in doing a kindness or service to friends or guests or companions, which can only be rendered when a man has private property. The advantage is lost by the excessive unification of the state. Two virtues are annihilated in such a state : first, temperance towards women (for it is an honourable action to abstain from another’s wife for temperance sake) ; secondly, liberality in the matter of property. No one, when men have all things in common, will any longer set an example of liberality or do any liberal action ; for liberality consists in the use which is made of property.

Such legislation may have a specious appearance of benevolence ; men readily listen to it, and are easily induced to believe that in some wonderful manner everybody will become everybody’s friend, especially when some one is heard denouncing the evils now existing in states, suits about contracts, convictions for perjury, flatteries of rich men and the like, which are said to arise out of the possession of private property. These evils, however, are due to a very different cause — the wickedness of human nature. Indeed, we see that there is much more quarrelling among those who have all things in common, though there are not many of them when compared with the vast numbers who have private property.

The magic potion that cures wickedness (and if you read further, ambition and hedonism), where is it?

His final words-

The worst thing you can say about libertarians is that they are intellectually immature, frozen in the worldview many of them absorbed from reading Ayn Rand novels in high school.

Intellectually immature and frozen in a Randian world view. That’s right. In a constantly changing world, we need to be “pragmatic.” All doors should be kept open. If there is a heavy food shortage sometime in the future, we should institute rationing. If that doesn’t suffice, we could think about population “rationalization”. One should not be dogmatic about concepts like freedom and rights – only the foolish libertarians do that. We, on the other hand, are pragmatic because we have declared that we are ideologically bankrupt.
And you could do much worse than read Ayn Rand; read Jeremy Bentham. Rand is good. So are Mises, Bastiat, Rothbard, Hazlitt and Hayek.

Like other ideologues, libertarians react to the world’s failing to conform to their model by asking where the world went wrong. Their heroic view of capitalism makes it difficult for them to accept that markets can be irrational, misunderstand risk, and misallocate resources or that financial systems without vigorous government oversight and the capacity for pragmatic intervention constitute a recipe for disaster.

Unlike the Marxists and the pragmatists, the libertarians don’t have a “model” beyond freedom and rights. They don’t plan to control the economy or society nor do they have some “desirable” ends in mind with people being the means to such an end.
Yes, they idolize capitalism – because its a system that guarantees freedom.
A market is not a person – reason is an attribute of a living person – a stone cannot be rational or irrational. But I am nitpicking; he meant irrational people, of course. Further, to know whether a market is “misallocating resources”, one should know what is the best allocation of resources; who decides that? Perhaps spending billions of dollars in Iraq by squeezing American taxpayers, or stealing from them through an inflationary monetary policy, or giving out loans to Wall Street based corporatists is. What is the definition of disaster and why is it so bad? What is “pragmatic intervention”? These are all undefinable concepts thrown up based on an assumption that there is someone out there who knows more about the market than its participants do – the government.

They are bankrupt, and this time, there will be no bailout.

Keep dreaming.

Now the question that I would have said blows a Titanic-sized hole in the “under-regulation is the root cause” theory, if this were not the case-

But Born was not questioning bets on pork bellies or wheat prices, the bedrock of futures trading in simpler times. Her focus was the arcane class of derivatives linked to fluctuations in currency and interest rates. She told a group of business lawyers in 1998 that the “lack of basic information” allowed traders in derivatives “to take positions that may threaten our regulated markets or, indeed, our economy, without the knowledge of any federal regulatory authority.”

The future that Born envisioned turned out to be even riskier than she imagined. The real estate boom and easy credit of the past decade gave birth to more complex securities and derivatives, this time linked to the inflated value of millions of homes bought by Americans ultimately unable to afford them. That created a new chain of risk, starting with the heavily indebted homebuyers and ending in a vast, unregulated web of contracts worldwide.

or this-

The 1933 Glass-Steagall Act, which set up the Federal Deposit Insurance Corporation and separated commercial from investment banking since the Great Depression in the US, was repealed in 1999. This meant that deposit-taking commercial banks like Citibank could underwrite and trade instruments such as MBS and collateralised debt obligations (CDOs), and set up structured investment vehicles (SIVs). In 2000, the elite investment bank J P Morgan which was reeling from an erosion of its traditional high margin investment banking business consolidated with Chase Bank.

or this, the innocuous “margin call”-

The AIG story illustrates two important aspects of the current crisis of confidence within the financial markets. First, AIG’s collapse in a matter of days resulted from the collateral requirements under the terms of contracts that are opaque, unregulated and difficult to track on corporate financial statements. As Buffett and others have suggested, the risk in the AIG derivatives portfolio was explosive — and ignored until it was too late.

Second, the AIG story illustrates how a collateral call under a CDS contract can have the effect of positioning the CDS counterparty — the institution on the other side that claims rights to the collateral — senior to the AIG policy holders and bondholders.

- while the crisis had its roots in sub prime loan defaults and the crazy proliferation of “unregulated” esoteric derivatives obliterated the “unregulated” investment banks, how did the “regulated” AIG suffer a near collapse and how did “regulated” banking behemoths like Citibank develop billion dollar leaks in their balance sheets?

The articles above give a clear answer – a combination of lack of regulation (derivatives) and failure of regulation (Greenspan). Monetary policy (government) and lending money to people who don’t deserve it (market, and government) still bear the primary responsibility. But lets try to understand the socialist view point – the government is ready to bear the risks related to monetary policy, and even that related to “housing for all”; what its not ready to bear is the cost of the havoc that has resulted from trillion dollar unregulated gambles. What answer does utilitarian libertarianism have to this problem? The socialists say if the derivatives market had been regulated, this bust would not have happened. Allowing for Murphy and the law of unintended consequences, I would agree with them purely on utilitarian grounds. Since the government is not going to give up economic stimulation or stop regulating or stop its bailouts anytime soon, the market will necessarily get distorted, and since the free market does not exist, it won’t be able to punish bad business decisions. The only utilitarian argument I can make is that if a “true” free market were to exist, it would be better for all concerned. But then as Weisberg says, that sounds just like the Marxists. The truth is this – you cannot defeat socialism by turning socialist yourself.

The argument is not about economics, its one about philosophy. The philosophy that lies at the heart of Weisberg’s writings and modern day government is pragmatism – the philosophy of compromise. A government based on such a philosophy does not care about rights; it simply want to serve an end that was conjured up centuries ago, and use people as a means to that end. You are not allowed to ask why that end, or, why should I be the means to such an end? The end is unfulfillable in a free society – rational people don’t enjoy self-flagellation, and so governments demand that it can only be fulfilled if people are “good”, or if they are forced into being good. People are told to be pragmatic. The end I refer to is egalitarianism – forcibly equalizing the unequal; and it has been actively pursued. Since making people rich is difficult (fiat money is not wealth; if it were, Mugabe would be the richest man on the planet), the policy has always been to steal from the rich – make them poor. This is where the idea of regulation comes from. Governments cannot create any value on their own, yet think that they know how to lecture others about the same, and how to “allocate” resources. And when people won’t agree to their diktats, or worse, question them, they come down to their real avatar – the brute brandishing a stick – if you don’t listen to me, I will beat you. A utilitarian defense of capitalism and free markets plays into their hands; that the “greatest happiness principle” is as bad as “from each according to his ability…”, if not worse, is a different matter altogether.

Any attempt at compromising with such an ideology necessarily means a destruction of your own.

Crisis

There are two sides to the current crisis that has enveloped the financial world – a crisis of liquidity and a crisis of credit. The liquidity crisis resulted from lack of immediate access to funds to meet liabilities that were due yesterday; the credit crisis resulted from large scale defaults on low quality home loans.

Liquidity
There is one cardinal rule when it comes to finance – never use short term funds to fund long term assets. And businesses that have their feet on the ground understand this – the manufacturer, the retailer, the service provider (their primary assets are people, but still). Everyone in fact, except most of the banking and financial sector. Why is the rule so important (although the names are self explanatory, an explanation will do no harm)?

Short term funds – loans – need to be paid back within a short period of time (the normal classification is anything that is payable within one year is “short term” and everything else – “long term”). So you should only use it to create assets that can be liquidized on demand or within a short period of time. Long term funds, on the other hand – whether your own money or money that is borrowed – is repayable or available to you over a significantly longer time frame. So, if an investment has to go into construction of a building, or buying machinery, or doing similar stuff, care needs to be taken that you are not obliged to return the entire money whenever the lender demands it. This requires that you either embark on the project on the strength of your own equity, or on the basis of a long term loan where the lender cannot demand that you pay up the entire money at once – something that cannot be done because all your funds are locked in a long term venture. The asset classification may vary depending on the business, but the classification still exists. And when someone fails to follow the rule, they end up with a “liquidity crisis”.

Every business more-or-less understands and follows this rule – that is why they differentiate between fixed assets and current assets; equity and long term funds, and current liabilities. And that is why they have a concept of working capital – the difference between current assets and current liabilities, a difference that is generally positive and which is therefore funded either through equity or through special funding in the form of cash credit facilities from banks. Every finance professional worth his salt knows about it, and the bankers even more so (but only when it comes to their debtors) – they will have a fit if you tell them you have a negative working capital – that you are funding your fixed assets from money payable to creditors or from your cash credit facility.

The problem in such a case does not result from the quality of assets – the business is still solvent, but from a mismatch in the time taken to liquidate an asset and the time when a liability needs to be repaid. It is a kind of asset-liability mismatch – a time-based one.

Banks, however, believe that they are exempt from this rule – that they can use demand deposits and lend the money for 10-20-30-year periods. Consider how your average bank operates. They accept “deposits payable on demand” – whether in the form of balances in a current account, or savings account, or a “fixed deposit” – the interest rate offered decided by the rules that govern each account; and they lend the money to businesses and individuals for long term uses. This is a serious mismatch and a disaster waiting to happen – a consequence of the “fractional reserve system” that banks follow, and the only reason banks can get away with this is because of an implicit government guarantee in the form of support from the Central Bank. If, for example, the Federal Reserve and similar central banks across the world were to be dissolved, modern banking will be history by next weekend. But the Central Bank and so called Deposit Insurance Corporations mask the perpetual liquidity crisis by guaranteeing enough funds in case of a bank run one one hand, and if a bank fails because it has to engage in a fire sale of its assets, guaranteeing a minimum amount that would be paid to every deposit holder. If you want to compare this with something you can relate to, think about the overbooking that hotels and airlines indulge in. The only difference is they don’t go bust when the chickens come home to roost – their business model does not depend on a balancing act.

Hence, fractional reserve banking, central banks and deposit insurance corporations are “solutions in search of a problem”, and these solutions fail when the problem raises its ugly head. The answer to this is full reserve banking and stripping government of its “monetary policy” making authority. Banks have to keep at hand a sum equivalent to all demand deposits they are liable for. The only money they can lend is that which they receive specifically for such a purpose. This system will raise the cost of banking, but will eliminate the need for central institutions controlling banks. A beneficial effect of this will be the elimination of inflation – a pernicious side-effect of government control on money supply.

Credit
Credit is a much simpler concept. When a prospective borrower meets a lender, in a free market, the lender will lend only if he is reasonably sure that he will get his money back. If the borrower defaults, the lender loses his money. And interest is the reward that the lender gets in return for taking this risk. So the whole system will work as long as people keep paying up the loans that they borrowed, and the scale of operations of banks and companies help them absorb the few losses that are inevitable when lending is done on a large scale.

The problem appears when lenders don’t pay attention to the risk profile of their borrower, either because of their increased risk appetite, or because they are forced by government to grant loans so that people can buy homes. Even in this case, when multiple defaults occur in a particular category of borrowers, as long as the loans are present on the books of the original lender, it is the one who would take the hit, and in a worst case scenario, it would go bankrupt.

The Current Crisis
In the present “credit crisis”, banks and other financial institutions threw caution to the winds, put their loans in a single basket and sold the basket in pieces to other companies who piled up even more complex financial instruments on top of them and sold them to another series of buyers. A pyramid was built on a fragile foundation, and the foundation collapsed when people who were granted loans way above their repayment abilities started defaulting. The shock wave was felt throughout the system and most banks and credit rating agencies realized that they had no idea of what they were holding and how to measure its risk or value-

ONE of the fastest-growing and most lucrative businesses on Wall Street in the past decade has been in derivatives — a sector that boomed after the near collapse of Long-Term Capital.

It is a stealth market that relies on trades conducted by phone between Wall Street dealer desks, away from open securities exchanges. How much changes hands or who holds what is ultimately unknown to analysts, investors and regulators.

Credit rating agencies, which banks paid to grade some of the new products, slapped high ratings on many of them, despite having only a loose familiarity with the quality of the assets behind these instruments.

Even the people running Wall Street firms didn’t really understand what they were buying and selling, says Byron Wien, a 40-year veteran of the stock market who is now the chief investment strategist of Pequot Capital, a hedge fund.

“These are ordinary folks who know a spreadsheet, but they are not steeped in the sophistication of these kind of models,” Mr. Wien says. “You put a lot of equations in front of them with little Greek letters on their sides, and they won’t know what they’re looking at.”

Mr. Blinder, the former Fed vice chairman, holds a doctorate in economics from M.I.T. but says he has only a “modest understanding” of complex derivatives. “I know the basic understanding of how they work,” he said, “but if you presented me with one and asked me to put a market value on it, I’d be guessing.”

Such uncertainty led some to single out derivatives for greater scrutiny and caution. Most famous, perhaps, was Warren E. Buffett, the legendary investor and chairman of Berkshire Hathaway, who in 2003 said derivatives were potential “weapons of mass destruction.”

And the market for these financial instruments vanished overnight leaving financial jargon like “mark-to-market” meaningless. As a reader of The Telegraph points out – “You can’t mark to a market that doesn’t exist.”

Most companies would have suffered losses but could still make it through if they did not suffer from a “liquidity crisis”, like AIG found out – even while being solvent – just – it had no money available to pay off creditors who demanded additional collateral. When Bear Stearns was being rescued in March 2008, this is what I said-

If the subprime mortgage crisis, and the Federal Reserve coming in with a huge bailout package for affected banks was bad idea, the Bear Stearns distress sale, underwritten by the Federal Reserve is worse. Conventional wisdom, and most pink papers, favors bailouts so that the overall banking system remains unscathed by such crises. But the fact of the matter is, bailouts fix the symptoms, not the cause. The main problem hardcore capitalists and libertarians (at least I do) have with bailouts is that those responsible for the mess don’t pay a financial price. If the tax payer has to pay for the financial jugglery done by employees of investment and commercial banks, and if the only thing that prevents people from losing their trust in banks is the backing of the government in the guise of the infallible Federal Reserve with an infinite credit rating, then a private banking sector makes no sense. In that case, nationalizing all banks should be the way to go.

There is a hint of sarcasm if you read a bit further, but my position is clear, and I stand by it. The crisis is a result of persistent government interference in the market, and the market failing to understand risk. And hence shareholders, bond holders, everyone who has invested in companies that took bad decisions should pay the penalty and take a hit. If they are not willing to do that, then the answer is not a bailout but a 100 % nationalization of the entire US banking and insurance sector. If companies don’t appreciate the free market but seek handouts on every available opportunity, socialism is what they deserve. And Bush can learn valuable lessons from Indira Gandhi on this one.