Pointing this out is not to claim I was particularly astute or prescient, but
to say that it is not possible that amid such clear signs of impending trouble
that those in charge of billion of dollars of other people's money, supported
by high-priced research, were caught off guard. Criminal dishonesty with
derelict of fiduciary duty is difficult to deny.
Moral hazard, while describing the tendency of bankers to make
bad loan based on an expectation of an eventual bailout, also applies to bad
loans made to borrowers that are considered "too big to fail" such as AIG,
Countrywide, Citigroup, JPMorgan Chase, GE Capital, General Motors or borrowers
such as inept Third World governments. In general, the principle of moral
hazard states that bailouts encourage future recklessness. Brady bonds to bail
out multinational banks with Latin American debts are labeled instruments of
moral hazard in conservative financial circles.
Most bankers reject the moral hazard charge because they welcome government
intervention when it comes to protecting their profits even as they oppose
regulations as hampering innovation and competitiveness with foreign banks.
Bankers only want to get government off their backs when government tries to
help the financially helpless and the poor. Private bankers support
privatization of profit and socialization of risks.
In global finance, the issue of moral hazard is more complex. Economic
imperialism uses moral hazard as an argument to oppose debt forgiveness for the
poorest economies. During the Asian financial crisis of 1997, the IMF imposed
harsh "conditionalities" (namely high interest rates, corporate restructuring
that results in lay-offs and massive unemployment, and austere fiscal policies)
justified by moral hazard arguments, punishing the poor in debtor nations for
the sins of their wayward bankers.
Many, including myself, have observed that the shrinking intermediary role of
banks in funding the economy, brought about by the rapid growth the non-bank
credit and capital markets has increased system risk in recent decades. (See
CREDIT BUST BYPASSES BANKS Part 1: The rise of the non-bank financial system
, Asia Times Online, September 5, 2007.)
This risk manifests itself only in a bear market when price corrections
dissipate phantom wealth. This systemic risk exposure is now building up to an
unprecedented crisis in both complexity and scale. The repeal in 1999 of the
Glass Steagall Act of 1933, which separated commercial banks and investment
banks, allows banks to compensate for their shrinking funding role by moving
into securitization and propriety trading through their investment banking
subsidiaries.
There is no doubt that all of the nation's biggest financial conglomerates,
whose commercial paper is the bellwether for the dollar and euro commercial
paper markets, will fall from borrower defaults and their interconnected size
will be the "too big to fail" reason for Fed intervention. It is very clear
that troubled debt-ridden corporations will now turn to the banks for help, not
because bankers are friendlier than bondholders, but because banks have access
to the Fed discount window.
All through his long tenure at the Fed, Greenspan's recurring message to banks
to continue lending during the first sign of recession was a clear signal that
the Fed would provide all the liquidity that is needed to prevent a systemic
collapse. The trouble is that the inter-linkage through structured finance
allows even tiny companies to trigger the demise of firms that are "too big to
fail".
The Nasdaq alone has made $3 trillion of market capitalization disappear in the
last nine months of 2000 during the tech bubble bust, which put many corporate
bonds under water. Unless the Fed is prepared to inject trillions of reserves
into the banking system, the debt crisis cannot be solved. And if the Fed does
that, what will happen to inflation and the exchange rate of the dollar? Cash
denominated in dollars is looking less a safe haven every day. That is why the
price of gold has jumped up.
Global imitation
It is an irony that at the very time when the US financial system is showing
signs of structural failure, the global trend to adopt US business models and
finance practices is reaching its peak. All over the world, governments are
rushing to privatize public assets, securitize debts and deregulate their
transitional economies away from socialism with the hope of reaping the
enviable results that the US free market economy has enjoyed for decades. The
bill of this enviable boom is now fast coming due and much of the world will to
have pay without ever having enjoyed the benefits. The "race to the bottom"
syndrome in wage competition has been enhanced by the "race toward risk"
syndrome in finance competition.
The marketplace of ideas, not unlike financial and commodity marketplaces,
often operates on mis-information until cruelly pulled back into reality by
unforgiving facts. In countries around the world, much governmental and
institutional aping of US deregulation practices is based on a misunderstanding
of what a fatal virus US neoliberal market fundamentalism really is.
There is some truth in the popular myth that US ways are more flexible, more
willing to innovate and to adopt to change. In the last two decades, US
innovation and quick response to new business opportunities have produced a
record setting long boom with only short recessions, with spectacular rise in
profits and asset value. US household net worth, until the recent (and early
wave) market crash, peaked at over $58.25 trillion in Q3 2007, doubling in a
decade. It declined to $57.72 trillion in Q4.
The end of the Cold War and the global eclipse of socialist tenets have left US
faith in market fundamentalism with the aura of a natural philosophy. The US
calls her system capitalist democracy. In doing so, care is taken to
distinguish democracy from equalitarianism. Conceptually, while the Declaration
of Independence claims that "all men are created equal", the nation that lives
by it readily accepts the premise that men do not create wealth equally.
The US system rejects social democracy, which aims to reduce glaring economic
disparity between people. The US system claims it promotes equality of
opportunities rather than equality of rewards. It believes that the logic of
the market is the most equitable arbitrage. Free-marketeers decry intimate
relationships between government, finance and business and oppose even
corporatism as an adjunct to the welfare state. They believe that the market's
unforgiving rules of selecting and rewarding winners and penalizing losers are
inherently fair, efficient and necessary for maximizing overall economic
growth. It is obscene that when they are punished by market forces for their
wayward manipulation that they call for government help for themselves in the
name of the common good.
The trouble with this view of free-market capitalism is that it is a fallacy to
assume that truly free markets can exist without regulation. Markets are always
constrained by local customs and rules, unequal conditions and unequal
information access by participants. In fact, markets come into existence
through artificial construction by initial participants with rules that
subsequent participants must observe as an admission price. These artificial
rules generally favor the market founders and put later comers at a perpetual
disadvantage. World Trade Organization (WTO) rules are the latest visible
examples. Often the only option left to late-comers is to start alternative
markets hoping that they will enjoy the very privileges and advantages they
oppose in existing markets.
Thus all markets require a wide range of regulations to check and balance their
inherent march toward inequality and unfairness. Trade, by definition, is based
on mutually balanced weaknesses. Mutual strength leads only to conflict, and
unequal strength leads to conquest of the weak.
Adam Smith revisited
Adam Smith advocated "free trade" in the mercantilist context as an activist
government policy to break down the protectionist policies of other nations
while subsidizing national industries to compete in a tariff-free and open
world market. "Free enterprise" was first developed by royal charters and
grants from the sovereign for business operations and for land development
within the royal domain, and for trading rights and command of the high seas to
"freely" exploit colonies and foreign locations.
In other words, free enterprise was launched and fostered with government aid
and grants that private investors found too risky or whose potential rewards
too remote. Royal charters, letters patent and copyrights are all instruments
of government for the privilege of exploiting the resources in the sovereign's
domain. Government and free enterprise have always worked in concert. Modern
free enterprise manages to prevent the monopolistic or oligarchic control of
markets only by government action. Business always wants government help before
the market is mature and after the market is saturated. It only wants "free"
markets to gain easy profit. Business by nature abhors competition and social
responsibility.
The notion of "too big to fail" is sacred in US regulatory philosophy. This
remains true even as the anti-monopolistic "restraint of trade" regulatory
regime of the New Deal was steadily modified in recent decades to permit
mergers and acquisition toward increased size and market share to achieve
strategic advantage.
The scenario of the ideal free market is that there should be only five
entities in every sector: two market leaders and three window-dressing market
followers to keep regulators at bay. The US economy has always been organized
along oligarchic lines in its core industries, allowing a high degree of
centralization while preserving only a token degree of competition. The rules
of competition are generally set by market leaders of every industry.
Self-regulation is the mantra.
Responding to the current crisis, US regulators are seeking to change rules to
ease bank mergers, by further loosening rules. The Fed has announced an easing
of restrictions that had forbidden regulated companies to transfer funds to
less-regulated and more risky affiliates, such as from commercial banks to
their investment bank subsidiaries.
While the US promotes globalization, the US attitude on foreign ownership of US
assets remains schizophrenic. Furthermore, there is an inherent contradiction
in globalization in that while capital is allowed to move freely across
political borders, labor is not. It is now conveniently forgotten, when the IMF
was established by the Bretton Woods Conference, its Articles of Agreement
specifically sanctioned restriction on movements of capital across national
borders. Until labor can also move freely, the lopsided globalization is
nothing but economic neo-imperialism. It is not a march toward one world, it is
a march towards an hierarchical world of structural inequality.
Another defining characteristic of modern US finance is the broad access to
credit. US businesses have long enjoyed access to open credit markets. In
recent years, until the current developing credit crunch, no US corporations of
any size was effectively shut out of the highly developed credit market,
regardless of credit rating. Low credit ratings only affect the interest rate
rather than credit market accessibility. In fact, debt securitization has
brought virtual security to credit unworthiness on a massive scale.
The commercial paper market first burgeoned in the 1960s and for four decades,
collateralized debt obligations (CDOs) dominated the global credit market,
until the credit crisis of 2007. Securitization is a process of turning
non-marketable credit instruments into marketable ones through pooling.
Securitization creates credit worthiness out of the theory of large numbers and
the theory of averaging to manage the risk of default by spreading it to a
large pool. When a lender lends to a risky company, he bears the full risk of
default. But if he invests in a collateralized debt obligation instrument, he
is lending to a pool of companies whose default rate may be reduced to a risk
level coverable by the interest rate spread.
The fatal enemy of securitization is a liquidity crisis when all exits from
purportedly open markets will be suddenly closed, when all participants move to
the sell side, leaving the buy side empty at any price. On September 16, 2008,
the Fed funds rate target is 2% and prime rate posted by two-thirds of the
nation's 30 largest banks is 5%, while the commercial paper rate is 2.7% for
211-270 days, and dealers CP (high-grade unsecured notes sold through dealers
by major corporations) is 2.75% for 90 days. The spread is not abnormal, but
few deals are closed. There is no shortage of funds or shortage of borrowers,
just shortage of willing lenders. It is clear evidence that it is not a
liquidity crisis. It is a confidence crisis.
Derivatives are financial instruments whose values are derived
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