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Political actors in the financial theatre

C. Gopinath

The papers in the US have been putting out banner headlines lately with regard to the financial crisis that has gripped the country. Editors and experts have had to reach to superlatives at different points of time, to describe the nature of the problems. The markets are in ‘turmoil,’ assets are ‘toxic,’ stock markets are in a ‘panic,’ the rescue plan is ‘sweeping,’ and so on.

In the last 20 years, the financial sector has grown to be a major part of the US economy even as manufacturing declined. While these companies made millions in profits for their shareholders and senior executives, the worry now is whether we have ended up with a system that privatises the gain while socialising the losses.

How it all began

To quickly review what has been happening, we first saw the firm Bear Stearns fail and be allowed to be bought over by JP Morgan at a fire sale. Then the government had to nationalise two failing mortgage re-financing institutions, Freddie Mac and Fannie Mae.

This was quickly followed by investment bank, Lehman Brothers, filing for bankruptcy court protection and hoping to sell parts to Barclays, while another Merrill Lynch was bought over by Bank of America. Then, the government again rode in to rescue AIG, the giant insurance company. Other firms are re-defining themselves by trying to merge, and so on. These are all long-standing companies with once enviable reputations and hold in trust billions of your and my money.

The problems began when the housing bubble burst and so sub-prime mortgages became a problem, as did mortgage-backed securities. Then, it spread to asset-backed commercial paper and auction-rate securities. Then, it started swallowing whole firms. In the absence of a clear policy, the administration was making its decisions on the fly. The only justification that could be given for rescuing some with government funds and letting others die or be bought over was supposedly the potential impact on the rest of the ‘system.’ There was no cut-off point and no way to establish this so-called impact. Individuals were trying to fight a system fire. Ironically, when the Asian financial crisis of 1997 began in Thailand with the de-linking of the baht from the dollar, it quickly spread elsewhere in South-East Asia, and then to Russia, Latin America and, finally, coming to rest in the US with the impending failure of the hedge fund, LTCM.

The Federal Reserve (US central bank) stepped in by convincing other financial institutions to save the firm 1998 due to its consequences for global financial markets (it has since been wound up). That was considered to be the end of that crisis and the first example of how closely financial markets were linked across the globe. But, clearly, the bad financial practices and questionable instruments that firm indulged in continued to bubble and now we have a new crisis with its origin in the US and spreading elsewhere.

Unfortunately, the US government apparently did not learn the lessons from neither that incident nor the failure of savings and loans associations (that take deposits and issue mortgages) earlier during the late 1980s and early 1990s when they had to be rescued with over a hundred billion dollars of taxpayer money.

Omissions and commissions

The lessons that the government did not learn was that the financial institutions were dabbling in securities that were ‘funny’ (such as derivatives or credit default swaps) and very few people understood them or how they functioned only going by the reputation of ‘whiz kids’ who cooked them up; the accounting systems that were being used were ‘shady,’ because it allowed firms to keep some items ‘off’ their balance-sheets; and rating agencies were ‘dodgy’ because they were accepting the ratings for securities that the bundlers themselves assigned, without independently verifying them.

Apart from not fixing these problems, the government continued to debate and almost convince the nation that the social security system in the country needed to be privatised, and to top that, in 1999, went ahead and gave up all the safeguards that the Glass-Steagall Act had put in place learning lessons from the depression of 1929. All these omissions and commissions have come to roost. And both political parties need to hang their heads in shame.

With the November presidential election date looming up, the two candidates, John McCain and Barack Obama, have just a few weeks left to clarify their stands on the economy and convince the voters that they have the right answers. Thus, their every word is watched, and analysed to reveal inconsistencies by the other party. And every past action of theirs is used as a foil to correspond with their current position. The result is that the picture is very confusing!

Confusing picture

Let us take John McCain, the Republican candidate. He first put his foot in his mouth by declaring, when the financial markets were in turmoil, that the economy was fundamentally strong. He has had to take this position since his party currently has the presidency and he cannot come through as being very critical of the economy. Then, perhaps some brave aide took courage and explained to him what was happening in the financial markets.

Soon after, he reversed his position, began acknowledging the seriousness of the situation and calling for more regulation. That got him into deeper trouble because he had been declaring, all along, that he is ‘fundamentally a deregulator.’ Finally, to confuse the picture further, he began calling for the head of the Securities and Exchange Commission to be fired for not having caught the problems earlier!

His rival, Barack Obama, has a plan that would involve raising taxes on the wealthy while cutting them on the middle-classes. This is a scheme that has not won favour with the US electorate and McCain is taking the time to remind his audiences of this on a regular basis. And so we find that as the US financial system tries to survive a crisis, the nervous public is getting increasingly worried about the political ideologies of each candidate and what is likely to be the decisions they will take. Unemployment has been rising and economists do not see the problems for the economy ending in the near future.

‘Mother of all bailouts’

The US President, Mr George Bush, explained that his administration first thought dealing with each problem separately as they came up. Then, he said, they realised that ‘the house of cards was… much bigger’, and that they felt that the ‘whole house can collapse.’

The ‘mother of all bailouts’ (to borrow Saddam Hussein’s phraseology) is being organised by the US government, to rescue the troubled institutions in the hope that this will give confidence to the markets that the US government has a plan in hand and is willing to act.

The Democrats are comfortable with the philosophy of an activist government but want the rescue to go beyond companies and also help individuals suffering from foreclosed mortgages. The Republicans, although ideologically in favour of smaller government and getting the government out of people’s lives, like it when public funds are used to save corporations.

Interesting characters

My recommendation is that after the dust settles, the government must call for a Truth and Reconciliation Commission to find out what happened and why. We would have an interesting cast of characters. Among others, Mr Alan Greenspan, who headed the central bank from 1987 to 2006 may have to explain how he created an environment that allowed sub-prime mortgages to thrive and brought us to this state.

Mr Henry Paulson may have to be witness for the prosecution (he is the current Secretary of the Treasury) and for the defence (he was head of Goldman Sachs, an investment bank, for many years). Mr Robert Rubin, former Secretary of the Treasury under the Clinton administration, also an alumnus of Goldman Sachs, in whose time the Glass-Steagall Act was repealed, should also be an invitee.

Mr Warren Buffet, the successful investor and head of Berkshire Hathaway, may like to come forward and say, ‘I told you so a long time ago’ for he has been one who has been warning everyone who would listen about the dollar slide, and consequences for the economy.

Message to take away

The lesson from this crisis is not that we are presented with a choice between free markets and government regulation as many are making it out to be. Financial markets were never totally free and any market requires some form of regulation to function. We must recognise that when markets work, they are more effective than bureaucratic decision-making when it comes to resource allocation.

The message to take away is that markets have a tendency to ‘fail’ to meet their expectations since times change, and behaviours change. When they show weakness, governments must be ready to intervene. And wise governments must also have the discipline to know to intervene and when to leave markets alone when they are working.

(The author is a professor of international business and strategic management at Suffolk University, Boston, US. blfeedback@thehindu.co.in)