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by Olaf Gersemann
Wednesday, Sep. 23, 2009 at 10:54 AM
Rating agencies were paid by the firms to be rated. Ultimately rational individual conduct led to an irrational collective result. The lesson is clear. On the way of regulation or taxation, banks must be given a massive incentive to remain small.
SYSTEM QUESTION: WHAT LESSONS DO WE LEARN FROM THE FINANCIAL CRISIS?
By Olaf Gersemann
[This article published in: Welt Online, September 1, 2009 is translated from the German on the Internet, http://www.welt.de/wirtschaft/article4441764/Was-ziehen-wir-fuer-Lehren-aus-der-Finanzkrise.html?print=yes#reqdrucken.]
[ Two years ago the financial crisis began. One year ago it escalated after the collapse of the US investment bank Lehman Brothers. The world economy was at the abyss. Billions in economic programs and historically low prime interests should put things right. Time for a mid-term review.]
The composure or level-headedness of intellectuals was the first that fell by the wayside when the world economy headed inexorably to an abyss. “Neoliberals” who believed in the market economy, Frank Schirrmacher wrote, must now “realize the rationality of their most important decisions was based on a purely speculative system.” The editor of the “Frankfurter Allgemeiner Zeitung” newspaper sees a “state like a world civil war.”
Twelve months later the world civil war is called off. Raising the system question is again left to outsiders. Nevertheless drawing the right conclusions from this historical financial- and economic crisis is important.
1. FRIEDMAN, NOT KEYNES, IS BACK
Capitalism experienced financial crises time and again. More than 30 crises occurred in Latin America alone over the past 25 years. Avoiding such crises is obviously hard. Combating them is a tricky business, above all in a world-spanning crisis like this. But we know at least what mistakes must be avoided to prevent an uncontrollable downward spiral. The central banks learned this from the past.
The past includes the worldwide economic crisis of the 1930s. Whenever this is discussed, the name John Maynard Keynes is heard. The Keynesian analyses from the “General Theory” of 1936 have undoubtedly enriched modern economics in many points. However it was not Keynes but his worst intellectual antagonist, Milton Friedman, who correctly described the nature of the Great Depression. Keynes assumed the importance of monetary policy in crisis times (and thereby justified his economic programs). Friedman and his congenial co-author Anna Schwartz demonstrated the opposite, that central banks were crucial in crisis times and a worldwide depression followed the stock market crash of 1929 through their blatant failure. No one said this more clearly than Ben Bernanke. On Friedman’s 90th birthday in November 2002, Bernanke, the governor and head of the US Federal Reserve at that time said: “I would tell Milton and Anna they were right concerning the Great Depression. We were culpable. But thanks to you, we will not do this again. Bernanke has kept his promise.
2. LIGHTNING RODS ARE CHEAPER THAN THE FIRE DEPARTMENT
America deals differently with risks than continental Europe. In the European understanding of consumer protection, everything not demonstrably harmless is prohibited – while everything is allowed in the US that is not demonstrably harmful. Instead of severe preventive regulation as in Europe, people in America prefer the deterrent effect of harsh punishments in case of loss.
CHRONICLE: THE ECONOMIC AND FINANCIAL CRISIS
Both approaches are consistent in themselves. On principle, both are somewhat correct with view to the financial sector. Bernanke and his predecessor Alan Greenspan argued for years that removing the consequences of speculative bubbles is simpler and cheaper than identifying them early and keeping them small.
There are hardly examples in economic history in which the latter succeeded. The past twelve months have shows: identifying and combating these bubbles is vital. Avoiding a massive financial crisis cannot be as expensive as combating a financial crisis. In Germany, the costs of the crisis – according to estimates of the International Monetary Fund – may force up the state indebtedness more intensely than in the 1990s with the financial burdens of German unity.
3. FINANCIAL CRISES ARE LIKE AIRPLANE CRASHES
“State regulations,” the Harvard economist Ricardo Hausmann formulated, “always strive to prevent the past accident.” This is a very effective approach in some areas of life – as long as two conditions are fulfilled. Technical progress is slow; the same kind of accident happens and accidents happen frequently. The regulator has ample opportunity for causal analysis. Just as constantly new innovations occur, accidents may be seldom but cannot be entirely prevented.
One example is air traffic where the technique of the flyer is ever more refined. Crashes are very rare. Another is the financial sector. Financial crises are so frequent; no regulator can keep up with the torrid innovation speed on the capital markets. At best the likelihood of financial crises can be reduced. A politician who claims these accidents can be completely prevented if the state only cracks down hard enough carelessly lulls the population in an illusory security.
4. ECONOMISTS ARE LIKE CLIMATE RESEARCHERS
Disparagement of economists has become a popular sport. Some economists specialize in economic predictions. “We must create a society that does not depend on the prognoses of idiotic economists,” as the best-selling author Nassim Talib rants and raves. When some business cycle researchers have little insight in their own fallibility, they are scolded for not fitting the crisis in their prognoses on time as though a meteorologist were insulted that his weather forecast made obsolete a meteor crash.
This is similarly true for academic colleagues of economic researchers. They are also criticized even in their own camp. “In the best case, the large part of the macro-economics of the past 30 years was spectacularly useless and in the worst case harmful,” says the Nobel Prize winner Paul Krugman. Capital markets and the crises that could start from them have been ignored for decades in the dead corner of macro-economic research – often out of intellectual convenience. Whoever makes economics professors responsible for the crises can blame climate researchers for global warming.
“Economics has not failed,” says Paul Romer, one of the most brilliant contemporary economic theoreticians. “The fundamental problem was the incentive, not that people did not understand what happened.”
5. WE ARE MORE RATIONAL THAN WE THINK
A year ago Frank Schirrmacher wrote about “destruction of the basic trust in the rationality of economic conduct.” The crisis did not come about only through irrational conduct. Quite the contrary! As Paul Romer intimates, people react rationally to the incentives that existed. No mathematical macro-model or previous knowledge of the national economy is needed to know what happens when a rating agency is paid by the firm to be rated, when the government wants to subsidize capital-weak citizens in their own homes, when provincial German politicians press their regional banks to turn the big wheel for lack of a business model on the global capital markets.”
Ultimately rational individual conduct led to an irrational collective result – a phenomenon well known to economics from other contexts. To counter this, removing economically perverse incentives is enough. Then one can spare the search for a new economic system.
6. BANKS ARE LIKE BOMB FACTORIES
When Ravi Jagannathan was young, he worked in an India hydro-pool for a firm that manufactured explosives. Much money is saved with production in large factories. The problem, according to the contemporary economics professor at Northwestern University, Evanston, Illinois, is that something will go wrong sooner or later. A single accident can have disastrous consequences. Damage control is only possible by keeping the size of the company small.
The parallels to the banking world are obvious since Lehman. “Large (and small banks strongly linked) banks are a system risk when they are “too big to fail.” No government should go to waste to bailout a bank that committed fraud.
The lesson is clear. On the way of regulation or taxation, banks must be given a massive incentive to remain small. What usually happens is also clear. Those banks that do not already have the “too big to fail” status will hasten to gain that status through mergers, takeovers or their own growth, almost regardless of cost. The next crisis is already programmed.
[This article published September 2, 2009 is translated from the German on the Internet, www.zeitenwende.ch.]
The upswing that was not an upswing ends slowly but surely as well as the belief of helping the economy to its feet with billions and trillions. The reasons are simple and banal and nevertheless were ignored by the general public. State funds were used to refinance debts of banks. The system was bailed out but citizens remain as clammy as before the state rain of money.
When old debts of banks are replaced by new debts of the state, the status quo is maintained in the best case. That is exactly what happens. Little money was spent for new projects, innovative ideas and the like that would have prepared the ground for the economy to begin a new upward cycle. The motivation was pure distress, not a wicked modus operandi or mens rae. During the boom phase, the banks extended their indebtedness possibilities to complete irresponsibility. The highest possible profit for their own capital was the matching ideology. A glance at the balance sheets would be enough to see that the enormous profits were only possible through the relative and absolute reduction of stock capital compared to the balance-sum.
In the fall of 2008, the system faced collapse. The following bailout measures made clear how over-excitedly the game was played… Such a dislocation with measures of billions could not have arisen overnight. The Lehman bankruptcy is made responsible. No way! Such statements belong in the land of fairy-tales of delusion artists. The Lehman bankruptcy itself was a consequence of excessive indebtedness. All investment banking was conducted with a leverage over 50-times the internal capital.
Whoever enjoys retrospective views may reread our article “Big Banks on Thin Ice” from June 2008.
The billions arrived at the banks but were not enough because the foundations of the economy – the consumers and businesses – were still debt-heavy. Now the tax funds for bailout rescue are lacking. If more debts are made, then investors threaten to flee out of fear of hyperinflation, rising interests and state bankruptcy. If debts are not made, then consumers must tighten their belts even more. Credit financing via the securities industries is still uncertain. A quick recovery after the past debacle cannot be expected.
In addition, there is increasing unemployment, a real estate market that has hit bottom, increasing taxes and miserable credit conditions. All this is not new. We have written about this for months. The question of all questions is: Who can still make debts without putting his credit-worthiness in doubt? With the states, conditions become tight. Other actors are not in sight. However fundamental data for the stock exchanges are not decisive. The mood is what really counts for the financial markets. This mood seems to be turning slowly but surely because the promises of politicians are not fulfilled for citizens. Look at the poll figures for Barack Obama. A torrid fall faces us instead of the promised sweet fruits. This may also be true for stockbrokers this time, not only for the real economy.
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