Percy S Mistry: Blame Bush and Greenspan, not just the bankers

Bankers are to blame but, in a macro sense, the crisis originated with the Fed and the government.

Bankers are at fault. At the meso (financial industry) level there can be no question that the financial services industry responded to a series of perverse incentives based on excessive: leverage, risk-taking and compensation. There was too much innovation of the wrong (value-destroying rather than value-adding) kind. But what do you expect a financial system — operating at Fed rates of 1-2 per cent for six years, yet expected to deliver returns of 6-7 per cent for pension funds based on their actuarial cash payout liabilities — to do? How do you deliver those returns without risk? The public would scream if pensions were not paid. And who was complaining when US house prices were rising at the rate of 5 per cent per month or the stock market was ballooning?

 

What should be condemned is that prices were allowed to rise so ridiculously without time-out being called by the authorities. Alan Greenspan claimed it was wrong for the Fed to prevent asset price bubbles! And financial newspapers thought he was the world’s greatest central banker! Markets can and do fail. But Japan has gone through 12 years of stagflation because of the unwillingness of its authorities to let creative destruction take place. China’s financial system is undercapitalised to the tune of $400 billion at least because of the refusal of the authorities to wipe out the value of NPAs from the books of its banks. But that is hidden. So which alternative is better and healthier? Quick, creative Schumpeterian destruction that compels rapid adjustment (traumatic though it is) or prolonged agony because of a refusal to recognise reality?

The bankers represent only the meso third of the problem. What about the macro and the micro?

Looked at with 20:20 hindsight, this crisis originated in a macro sense with the US Federal Reserve and the Bush administration. Since the dot.com bubble burst in 2000, and in the aftermath of 9/11/01, the Bush administration ran unprecedented fiscal and current account deficits to finance: bizarre wars, tax cuts and egregious public over-consumption, all fuelled by debt bought by the rest of the world. Such insane profligacy was financed by a massive Fed-blown bubble of liquidity. Estimates of the cumulative excess liquidity bubble blown by the Fed to finance these and other private follies range from $8 trillion to $12 trillion. The US Congress was equally culpable, for letting government borrowing limits expand so elastically. So one should be sceptical of the righteous indignation of posturing politicians. The US administration, Congress and Fed were the three main macro-culprits in blowing the money bubble. Gordon Brown in the UK is now doing the same thing as is Silvio Berlusconi in Italy. Japan did much the same between 1991 and 2005 but not at the world’s expense; mostly at its own.

Until 2007, all of this excess dollar liquidity went into asset price inflation. US and EU property price increases and stock price increases amounted to about $8 trillion of real estate stock and market cap revaluation in 2000-07. Commodity price inflation (especially oil prices) absorbed another $3 trillion.

Average house prices in the US are now reverting slowly to a multiple of 7-8 times average annual incomes, rather than the 14-15 multiple which they reached at peak and which was unsustainable. This revaluation through de-leveraging is traumatic in the short term, but healthy in the long term. It is a good example of how the market works to shake out its own excesses. That needs to be applauded, not condemned. Only an Indian socialist mindset would condemn it as dislocating, as if the socialist alternative delivered anything better. Markets may fail occasionally. But by and large they still work better than governments do. Let’s not lose sight of that.

What about the micro- or individual-level failure? The Bush tendency to over-borrow and overspend was mirrored and exacerbated by ‘buy-now-pay-later’ citizens (not just in America but around the world, including India) indulging in consumption excesses, not out of present or future income, but by exerting leverage. Therefore, when we look for whom to blame, we should be looking in a mirror! When markets fail, it is invariably because people do. What about individuals who over-borrowed to avoid losing out on the house price boom? What about their auto loan, credit card, refrigerator, washing machine, TV, and holiday debt? Are they not to blame as well for being irresponsible and overstretching their credit take-on? Have we finally created a credit culture where it is always the fault of the supplier of credit when indulgence in excess is concerned, rather than its user, who is always blameless? If so, we are in for even more trouble.

And what about the regulators who let all this happen? This was not just market failure but regulatory and monetary failure on an even grander scale. Have they lost their jobs yet or seen their net worth fall by 70-100 per cent? We in India are extolling the virtues of the RBI for saving us from this mess. But what about the excess liquidity created in India to stabilise the exchange rate that has resulted in 13 per cent inflation? It is not just a cost-push effect, as alleged. We have created too much money and not let the market work to suppress demand (because of subsidies) and curb price rises. We have created enough money for inflation to rise well above what it should have risen to (around 8 per cent) and yet we are congratulating our wise policy-makers? Alice in Wonderland would have been amazed.

Why should innocent taxpayers be bailing out irresponsible banks? As the crisis unfolds, righteous indignation sweeps the world; resonating most loudly in that ultimate rotunda of hypocrisy, the US Congress. Legislators and erudite commentators allude endlessly to taxpayers “bailing out” rotten banks and criminal bankers. They add up the cost of saving Bear Stearns, Merrill Lynch, Fannie Mae, Freddie Mac, AIG and TARP.

But what was the cost of letting Lehman Brothers go bankrupt, in terms of collateral damage and the aggravation of endemic fear which tipped the system over the edge? It was a gamble that failed spectacularly. It triggered the necessity of coming up with a $700-billion bailout funded by taxpayers. Well let’s examine the terms taxpayers and bailouts a bit to help understanding.

Are these taxpayers the same people who over-borrowed on their mortgages, thought spiralling house prices would keep going up and never down, and have now defaulted? Are they the ones who used home-equity lines to go on spending binges, which they are now reluctant to pay the price for? Are these the same people who need their salary checks or their pensions to be paid (which won’t happen if credit chokes up) and who need loans to educate their children or cope with their vacation bills? What will happen to these taxpayers if banks fail on an industry-wide basis? So who is actually being bailed out? The banks? Or the taxpayer as the eventual beneficiary of credit markets working and returning to normalcy?

The author chaired the high-powered committee on making Mumbai an international financial centre

(On Tuesday: What bailout? The treasury will earn a profit)

StatsGuru will appear on Thursday