Friday, October 24, 2008

To owe or not to owe

There is no doubt that the economic crisis in the US will get worse and thousands more will lose their jobs. As I indicated in an article a few weeks ago, the original bailout plan fashioned by Congress would not have had any effect on the credit or equity market because it did not address the underlying problem, but rather sought to deal with wiping the blood from the wound rather than putting a stop to the bleeding. It wasn't until after the statement that interbank loans would be guaranteed that some hope of credit came back to the market, thanks to the solution proffered by the Europeans.

In my own view it was not even necessary to commit any funds to the crisis, as all that was needed was to bring back confidence to the system. The amount of funds offered in any bailout plan will have no effect if a market loses confidence, because markets survive by the will of behaviour rather than any amount of funds or government intervention. The best role for a government is to support the natural laws of the market rather than intervene too much, as we have come to realise from our own experiences.

The effect of debt
The other consideration coming out of the current US crisis is the matter of debt. This is an effect we know only too well in Jamaica, as during the second half of the 1990s we began a path to racking up a level of debt that would eventually condemn us to the serious economic challenges we face today. I guess we can always boast that the great US followed our own strategy of living beyond our means and take some pride in the fact that we are in the company of the US.

As I have always said, the absolute level of debt is not an issue. So whether we owe $100 million or $1 trillion is irrelevant. What matters is the marginal return on each dollar of debt compared to the marginal cost. As long as the marginal earnings from each additional dollar we borrow is greater than the marginal cost, then it is okay. As soon as the cost of the debt becomes greater than the return from each dollar of debt, then it becomes an issue. So when debt is used for consumption rather than production it is always going to have a higher cost than the return, as maybe the only return one gets from consuming borrowed money is an increase in the numbers of "hangers on".

So what happened to Jamaica was that we borrowed money to support a lifestyle that we did not earn. In other words, even though we owe a lot of money which our grandchildren will continue to pay, we look good owing the money. Some of my friends argue with me that Jamaica is more developed than other countries in the region as we have better-looking cars, more cellphones and technology penetration, better-looking roads, and better houses. While this may be true, I don't think this alone is a measure of development.

This has been illustrated by what happened in the US also. And I have no sympathy really for anyone who by reason of their excesses find themselves in serious financial difficulties. Jamaica itself has earned the right to the economic difficulties we find ourselves in. No one put a gun to our heads and forced us to borrow the money and waste it on consumption and activities that cost us rather than provide us with a return greater than the cost of the funds borrowed. We made that decision on our own. The problem is that even those who had no part in the decision are suffering. Similarly no one forced the US consumers to find themselves in a position where the savings rate was negative. And while they were enjoying the fruits of poorly managed debt (the latest car, big house, etc) they never sought to share it with those who were being prudent. So why then when the chickens come home to roost do we hear of the difficulties being faced? Just as they were enjoying the previous excesses, then they should similarly enjoy the results of the excesses.

World crisis
Because of the excesses of the US economy over the years, the world is now faced with an economic crisis that will get much worse and which we will not be able to recover from for years to come. The basic principle of what happened is that the US consumer was living on debt with no real income to support the debt. So they would borrow money to buy a house and even while owing on the house then they would borrow money on the equity in the house for personal spending. Because everyone was doing it the market price of houses escalated beyond the real value, based on expectation, and seeing more equity in the house the consumer borrowed even more for consumption. The money that was borrowed on the basis of the artificially growing equity was not used for investment but rather consumption, which had no returns attached to it.

So when the prices of houses started to fall because of a fall-off in demand, the money borrowed based on the equity became a problem because the equity in the house had fallen off significantly. So the "poor" consumer ended up with a debt far exceeding the value of the asset, and what is more, because the market value of the asset was being driven by unreal expectations, then it will not for the foreseeable future come back to the peak value on which debt was borrowed.

This created not only an issue for the consumer but also the bank that lent them the money as the asset values on the balance sheet now started to decline, and the liabilities were increasing as loans grow based on the rate of interest. Now multiply this effect by millions of people and we have the current global financial crisis. The problem now is that we will not in a very long time recover the wealth lost, which will continue to lead to cutbacks in companies and personal consumption. The result is similar to a balloon that is quickly losing air and so gets out of control.

In Jamaica we did the same thing by borrowing money to postpone the medicine of market adjustments. We borrowed to control inflation, the exchange rate, and buy more cellphones and cars, building a few stadiums along the way. In other words we took part in the same excesses as the US consumer. But it was okay to do so as long as the world economy was growing as it meant that more wealth was being created and we could always get more money to borrow to support our "champagne" lifestyle even with our "soft drink" income. Our desire for the farcical development meant that we were always willing to borrow money to spend on consumption, as even though we owed a lot of money we looked good while doing so.

What has happened to Jamaica now is that the curtain has been closed on the grand global partying. The final act has been played and we find ourselves as actors out of work. We can no longer get money from foreign investments and debt as easily as we used to and even if we do it will cost us more. This will no doubt lead to us having to cut back on our national standard of living as the US consumer has to do. The difference between Jamaica and the US is that unlike them we have no reserves to help to cushion the effect of the crisis. So when one calls on government to intervene financially it seems as if there is a failure to understand that even in the good times the money that we were spending was never ours, and as a country we had no savings.

The only thing we can do as a country is cut back on our lifestyles and change fundamentally our production relationships. Of course another problem is that the economy is 70 per cent services, and without real production there will be little money to buy any services. Even as we move forward with this dilemma we will be tempted to borrow even more to ease the pain. The question will surface again, "To owe or not to owe". The answer has always been, and continues to be, only as long as the marginal revenue is greater than the marginal cost, and we ignore this at our own peril.

Friday, October 17, 2008

Is capitalism dead?

Recently the world has witnessed the biggest financial meltdown in almost a century in the great superpower, the United States of America (USA). Because of the financial crisis in that country the world is facing a global economic recession and is also on the verge of financial and economic reorganisation. The result for many is that there has been a significant loss of wealth, which in my opinion will never be fully retrieved in the short to medium term.

The global meltdown has raised the question of whether or not capitalism is a sustainable economic system. Even my friend Betty Ann Blaine has written about "The free market farce" in last Tuesday's Observer. The global events that have overrun us will no doubt lead to a vibrant debate on which economic system is best for development. Even in the US presidential debate the question of how much government intervention is appropriate in the markets is a point of discussion. I have heard many people use the recent financial events to even go as far as to suggest that capitalism is dead.

Best economic system
I myself am someone who believes in the power of the market and I still believe that capitalism, as an economic system, is the best ever developed. Despite the 1929 Great Depression, and today the 2009 Great Financial Crisis, capitalism as an economic system has delivered the best results to global economic progress.

Anyone who did economic history will understand how much capitalism has contributed to the development of global economies. Economic systems have included slavery, feudalism, socialism, and communism. In both the cases of slavery and feudalism, it has included a clear ruling class that by virtue of their colour, or class, has controlled the capital of the country. So, in both these cases, capital was not allocated to the person/activity that had the best idea, but rather was distributed according to birthrights. Under socialism and communism, the distribution of wealth and capital undertaken primarily by the state, and disrupts the efficient workings of the market.

We have seen in recent years the fall of communist economic systems such as in Eastern Germany, Russia, China, and closer to Jamaica, Cuba. In fact, China's economy has developed more since it adopted a market economy than any other time in its communist history. This is because the strict allocation of capital by the state will eventually lead to corruption and inefficiency, which will mean that the efficient adjustments in markets will be disrupted, eventually leading to very low productivity levels, uncompetitiveness, and lack of opportunities. This is not dissimilar to the way Jamaica implemented the MOU, which resulted in no incentive for productivity. So instead of helping our productivity, in the long run it has caused further strains on the public purse and kept the government bureaucracy inefficient, resulting in a loss of productivity in general, as I stated would happen when it was first introduced a few years ago.

So even though Jamaica has purported to promote a market economy, the fact is that we have only had an attempt at a market economy, and this is a primary reason why we have failed to grow at internationally comparable levels over the years. In fact Jamaica has never really benefited from globalisation because we have never really opened up the market to competition, as the state has always sought to control most of the resources in the country. This was formalised during the 1990s when the creation of FINSAC formally gave the government control over the private sector.

The challenges in the financial system, first in the US and then globally, are in my view not a good reason to call for the end of the market economy, which is undoubtedly the best economic system available. The market economy works according to the natural laws of nature, in that it will always adjust to equilibrium in the long run. Economists have long accepted, however, that laissez-faire (totally free market workings on which principle capitalism is based) is not a desirable economic system. The reason why laissez-faire would not work is that man rightly understands that he has a responsibility to protect the weak in the society, and if there was no government, then the weak would die as the laws of nature dictate. Even in the animal kingdom the weakest animals, even within the same species, will die. So economists have long recognised that government is necessary to protect the rights of the weak and also to ensure a country's development, because if there was no government we would not necessarily have roads or a security system for all (which we don't have even with government).

So we can all accept that government is necessary if we are to protect the rights of all people. Whether the rights of people are protected or not depends on what political system is in place, of which the most successful has been democracy with a republican-style constitutional arrangement. When government gets too involved in the efficient running of the market, then markets will fail over the long term and long-term growth will be sacrificed. Because a market economy has failures every 100 years or so does not mean that capitalism has failed. Such an emotional reaction is, as we would say, throwing the baby out with the bath water. For if we look at capitalism's long-term contribution, the benefits far outweigh the disadvantages. A true market economy, with government in a support role, is the only way to develop in the long term.

The current global crisis, and even our own 1990s crisis, was not caused because the market failed but because there was too much government intervention. It was because both the US and Jamaican governments intervened too much in the efficient running of the economy that both crises happened. In the case of Jamaica, instead of allowing the markets to adjust by forcing us to be productive, we sought to control inflation and the exchange rate, which is what forces us to adjust our production arrangements, by keeping interest rates too high for too long. This, in effect, killed businesses in Jamaica.

In the case of the US, because the politicians wanted to give people the opportunity to own homes they kept interest rates too low for too long. This resulted in the natural laws of the market going to work and people borrowing at the low rates to make money, eventually leading to a credit bubble that had to burst. A market economy does provide controls on excesses, such as an animal has a limit to its stomach's capacity to prevent it from overeating. But if an intervention is made to surgically extend the size of the stomach, then overeating could cause death.

So in both cases, it was not the excesses of the market that caused the challenges in the market but rather the excesses of politics. It was government intervention that put the spoke in the wheel of capitalism, eventually leading to the collapse of the markets. This is why it is essential that the proper political system accompanies the efficient market economy system, which is the problem our own country has faced over the years. And this is why I have always said that Jamaica does not have an economic problem, what we have is a political problem, as our constitutional arrangement is at the heart of our problems.

So to everyone who wants to question capitalism as an economic system, I say capitalism forever. It is the only system that has delivered the global progress we have seen since the 1980s, and has delivered to us a better standard of living. The problem with capitalism is that it has always had to contend with the excesses of politicians and inefficient political arrangements.

Friday, October 03, 2008

Understanding the US bailout plan

The last two weeks have been tsunami like for financial markets across the globe. The failure of the US bail out plan to pass Congress on Monday made things seem worse, as markets reacted to the decision of the Congress . And unlike what we have become accustomed to in Jamaica, the members of the lower house listened to the people who put them there, for better or worse.

I am one who believes that the bailout plan, as was being proposed on Monday, would not have made any fundamental difference to the crisis being faced. What happened in equities on Monday was more a reaction to disappointed expectations more than any fundamental changes in market conditions. If you look at it what significant changes happened to markets between Friday and Monday last. The only difference was that there was an expectation that the bail out plan would pass and it didn't.

Disappointed expectations
As I have always said, we must remember that economics is a social science and so it is about market behaviour. The reason why it became necessary to pass the bill on Monday was that it was clear that expectations were that if it didn't pass there would be a significant fall out of equity markets. Consequently the market priced in the expectation that the Congress would pass the bill, and when it didn't the market became jittery amongst the gloom and doom predicted and sold off the purchases they had made, as they expected that markets would plummet. So said so done, as the DJIA had its largest point drop ever and the highest percentage drop since 9/11.

My view is that because of market expectation and reaction the bill will pass today, as fear sets in based on what happened on Monday. And although I agree it is important to be passed it is even more critical that careful thought is given to the details of its implementation, as just merely pumping in US$700 billion in the market will not make any long term difference if it does not address the underlying problem, as we found out with our own bailout plan. Even though we cauterized the fallout of the financial system, in the 1990s, we did it at the expense of negatively affecting long term economic prospects, thus resulting in an economy based on credit just as the US is today.

In order to understand whether or not the bailout plan will work it is not enough to look at the size of money involved or whether it will stop the slide of the stock market but rather will it address the underlying problem. What the initial plan failed to do was to address the underlying problem, and the fact that it was designed by Paulson and Bernanke, and supported by Bush, makes no difference to its credibility. Paulson and Bernanke have been incorrect about the economy for the past two years, and if they were more aware could have prevented the extent of global turmoil we see today. Bush we all know has been totally off base on the Iraq war, which is one of the reasons for the decline in the US economy today, as it is costing the US billions. So anything they support should be closely scrutinized as a prolonged financial crisis would be just as devastating as any world war.

The fact is that any reaction on the equity markets is just a symptom of what the underlying problem is, and any bailout plan should be addressed at dealing with the underlying issues rather than catering to the cry of a few overpaid persons, who were the ones that created the financial crisis in the first place by their irresponsible risk management practices. Just a note, these are the same people that we revered as financial geniuses, even while the soundness of our financial system was secured by locally designed legislation. Big up our own Jamaicans, who have always been underestimated, unless of course accepted internationally first, while we continue the export of capital and expertise by preferring the foreigners over our own.

Address the underlying cause
The underlying issue to be addressed in the US, is not to be found on the asset side of the balance sheet, but rather on the liability side. The problem is not that assets are losing value, and are making balance sheets look bad. The problem is that there is a very high degree of uncertainty in asset values and this has resulted in no one wanting to lend to anyone else as they are not certain about balance sheet exposures for fear of the companies they lend to having to liquidate as Lehman did. Note that when the Fed showed its willingness to save bear Stearns markets responded positively. The uncertainty got heightened only after the Fed allowed Lehman to fail, and at that point the risk of lending in such an uncertain environment increased significantly.
This means that any bailout package needs to address the uncertainty surrounding the lending of money. Everyone who has money to lend would want to protect their own balance sheets from any unknown risk, hence the moves to Treasury Bills and Gold. The revised plan passed by the senate seeks to do that by increasing the insurance limit at the FDIC. What this does is guarantee to those who lend money, through deposits or other facilities, that the US government is backing those funds and so they can sleep at nights. This way people will feel confident about lending monies to the system again.

If on the other hand the government pumps US$700 billion into these companies, by buying bad assets, and the uncertainty about balance sheet values and exposure still exists then this will not free up credit markets. After all before we knew the real effect of the mortgage backed securities we did believe that the balance sheets were sound, so the details surrounding how the government identifies and values bad assets is going to be important, and even itself is uncertain. And this is why the liability side of the balance sheet ( liabilities to customers and counter parties) is more important than the asset side, which is the original bill's focus. I think it may have been a blessing in disguise that the bill didn't pass on Monday, as a false impression may have been created, from the equity market response, that the problem was fixed when uncertainty remained.

The revised bail out plan includes (I) tax breaks for some home owners; (II) restrictions on compensation to executives; and (III) an increase in insurance on liabilities, and makes a lot more sense but will not be enough to prevent the slowing down of the economy. It will only prevent a ceasing up of credit in the markets. There have been calls also for the suspension of the mark to market accounting rules, and as many of the analysts have said, this is really ignoring the problem. The fact is that people already know there is uncertainty around values and any removal of transparency will heighten uncertainty.

The details of the bailout plan will be important for the world in, as any further tightening of credit in the world's largest economy could have devastating consequences. Even with a proper plan in place the global economy will still slow, and we have not seen the full effect on other developed economies such as Europe and the UK and the emerging economies of China, India, Asia and Russia. It is going to be a wild ride but the powers that be need to be careful not to make the mistake we did in the 1990s of so much intervention that it prevented markets from working efficiently thus causing long term economic stagnation, as where in our case it affects Jamaica only, in the US it will have a global impact.