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Adam Smith isn’t dead

Historians will look back on what has happened — and the crisis has a few more phases to go — and call it the Day 21st Century Capitalism was Born, writes Pramit Pal Chaudhuri.

india Updated: Sep 28, 2008 20:57 IST
Pramit Pal Chaudhuri

Capitalism does two things well. Creating wealth and making a bad name for itself. The sub-prime crisis and its fallout have meant a lot of the second, not much of the first. However, Adam Smith isn’t dead. Capitalism is just making a poor job of adjusting to a new financial order. And a large part of why it’s tripping is bad governance. Here’s a market-friendly guide:

Sub-prime is a consequence of greedy politics: Sub-prime’s origins lie with the US government. Sub-prime loans were mortgages doled out to people who couldn’t afford them. One variety was ‘stated loans’ where a person just had to declare his income, without proof, and get a cheque.

The largest players in this were the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation and the State-owned federal home loan banks. The first two alone underwrote 44 per cent of the US sub-prime market in 2004. Better known as Fannie Mae and Freddie Mac, they were private in theory but crony capitalist in fact.

Under the aegis of providing ‘affordable housing’ — giving home loans to people normal banks wouldn’t touch — the US Congress exempted Fannie Mae and Co. from the regulatory and accounting norms of private banks. In return, these institutions showered political constituencies with dud loans and donated money to campaign coffers.

Because it was correctly believed these hybrid financial institutions could count on an implicit government bailout, they were dubbed ‘government-sponsored enterprises’. Three-quarters of the $1.3 billion sub-prime loans were handed out by these enterprises. The US government spent $400 billion bailing them out, as opposed to $113 billion for private sector firms who joined in the feeding frenzy. Sub-prime’s rise was socialism masquerading as capitalism and capitalism falling for the disguise.

Wall Street’s financial bust shows markets work: When Lehman Brothers bought up securities backed by dud loans with borrowed money, it decided to load up on risk. Months before the present meltdown, I was told by a senior Federal Reserve Bank official that the market would be better off if stand-alone investment banks like Lehman died — they were gambling on credit cards.

If Lehman had survived and prospered - that would have been market failure. Instead, capitalism put it to the sword. Economists like Joseph Schumpeter adopted nihilism’s description of capitalism as ‘creative destruction’ but argued this was the system’s strength. When firms get greedy and stupid the market wipes them out, making way for more sensible firms. American International Group, as a boring insurance firm, was doubly stupid to have submerged itself in sub-prime and deserved to die. Politics and panic are why the only price it is paying is 11 per cent interest on its $85 billion US government handout.

Yes, it took a long time for supposedly efficient markets to bring down these faulty towers. There was regulatory failure by the US central bank under the once-sainted Alan Greenspan. Gree-nspan, a laissez faire advocate who headed a government regulator, also believed central banks shouldn’t pre-empt asset bubbles, that they should just clean up after they popped.

He should have been warier. Over the past decade or so, the world has become submerged in an enormous tidal wave of dollars, with credit growing nearly a fifth more each year than the real world economy. Capital was abundant, so it became cheap and eventually abused.

Forget sub-prime, this cheap capital has led to speculative bubbles in everything from petrol to platinum. Two years ago,
at an Aspen world economy conference, I heard analysts fret that $400 billion worth of the homes being bought in the US were being bought as investments. When, they asked, would someone stop this? The market did. It just took a while because the money flood obscured the reality.

Government regulation is no answer to modern finance: The experience of quasi-government enterprises like Fannie Mae and the US central bank over the past decade shows bureaucrats are as clueless about the financial world as their private sector counterparts.

A simple example are the new-fangled mathematical models being used by both regulators and bankers to calculate the risk in buying and selling things like sub-prime mortgages. The nerds who did quantitative analysis, ‘quants’ in New York parlance, underestimated the sub-prime risk. What they accomplished was to take bad debts, run them through a computer, and then stamp them with ‘AA’ credit ratings. Everyone fell for it, regulators and investors alike, because the stochastic calculus-based financial superstructure was indecipherable. Lehman and the others do not seem to have strayed from the rules, the world of finance had moved beyond the rules.

Not everyone in Wall Street believed in these models. Goldman Sachs didn’t, which is why it survived the panic. Last year, while being quizzed by a Manhattan fund manager on India’s financial sector, I was asked, “Have the MIT quant guys got to India yet?” No He smiled, “Thank god.” I presume he bought Indian bank stock after that.

The other reason the world will have to find ways to let markets be regulated by economics is that bailouts are getting too big for governments. Washington has deep pockets. But Deutsche Bank has liabilities equal to 80 per cent of Germany’s GDP. In case of a meltdown, what would Berlin do?

History won’t declare this the day capitalism died, Perhaps the Day that Lehman Died. Capitalism will go on, not because it is perfect but because no alternative comes close in terms of creating wealth. My guess is historians will look back on what has happened — and the crisis has a few more phases to go — and call it the Day 21st Century Capitalism was Born. Much of what has happened is a consequence of the intersection of two or three developments in the international economic system.

One, already mentioned, was the sheer expansion of capital in the economy. In 1945, only the US generated surplus funds for the world economy. Today, everyone from China to India, Brazil to Bahrain, adds to the global pool. When its capital that’s on tap, no one has the necessary plumbing. This capital flow then joined with an information technology revolution whose intangible impact on finance, one, reduced regulation to guesswork for people like Greenspan and, two, paved the way for quant-based risk assessment. Most quants used a measure known as Value at Risk that drew on historical data. But what if you live in ahistorical times?

Finally, because even regulators are groping with the new financial order, the man on the street is less willing to trust governments to do the right thing. This is crucial because much State intervention in the market is not based on financial logic; it’s just a gut judgement of what is needed to restore public confidence. If Joe Investor believes central bankers don’t know what they’re doing, he will join a vicious cycle of financial panic. If he does so, he will join a virtuous cycle of financial recovery.

Welcome to 21st century capitalism. The ride has just begun.