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Rebuilding the Global Financial System (part 2)

Lipstick on a Recycled Pig In Part 1 of this series, we discussed how the financial crisis came about. This discussion was very U.S.-centric, but it was a summation of a holiday dinner conversation I had to try and explain the crisis to someone on Main Street. What follows is a more expansive answer to how the crisis came about and what is being done.

Recycling Trash Assets and Pigs With Lipstick

Solutions from global policymakers for the financial crisis have been attempts to put the lipstick back on the pig of trash assets. This does not solve our problems because what is needed is wholesale recycling of the system, not just prettying things up.

I. The crisis to date

Here is a brief, biased history of actions in global finance and results so far:

U.S. The treasury and Fed correctly see part of the problem as a breakdown in credit, however, they mistake the symptom for the cause. Bailouts have been attempts to boost liquidity and stimulate lending, they haven’t worked because the problem is a solvency crisis (Bank A doesn’t know what credit problems Bank B may have, so it won’t lend no matter how much cash it has).

England. Gordon Brown was ahead of Washington in large bank bailouts and restoring solvency, though this has been at the expense of the British Pound and possibly Britain’s sovereign credit rating.

Europe. Early and even later on in the crisis, the European Central Bank (ECB) kept interest rates high, practically repeating the same mistake made by the U.S. Fed in the Great Depression. Once Euro rates came down, reforms and bailouts have been an every country for itself affair demonstrating that Europe is far more in need of recycling its system than other parts of the world.

China. The mistakes of allowing property and asset values to rise too far may work in China’s favor by forcing the government to compensate with domestic stimulus, creating a larger Chinese consumer economy. The Chinese consumer won’t be a factor this time, as China is export dependent, but it will next time, meaning China’s fate won’t be tied to that of the U.S. or Europe.

II. The three failures that led to crisis

The financial crisis occurred because of a system built on an ever crumbling foundation. That foundation is the use of credit to enable financial transactions. How we allowed the foundation of credit to go rotten was the result of three failures:

  1. The failure of imagination. While bankers and brokers were busy packaging mortgages, CDS, LBOs and the like, the excuse for allowing no-collateral, no-oversight, no due diligence credit to be extended to epic proportions was the mantra “in the long run, markets always go up.” Financial wizards failed to imagine a world in which prices could go down, though such information was readily available as in our post on Charts to Show That Markets Don’t Always Go UP!
  2. The failure of leadership. The financial crisis is one of government as much as it is one of finance. First is the misalignment of interests between money and its managers (namely, allowing banks to leave the partnership model for the corporate model). This misalignment led to the culture of excessive risk taking, immunity from failure and greed by fee or bonus. Second is governments’ unwillingness to curb the excesses because of adherence to free market ideology. Sometimes intervention is necessary to protect the free market, though that seems to have been lost on the last group in charge.
  3. The failure of knowledge. We are also here because we failed to understand the deals we were transacting. Ignorance is a partner to a no-collateral credit package and a high level of ignorance had to be called upon for the credit booms of the 90s and 00s. Our predicament is also our failure to know the warning signs of past situations. Many Great Depression era professionals are gone or long retired, the youngest being in their late-80s. Fewer still are people who have seen recent crises in Russia, Ecuador or Argentina and work in the Western markets of today. See our post on Stories From a Recent Depression.

III. Ending the crisis

In our next part of this series, we will discuss some ideas for getting out of the financial crisis. More importantly, we will stress why “recycling” our global financial system is a far better option than doing nothing or putting lipstick on a pig.

And that’s how it goes . . .

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