Wall Street lessons

Sep 23, 2008 Editorial

As the American politicians negotiate the exact terms to the agreed rescue of Wall Street from its ongoing meltdown, all that is certain is that it will end up costing the American taxpayers plenty – at least some $700 billion and counting.

These are numbers beyond the ken of citizens of a small economy such as ours, but there are yet some cautionary lessons for us.

Firstly, we have followed the Washington Consensus’ prescription of liberalising our financial infrastructure to permit its integration with the rest of the world, especially the developed world.

We can therefore expect that, as the major overseas financial institutions try to retain as much capital as possible within their own balance sheets, to tide them over the inevitable demands ahead, credit will tighten and rates will rise.

With the endemic high interest rates in our local banking system, this is not good news for our investment climate.

The second lesson is that of regulation. Even though the most ardent capitalist may extol the primacy of markets guided by an “invisible hand”, he would never pretend that this condition was equivalent to “no hand”.

In the modern world, it is expected and prescribed that one of the government’s roles is to regulate markets, especially financial markets, which in the case of the US had become the tail that was wagging the dog.

If and when there is an enquiry into what caused the meltdown in the US, a major question has to be: “What were the regulatory bodies doing while what we now know to be unsustainable credit obligations were being piled up?”

Even quasi-governmental financial outfits like Fannie Mae and Freddie Mac had nonchalantly overstepped their guidelines on investment and coverage, without being pulled back into line. They, of course, had to be nationalised.

In Guyana, a few years back, we had the case of a financial institution – Globe Trust – overextending itself, and, based on the standard prescription, was allowed to fail. To act otherwise, we were informed, was to encourage what economists call “moral hazard” issues.

The harsh lesson of financial profligacy had to be taught – failure of the institution. Unfortunately, most of the ones who were forced to imbibe the lesson were the small depositors, and not the financial big wigs that escaped mostly unscathed.

We see the same pattern playing out in the US, as the bail-out looks as if it will leave the overextended small homeowners, who were, and are, being forced into bankruptcy, out in the cold.

We in Guyana will have to strengthen our regulatory framework and institutions, and enact legislation that would protect the small individual investors.

The third lesson is that political and economic leaders in the US allowed financial speculation to surpass basic economic activities, such as manufacturing, as the main engine of its “growth”.

The mortgage crisis that eventually brought down the house of cards was driven by 10 per cent to 20 per cent yearly increases in property values that were unprecedented and had to be “pure bubble,” since they were not connected with increases in wages, demand, productivity, capital investment, or GDP growth.

New financial instruments and institutions, such as hedge funds, collateralized debt obligations, credit default swaps and other financial schemes and strategies, were geared toward decreasing credit risks, but eventually became legalised gambling with no connection to real world production and distribution.

The derivatives market alone (of which the credit swaps that brought down Lehman Brothers and humbled AIG are a part) is worth notionally US$600 trillion – no one knows for sure. And this is a consequence of the slack regulation problem that became endemic.

Fuelled by ever-increasing greed, the money managers grew bolder with each new declaration of paper profits, and the rest, as they say, is history.

This last lesson has a further caution. In the eighties, the US was able to weather a trillion-dollar crisis in its Savings and Loans banking system. But this was possible because the S&L’s held tangible assets – shopping centres, etc., that could be sold off.

In the present debacle, what will the US do with the various and sundry ethereal derivatives contracts – not just the mortgage securities that have been broken into more pieces than Humpty Dumpty? Let us watch “making money on money” with a hawk’s eye.

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Wall Street lessons

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