The Origins of the Crisis

There were several reasons for the mess we are in. I’ll start with perhaps the most controversial, which is institutionalised greed going back a long way. Basic economics tells us that as long as currencies are pegged to a real thing – gold, silver, goods, services – you are limited in what you can do to  stimulate or rein in the economy, because the currency will function on its own basis. Once you detach a currency from its link with real things you can better manipulate the currency - and therefore the whole economy.

Over time Governments have become increasingly ‘economical with the truth’ and statistics have been systematically manipulated over the last 25 years. Three years ago it could be identified that inflation was being underrated by 7% and the same principle could be applied to unemployment, empty houses or any other major statistics.

The introduction of Government sponsored securitisation in the 1970s was a good thing - just as fire is a good thing, provided it is kept within bounds. But without bounds, what we had was  reckless, unprincipled securitisation with devastating consequences.

Finally, the US Legislature in its wisdom came to the conclusion that big deals did not need to be registered. So we had the strange situation around the world that you could not be born, or die, or pass exams, or get a job, or even buy a share, without being registered, but if you wanted to do multi-billion dollar deals nobody needed to know. That was the catalyst for unbridled speculation - most notably oil price increases that were later revealed to be 91.2% due to speculation.

The Immediate Causes

One or two minor factors have been attributed to the crash and certainly misaligned incentives played a role - I would liken it to incentivising people to play American football when the other team thinks it’s playing soccer! Also, so-called economic imbalances due to the patterns of consumption in the States versus patterns of production in China and the relative amounts of currency manipulation that were going on in the two countries.

However, the real cause was the Sub Prime Mortgage Crisis. Here was a  phenomenon that began 30 years ago, so what caused it to produce a crash now? The reason was that commodity prices went through the roof. The oil price shot up from roughly $80 to $140, and just about everything else went with it. The average American household used to spend 7% of its total income on food and transport, and it was now spending 20% on these items. If 91.2% of the increase in oil is caused by speculation, you can clearly see how speculation in the commodities sector caused the crisis.

The Consequences

By the summer of 2008, 100 million people had lost their jobs as a result of the crash. The last two crises we experienced were more or less jobless recoveries. If that happens again the implications for society, politics and business will be played out for a generation or more. The leading economies of the world are in a situation of unprecedented national indebtedness, which will also have a sizeable impact on public spending, health, police and so on.

We can be quite clear that there are going to be new rules to the game, and without this we will not convincingly find a way out of the current crisis. The good news is that solutions are being debated at a global and national level. Solutions to issues such as: bringing incentives back into line, registration for big deals, counter-cyclical measures for banks and financial institutions - which means that at times of boom we put more money away and reduce the ability to lend, and when the economy goes down we encourage them to have lower buffers and to lend more.

Another important subject for debate is how to prevent the ‘too big to fail’ institution. Why do we have institutions that are so big they have to be rescued? This gives them an implicit state guarantee which we, as tax payers, must meet when it is called upon, yet we don’t get a return for the guarantee we provide. Should there be a higher tax, or rate of interest applied to big institutions in exchange for this implicit state guarantee? Should there be automatic break up of these institutions once they cross the threshold of being too big?

We are in the middle of a global civil war that no one is aware of. The issue is what kind of global rules are going to be put in place. The more pressure we can put on our representatives to come up with sensible rules the better - unfortunately, at the moment it is coteries of people debating esoteric subjects around global rules and I’m not confident that we will get the rules we should. The biggest lie being put about is that ordinary people cannot understand what’s going on. Finance is not rocket science. Yes there is sophisticated detail, but everyone understands that if you spend more than you earn you’re going to get into trouble; that’s true as an individual, a family and a country. How do we organise our personal and our national household in such a way that we are not living beyond our means? If more people entered the public debate we would have more sensible decisions.

These would be my priorities:

Multiple exchanges for registering large deals - a central exchange would be better than none at all, but in a free market economy we should have choice.

Not being able to leverage more than is sensible – Goldman Sachs, the most respected investment bank in the world, was in hock up to 50 times its market value when it ran into the arms of the Government to be rescued.

Sensible capitalism, not the global casino that we have at the moment. A retreat from casinoism into rational, sensible global capitalism can only happen on the basis of a level playing field for everyone according to rules that make sense.

The world is not short of money – there’s far more liquidity than there should be in the global economy, the problem is that the liquidity is not being deployed rationally. If you don’t know what the rules are, you as an investor won’t invest unless the returns are worth the risk.

© Caret, 2010. All Rights Reserved