Smackdown / GFC

I told you so.

Some eighteen months ago, in September 2007, I wrote of the danger inherent in escalating imbalances:

“The power and inevitability with which corrective force strikes never seems to register with the average person.”

Given my aversion to the overused cliché of GFC (Global Financial Crisis) and other variations and iterations of the recession thematic, I am simply going to be blunt, referring to it as ‘Smackdown;’ having fashioned a suitable working definition that goes something like this:

Smackdown (n.): ‘punishment’ of epic proportion inflicted upon an oblivious/unwary mark.

Unlike the average economist, I won’t pretend to have exceptional insight through which I can neatly explain and rationalise the Smackdown to cause and effect. Instead, this ‘analysis’ (I use the term lightly) will be an exercise in interdisciplinary synthesis between economics and social psychology – hopefully ending up with an Iron Chef Michiba (86.5% win ratio from 38 battles) style dish by the end of it.

We will commence by delineating the economics, so as to provide grounding for the analysis.

State of Play

In very simple terms, the present debacle originated from cheap debt coupled with aggressive risk-taking, greed and stupidity. Speculation and optimism created a bubble in asset markets, which supported growth in spending, financed by increasing asset values.

Imagine purchasing a house for $100,000 with a loan, and a few years later, the house is worth $200,000. Given interest rates are so low, you draw another $50,000 against the house to buy a Hummer and holiday in Cancun. This simplistically encapsulates the original perpetrator of this crisis – a consumer who finances overconsumption by way of debt.

So long as rates remain low, mortgage-holders retain their jobs, and property values don’t reverse significantly, everything remains fine.

Any self-respecting banker would see how lucrative this picture is: low interest rates and an economy humming along. Naturally, they took advantage by tapping the demand for money – lending out aggressively, and to high-risk customers. They were then able to ingeniously ’securitise’ (pool together) all these loans and sell them off in tranches with different levels of risk and return.

Here’s the premise: if I lend $1,000 to one person, there’s a disproportionate risk they won’t be able to pay me back. But, if I lend $1 to 1,000 different people, there is much less of a chance I’ll lose my $1,000. By packaging a thousand loans together, risk is diversified, and the pool can be sliced and diced in such a way as to create investments with different levels of risk/return. For example, let’s say we take 1,000 loans, package them together and create a few different securities:

1. Low risk; having first rights (i.e. low risk) to loan cash flows, carrying a low return
2. Medium risk; having rights to cash flows after the ‘low’ securityholders are paid, carrying a higher return
3. High risk; having rights to cash flows after ‘low’ and ‘medium’ securityholders are paid, carrying a very high return

Banks created these products, called ‘mortgage-backed securities’ and on-sold them to investment funds, absolving themselves from carrying risky loans on their balance sheets, and taking a healthy profit margin along the way.

The popularity of these mortgage-backed securities and their derivatives spread like wildfire, hundreds of billions of dollars of spore caught in the winds of a global system, finding their way to balance sheets of financial and investment institutions worldwide. For quite some time, the ploy worked. Investors received the promised returns from their securities, and securitisation would’ve appeared a compelling proposition for all parties involved.

Then, the spores started spawning rather unsightly toadstools.  The low ‘teaser’ rates on these loans began to revert to much higher levels. Suddenly, a lot of people couldn’t afford their loan repayments and defaulted. Banks repossessed mortgaged houses and large volumes of foreclosure sales began to hit the market. As the logic of supply and demand dictates, when supply increases without a commensurate increase in demand to absorb the surplus, prices must fall, and that is exactly what happened.

A vicious cycle began as the value of the assets pledged as security for these loans fell, resulting in negative equity and loans being called in. Financial institutions ended up with skyrocketing levels of bad loans, which resulted in reduced capacity to lend (capital adequacy is put under pressure by bad loans) and higher spreads where they did choose to lend. With the cost of debt blowing out, companies were forced to curtail investment and cut costs, meaning ‘restructuring’ and lay-offs. Higher unemployment means less people with income to spend, which lowers consumption, reducing company revenues squeezing profits, thus providing further impetus for companies to lay-off staff, and the cycle begins again.

We can thank globalisation for the worldwide diffusion of the crisis. Though the core subprime problem was isolated to the United States, because of the interconnectivity of the global financial system and the fact the infection occurred at the centre, transmission was almost inevitable.

Since late 2007, the global economy has deteriorated markedly, we have seen asset markets crash, multi-billion-dollar bankruptcies, banks nationalised, the collapse of Latvia, escalating geopolitical tension, and perhaps most significantly, a wholesale destruction of confidence.

Books have been written on the topic, but in a rudimentary nutshell, that is the anatomy of the present mess.

~

The Social Consciousness

Whilst an economic system may have its foundations in rationality (efficient allocation of resources, maximisation of output et cetera), its participants are emotive. Confidence, ergo, impels the economic system. It is a nebulous concept of affective state and expectations, the sentiment heralding action.

Though the very concept of a social consciousness may seem far-fetched and somewhat frivolous, I maintain it does exist. The social consciousness is what elects governments, sets trends, defines issues and determines the developmental path of humanity. It is emotionally driven, ruled by sentiment and characterised by myopia, suggestibility, narrow-mindedness and a propensity to herd.

History has proven it is the single most influential force on this planet, more powerful than any army, and capable of inflicting destruction greater than that of a nuclear bomb. Effectively, if you control the social consciousness, you are God, and this is precisely why the institution of The Vatican wields such awesome power. As a financial enterprise, the Catholic Church is worth more than General Electric.

The aforementioned wholesale destruction of confidence is akin to a disease afflicting the social consciousness: escalating depression on a societal level. A normal session with a Psychologist for clinical depression would involve an exploration which attempts to find and address its underlying causes. Action taken on the ‘financial crisis’ to date however, amounts to prescribing antidepressants, without endeavour to interrogate and assail the root cause of this crisis.

To the underlying problem, money (be it fiscal stimulus or bailout packages) is not an enduring solution. Humanity’s inherent selfish and comorbid materialistic nature is only validated further.

Extrapolated Optimism

Fundamentally, greed is the underlying problem, and greed has driven the risk-taking, morally hazardous behaviour which led to the Smackdown’s opening act, the Sub-prime crisis. Recall that one of the philosophical pillars supporting securitisation was reliance upon the continued increase in house prices – an example of what I term ‘Extrapolated Optimism.’ A lot of smart people got sucked into this, and one could argue greedy, spivvy Wall Street bankers are to blame.

Could it be so simple an explanation as a few ’smart’ people doing dumb, morally hazardous things? That being the case, I’d be able to put on my latex Jim Cramer mask and lament that we wouldn’t be in quite such a predicament if the people behind the wheel had their fingers on the pulse as opposed to up their arses.

Alas, it is not that simple. Blame is more appropriately apportioned across broader society.

Under economic prosperity, today is bright, and we project this brightness into the future, to tomorrow. We thank and act under the misguided assumption we’re on an ever-increasing tangent, spending like there’s no tomorrow, and financing hedonistic lifestyles which (supposedly) won’t be a problem repaying due to the perceived perpetually escalating uptrend. In short, the mindset is that we can live for the moment because the future will take care of itself. Contingency for a rainy day isn’t given so much as a cursory thought when all we can see are clear blue skies. People don’t seem to consider “oh hell, not even Che Guevara can save us now” type outcomes.

As useful as optimism is, it should never be favoured at the expense of realism. Much of my theory concerns the ability to project thinking forward, look around the upcoming corner rather than the short span of road immediately in front. Optimistic extrapolation is myopic, and as mentioned in a prior piece entitled ‘Perspective,’ myopia is incredibly dangerous.

Planning as a natural phenomenon is nothing new. Squirrels have hoarded acorns for the winter ever since…well…ever since there were squirrels. Self sufficiency is an imperative survival trait unless you intend on living at home with your parents for the rest of your life.

To the extent people believe things will take care of themselves and do not consider, plan, and make contingencies for worst case scenarios, then there is a calamitous accident waiting to happen, the likes of which we are now seeing transpire, and the pain is real. People are losing their jobs, their homes, and the flow-on social consequences are nothing short of disturbing.

Admittedly, there is an element of Schadenfreude on my part for a sense of poetic justice in seeing essentially dumb people who made obscene amounts of money on the back of unskilled momentum investing getting hit with margin calls. Kind of like not feeling any pity or sympathy for the little rich kid who wraps his parentally-funded Porsche around an electricity pole whilst speeding around showing off.

On the rare occasions I watch the news; I witness stories of both genuine hardship and consequences of ignorance. Whilst I feel empathy toward the former, I laugh derisively at the latter.

The Media

Whilst on the topic of the media, it is important to draw a linkage to their role in the social consciousness. Having long held the mantle as the institution most capable of and active in influencing the social consciousness, the media wield incomprehensible latent power, latent because it is currently underutilised.

Paradoxically, we elect governments, yet are suspicious of politicians. Any smart politician knows they can overcome this suspicion by manipulating the media. Judging from the extent and efficacy of the Nazi Propaganda (literally advertising in Spanish) campaign, Hitler (or at least his marketing machine) would have understood this quite well.

At this juncture I repeat: if you control the social consciousness, you are God. The media possesses this power to a degree through pervasive reach and persuasive influence.  It can bring any government or corporation to its knees because it has the means to push information to billions of people through a path of minimal resistance. Forget Matthew, Mark, Luke and John – these days, people hear the Gospel as taken from the book of Oprah.

~

The Australian media have personified the recession, and one evening whilst channel flicking I encounter a ’special presentation’ on Channel 7 entitled ‘Beating The Recession.’ Perhaps if I wasn’t so concentrated on fervently flipping through the yellow pages for a reasonably-priced contract killer, I’d see the value in David Koch telling me that I could save $10 a day by bringing a packed lunch to work, which is $50 a week, $200 a month, and $2,400 a year. Whoever knew basic arithmetic could give us such explosive insights? Or are people really that dumb?

The Solution

Personally, I was intrigued by the programme in that a recession is not an enemy that can be fought, being both formless and polymorphic, and yet the media chose to personify it as a corporeal opponent we could spar with. Second to that, the futility of ‘fighting’ a recession lies with the fact that the action of fighting actually strengthens the recession, and ensnares us deeper in the more, in much the way struggling in quicksand makes one sink faster. In terms of a solution to a house on fire, their suggestion was more accelerant than retardant.

Real Gross Domestic Product, interchangeable with aggregate demand is a function of consumer spending, governments spending, and net exports. If a consumer believes he can fight the recession by reducing his spending, then he is sorely mistaken. By saving, he is actually contributing to economic contraction. An increasing in savings is commensurate with a decrease in spending. Due to the linkage between output, income and spending, when one plane of this triangle is affected, all are.

Keynesian economics suggests the role of government is to act in a countercyclical manner, that is to say, when the economy is flourishing, the government runs surpluses and is a net saver, taking money out of the system. By contrast, when times are difficult and the economy is contracting, the government spends more, running deficits, pumps more money into the system and becomes a net borrower. The underlying logic here is that the government can manage its spending such that it ‘flattens’ out the economic cycle, smoothing out the peaks and troughs.

Digressing to a small aside on the varieties of government spending, I will now explain why cash handouts are bad. They encourage spending, but they are not an efficient way of stimulating aggregate demand because a proportion of the handouts are saved by consumers, diluting the effect. Contrast this with the government undertaking capital expenditure on infrastructure projects, which is direct demand. It mobilises labour and creates longer term structural benefits (logistics) for an economy. If you’re going to spend money, you should logically spend it where you’re going to get the most bang for your buck.

~

In the context of the Smackdown, we were faced with a binary decision: either spend to prop the system up or allow it to collapse. In previous recessions of lower severity, Governments could have sat on their hands and the economies would have eventually corrected (though the recoveries would have been considerably protracted).

This time, there is no choice because the financial system itself is being called into question and social stability depends on the solvency of banking institutions. The moment fear takes hold that a bank may become insolvent, all its depositors seek to withdraw their funds; concerned the bank may not be able to honour them. Banks work be lending money out long term (think 25 year home loans and 3 year corporate facilities) and financing these using short term borrowings (term deposits and on-demand savings accounts). A bank holds a certain amount of capital in reserve to ensure it always has enough liquid cash to meet depositors withdrawals, without having to liquidate its assets (i.e. call in loans). If a critical mass of people withdrawal substantial amounts of money at the same time, this ’safety buffer’ of capital quickly disappears and the bank has no way of meeting withdrawal requests because it runs out of money. Either the government must step in to provide liquidity or the bank must freeze deposits. The latter option creates civil unrest, which can quickly descend to social instability and anarchy if it occurs on a wholesale level. What do you do if you can’t get money out of the bank to buy food? Exactly.

So, whilst it makes little sense that cowboy Investment Banks on Wall Street should be rescued, after years of making supernormal profits on what is essentially gambling with financial derivatives, realistically, there was no choice in the matter. Running the printing presses and pumping liquidity into the system is dangerous for reasons I will later touch upon, but allowing the gears of the credit system to grind to a halt is terminal.

Prognosis

To its credit, humanity is amazingly flexible in that it tends toward finding a solution for every crisis. Whilst these solutions may create problems of their own, in general, they do break the crisis. The present crisis will be solved, but it will only delay the inevitable.

This may well be the point where capitalism collapses upon itself. Printing more money doesn’t really solve the problem – reflationary policy merely sets the stage for the mother of all crashes. Money is chasing limited resources. Money has value because it is scarce. More money in the system comes at the expense of the existing stock of money. If there are ten dollars in the economy, one incremental dollar devalues an existing dollar by 9.1%. The total value of money, in aggregate, does not change. Prices merely adjust upward (inflation) to reflect the reduced purchasing power of money.

What we are seeing now are the beginnings of a massive intergenerational burden transfer which is criminal in nature. To save current generations from their own mistakes, future generations will bear the cost by way of higher taxes and interest rates for years to come. The system should have been purged properly. I pay enough tax already and do not see why I should have to finance an economic bailout. Were I to personify with brutal cold reason, I would liken it to expending resources on a sick murderer in hospital. It can’t be justified unless you believe murderers don’t deserve to die. But the value judgement on who deserves to be saved is not the key issue here; economic policy is a pacifying band-aid solution that does not involve revolutionary ideological change.

The integral matter are the premises upon which the social consciousness, or ‘ether’ rests. They are by and large material in nature. Insofar as the world’s present ’situation’ goes, I can gauge the ether, every morning on the train, walking the city streets, and through the course of interaction. What I see is a society faced with material uncertainty. Is my job safe? When will the market turn? Will I get the government handout?

How I read the ‘ether’ is that adversity, instability and uncertainty necessitate an increase in the general level of anxiety, which has first order manifestation, and incites second order effects such as heavier need and hence inclination toward escapism, alcohol and entertainment being the two chief outlets.

Our world would work very differently if the ether were premised on spiritual rather than material considerations, if people resorted to the pursuit of understanding rather than escapism when adversity transpired, if perspective were broad rather than narrow, if the mindset were co-operative rather than competitive.

We are presented with a unique opportunity, the old illusion is weakening perceptibly and the fairytale is disintegrating. Society finds itself at a turning point where the inertia and momentum of consumerism have taken a considerable hit. From this point there can only be two outcomes, a reversion or a revolution.

Do we rise to the challenge? Will we learn from our mistakes? Or will we come out of this none the wiser and go back to our old ways? The opportunity involves rebasing the entire superstructure and replacing the maximisation imperative with an adequacy one, and redrawing lines such that ‘fulfilment’ is anchored to something more meaningful than wealth and status. ‘Awakening’ and ‘Enlightenment’ are the functional elements of such a revolution.

Granted it is still early days, I will nevertheless stick my neck out and speculate that we will see the ultimate or penultimate round of band-aid solutions, as key participants scramble to plug the holes and keep the ship afloat. There will be a period where concern for the hull’s integrity cause people to sail more prudently, and this will last so long as the balance of power persists in fear’s favour. Eventually, a point will come where the reckless activities of greed will again ensue, although in a way which does not seem reckless at the time. Imbalances will return, and their correction will be heralded by a catastrophe of unfathomable proportions. When all the band-aid options have been exhausted, the only way out will be an actual purging of bad blood; and it will be some bloodletting. What I do not care to speculate over is whether the blood loss will be survivable.

The shock magnitude of the Smackdown would suggest people will learn, but the level of delusion advocates otherwise: learning may not occur in earnest unless the consequences of this crisis are allowed unmitigated impact, the full force of which will shatter the delusion and pave the way for a clearer understanding to develop.

Under fatalistic rationale, I do not hold out in the hope of this happening in the course of my lifetime. Adversity is a more competent teacher than prosperity, and when you reduce adversity, the cost is complacency. People must learn the hard way, it is an inescapable reality. Prior to the Smackdown, we were beginning to make progress – emissions trading and what appeared to be a fledgling genuine interest in social issues. The moment the economy turned sour, these things became a distant sideshow. If you need proof of what matters to people, look no further.

The sun sets, but will a new day dawn?

I don’t know.

~ by X on March 30, 2009.