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Visible and the Invisible Hands
How did it all happen? What went wrong? Does the market no longer work?
I have some good news and I have some bad news. The good news is: yes. Markets work. The bad news is, our world is not a perfect world. At least, it is not perfect in the sense described in Economic Theory Books for the Invisible Hand to do all the work. This time, the Visible Hand must help the Invisible Hand do its thing.
Markets do not operate in vacuum. They do not operate in Wonderland. They operate in our imperfect world. If we want markets to work, we must realize how our real world differs from the perfect world of Perfect Market Theories.
In October 2008, Alan Greenspan said: “Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity -- myself especially -- are in a state of shocked disbelief”. OK. Let me spell it out. The problem lies in the word “self-interest”. The fact is, Market Theory is based on an assumption that both sellers and buyers will take decisions in their best interest. But since separation of management and ownership ages ago, the word “self” is no longer valid. There is no self. Who is to say which “self”? Is it the managers, workers, short-term owners (usually speculators and quick cap gain seekers) or long-term owners, those who really have the long-term “interests” of the “self” in mind, heart and pocket?
First, let us say that for the Market to work, we need laws, courts and enforcement to protect the idea of personal property or ownership. The market will not work if the concept of property is not there or is unprotected. To buy, is to obtain the title of ownership of the goods bought. So, we need a “regulator” in that area to start with. This means erecting a government to make laws, build courts, hire enforcement officers, or even agree on an arbitrary body elected to take these responsibilities if you are an anarchist.
Now, when a Loan Officer knowingly approves a loan to a borrower who will most likely default, does he commit a crime or not? He and his superiors who allow such practices, have compromised the long-term “interests” of the shareholders, the seller really, for now, the “real” owner of the money lent. When someone else introduces what is known as Teaser-Rates, where unqualified borrowers are lured into borrowing amounts they can never repay, by setting up a scheme of Introductory Payments which are significantly LOWER than Real payments to come, overtly promoting the business and covertly to delay the delinquency, or the discovery of default on such a loan, again, that should that person, his bosses and watchdogs all combined be locked up?
These officers and managers deliberately act AGAINST the best interests of their OWN employer, their own shareholders, for now, the real owners who pay their FAT salaries and bonuses hoping that such generous compensation will make those officers look after the owners “self” interests. They trust them to protect their assets. Such hope was proved false. Such trust was systemically ill-placed. Why? Because the more those officers lend, the more they make “temporary” profits of money which is not really theirs or even owned by their company. Everybody borrows from somebody else. And the leverage ratios are staggering. They can reach 1:100. Meaning that an intermediary could have debts of $100 million (in funds borrowed from real banks or yet some other intermediaries) and assets of $101 million (in toxic loans to unqualified mortgages). This company has an equity of only $1 million but is gambling with $100 million! Great! What makes things even better, they securitize their toxic assets yet with some third company which means they transfer the risk to another entity. And the other company transfers the risk to another. And so on. It is the perfect bubble. A perfect pyramid scheme of defrauding the real owners of the money, the simple depositors in real banks, of their hard-earned money.
A Pyramid Scheme?
El Rayan and El Saad of Egypt’s famous pyramid scheme of the 80’s are innocent kindergarten toddlers compared to these guys whom we can never really blame because we all knew and all watched. So, the loan officers and the CEOs get their FAT bonuses for these seemingly marvelous achievements. These achievements, however, are short-lived. Like all fraudulent schemes. Eventually they are exposed when the pay-back comes. Like all bubbles, they eventually burst. Into tears. Only someone else’s tears. So, have the officers and their superiors committed a crime? It depends. By the time the company, or the economy for that matter, collapses, those officers would have retired - or are happy to retire - and live comfortably on the ILLEGAL or semi-legal fortunes they had made by abusing the power given to them.
The Perfect Theory is based on one assumption. That a seller would always work to achieve his best economic interests. But what happened here is that the SELLER (who really owns the business) is different from the SELLER who represented him at the time of giving the loans or selling the merchandise. Both people (albeit being labeled as the seller) have Different Interests. This is a clear case of Conflict of Interests. Worse, the managers who set the Lending Policies inside the seller's organization have a different set of interests as well. Worst still. The Short-Term Investors who bought the stocks of the Sellers company, do NOT really care about the Long-Term interests of the Company. Because they make a quick buck of capital gains (speculation) and then they sell the stocks and go their way. Another set of conflicting interests. Worse still. Even the long-term owners, they do not really own the money which their employees had lent or even a fraction of it. Their highly leveraged company borrowed the money. They will not, in theory, suffer from the consequences because their toxic waste is securitized with some other company who in-turn transfers the risk to another company and so on. The chain is long, sophisticated, complicated and everyone is closing an eye or even two.
The money, at the end of a very long chain, truth be said, is owned by some poor guy who deposits his savings in a local bank. Or a group of guys who cut a piece of their salary and save it in a pension fund. Or some foreigner, Arab, Japanese or Korean High Net-worth Individual or Foreign Bank (and its depositors) who trusts Uncle Sam enough to buy treasury bills which are systemically used to cover an $11 trillion public budget deficit and rising and an enormous amount of US private consumer credit. Truth be said, everyone is accused of greed. Everyone, one way or another, knew, or at least felt that it was too good to be true. Well, guess what? It ain’t true.
Now, to prevent all these crimes and misdemeanors, regular police cannot go snooping around in the books and policy guideline papers of investment companies and banks. Hence a lucrative job of someone else is created. This is the SEC, Securities and Exchange Commission. Here the regulator’s job will be to install measures and policy guidelines to make sure that the practices of the management provide a balance between the interests of all stakeholders involved. These guidelines become amongst the Rules of INTERNAL GOVERNANCE of every investment company. But we still have a big PR job to try to rid the public of this blinding greed. Then figure out what to do with the United States of America who insists on providing unsustainable lifestyle to its lucky citizens on the expense of the rest of the world. By the way, the $11 trillion, these are just the public debt. Private US debt to foreign creditors is probably many times more than that.
Splitting of “Self”
The simple Conflict of Interests has arisen from complexities and sophistication, sometimes deliberate over-sophistication designed to boggle anyone who tries to trace the leakage. For instance, conflict of interest and the “splitting of the self” came when we separated Management from Ownership. A modern management MUST-DO. It came with these fancy derivatives which transfer risk and responsibility to someone else. It came when speculation became more lucrative, and therefore more important, than working the land, producing gadgets or waiting on tables, serving others, providing real value. Today, some argue that out of each $1, ninety four cents would come from virtual economy. Where no real value is added. Fiction money. This is when “the self was split”. It reminds me of “splitting the atom”. It unleashes such a great deal of uncontrollable power. And I am not just talking about heat, pressure or radiation. I meant the power to corrupt human conscience.
With freedom also comes responsibility.
With great power comes even greater responsibility.
Let us hope that those who have power and the liberty of using that power have actively operating conscience and an adequate sense of responsibility.