G-20 or 420?

By | November 19, 2008

The “Group of 20” nations met in Washington over the weekend. The weather was cloudy and cool. The winds were blowing west-by-north-west at 14 miles per hour. But what came out was mostly hot air. Stale, hot air.

President Bush who is destined – unless saved by some miracle – to go on record as the worst President in the history of modern day USA laid the foundation for this nothingness.
Before the meeting began President Bush reminded us all that this financial crisis was not a failure of capitalism – there was no need to discourage financial innovation with excessive regulation.
Sure, the world needs a lot more financial innovation to be wrapped around the greed and slimy business practices of the financial geniuses.

The Europeans wanted more global oversight, more regulation. Eventually, the G-20 came out with a list of 20 points: a promise to do more and put in action with a notice that “we will meet again by April 30, 2009, to review the implementation of the principles and decisions agreed today”.

Doctor, what’s the problem?
But before any doctor sets forth a prescription, there must be a clear understanding of the disease. A treatment can only be effective when one understands the illness and identifies the cure.

So, what are the events that led us to where we are? What are the crises that led to a dinner and weekend meeting of the leaders of 20 countries that represent about 90% of the global GDP and 75% of the world’s population?

This is what the statement of the G-20 had to say (points 3 and 4):

“Root Causes of the Current Crisis

3. During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence.

At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system.

Policymakers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.

4. Major underlying factors to the current situation were, among others, inconsistent and insufficiently coordinated macroeconomic policies, inadequate structural reforms, which led to unsustainable global macroeconomic outcomes. These developments, together, contributed to excesses and ultimately resulted in severe market disruption.”

Now let’s put that in English.

G-20: During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence

The English version: After the technology bust in 2000 and the 9/11 terrorist attacks on the US, the global economies were on the edge of a long recession and – to prevent that from happening – the central bankers of the world kept on cutting interest rates with a view to encouraging economic activity. Whenever there is pain around the corner, the doctor prescribes the pain killer to remove the pain. The central bankers prescribed the drug ecstasy to turn that pain into the most orgasmic experience. The central bankers printed so much money that the financial geniuses figured out what to do with it: they gave it to people who could not really afford to ever repay it. And each time they lent money, the financial geniuses made a profit. And each time they made a profit, the financial firms rewarded themselves with salaries and USD 65 million bonuses.

G-20: At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system.

The English version: Hey, if you were cleaning out USD 1 million in salary every year (and there must have been 100,000 people in the field of finance, law, accounting, and consultancy who made that much money) and then getting a bonus and stock options over and above that – would you care about the vulnerability in the “system”. Man, you were the “system”! People relied on you for ethical practices and you didn’t give a damn about that – your annual salary and the sound of the bonus money getting to your bank account sounded sweeter than God’s church bells.

G-20: Policymakers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.

The English version: Mr. Alan Greenspan was the head of the US Federal Reserve. He knew what he was doing: giving money away for free to encourage businesses to take risks – and spur economic activity. The European central bankers were appalled at the “cheap money” policy of the US. They knew what Mr. Greenspan was doing – building a bubble economy. An economy fuelled by higher debt at the consumer level. An economy oiled by financial products that needed more global supervision. Mr. Brown, the then equivalent of the Finance Minister of the UK (and now the Prime Minister) did not want more regulation and oversight in Europe. His reason: because the US was grappling with the post-Enron and post-WorldCom frauds by putting in place more reporting standards for corporate governance, financial businesses were moving more of their innovation to London and Europe. If Europe placed more regulation, then it would lose its “competitive” advantage. London could no longe r challenge New York as a financial centre. Mr. Brown’s arguments prevailed. Back in the US, the current “Finance Minister” Hank Paulson – who was then head of Goldman, Sachs pleaded with the SEC to allow Wall Street firms to borrow more. And the SEC approved that: more of Mr. Greenspan’s free money found its way into hands of the financial geniuses. The bonuses got higher and higher.

G-20: 4. Major underlying factors to the current situation were, among others, inconsistent and insufficiently coordinated macroeconomic policies, inadequate structural reforms, which led to unsustainable global macroeconomic outcomes. These developments, together, contributed to excesses and ultimately resulted in severe market disruption

The English version: Maybe the Chinese have not picked this one – but they are being blamed for the “current situation”. Follow me on this line of thought. The US central bank wants to give money free in the hope that businesses borrow this money and businesses invest. This investment creates jobs. Job creation leads to higher income. Higher income leads to more consumption. Higher consumption leads to higher economic activity. This leads to businesses investing more. More jobs, more incomes, more consumption…a virtuous cycle is established. But that is in the text books.

This is what happened in real life: The US central bank gave free money. The Wall Street firms lent this money to individuals in USA to consume more. The individuals consumed goods that were “Made in China”. Investments did increase: in factories in China. Salaries did increase: of the labour class in China. Businesses did flourish: that is how the Wall Street firms could afford to paid out the big bonuses. The “structural” imbalance was caused by the fact that the Chinese – and other exporting countries that benefited from the surge in US household consumption – did not allow their own currencies to strengthen. If the Chinese currency had strengthened, exports from China would have been more expensive – and China would have lost out to other exporting nations like Vietnam, Indonesia, Thailand, Malaysia, and Mexico. Exports to USA allowed China to create jobs and increase employment and brought stability within China. All this because China kept its currency low and allowed exports to flourish.

At the US end, the packaging and re-packaging of financial loans – as one commentator noted – was the only export. The US exported USD 300 billion worth of these loans mostly to the European banks (remember London wanted to be the centre of the financial universe) and some to the Japanese and Asian banks.

The “problem” was not that Wall Street was giving loans to US consumers. That is the job of any finance company: to arrange finance.

The “problem” was that Wall Street and the credit rating companies like S&P and Moody’s were rewarded to help sustain a lie: the lie that the loans being given to people who could not really afford them were able to pay these loans back.

Along the way, everyone got their pound of flesh: the Wall Street firms got the salaries and bonuses; the rating agencies got their fees; and the Chinese and the exporters got their jobs and built foreign exchange reserves.

And, yes, the US consumer – financially illiterate and unaware of www.personalfn.com – was able to buy new homes, new cars, new everything. All for some debt obligation and interest payments that seemed really cheap – and (due to financial innovation) began sometime in the distant future.

So, if this is indeed the problem – in simple English – what is the cure?

Complexities of drugs
The last time there was a problem – and, sigh, it involved the same Wall Street firms – the US Fed prescribed “cheap money” as the cure.
But drugs have side-effects. Any doctor knows that.
And in certain combinations – they can be lethal.
Mr Greenspan knows that by now – you mix free money, with the ability of Wall Street firms to borrow infinitely, and sprinkle that with self-regulation – you end up where the world is today.

So the action plan that the G-20 has recommended is one of more oversight, more regulation. And more transparency of the accounting standards used to evaluate the risks of the financial instruments created by the financial geniuses.

Good stuff, I am sure and the G-20 will figure what the new system will look like.

But they have not addressed two issues:
1) The G-20 statement was silent on whether they will punish the crooks who mis-sold financial products to borrowers and to the lenders, and
2) The G-20 statement did not spell out how “unsustainable global macroeconomic outcomes” will be addressed. Will China – and other exporters – allow their currencies to strengthen so that they stop exporting – and will China risk a social upheaval at home due to job losses from shutting down export factories? China had already announced a USD 560 billion stimulus package – to offset the decline in exports to countries like the US.

So the G-20 was what it was: a lot of good photo ops for the leaders and some long-worded statements.

But, “hot air” is sometimes a good thing.
It tells the doctor that the patient is still alive.
Still pretty sick – but alive.

The world will take some time to get back on its feet and run again.

And India? I hope that the policy makers get their act together and start chalking out some serious investments in infrastructure (and not just the electronic voting machines) to build the base that India needs to take it to an 8% rate of annual growth in the economy – on a sustainable basis.
And the Indian stock markets? Let me know when SEBI shuts down P-Notes then we can have a rational discussion.
Until then, it remains a casino.

A wonderful, no-failure-in-settlement-systems, highly efficient casino.
But a casino – not a vehicle to allow Indian companies to attract long-term capital to build out India’s economy.

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