Expect nothing, live frugally on surprise.

Sunday, October 26, 2008

Economic crisis: Who pays the price?

As those responsible for a financial crisis do not have to pay for it, they have no compunction about creating once again the conditions that caused it.
The 26,000 employees of Lehman Brothers will lose their jobs now that the bank has collapsed. Here, some of them leaving the company headquarters in New York with their belongings, on September 15.

FINANCIAL crises bring out all sorts of skeletons from the cupboard. Mostly, these reflect ineptitude, irresponsibility and unrestrained greed, which are usually responsible for creating the internal conditions for the crisis even if there are other proximate or external factors. But those dealing with any crisis have to confront another huge problem – that of moral hazard – one that could even lead to future financial crises.
The Palgrave Dictionary of Economics defines moral hazard as “actions of economic agents in maximising their own utility to the detriment of others, in situations where they do not bear the full consequences”. This problem is especially rife in financial markets because such markets are anyway characterised by imperfect and asymmetric information among those participating in them. The moral hazard associated with any financial bailout results from the fact that the bailout implicitly condones the earlier behaviour that led to the crisis in a particular institution. Typically, markets are supposed to reward “good” behaviour and punish those participants who get it wrong. And, presumably, those who believe in “free market principles” and in the unfettered operation of the markets should also believe in its disciplining powers.
But when a crisis hits, the shouts for bailout and immediate rescue by the state usually come loudest from precisely those who had earlier championed deregulation and freedom from all restriction for the markets. This has been very marked in the current crisis hitting the United States’ economy, reflected in the failure of major mortgage institutions, insurance companies and Wall Street banks. The arguments for bailout are related either to the domino effect – the possibility that the failure of a particular institution could lead to a general crisis of confidence affecting the entire financial system and rendering it unviable – or to the perception that some institutions are so large and so deeply entrenched in the financial structure that too many innocent people, such as small depositors and pensioners, would be adversely affected. It is this latter perception that has apparently led to the decision of the U.S. Federal Reserve to effectively bail out several major financial institutions in the past few months, beginning with providing a dowry for the failing bank Bear Stearns in its shotgun marriage to JP Morgan and then going on to protect and then effectively nationalise the mortgage-holding agencies Freddie Mac and Fannie Mae. Now, with the collapse of Lehman Brothers and with the problems of the world’s largest insurance company, American International Group, looming ahead and as more large Wall Street banks and finance institutions reveal the full extent of the problems they have accumulated during the latest housing finance boom, the issue of more, and possibly even bigger, bailouts is likely to become more serious. Each of these huge bailouts is being presented as a one-off, inevitable move designed to save the system. Alan Greenspan, the former Chairman of the U.S. Federal Reserve, whose easy money policies were strongly implicated in creating the speculative bubble that has now collapsed, stoutly defends these bailouts and suggests that more may be necessary. In a recent interview he is said to have declared: “This is a once-in-a-half-century, probably once-in-a-century, type of event. I think the argument has got to be that there are certain types of institutions which are so fundamental to the functioning of the movement of savings into real investment in an economy that on very rare occasions – and this is one of them – it’s desirable to prevent them from liquidating in a sharply disruptive manner.” Forget, for a moment, whether this argument is correct or even whether it will actually be successful in preventing a wider financial collapse. Consider instead what sort of signal is being sent out to those who headed the institutions that are being bailed out. The really great moral hazard in the financial system today is not just related to the bailout of the institutions; it is even stronger among those who are in charge and should themselves be directly paying the price for taking wrong and irresponsible decisions. Instead, financial markets are now so structured that those running the institutions that collapse typically walk away from the debris of the crisis not only without paying any price but after substantially enriching themselves. Consider, for instance, Lehman Brothers, the major Wall Street bank, which collapsed essentially because it went on a completely unsustainable borrowing and lending spree, buying assets with as little of its own money as possible and without due diligence or prudential concern. Now that the bank has collapsed, its 26,000 employees will lose their jobs, and most of them are unlikely to find new jobs easily in the current market context. Since they held 25 per cent of the bank’s stock as employee stock options, much of their savings is also now valueless. But Richard S. Fuld, Jr., chairman of the board of directors and chief executive officer (CEO) of Lehman Brothers and the man who was at the helm of affairs during its period of completely irresponsible behaviour, received a pay packet of more than $40 million last year. According to the terms of his contract, if his services are terminated, he will apparently receive more than $63 million as part of his golden handshake.
Since the much-publicised jail terms awarded to some of the Enron managers in the early part of the decade, CEOs of finance companies and banks have also grown more savvy in protecting themselves, ensuring that the writing in their contracts provides for the absence of any personal liability in the event of failure. And the compensations of those in charge in the financial sector are increasingly divorced from the actual effects of their management. According to a recent report in Financial Times, the compensation for major executives of the seven largest U.S. banks amounted to more than $95 billion over the past three years even as the same banks recorded around $500 billion in losses.
Clearly, therefore, the issue of moral hazard cannot be dealt with only in terms of faceless institutions that are being rescued with taxpayers’ money. There are individuals – in fact, a relatively small number of individuals – who were enriched by the boom, who were able to manipulate government policies, the media and the gullible public to ensure the creation and prolongation of what was always a speculative bubble. And these individuals also appear to have rigged the system to ensure that they are protected from the adverse fallout when the bubble finally bursts. f course, what is happening in U.S. capitalism today is only a repeat of the pattern of the financial crises that spread across the developing world in the 1990s and early 2000s. In all those cases, those who were responsible for the policies and financial actions that created the crises, and who were the major beneficiaries of the preceding boom, did not pay the costs of the crises. The costs were borne by workers who lost their jobs directly because of the crisis as well as those who were then affected by the stabilisation measures imposed to control the crisis. The losers included small businesses that collapsed because of a regime of the high interest rates and tight money that is a typical post-crisis response. Since those responsible for the crisis do not have to pay for it, they have no compunction in once again creating the conditions that caused it – and this is what is happening now in many of the formerly crisis-ridden emerging markets. Now, it is in the U.S. that we see how the agents of irresponsible and predatory finance survive and even prosper as everyone else goes under. In this case, it is a case of the executives laughing all the way to the bank.


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