Managing Moral Risks: Private vs. Public

The world liquidity crisis has renewed the discussion over the public sectors intervention in the economy and the rise of moral risks associated with said intervention. The simplified and liberally against government intervention in the economy argument, says that it is preferable for financial institutions that abused the leverage boom and made bad investments to go bankrupt, rather than having the government come in and save them. They believe that the only form to teach us all the lesson about being moderate in what we do with credit, investment, and consumption, is taken us into bankruptcy if we haven’t been careful with our use of credit and selection of risk. If the kid wants to put his finger in the flame, let him, that way he’ll learn that the flame burns and he will never do it again.

The argument if favor of government intervention, to avoid a massive bankruptcy by abusers of the system, is that this bankruptcy would make just people pay for sinners. The way the just would pay would be through a global depression with job losses and massive impoverishment, which sadly, would hit the most vulnerable, that are not necessarily those that abused free enterprise.

Truth, as in many other of life’s arguments, is hidden a bit by all sides. I believe in the system of free enterprise. It is the one that encourages the most creativity of the argument and greater productivity and personal and collective satisfaction in the human community. What makes the human species so special is its capacity to innovate, and free enterprise promotes creativity and innovation. On the other hand, it is undoubtable that there are benefits to be found in diversifying collective risk through systems of domestic and international diversification. If we have to live in an island we die lonelier and quicker than if we depend on one another.

How much to depend on one another is a fundamental question. Children depend on their parents till they are 18 or 21 years olds (some more, others less). Parents depend on their children (some more than others) and it has been impossible to eliminate relative poverty, even though relative poverty has been greatly reduced in the last 10 years of a free and global economy. To let the banks fail in an economy is catastrophic because banks administer the payment system. Because of this, governments are forced to intervene when confidence in banks falls to a level where the credit and payments systems stop working. That is where we are today.

The government can and should intervene in order to reduce and diversify the risk in the system when the cost becomes high. Cost becomes infinite when all credit dries up. But when the cost of risk comes back to relatively normal levels, it is no longer necessary to distribute risk between the private and public sectors. Police protection and national defense are basic and permanent community risk reduction functions of the government. Most other risks shaving functions should be counter cyclical and on an exceptions basis. It is unforgivable when the public sector decides to increase social risk and its economic cost by intervening in the economy, when such an intervention is not necessary.

The Argentinean government has just announced plans to nationalize the private savings system, even though it is not in crisis and has allowed Argentineans to save for old age. That type of intervention is criminal and destructive because it does not reduce, but rather raises the risk exposure of all the country’s inhabitants. The risks of the Argentinean State are better diversified internationally and not confiscating Argentinean’s private savings.

Government intervention in the economy is only justified as an emergency mechanism to reduce short and long-term economic risks, but only as a temporary action and aimed at the return and regularization of supply and demand. Most government interventions in private banking is done to restore payments, credit and liquidity and is transitory and subject to disappear once markets stabilize.

The crisis also signals that the IMF’s capital must be increased many times and its governance and quota distribution modified to include more surplus countries, in order to help diversify global risk more efficiently than what each country can do individually. It is equally necessary to make sure that no financial intermediaries of significant size (“too big to fail”) can dip below banking standard capital adequacy ratios of 8-10%. It is time to establish more permanent mechanisms for the reduction of global risks.

Anatomy of the Financial Crisis: a Drama in 9 acts and one intermission.

Like all crisis, in hindsight, it is easy to analyze its causes, although impossible to ever know the instant they are going to unfold, just like death. The global banking crisis stems from an insufficient capitalization, in the presence o volatile financial assets, that because of this volatility tend to be over-valued from time to time. The banking crisis – that threatens with creating an economic crisis, because of its possible impact on companies and the ability of individuals to finance investing and consumption – can be described in nine acts and one intermission of the tragicomedy of the global economy’s life:

1st Act: Global economic growth.

2nd Act: Increase in liquidity and securitization.

3rd Act: Reduction in the volatility and perception of risk and a rise in the prices of real and financial assets.

4th Act: Increase in financial leverage to maintain or increase the yield of appreciated assets.

5th Act: Increase in the price of raw materials – reaching speculative levels because of the price inelasticity of offer and demand.

6th Act: Real estate prices begin to decline because of excess construction and an increase in interest rates.

7th Act: Financial assets based on real estate prices warn about losses and affect the capitalization of the most leveraged and vulnerable financial intermediaries. Bear Stearns, Lehman Brothers, Morgan Stanley, Goldman Sachs, WAMU, AIG, etc; the investment banks and insurance companies specializing in insuring financial risk.

8th Act: Vicious circle and collapse. Marking-to-market: In the measure that accounting rules force us to mark-to-market, the falling price of assets begins to affect the capitalization of all Banks (105 of total assets), accompanied by uncertainty about the value and nature of all banking assets.

9th Act: Intensive Care Unit. The role of China and others when faced by the possible collapse of global consumption and its impact on the domestic growth rate. China has two alternatives and infinite combinations of those two alternatives. Sell their inventory of raw materials and products at a discounted price or sell their financial paper and invest in domestic infrastructure. Either of these two scenarios in extreme, like anything in extreme, have bad endings. If China liquidates its inventories in order to maintain revenue and jobs, we have a massive liquidation of inventories in the world, deflation and depression. If China goes in the opposite direction and liquidates its assets for internal investment or recapitalization, this can create inflationary pressures, increases in government bond interest rates and a negative impact in the global economic growth rate. Extremes are always bad. The most probable scenario is one in which a little bit of both measures is taken, leaning towards the inflationary side.

Intermission: What’s more desirable and probable, is that the global economic growth rate will come down about half of were it has stood over the last 5 years, unemployment will rise by 25% (from 6% to 7.5% in the U.S.), China will sell 10-20% of its international assets, and all sellers of consumer products in China and the rest of the world will lower their prices (realization in 75% of the year instead of 50% of the year). A paused equilibrium between savers and consumers, will serve as an intermission in this economic drama.

Extremist governments and politicians are no good anywhere in the world. You need cooperation among countries, the private sector and the public sector. You need constructive dialog instead of lynchings. We need to keep maturing and growing as a species and learning how to solve, with good intentions, knowledge, sensible analysis and maturity, the crises that will inevitably pop-up.