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The G-20 and the international financial crisis

crisisburbuja.jpgThe author says that, while many people are expecting the current world crisis to lead to the sounding of capitalism’s death knoll, others will try to look for new ideas to revive the market pull, improve and innovate, and promote the creation of wealth.

(From Madrid) WITH SEVERAL WEEKS HAVING already passed since the eye of the financial crisis hurricane passed over our heads, the G-20 summit in Washington is approaching. During said meeting, a group of nations from around the world will try to define – if possible – new rules to replace the Bretton Woods system.

Spain wants to take part in this meeting, feeling that the current weight of its economy provides it with sufficient merit. But mainly, President Rodríguez Zapatero states that Spain should participate because it has a lot to contribute to the debate. “At the origin of this crisis we can find the element that has had the honor of giving it its first name: subprime mortgages”

Surely the president has his own ideas as to how the network of institutions that regulate and support the international economic system should be redesigned. But what is really interesting is observing the variety of analysts and intellectuals from the entire spectrum who, with less humility than the Spanish president, claim to have the keys to explain the past and unveil the future.

In reality, the whirlwind of statements and manifestos being disseminated through both traditional media and the new spaces of social expression provided by the Internet ends up being natural. In light of the financial disaster and widespread uncertainty, many are looking for the final revelation of the road to salvation, the formula that will forever protect us from instability, crises, and the atrocity of capitalism.

THE ROOT OF THE CRISIS

In order to be able to visualize potential solutions, it is important that we understand how we have gotten here.

“There is not much logic in thinking that so many different financial executives have joined forces in order to take actions to result in the bankruptcy of half of the world’s finances” At the root of this crisis we can find the element that has had the honor of giving it its first name: subprime mortgages. It is a sophisticated and rather elegant name for a phenomenon with such unpleasant consequences. What is important to understand is that a great number of mortgages at low interest rates were granted, and this low interest rate implies that their risk was not properly reflected. As such, a large part of these loans began to become essentially insolvent.

Why did it happen? How is it possible that the brilliant economists and well-paid bank executives did not warn us about the spread of these junk loans?

Those who love conspiracy theories are probably sure that said people knew exactly what was happening – and even foresaw the end – but did nothing because they always have an intricate plan worked out to make sure that they end up with the money.

Even if it might be that some executives have a legal or ethical professional responsibility for the neglectful spread of the subprime loans, it is hard to explain how so many people from different financial companies in different countries coordinated together so efficiently in a fraudulent plot to take people’s money. There is not much logic in thinking that so many different financial executives have joined forces in order to take actions to result in the real or potential bankruptcy of half of the world’s finances.

A HUMAN ERROR?

The key lies in understanding the essence of the banking activity behind all of the paraphernalia of complex modern financial operations. When it comes time to grant loans, banks must answer the basic question regarding where the funds are headed: is the project to which the loan is being allocated a good deal?

“There is no way to scientifically determine the point at which prices have increased so much that they no longer reflect genuine demand, but have actually entered the bubble stage” It appears simple. However, the misleading matter in this process is that formulas to determine with certainty whether a project is a good deal or not do not exist. Banks, using sophisticated tools of valuation and risk measurement, can evaluate if a project, whether it be the installation of a plant or the purchase of a house, is profitable and sustainable. However, these techniques are useless if the assumptions about future events are incorrect.

In reality, the most important tool in business evaluation has little to do with sophisticated techniques. Instinct is the true guide when it comes to determining which businesses will be successful. Great entrepreneurs are neither economists nor engineers, nor people of any occupation in particular. They are people with good instinct and vision who manage to put their gut feelings above the uncertainty inherent in any project.

Obviously, possessing a superior business instinct is not a common skill. The majority of mortals, including qualified professional financiers, have an average business vision, at best, one of the average skilled person. That is to say, they know neither more nor less than the average person, and this tends to lead to the formation of business trends that depend on the actions of the majority. Consequently, the natural behavior of people often tends to create market bubbles. There is no way to scientifically determine the point at which prices have increased so much that they no longer reflect genuine demand, but have actually entered the bubble stage.

WISHFUL THINKING ABOUT THE BUBBLE

On the other hand, within the context of growth and prosperous markets, it is not necessarily expected that brokers will realize when they are in a bubble. Today many people accuse economists and financial executives of not having timely identified the fragility at the base of the loan expansion. Explanations given in hindsight always seem to be obvious.

“It is easy to blame bankers for contributing to the bubble with the irresponsible promotion of mortgage loans” However, there is a universal phenomenon of human behavior that helps to explain part of the story: wishful thinking. This term is governed by the concept that we humans are naturally biased to expect the results of a specific situation to be more positive than logic and evidence indicate. Basically, this means that in a situation in which things are turning out well, we naturally expect that the good times will last, and we tend to not focus on the potential threats to the prosperity. This behavior – so human in nature – is a factor that explains market bubbles much better than conspiracy theories that attribute the catastrophe to powerful speculators who always end up taking a big piece of the pie home with them.

The growing real estate market prices in different cities around the globe during the past ten years (and even earlier than that) indicate that, up until very recently, various people all over the world were not too convinced that a bubble existed. It is easy to blame bankers for contributing to the bubble with the irresponsible promotion of mortgage loans; however, neither those who took the loans nor those who invested their own funds in real estate would have continued buying up property if it had been foreseen that the prices would eventually nosedive.

Financial institutions put their faith in the trend of growing real estate prices, in the same way that many people all over the planet did. Clearly, they were mistaken… who will cast the first stone?

A MAGIC CURE

“One of the traditional flags waved by the political left is a demand for broad (if not not lax) credit policies focused on the people There are two words that are constantly thrown around these days in reference to the future of the financial system: control and nationalization. It is not difficult to see that they are two concepts at the center of the classic ideological battle between the liberals, who favor the market, and the interventionists, who favor the role of the State.

In the current scenario, the second group, which nowadays is politically associated with the left or progressivism, naturally rules the roost. In light of the apparent failure of the markets to create sustainable prosperity, it is easy to point an accusing finger at the liberal side.

However, it is worth carefully examining some of the arguments that are most often wielded by the accusing side.

“It is important to understand that regulation functions principally in familiar situations”

One of the things for which the market is being condemned during the current crisis is its irresponsibility and lack of control in view of the spread of so many junk loans. However, it is interesting to note that, one of the traditional flags waved by the political left is a demand for broad (if not not lax) credit policies focused on the people. What happened with the subprime mortgages was that the loans reached a great mass of people with modest economic resources, which is precisely what the left is clamoring for. Therefore, we should ask whether the demand for stricter controls over expansive loan policies is compatible with its classic positions.

Another of this sector’s common demands is to curb speculation. However, as we have already analyzed, there is no scientific formula to determine when prices have reached a speculative level. In the end, defining a scenario as being one of speculation boils down to a discretionary human decision. To whom will we give the power to determine this critical point? It does not seem very democratic to have the decision of an official carry more weight than the free decisions (expressed through transactions) of the people.

GETTING USED TO THE SURPRISE FACTOR

In contrast, it is important to understand that regulation functions principally in familiar situations. Logically, it is impossible to design a system to efficiently control and regulate unknown elements. The innovation that is constantly being developed in the financial markets makes it impossible in practice to design infallible regulatory systems. “In many cases, state banks are sources of corruption and embezzlement, with absolutely no transparency” Unless we have decided to stifle innovation, which does not seem like a desirable objective, we must get used to the idea that the possibility of being surprised by unexpected phenomena will always exist, and the only option will be to search for new creative solutions.

The idea that markets need some regulation is something that practically no liberal would dispute. But aggressively suggesting that the time to control and regulate the markets has come does not mean much if we consider that the real difficulty lies in defining the level and characteristics of that control. Expecting definitive clarity in an organism of financial control carries with it a strong element of self-deception.

With respect to nationalization, the effectiveness of this solution is even less clear. There is no clear evidence that the nationalization of the financial system will guarantee greater prudence and stability in the administration of people’s savings. In many cases, state banks are sources of corruption and embezzlement, with absolutely no transparency. Moreover, the financial systems of countries in which the State has a stronger presence, such as Germany, have encountered the same problems as the more liberal systems.

Surely, the liberal side has a lot to reflect on regarding the current crisis, as Alan Greenspan recently admitted in front of the United States Congress. However, as we have seen, finding answers is not as simple as changing teams.

THE LIGHT AT THE END OF THE TUNNEL

It is hard to predict what type of institutions or agreements will emerge from the next G-20 summit, but what we can be sure of is that the appearance of a light at the end of the tunnel (a crisis proof system promoting egalitarian prosperity with guaranteed stability) is not the most expected result.

However, crises create new possibilities for cooperation. They open up new windows to understand, improve and innovate, as has repeatedly occurred during previous crises. It is fundamental that we face these processes without prejudices, and be open to the contributions of different sectors (including those that have supposedly failed), capitalizing on what history can teach us and refraining from pursuing definitive solutions.

While many people expect that the turmoil will lead to the sounding of capitalism’s death knoll, others will try to look for new ideas to revive the market pull, improve and innovate, and promote the creation of wealth. If we can be sure of something, it is what the expert chaotician Dr. Ian Malcom repeated in Jurassic Park: Life finds a way.