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Another take on the cause of the recession.

As words like global financial crisis, credit squeeze, bank rescues get thrown around more and more often. There is no dooubt now that we’re in a global recession scenario. The only question left is just how bad it’ll get.

It’s interesting that on the same day, while the PM tells us not to over react, SM Lee was saying that the optimistic scenario was a recovery in 3 - 5 years, if the financial markets do not malfunction. That is a very very big if at this point in time.

I don’t know about you, but I’ll rather believe the father than the son.

Now they’re all sorts of reports out there on the cause of the recession, and what needs to be done to prevent it. The people are blaming the poilticians for the lack of regulation, the politicians are all blaming the greedy bankers, and the bankers are all too busy trying to not lose another more money.

The blame game is never ending, so I think it’ll be interesting to just step back and look at the macro situation from a global and slightly more academic stand point.

The cause of the crisis is an asset bubble burst, most notably a property market collapse. First rule in any market, if it can go up it can go down too. A lot of asians learnt that the hard way during the 97 Asian crisis. The Americans are learning that lesson now, and the Chinese are only starting to figure out that they’re not immune too. Fact is most people need to learn the lesson themselves, learning from other people’s mistakes just doesn’t happen.

Sure credit derivatives plays a part in the whole crisis, it allowed banks to carry on their lending to far more people and for longer than they otherwise would have, by allowing lending banks to sell the risk away to other banks and investors. Make no mistakes about it, the buyers of these credit linked products know what they’re getting into, as they’re professionals with their own systems and models to value them. Of course retail clients are another matter all together.Credit derivatives was a tool, and it played it’s part exactly as it’s creators intended it to. It diversified the risk of those lendings, far and wide, so much so that swiss and chinese banks are paying the price for an american mortgage default. And ultimately by spreading the cost of the collapse, it made sure that the world shared in paying the bill for a lot of the excesses in the US markets. But  the rest of the world is not a victim here, the world cheered and poured money in to the US markets when it was hitting new highs, sharing in the massive wealth effect of the bouyant market.

Sure bankers were greedy, but that’s the nature of finance, and a time and again, even the smartest brains in the world, with the most sophisticated models, will not take into account the effects of contagion. It has been proven time and again, that models are not infallible. A lot of banks and funds got burnt when their models blew up.

But blaming the recession on bankers or credit derivatives is like blaming the tree, when someone drives into a tree. It’s not the cause of the problem. The tree was involved in the accident, but the cause of the accident is the driver.

The cause of the problem in this case is leverage. Not just bank leverage, when banks lend out 40 times what they have in liquidy cash, but also consumer borrowing. It takes 2 hands to clap. And while banks were reckless lending, consumers were recklessly borrowing as well. It has been a known fact that US consumer household debt has been at an all time high since the start of 07. The consumer was addicted to debt, more precisely it was addiction to buying.

Not just in the US but everywhere in the world, economic growth has been fuelled by debt. Debt like any medicine is nto a bad thing when it’s used judiciously. But when all economies and companies are racing for higher and higer growth rates, you have to keep adding debt to achieve the ever higher targets. After all stock prices will only go up when your growth and profits go up, the market does not reward a flat profit, even if it is a good one.

In the end it’s the nature of capitalism, it’s prone to booms and burst. It will overshoot both on the upside and the down side. Capitalism certainly has it’s flaws, and it has no moral and social compass, so it rewards and punishes indiscriminately, but it is the most efficient system known to us so far. The alternatives ofsocialism, or in the extreme communsim, have over time proven to be less successful. Over the last hundred years, this capitalistic system has shown that it does create wealth and better the lives of the people in it, of course it has also recorded some spectacular crashes and in the process destroyed and disrupted a lot of lives but over time more people benefited from it.

And that is why it was heart breaking to watch Alan Greenspan apologise for his free market view. Sure he had his faults, and was at times deemed too market friendly, but no one can say he did not give fair warning on the troubles as far back as on 2004. Sincehis famous ” irrational exuberance” speech in the 90s, years before the dotcom bubble burst, he had always maintained that he could warn of market excesses, but that he could not stop them, and that personal judgements as to when and how to interfere will always be flawed. He did warn that when an bubble deflates, like is going on now, governments will have to step in to provide social support, because that is the role of the government. Purely from a logical stand point, I can’t fault him on any of those arguments.

So who is to blamed for this particular recession? I don’t think anyone really is to blame. The political witch hunt that is going on globally, and particularly in the US, is a propaganda exercise, to be seen as doing something for the people. Afterall giving the masses a villain to crucify, is always more crowd pleasing than actually doing something constructive, but it completely misses the point.

It is the job of the governments now to provide social support to it’s citizen and tax payers to ensure that they can ride out this storm as best as possible. Because these citizens were the ones who voted them into power, and paid their taxes into the coffers of the government, precisely for a scenario like this. 

Posted under: Money