Wednesday, May 25, 2011

When free markets fail

THREE years ago, the world narrowly averted an economic meltdown resulting from the United States sub-prime home loans crisis. Today, the euro zone is struggling with the massive sovereign debts of seve-ral of its weaker members


Economics writer John Cassidy wonders whether the world has truly understood the roots of the 2008 crisis, or is simply biding its time until The Next Big One.

The 48-year-old staff writer from The New Yorker magazine, who was in town recently to give a talk at the Civil Service College, told The Straits Times: 'Governments have learnt some lessons, but perhaps not enough of them.'

Governments now know, for example, that free markets are not fail-safe, and 'active government intervention can forestall a global economic collapse'.

However, he fears they have not quite grasped the underlying dynamics.

At play is what he calls 'rational irrationality', where actions taken by people may be rational on an individual scale but completely irrational when taken collectively.

The financial crisis, he argues, was not singularly the result of greed, fraud or a failed government policy, but of all the individuals in the food chain pursuing their rational self-interest.

Low-income Americans, for example, were acting rationally when they bought homes with 100 per cent loans because it amounted to a cost-free way to make money from the housing bubble. The banks were similarly rational in dishing out such loans as they received commissions on the loans. They did not have to worry about repayments as they palmed these mortgages off to Wall Street firms.

'As long as the market holds up, it's a perfectly rational strategy, so rational that if you don't do it, you lose out.'

While many of Wall Street's head honchos were fingered for the disaster, Mr Cassidy calls them 'cogs in this machine'.

'They can't really opt out even if they wanted to,' he says.

He adds: 'Most traders don't have a long-term basis because they are judged every quarter... The best thing to do is to try and mimic everybody else.'

In the financial market, it does not pay to be a contrarian. Traders are not punished for doing badly when everybody else is doing badly. But they can lose their shirts for hanging back while their peers are busy chasing profit, however dubious the circumstances.

'It's sort of sensible to be stupid, sensible to follow the crowd,' he says.

Someone working in a financial magazine or institution would feel immense pressure against taking a bearish stance on a speculative boom because that is against the interests of his employer.

'The guys who warn against it early, most of them are fired by the time the bust comes.'

In fact, even those not in the financial trade will find it easy to get caught up in the 'self-fulfilling' bubble.

It is in everybody's interests to keep the good times coming. Advertisers bank on sales made when sentiments are good, while the media industry enjoys higher advertising revenue. Even governments cherish such bursts of activity as they look like economic booms and generate tax revenue.

What all this means is that the financial industry needs to be kept on a tight leash, says Mr Cassidy.

He cites a little-known fact that even the 18th-century economist Adam Smith, who introduced the world to the idea that the 'invisible hand' of the free market allocates society's resources efficiently, had advocated the idea that banks be regulated to stop them from lending too much.

Centuries later, the world has been reminded that banks are 'like nuclear power stations' that can cause 'enormous damage' when they go wrong.

They provide essential services as intermediaries between savers and borrowers but have spawned an industry that may be too bloated for society's good, according to Mr Cassidy.

'People are overcompensated,' he says. 'The great mystery is how it sustains itself.'

He poses a puzzler: Microsoft founder Bill Gates is a billionaire because of the software he created, while Apple founder Steve Jobs earned his fortune from computers and related products. But bankers earning millions of dollars do not seem to create anything of genuine social value.

'In the financial industry, a lot of things which seem to be creating real value are ultimately just seeking rent.' Traders can create what look like profits on a short-term basis and be able to walk away with huge stock options and bonuses before the losses from the failed investments are realised, Mr Cassidy contends.

In essence, the financial world is a key example of an industry where the laws of the free market fail. The usual supply and demand pressures do not create the best allocation of resources because most financial products are opaque by nature.

Then again, the idea that the completely free market has always driven global growth is a 'myth', says Mr Cassidy. The 'mechanism which delivers wealth and freedom and opportunity and works by itself' has never existed.

In almost all economically successful countries, the state has played a leading role in the early stages of development.

'That's true of the United Kingdom, it's true of the US, and now in the late 20th century, it's been true of India and China.'

Leading American aviation companies Boeing and Lockheed Martin got their edge with technological advances developed together with the US Department of Defence, he notes. Britain and the US sponsored authoritarian regimes in the Middle East to gain access to cheap oil, and this strategy is being similarly deployed by China in Africa.

Still, he frowns on 'making underhand deals with African dictators'. China is 'big enough, powerful enough and financially strong enough' to be more transparent in its deals and is also rapidly approaching a stage in its development where it has a lot to gain by falling in line with international trade rules.

'Once you become a successful exporter of goods and services... and once you move into higher-value industries, then things like intellectual property rights start to work for you too.

'The Chinese won't want everybody else stealing their technology.'

Closer to home, the nature of state involvement in Singapore's economy also needs to be calibrated according to the level of development.

Singapore has a tiny domestic market - just five million people - so the state has a role to play in building up the capability of domestic companies.

'If you are just relying on pure market forces, local businessmen, there is an issue of whether they can build sufficient scale to be able to compete with international companies.'

The role of the state, however, diminishes as a country gets richer and local companies gain market traction.

This is because 'economic success is based on innovation' after a certain stage. State-led economies have generally fallen down on this front as they are too far removed from the commercial discipline that market conditions can mete out.

Still, he reiterates that there will always be some sectors that require keen regulation because the market will not keep them in check.

'The financial sector obviously is a big one.'