Bubbles and The Current Financial Crisis

--- Still Relevant after three years!!!

Source:http://desicritics.org/2008/10/21/143655.php

OPINION
Bubbles and The Current Financial Crisis
October 21, 2008
Ravi Kulkarni

"Bubbles! Bubbles!... My bubbles!"
-a cartoon character from Finding Nemo

Is there an end to the current financial bloodbath that is plaguing the world markets? Like a recursive nightmare, you wake up from one nightmare to find yourself in the middle of another. I am still in the middle of my productive career, and I don't find it amusing that my life savings go down 5% everyday. I just can't imagine what it must be for those who are staring retirement in the face or who have already retired. The only light I see at the end of the tunnel is the proverbial headlight of an approaching express train.

Folding banks, closing auto dealerships, collapsing companies, massive layoffs, government defaults; the looming specter is stunning. Many pundits are saying that this will be a mild recession and we should be back on track in a couple of years. In particular let me quote the following:

'Standard & Poor's chief economist David Wyss expects a mild recession that ends next spring. "Gradually we will regain confidence in the market. Lower oil prices and a falling trade deficit will help," he says. "This is a financial panic, not an economic one." '

I don't know what weeds these people are smoking. A lot more bad news awaits us. What we are seeing today is a result of 60 years of unbridled growth and reckless spending. The dominoes are falling and there is no telling when or where they will stop. They blame it on many factors: corporate greed, extreme leverage, wall street excesses, mortgage crisis and so on.

I remember reading this article by S Gurumurthy of RSS. Though the article itself has been ridiculed by the economists and intellectuals in various forums, and there are some factual errors in the numbers quoted, I felt there was an element of truth in it. This article was written in 2002 or thereabouts. Common sense tells me that I can not continue to spend more than I have. A day will come when the bill collectors come calling. This is true for individuals and also true for institutions. But there is a white elephant in the room everyone seems intent on ignoring.

I laughed out loud when President Bush doled out money to people as a stimulus package. The trouble with the economy was not that people were not spending enough; it was that people have spent way too much and they can no longer finance their profligate ways. During the last several years rate of personal savings by Americans has turned negative. The so-called stimulus package only inflated various bubbles a little more. Besides it encouraged people to be even more reckless with their money.

Since the 1940s, America has managed to build a huge economy based on consumer spending. It starts with how money is created (primarily through bank lending, see here). Every time someone borrows money (say to pay for a new car), the system creates a little bubble and new money is injected into the system. This money is supposed to be taken out at a later stage when the loan is paid off, but people keep spending money all the time so the money is never really destroyed except during serious economic contractions. This is not specific to the US economy, most of the modern economies have grown in this way.

This bubble creates other bubbles. Consider this: when there is more economic activity, the governments have more tax revenue and therefore bigger budgets. The current political wisdom tells us that the money should be spent immediately on populist and not-so populist schemes such as the earmarks. After all, one must get elected again in a few years. Once a particular expense head has been created by a government, it seldom goes away. Many economists argue that deficit financing is good for the economy. Wars and natural disasters have contributed by further expanding the budgets. Among certain quarters, there is almost a macabre glee whenever natural disaster such as an earthquake or a hurricane hits.

Without intervention this unstable system will seek some stability through cyclical economic downturns and many of the bubbles will gradually deflate. There have been downturns in the American economy, such as the recession of 80s and 90s, hyper inflation of 70s, stock market crash of 1987 and dotcom crash of 2000. Every time the government intervention has been short sighted with no attention paid to long term consequences of these actions. None of these events convinced the political leaders, financial leaders and individuals that they must spend less than they have or else...

If you remember the dotcom bubble of the 1990s, many people believed that the stock market will never go down. Ditto with housing markets of early 2000s. Similarly for too long, investors all over the world have nursed a belief that dollar is a safe haven and Americans will never default. This has caused them to send money to America in unrealistically large amounts of money through real estate investments, government bonds and lately purchases of assets of large financial institutions. This has significantly contributed to the financial bubble.

To keep this bubble inflated, governments and institutions have to spend more money and foreigners have to keep pouring their savings into American economy. To encourage these events, the lowest pillar that is bearing the weight of all these bubbles, our friend Joe, must keep spending. The trouble is that Joe can't spend any more money because his account is overdrawn. Nobody is willing to lend him either.

The credit crisis is a sign that people have understood the true nature of our economy. Money in my pocket is better than money in yours. Nobody trusts the bogus credit ratings of individuals and institutions anymore. At some level one can blame the banks for lending to one and all, but the blame must be shared by everyone; legislators for not providing enough oversight; bankers for not ensuring the borrowers have capacity to repay; borrowers for being greedy.

Americans have a total debt of about 120% of the GDP. The companies collectively have a debt of 160% of the GDP. Total American debt reached 53 Trillion dollars. That's about $176,000 of debt for each resident of the country. People and institutions have leveraged way beyond their means to pay back. To paraphrase Nouriel Roubini, now "the housing bubble, the mortgage bubble, the equity bubble, the bond bubble, the credit bubble, the commodity bubble, the private equity bubble, the hedge funds bubble are all now bursting at once in the biggest real sector and financial sector deleveraging since the Great Depression".

The casino culture has taken over the American financial markets. Short selling of stocks is the most obvious and glaring example of the gambling that savvy stock market players indulge in. There is also the futures market for commodities. For example the much maligned speculators who have presumably driven up the price of oil and other commodities. In the 1990s new instruments of financial trade called derivatives were created. These are the CDOs, the CDSs and many others from the alphabet soup, which Warren Buffet famously called financial instruments of mass destruction. That bubble is now worth 55 Trillion dollars. To put it in perspective, it is more than the annual gross product of the entire world. This is nothing but suicidal gambling by large financial institutions hedge funds, and wealthy individuals with no added benefit to the society at large. This is another bubble that is waiting to burst and who knows what happens then.

If my hypothesis about the economy is correct, then there are three ways this crisis will resolve itself. Firstly the obvious one, in which there will be a catastrophic crash of markets and institutions all over the world. This will be too chaotic for anyone to predict the sequence of events accurately. The consequences are too horrific even to contemplate, but humanity will survive. It may take a decade or two to recover to some semblance of normalcy.

Second way is that the current patchwork of interventions will work and somehow the world markets will be stabilize. However, I think this only be temporary and we will come back to the same situation sooner or later, perhaps with a bigger bubble, because we not really addressing the underlying causes.

Third way is when our leaders act responsibly, the markets respond in a sane manner and people correct their ways. Government will stop wasteful spending, wall street will stop being greedy and people will start saving more responsibly for their retirement and their children's education. If by some miracle this sequence of events comes to pass, then it will still take a couple of decades for us to come back to stability. The reasons are obvious, the the bubbles are simply too large and they can't be deflated in a short time. However the likelihood of this happening are extremely remote. Consider:

Law makers are short sighted and often ignorant
Government likes to keep borrowing to spend even more money and has zero credibility with the main street having spent all of its political capital waging pointless wars
Washington is full of wested interests, but none protecting Joe's interests
Wall Street has a short memory and within a few years it will retrace the history
Regulators have no credibility as they are either corrupt or ideological but almost never right

This problem is not unique to America. I am only using her example because I have lived here for the last 8 years or so and seen what is happening first hand. I am sure similar things are happening in many other countries as well.

The situation is rather bleak, but people change only when there are catastrophic events that overtake them, or a JFKesque leader guides them. Is Obama the JFK of our generation? I sincerely hope so, but I am very skeptical.

What are the lessons for India in this crisis? Unfortunately I don't believe India will escape it unscathed. The only silver lining is that India is not yet that highly leveraged that it will suffer as deeply as the US. However, India is following the path that US took in the '50s and '60s. We can yet avoid it by ensuring that the truly important issues are addressed and never compromised in the name of capitalism. These issues are, savings for retirement, ensuring universal health care and providing good education to all those who want it. Most importantly we should not build our future on bubbles.

Ravi is an IT professional with a penchant for philosophy, numbers, science fiction, chess, economics, hindustani classical music and... you get the picture. He has much to say, but not enough words to do it. He welcomes any criticism, sincere or otherwise, and will not take anything personally.
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NEO-ECONOMICS: SAVINGS AS SIN, SPENDING AS VIRTUE By S. Gurumurthy, 18 Aug 2002

Japanese save a lot. They do not spend much. Also Japan exports far more than it imports. Has an annual trade surplus of over $100 billions, that is Rs.5 lakh crores. Yet Japanese economy is considered weak, even collapsing.

Americans spend, save little. Also US imports more than it exports. Has an annual trade deficit of over $400 billion, that is over Rs. 20 lakh crores. Yet, the American economy is considered strong and trusted to get stronger. Indeed a contrast.

But where from do Americans get money to spend? They borrow from Japan, China and even India. Virtually others save for US to spend. Global savings are mostly invested in US, in dollars. India itself keeps its foreign currency assets of over $50 billions in US securities. China has sunk over $160 billion in US secur! ities. Japan's stakes in US securities is in trillions.

Result. The US has taken over $5 trillion from the world. Want to know it in rupees? Rs. 2,50,000 crore crores! So, as the world saves for US, Americans spend freely. Today, to keep the US consumption going, that is for the US economy to work, other countries have to remit $180 billion every quarter, that is $2 billion a day, to the US! Otherwise the US economy would go for a six. So will the global economy. The result will be no different if US consumers begin consuming less. A Chinese economist asked a neat question. Who has invested more, US in China, or China in US? The US has invested in China less than half of what China has invested in US. The same is the case with us. We have invested in US over $50 billion. But the US has invested less than $20 billion in India.

Why the world is after US? The secret lies in the American spend, in that they hardly save. In fa! ct they use their credit cards to spend their future income. That the US spends is what makes it attractive to export to the US. So, US imports more than what it exports year after year. The result. The world is dependent on US consumption for its growth. By its deepening culture of consumption, the US has habituated the world to feed on US consumption. But as the US needs money to finance its consumption, the world provides the money. It's like a shopkeeper providing the money to a customer so that the customer keeps buying from the shop. The customer will not buy, the shop won't have business, unless the shopkeeper funds him. The US is like the lucky customer.

And the world is like the helpless shopkeeper financier. Who is America's biggest shopkeeper financier? Japan. Yet it is Japan which is regarded as weak. Modern economists complain that Japanese do not spend, so they do not grow. To force the Japanese to spend, the Japanese government exert! ed itself. Reduced the savings rates, even charged the savers. Even then the Japanese did not spend. Their traditional postal savings alone is over $1.2billions. that is. Rs.60 lakh crores, about three times the GDP of India. Thus, savings, far from being the strength of Japan, has become its pain.

What is the lesson? That is, a nation cannot grow unless the people spend, not save. Not just spend, but borrow and spend. Dr.Jagdish Bhagwati, the famous Indain-born economist in the US, told Dr. Manmohan Singh that Indians wastefully save. Ask them to spend, he said. On imported cars and, seriously, even on cosmetics! This, he counseled, will put India on a growth curve. But like Japanese we too are not obliging. Modernists may not, but one who has read the Mahabharatha will, know. A Rishi by name Charuvaka gave the same advice when Pandavas were around, which modern economists are giving today. He told the people to spend and be happy, if need be by b! orrowing. No need to repay, if you cannot, he counseled. No sin would attach, he assured. Fortunately his advice was rejected by us thousands of years back. That is why perhaps we are alive as a nation. Our old companions are in archives today. Now we have the very same advice. That is saving as sin, and spending as virtue.

This is central to neo-economics. Caution. Before you follow these neo-Charuvakas, get some fools to save so that you can borrow from them and spend, after you exhaust your savings. This is what US has successfully done in last two decades.

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