Saturday, January 31, 2009

Economic Crisis: Was a Soft Landing possible?

Was there a way to avoid this messy Financial crisis? Could we have avoided this in the first place or at least could have arranged for a soft landing? Lets analyze some perspectives.

Greed, fear, artificially concentrated growth and Lack of proper oversight are the four main root causes of this Economic Crisis. In last decade or so we were behind easy money. Short term results defined the success. The policymakers never thought big enough for sustainable growth which needs inclusive growth. Don't make a mistake here. Inclusive growth does not mean just communism or providing free money to poor people. But this means creating more jobs in unexplored areas and new technologies to solve the biggest problems facing mankind(like green technologies, future energy solutions etc.). To
save capitalism from the capitalists we need to create wealth and buying power at the bottom of the pyramid and the only way to do that is to redistribute wealth by creating huge amount of well-paid jobs. Instead what we saw is huge difference in salary structure between the working class and the management class(The differentials between the lowest and highest paid have risen to 1:300). Very few people made enormous amount of money by doing some Investment Baking and Management jobs. Most of these people were creating some artificially inflated wealth by derivatives and different other esoteric financial instruments. They were also fantastic in packaging and selling these produts to common people who had no idea about what they were buying. For short term profit they sold home-mortgages to people who did not have capability to repay those loans. They thought that is not a problem as the price of homes will continue to increase indefinitely and in case of foreclosure they can still sellout the house and make profits. American consumer consumed like anything by taking loans from all over the developing world the world. The developing countries found opportunities in selling their products and services to the American consumer and all those earnings were again reinvested in US as Treasury bonds. Unfortunately this loop of lending and consuming can not sustain and nobody thought about systemic risks of all these transactions. People were greedy and lacked common-sense. Stock market prices of emerging markets gained like anything and people stopped valuating stocks by Financial ratios. At the same time common people were not getting the benefit. They did not have health insurance or retirement savings or consumption capacity. Still they were lured by tempting advertisements to lead a quality lifestyle by borrowing on Credit cards and buying homes on loans which they can not repay.Government and other oversight agencies never did their jobs by properly controlling this greed. Opportunistic market makers created cheat funds and ponzi schemes. Hedge funds charged crazy amount of service fees and made huge amount of over-the-counter(OTC) risky transactions. And the most interesting thing is that all these unsustainable business continued for more than a decade. And then came the shock! Home prices went down, Foreclosure rate increased,Stock market plummeted, Default rate increased on Credit card loans, million of jobs were erased, banks failed, thousands of business went bankrupt, government bailout continued without any positive results, credit market collapsed, government debt increased and everyone is today fearful and puzzled how all these happenned so soon.

Was there a way to avoid this crisis? The answer is Yes and No. Theoritically 'Yes'. We could have done right things at the right time. We could have had more effective oversight and compliance, we could have planned for right kind of human resource allocation(best minds of the nation could have done research on green technologies and work on solving future energy problems instead of creating esoteric financial contracts), we could have planned for sustainable job creation and wealth distribution for creating a bigger market. Connecting dots backwards is easy but life needs to lived only in the forward direction. Hence I believe considering the condition present at those times it was not possible to stop this crisis. When things are going good it is very tough to take hard decisions like increasing government control and executive pay, investing in not-so-attractive green technologies, controlling credit limits and thus creating better spending habbits of the people. Hence in practical sense this crisis was due.

Let's see if there are anything good we can make out of this crisis. What are those important decisions which can help us out of this crisis soon. Following is my recommendation:

Greed and Fear are the root cause of this crisis. First it was greed: which inflated prices by creating artificial demands and then it was fear: which deflated prices to the artificial rock bottom. I call it artificial because if you think critically you will appreciate that our capacity of supply and demand should not change so drastically. We had almost same number of people living in 2007 and 2008(actually more) and the total natural resources avaiable in the world was actually less. Then why our home prices were dropped so dramatically. Why limited natural resources like gas prices can drop so significantly? Why we needed so less products or services in 2008 because of which we had to cut so many jobs? The answer is that the market sentiment changed from greed to fear. Previously people were getting much more than needed and they consumed much more than needed. After the shock it just reversed. People started a selling wave in Share market, stopped any discretionary spending and the sentiment continued to drop. One way we could have(or in that we still can) ensured a soft landing was through adjustable pricing of everything we transact. When demand drops down share, commodity and home prices fall but few things do not change in so linear fashion. For example salary or value of a mortgage loan(in general sense value of currency). Instead what we see is job cuts, or mortgage foreclosures etc. This process creates shocks in the market and creates more problem in Federal budget. People loss jobs and they bcome unproductive. At the same time they continue to cost in unemployment benefits increasing federal defecits. During the housing boom period people had baught houses in very high valuations and now those property prices have dropped creating loss for sellers and banks having foreclosure inventories. This is a vicious cycle which continue to decrease the price of the properties and the foreclosure rate. How can we solve these problems. Reprice the instruments and share the loss through mark-to-market accounting so that this process stabilise soon and we can again get back to the right track. I would suggest ban any future job cuts and foreclosures. Instead start a price discoery process to reprice the salaries and property values. Typically I am suggesting to follow simple demand-supply pricing. If the job demand is less you need to accept the paycut(it is still better than unemployment right?). If the value of a house decreases it is still better to renegotiate the loan terms and stop foreclosures. In both these cases all parties(including government) need to accept some loss but that should stop the downward spiral fast.

Economy depends a lot on the market sentiment, risk-taking mentality and consumer spending. Hence one good way to help the economy to recover is to instill consumer and investor confidence. Today both leaders and media are saying all negative things about the economy. This is actually lowering consumer and investor confidence. Instead of this if the leaders and the media(President Obama and other leaders, CNN, CNBC, FT, WSJ, NY Times)start saying some convincing but optimistic views the Economy can recover faster. If all the people again start buying stocks, houses and products the economy will be back on track very soon.


Venu Madhav Tammali said...

Hi Abhishek ,

I think the blog was a very good read .You successfully listed( with reasons )most of the events responsible for this finanical mess.

Can you elaborate what exactly triggered the slump in home prices ( which according to you started the downturn ).

Abhisek said...

Demand-supply gap. Any boom starts with over optimisim that things will go well for ever and vice versa for the burst. Whenever any pricing(commodity/real-estate/securities)is not in line with the overall economic growth it must come down one day. Hence I strongly believe that the only way we can create sustainable prosperity is through economic growth by creating a larger market (inclusion of main street). Proper resource allocation and Financial prudence are the need of the hour. We were too much influenced by few greedy people who made a lot of money by showing virtual prosperity.