Friday, April 24, 2009

The Folly of the Blame Game at Davos

This year, the meeting at Davos was reported to be somewhat subdued. One of the most interesting news that came out of the meeting was the criticisms leveled by some participants towards others regarding their respective roles in bringing about the current global economic crisis. These participants seem surprisingly unaware of the fact that in reality the fault lies in the global financial system itself. Therefore, it is a mistake to put the blame on one or only a few parties when in fact everybody who is involved in the system is responsible for the crisis, albeit in different degrees.

The group receiving the most amount of criticism is people from the banking industry. Realizing that harsh criticisms will be directed towards them during the Davos meeting, many of them failed to turn up. The main criticism regarding the banks is that their reckless behaviour in providing loans, especially to sub-prime borrowers, was the main cause of the crisis. It is argued that as a result, the banks themselves got into trouble with many of them becoming insolvent. This had the effect of drying up the credit market thereby starving firms in the real economy of much needed funds for their operations.

However, in reality that argument is overly simplistic. In the first place the crisis is the outcome of a situation of over-indebtedness in the global economy and especially in the US and the UK. The sub-prime mortgage crisis merely represents a `tipping-point’ or the proverbial `straw that broke the camel’s back’. The proof of this is the current problems faced by firms in almost all sectors including the car and airline industries. The reason why General Motors, Chrysler and Ford are in trouble is that they are highly indebted companies whose operations rely on borrowed funds.

Moreover, blaming the banks alone for the troubles that are being faced is grossly unfair. As the English saying goes, “It takes two to tango”. Lenders cannot lend recklessly without the existence of borrowers who borrow recklessly. That is why whenever we read of stories about borrowers getting into trouble with loan sharks or Ah Longs, we cannot help but also apportion some blame on the borrowers too. The fact is, the problem of over-indebtedness in the financial system is not possible without the active participation of willing and reckless borrowers.

However, it will also be a mistake to pin the blame totally on `reckless borrowers’. Notwithstanding the reports on the US carmakers ownership of corporate jets, in reality the firms in the car industry are not in a state of high indebtedness through choice. GM, Chrysler and Ford borrow money because they need it to compete against their competitors from Japan and Southeast Asia who are themselves huge borrowers of money. In other words, competition from firms who borrow huge sums of money forces firms to also borrow in huge sums. Otherwise they will be left far behind.

Moreover, banks also compete against one another and therefore banks that are reluctant to engage in risky leveraging activities will be less profitable compared to banks that are not so risk-averse. Managers of the latter group will not be able to hang on to their jobs for long if their competitors were showing stellar profits. Competition in the banking industry also forces banks to engage in risky lending. The reason why some banks in the US lend money to sub-prime borrowers is largely due to the fact that their competitors are also doing it. As such not engaging in it would have meant lower profits compared to competitors.

One irony that needs to be highlighted is that now some people are still blaming bankers for the credit freeze saying that the reason the economy is not moving is because bankers are reluctant to lend. Logic will tell you that if banks realize that the reason they got into trouble was because they were not cautious enough when lending money, now that the economy is in a downward tailspin the banks must be extra-cautious when lending.

To be sure, the blame game at Davos also involved parties other than banks. The Chinese premier, for example channeled his criticism towards the American authorities for their failure to control the consumption binge of their consumers. However, this is also ironic because all this while the Chinese have been very proud of their booming economy, which would have impossible if the US had not been swallowing up Chinese exports over the past decade or more.

The American authorities on the other hand blame the Chinese for their manipulation of the exchange rates. According to the Americans, Chinese intervention to prevent the Yuan from appreciating was the reason Chinese exports remain cheap and why the US continually records a trade deficit with China. However, the US forgot that the core of the problem is over-indebtedness which is due to the willingness of American consumers to live beyond their means. Their overconsumption was largely due to the ease with which they can obtain credit rather than the cheapness of Chinese goods.

The blame game at Davos was therefore a pointless and fruitless activity. It is very much analogous to motorists blaming each other when getting stuck in a traffic jam. A more useful activity is to identify the root cause of the problem and to figure out a way to remove it.

But obviously this has not happened as evidenced by the willingness of many governments to stimulate their economies by using borrowed funds and to encourage banks to be more liberal in lending. As pointed earlier, the root cause of the problem is excessive indebtedness. Even a primary school kid can tell you that promoting further indebtedness in order to solve an economic crisis caused by over-indebtedness simply does not make sense.

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