Here's some thoughts on what went wrong...

There are probably a lot of people shouting out their causes for the slide in the stock markets over the past month, and maybe people who go as broad as covering the full year. My bet is that most of them are wrong.

A good way to test this theory is to quickly find people who have distilled the problems to 3 or fewer issues. As much as I’d like to buy that pill, there is no way a rational person can say that there have been only three factors contributing to the slide in the status of the world of finance.

I have put together a list of “causes” that I’ve complied from my study of macro-economics over the past 10 years. These are preliminary thoughts on the matter though. I have not had a chance to study the events of the past four or five weeks enough to say that any of them are certain or that the list is exhaustive.

This is just a starting point.

In no particular order (description to follow):

1. Elevated propensity to consume
2. Decentralization of debt
3. Barriers to entry in financial markets are to low
4. Predatory lending
5. Upper class decadence feed back loop
6. American Capitalism
7. Misguided investment, primarily in non-productive assets
8. ‘Understanding’ valued much less then ‘doing’
9. BS
10. Due diligence repeatedly ignored

Additions to this list are welcome, as are criticisms.

Elevated Propensity to Consume

This is one of the most technical points in the list of causes of the financial fall out causes. It stems from the economic theory of human behaviour centered on an individuals spending habits relative to income and wealth. What this theory says is that people have a tendency to try and maintain a stable level of consumption over time. What this means is that as people see their income or wealth rising in the future they will adjust their current spending patterns to consume more now in expectation of future payoffs.

It isn’t a difficult task to show that the public around the US, and possibly other countries, had (may still have) completely bought in to the idea that house prices and incomes were going to rise consistently into the future. This assumption seems not only to have been misguided but also hugely miscalculated. It appears to be the case that the American public not only expected house prices, asset prices, and incomes to rise steadily but that they expected them to rise at an increasing rate. These assumptions have also been striking because there appears to have been little consideration that any of these proxies for standard of living would stagnate and the notion that they could fall was thought not only improbable but inconceivable. Those who dared question common knowledge were promptly laughed off as the ranting of lunatics.

Additionally, it is possible that people have thrown off the notion of consistent consumption in favour of increased consumption today on the back of theoretically reduced consumption tomorrow.

All of these factors, the assumptions of constantly increasing income, the refusal to consider stagnation let alone reduction, the culture of personal justification of excessive consumption, all resulted in a ballooning individual debt burden.

Decentralized Debt

In January 2002 Argentina defaulted on a significant portion of its sovereign debt. This debt had been accumulated in the form of loans from the international community because in the period between about January 2000 and the eventual default Argentina was seen to be having a credit crisis.

The IMF, one of the major lenders who got burnt by the default in 2002, decided that it wanted to know what happened and commissioned a report by the Independent Evaluation Office (IEO) (http://www.ieo-imf.org/eval/complete/eval_07292004.html).

One of the problems that the IEO report noted was that in the run up to the default of 2002 the scrutiny of the health of the public finances in Argentina was not accurate due to the amount of debt held by individual states.

It is quite possible that this debt decentralization has occurred on a massive scale in the US, and possibly around the western world. There is no question that the Federal Government has run up, and continues to run up, a massive debt. There is also little question that the individual states are in dire straights when it comes to balancing the books. Consumers, aka ‘the public’, are also breaking under mortgages, credit cards, car loans, lines of credit, student loans, and other obligations. What is not commonly scrutinized is the amount of debt held by the corporations (which the Federal Government now seems to all but guarantee they won’t fail), the small businesses, and the other levels of government (the Financial Times recently had an article detailing the difficulties of municipalities in selling their bonds on the muni-markets).

It is quite possible that the decentralization of debt has obfuscated the extent of the debt outstanding in the US causing credit to be artificially cheap for long periods of time. It’s even possible that it is still to cheap right now, representing an undervalued risk premium for potential default.

Barriers to Entry in Finance Are to Low

It is clear now that things are really starting to fall out that there are a lot of people operating in the financial industry who have no idea what is going on. This would not have happened if more scrutiny of those people who operate in the global financial industry had taken place. A professional organization that backs a given title in the same way that ‘Engineer’ and ‘Doctor’ are backed by their own legislative body, would add significantly to the validity of finance.

An area that could easily stand this kind of regulation is the body of ‘Economists’. Currently ‘Economist’ is not a protected title, any one can call themselves an ‘Economist’ for any reason they feel like. This is particularly troubling because the media portrays them (people who call themselves Economists) as being authorities on matters financial, and in certain cases in other matters. A professional organization would do things like make sure that anyone who uses the title ‘Economist’ is held to certain standards of due diligence (if the shit hits the fan they have to prove they did their work), standards of economic modeling, and they will be held accountable for forecasts that can be proven to be wrong.

Predatory Lending

It is clear that the incentives and the pressures to expand and grow were causes of some of the worst cases of mortgage lending around the US. These mortgage brokers took advantage of people who did not understand the nuisances of the financial obligations they were taking on. It is possible that not even the mortgage brokers understood the scope of these responsibilities. In either case it is the brokers who should be held responsible for the messes they have created. Figuring out how to do that will be difficult. It may simply involve letting the companies who were the worst offenders fail.

Upper-class Decadence Feedback Loops

This conceptual argument is based on the ‘Keeping up with the Joneses’ mentality of suburban America. It notes the sociological pressures that people feel to live at the same standard of living as those around them, their peers, their co-workers, and their family. The Western world has been under this effect for decades now. The constantly increasing standard of living is almost unnoticeable to those living in the Upper-classes (all of America) but is quite stark when compared with developing world countries.

Two generations ago a washing machine was a luxury, as was a TV. Now TVs, washer, dryer, refrigerator, dishwasher, microwave, DVD player, computer, air conditioner, heated pool, internet connection, phone connection, running water, 24 hour power, cell phone, cable TV, and radio are all considered near basic standards. It is not long before houses without an air conditioner are the exception not the rule.

These increasing standards in the upper class world have been feeding back upon each other faster and faster in the past two decades. It has caused a sense of

American Capitalism

Originally capitalism involved providing labour in exchange for money, living below the highest possible amount of consumption to save money, investing saved money in productive capital, using productive capital to generate more money. Unfortunately this model has evolved to the point where the cycle breaks down early on.

People have not been consuming below their maximum potential rate of consumption, they have not been saving so that they can re-invest. This break down in the second step, and the consequent break down of the third step, has lead to the American Capitalism which is based on borrowing money to invest and then trying to make more money then the charges being built up by the interest rate.

It is not that this American Capitalism is impossible only that it involves a lot more risk and the down side of the risk is a lot steeper. If an investor fails in their capitalist venture they *only* loose all they invested. If an investor fails in their American Capitalist venture they not only loose all they invested but they also end up owing money after they have nothing.

Could this failed American Capitalism model be aggregated and applied to a whole nation?

Misguided Investment

The evaluation of the problems that arose in Latin America in the 1980s and later the specific case of Argentina in the late 1990s found that a significant amount of the debt that had been built up had been used to fund consumption and/or had been invested in other countries around the world. Specific examples include the marked increase in imports of wine and perfume. These uses for debt were cited as one of the major factors contributing to the eventual crises that arose in the region. The debt had been intended to be invested in productive assets that would generate long term gains for the whole country.

The same case can be made for the investment in the United States over the past two decades. The massive debt that has been generated has been invested in consumer goods, housing, and cars. Although cars and housing can be productive given the right conditions, they are not generally classified as productive assets. They are by no means creative (assets that create something), they are at best speculative or facilative. The sizable amount of debt stored in housing is most disturbing as it will be difficult to convert to anything productive without immigration or other forms of population expansion.

‘Understanding’ valued much less then ‘doing’

In finance and in many other industries there has been an undue amount of pressure and associated reward, placed on actions, even actions that are wrong. This is evident in the time allocation choices of business. Time is generally considered ‘wasted’ if no concrete output is produced. The intangible gains from building understanding and knowledge have no verifiable output, as such there have been no rewards associated with them.

For example, a worker who spends half a day studying a situation and half a day carrying out a solution is not compensated as much as a worker who ‘produces’ constantly, even if a large amount of the time ‘producing’ is correcting mistakes they (or others) created because they were ‘doing’ things they didn’t understand.

The pressures for sales and constantly increasing revenues, numbers, and metrics has clearly been assigned a premium in terms of compensation in the financial markets. The fall out has, and the subsequent silence of people on the issue of where things are going, shows quite clearly that those who were doing did not understand what they were doing.

It is inconceivable that a nuclear scientist would be pushed to make more power using processes they didn’t completely understand, yet financial instruments that effect the whole interconnected global economy have been sold without a premium on understanding. This type of approach would never be accepted in the scientific community, why is it accepted in finance?

BS

Too many people have been simply hiding behind the taboo of asking someone if they read something or if they did the math. This needs to change.

The global economy has become too intertwined to allow decisions to be made by people who do not take the time to ensure that they are well informed.

Case in point, the plan ratified by the senate on October 1st, 2008 which authorizes $700 billion worth of financial aid for the economy is 451 pages long. It seems unlikely that any of the members of senate had a chance to read the whole document they voted on. It seems even less likely that those who did have a chance to read the entire document had the time to scrutinize it, to consider its implications, and to consider alternatives. It begs to question, how many people actually analyzed this massive package? Who were they?

Due Diligence Repeatedly Ignored

Once again referencing the IEO report on Argentina, the report concluded that one of the causes for the problems was that investors assumed that the support of the IMF was all they needed as a criteria for investment in the broader economy. It speculated that many of these investors should have carried out their own due diligence to ensure that their investments were protected.

The Western world has been suffering from the same type of herd mentality. There has not been enough scrutiny of the complex structures of debt or of the broader financial institutions which have been directing the significant funds of millions of people. It is difficult to sympathize with people who did not carry out their own due diligence. It is despicable that those who have professed to be doing so as a part of their career have not been doing it.