Thursday, March 05, 2009

The Fall of Babylon

Give me back the Berlin wall

Give me Stalin and St Paul
I've seen the future, brother:
It is murder.

Arnold Schwarzenegger called it Financial Armageddon, and he is not alone in describing the current meltdown in apocalyptic terms. It is quite amazing how many educated men suddenly use biblical imagery, now that the financial party is over.

We created this mess, then repackaged it and sold it to the rest of the world. And the world blindly followed and bought into our flawed reasoning. One can be excused for thinking this is a sorry reference to the basic state of human nature.

It might be possible to get out of this, but the repairs will have to start here in the USA. But the real problem is the unintended consequences of our actions and the damage it has done to the world’s financial health. If we think the carnage it has wreaked on the American economy is severe, let’s just pause a second to consider the plight of other countries. Iceland is bankrupt; Russia seems to be teetering; most oil producing countries are in trouble; Eastern Europe is sinking fast; and so the story goes. Worldwide job losses could exceed 50 million by the end of 2009.

So which way will it go? Is there reason to hope, or will the whole situation spiral desperately out of control?

The Root of the Problem

Any solution to this crisis will depend a lot on fixing the fundamental reasons why this happened in the first place. So was it greed (according to Main Street), lack of regulation and oversight (Obama’s position), or a few bad apples (Wall Street’s take)? Surely, all of the above played a role. But for a better understanding one has to dig deeper.

The best explanation I have heard thus far was voiced by John Bogle, retired CEO of The Vanguard Group, who claims that something profoundly has gone wrong with American style capitalism:

The classic system (Owners Capitalism) had been based on a dedication to serving the interests of the corporation’s owners, maximizing the return on their capital investment. But over time a new system (Managers Capitalism) had developed in which corporations are run to profit and reward their managers “in complicity if not conspiracy with accountants and the managers of other corporations”.

This happened because corporate ownership has been so diffused by the modern markets that no responsible owner exists anymore, and because of the unwillingness of the agents of the owners (the boards of directors) to honor their responsibility to serve, above all else, the interests of their principals - the shareholders themselves.

In the final analysis, Bogle’s ideas are not that far off from Obama’s understanding: Since men are no angels, how do we safeguard the system against behavior that can undermine its very foundation?

Is Recovery Possible, Or Are We Toast?

If the problem was smaller, maybe Obama's plans could have worked. But as the AIG disaster is starting to show ($180 billion bailout, with another $300 billion of potential losses still outstanding - possibly more), even the US government does not have the money to pay back all who lost money.

Actually, they are not trying to do so, but only to support those who are critical to the continued financial health of the system. But the sad reality is that even this "smaller" hole might be too big to handle. For that to work we hope that overseas governments and investors will continue to fund our runaway debt. Unfortunately their problems are also mounting. So the question becomes, at what point do they start to back off?

As Buffett has just said, our last resort (the US Treasuries) is a horrible place to park money now. Why, because everyone is doing so - in effect creating another bull market. This means our debt is overpriced, and the yields are miserable. At some point the $9 trillion in short term money now hiding there might begin to flee, leaving us no other alternative but to print what we need. (To put this figure into perspective, the value of the entire US stock market is around $8 trillion and falling).

In the end our only choices might be to get this over quickly, or to extend the pain (which is what we are doing now). Either way, the eventual outcome will be brutal, beyond our wildest dreams.

But undermining our best efforts we have an even more fundamental problem: if our best minds could not prevent us from getting into this, how are those same people going to save us?

Is this just another hiccup in the world’s history? Or are we witnessing the final fall of Babylon?

I am not sure we know the answer.

No comments: