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Bill Clinton reversed the Glass-Steagall Act, which separated retail and investment banking. Lucas Jackson / Reuters
Bill Clinton reversed the Glass-Steagall Act, which separated retail and investment banking. Lucas Jackson / Reuters

The Insider: Moral hazards grow when buyers do not beware

Political pressure allowed many people to get permission to participate in economic matters they clearly did not understand.

Moral hazard has entered current parlance with a vengeance that caveat emptor - Latin for "let the buyer beware" - never did. Newspapers report commentators growling with disdain at the suggestion of encouraging default.

Let's set some parameters to what moral hazard is. Fundamentally, it is where an individual or institution takes a risk and has the opportunity to allow the mitigation of some element off the downside at a later time. A potentially criminal action you might say. In legal speak, two elements are required to commit a crime: actus rea and mens rea.

The first deals with the act and the second deals with the conscious decision to commit that act knowing it was illegal. Given the scale of involvement in this recession, it is not reasonable to assume that the vast majority of participants understood the consequences. It was greed on a global scale and that is a human failing, not a statutory one.

How did so many people get permission to participate in economic matters they clearly didn't understand, couldn't afford and utilising tools beyond their skill sets? There were two elements at work, and in a push-and-pull fashion, globalised what should been kept at a national level.

First came political pressure and action to allow individuals to become homeowners (think the US); any individual, especially the ones who would typically trigger refusal letters by the physical act of entering a bank. The reversal of the Glass-Steagall Act in 1999, which separated retail and investment banking, by the then US president Bill Clinton set this proverbial snow pebble rolling from the top of Everest.

Financial institutions faced with reckless lending took a trick from the insurance world and created a reinsurance industry just for mortgages. Insurers insure you and then reinsure an element of that risk with specialist brokerages. This dilutes exposure. The mortgage industry took these politically driven mortgages, wrapped them with a few quality ones and sold them. Welcome to the sub-prime market.

Second came the unwelcome present of low interest rates in countries that had no history of the same. The anchor members of the euro have lower home ownership levels than the peripheral countries; hence, they also have lower long-term interest rates. With cheap euro money from prudent saving nations flooding the system, it was not long before it was being drawn down to finance a building boom worthy of Ozymandias, the poem by Percy Bysshe Shelley.

In the US, a political front blew open the door to casino chattels; in euroland, lower interest rates did the same. Once the beneficiaries had gorged themselves locally, they got on planes and exported their disease, buying up assets for any price, pure in their belief that a buyer was only a couple of months down the road at a comfortable mark-up.

This trail of construction devastation has left its debris everywhere, from Hungary in eastern Europe to the Middle East - unfinished, unwanted and in so many cases unpaid.

National expansion of money supply driven by debt pushed into local markets went global, pulling in uninvolved countries to expand and sustain their domestic bubbles.

Solomon's wisdom might be to judge governments guilty of idealism, financial institutions of monetary myopia and individuals of bandwagon greed, but finger pointing benefits only the legal profession.

Solutions are needed. So what are economists doing?

Last month, the American Economists Association, a non-partisan group, held its annual meeting and washed its professional hands of responsibility for not forecasting the current crisis. Such solidarity; given the maxim that if all the economists were laid end to end, they would point in all directions.

There are two schools of competing thought, both led by Nobel prize winners. In the left corner is the late John Maynard Keynes and government-led monetary intervention. In the right corner is the late Friedrich Hayek (Austrian Business Cycle Theory) and the application of a light regulatory touch to allow markets to clear.

In essence, the current debate comes down to the intelligence of money. Hayek would argue that the credit boom led to inefficient investment decisions as the best opportunities quickly dried up, and pouring more money into the economy would only exacerbate the problem. The market needs to re-establish its equilibrium.

Greece and Ireland have had turbo Hayek imposed on them by the IMF. Countries such as Britain are choosing to follow Hayek, Germany is with Keynes as is, strangely, the US. This is sadly because of the budget partisanship that today plagues Capitol Hill.

Never wasting a crisis, an intellectual (with practical outcomes) tug-of-war between interventionists and libertarians is in full flow globally and the outcome affects your assets. Like many experts, they're not consulting you. After all, they are the professionals, the same ones who missed the omens.

 

David Daly is the chief financial officer of The Sifico Group. pf@thenational.ae

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