Sunday, May 16, 2010

Greed not the only reason for financial meltdowns

Published in The Tennessean, May 16, 2010

Greed not the only reason for financial meltdowns

by Richard J. Grant

Is Greece a derivative? Its government has certainly allowed the value of its debt to become dependent on outside events. Rather than face voters with the full cost of their demands, the Greek government has pushed off the day of reckoning by borrowing to the point of financial failure.

Few people take the trouble to learn about financial derivatives, so it is easy for demagogues to distract everyone by making derivatives the scapegoat for our financial crisis. But most derivatives are quite simple, and even the most complex ones still look like child's play when compared to the complexity of the macro-economy.

The biggest problems in our financial system have been caused, not by complex financial instruments, but by a repeated failure to observe the most basic rules of civil and commercial conduct. Mere greed is not the problem: greed has always been with us, and we have developed elaborate social means to redirect (if not transform) it toward positive goals. But all this breaks down when we fail to hold people to their word, when we forget that forgiveness should be edifying.

A century of bailouts and special protections has progressively conditioned the managers of large financial institutions to underestimate the risks that come with the pursuit of higher investment returns. The service of natural selection provided by market forces has been overridden by politicians often enough that each succeeding generation of managers has a less reliable menu from which to model best practices.

The financial industry is just one aspect of society. The perverse incentives that face politicians have encouraged a moral slothfulness that has affected all citizens. It is difficult to say “No” to a generation of voters that has been taught to believe that governments have an unlimited supply of money, immaculately conceived at no cost to society. There need not be a majority that holds such na├»ve beliefs in any society: they need hold only the balance of power to change the course of history.

The problem in Greece is at least that bad. The Greek government, despite having agreed in the treaty establishing the European Community to limit the size of its deficits and public debt, has allowed its public debt to grow to about 120% of its GDP. With increased debt comes increased leverage and risk, just as can be created with any derivative. But the question facing the Greek government is the same one that faces every mortgaged homeowner and every issuer of credit default swaps: Will you keep your promises?

The question facing lenders is just as important: What were you thinking? If your loans go bad, will you be able to keep your promises? Have you made adequate provisions, or will you come begging for bailouts?

We remember that the apostle Paul urged the Romans to refrain from doing anything that would cause their brothers to stumble. But just when Europe needed Dave Ramsey, we sent them President Barack Obama, not exactly a paragon of governmental thrift and good stewardship.

Obama spoke with French President Nicolas Sarkozy and German Chancellor Angela Merkel to urge "resolute action to build confidence in the markets." By a not so strange coincidence, the EU (and the IMF, which includes the US) has offered Greece a $1 trillion bailout. That'll teach them.

In the small consolation that world markets rose on this news, we are reminded of derivative results. The bailout money need not go directly to the lenders: a bailout of the Greek government will serve the same purpose. That'll teach them too.

The moral edification that is derived from the expectation that we live up to our promises comes from the practice of preparing ourselves to keep those promises. Each day that we prepare ourselves to live well without theft, fraud, or aggression is a day that we are able to help our fellows through trade, good works, and a good example.

Richard J. Grant is a professor of finance and economics atLipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays.

Copyright © Richard J Grant 2007-2010