What will solve the credit crunch?

Saturday July 4, 2009

Since the end of 2006 and the financial crisis of 2007, which became universally known as the ‘credit crunch’ there has been much hand wringing and soul searching as to how this situation can be avoided in the future.  There is also a feeling that the credit crunch has to be ‘solved’, lessons learned and so on.

The credit crunch happened as a result of lenders taking risks and lending to people with poor credit ratings and/or lending at a higher rate of interest.  People struggled to make the payments.  Then foreclosures started, shortly afterwards the housing market was affected and the crunch happened, all in the period of a few months.

Banks, financiers and all kinds of businesses were to find that nothing (particularly not them) was sacred and no players on any financial scene would be safe.  Even banks such as the US bank, Bear Sterns, would find that one week they could seem in not too fragile a position, next week, they had folded.  Life suddenly started to look very bleak, not just in the US, but around the world, as the institutions that had made loans to the US lenders, suddenly found that they could not get their money back.

The problem of how to solve the credit crunch, is usually looked at in two ways.  First there is the old style view that regulation should be increased.  Instead of leaving everything to market forces, we should be actively seeking to regulate and to try to control both the economy and the activities of those who are the driving forces behind it.

The second way of looking at the credit crunch and how to solve it, is to think about actually just letting things be. 

Many economists and financial analysts simply look at the credit crunch in terms of shrugging their shoulders and asking, rhetorically “So what?”
Night follows day, they say, and thus a boom will always be followed by a bust.  So let things be, calm down, let everything alone and soon we will see things start to pick up.  It is how things are: it is the nature of capitalism, it is the natural laws of economics.

The third way is to innovate out of the mess.  That is for bankers and financiers to come up with new ways of regenerating the economy, of making things come back together again and move forward.  It involves leaving behind old ways of thinking and establishing a new way to meet the demands of our age.

Regulation : The Answer?

If we regulate an economy, then surely it becomes more stable, or at least that is how we can think about regulation.  The government drives the economy, controlling how much money is in circulation, how many new houses are built, it even goes so far as to launch new contracts, not because they are actually of vital necessity, but because they can actually make the economy pick up after some lean times.  Governments have even been known to go into debt to achieve this.

It is something akin to the Communist philosophy of the 5 Year Plan, where the whole economy was planned for a period of 5 years and nothing was subject to change.  No matter how desperately the policies planned were in reality, the government ploughed on.  Everything was planned, so even if it wasn’t working, then it would work eventually.  There was no deviation, no room for any innovation.  It was a definite.

Whilst many capitalist countries did embrace the ‘regulatory’ approach, in a much less strict fashion than the Communists, it was, and to some extent is still, perceived to be relatively successful.  After all, countries such as Japan and Germany have successfully regulated their economies and this has been successful.  However, Japan is certainly feeling under a great deal of threat in 2008, with a very precarious economy.

Regulation could be taken much further if we are to provide stability.  If businesses and the finance markets are more scrutinised and regulated, then we will have the ability to control them. 

One suggestion currently on the table is that if finance officials, bankers and businessmen all needed a licence to operate and do their business, then they would soon start to act ethically.  This could prevent activities that are phenomenally risky being undertaken and what is more, lenders would have to start being more careful about whom they lend to.  This would result in more caution being exercised in the world of finance and therefore we are less likely to see a credit crunch happening again.  It is a bit like a monitoring system. 

A code of ethics would have to accompany this licence and all those who were practising would need to be aware that they had to act ethically and with probity, or their licence would be taken away. 

A watchdog body would have to come into being, just to check that everyone was playing by the rules.  Standards would be set and everyone would know that their activities could be subject to scrutiny and this would rein them in. 

Lenders would only take minimal risks in terms of who they made loans to.  People would have to act responsibly and to ensure that they were making clients aware of the pitfalls of high risk lending.  Everyone would therefore act responsibly, everything would ‘become’ stable and phew, no more credit crunches.  Perfect bliss!

But the reality is probably that regulation would prove ineffective.  Even if quite stringent criteria are introduced to regulate those operating in the financial markets, there is one major factor that may well come into play.  If regulation is tight, then there will be some people willing to stretch the rules, which would mean that their rewards would be significantly greater than for others, who are playing according to the rules. 

Effectively this would mean that the small minority of traders and financial gurus, who pushed the boundaries and took the risks, would end up being the big winners.  All the others would potentially lose out.

Moreover, the strict regulation of the markets could lead to their becoming very stagnant and much less enterprising, as traders became more cautious and more worried that any ‘risky’ activity they may undertake could be viewed negatively by the watchdog.  So, instead of having booms and busts, we just have a steady, less buoyant market.

Potentially, there are also some political implications in terms of regulating the market.  Markets all now exist within the global framework.  This is a fact and cannot be ignored.  So, if regulation could be agreed as a potential for the way forward, then all major and some not so major countries would have to sign up to it.  If they don’t then some markets would be constricted by the regulations and others would not.  This hardly seems like a level playing field.

Then again, some countries could actually play some kind of double bluff.  Sign up to regulate their markets and how financiers operate and make loud noises about how important this is and why it really matters.  To the outside world, all seems above board and lawful.

But behind closed doors, certain governments could simply adopt a very lax attitude to actually enforcing the regulations.  Thus we have a system whereby on the face of it, everything would seem to be in order and yet an unfair advantage is gained by poor enforcement.  Again, this is hardly a fair system for everyone.

And are there dangers associated with the regulations of markets?  Well, basically the answer is a resounding YES.  The European Union found that Microsoft was acting inappropriately; because it had its product had windows already installed.  The ruling indicated that this was inappropriate because it was in effect running a monopoly. 

Whilst this may or not be the case, it does raise some interesting questions.  Is the role of the European Union to rule on activities of US companies?  Is the European Union going to become some kind of vigilante, hunting down and the ruling against any company, anywhere in the world that has ‘bad’ or unfair practices and policies?  Is the EU going to investigate a company like apple, with its iPods that rely only on iTunes? 

The EU may have made a bad call with regard to Microsoft, but the scary thing is that if regulation is increased, then bad judgements and enforcements or rulings will be made: no system is perfect and so there will be errors made.  Could this potentially be worse than no regulation?

There is also another reason why regulation may not work and that is purely down to the fact that we live in such a technological age.  Gone are the days when money could easily be tracked, accounted for and sorted out.  Now, money can be moved throughout the world at the click of a few buttons.  If it weren’t so easy to move money around, the problem of money laundering simply would not exist.

But since it is so easy to move money around, it is also very easy for money to ‘disappear’.  Central Banks are already finding it almost impossible to regulate money coming in or out of countries, simply due to the fact that money is sent off shore, then it is sent back and comes in and out so often that it is practically impossible to monitor.  Consequently, there is potential there for hoodwinking any regulatory body by sharp practices of moving money.  And where there is potential for something, someone will take up the opportunity to make good use of it!

The laissez-faire attitude is completely market driven.  This approach lets the market have its own swings and roundabouts, its ups and its downs, its booms and then the busts.  Yes, there will be casualties, yes many people will lose out in the bust times, but then a lot of people will have had a ball in the boom times: so what is there to regulate, just let it happen and leave things be.

The laissez-faire style of economic policy is based on the principles of monetarism.  This was very much the flavour of the month in the 1980’s and to some extent the 1990’s.  It was mainly introduced in the US and UK, through Ronald Reagan in the US and in the UK, Margaret Thatcher.

The net result of the policy was to make everything operate within the free market economy.  Margaret Thatcher even introduced private practices into the National Health Service and privatised many of the state run businesses, such as the railways and the water supply company.

Yet the reality of the free market prevailing, when many countries in the world are facing a very anxious time, as food prices rise, oil prices escalate and things look very bleak in terms of the housing market, is actually quite frightening.  Just how many casualties will there be until the market picks up?  Does the government just have to stand idly by as people lose their homes and businesses and start to be unable to afford even the basics? 

Politics and the economy are strongly linked.  Every government in the world wants to be able to afford its people some kind of economic stability, or else they will probably lose power (even dictatorships have fallen on this issue).  So no government will be able to simply watch as its economy goes into a massive crisis.  The danger of intervention here is that the policies the government will bring in will simply be knee jerk reactions and those are not the best kind of policies to be able to keep an economy afloat and in the longer term may lead to the economy growing more slowly.

Is innovation the key?

The concept of innovating your way out of something as serious as the credit crunch is a very risky business indeed, but some financial experts reckon that it is the only way that this situation can be remedied.

Innovation could take the form of selling some kind of derivatives, so, for example, a company could take out a derivative that would allow it to sell shares at an above market rate level, if shares were to sink beneath this level.  The derivative is simply some kind of insurance that the company would have to pay, but it would mean that it would be protected from the worst ravages of any share dip.  Financiers would gain because they would be able to take a fee for establishing the derivative.  On the face of it, everyone seems to have won.  These kind of insurance deals would be expensive but they would bring about an increased peace of mind and a feeling of confidence.  Confidence has been much lacking in all financial markets of late, so this alone would be a great benefit to a very nervous and rather anxious economy.

There are many financial ‘deals’ such as this, which could easily inject some much-needed cash into the US economy and indeed economies throughout the world.  They are potentially much riskier than standard policies, for the people who are underwriting the policies, but then until risks are taken, nothing can be gained. 

It could also be quick, with derivatives being very quickly established and therefore less labor intensive than if the standard policies and procedures are used.  In short innovation and new ways of looking at solving the problem of the credit crunch could actually be a quick fix.  That is certainly better than just sitting back and waiting for the markets to recover and probably viewed by financial experts as being better than being bound by new and taxing regulations.

Innovation could also ensure that the financial experts retain some autonomy.  If regulation does become more stringent, then they could potentially lose this freedom.

Whilst some people may claim that new methods won’t stimulate the economy, this cannot be stated as a fact, only a supposition.  And the traditional methods have left financial markets all over the world in a very shaky position, so perhaps it is time to think about new ways of doing things and injecting a little confidence into the markets.

Obstacles to Innovation

The main obstacles to innovation being an effective tool to work a way out of the credit crunch rest with the fear that many financiers now feel about introducing new packages and deals.  Firms’ bosses have been stung just once too often and now they feel more reserved and less willing to indulge in anything that could be perceived as high risk.

There is also a fear that if high risk activities become too widely practised, the government may intervene and start to regulate more closely.  So innovation may offer a third way out of the current credit crunch, but it is likely that only a few will be brave enough to try it.  But who knows, they may succeed, where traditional practices have so spectacularly failed of late!