Let’s ‘invest’ in a little of our own thinking instead
Written by Writer on Monday, October 13th, 2008
Let’s ‘invest’ in a little of our own thinking instead
SANITARN SATHIRATHAI
‘In God we trust” it says on the American one dollar bill. The only problem is that when it comes to the question of where to put our dollars, people tend to believe in just about anything but that. History has shown how humans have repeatedly placed too much faith in the hottest “money making machines” of the era as if they can defy the law of gravity. These machines have come under different (now infamous) abbreviated names: S&L (Saving and Loans) in the 1980s, dot.com at the turn of the century, and MBSs, CLOs and CDOs today. This cycle of “manias, panics and crashes” is widespread, both among developed and emerging market economies. For Thais, “BIBF” (Bangkok International Banking Facility) is a four-letter title that has left a permanent scar, nicknamed the “Tom Yum Kung” crisis, in their memories.
A pedestrian walks past a screen displaying market news and European stock exchange indexes in Paris on Friday. There are no easy solutions to preventing future financial crises, but investors could take more responsibility by not following ‘‘fads’’.
Financial crises are not new. Every time something collapses, we turn around and ask: “Oh no, what went wrong this time around?” Perhaps we have not been asking the right question. If something fails so often, isn’t it easier to ask the opposite: Why did we think everything was right back then? We spent too much time on trying to understand why modern financial markets fail and way too little effort on thinking whether it should work in the first place.
Modern finance works (or arguably doesn’t) in a peculiar way. The fact is that today we are often reluctant to lend even a dime to our neighbours who we know for a long time are trustworthy. Yet, we are more than willing to put our life-time savings into something we know little about and hoping it will turn into gold. In the past our money just goes into financial intermediaries such as banks who simply use a more sophisticated method of screening who is smart and trustworthy with the money.
Today, things go further. Money we put in the funds in, say, Thailand or China can somehow end up in the hands of sub-prime mortgagers with five credit cards in California (yes, we are funding their obesity). Better yet, sometimes banks may not even have to think about risks as hard as they used to as the loans made will not stay with them but are packaged with the labels CDO or MBS and sold to someone else. So then why not let those somebody elses like Freddie, Fannie, or hedge funds help do the thinking? And if that “somebody else” does not wish to bear all the burden, they can even find other groups to help them, the guarantors such as American International Group (AIG).
One of the beauties of the system is that “trust” is being transferred very efficiently. Lending money is now less about the person and more about the “label”. Trusting US$1,000 with Somchai does not mean you can give the same amount to Joe, but believing in a CDO, MBS, CDS, etc implies that we can trust anything that goes by those labels. This is especially easy when those products are rated AAA by a “third party” paid by the producers of these rated products. After all, we are also taught to have faith in the “wisdom of the crowd” - if those products do not work why would smart people pour their money into them. Price trends can easily signal where the other intelligent players are placing their bets.
Perhaps that is exactly the problem. If we all believe in the wisdom of the crowd then we are free-riding upon others in doing the most difficult part of the thinking, which is about risks - so who is actually doing that? Banks do a bit less screening as they know they will be sold to other investors, those people then do a little less thinking because they think the guarantors and rating agencies are helping them do that, and other investors follow suit thinking that these guys have done all the hard work. Sounds familiar? The paradox is that the wisdom of the crowd can only exist when we do not believe in it too much.
The very strength of the system is also its biggest weakness. Trust is easily transferred but so is distrust. Somchai defaulting on you does not mean Joe will, but a single pop in a BIBF, CDO, or the like goes a long way. These branded financial products stop working the minute you stop thinking that they work. Only the fear that “if those instruments do not work then what about ours?” can trigger the market to unwind. The price collapse is then a self-fulfilling process, stemming from the initial fear, causing a vicious circle.
The process will not stop until trust is restored, often by another well-known label, called “the government”, this time along with US$700 billion. When it comes to bailing out banks though, the US is a bit more fortunate than other crisis-hit countries. First, if there is anything that the US has right it is her national currency, the dollar. While any government can print money to bail out banks, only the US can ensure that the money printed will be held and treasured by people and therefore has value. This is why we have not witnessed in the US (at least not yet) a currency crisis like we had.
Second, and more importantly, the US government does not have other authorities forcing them to let banks fail. Remember? Back in the late 1990s, the US government and IMF preached to Asian governments about how we should not help our banks and finance companies so that they can remember how not to lend carelessly next time. Well, perhaps they are right, maybe we did learn, but the question is: Have you? When it comes to their own destiny, it is all so convenient to forget the so-called philosophy of “invisible hands”, because we all know that people during a crisis only believe in the visible ones. Let us hope these visible hands of government can restore trust and prevent the giants from falling on all of us.
So what can we do to avoid the next financial collapse? There are, unfortunately, no easy solutions. We know that the tragedy of mankind is that people forget, and this holds even among the geniuses on Wall Street. Thus, financial crises will come again in different names and places so long as the modern financial markets exist. Strengthening regulations alone can never be the solution when we are paying the “cats” less than half of what we are paying the “mice” whose job is to beat the system.
The first basic step starts with ourselves. It is to learn when to stop. Our King has presented us with the starting point, the principle known as “Sufficiency Economy”, based on the philosophy of sufficiency. Once we admit crises are inevitable then the best solution is to create immunity to shocks by limiting our exposure to these fads to a reasonable level. Do not just “go with the flow” and leave all the thinking to others. In fact, whenever you see so much money and so many graduates from the top business schools flowing to concentrate in one place, that is where you should monitor your exposure. Only when we start thinking for ourselves can the market price truly signal the wisdom of the crowd. Ironically, the Eastern philosophy of Sufficiency Economy might be the only way to make the Western philosophy of “invisible hands” really work.
Sanitarn Sathirathai is a PhD candidate in Macroeconomics and Financial Policy at Harvard University.
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