GREED and FEAR

(Submitted by Willard Hertz)

by Peter Ruof

We asked Peter Ruof, president of the Blackwood Capital Group, a transatlantic merger and acquisition advisory organization with offices in New York, London and Zurich, to comment on the international dimensions of the financial meltdown. Peter was a program officer in the Ford Foundation's European/International Affairs program from 1973 to 1982.

Today, we find ourselves in the worst economic and financial crisis in two generations, and we do not yet see the outlines or extent of this crisis. It may well become known as the “World economic crisis of 2007 to 2010”. What were the decisive elements that led us into the eye of this needle?

Internationally, we were looking at a rapidly expanding global boom in economic activity generated by abundant liquidity and a transfer of production of industrial and consumer goods from Europe, Japan and North America to low-wage countries like China, India and Brazil. The increase in oil prices taxed consumption of wealthy countries and transferred billions of dollars to the oil and gas producers.The resulting rapid financial expansion did not lead to high inflationary pressures because of the compensation through low and steady prices guaranteed by low wage earners in the emerging markets. China with real growth rates of over 10%, India, Brazil and Russia with growth rates greater than 6% became major engines for international economic expansion. In parallel, we witnessed a devil-may-care attitude in the US and Europe about the rapid expansion of financial markets and their growing divorce from the real economy and from their underlying assets.

Parallel to the creation of an unimaginable hedge fund and private equity industry with billions of dollars being transferred from creditor countries to debtor countries, a new cockiness spread in the financial services industry which overshadowed any and all real economy developments. During the period of 2002 and 2008 the hedge fund industry grew from about 2000 funds to over 10,000 funds. Hedge funds could never have grown so fast if on the one hand, large investment funds had not been available to them, both in the form of equity and of lines of credit, and if new financial instruments had not been created for their use.

Examples were the expansion of CDO's (Collateralized Debt Obligations) and CDS (Credit Default Swap) instruments as well as the development of real estate based debt instruments that were packaged by mortgage wholesalers into debt instruments permitting easy arbitrage for the hedge funds and other market players.

The crisis of the mortgage defaults began with the rapid increase in the value of real estate of all types and the aggressive behavior of banks in the US to lend against housing assets whose nominal value had increased because of the housing inflation. While 2007 was already a crisis year for many mortgage owners and banks who saw increasing numbers of defaults on mortgages, both the industry and the government did not take the first signals seriously enough to act decisively. A lot of blame goes around, particularly to governmental authorities including the Treasury and the Federal Reserve. What was eventually undertaken as measures to counteract the deteriorating situation in the mortgage area was too little and too late.

The accelerating tightening of the financial markets demonstrated that the contraction was not reserved only for the housing and mortgage industry. It now extended to the whole banking system involved in financing huge takeovers initiated by the equity funds. The financial crisis deepened because we were suddenly faced with astronomical billions of dollars worth of defaults on account of misjudged and overvalued transactions in many fields.

When the stock markets began to soften and then weaken over the last 12 months, the message suddenly hit home that this was no longer a crisis reserved for the housing and mortgage industry, but it now began to embrace every aspect of both the national and increasingly of the international economy. Belt tightening became the buzz word on Main Street and began to bite on Wall Street.

Luckily, the Federal Government began to ignore inflation targets and began to dole out many billions of dollars to banks, insurance companies and other intermediaries that the government needed to keep alive in order to save “the system”. To define what “the system” actually means is a major undertaking. However, it must be realized that it includes the key pillars of the national economy. Increasingly, they also include the key players in other countries.

Inter-related, yet sometimes independent of the US economy, because of greater interaction and globalization, Government subsidies such as the Paulson Plan for $700 billion and the bailout of institutions like AIG and major banks in this country found their parallel in most European countries. Many foreign banks have been active buyers of over-valued US real estate related paper (CDO's). They, too, began to feel the pain of domestic slowdown due to an accelerating decrease of demand for their own industry.

The dismal picture painted here is not yet behind us. In fact, we are in the midst of the economic catastrophe of 2008. The authorities, politicians and economists as well as financial experts have not yet found a middle ground of how to cope with the problems and resolve the crisis. While it is agreed that creating liquidity through state intervention in the economic process is a good thing to do at this time, it is certainly not yet clear where the main support for the economy should be placed (finance sector, mortgages, infrastructure, special industries, such as automotive, or simply undertaking another round of tax rebates to the consumer). As a confidence building measure, this strategy moves us in the right direction.

The chain reaction originating with the housing industry, leading to hedge funds, private equity funds, the insurance industry and the banking system as we knew it, has not yet found one solution which guarantees us an exit from this mess. Recent lack of clarity of the intent of the Treasury and the Federal Reserve, uncertain supervisory roles being exercised by governmental institutions and rating agencies and growing criticism of international institutions, such as the International Monetary Fund and OECD as well as the European Central Bank, all are cause for uncertainty. Participants in this process are looking for leadership with a solid political backing.

One bright spot in this whole dismal scenario is the election with a solid majority of a new President in the United States of America. While President-elect Obama cannot yet play a decisive role in leading the charge to bring this economic crisis behind us, he at least has the political backing and mandate from every major economic player in this world to reset the signals of economic management and to lead the world out of the depression.

The task before him is monumental, requiring fresh thinking and decisive action and importantly, a review of all aspects of globalization. The Bretton Woods system, established after 1945 and based on the pre-eminence of the US economy, is no longer a sufficient structure to manage the world economy. It may well be that new bodies will have to be created with a much fairer and much more diversified membership and a majority power structure that is expanded to include new economic leaders.

World economy decision makers will need to evolve in light of the threat that emanated from failures from supervision in the US economy. It behooves us to invent new agents who will be able to understand better the world's commodity markets, the world's export nations, the interest of importers and the role to be played by those who control intellectual property and the most advanced technology.

The different economic actors need to be integrated into an evolving world economic system for which the US obviously will want to and will have a major role to play.

I believe that the crisis will work itself out over the next 18 months. It will produce positive results even though the world had to undergo a depression and an increase in poverty, but as an optimist I believe that we have the brains and the instruments to remedy the failures of the last decade. I suspect that once clarity is being created in the process of governmental subsidization and certain signals have been sent, that the stock markets will anticipate a turnaround and will begin to strengthen during the course of 2009.

Barring any unforeseen circumstances and particularly no increase in international conflicts, it would be macro economically highly desirable to continue the belt tightening process, produce greater savings and to reduce military expenditures in favor of infrastructure investments everywhere. Long term investment by governments in infrastructure, energy, climate control, health care, poverty programs and education will bear the most fruits and could well represent the pillars for a new platform from which the international economy will find its own greater potential.

Having been involved in the field of international economics all my life and as an investment banker active in the field of mergers and acquisitions, I have found that he innovation in investment banking has been driven by “greed and fear” with outstanding financial results for many individual bankers.

At the same time the economics profession with the exception of a few leaders such as Paul Krugman, Jagdish Bhagwati, Peter Galbraith, Dean Baker, Joseph Stiglitz and a few others has not subjected policy makers and activists to the proper value-neutral intellectual scrutiny and therefore have not been able to prevent this crisis from happening. Many of the institutional economists as well as academic economists will need to revisit their work to serve the international economic community more effectively and with better tangible results.