Was the Lehman collapse a failure of capitalism?

Jan 20, 2012

Los Angeles, California

The Financial Times continues its series on "Capitalism in Crisis." We're getting a little tired of it. We were hoping at least one of the writers might tell us what the crisis was. Instead, we've gotten a variety of opinions; none offering much light on the nature of the crisis and several offering more darkness about how to make it worse.

In yesterday's installment, for example, we discover that in 2008, "leaders of rich and rising nations sidestepped their differences to avert a worldwide slump."

Really? If the writer had any appreciation for capitalism at all he'd know that the politicians did no such thing. Instead, they sidestepped their differences to prevent capitalism from doing its job. In 2008, after the fall of the House of Lehman, capitalism was aiming its wrecking balls at the House of BAC, the House of Deutschebank, the House of Goldman...and many others. But the feds stepped and stopped the wrecking balls in mid-air. The process of price discovery halted.

Instead of allowing capitalism to fix the problem, the feds made it worse. They gave more money to the very institutions and managers who had proved they couldn't be trusted with it.

We don't want to rehearse the whole sequence of events that got us to where we are. But it's important to understand what happened.

The FT writers - along with practically every financial journalist, economist and 2-bit big mouth - gets the whole story wrong. They seem to think that Lehman Bros. was a failure of capitalism. Symptomatic, they say, of a larger failure, which almost all believe came from a lack of effective regulation.

"Too much capitalism..." is how one sage put it.

"The big lesson from all this is the extent to which globalized capitalism has outstripped the ability of governments to manage it," says the FT.

Manage it? They must be dreaming. If the guys who ran Lehman Bros. couldn't manage their own business, how were a group of bureaucrats going to do so? On the evidence, the feds had even less idea of what was going on than the 'capitalists' themselves. (About which, more below...)

The real problem was not too much capitalism. Instead, there was too little, especially when we needed it in 2008. The financial industry had been corrupted by government. Federal subsidies to the homebuilding industry...along with artificially low interest rates from the Fed...created a bubble in the economy and a frenzy on Wall Street. The financial industry became obsessed with fast profits. Bank managers learned that they could earn fees by making loans; who cared about collecting them?

Also, most Wall Street firms had ceased to be genuinely capitalistic. The benefits and the control were no longer in the hands of real capitalists, but in the hands of the managers. Over the last ten years, for example, the owners of financial industry stocks have made zero. Not a penny. But the managers - employees - have gotten rich. Goldman Sachs alone transferred $125 billion of shareholders' money to it labor force over the same period that the shareholders themselves made nothing.

This left the employees with nice pads in the Hamptons, but it left the shareholders will little in real value. Today, many major banks have equity of less than 2% of their assets. That means, if their holdings of government debt - for example - go down 2%, they are broke. And it leaves them vulnerable to the next crisis....just as they were to the last. When the crisis came in 2008, there was not enough equity - real shareholder value - to prevent bankruptcy.

This was not a crisis of real capitalism. It was a problem of geriatric capitalism...a simple problem that real capitalism knew how to fix. Left to do its work, these banks would have gone out of business...as they should have.

Collapsing banks would have meant the collapse of many other things too. Greek debt, for example. The banks' holdings would have been subject to fire-sale prices...driving down their prices...and putting Greece and other major debtors into bankruptcy too.

This, of course, is just what the feds wanted to avoid. Today, more than 3 years later, they're still trying to avoid it. That's the drama we follow in Europe almost every day.

But far from illustrating 'capitalism in crisis,' it shows the crisis caused by the fixers themselves. Now they've got banks that would be bankrupt...if Mr. Market were allowed to fully express himself. The bankrupt banks are kept in business by governments, who should be bankrupt too.

And since Mr. Market is sidelined...he can't solve the real problem. The bankrupt institutions stay in business...shifting more and more real resources to zombie institutions run by incompetent, but highly paid, managers.

This leaves the illusion of repairing things to the managers themselves and their fixer friends in government.

The FT gives a claptrap solution:

"...extend and refurbish the multilateral order to make economic integration with great global governance."

We're not sure what that means. But we know it is a mistake. ---------------------------------------- Have an enriching Saturday! ----------------------------------------

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*** People may not know what capitalism is, but they know they don't like it. A poll by Globescan found that support for capitalism has fallen by 20 percentage points in the last ten years. A few years ago too, Mitt Romney's success at Bain Capital would have been a plus on the campaign trail. Now it is something he needs to explain and defend.

The poll found higher levels of support for capitalism in China, Brazil and Germany too.

Here is Qin Xiao, a businessman from China who has experienced state planning in a direct and personal way. In the 1960s, he was exiled to the countryside of Inner Mongolia to be "re-educated." The purpose of the re-education was to help him learn that "government was the savior of the poor and free enterprise was evil."

Instead, what he learned...and observed since...was that the free enterprise system works. A planned economy doesn't. His advice to China: "An economy now dominated by the government needs to become one led by the market...the government must scrap procedures for approving economic and market activities....it must stop interfering with market prices and transactions..."
What gives? Are these emerging market thinkers naive?

Nope. We don't think so. Here at the Daily Reckoning, we expected them to be pro-free market. Why? Because people are neither bad nor good, smart nor stupid. They are subject to influence.

They will favor market systems when market systems are making them rich.

US capitalism - fettered by zombies...managed by incompetents...regulated by bureaucrats - no longer makes people rich. It has cut the real hourly wage of a non-high school grad by 47% over the last 32 years. No wonder Americans don't like it.

In the emerging world, on the other hand, real wages double every ten years or so. They like capitalism. They want to practice it.

A real stress test: could any major bank or developed nation survive?

By Bill Bonner

Last week, Spain and Italy were able to offload 22 billion euros worth of debt. This quieted investors' fears. Newspapers reported that calm and confidence had returned to the markets. Lenders and borrowers breathed more easily. Bankers put their feet up. Apparently, no major bank in Europe was so far underwater that the European Central Bank couldn't bring it to the surface. None had its lungs so full of bad debt that the ECB cannot breathe life into it.

Then, on Friday, S&P downgraded several European nations' debt. This brought the debt of Europe's stabilization fund, the EFSF, into doubt too. Suddenly, Europe was gurgling again.

Mario Draghi, head of the European Central Bank, wondered on Tuesday if the ratings had any value. After all, he had given the banks 489 billion euros in December. A lack of cash will no longer bring them to grief. Then, what will? That is, of course, what we will find out.

The ECB is scheduled to relax its bungee collateral requirements. The bank will now lend against used cars and day-old bread. But Draghi suggested that he had no intention of following America's Fed in its irresponsible "quantitative easy" path. Instead of buying the bonds directly, he and the banks will collude to defraud the public. The ECB will pretend to be in control of the situation. The banks will pretend to be solvent.

The conceit of modern public finance is that people with good political skills can do a better job of deciding which banks are solvent than the marketplace. 'Raw capitalism,' is just too impulsive, they claim. It makes hasty decisions, often throwing out the baby with the bath water, and the bathtub too. By contrast, wise bureaucrats keep their wits about them, even in a crisis.

The Financial Times is running a series it calls 'the Crisis in Capitalism." The writers claim capitalism needs adult supervision. Samuel Brittan, for example, says it "requires...the use of monetary and fiscal policy..." to keep it doing what it is supposed to do. Where's that? He thinks he knows. It is "a means to freedom and prosperity, not an end it itself."

We disagree on both points. Capitalism could care less whether people are prosperous or poor. As to fiscal and monetary policy...he presumes settled the very point that is at issue - whether central planning, by bureaucrats, improves market outcomes.

Last Thursday, the US Fed helped to resolve the doubt we never had. It released records of its internal discussions in 2006, when the US housing and finance bubble was reaching its peak. On the evidence provided, the feds never had their wits about them, even when the going was good. Resumed in the New York Times, we discover that " top Federal Reserve officials marveled at the desperate antics of home builders seeking to lure buyers. The officials laughed about the cars that builders were offering as signing bonuses, and about efforts to make empty homes look occupied. They joked about one builder who said that inventory was "rising through the roof." But the officials, meeting every six weeks to discuss the health of the nation's economy, gave little credence to the possibility that the faltering housing market would weigh on the broader economy...instead they continued to tell one another throughout 2006 that the greatest danger was inflation - the possibility that the economy would grow too fast."

While the American authorities couldn't spot a crisis, the Euro- fixers were actively creating one. Draghi is a veteran of the World Bank, the Italian Treasury, and Goldman Sachs. He was on the job in Rome while Italy was building up the debt it now finds so hard to pay. Christine Lagarde, now head of the IMF, was French finance minister from 2007 to 2010 - when France increased its public debt by about 50%. Dust any financial crime scene from the last 20 years and you will find prints from them and the whole confrerie of public payroll dunces who now claim to be fixing the system. They are the very same people who brought Europe...and the world...to the brink of financial disaster. And now they preside over more monetary and fiscal policy tweaks, more controls, more regulations, more 'stress tests.'

Most likely, the leading financial institutions...as well as most of the sovereign nations of the developed world... are already insolvent. We say "most likely" because neither we nor anyone else can know. Real solvency - like the value of the ECB's collateral -- is not judged by earnest ratings, phony stress tests, or bureaucrats. It's determined by the real stress test of the marketplace.

No one ever knows what anything is really worth - especially what financial institutions with complex holdings and obscure business models are worth. Not even their owners know. The accountants had to interrupt Jimmy Cayne, CEO of Bear Stearns, during a bridge tournament in 2008, to tell him his company was broke.

Insolvency is like death. When conditions change so does life expectancy. You discover when a company is broke by testing it. We saw, for example, what the banks were worth under the benign credit conditions leading up to 2007. Then, market conditions changed. Under the stress of the market's new challenge, Bear Stearns and Lehman Bros died. This caused investors to wonder about the rest of them. But instead of allowing the process of price discovery go on, US authorities stopped the test.

What a pity. We don't know which bank...or which nation... is insolvent. Most likely, they all are.

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

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2 Responses to "Was the Lehman collapse a failure of capitalism?"

Hasit Hemani

Jan 23, 2012

The world is not going to end even if Whole of Europe and US goes broke.Just the reins of Global economy will shift gradually in the hands of other strong solvent entity. And that other entity is China.US and Europe will become more and more dependent on China for their day to day necessities of everything from material things to financial help China will reign supreme on the world stage economically,politically and militarily. India's corrupt political leaders will see towards China for their survival instead of US. The world will have a new policeman for at least another 50 years.



Jan 23, 2012

Today's faux capitalisme says: "Give me a free hand, don't cramp my ability to create 'wealth', (mainly for myself, but how else can you get 'trickle-down', remember?). When I'm lucky, remember I'm a Capitalist genius; when I'm screwed, better bail me out, because my bad luck will 'trickle down' faster than my good luck ever did!".

What to do? Join them - if you can.

While we write and read these diatribes, they're holidaying in their yatchs off the Riviera.

They obviously know a few things we don't!

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