It looks bad, right? Right. It could get worse, right? Right. It could get even worse than the worst ?experts? are predicting, right? Probably right. So capitalism, especially the high finance part of it, is bad business, right? Wrong. High finance whizkids who were Page 1 darlings until a few weeks ago won?t say this now; some of them are too busy wondering which was a worse buy, the yacht or the complex clutch of derivatives on the firm?s books that no one quite understands. But the argument that the current global financial crisis is proof again of capitalism?s essential vitality can start by referring to yesterday?s Page 1 whizkids. Many of them are running for cover, and they are doing so because as capitalism has evolved, its ability to quickly punish over-confidence and over-cleverness has increased. The very speed with which many financial institutions? vulnerability is being exposed and the brutal questions being asked about financial instruments that were hailed as proof of near-genius a year ago, are demonstration not only of capitalism?s systemic intolerance of wrong calls but also its capacity to self-correct relatively quickly. Right here, big players have had to adjust their ideas to market correction: Reliance Power?s public issue and the post-disappointment scramble by the company is particularly instructive. Many more examples will come from home. But to make the point, let?s take the example that scared world markets: Bear Stearns.
Roughly a decade ago, in September 1998, Bear Stearns was among the nine Wall Street firms that were asked by the New York Federal Reserve to rescue Long-Term Capital Management (LTCM), a superstar market player led by a legendary bond arbitrageur and two Nobel-winning economists, which went bellyup when Russia defaulted on its sovereign bonds. With prodding from the Fed, a consortium of banks and investment houses rescued LTCM. In 2008, Bear Stearns has been rescued, importantly, with direct financial help from the US Fed, which has provided $30 billion to the buyer, JPMorgan Chase, to help the latter absorb some of Bear Stearns? unlovely assets.
This is a crucial distinction because official help is usually given to commercial banks?big banks?that tend to be more closely regulated than investment banks like Bear Stearns. The question is already been asked, and the answer will come sooner rather than later: if brokerage houses receive official rescue funds, shouldn?t they be regulated more closely? Financial authorities don?t want an entity like Bear Stearns going down right now because high finance, principally via derivatives trading, is now constituted of several large players with interlocking trades and huge outstanding bets; Bear Stearns? trading calls reportedly aggregated $10 trillion. This reinforces the ?more regulation? question: shouldn?t more light shine on the fiendishly complicated instruments on the trading books of investment houses? So, yes, raise questions about moral hazard. Why rescue firms?Lehman Brothers and Merrill Lynch are reportedly vulnerable?that thought illiquid, long-term assets and short-term funding sources were forever compatible? Also, how many investment entities can be rescued? Should be rescued? But also recognise that capitalism will extract a high price for such help. After the dotcom bust, the separation of analysis and investment banking was enforced (that effort was led by Elliot Spitzer, who, as it turned out, didn?t pick up enough shady finance lessons, like avoiding one?s personal bank account for covert transactions). After the Enron scandal, the Sarbanes-Oxley Act on greater accounting disclosures came into force. For sure, some US legislators looking to seal re-election are pondering a post-subprime law now. Whether through lawmakers or regulators, investment houses will feel the heat, and they must. This is a certainty as the financial meltdown proceeds; a bet you can safely put your money on (if only you could find a punter in today?s market). The deeper the mess, the greater the extent of systemic reform, and interventions will be quick. This is a lesson Indian authorities must learn. Some Indian banks and companies are reportedly staring at derivatives-related losses. Regulator response must be quick but not ham-handed; don?t ban derivatives, force more disclosures and finetune the caveat emptor principle.
The late JK Galbraith had a formula that works remarkably well in describing every financial bubble: some new thing?subprimes, complicated derivatives?catches everyone?s fancy; a lot of people make money; some of them are held up as geniuses. After the big bust occurs, as Galbraith concluded, the system looks for scapegoats, who are usually yesterday?s geniuses. But capitalism also tries to and mostly finds its own solutions. That?s no guarantee against a future crisis, of course, because some other new thing will catch people?s fancy.
But it?s a guarantee that capitalism is self-regenerative.