A lot of media and academic attention has been engaged in the post-mortem of the financial crisis that took almost everyone (as perceived and presented by media) by surprise last year. The symbolic equivalence of that event is now entangled with (the demise of) Lehman; although there were others in the club of Lehman, and there could have been all the other bigger names of Lehman’s class that had a near death experience had it not been the interventions.

A myth doing the round since then, and gaining in terms of credibility lately due to media-megaphone syndrome, has been that no one foresaw this crisis. JFK once stated something that we find of regular relevance now-a-days, and the last crisis is no exception. It was, ‘the great enemy of the truth is very often not the lie: deliberate, continued, and dishonest; but the myth: persistent, persuasive, and unrealistic.’

Two such myths have emerged since the last crisis. First that no one foresaw this outcome (barring exceptional names like Nouriel Roubini or Nassim Nicholas Taleb of Black Swan fame although Taleb himself stated that the crisis was not a Black Swan event), and second that it was primarily the fault of the Wall Street (and lesser to its regulators) that led to the crisis.

A deeper examination may prove that both are not true, probably. The root cause of the crisis, if one indeed wants to go to the root of the problem, is actually somewhere else which explains the excesses of the Wall Street as a symptom. It may sound a bit non-academic economic sense to apply one of the best industry practices that Toyota applies to minimize waste and to continuously improve processes to have error-free standardized systems. However as the concept is more philosophical, it surely can have its applications in the way financial markets or monetary policies work.  Employees at Toyota are taught couple of basic lessons like ‘go and see yourself’ and ‘ask ‘why’ five times’  whenever one faces a problem. The argument is – it helps one zero down on the root cause by understanding the complete problem rather than finding an ad hoc solution (or alibi) to the problem for the time being.

If we apply above two in analysis of the last crisis, we come out with drastically different conclusions than what’s popularly perceived to be true as myths. It was the easy liquidity policy of the Federal Reserve (and its consequences) that led to the crisis. And it was again Federal Reserve which failed to see the fundamental changes that happened in the US economy over last couple of decades as services comprised nearly 80% of the economy, and within that, financial services comprised nearly 31% of the economy. And when the 31% contribution of financial sector (2006 figure) is viewed in comparison to 1990 when it was merely 23% (still high!), the financial sector contributed a whopping 42% in the absolute growth of $ 5trillion real GDP from 1990s to 2006. That means that out of every 2nd dollar of additional goods or services that the US produced in 2006 compared to 1990, nearly a dollar came from financial services.

While identifying waste, the 1st and topmost importance in Toyota Production System (TPS) is attributed to overproduction. The long term philosophy (or the True North) as practiced by Toyota states that (1) Philosophy supersedes short term decision making, (2) steer the organization toward a common purpose that is bigger than making money and (3) generate value for the customer, society and the economy. If we for a moment think what true long term philosophy the Federal Reserve should have, it’s a balance between employment, (real) economic growth and inflation. While trying to balance that, the Federal Reserve has often fallen into the trap of overproduction of money. And thereby it has resulted into wastage of money – as perceived by the end customers – the citizens.

Obvious question comes – why?

It’s because the way the Fed. channelizes its liquidity to the society (or any central banker does). It’s through the intermediation of (fractional reserve) banking system. So the banking system in the US has been flooded with cheap money for a long time. This led to the housing boom, which to an extent meant that the end-customers got real economic value and real assets (houses) were created, true with borrowed money. However it also meant that risks taken were high as many were not credit-worthy. But why did banks lend to them? Because they were having too much cheap money in hand and wanted to have a better return of that (profit maximization when all other asset prices were also high). And they subsequently went to find esoteric derivatives to find further application of that excess money and to mitigate risks, if any perceived, and to generate further cash for further lending using fractional reserve banking system.

An analogy of above, although not exact, would be comparing money with water. Water is a useful natural resource, and it’s likely that the wastage of water is much more near its source. Contribution of water to the economy is through its usage in our daily lives (domestic, agricultural of industrial use). However if and when half of that contribution comes from channelizing water amongst participants (users of water), one can be certain that the resource is getting wrongly used. Moreover the concern of generation and application of liquidity grows globally when one frequently sees flooding near the source, whereas acute deficit exists and is a common place thing where real applications take place.

2nd, was the crisis really not foreseen by any as popularly believed? On the contrary, many did foresee the crisis. True, most of them were not well-known economists, or policy-makers from Central Banks. However those who foresaw the crisis for many years didn’t know what symptom would result from the crisis. That’s quite acceptable as no one knew what consolidated action global policy-makers would take. The most prominent of the group that could forecast the crisis was the gold-bugs, although many consider them as outcast, brainwashed by a conspiracy school of thought. Excluding the gold-bugs, there were many more in the web (in blogs) – the nameless, faceless people who foresaw the crisis other than the rare few eminent people who also felt the going wasn’t right.  Their primary concern was on increasing indebtedness of the US, and that analysis primarily resulted in the often forecast symptom of a collapse in the value of dollar. It was not wrong to come to that conclusion – as the likely visible symptom of the highest level – from the imbalances as a crisis. True, in last one year we rather saw the opposite of that as dollar strengthened against most currencies (and now again losing ground).  

How I know that is because of a book (Wondering Man, Money & Go(l)d) I authored back in 2006 (after the severe market correction in summer of 2006) where I borrowed significantly on what others stated on the sustainability of the financial markets. Unfortunately, many of these websites have changed since then (the URLs changed/don’t exist). Here are few examples, taken from that book,  on how many bloggers saw things back in 2006 (or even earlier as I completed the book by August 2006):

·         ‘The turkey (dollar) is being fed by the foreign investors (who have little choice) and the Central Banks are keeping it from choking. Until Thanksgiving !’

From RGE Monitor by one JAVO back on 15th September, 2005. Unfortunately Lehman became the ‘Turkey’. The specific  URL in RGE Monitor changed.

·         ‘While real estate values hit all-time highs, total home equity (of mortgaged homes) as a percentage of the average-priced home was down to 18 percent from 50 percent in 1984. A 20 percent correction will wipe out all real estate equity in mortgaged houses.’

From ‘2004 – The Year In Review’ in Bullion Management Services Inc.

·         “the U.S. government is, indeed, bankrupt, insofar as it will be unable to pay its creditors, who, in this context, are current and future generations to whom it has explicitly or implicitly promised future net payments of various kinds.”

‘Is the United States Bankrupt?’ Professor Laurence Kotlikoff, working for the Federal Reserve Bank of St Louis,

·         ‘The entire world wide economic system is a con (confidence) game that can only work if the cost of goods and services is steadily inflating over time. If that steady inflation is interrupted the system collapses. This process has already begun and is beginning to unravel all over the world.’

The Fed, the Constitution, derivatives and Enron, http://myhomelender.com/fed.html (doesn’t work any more)

·         ‘The global financial system seems to have a black hole at its centre. Over the last two decades, US residents have sold a total of about $5,500bn worth of IOUs to foreigners, yet the officially recorded net investment position of the US has deteriorated only by a little more than half of this amount ($2,800bn). The US capital market seems to have acted like a black hole for investors from the rest of world in which $2,700bn vanished from sight – or at least from the official statistics.’

Discrepancies in US accounts hide black hole. Financial Times (2006)

·         Each US-American owes to the World one Million Dollars. Figures here can be questioned, however a similar post in the USA Today back in 2004 stated : (we)  ‘found that the nation’s hidden debt— Americans’ obligation today as taxpayers — is more than five times the $9.5 trillion they owe on mortgages, car loans, credit cards and other personal debt.’ 

·         ‘Since the present monetary system is fundamentally unstable, the central bank is compelled to print money out of thin air to prevent the collapse of the system. It doesn’t really matter what scheme the central bank adopts as far as monetary injections are concerned. Regardless of the mode of monetary injections, the boom-bust cycles will become more ferocious as time goes by…After all, the present system survives because the central bank, by means of monetary injections, prevents the fractional reserve banks from going bankrupt… Whether the central bank injects money in accordance with economic activity or fixes the rate of growth, it further destabilizes the system. The only way to make the system truly stable is to permit the free market to take over.’

How Much Money Should There Be?, back in 2001 

So were those people wrong who didn’t foresee the collapse of financial markets or Lehman (as a symptom) as they often foresaw the collapse of the US dollar as a likely bigger event from the root causes that manifested during 1990-2006 (and still does)? Probably no, because the symptom (of collapse of financial markets last year and the demise of Lehman) was an early one, and not the last or biggest one that the ongoing crisis may result in, unless the time gained in between is wisely used to mitigate the crisis from its root.

Prof. Ranjit Goswami is with Indian Institute of Foreign Trade, Kolkata. In his 2006 book, ‘Wondering Man, Money & Go(l)d’ he explained the unsustainability of the financial markets (and underlying monetary policies). Many others also saw that (above quotes were few of the examples used in that book in that context).

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