Envío Digital
Central American University - UCA  
  Number 334 | Mayo 2009



When the Addiction Leads to Recession

From Venezuela, a simple yet profound explanation of the North’s international economic crisis, which is already affecting all countries because they’re interconnected in a now-globalized world.

Eduardo J. Ortiz

There are innocent games and dangerous games. Some people get together once in a while to play cards or dominos, and if they bet they do it for small amounts. Others can’t live without playing; they risk ever greater amounts, endangering the family wealth. They’re sick, and their addiction to gambling is called ludomania.

The indignation and discomposure triggered by the economic recession currently racing through the world comes from well-grounded suspicions that it has been brought to us by highly regarded and copiously remunerated people who have been playing fast and loose with other people’s money, assuming unnecessary risks, and bringing us to the brink of ruin. That’s why, when the US Congress met for the first time to seek a cure for the crisis, hundreds of people demonstrated outside with placards demanding “No bailout!”

When money is loose…

The conditions for today’s crisis, quite similar to those that caused the New York Stock Market crash in 1929, have to do with money’s aging process. When it was young, money was used as a means of payment. But soon a few people started accumulating more than they needed to live, and looked for ways to do business with it. Banks were born to play that role, granting loans with the savings they attracted from those with disposable income. But with the passing of time more disposable money became available than was needed even for loans. This was seen as a good sign because it indicated that, at least for some, things were just getting better and better. But the panorama got a little messy when those who had amassed these fortunes wanted to earn even more money with them. That was when we began to see what is currently called financial engineering.

…and securities packages are closed

Stock exchanges are where shares in corporations are traded, but they also sell securities: pieces of paper that sometimes represent the imaginative creations of those who issue them. Even those who have never set foot inside a stock exchange participate in the dance, because that’s where the banks in which they deposited their savings invest excess money they can’t place as loans. As a result their money might be trading the currency of a country the depositor has never even thought of visiting, or immense quantities of a good they’ll never use. All this frenetic buying and selling is for no other purpose than the hope of earning something each time.

The recent rise in oil prices was in response not only to the real supply of those who produce it and demand of those who need it, but also the speculative operations of people who’ve never laid eyes on a barrel of petroleum, but who, directly or through brokers, have traded quantities that sometimes exceed what a small country consumes in an entire year. It is said that financial transactions can move a greater amount of money in a single day than changes hands in a whole month of real merchandise transactions.

To diversify the risk, i.e. to try to compensate the losses with winnings, a whole set of securities are generally handled simultaneously in these financial operations, and often the person who put the package together is the only one who knows its contents. When we go shopping in a supermarket, we find most food already packaged and labeled. When we get home we often find that the best potatoes were on the outside of the sealed bag and a half-rotten one is concealed inside. Something similar happens in financial operations. In the investment packages traded by speculators one finds some securities that are more profitable and reliable than others.

But there’s a big difference between potatoes and securities. We all know how to tell a healthy potato from a spoiled one, but hardly anyone knows how to distinguish a desirable security from an unstable one. That’s why people with a lot of money have to put their trust in a financial adviser, who acts in their name. Those who have few savings and deposit them in a bank aren’t even aware of what’s being done with their money. It’s true that people who hire a financial adviser receive a monthly report of what’s being done with their funds, but those reports refer to the trading of packages often identified only with impenetrable names.

But let us not exaggerate. Generally, financial advisers are trustworthy and competent, which is why your typical investor sees that after all the buying and selling that goes on in a month, his or her account keeps growing. Banks and securities exchanges work reasonably well most of the time because each player does what is expected: pays and collects on time. Some win, some lose, but the world keeps turning on its axis without major hiccups.

The collapse of the mortgage market

This time the crash started with the mortgage market, which has also functioned correctly for decades. Nearly all families who buy a home need to take out a loan to do so. The bank protects itself by requesting collateral from the applicants and verifying their solvency by looking at the movement of their bank account, their income and other assets or properties they might own. In addition, the real estate remains mortgaged to the bank until the debt is entirely paid off. If at some time the home buyer can’t meet a payment, the bank gets the house.

We still don’t understand very well why various US and European banks were so eager to spur the sale of housing complexes—perhaps partly because they had often financed the construction themselves—that they began granting mortgage loans to people they knew couldn’t meet their payments.

In the jargon born of this crisis, this type of client is called a “ninja”: No Income, No Job, no Assets. The mortgage market started filling up with rotten potatoes, or subprime loans, hidden in investment packages behind first-class securities. Some banks who grant ten- or twenty-year loans try to recover the money earlier by selling the mortgage to somebody else; since long-term securities pay more in interest than short-term ones, they assume there will be investors out there willing to buy them.

We can’t forget that stock exchange operations work because of the different expectations of those who participate in them. Both those who buy and those who sell think they’re cutting a good deal, because they’re planning their future from different perspectives. Some turn out to be right, others make mistakes, but as long as a good wind keeps filling the economy’s sails the earnings will be greater than the losses in the multitude of operations over time.

When mistrust
and panic take over

When an explosion, a fire alarm or even a false rumor is set off in a crowd, the panic alone can cause deaths. The stock markets work similarly. It’s oft-said that money has no nationality, and nowhere is that truer than in the financial market. Most committed stockholders in a company will put their shoulder to the grindstone if things aren’t going well, but when the person who has invested in a package without knowing what’s in it and who barely even understands the concept discovers the package is losing value, the tendency is to sell. As we saw in the first weeks of the financial crisis, stock markets can climb rapidly when hope is greater than fear and can collapse the very next day due to bad news.

But let’s get back to our ninjas, those who at some point declared that they couldn’t pay their mortgages. Each time it happened, the banks got saddled with real estate they didn’t need, so they put it up for sale. That unexpected glut in the housing market caused prices to drop. Those who were amortizing a healthy mortgage quickly realized that the new price of their house was worth less than they were paying for it. That’s why many of them, above all those who were buying a second or third piece of property to rent or fix up and resell, did the math and discovered they could cut their losses by simply not paying the mortgage.

When an individual client stops paying the bank, the person is in trouble, but if many stop, it’s the bank itself that’s in trouble. We can’t forget that the function of banks isn’t to sit on your money but to make it circulate. That’s why the bulk of your deposits are in other hands and your bank only keeps as reserves the amounts it needs to respond to the hopefully partial withdrawals depositors make from time to time.

Bank balances square because those reserves and the outstanding loans are the counterpart to the deposits banks attract. If most loans are paid punctually everything goes smoothly, but when panic spreads crisis ensues. First came the increasing numbers of mortgage holders who couldn’t or didn’t meet their monthly payments. Next came the easily spooked investors who offloaded packages that had both good and bad securities, causing the price of the good ones to fall together with those that had set off the alarm bells. In epidemics we end up mistrusting everyone and stay away from strangers to avoid contamination.

In the end, the problems in the stock market ended up affecting both banks and their investments. Because their debts exceeded their capacity to pay, major banking institutions previously seen as symbols of financial stability began to fall. When the newspapers started announcing that banks considered unshakable could be facing problems, the fear mounted. The crisis will suddenly get much more serious if there’s a run on the banks by depositors afraid of losing their money, and even the most solid financial institutions will have to ask for help to survive.

When a financial crisis becomes a recession

A large part of any economy functions through credit. But in a crisis, banks in trouble can’t lend. Because both consumers and producers rely on banks to keep functioning, a reduction or halt in the flow of credit paralyzes the economy to a lesser or greater degree. Some banks have dared to buy up other banks that were in trouble, but this move usually entails firing top managers, slashing personnel and radically restructuring the loan portfolios, which results in a new reduction of the economy’s financial flows. The illness even spreads to those not directly affected by the crisis because people who need a loan start asking friends and relatives, who now even more than usual fear giving money to those who can’t pay it back.
To sum up, we could say that the problem began with an increasingly “creative” and risk-taking financial market, moved to the ninjas who couldn’t pay their loans, continued with the collapse of the mortgage market, causing a crisis among some banks, and ended with a credit system that responded by severely restricting the air the whole economy needs to breathe. At such a critical moment, who can lend a hand?

The “visible hand” of the state

In the Great Depression, English economist John Maynard Keynes turned conventional economic theory on its head. Countering classic orthodoxy, in which the public treasury firmly insisted that a government can’t spend more than it receives, Keynes proposed using deficit spending to finance the crisis.

Private enterprise pulls back in recessionary periods because it is unwilling to produce what it won’t be able to sell. While a reasonable response on an individual level, it increases unemployment, reduces salaries and aggravates the crisis in the larger scale of things. What’s needed at that point is for the government to aggressively grant credits, increase public investment, implement aid programs and stimulate the construction of public works. Curiously, the United States listened to Keynes more England did, and Franklin D. Roosevelt’s New Deal slowly pulled the country out of the crisis.

Ever since Adam Smith coined the concept in 1776, classic economists have referred to the market as an “invisible hand” that acts like this: each person acting in his or her own self-interest improves the collective situation of all citizens. Economic neoliberalism reached new heights in the eighties, when Ronald Reagan was in the White House and Margaret Thatcher at 10 Downing Street. The doctrine of the “invisible hand” and the neoliberal current flowed to the universities, with new economic texts expounding the free market’s achievements in triumphal tones.

Today Keynes is back in vogue. Governments all over the world are again injecting money into financial institutions that are in trouble, requiring as a guarantee greater involvement in regulating and controlling the financial markets, and even in some cases demanding a partial transfer of the affected institutions’ ownership. At first, this state assistance went mainly to the banks to back up the deposits of millions of citizens who could end up in ruins if those financial institutions were to declare bankruptcy. There has been more reticence to help the auto industry, which in olden days was the motor force of the US industrial revolution, but finally the government has agreed to help them to save thousands of jobs, imposing certain conditions to guarantee their autonomous functioning in the future.

We don’t know how long this storm will last. The most optimistic speak of between 6 and 12 months of continued scares.

What about Venezuela?

It’s incomprehensible that some governmental spokespeople are still saying the crisis won’t affect Venezuela, even when we’re already caught up in it. There is, however, one aspect in which they’re right. The asphyxiating regulations imposed on Venezuela’s national banking system, with controls on exchange rates, prices, interest rates and commissions, made it hard for the banks to get mixed up in the international financial market madness. That hasn’t totally protected us from the backlash, however, because both national public and private banks placed various investments in foreign banks affected by the crisis.

The greatest effect we’re feeling is from the drop in oil prices, partly because real demand fell and partly because the speculative trade in imaginative barrels has stopped. Because less credit will be available in Venezuela this year, businesses, starting with PDVSA, the state oil company, could react by cutting production, with a resulting increase in unemployment, poverty and hunger.

It’s hard to predict with any security what will happen in coming months, because just as an unexpected phenomenon unleashed the crisis, another one could reverse it. Nonetheless, while we mustn’t lose hope, it wouldn’t be a bad idea to tighten our belts a little more.

Eduardo J. Ortiz has a doctorate in economic sciences. This article appeared in the January-February 2009 issue of SIC, a publication of the Jesuits’ Gumilla Center in Caracas, Venezuela, and was edited by envío.

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