The Business Times, Saturday 22nd Nov, 2008

(An abridged version of this essay appeared in the Business Times of 4 October 2008)

WEALTH INSIGHTS

Lesson one: Caveat ideology

There are no tailor-made ideological solutions for problems. Capitalism and socialism are tools, not turn-key solutions

By JOSEPH CHONG

CEO, New Independent

MANY books will be written about the current global financial and economic crisis. Blame and mistakes will be found in abundance. However, it is clear that serious mistakes were made by US regulators before and during the crisis.

Among the errors, perhaps the mistake of a lifetime was the bankruptcy of Lehman Brothers. Financial data shows that markets expected some sort of nationalisation - not bankruptcy. Ironically, prior to this bankruptcy things appeared to be stabilising, as mortgage and other interest rates were trending down. The bankruptcy was the heart seizure that deprived companies and consumers worldwide of credit, which is the lifeblood of business activity. This was the tipping point that pushed the world into recession.

So far, three different excuses have been given by Messrs Paulson, Bernanke and Co (PBC). First, they assessed that the market could bear it. Later, it was because, unlike AIG, Lehman did not have the assets to get a loan from the Fed. Finally, they settled on prevailing laws not permitting them to nationalise Lehman. Will the real reason please stand up?

Lehman's bankruptcy was a trillion-dollar bet by PBC that should never have been wagered. That one bankruptcy was the equivalent of 30 of our local banks going bust around the world at the same time without deposit insurance. Any wonder that the world's financial system seized up? US Treasury Secretary Henry Paulson will be gone by Jan 20 next year. If incoming president Barrack Obama is consistent with the principles of management accountability, I would not be surprised if Ben Bernanke is not renewed as Fed chairman when his term is up.

PBC are obviously very intelligent and qualified. Therefore, the mistakes committed were perplexing. Although conspiracy theories are circulating, I believe PBC were blinded by ideological moralism - a misguided belief that the free market is the cure for all ills. In the case of Lehman, the markets needed to be taught a lesson on moral hazard - no one is too big to fail. They allowed Lehman to fail despite publicly acknowledging that bank bankruptcies were one of the major reasons for the Great Depression.

Indeed, there is a common thread of blind faith in self-regulating markets running from the past:

• Failure to regulate the credit rating agencies, allowing them to rate sow's ears as silk purses.

• Failure to regulate credit default swaps despite all the warnings from experts.
• The refusal by former Fed chief Alan Greenspan to regulate mortgage brokers, despite being empowered by Congress since 1994 and despite warnings from his colleagues of widespread predatory lending.

• Allowing investment banks to be so highly leveraged - far more than commercial banks - in the name of free market deregulation.

Ideology may have blinded PBC to the most basic understanding of the financial system they were regulating. All modern banking systems are inherently unstable without the implicit guarantee of central banks. Banks take short-term deposits and lend long term, supported by equity amounting to less than 10 per cent of all loans granted. Central banks ultimately function as lenders and shareholders of last resort.
Indeed, before the creation of the US Federal Reserve in 1913, bank runs and failures were common. Even in the best of times today, no bank today could survive a run on 10 per cent of its deposits without help from its central bank. Moral hazard is thus inherent in the modern banking system.

Indeed, government involvement in the banking system is not only implicit but explicit - and 24x7. Central banks are constantly regulating the price of short-term money through interest rates. Therefore, to say we have a free-market banking system without government involvement is nonsense.

What stood out during this crisis were Singapore and China. Singapore has been constantly assessed as one of the world's freest economies, while China is a communist command economy. However, the commonality between the two has been the philosophy of economic pragmatism.

Herein, there is a view that there are no tailor-made ideological solutions for society's problems. Capitalism and socialism are viewed as tools, not turn-key solutions. And Milton Friedman and John Maynard Keynes are mortals, not deities. Indeed, in both countries, progress has been made using a variety of capitalist and socialist tools to address the basic goals of society, which are on-going goals even in the US:

• Food - at least three meals daily.

• Housing - without 'socialist' HDB, capitalist Singapore would still be Third World

 • Education - literacy.

• Healthcare - access to basic medical care for everyone.

• Security - internal (crime) and external (invasion).

Indeed, in its purest form, free market capitalism is dysfunctional because people tend to cheat. It is also inconsistent with Second Law of Thermodynamics. Because of the Second Law, the tendency of any system is to dissipate useful energy, which is why perpetual motion engines are not possible. The 'invisible hand' as postulated by Adam Smith is the impossible perpetual motion engine of the economy.

Hence, to keep things moving, work and energy have to be input to reverse the on-going dissipation. This is the human factor of skill, effort, honesty and adaptive thinking. This is the rationale for having good people leading in society and the compelling rationale for good government. Perhaps, Singapore should develop economic pragmatism into a guiding philosophy. Perhaps, having it as a state philosophy would be too much, but we could have it as a little booklet to be issued and taught in schools, thus inoculating future generations against ideological thinking. Mao had a little red book, ours could be grey. Meanwhile, it must be caveat ideology for investors going forward.

The writer is CEO of financial adviser New Independent. He welcomes feedback at : josephchong@ni.com.sg

This article is for information only. Readers should seek independent advice before making any investment decisions