Opinion Archive

What to Make of Financial Confidence Tricks

October 1, 2008

Finance is a little like a confidence trick, a shell game, or a pyramid scheme. Without trust there can be no transaction. Without transactions there is no economy. This is the rabbit hole that Wall Street has gotten into.


The use of what Boston financier Eric Connerly calls "a medieval metal", under the gold standard, was a previous generation's attempt to provide a universal foundation for money. Gold provided confidence because people knew that it could not simply be printed, the way paper money can. But, with a deliciously self-serving declaration that "we are all Keynesians now", President Nixon pulled the US out of the gold standard in 1971, at the nadir Vietnam, another shoddily-funded war.


Today, confidence is scarcer than gold. And confidence is what the Bush administration wanted to inject into the system in the form of what was basically an unlimited amount of funds. Under this plan, financial sheriff Henry "Hank" Paulson would be given free reign to round up the bulls that are loose in the financial China shop.


Of course, given enough political will, the US can always "print" more money, getting out of any financial mess. This would certainly make the dollar worth less and cause more inflation. But, given enough tolerance for budget deficits and inflation, any financial crisis is surmountable in the short term.

Been there, done that...

Mexico didn't have the benefit of issuing reserve currency manna from Treasury Heaven when it legislated its massive bailout in 1994/1995 (called "FOBAPROA"). The result was a rescue plan equivalent to 19.3% of GDP, compared to "only" 5.8% of GDP if the whole Paulson enchilada were to be used, according to The Economist.


In the case of Mexico's rescue, the US taxpayer actually made money. As former president Bill Clinton observed last week on Larry King "Live", his creative use of the Exchange Currency Stabilization Fund to help bail out Mexico actually generated a $600 million dollar profit. In what has to be one of the great historical ironies in international political economy, both the Mexican leftist conspiracy theorists and the American rightist conspiracy theorists had a hissy fit. But, against the naysayers, it worked. Mexicans were able to cash their checks and Americans made a tidy profit.


Today, eggheads are pointing to the Swedish model of bank rescue for guidance (cost: a mere 3.6% of GDP). In that case, the authorities snagged a whole bunch of equity when they filled the coffers of their banks with government money. Once the system recovered, the taxpayers made out like Erik the Red because they owned equity (shares). Once confidence was restored, life was good: confidence+invested wealth=bonanza.

Not seeing the forest for the trees

Capitalism works its magic when the virtuous circle of investment, trust and talent come together. Productive enterprise channels money and creates wealth. Wealth creation then raises the quality of life. Paraphrasing Churchill, "there is no system worse than capitalism... except for all the rest."


The truth is that never in all of history has so much wealth been generated for so many. The spectacular rise of China has put paid to the old argument about global "winners" in the economy exploiting Third World "losers". We have seen that "win-win" situations can be common. To use the current financial dip to justify an attack on the entire wealth creation machine that is the global free trade system is to condemn billions to poverty. Today's crisis is a footnote in a generally happy narrative of global growth: just look at the difference between Seoul and Pyongyang. In fact, google images of the "Korean peninsula by night" and guess which side is attempting autarky and which one has benefited from free trade capitalism.


In Mexico's case, the country's "fundamentals" (budget, monetary policy, etc.) are sound, but its projected growth for 2009 has just been reduced from 2.8% to 2.4% because of the slowdown in the US and lower oil production. In general, both the economic troubles and the shocking levels of violence nationwide will probably affect the country's third-largest earner, tourism. At the same time, the collapse of the construction industry in the US means that remittances (running at about $25 billion dollars a year) are falling. Nevertheless, Banco de México seems to have things stable and the country should avoid a recession, as well as high inflation.

...and the (le) denouement?

As for the Mother of All Bailouts, determining whether it was the right thing to do is, to quote Senator Obama, "above my pay grade". As an investor, your correspondent prays every night that the sub-prime submersion will go away. When that happens will depend on when society gets its mojo back.

For the latest thought-provoking article by Agustin Barrios Gomez please go to our Opinion Column page

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