The Invisible Hand is Sick

Recently, I was watching a well-done CNBC documentary about the causes of the credit crisis. The program included a series of interviews with people who took out subprime loans, people who sold them those loans, people who securitized the loans, and the representatives of foreign entities who bought those securitized instruments.The running theme of all these interviews was “Greed.” The interviewer would ask, “So, it was greed that made people do so-and-so, right?” The answer was always “yes”That made me think.This greed that everyone is attacking as the cause of the breakdown – isn't it really what we preach in all our schools of business and economics? It has another name: the profit motive. Don’t we teach that the more earnings per share, the better?True, profits have to take into account the long term needs of the organization. Very often, however, the question that must come first is, How does one survive in the short run?Here comes the second ingredient that we need to take into account: competition. If a certain CEO refuses to follow the short-term profit orientation, and thus his or her earnings per share are continuously inferior to what the competition is getting, he or she will be fired. Not only that: This individual will be sacrificing a significant amount of his or her personal remuneration, because a significant part of it is almost certainly based on stock options.So what's happening? Everyone tries to make as much profits as they can in order to be better than the competition, and in order to show successful performance.There is an expression in the Balkans: “If you join a circle dance, you'd better dance.” Similarly, if you operate in a competitive market economy where you are measured by earnings per share, you'd better gets those profits in – or you will not survive in your position.I recognize the fact that this principle is not always universally true. The new economy, the one based on the Internet and e-commerce, can get high and growing valuations for years without making profits, as Amazon did before it moved into the black. But please notice; this only happens because the investors believe that eventually the company will in fact make money. So the profit motive is still the driving force.As I watched the interviews, I noted with interest that all the players were acting legally. No one went to jail for the credit crisis. That's because no one did anything illegal. The buyers of the subprime loans believed that their equity in the house would in fact grow. So they bought those houses assuming they would be able to refinance them later on. The salespeople selling those subprime mortgages were following their profit motive: there was a market for those mortgages: Wall Street. Wall Street was following its profit motive, buying those mortgages, putting them into a portfolio, rating them with a rating agency and selling them abroad. And Wall Street was making money doing so. Any of those Wall Street companies that refused to follow the profit motive would disappear. So everyone had to join the “circle dance.”The rating agencies were giving AAA ratings because they assumed, like everyone else, that the value of homes would continue to increase; no one could predict when that upward trend would stop. And if any agency had made a policy of being too conservative and refusing to pass along the AAA rating, it would have lost business to the other rating agencies, and might even have disappeared from the market.The buyers abroad were similarly motivated by the promise of profit. They bought those securitized AAA financial instruments that promised such high returns on investment, and seemed not too risky ... because of the AAA rating.The famous “invisible hand” was working well. (Economist Adam Smith used the phrase “invisible hand” as a metaphor for free market forces, to explain how the market self regulates itself, brings growth, and secures optimal allocation of resources.)Yet trouble was ahead. People were taking mortgages they could not afford to pay if home values ever stopped going up. That, of course, is precisely what happened. The bubble exploded, as bubbles do. Nothing is forever.In the interview, Alan Greenspan, the chairman of the Federal Reserve Board at the time, was asked, “Why you did not do anything in time to stop this potential disaster?” His response: “You think the Congress would let me?”Greenspan was right. Which politicians would dare to stand up and stop Americans from owning their home? They would be crucified by their competing politicians and would lose their offices in a hurry.So here we have three interconnected factors: the profit motive, competition and a political system based on being elected by promoting popular agenda.No one went to jail for the worst economic crisis we had in years. So who was at fault? All of us, and no one in particular. The system was at fault.It was that invisible hand that is not working well, thanks to a three-legged stool: a combination of profit motive, competition, and democracy based on people being elected by following popular causes.I repeat: No one in particular is guilty. They all individually did what they were trained, and rewarded, for doing. The system itself is the culprit, and until the system is fixed we can assume more crises in the future.We have a systemic malady and it requires fixing. Singapore fixed this problem by removing one of the legs from the three-leg triangle above. They do not have a competitive election system where political parties compete for power. There is no opposition to speak of. One party runs the show. Party members are highly paid, and there is no corruption to speak of. Singapore has a strong government that does not cater to the electorate and does what it believes to be right.President Obama is trying to fix the problem by fixing a different leg, that of open competition. He is putting more regulation in the system, but doing so is making him politically weak. He will not be reelected for a second term. It is possible that he has already decided that losing an election is the price he is willing to pay to fix the system.The third leg of the profit motive is untouched. The new generation of young people criticize the profit motivation and would rather go surfing, but until we find another way to measure performance and reward for it, the profit motive will remain a driving force in our society.I believe we need to redesign the system not one leg at a time, but in its totality. The capitalist market economy and democracy as we know it and experience it need reengineering. This reengineering will probably happen only after a crisis even bigger than the one we just experienced. Unfortunately, such a crisis now seems inevitable.