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US Economy Still on Life Support

Politicians and the Global Financial Crises

Politics / Credit Crisis Bailouts Jan 21, 2012 - 12:23 PM GMT

By: Akhil_Khanna

Politics

Best Financial Markets Analysis ArticlePolitical System
The seeds of the global financial crises which were triggered by the collapse of Lehman Brothers in the USA in 2008 had been sown during the last number of decades. The basic reason for the emergence of the crises is the manner in which we select our leaders or politicians in our society. The politicians are the key persons responsible for laying down rules and regulations which the population of the country are expected to follow. The strict, severe and swift penalties for not adhering to the rules and regulations are supposed to act as deterrent for people from breaking the law. In the current system of elections there are some inbuilt weaknesses which do not allow the politicians to follow their basic responsibilities.


The process for a politician to be elected in a democracy today has become a very expensive venture. The political candidates have to incur heavy expenditure to cover as much print and media space as possible before the elections to project themselves in a favorable light in front of the people who cast their vote to elect them. The political candidates can incur such huge expenditures for fighting elections only if either they themselves are deep pocketed or they are backed by rich individuals or corporate sponsors. This can be verified from the fact that how many political candidates have arisen from middle or poor class families and won elections. The percentage of such people would be miniscule.

The government is the biggest entity which collects and decides where to spend the money of their citizens in any country. They collect taxes from their citizens and have the powers to borrow money from rest of the world by selling government bonds against the future earnings of the country. They also have the powers to decide where that money has to be spent and who would be the beneficiary of the money they spend to develop their country. The government allocates financial resources in an economy through government contracts for building infrastructure in a country and pay for services like medicare, security, education etc. necessary to run the country and implement the rules and regulations laid down under the constitution. The government is under no pressure to run their organization efficiently like a private sector as they are not encouraged to cut costs wherever necessary and achieve maximum results using minimum resources. The politicians like a bigger government as more the resources they control, more the power that they enjoy in almost every aspect of running the country.

The elected politicians are aware of the fact that they have the powers and benefits of the office for a few years before the next elections take place, when they might or might not get elected again. The loyalties of the elected politicians lie towards the individuals, corporations and unions who have helped them get elected and they do everything in their powers to provide them with maximum benefit. The desire to do something for the upliftment and benefit of the citizens of the country takes a lower priority. This creates a cycle of corruption whereby the rules and regulations laid down favor a small percentage of well connected individuals and entities. The government contracts are allocated on the basis of political connections or for kickbacks to the official empowered to allot them. The most preferred path to tackle the actual problems facing the economy is to postpone them as far as possible in the future so that the subsequent governments have to deal with them. Rarely would you find a politician who would be willing to go against his/her sponsors wishes and take tough decisions which would be beneficial for their country or a majority of the citizens of the country. 

The result of this leadership process is that the income disparity in the country keeps on growing as the small portion of the individuals or companies, enjoying the patronage of the politicians, keep on getting favorable working environment and accumulate wealth at a great pace. A study done at the World Institute for Development Economics Research in 2008 revealed that the richest 1% of the world population owned 40% of the global assets, the richest 10% of the population owned 85% of global assets and the bottom 60% of the world population owned barely 1% of the global assets.

The rest of the population have to be content with tough living conditions and begin to depend on the small influential portion of the society for their livelihood. They realize that they have to pay bribes or seek out favors to get any job done from the government. The corruption in the government seeps from higher levels to the lower levels in the hierarchy as the junior employees see their seniors getting away with illegal gains without any risk of punishment for their actions. Corruption also flows in all the departments which provide services to the citizens, like healthcare, education, infrastructure, security (police and armed forces) and judiciary.  This breeds discontent in the country and gradually the citizens’ loose trust in the law or law makers and their leadership skills to make their lives better as they face higher taxes and in return have to live with poor infrastructure and services.

As the government grows bigger, a majority of the tax collections and government borrowings are spent in maintaining the government (in the form of ever increasing employee salaries and benefits) and paying interest on government borrowings as the government does not adhere to the norms of living within their means and cutting expenditure wherever unnecessary. A corrupt government encourages weak and corrupt law enforcing agencies so that they can achieve their objectives with minimal resistance. Hence, there is little the majority of the citizens of the country can do to stop the elected officials, while they are in office, from diverting the financial resources of the country to their favored group of entities or individuals.

Over the years, the tax laws have changed from higher tax rate on higher income to lowest tax rate for the rich and influentia­l and higher tax rate for the rest of the citizens. This too is leading to increased concentrat­ion of wealth in the hands of a small percentage of the population­. The result of this is that the influential financial institutions and companies who have paid a small portion of the total tax collected over the last decade have walked off with billions of dollars of bailouts which have been funded by the tax collected from the rest of the population which is now bearing the brunt of unemployme­nt and foreclosur­es.

Politicians and the Ongoing Financial Crises
The failure of a major finance company like Lehman Brothers in 2008, set off a chain reaction which burst the biggest credit bubble created in the history of our planet. Many of the life insurance companies, public fund management companies who had invested in the, presumed safe, mortgage-backed securities and exotic financial products marketed by the financial institutions were facing heavy losses and were holding assets which they could not sell. Apart from this, the banks faced heavy losses and were on the verge of bankruptcy asked the governments for bailouts without which they could not survive. A major liquidity problem had arisen.

The elected politicians and central bankers adopted the only solution that met their objectives and was in the best interests of their sponsors and donors. They decided to adopt measures which postponed the hard decisions in the future even though it would create a much bigger problem down the road. The governments could have let the big risky commercial banks go bankrupt or could have taken over their management and broken them into smaller banks which would no longer be a threat to the global banking system, before giving them bailouts to tide over the prevailing crises. They could have used their reserves or raised more money by selling government bonds and utilized that money to improve the infrastructure of their countries by building roads, bridges, transport system etc. This would have contributed to immediate creation of jobs and improved the efficiency with which the domestic companies conducted their businesses. The excess debt raised for this purpose could have been paid back by improving tax collections from the recovering economy.

Instead the short term approach to problem solving led to the decision by the governments and central bankers around the world to provide trillions of dollars of bailout to banks to keep them functioning even though by traditional parameters they were bankrupt. Even the managements of the big financial institutions which had brought the world financial system on the brink of collapse were neither sacked nor were any criminal charges brought against them. The central governments allowed the banks to value the investments on the basis of costs instead of the earlier practiced method of cost or market value whichever is less. This portrayed the illusion that the banks were solvent and did not have to provide for losses had they valued their investments on it’s market value. The governments bought these investments from the banks at cost value which was much higher than the value for which they could sell them for. The governments effectively transferred the bad loans on the books of the banks to their own books at full value in exchange for government bonds.

The economic system before the bursting of credit crises was one of capitalism and free economy where businesses took risks to earn profits and bonuses and closed shop if they were not successful and incurred losses to be replaced with better managed companies. Since 2008 this has changed to one where the influential and well connected corporations enjoyed enormous profits and bonuses when they took exceptional risks with other people’s money and if they incurred heavy losses, the sympathetic governments and central bankers would arrange for the taxpayers to bear those losses so that they continue to take huge risks and enjoy their bonuses. As a result of this short term approach to problem solving and having transferred the private losses to the country’s balance sheets the debt levels compared to GDP of countries has shot up sharply in the last couple of years. Many governments find themselves overburdened with debt and this is leading to a risk of higher borrowing cost of funds for countries and the economically weaker ones are on the brink of bankruptcy.

The short term approach to problem solving is very evident even today. The EU is offering billions of dollars to Greece to save them from default, who is suffering from excess borrowing and spending and the repercussions of a housing bubble burst. There are only three final outcomes to debt, Repayment, Default, Part repayment part default (Lender books losses). No logic suggests that a problem of someone suffering from excess debt can be solved by taking on more debt. The only thing this solution does is assure a bigger default in the future. Even if Greece adopts the austerity cuts and reduces its expenditures by sacking government employees, the subsequent result would be lower GDP, lower tax revenues and higher deficits resulting in increased borrowings. Moreover lending money to Greece by the foreign banks and lenders was a commercial decision whereby they received a higher interest rate to compensate for the risk they took in lending to Greece. The losses of this mess ought to be borne by lenders who enjoyed supernormal profits in good times and knowingly took the decision to lend to Greek banks and should not be borne by the tax payers of Greece or the taxpayers of other European countries by funding endless bailouts. The foreign banks being backed by politicians of bigger and stronger countries and global financial institutions are insisting that the Greek banks repay them in full even though this is likely to push the Greek economy in recession for the foreseeable future. The politicians of the weaker or highly indebted countries facing default are being pressurized to keep the interests of the lending financial institutions ahead of what is in the best interests of the citizens of their countries.

There is another reason as to the immense political pressure being applied on Greece to get their bond holders to accept a voluntary default on the sovereign bonds. The too big too fail financial institutions have sold trillions worth of credit default swaps (CDS) on the debt borrowed by the countries around the world. The derivative markets are unregulated and there is no limit to the CDS that can be sold against the amount lent by the bond holders. Anyone can buy CDS on debt by paying the prevailing premium even if they have not lent a single dollar to any country. CDS worth trillions of dollars can be sold against the 350 billion dollar Greek debt. There is a major conflict of interest here. The sellers of the CDS would do anything in their power to stop an involuntary sovereign default to avoid making obligated contractual payment, whereas the buyers of CDS would go out of the way to ensure the event of a forced sovereign default to claim the amount in full from the CDS seller.

In times when the sovereign default risks were low, the financial institutions were pocketing premiums on the CDS which was one of the major sources of their revenues and resultant bonuses. As the risk of sovereign defaults increased the demand for the CDS and their premiums increased, resulting in more revenues for the CDS sellers. If the bond holders accept a voluntary sovereign default by the borrower country, the CDS are not triggered and hence no payment has to be made by these institutions.

However if the default is involuntary or forced, these institutions would find themselves unable to make payments to the CDS buyers resulting in their bankruptcy overnight. Hence all lobbying efforts are being used to prevent an involuntary sovereign default which is likely to trigger a chain of bankruptcies around the world which most likely cannot be controlled by all the governments and central bankers put together because of the sheer size of the CDS market. Hence the pressure on the politicians to get the bond holders to declare all sovereign defaults voluntary so that the major financial institutions do not have to make payments against CDS while continuing to collect the premiums on them for their future revenues.

Akhil Khanna

Articles previously written by the Author

By Akhil Khanna

akhil.capricorn@gmail.com

I am an MBA Finance from the University of Sheffield, 1992 and have more than 15 years of experience in the field of Financial Management. I am a keen student of the Flow of Money around the World and enjoy studying the fields of Currencies, Stock markets, Commodity Markets and Bonds.

© 2009 Copyright Akhil Khanna - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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