(noun, etymology Dutch from ‘boedel’: estate, possession, inheritance, stock.). 1. Crowd, pack, lot, as in ‘the whole boodle.’ 2. a. Counterfeit money b. Money acquired or spent illegally or improperly, particularly when used in bribery for political purposes. 3. Slang for money in general.

Raise the Interest Rates and Call Me in the Morning (Part II)

Posted on: Jun. 21, 2011  |  By: Ronnie Kahn  |  Category: General

In Part I, we compared the body and the economy as integrated systems where everything affects and is related to each other.  This means that economists and physicians have to understand their field from a holistic point of view.  One of the biggest mistakes of the Financial Meltdown of 2008 was the government allowing Lehman Brothers to fail and go bankrupt.  The problem was that so many other products and companies were linked to them that it was not just allowing one company who made mistakes to fail but affected companies who had not taken undue risks.  Since everything is affecting each other, this also means that it is difficult to have rules of thumb when it comes to strategies for cures.  If steroids are used for asthma or inflammation, the immune system may be compromised which may bring on an infection.  If you are taking a number of medications, it is difficult to know how they will interact with each other.   The mortgage crisis ending up affecting a problem with emerging markets as well as huge liquidity crisis.  Even though interest rates were lowered to practically nothing, no money was flowing out into loans for businesses and even credit cards felt the effects too.  Economists also have difficulty knowing how their moves will affect the economy and just as importantly how their moves will be perceived by investors and everyone else.  Combine this with not knowing when to make the moves and you may be too late to head off the problem.  In one case, devaluing a currency might help when in the next it would be better to let the rate float, meaning to be determined by the market.   Keeping interest rates high may hurt business and cause a recession but it may also keep capital from leaving a country or stimulate foreign capital investment.   Capital investment in a country will cause the currency to rise.  Allowing markets to be free is generally perceived as a good thing but when banks use too much leverage or make bad loans and then the bank fails, this can then cause ripples to be felt all down the line.

As mentioned in Part I, when demand starts to shrink, this can start a stampede where everyone wants to cash out of an asset, a bank, or a country in the form of currency, bonds, or capital like the bank run scenario described above.  At this point, economists and institutions try to step in to curb the run.   Many have heard in the news of the problems with Greece.  The International Monetary Fund (IMF) can try to provide loans or money to help stem the tide.   However, when the IMF comes in, the perception is that we are at the point of last resort.  It would be like a patient in a hospital trying to convince you that all is well.   This is where the medical and financial comparisons differ a little.   If the patient is crashing, the options are shocking the heart back or giving some type of stimulant, such as adrenaline.  This is no time for a placebo.  If you remember the three legged stool of real economy, financial instruments and confidence, a decision must be made as to what to tackle first.  When a country is in crisis, what needs to be done is anything that will reverse the confidence and get demand back.  This means you may have to sacrifice the real economy in order to get confidence back.  You can raise interest rates or help the currency which may keep capital in the country but could hurt the companies back home and even start a recession.  This is why in Part I of this piece, I told of the case where you went to the doctor and the advice was to use cigarettes in order to help the ailment.  You need to do something to change perception even if it goes against normal economic principles or even if it might be the wrong thing to do.  In one case you can go out and defend your currency and in the next case you have to let your currency take a hit just to see if the reaction will be favorable.   Sometimes the answer is counterintuitive like giving Ritalin or speed to an ADHD child.  At some point though, the perception is that the bottom has been reached and it would be a good time to get back in before demand starts rising.

This means no one really knows what the reaction will be or whether it will work or not.  Does electric shock therapy work or not?  Should it be avoided at all costs or are there times when it can be effective?  Economists do not know what will work to change investor psychology.  Also, there are so many other factors that interrelate that economists cannot tell which factor will weigh in or which will drag down another.  There are hedge funds buying and selling currency and making bets that a currency will go down or up, there are corrupt governments and cronyism, and there are banks making bad loans.  If you give pain medication, you may help the pain but perhaps at the expense that the patient becomes addicted or depressed.

The next medical comparison underlies almost all the financial crisis we have experienced in recent times.  In many situations involving risk, there are principles that use agents.  If the agent and/or principle does not suffer from loss but is able to pass it along to someone else or some other institution, then you have what is known as a moral hazard.  Many persons are outraged that in the financial crisis of 2008 that no one paid the price either criminally or financially for misdeeds.  Then, the government stepped in by considering the financial institutions too big to fail further insulating the original culprits.  As a society, we want to have risk takers since they can have a positive effect on an economy by developing new products and services.  Bankruptcy laws allow a society to have individuals take risk and promote progress but with a safety net that allows them to take the risk.  However, bankruptcy still has consequences for the individual.  If an institution is too big to fail than the culprits do not pay a personal price.  If someone can game the system and make short term profits at the expense of everyone else than that does not advance the common good.  We want to have a balance between personal freedom, decision making, risk taking and being able to protect others, the common good, and to take personal responsibility.  For example, states make purchasing auto insurance mandatory.  However, the United States as a country does not like to tread on personal freedoms.  The medical comparison would be that those individuals who are overweight generally have more health problems than those who are not overweight.  Since insurance premiums are generally spread among all individuals, all of our insurance premiums go up because of these types of unhealthy decisions.  Generally, it is not our style to reward healthy choices or put pressure on making better ones. There is also a vast schism of income inequality in the United States which is only getting wider and wider.  At the same time, there is a correlation between longer life expectancy and wealth as well.

Is it time to start rewarding choices that help the common good?  While the system we have now does reward motivation it seems out of touch with pushing freedom over those who can game the system, cheat, or free ride.  In many cases, there are a lack of controls on using leverage in many of the institutions that bring down the system.  Leverage is being able to buy assets by only using a small portion of the cost and borrowing the rest.   When the asset keeps rising, more and more money is made and the bubble forms.  Then, when the price starts retreating, the businesses cannot come up with enough money to pay back what they have borrowed.  In the 1990’s, the new globalization allowed currency traders using such techniques as leverage and short selling, selling an asset first and buying the spread later when prices drop, to cause whole countries’ currencies in Asia and South America into a currency meltdown which then led their economies to go into a financial crisis.  Allowing these types of risks where a limited few gain at the expense of all others would be like that if we would still allow financial bloodletting and financial lobotomies to occur.  These obsolete methods need to be replaced by sensible ways to allow freedom while keeping safety nets in place or putting making the agents and principles accountable.  This uses a leverage of fairness and not moral hazard.  This is not even to mention there are less controls on investment banks and few controls on banks that act as bank but actually aren’t, along with hedge funds, currency, and commodity speculation and manipulation.  The combination of lack of regulations along with moral hazard usually contributes to a financial mania and then turns lethal after the bubble bursts.  Also, in a global financial world, capital is flowing in new ways that create new bubbles.  Extreme financial contagions take all of us down.  When this is due to the normal ebb and flow of supply and demand, most of us are okay with that type of stampede.   When the rare extremes stampede is started by moral hazard risk though, I think all of us, except the risk beneficiaries, want this to change.  Also, the real economy part of the three legged stool seems to take a backseat to needs of financial instruments and central bank strategy which is why our businesses seem to be less competitive and jobs aren’t being added.  We now have a divide between Main Street and Wall Street yet each should be working for the benefit of the other.  Our financial system not only has a weak heart when it comes to the common good but it needs an outright heart transplant.

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