Martin Wolf: new and improved ants and grasshoppers (contains locusts)

two reader questions

Martin Wolf has written a second version, an “elucidation,” of his ants and grasshoppers fable in the Financial Times. It comes in response to readers queries, and tries to answer two questions:

–why, if the process is as simple as ants and grasshoppers, both of whom are disadvantaged at the end of the day, doesn’t someone realized what’s going on and stop?  Why is it only when the ants are left with dubious debts and the grasshoppers are up to their ears in half-built tract houses and unsalable McMansions that the light bulb goes on?

–what should the ants do with their trade surpluses, if not lend to grasshopper nations, effectively providing vendor financing for their purchases?

answer #1:  locusts

In Mr. Wolf’s new and improved fable, there are a third group of insects, which he calls “locusts,” the term Central European officials use to describe hedge funds.  Locusts are “financial capitalists,” fashioners of and dealers in financial products that help the flow of money along between ants and grasshoppers.  But, either by accident or by design, these products don’t reveal the true nature of what’s going on.  They obscure it,  preventing both ants and grasshoppers from realizing the situation they’re in until the damage is so overwhelming it can’t be ignored.

To my mind, there’s certainly a lot of truth in what Mr. Wolf says.   Investment bankers are the intellectual heirs to the American empresario P. T. Barnum.  In one of his more famous gambits, Barnum, unable to admit more customers because in his mind people were lingering too long in his carnival tent, put up a sign reading “This way to the Egress.”  Thinking this was a new attraction, customers followed it and found themselves out on the street.

How different from that are the claims, “It’s as safe as cash, but with twice the yield.”, “It has all the return of stocks but none of the risk.” ,”Yes, they’re all sub-prime, but if you arrange them in a certain way they’re really AAA.” ?  Not much.

While highly unethical behavior by investment bankers may be a large part of the story, it isn’t everything.  Specifically:

1.  Western commerce operates under a semi-religious belief in the “invisible hand” of the market, articulated by Adam Smith in his Wealth of Nations.   The idea is that the optimum economic result is achieved when individuals all act in their own (narrow) economic self-interest–without coordinating with each other, and without knowledge of or thought about what the optimum result might be.

This idea has been repackaged by academic finance as the efficient markets hypothesis.   Whatever the merits of the hypothesis (none that I can think of), it’s what every MBA student in the most prestigious business schools in the world is taught.

These beliefs provide some justification–maybe create a disposition–for both creators and buyers of shady financial instruments not to worry about the consequences of their actions.

2.   It’s not just locusts.  There’s another side to the coin.  In the cold harsh light of day, the sales pitches I mentioned above sound absurd.  The last one–that if you arrange the deck chairs in a certain way, you’re no longer on the Titanic–is perhaps the most unbelievable.  Yet lots of people did.

Investment bankers may have sold toxic products, but clients bought them, often apparently without doing even elementary due diligence–and even though on some level they must have known that the claims were too good to be true.  One early case of sub-prime trouble involved a Nordic municipality which had invested a large part of its treasury in a product created by Citigroup.  the offer documents were in English.  A local sales agent, a regional investment bank, prepared a summary in the local language, in which it “forgot” to mention any of the risks.  The town reportedly risked its fiscal future on an exotic foreign derivative without even reading the offer documents.  Must have been a great dinner the sales guy invited the town fathers to.

answer #2:  lend to younger ants

I agree.   The trick, though, is being able to do so.  It’s harder than it seems.

For one thing, as Mr. Martin correctly points out, history is littered with cases of loans to developing nations that have gone bad.  Some of that history isn’t particularly relevant, however, because lenders often engaged in abusive practices that predisposed borrowers not to repay.

Western “foreign aid” loans often had provisions requiring the recipients to purchase from companies domiciled in the lending country.  These firms charged prices hugely above the going rate, knowing that the buyer had no choice.

The Seventies and early Eighties were the era of Walter Wriston, the now-forgotten head of Citibank, whose mantra was that sovereign credits never default, and who urged commercial banks to increase their lending to developing countries.   At that time, banks made their biggest money from loan syndication fees, not from interest income.  Often, loans for projects that would generate foreign currency for the developing country were deliberately designed so that repayment was required shortly in advance of project completion.  In other words, all parties knew from the outset that the loan would need to be refinanced–generating a second round of syndication fees for the bankers.  Yes, an abusive practice–but developing countries again felt they had no other option.

There’s a second issue with investing in developing nations, having to do with equity rather than debt.  Several decades ago, the IMF tried to encourage developing nations to allow foreigners to take equity states in local companies, rather than just lend to them.  The idea what that in times of economic weakness, these firms would not have to contend with the potentially crushing burden of continuing interest payments.  The IMF arm-twisted Korea and Taiwan into creating closed-end equity funds that were closed to foreigners.  Otherwise, it got no takers.  Why not?  No one wanted to sell their country’s crown jewels to foreigners at a price that would seem absurdly low five or ten years hence–the same reasons foreigners are eager buyers of emerging market assets.

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