Receeding Capitalism

The series of unfortunate events in banking, spreading to manufacturing, to job losses had to reach governments too. Governments, like the brave kings of yore have ridden in to the rescue. They have bought up banks, guaranteed deposits, secured pensions. Do not worry, your money is safe with us. (To discuss whether these governments are safe would border on political, which I declare out of the scope of this space).

For years it is these very governments that have prided themselves on being the vanguard of capitalism. Through the IMF they have declared large public sectors evil. They have made privatisation a condition of more funding in many emerging markets. Conditions there were similar – high debt, high public sector deficit, high trade gaps and high levels of unemployment.  Then, these conditions were chronic, and the solution was to shrink the size of the government. Now, it is ironic, that the same issues result in expanding the government. Did I hear that right?

 

So what happens to capitalism in this brave new world? Does it get redefined? Are free markets an unsustainable myth? Is equilibrium a mirage? Will there always be power and politics that controls the balance between safe and sorry, between creative and chaos, indeed between rich and poor?

 

They declared the death of communism a few decades ago and now capitalism is on the wane, for it has proved once again to be a false god. Will we forgive this once again and go back to being ruled by fear and greed, or shall we choose new gods to rule over us.

Or maybe, is it just possible that we emerge into this world, where there is funding for every good idea, rewards for every honest saver and investor and security for every home while keeping freedom for every individual? If this sounds like a fairy tale, maybe it is, for it does not mention the dark underbelly of risk – where things go wrong.

I wonder, and this is just a thought, that if we did not deal with chunks of money, and dealt only with slivers, would things be different? We aggregated money traditionally only because of intermediaries who knew how to deal with them. Truly, in this day of web 2.0 (and growing), do we need these intermediaries at all? We need information, analysis, processes and transactions. But do we need these to be consolidated in financial intermediaries? Or can we throw this yoke off now?

Fear and Greed

Fear and Greed

 

There was a time, I admit, when I was an investment banker. And the one lesson I took away from there is that the world of money is controlled by two emotions – Fear and Greed. Economic models are all very well, as are the sophisticated financial models that predict markets that only rocket scientists could understand. (By the way, it is true, the myth that rocket scientists have contributed to financial market models). But every trader at our desk knew, that whatever the models said, the only way to predict which way the market would go was to be an astute judge of emotions.

 

So, how did they get it right all the time? They did not. Nobody can be a perfect judge of emotions, even their own, let alone an entire markets’. Ever been in a relationship? Yup, see what I mean? As long as you win more than you lose, you are doing well. If you win more than 80% of  the time, you are one of the greats. If you win all the time, you are a star for now, but every star falls sometime.

 

Is that what was happening in the markets? Were our billions being traded, nay gambled, on somebody’s opinion of whether fear would rule the day or greed?

 

I believe so. And I do not disapprove at all. For years, when things were going our way, neither did we. Now, now, gotta be fair.

 

What is really important here and now is to realize this and build it into our future. We cannot let this happen to us again. If we do not know what went right and what went wrong, we will never be able to make things go right for us. Economic rationality is not all, which is why economists came up with bounded rationality. (more on that later, if anybody is interested). 

 

We need to be able to build emotions into financial decision making models – like impulse, inertia, temptation, greed, peer pressure. All of these have played a role in our financial decision making at some time or the other. The big question is how.

Watch this space, I’ll think of something(!)

 

(c) meetasengupta

Of Rationality

Assumption number one of all socio economic sciences is rationality. All economic theories depend on this assumption, all models of financial behaviour are built to the expectation that the participants in the money game will behave rationally. If rational behaviour does not occur, the theories and models are rubbish – of less value and must be looked at again (rubbish).

So what is this rationality? It means that given a set of choices, people will always choose the option that gives them maximum value. So, if you have a choice between two banks to save your money in, one offering 3% and the other offering 4% returns, you will choose the one that gives you higher returns. Another example: if you have a sum of money to invest, you will invest it in a project that promises you the best returns (adjusted for risk).

Sometimes this does not work, of course. We are human beings and do not always operate in our best interests. (My coaching business is built on this assumption!) Going back to the example of the investor in a project: suppose he has two choices. One with a cousin whose family have been very kind to him and put him through school where the investment will yield 10% return. The other option is to invest in the bank at 10.5%. Both investments are for the same time period. The cousin’s business is of course more risky than the bank, but not really very much more. It is an established business and he just needs the money to refresh his machinery. The business has been giving higher profits than the 10% promised for this deal, so we are quite sure we will get the money back. What should our investor do?

Rationality demands that he maximises his returns and invest in the bank. But when unquantifiable emotions of loyalty, friendship or even fear come into the picture, economic decision making will not necessarily be rational. How will the computers and the financial models deal with this issue?

This is not the only time when rationality is abandoned. How many of us have said, “I must have a salad for lunch” and ended up eating something much more calorific? The rational decision making process was abandoned for something that gave a different kind of value. Or invested our purchasing dollars in the chocolate market when other markets made stronger calls on our wallet.

Why bother with rationality at all? Why does it matter? Because all of our markets are built and sustained on their ability to predict. The salad bar stocks as much salad as they predict rational customers will buy. If impulse takes over from rationality, then the shopkeeper must hold wasted stock, which, since it is perishable is a clear loss. 

Banks too have the same principle. They hold only as much loose cash as they predict will be required by their customers on a daily basis. The rest of the money that we put with them is invested in other people’s projects – locked away for a few years – you many say. If rationality gives way to fear, there will be a run on the bank. They will need to pay out more than they predicted, which of course isn’t there, at least for now.

What does that mean for us, the ordinary joe-on-the-street? Do we hold on to rationality just to keep their precious models and big banks going? Because, I’m going to do what’s right for me.

 

Yup, agreed.

And that’s the difference between micro and macro economics. Ditch the jargon, stay with the story. If I, blogjoe, feel insecure about my income and savings, I will start hoarding my money. Hell, I’ll even buy 50 cans of baked beans every few months and save them up. And so will a lot of people, because they are doing what’s right for them. If I could, I’d even stock up electricity payments and such like. And, I’m going to stop buying shoes, bags, chocolate, newspapers, cut back on cigarettes and alcohol.

What does that do to the economy if all of us do this? It kills the shoe industry, bag industry, chocolate industry etc. And they are employers too….but not for long. No income for them means no pay for their employees. Redundancies loom. Less money to spend means more companies in trouble, means more redundancies.

Does everybody suffer? And what does this have to do with rationality?

No, everybody does not suffer: The baked bean companies should do very well if all of us keep buying (till we get sick of them and the economy picks up!) Utilites are essentials, they should do well, as should discount retailers.  Our economic behaviour is perfectly rational, from our point of view. But my rationality is not our rationality. Once we understand that, we begin to understand why we are in a recession.

 

(c) meetasengupta

The sky is falling!

Yes, of course, its the credit crunch. And we are all worried. Nothing seems safe, least of all money in the bank. In these insecure times, I believe it is a good idea to go back to the basics and reframe our personal financial strategies.

This blog is aimed at the novice and the expert who is not afraid of 101. There are times when a science gets redefined, just because the assumptions made earlier do not exist anymore. Maybe this is one of those times.

This blog seeks to test the basics. Some are undeniable truths. Like savings are good – right?  Wrong. There maybe times when too much saving makes things worse for us all. Ok, here’s another one: If I borrow money, I will definitely be in trouble. Hmmm… Not always true, is it? How about, “I have a diversified portfolio, I’ll be fine in this turmoil”. Not if Mr. Systemic Risk kicks in.

I plan to start with links to various financial literacy sites. There are strong financial education programmes for teenagers and adults in many countries in the world. In some places, it is part of the curriculum at school. Others have to to sign up for business studies. Personal Finance Coaching is offered in the workplace in some corporations. But for most of us, it is the deep end … swim or sink, or just paddle and survive. Pick up tips as we go along, maybe an Olympian will tell us something as he swims past us.

The primary focus of this blog is Personal Finance Education. I DO NOT GIVE ADVICE. I will discuss the basic principles of personal finance, point you towards some fantastic tools available in webspace. I will also watch out for some interesting government policies and talk about how they influence your personal finance decisions. For Educators out there, there will be links to lessons and resources. And for Educationists, there will (hopefully) be an international comparision of personal finance education policies.

In any financial meltdown, we suffer. But it is times like these when a system changes and evolves. We live, make mistakes, learn and re-form. It is time to go back to the drawing board. For all you know, we might even use money rationally!!

 

(c) meetasengupta