Friday, October 21, 2011

Europe pays for lost character....

Europe pays for lost character....
By Reuven Brenner

Should the European Union extend credit to its risk-of-defaulting members? Can Greece and Italy be looked at like some misbehaving heirs who got easy money from their indulgent, dotting parents? Can "tough love" be a remedy?

Parents, after all, occasionally advance far too much capital on far too easy terms to their undeserving offspring - with disastrous consequences, as noted in last week's column (see
The vital few, Asia Times Online, October 15, 2011). I am not even talking here about Shakespeare's King Lear, giving away his kingdom to his two ruthless daughters, but the quite common occurrence of the saying "three generations from shirtsleeves to shirtsleeves". The

first generation is the entrepreneur builder, the second expands - and the third often destroys.

This happens as the third generation perceives the business as serving them, the self-indulgent generation - rather than them continuing to serve the business, and find ways to accountably match capital with talent and character. But parents' misallocation, being blinded by misguided "love", does not bring about national crisis, big as the business empire might be - unless they happen to be either dictators, be it in the Middle East, Africa, and not long ago Latin America.

But what has been blinding Washington's politicians/ Wall Street's banks/ the rating agencies to lead them to advance so much credit to households who had no glimmer of hope of returning the loans? And what is it that blinded European banks and governments to advance directly or indirectly so much credit to profligate countries?

J Pierpont Morgan once said there was only one basis upon which he would extend a loan. It was "character" - not money or anything else, "because a man I do not trust could not get money from me on all the bonds in Christendom."

Trust? Character? When was the last time you heard these terms applied to anything, whether in Washington, Wall Street or Europe's political class? And what would "character" mean when credit is extended to countries?

Years ago, when working in Monterrey, Mexico, a company called Electra was prominent in the consumer distribution business (it still is). In practice it was a finance company, offering credit and decent instalment payments to poorer Mexicans to whom the banks would not give loans or credit cards. It has been a very successful business, most people paying in time.

Electra was also building up a good database on people who had solid reputations and paid back their loans. Electra dealt with the occasional bad apples by sending messengers in colorful uniforms to their houses (orange as I recall), so the entire neighborhood could take note of the delinquents, making the neighborhood grocery stores think twice if and on what terms to advance even daily credit to that family - an everyday life application of the adage "trust - but verify".

A few years ago Electra obtained the license to become a bank officially (though it was really a "bank" all along) - and is now gradually, successfully, penetrating South American countries. With decades of experience and data on which families could be trusted, it has the ability to price credit better than any bank.

In a recent speech, Federal Reserve chairman Ben Bernanke said he learned much about banks during the recent crisis, especially about the dangers of "too big to fail". The inference from Electra's example and J P Morgan's observation could have given him strong guidance where some of the solutions are: let the big banks go bust, and let regional ones, knowing their customers more intimately, expand. They would find ways of advancing credit to people and companies with "character" - while keeping the old adage "trust but verify" in mind in a variety of incarnations.

In the United States, it was a wide combination of mistakes and blindness - real and pretended - by politicians, the central bank, Wall Street banks and rating agencies, all intertwined and judging events from a great distance, that eventually led to the saying among mortgage originators that the main requirement to get a mortgage was to have a pulse. A financial institution that would have to hold the mortgage on its books would have done due diligence to see if the borrower had something a bit more than a pulse.

As to global companies, if the "too big to fail" banks had broken up, the securitization of loans would have quickly re-started, holding all parties (rating agencies included) accountable. After all, bankers were never in the best position to do solid due diligence and credit assessment on them; traders do such due diligence constantly, re-assessing credit every minute of their trading day.

With parts of the businesses of today's big banks shifting to smaller, regional ones, and other parts being taken over by accountable securitized markets, there would be far fewer "too big to fail" financial institutions to be worried about, and risks would spread more widely.

In Europe, banks and investors advanced credit to countries lacking even a pulse. By this I mean that their population was known to be rapidly aging, that some were mired in black markets, had a happy-go-lucky preference for leisure and "apres-moi-le-deluge" mentality, and were subsidized by a legacy of entitlements based on the assumption that the demographic pyramid would have an expanding young base forever - never mind the demographic realities.

What blinded Europe's politicians and bankers? Decades of easy living weakened many of the institutions that once built up Europeans' "character". Unfortunately, no financial engineering can offer short- or medium-range solutions to restore "character". It can take a generation or more.

The uniqueness of the dozen Western type democracies after World War II and until 1990 permitted the continuous misallocation of capital and the destruction of character. The capital and talent flocking to their shores from the rest of the world, escaping dictatorship of one kind or another, helped cover the compounding mistakes.

During these long decades, new generations in these dozen or so Western democracies grew up adjusted to subsidized and prolonged years of staying in schools and universities, which are now producing much inequality and much vacuous intellectualism - of the economic/astrology kind included.

Present-day education achieves inequality since the brighter youth are subsidized to the tune of hundreds of thousands of dollars, whereas youth with neither ambition nor talent for study, but wanting to operate skillfully a grocery, garage, or other small business, get nothing. And a good fraction of even those who stay for prolonged years on the grounds of real estate called "universities" do not get out much of it, since most universities have long given up on the principle of selection. The result is a generation of self-indulgent youngsters with high expectations - though backed by little more than pieces of paper.

The lucky decades allowed not only cover for the above accumulating deficiencies, but also promised generous entitlements, shorter hours of work, early retirement, nice pensions - and numerous other perks. And while taxes increased over time, Europe had plenty of monuments built in their less lucky pasts to sustain the illusion that permanent pleasures for future generations nevertheless exist and so they can have their short-lived pleasures too. Briefly, the European perception over their lucky decades has been that they can have their cake and eat it too. With all these mistakes compounding, the once more-disciplined character of Europeans got lost.

I do not know if Europe will be able to embark on the drastic changes needed to rebuild it's peoples' character, and even if it does, it can take a generation. Bankruptcy, though, may speed it up: as in business, so in political lives, fear of default is the mother of re-inventions.

Meanwhile, perhaps it is not too late for the United States to learn from Europe's grave, compounding mistakes and correct them in time, as, for the moment, it committed fewer of them. That is why, notwithstanding all its troubles and weakening of its character too, the US remains stronger - and so more worthy of better priced credit than its European counterparts.

Reuven Brenner holds the Repap Chair at McGill University's Desautels Faculty of Management. The article draws on his Force of Finance (2002).


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