Sadder, but wiser, in economics…

If you want to blame someone for the recent crisis, the easiest, and the most socially acceptable way of find a scapegoat is pointing at bankers. After all the bankers were granting mortgage loans to borrowers who could not afford even to make the first repayment. After all the bankers pooled the subprime loans, repackaged them and sold them to naïve investors, spreading the disease all over the world. After all bankers were living like lords, reaping profits when good times were rolling in and refusing to take responsibility for their wrongdoing when the house of cards fell apart.

I do not aim do detract from the banking sector’s salient and undisputable contribution to the crisis. I (not as a bank employee, but as a citizen and economist) call for looking at bankers’ faults in a broader social, economic and political context.

If you carefully dissect 20 years of run-up to credit crisis in the United States, you should notice:

- millions of people chasing the American Dream, part of fulfilment of which was home ownership – these were millions of people who could not afford to buy a house, but who thanks to easy access to credit were given a chance to fulfil their dreams, a considerable percentage of those people were those who wanted to live beyond their means,

- politicians and central bankers who wanted to make voters happy, and by decreasing cost of credit and passing laws facilitating home purchases fuelled the housing bubble,

- bankers, who noticed the excessive demand for mortgage loans, decided to earn on it and then discovered ways to earn even more without taking more risk by granting the loans and instantly pushing them away from their balance sheets.

The bottom line is that the whole societies, not only bankers and politicians, can be accused of lack of forethought. Beware though, applying collective responsibility is quite unfair in this case, as the there were several people, ordinary and among the elite, who refused to indulge in the bubble spree.

The problem is, however, that common sense advocates who try to warn of the impending moments when bubbles burst, are disliked, not only when a bubble swells, but also with hindsight. I recently read a comment under another article on property prices that in 2007 in which somebody argued six years ago, when property bubble (?) in Poland was reaching its peak, an average salary in Warsaw would buy 1/3 sqm of a flat, banks eagerly were giving out loans, everyone was happier than now, when banks rebuff many would-be borrowers, despite 20% lower (in nominal terms) property prices. These days for an average salary you can buy 1/2 sqm of a flat, so the purchasing power on the property prices has risen by 50%. Paradoxically, despite less steep prices, banks’ reluctance to grant new mortgage loans will hinder your decision to buy a dreamt-up flat. Thus I come to the conclusion people do not behave rationally – consumerist desire to possess goods without considering whether they can afford them distorts economic decisions…

To shed a different light on the issue, some more examples…

The Polish government blames pension funds for fetching inadequate returns and charging exorbitant fees, without emphasising the crucial role policymakers who set stringent investment policies, flawed system of benchmarks and capped fees at sky-high levels. Companies who were allowed to deal with pension fund management acted rationally – abided by the rules, didn’t try to stick their necks out, reaped profits and ripped off future pensioners quietly. The government regulations coercing every taxpayer to participate in private-run part of public pension system generated demand for pension fund services. Pension fund managers just came up with the supply.

Tobacco companies produce stuff that addicts is unhealthy and generally is considered harmful. Each pack of cigarettes needs to contain properly sized information on destructive impact on smoking on health and cigarettes carcinogenic effects. Are the cigarette-makers blamed for deaths of millions of people from lung cancer?

Carmakers for years have been producing vehicle reaching maximum speed at which any accident could be fatal. Does anyone who hears news of an accident with several fatalities caused by speeding think of blaming automotive industry for producing deathful machines?

Alternatively, when you have in mind the problem of prostitution, do you blame escort agency owners or prostitutes themselves for the phenomenon of the oldest profession? Maybe you see a giggling sleazy guy who runs a massage parlour who claims he runs a relaxation facility and what his female employee and his male customer do when they go together to a dim-lit room with red walls stays between them. Virtually anyone who looks into the issue of prostitution highlights misconduct of procurers and prostitutes, while has anyone bothered to delineate a profile of a typical customer of escort agencies?

Coming back to bankers – in Poland the banking sector has become a scapegoat for CHF-denominated mortgage loans and currency option crisis.

In the former case, many think the banks have earned on appreciation on Swiss currency and CHF-borrowers have been duped by the banks. In fact banks have earned on fees, margins and FX rate spreads, which are all loosely tied of FX rates. In other words, banks’ earnings have been independent of FX market movements and thus banks have not had uncovered FX risk exposure. The other story is that banks were encouraging borrowers to take out loans in CHF due to lower interest rates, which translated into lower instalments and higher creditworthiness. All this was because of the demand for cheap lending. When CHF-denominated lending was rampant, few voices of concern were audible. Banks were happy to earn on margins and FX spreads, borrowers were happy to see their dream of own flat coming true. Some even were called idiots, when they were converting their CHF-denominated loans into PLN at the rate of 2.10. With hindsight, their foresight is enviable. In Poland, unlike in other countries, all borrowers had to be extensively informed on FX risk and had to sign documents to confirm they were familiar with the risks, if they had not been properly informed by a salesperson in bank’s outlet, they should have badgered the salespeople to explain the risks… Ignorance of law is not an excuse and taking those loan contracts to the court would be senseless then…

In the latter case, when PLN was evidently overvalued, there was a natural demand from exporters being on the verge of breaking even, to hedge against risk of further appreciation and a supply from financial institutions coming up with solutions suitable for exporters (if properly used). Exporters noticed FX derivatives helped them not only offset unfavourable effects of PLN appreciation, but also earn extra income, if the same position was hedged more than once with more than one bank. Banks noticed they could earn extra income on margins and fees, if volumes of transactions hedged were higher and so foisted upon exporters the double-edged swords of currency options. When FX market capsized there was actually no winner in Poland (if Polish banks’ counterparties had their positions uncovered, they could have taken large profits). Exporters were facing financial distress, while banks had to face credit losses if their corporate counterparties defaulted. When things were going well and companies benefited from sophisticated derivatives, nobody cried out in outrage, when the tide turned against the companies some politicians were calling for nullifying options contracts. Until today I wonder if those companies that made profits on FX hedging would have to return their profits to banks…

In brief, all the paragraphs above narrow down to subject of sharing responsibility for a misery between the supply side and demand side. In each case described above, there is a demand for some service or product, matched by supply. You could of course argue, demand is a response to supply. I would point out in turn, the problem is not akin to egg and chicken dilemma. In overwhelming majority supply matches demand. Imagine there are no males willing to buy sexual services – then all escort agencies would go bankrupt and prostitutes would be jobless. Imagine nobody wants to take out a risky loan – would banks keep on foisting them upon not eligible reluctant clients?

The separate matter is whether the government should step in and impose restrictions which would prevent demand for harmful services or products from being matched by supply?

Should the government protect individuals from their own recklessness, ignorance, short-sightedness, etc. The answer to this questions probably depends on your view of a human and its autonomy. Conservatives and liberals claim a human is wise enough to take rational decisions and take responsibility for them. Socialists argue a human is fragile and pliable and someone else knows better what should be forbidden and what should be warranted. Moreover, the answer might depend on existence of spillover effects of an individual’s detrimental decisions. If a reckless individual is the one who pays the price, then OK, may the government stay away, but if price for one person’s decision is paid by other people (which indirectly limits their personal liberty), these other people are most often all taxpayers who chip in for government-funded bailouts, there is a deep rationale for governments to intervene.