Where to look for structural weakness : continued
Spotting Structural Weakness
Barriers to Seeing Structural Flaws
The 1997 Indonesian crisis was caused by structural weakness in the financial system that went unnoticed, even when the dangers should have been quite obvious:
- Minding One's Own Business: Most bankers that made the loans that led to the Indonesian financial collapse were focused on day-to-day routines of credit analysis, selling financial products, meeting budget goals, and overseeing loan documentation. Few bothered to look into the big picture; even fewer studied Bank Indonesia statistics (published on the Internet) that revealed the fatal flaw in the banking system.
- Trusting the Competence of Experts: It was well-known that the economists of the IMF, the World Bank, and the 'Berkeley Mafia' of technocrats in the Indonesian Finance Ministry, had run the country successfully for decades. Most people felt comfortable in assuming that these experts knew what they were doing and that there was no reason to look over their shoulders.
- Fear of Being Labeled a Cassandra: In boom times, anyone who goes out of his or her way to point out dangers to the economic system is shunned and treated as a kook or loony.
- Assuming that Others Behave Rationally: Sudradjad Djiwandono, governor of Bank Indonesia, was shocked to discover — too late — that most Indonesian businesses had not bothered to hedge their foreign currency exposure. As an economist, trained to believe in Rational Man, while looking at macro-economic numbers, rather than questioning the nitty-gritty of consolidated balance sheets of the banking system, the governor was professionally pre-disposed to be blind-sided.
- Assuming that When Things Go Wrong, Corrective Action Will Be Taken: This was perhaps the greatest error of all. When the risk of economic collapse became apparent, government officials and IMF experts froze, like deer in the headlights of an oncoming car, unable to think rationally or find people who could.
Commonsense solutions, like a moratorium on payments or the issuance of Brady bonds, or even Steve Hanke's suggested currency board, were ignored or dismissed.
Commonsense solutions were ignored or dismissed.
The Clinton State Department, more interested in toppling the Soeharto regime than in saving the Indonesian people from economic hard times, added political intrigue to the poisonous atmosphere.
The initial lack of comprehension of the situation by economists was similar to the stock market crash of 1929, when Irving Fisher, 'America's greatest economist', expected the end of the economic crisis by mid-1930, never suspecting the disastrous political meddling of a new president, Franklin Roosevelt, who upturned capitalist economics, attacking businessmen as useless and un-needed, abandoning the gold standard, raising income taxes to incredible levels, and generally inviting socialism into the United States, thereby driving investors into hiding for a decade, until the Japanese got the economy going again by bombing Pearl Harbor. (See the essay: 'FDR and Worker's Capitalism')
Structural Weakness: Places To Look
If we are to be successful in spotting weaknesses in the economic system, we must be willing to look for trouble.
From Capital Flow Analysis of the U.S. economy, we note two outstanding forces that have driven a twenty-year rise in prices of bonds and equities:
The Trade Deficit: The massive accumulation of dollars in the hands of foreign exporters has created a steady increase in demand for dollar bonds.
The Buyback Movement: The over one trillion dollars of stock repurchases and cancellations by U.S. corporations has driven stock prices and price-earnings ratios upwards, and dividend yields down.
Anything that causes either of these trends to be reversed will almost certainly have an effect on prices in the stock and bond markets.
Reversal in the trade deficit or the buyback movement will effect prices of stocks and bonds.
In the case of the trade deficit, anything that closes U.S. ports would lead to a serious decline in bond prices.
In the case of the buyback movement, a sudden change seems less likely, although the unethical aspects of executive remuneration, the coming retirement of the baby boomers, and the countervailing force of foreign equity issues into the U.S. market are things to watch.
There are yet other kinds of structural weakness.
In the U.S., we might mention over-dependence of foreign oil and non-renewal energy sources in general.
Despite many books and articles about these vulnerabilities, not enough is done to ensure against disaster.
Historian Barbara Tuchman's 'The March of Folly' is an description of how governments throughout history have ignored commonsense solutions and have sat by helplessly as debacles have unfolded.
Before proceeding, check your progress:
Self-Test
Impending crises are sometimes hard to predict because we tend to:
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Governor Djiwandono was shocked to discover that:
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Which would have the least effect on the market value of U.S. financial assets?
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