Interview by James Debono | Sunday, 28 September 2008

The ugly side of capitalism

Seasoned economist Karmenu Farrugia believes the collapse of financial markets in the United States has brought an end to the myth that the State has no business in regulating markets

“They have screwed us up. There is no other way to describe what happened.”
So says veteran economist Karm Farrugia about the “fat cats” of the intricate world of global finance, whom he holds responsible for the current crisis, and also for giving capitalism “an ugly face.”
Farrugia has just returned from a class reunion marking the 50th anniversary of his graduation from the London School of Economics. It was a nostalgic occasion, but it also served to put into perspective much of what traditional economists have been taught over the past half-century.
Among the ‘new lessons’ discussed with his fellow LSE alumni was the need to revisit prevalent attitudes towards the free market economy, in the light of the Wall Street crash. For the ‘fat cats’ are not the only ones to have brought about the current financial meltdown. Farrugia also blames right wing ideologues for their obsessive phobia of any state intervention.
“Those whose mantra for the past decades was 'deregulate, deregulate, deregulate' should take a break for some introspection, and realise that the best way forward is to regulate more where necessary,” Farrugia says.
“Since the end of communism the right wing has venerated capitalism as if it were a new deity. In their veneration they created a sort of theology which one cannot even question. Blinded by this belief we have allowed too may things to happen behind our backs.”
Karmenu Farrugia does not doubt the great merits of capitalism in generating wealth and prosperity.
“One should surely deregulate when one has excessive and unfair regulations which restrain the productive forces, but one cannot do so in sectors where regulation is lacking. As a result of the lack of regulations, the authorities were not even aware what was happening behind their backs.”
So what was the fishy business taking place behind the people’s backs?
Unlike many economists who resort to technical jargon which baffles everyone, and who portray economic crises as though they were as unpredictable as the weather, Farrugia explains the crisis in layman’s terms in a way that one can understand who is to be blame for the ruin of millions of small investors.
Rather than investing in real and tangible goods like property or industry, the big financers made a fortune from an endless chain of investments which, in turn, were based on returns from other investments – basically a system where more money is made purely by speculating on other people’s investments.
The banks and financial institutions were very inventive in creating new products in the financial market. But as Farrugia points out they did not create tangible commodities “like a new variety of baked beans, or a new tourist package.”
“The public did not even know these products existed. These products were shared between banks and investment companies. In the end they found out that they were choking each other.”
Farrugia compares the financial world to an edifice in which each pyramid is build on another pyramid, and where the big banks and financers depended on each other for the provision of credit.
As long as the machine was well oiled it worked well, and nobody suspected that something could go wrong. But it was a small crisis in the housing sector which brought the collapse of this entire edifice.
“As soon as confidence in the housing market was undermined everything was exposed as the world learned of the existence of these toxic bonds.”
Farrugia recalls that in the 1980s these bonds where described as “junk bonds.”
“They were considered unhealthy to the economic body just as junk food is unhealthy – but not lethal – for the human body. Now, we consider these loans to be poisonous and even lethal.”
Why was the property market the first to be hit?
“The big financers had found a market which was constantly expanding because home ownership was encouraged by everyone.”
People were encouraged to take loans which they could not even afford, and instead of scrutinising each loan and making people aware of the serious consequence of any default in payment, they gave credit to all and sundry.
“They exaggerated so much that the first bubble burst. But because of the elaborate system linking the housing market to the rest of the financial world, as soon as one property bubble burst, another 20 bubbles also burst...”
What’s scertain is that the current crisis has seen the conversion of the strongest advocates of unfettered capitalism into believers in state intervention.
“We have come to the point where a US Republican government – which is the least likely to intervene in the economy – is committing US$700,000 billion dollars to buy off these toxic bonds to rescue the financial institutions.”
But is it fair to use taxpayer money to bail out the very companies which have profited from lax regulation in the past decades? For Farrugia, the bail-out is unjust, but cannot be avoided.
“The common citizen is right to be angry at these people. It was the small investor who suffered most and not the companies who made millions in the past two decades. Companies like Lehman Brothers were using other people’s money to become rich; but as soon the tide turned against them, instead of digging their hands in the fat accumulated in their own fat belly, they filed for bankruptcy.”
But for Farrugia there is no alternative to the bail-out proposed by President George Bush.
“There is no other solution. There can only be a financial solution to a financial problem. One cannot solve this problem by resorting to actions meant to prop up the economy.”
Farrugia also believes that although the US economic system has shown its ugly face, its political system is very efficient when it comes to clamping down on abuse.
“Bush has clearly said that the state intends to investigate four financial institutions which benefited from toxic bonds. The US might be the most pro-capitalist country in the world, but when it comes to conducting investigations and when they decide to regulate they are stricter than most Europeans, and surely better than the Maltese.”
For Farrugia this ability to regulate is the redeeming feature of a capitalist economy.
“That is what saves capitalism,” says Farrugia.
What is in question is not capitalism but right-wing economics, Farrugia argues.
“Right-wing economists have always insisted that capitalists know best how to regulate themselves. This episode shows that this is not a reliable philosophy because capitalist never regulate themselves sufficiently and tend to allow fishy business on the fringes of the economy.”
But despite the global repercussions of the current financial crisis the direct consequence on Maltese banks will be minimal, Farrugia contends.
He does not blame Bank of Valletta for taking the small risk: an investment equivalent to “a half of one percent” in Lehman Brothers.
“It was unlucky for them, but one cannot blame BOV for making this investment in one of the largest financial bodies.”
And if Bush’s financial package works, the current financial crisis will not leave any long term devastating consequences for Malta.
What is here to stay is the parallel global economic crisis. Karmenu Farrugia distinguishes the financial crisis and the enduring economic crisis. While the former was caused by irresponsible financers and bankers, the latter is brought about by the increase in the price of oil and food prices, as the demand for these products rises in emerging economies like India and China.
“The heart beats where industry, services, consumption and production beats. The toxic bonds were completely unnecessary for the economy as they created few jobs and little added value.”
The nightmare scenario for the world economy would be the failure of the multi-billion rescue plan offered by the US government. In that case there will a complete deterioration as the economic crisis overlaps with the financial one.
But Farrugia is quite optimistic, foreseeing that the crisis could well be solved in two months’ time. But even if that happens we will still have to contend with the economic crisis whose consequence can be even more devastating.
To facilitate recovery from the economic crisis the European Union should abandon its obsession with controlling inflation.
“We rely too much on central bankers obsessed with the stability of the currency.”
Farrugia compares inflation to an ailment with which any patient can live.
“If this patient is struck by a more serious illness, it is only logical for the doctors to concentrate their energies to stop the latest infection.”
He blames the European Central Bank for refusing to lower interest rates – a measure which could stimulate investment. As he bluntly puts it: “Governments should tell the European Central Bank to shut up.”
Farrugia also calls on the government to give up on its plan to achieve a balanced budget in two years’ time, as this would harm the prospects of economic recovery.
Farrugia distinguishes between the fiscal crisis faced by the Maltese government and the current global financial crisis.
“Nobody’s pensions or bank savings are at risk in Malta. What we have is a fiscal crisis affecting the government’s coffers. The government has to decide whether to increase its revenue, decrease its expenditure, or simply say that its aim cannot be achieved.”
What is Farrugia’s advice for the government for the forthcoming budget?
He expects Tonio Fenech to emulate the British chancellor of the Exchequer Alastair Darling who admitted that the situation is very bad.
“The government should admit that a year ago, when it presented rosy projections, it was looking at a different horizon than what exists today. Nobody expected the financial crisis at that time.”
Still, was it responsible to present a rosy picture and promise tax cuts before the election when the international economic situation was already bleak?
“Which politician in the world paints a sad picture before an election? That is asking the impossible. Even the US Presidential candidates are at a loss on how to handle the crisis.”
Still despite the ominous international scenario, Farrugia credits the Maltese economy for being resilient.
“I praise Maltese governments for moulding the economy in such a way that it is resilient in the face of global rebuffs. It is even more resilient than I expected, considering its underlying fragility.”
Farrugia compares the Maltese economy to a fragile-looking baby which surprises its parents by its resistance to sickness and bad weather.
What Farrugia does not like is how successive governments have allowed strategic parts of the economy to fall into foreign hands.
“The airport is not Maltese. More than 80% of the banking sector is foreign. Our communications have been sold to foreigners. Even SmartCity is foreign-owned. The Maltese could end up without any say in the economy.”
He still contends that the Bank of Valletta should not be sold to foreigners.
“I am not against privatisation. I am against privatisation which is directed solely at foreigners.”
Another problem in the economic horizon is a slowdown in the property market.
Farrugia recalls that following the property boom in the 1960s, the whole market went bust.
“At that time the National Bank of Malta had to create a subsidiary company to take back properties whose owners could no longer afford to pay their mortgage.”
He would also like the government to take a more active role in discouraging people from buying property simply to sell it again at a higher price.
“In the long run this is not good for the economy, it is only creating an artificial demand which is creating an over-supply. Encouraging home ownership is socially and economically a good thing. But encouraging people to invest in property is not good. I would never encourage speculation as it only harms the economy.”
On the other hand he distinguishes speculation for its own sake from investing money in property which is rented to tenants.
“This is an economic service as one would be providing accommodation for people to live in while earning a return from one’s investment.”
Farrugia also recommends a lower tax rate to encourage landlords to rent out their properties.
How can the government avoid a bust in the property market?
“We should be against the philosophy of those who want to leave the market unregulated…those who think that the market is like the all-knowing God. The first hurdle is to convince these people that the government should regulate.”
One of the best tools to regulate the property market is through the Malta Environment and Planning Authority.
“MEPA should not be used to accommodate Peter instead of Paul. Why shouldn’t the government issue a public policy aimed at slowing down the approval of planning application to decrease the supply?”
Even the government itself can ward off a potential crisis through sheer honesty.
“The government could advise the people not to exaggerate in their investments in property because by creating such a big supply property investors are only harming themselves.”

(Note: James Debono interviewed Kam Farrugia before the US Congress voted on the bail-out package last Friday)


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