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You Cannot Drink Yourself Sober
Albert Einstein once said “Insanity is doing the same thing over and over again and expecting different results”. Yet as governments work furiously at solving the global financial crisis, I see that happening more and more.
I never really understood the logic behind the government stimulus packages. How can you ask people to spend money on buying clothes and CDs when they have trouble paying their mortgages and others face the possibility of losing their jobs in the near future? This logic totally goes against what I would do at home if I thought my husband might be losing his job. The first thing we would do is to cut discretionary spending e.g. clothes and CDs, try to reduce debt and increase savings in case things get worse. That, to me, would be the financially prudent thing to do. Initially, I did not dare to make my views known, after all what do I know about macro economics? I am not an economist and all the economists working for the government are advocating we spend out way out of a recession. Perhaps macro economics is a completely different ball game from micro economics which I am familiar with.
I am quite relieved to see now (18 months into the global financial crisis), after many stimulus and bailouts by governments worldwide, things have not really improved and some financial gurus are now saying the same things that I have been thinking all along. This video You Can’t Drink Yourself Sober is one of the most recommended video on Yahoo Finance. It is an interview with Barry Ritholtz, CEO of Fusion IQ and author of the book Bailout Nation. Barry questions what caused the crisis and I think everyone now agrees it was due to over leverage. Credit was so easy to get so everyone borrowed to buy assets and asset prices became inflated because there were so many buyers. When the asset bubble burst and asset prices started to come down instead of go up, many buyers became insolvent very quickly. For example, if you buy a house with 10% of your own money and borrowed 90% from the bank (leverage of 9 to1), you would be technically insolvent if the house price came down by 10% or more because if you had to sell the house, you probably would not have enough money to pay back your loan. Some banks were leveraged 40 to 1 so a small decrease in asset values would cause the banks to become technically insolvent. This was why banks had to be bailed out i.e. to have capital injected to maintain their lending ratios as asset prices fell.
Governments are now borrowing massive amounts of money to provide bailouts and stimulus spending. Spending money that you don’t have seems like we are repeating the same action that got us into trouble in the first place so how can we expect a different result? When the US government asked for money for the first bailout, everyone said it had to be done as it was like applying first aid to a patient dying of a heart attack. You had to apply CPR and not advise the patient to change his diet. However, the patient has to change his diet to not eat the things that caused him to have a heart attack in the first place, in order to prevent another heart attack from happening again but I just don’t see any government initiatives to get banks to improve their risk management and reduce leverage. In fact, the government is a bad role model because it is borrowing more than it can afford. That is why I don’t buy into the recent rally in the stock markets especially in financial stocks. After applying CPR, the patient has shown some signs of life again but there is still a long road to recovery before he becomes a healthy person again. If nothing is done to address the cause of the problem in the first place, it won’t be long before another heart attack occurs.
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