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By Sam Vaknin
Author of “Malignant Self Love – Narcissism Revisited.”
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Market failures signify corruption and inefficiency in the private sector. Such misconduct and misallocation of economic resources is usually thought to be the domain of the public sector, but actually it goes on eveywhere in the economy.

Wealth destruction by privately-owned firms is typical of economies with absent, lenient, or lax regulation and often exceeds anything the public administration does. Corruption, driven by avarice and fear, is common among entrepreneurs as much as among civil servants. It is a myth to believe otherwise. Wherever there is money, human psychology is in operation and with it economic malaise. Hence the need for governmental micromamangement of the private sector at all times. Self-regulation is a costly and self-deceiving urban legend.

Another engine of state involvement is provided by the thrift paradox. When the economy goes sour, rational individuals and households save more and spend less. The aggregate outcome of their newfound thrift is recessionary: decreasing consumption translates into declining corporate profitability and rising unemployment. These effects are especially pronounced when financial transmission mechanisms (banks and other financial institutions) are gummed up: frozen in fear and distrust, they do not lend money, even though deposits (and their own capital base) are ever growing.

It is true that, by diversifying risk away, via the use of derivatives and other financial instruments, asset markets no longer affect the real economy as they used to. They have become, in a sense, “gated communities”, separated from Main Street by “risk barriers.” But, these developments do not pertain to retail banks and when markets are illiquid and counterparty risk rampant, options and swaps are pretty useless.

The only way to effectively cancel out the this demonetization of the national economy (this “bleeding“) is through enhanced government spending. Where fearful citizens save, their government should spend on infrastructure, health, education, and information technology. The state’s negative savings should offset multiplying private savings. In extremis, the state should nationalize the financial sector for a limited period of times (as Israel has done in 1983 and Sweden, a decade later).

It is a maxim of current economic orthodoxy that governments compete with the private sector on a limited pool of savings. It is considered equally self-evident that the private sector is better, more competent, and more efficient at allocating scarce economic resources and thus at preventing waste. It is therefore thought economically sound to reduce the size of government – i.e., minimize its tax intake and its public borrowing – in order to free resources for the private sector to allocate productively and efficiently.

Yet, both dogmas are far from being universally applicable.

The assumption underlying the first conjecture is that government obligations and corporate lending are perfect substitutes. In other words, once deprived of treasury notes, bills, and bonds – a rational investor is expected to divert her savings to buying stocks or corporate bonds.

It is further anticipated that financial intermediaries – pension funds, banks, mutual funds – will tread similarly. If unable to invest the savings of their depositors in scarce risk-free – i.e., government – securities – they will likely alter their investment preferences and buy equity and debt issued by firms.

Yet, this is expressly untrue. Bond buyers and stock investors are two distinct crowds. Their risk aversion is different. Their investment preferences are disparate. Some of them – e.g., pension funds – are constrained by law as to the composition of their investment portfolios. Once government debt has turned scarce or expensive, bond investors tend to resort to cash. That cash – not equity or corporate debt – is the veritable substitute for risk-free securities is a basic tenet of modern investment portfolio theory.

Moreover, the “perfect substitute” hypothesis assumes the existence of efficient markets and frictionless transmission mechanisms. But this is a conveniently idealized picture which has little to do with grubby reality. Switching from one kind of investment to another incurs – often prohibitive – transaction costs. In many countries, financial intermediaries are dysfunctional or corrupt or both. They are unable to efficiently convert savings to investments – or are wary of doing so.

Furthermore, very few capital and financial markets are closed, self-contained, or self-sufficient units. Governments can and do borrow from foreigners. Most rich world countries – with the exception of Japan – tap “foreign people’s money” for their public borrowing needs. When the US government borrows more, it crowds out the private sector in Japan – not in the USA.

It is universally agreed that governments have at least two critical economic roles. The first is to provide a “level playing field” for all economic players. It is supposed to foster competition, enforce the rule of law and, in particular, property rights, encourage free trade, avoid distorting fiscal incentives and disincentives, and so on. Its second role is to cope with market failures and the provision of public goods. It is expected to step in when markets fail to deliver goods and services, when asset bubbles inflate, or when economic resources are blatantly misallocated.

Yet, there is a third role. In our post-Keynesian world, it is a heresy. It flies in the face of the “Washington Consensus” propagated by the Bretton-Woods institutions and by development banks the world over. It is the government’s obligation to foster growth.

In most countries of the world – definitely in Africa, the Middle East, the bulk of Latin America, central and eastern Europe, and central and east Asia – savings do not translate to investments, either in the form of corporate debt or in the form of corporate equity.

In most countries of the world, institutions do not function, the rule of law and properly rights are not upheld, the banking system is dysfunctional and clogged by bad debts. Rusty monetary transmission mechanisms render monetary policy impotent.

In most countries of the world, there is no entrepreneurial and thriving private sector and the economy is at the mercy of external shocks and fickle business cycles. Only the state can counter these economically detrimental vicissitudes. Often, the sole engine of growth and the exclusive automatic stabilizer is public spending. Not all types of public expenditures have the desired effect. Witness Japan’s pork barrel spending on “infrastructure projects.” But development-related and consumption-enhancing spending is usually beneficial.

To say, in most countries of the world, that “public borrowing is crowding out the private sector” is wrong. It assumes the existence of a formal private sector which can tap the credit and capital markets through functioning financial intermediaries, notably banks and stock exchanges.

Yet, this mental picture is a figment of economic imagination. The bulk of the private sector in these countries is informal. In many of them, there are no credit or capital markets to speak of. The government doesn’t borrow from savers through the marketplace – but internationally, often from multilaterals.

Outlandish default rates result in vertiginously high real interest rates. Inter-corporate lending, barter, and cash transactions substitute for bank credit, corporate bonds, or equity flotations. As a result, the private sector’s financial leverage is minuscule. In the rich West $1 in equity generates $3-5 in debt for a total investment of $4-6. In the developing world, $1 of tax-evaded equity generates nothing. The state has to pick up the slack.

Growth and employment are public goods and developing countries are in a perpetual state of systemic and multiple market failures. Rather than lend to businesses or households – banks thrive on arbitrage. Investment horizons are limited. Should the state refrain from stepping in to fill up the gap – these countries are doomed to inexorable decline.

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Also Read:

•    Governments and Growth

•    Is Education a Public Good?

•    The Dismal Mind – Economics as a Pretension to Science

•    Economics – The Neglected Branch of Psychology

•    The Fabric of Economic Trust

•    The Distributive Justice of the Market

•    Scavenger Economies and Predator Economies

•    Notes on the Economics of Game Theory

•    Knowledge and Power

•    The Disruptive Engine – Innovation and the Capitalist Dream

•    The Spectrum of Auctions

•    Market Impeders and Market Inefficiencies

•    Moral Hazard the Survival Value of Risk

•    The Principal-Agent Conundrum

•    The Myth of the Earnings Yield

•    Trading in Sovereign Promises

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Both presidential candidates want to crucify SEC Chairman Cox for failing to control our creative financial institutions. But rumor has it that Congress specifically excluded the devilish derivatives from SEC purview. Let’s fire the right bunch of “poips” for a change!

Scary markets are brought about by many factors, some normal, and some not so normal. It’s often helpful to look backwards before getting too paranoid about the present. The S & L crisis of the early 80s might be an appropriate starting point.

Later that decade, a multi-year rally had its head lopped off by high interest rates, high inflation, and a computer loop. Ten years later, another soaring market was toppled by economic factors. The turn of the century witnessed the bloody demise of the no-value-at-all dot-com illusion.

A profit taking strategy during the rally days was all that was necessary to cash in on “The Crash of ’87.” In 2000, the route to immunity could be summarized as: “no IPOs, no mutual funds, no dot-coms, no problem.”

The common historical (hysterical) thread is clear. Rally begets correction; correction spawns rally. This time around, ironically, conservative investors had no trouble avoiding the derivatives that eventually sunk the markets. But, the products were so “out there,” and the regulators so out-flanked, that the unwinding has unglued several investment world icons. This correction is different— but not in the ways you might think:

The scope of media coverage, analysis, and sensationalism; masses of inexperienced, non-professional, speculators; and the popularity of investment products are new phenomena. Millions of nameless non-credentialed Internet investment experts and financial bloggers add to the pandemonium.

Similarly, the proliferation of passive investment mediums (index funds); regulatory tolerance of speculations of all forms, shapes, and sizes; and the relaxation of the trading safeguards that have protected investors for decades encourage a reckless, gambling approach toward what was once investing. We’ve seen what conscienceless commodity speculators have accomplished in world markets.

We have experienced a major movement away from plain vanilla stocks and bonds, and have popularized the thrill ride of speculative activities. 401(k) fund selections include short-long funds, currency trading strategies, and commodity futures. IRA investors seek out the most exotic forms of speculation, convinced that, with a Blackberry and a lunch break, they can master the complexities of high finance.

Regulators have allowed funds of hedge funds into small investor portfolios; brokerage firms short shares that don’t exist multiple times; the once sacred up-tick rule has been abandoned when shorting itself should be a banned substance; and CDOs make it difficult to determine just who owes money to whom.

Enough? There’s more, but you get the idea. Today’s problems are much more visible than yesterday’s. Today’s worries involve bigger numbers. Tomorrow’s solutions will undoubtedly bring creative MBAs to discover new financial WMDs. The investment gods are angry. We need to bring back that old time rock and roll, and an investment world content with individual stocks and bonds.

In less complicated times, the difference was in the fixing. Speculators suffered, but safer investment styles were less vulnerable. Let’s elect a Congress that will regulate the speculations and allow us to get back to the basic, fundamental, adventure of building and protecting our nest eggs. Think back, just a few cycles ago— familiar?

The Market was breezing along during the summer of ’87, enjoying one of the broadest rallies ever experienced on Wall Street. From the very start, equity prices seemed incapable of going down. The mystical DJIA 2000 barrier was shattered early in the year and upward the market soared.

On through 2100 it rumbled, then 2200, and 2300— even the comic strip, dartboard approach proved successful, and many subscribed to it. The securities markets were simple, with fewer labyrinthine products, and only the dark cloud of rapidly rising interest rates in an otherwise clear sky. 2400 on the DJIA by July and on it went. No end in sight.

The institutions introduced hundreds of new mutual funds, pumped up their marketing efforts, and pushed the rally skyward— 2500, 2600, 2700, just incredible. None of the salivating mutual fund unit holders saw it coming; Wall Street didn’t care. The Dow topped out at 2722 that August— about the same number of points involved in a swinging September 2008. Only the names and the products have changed—

The parallels to today’s markets are interesting. Value stocks and bonds were moving lower while IPOs and other speculations were bubbling higher. As prices weakened, analysts began to mumble. The economy certainly didn’t look like a doom and gloom scenario— just those pesky interest rates. And then it hit the fan.

Technology bombed the market when programmed-trading sell signals ran fast and furious down the cables, resetting themselves lower, and lower, and lower— but the stock being sold actually existed! Wall Street panicked! Inflation fears, higher interest rates, tension in Europe, foreign oil, war in The Middle East, and so on. All of the usual suspects were touted by the media as the culprits that caused “The Crash of ’87.”

It just doesn’t take a whole lot of Wall Street manipulation (or arrogance) to turn speculative greed into investment fear. The wizards had done it again, sucking the franklins from unsuspecting individual investor portfolios, just as they would two cycles later when their dot-coms sealed the fate of another generation of speculators.

Yes, the similarities are striking— one meltdown to the next. But this time is slightly different. This time the Masters of the Universe were helped by Congress and the SEC to pick our collective pockets, and a few of them have actually, and appropriately, drowned in their own garbage. I’ll shed no tears for the fallen giants, but let’s all cry out loudly about the problem— a problem that both Barack and John were a part of.

It’s Congress that gets to chastise and create regulations for the bad guys. This year, and in those that follow, let’s fire the DC fat cats that caused the problem, and find some regulators with the guts to label speculations as thoroughly as they do medications.

About The Author: Steve Selengut — Author of: “The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read,” and “A Millionaire’s Secret Investment Strategy.” Visit Steve’s websites: http://www.sancoservices.com/ | http://www.kiawahgolfinvestmentseminars.com