Government of the people, for the people, by the people!

Events since the start of the financial crisis in 2008 have been revealing. Politicians are being exposed for serious errors in the past and are ill equipped to provide solutions for a world in distress. This is the first in a series of discussions about why politicians are unsuited to manage, and suggestions as to how that can be fixed.

It’s common knowledge that one of the primary causes of the crisis was the crash of the sub-prime market, and the focus for the blame has been the “big banks”. And, while they continue to collect astronomical bonuses, senior executives of the big banks say that the fault lies elsewhere. Ragharam Rajan, in his book “Fault Lines” argues persuasively that the bankers may have a case, and that politicians seeking re-election are also at fault.

The growth in the disparity of wealth forms the foundation of Rajan’s argument. In 2007 23.5% of all American income flowed to the top one percent. The earnings of the top 10 percentile increased by 65% more over the period 1975 to 2005 than the wages of the other 90%. That the majority of voters has not benefited from the income growth in America encouraged politicians to intervene.

Simply put, economic data shows that the country is getting wealthier and wealthier, and that wealth is mostly concentrated in the hands of a select few.

So, to create the appearance of wealth, the solution for the politicians appeared in the magic of finance. If mortgage rates decline property values increase.

Let’s see how that works. On a $100,000 loan, If the mortgage rate is 12%, the repayment will be a little over $1100 a month, and the total interest paid over a 20 year mortgage amounts to more than $164,000. When the mortgage rate drops to 2%, the repayment drops to $505 a month, and the total interest over the period of the loan is a more reasonable $21,400. People who need to borrow money to purchase their homes look at the affordability of the monthly repayment. As interest rates drop there is more money chasing the same number of houses, and property values increase. The increase in house values encourages some people to buy new homes, and others to borrow against the increased value of their existing property. People have an increased sense of prosperity, founded on an illusion.

The increase in house prices lags behind the drop in interest rates by a number of months, sometimes years, and so improved affordability also affects those who have never owned their own homes, including the sub-primes.

At first the sub-prime market was very attractive. The new borrowers with little credit history attracted higher rates of interest (but not so high as to impact affordability) in recognition of the greater risk of default. But in the minds of the bankers, these loans were secured against properties, the values of which were increasing, negating the perceived increased risk. Showing massive returns, the market grew exponentially, attracting investors from all over the world. That was fine while property values increased.

Then economists started saying that it was unsustainable. And as Herb Stein said, if something cannot continue, it won’t.

The markets froze. The banks stopped lending to each other, and suddenly there was a liquidity crisis. Lehman Bros failed, and the potential for a widescale bank run seemed imminent. The Federal Reserve stepped in and the initial crisis was averted.

But the cat was out of the bag. Stock markets and property prices around the world crashed. Economies, especially those in the developed world, went into recession.

Then another financial fiction was exposed. For risk purposes the countries making up the Eurozone had all been given the same credit rating. The cheap funding encouraged governments to spend lavishly. The responsible governments contained borrowings, spending mostly on necessary infrastructure improvements. Others wasted money, often buying votes through unnecessary government employment. Greece being the worst example.

Realising that the credit risks of the various Eurozone countries were unequal, the markets reacted. Interest rates for the delinquents rose, and rose. An interest rate above 7% is considered to be unsustainable. Greece’s rose to more than 20%. Analysts confirmed that the country was insolvent and uncompetitive. Constitutional flaws in the concept of the Eurozone prevented both the Greek government and the technocrats in the European Central Bank (ECB) from providing the conventional solutions.

The Euro politicians, led by Angela Merkel, muddled and prevaricated, making a bad situation worse. The politicians were unable or unwilling to suggest the solution: the creation of Eurobonds and empowering the European Central Bank (ECB) to intervene. The solution requires a devolution of powers that the politicians are unwilling to relinquish.

In 1947 Churchill said that “democracy is the worst form of government except all those other forms that have been tried from time to time; but there is broad feeling in our country that the people should rule, continuously rule, and that public opinion, expressed by all constitutional means, should shape, guide, and control the actions of Ministers who are their servants and not their masters”.

Democracy is not a meritocracy. In the 1980s Jackson Browne groaned that “they sell us the president the same way they sell us our clothes and cars. They sell us everything from youth to religion, the same time they sell us our wars.”

Politicians on both sides of the Atlantic have focused blame on each other, rather than developing solutions through consensus. Voters in Greece, Spain, Ireland and France voted for the most popular alternative to the incumbent, voting in untried novices whose policies and solutions, if they exist, are unknown or at best vague.

The accounting principles adopted in the production of national accounts add to the difficulty in developing the solutions. Improvements to infrastructure, especially those leading to capacity improvements are expensed in the year in which they are incurred. In a commercial enterprise such capital expenditure would be allocated to assets on the balance sheet and expensed over the lifetime of the asset. Accounting for improvements in the year they are incurred acts as a disincentive towards what is often beneficial and necessary expenditure, especially in the long term.

The much bandied term of austerity should distinguish between expenditure which can elicit growth, and expenditure which is unnecessary and wasteful. That the politicians dealing with the crisis have not made this distinction suggests that they either do not understand it, or worse, believe that the electorate won’t.

We would never allow the executives of leading corporations to be appointed for their public appeal, like some bad reality TV show, and yet that is how politicians in Western democracies are elected to run the world’s leading economies.

The appointment of world leaders should be based on proven merit. Government of the people, for the people, by the people needs to take a better form.