| April 02, 2008 | Wednesday | Rabi-ul-Awwal 24, 1429 |
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The economics of greed
WHAT happens to a man who has run a flourishing bank into bankruptcy, costing taxpayers billions, wiping out further billions in equity, and causing thousands of employees to lose their jobs? Well, in the case of Adam Applegarth, former chairman of Northern Rock, he is set to walk away with a 760,000-pound severance package.
And although the bank, still on life support being provided by the government, is reeling from a series of poor decisions and seemingly terminal loss of confidence, its new chairman, Ron Sandler, is raking in 90,000 pounds a month. This translates into a monthly salary of around 10 million. This sum is dwarfed by the payments made to his predecessor over the five years he ran the bank: Applegarth received nearly ten million pounds, while accruing an annual pension of over 300,000 pounds. According to reports, he also sold two million pounds worth of Northern Rock shares before the crash.
But it is his ‘golden goodbye’ that is the subject of much fury in Britain. Even though his contract stipulated that he would get a year’s salary on his departure, critics feel he is being rewarded for bankrupting Northern Rock, a once-proud financial institution that was considered rock solid until its woes began some five years ago. Caught up in the storm of blind greed that has engulfed the property market, and forgetting the dictum ‘what goes up must come down’, Northern Rock handed out thousands of mortgages to homeowners on highly competitive terms. But as interest rates went up, and the market cooled, many of the bank’s loans began looking distinctly dodgy. Investors, nervous about their accounts with Northern Rock, began to withdraw their money, followed by ordinary depositors. Soon, this sentiment snowballed into panic, and lines began forming outside its branches across the country.
Televised images and lurid newspaper reports compounded the bank’s liquidity problems. As the run on the bank continued, the government dithered until it finally stepped in, guaranteeing the money the bank owed its depositors. Thus far, it owes the Treasury 24 billion pounds, but the jitters in the city and the stock exchange have been stilled for the time being.
Another major financial institution that has been caught up in the property market slowdown is New York’s Bear Stearns. Here, too, it has been rescued by the US Federal Reserve, and is being sold in a fire sale to a competitor. Both cases – and they are far from being isolated – indicate the greed that drives experienced bankers to shed all sense of prudence as they join the feeding frenzy. In their unending drive to gain bonuses, promotions and stock options, executives forget everything they learned about exercising due care and diligence while scrutinising loan applications. Secure in the knowledge that people applying for mortgages will not default due to high property prices, they encourage clients to pledge their homes to get cheap loans that are used to finance vacations, the latest goodies and their children’s education.
This works only as long as the bubble does not burst. But when interest rates begin climbing, and the value of property falls, the lenders are caught in a squeeze. Many cannot meet their instalments, and banks threaten to foreclose. Desperate, some home-owners are forced to sell their homes, but these sales push the housing market lower still. However, those who handed out easy loans earlier walk off with their bonuses and index-linked pensions intact, often thanks to state intervention.
According to classic capitalist theory, firms compete with each other on the basis of efficiency, with the less efficient ones going to the wall, while the more competitive ones thrive. In this Darwinian model, there is no concept of state intervention to give first aid to ailing companies. It is a world where only the fittest survive, and the Devil take the hindmost. The consumer benefits through choice and lower prices produced by competition.
In the real world, however, other factors intrude: instead of competing, often firms form cartels to fix prices; and to avoid a loss of confidence in the economy, governments often intervene to save individual companies. Thus, executives can indulge in corporate greed, safe in the knowledge that below them is a safety net provided by the state.
Auditors are supposed to restrain the worst excesses, and point out areas of concern, by giving shareholders an accurate picture of how a firm is faring. But as we saw in the case of Enron, the auditors colluded with management to fleece shareholders to an unprecedented extent.
And although privatisation is the mantra of our age, we in Pakistan have experienced the downside of the process. KESC, Karachi’s electricity supplier, is a classic example of how not to privatise. This utility was sold to a Saudi group with no experience in the field. They brought in Siemens, the German multinational, to run the company. Now Siemens is a major manufacturer and seller of electrical equipment, but it has no experience in running utility companies. A combination of inexperience and greed has seen the already low level of KESC’s efficiency plummet, with consumers suffering from extended power-cuts, and no relief in sight.
And what was the government’s role in this fiasco? Selling the family silver to cover the growing gap between income and expenditure, the Privatisation Commission has laughed all the way to the bank. The MQM, the party that was supposed to represent and protect Karachi’s interests, was too busy currying favour with Musharraf to protest against this swindle. The people of Karachi were simply not consulted, and now have to bear the consequences of a poor decision, poorly executed.
Another example of state intervention against the public interest is the habit in Pakistan of periodically bailing out the textile industry. This sector, pampered and cosseted with subsidies and protectionist policies over the years, is largely uncompetitive as a result. Instead of letting inefficient units shut down or be taken over by competitors, thus allowing large, competitive holdings to emerge, the government has subsidised archaic technology and inefficient, greedy management to continue at our expense. Thus, the lessons to be learned here that state intervention is more harmful than helpful in the long run. And ultimately, the private sector does not have all the answers.
