On November 9, 1989, the Berlin Wall that divided the East and West Germany, both physically and ideologically, finally fell. It was a political earthquake which signaled the end of communism.
Communism was characterized by its contempt for private property, by the complete control of the state over the economy, and consequently, by its disregard for price as a signal of scarcity and guide for investment. For over fifty years, price of bread did not change in the erstwhile Soviet Union. Not surprisingly, for much of that time, there was hardly any bread available for increasing number of people.
Communism collapsed not because of its ideological baggage, but because of the practical cost of the ideology that tried to make private property redundant.
The 20th anniversary of the fall of the Berlin Wall has become particularly poignant, because the current economic slowdown in much of the rich countries, particularly in that apparent bastion of capitalism, the United States. Over the past two years, the foundation of global finance has been shaken, not because of any Marxian foresight, but because of the failure on the part of the capitalist world to appreciate the relationship between property ownership and valuation of that property.
The blame for the financial crisis has been ascribed to many – from easy money, to human greed; from a lack of government oversight, to the lethal financial derivatives.
The fact is that this dramatic chain of events was triggered by the collapse of the housing market in the US, in 2007. The housing bubble was supported by public policy aimed at widening home ownership, and facilitated by an elaborate network of financial institutions. These institutions created an ever more elaborate chain of securities that funneled savings from all over the world into securities that were issued against mortgages taken out by US home-owners.
Originating in single, often modest, loans taken by US families, these mortgages were packaged by banks into so-called MBSs (Mortgage Backed Securities). First, a retail bank in a small town would bundle its mortgages and transfer them to a regional office. Within days, often hours, the paper would find its way to New York. There one of only six rating agencies would slice the bundles into layers of securities. Based on statistics of housing loans over the earlier decade, the rating agencies would determine what proportion of the securities should be rated AAA (the safest, with correspondingly low interest rates), and how the remaining paper should be pegged down the ladder of safety – and up the ladder of return.
Thus rated, the paper would be offered to buyers across the world, to banks and funds. With electronic transfer from a US suburb to a small town in Germany, these securities were virtually ‘virtual’ in nature. The savings institution in Germany had no way to assess the risk underlying the paper it owned, except via the rating stamped on it in New York, and disseminated to it, perhaps by way of London and New York. When the bubble burst, as invariably happens with all asset booms, there were no reliable mechanisms to reassess the risk underlying the securities.
This financial crisis illustrates what happens when the relationship between property and ownership is lost or gets fuzzy. A modern economy is built on clear ownership of property, whether tangible or intangible, be it land, shares or intellectual property. It requires a commonly accepted form of documentation of that ownership, a continuous flow of information about the owners capacity to harness the property, and an unencumbered market where the transactions can be undertaken leading to the discovery of the real price of the asset concerned. This price information is critical, because it allows capitalization and ensures the flow of credit, which in turn keeps the wheels of a modern economy turning.
The stock market operates on the basis of continuous disclosure of financial performance of companies, and facility to freely trade the information. So despite the widely dispersed share ownership, the information regarding the value of the assets, the market capitalization, future prospects, gets continuously updated and vetted.
In contrast, for the various financial derivatives backed by the mortgages, it was no longer possible to identify the actual assets, no way to assess the financial health of the owners of these properties, and therefore no real market to vet the prices of these papers.
Unfortunately, much of the public discourse has ignored this fundamental dimension of the present economic woes. The housing bubble and the consequent banking crisis provide a glimpse as to the tragic consequences of decoupling between property ownership and property valuation.