The biggest threat to capitalism

Most of us spend more time thinking about the latest London Olympics results than the scandal surrounding the London InterBank Offered Rate, or Libor. That is a big mistake.

We should be paying more attention to the Libor scandal.  And we should be terrified.

The public has been so fatigued by the flood of awful financial news during the past few years, that a scandal surrounding an interest rate that most of us have never heard of doesn’t seem like that big a deal. But in fact, the Libor scandal is potentially a bigger threat to capitalism than the subprime meltdown, the eurozone crisis, the Madoff scandal, and the MF Global bankruptcy.

Although these misfortunes are costly, they pale in comparison to the threat posed by the Libor scandal. The subprime crisis can be blamed on bad policies: irresponsible fiscal policy combined with loose monetary policy and poor regulatory enforcement. Similarly, the euro crisis can be blamed on one poorly conceived policy: creating one currency when retaining 17 distinct currencies would have been more workable. And the Madoff and MF Global debacles can be chalked up to a few unscrupulous and reckless individuals.

By contrast, the Libor scandal is nothing less than a conspiracy in which a few shadowy bankers conspired against the majority of participants in the financial system—that is, you and me.  Worse yet, evidence is now trickling in that regulators on both sides of the Atlantic may have had more than an inkling that something was fishy with Libor.

Suspicions of financial conspiracy are about as common as theories on the Kennedy assassination and the kidnapping of the Lindbergh baby. Usually these are unsubstantiated.  This time, however, e-mails have surfaced demonstrating conclusively the extent of the conspiracy.  In one such e-mail, a grateful trader at Barclays bank thanked a colleague who altered his Libor submission at the trader’s behest: “Dude.  I owe you big time!  Come over one day after work and I’m opening a bottle of [champagne].”

Why is the Libor scandal such a threat to the financial system?

Interest rates on some $800 trillion in financial transactions are tied to Libor, including everything from complex derivatives to far more commonplace mortgages, home equity lines of credit, and credit card balances.  The number of ordinary consumer affected by Libor is enormous and the potential for litigation emanating from the scandal is enormous.

But the problems do not end there.

The key role of the financial system is to channel the accumulated savings of society to projects where they can do the most economic good—a process known as intermediation. My retirement savings may help finance the construction of a new factory; yours might help someone pay for a new house. Although Goldman Sachs CEO Lloyd Blankfein exaggerated when he called this function “Doing God’s work,” intermediation is nonetheless a vital function.

However, intermediation will come to a stop if individuals, corporations, and governments no longer trust the financial system with their savings. If people believe that the interest rates they pay and receive are the result of a game that is “fixed,” they will opt out.

They may not go so far as to stash their savings under their mattresses, but they will certainly keep it away from the likes of bankers they believe have been cheating them.  Instead they will hold it in cash or in government bonds which will reduce the amount of money available for productive purposes.  And that is the end of capitalism as we know it.

Despite our recent ups and downs, most people still put their faith—rightly, in my view–in capitalism, believing that it is more likely to deliver a high standard of living than any other economic system that the world has ever known.  Politicians need to be aware that this faith has its limits.

If our leaders do nothing to restore confidence in the market economy, the consequences will be far worse than anything we have experienced in the last few years.