Long wait for this reply. I've been trying to put all the ideas into a rational statement that tries (perhaps fails) to tie things together.
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The final guarantor in financial crises is the economy itself; specifically, dilution of the currency. The public bears the burden, distributed over time: "all at once" provokes collapse.
Talk about "moral hazard", while justified, ignores the fact that there are only two choices when these crises occur - collapse (which serves no useful purpose) - or spreading the pain. So in fact, there's only one choice. The likelihood that the currency (as opposed to guilty players) will pay the price increases with the size of the transgression. When other parties become too numerous or too big to fail - the currency itself will pay, and the outcome will be distributed fractionally on every man, woman and child: even the poorest.
This isn't the first of such occurrences - historically there've been many: voxeu.org
Tangent to this are other social aspects of the question: the macabre spectacle of guilty perpetrators (such as traders) getting off entirely, or investment fund executives being terminated with huge bonuses - even after receiving princely compensation in the first place - when they have manifestly failed in their duty.
I don't want to go too far with this, except to say there's a sleeping beast, stirring uneasily: public perceptions, and what I've been calling (for want of a better term) The Failure of the Elites. When it goes really bad (which it may do) there will be social unrest, and rightly so. But by then, the damage will be done.
Looking at caustic and cynical commentary recently, it's evident that nobody is adequately addressing the root problems, and worse, few in positions of responsibility seem to really understand them.
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IMO there are two aspects to the question. The first is whether the financial system is flawed, and the second is how the network effect affects the answer to the first question.
In theory, hedging (credit risk included) should be flawless. The problem lies at the interface between theoretical concepts and their practical implementation.
On reflection, I can think of NO regulation or policy that will prevent further mischief, save one: make the participating players guarantee each transaction on a dollar-for-dollar (not leveraged) basis. Disregarding the burden that would place on the financial transaction system, that would ensure that each player has underwritten the potential failure of each transaction, and that the consequences would be confined to the perpetrators. That's more like the old days, before Merton and Scholes - but it's "clunky".
It's precisely that "clunkiness" that derivatives are being used to improve upon (or evade), usually without evil intent, and largely with great success. Intent is irrelevant, however: for practical purposes, there's no way to distinguish between those who are gaming the system, and those who are merely incompetent. We have a network of linkages, where scrutiny and evaluation is performed with widely-varying degrees of effectiveness. The 'system" such as it is, is pervaded with what I call The Myth of the Perfect Practitioner: the idea that players are cognizant of transactions passing through their sphere, aware of the implications in every way, and responsibly dealing with them.
Ratings agencies have been rightly criticized, but with what should we replace them? What won't be equally fallible, or fallible in a different way? Especially when faced with an ever-increasing flood of real-time transactions, most of them complex packages or wraps, requiring deep analysis? Coming and going at the speed of light, by increasing thousands, every day?
The only guarantee lies in hard assets, pledged by the players themselves. Hedging works, but only in a positive environment; in a negative environment, it's not guaranteed. In a negative environment default becomes increasingly likely at the interface between human activity and theoretical constructs. It's a domino effect, a cascade where each failure exposes the failures in its predecessor.
The system is only perfect when every link in the chain works perfectly, and that's never true.
Revisiting caustic and cynical commentary, I can't tell you how many "Old Hands" I've read, who without exception look with disgust and disdain on the evolution of financial management consistent with the concepts encapsulated in Modern Portfolio Theory. They're disgusted, because managers are wilfully disregarding the human factors that the Old Hands know will complicate and sometimes defeat the theoretical constructs. The financial sector has been permeated by an ideology, a religion that appears to work very well most of the time - when in fact, it's not working well at all - and the Old Hands know it.
The multiplication and increasing speed of such transactions makes them a victim of their own success. Just like Disney's Sorcerer's Apprentice, the players can't keep up to either the speed or rapid multiplication of the transactions. They're at a high-speed conveyor belt carrying black boxes, "wraps", and securitized transactions, which are just being stamped and passed. Often, negligent overview is encouraged by a profit incentive. Even without an incentive, individuals still have a mortgage to pay, and a life to live. So they're unlikely to buck the system in any way. They'll be compliant, or they'll be gone.
The network effect works internally and externally: it's a huge accelerant, creating a virtuous or vicious cycle (depending on your viewpoint) of rapidly-increasing usage coupled to unchecked propagation.
Apologies for the long post. I'll close with the following: not the first article about Taleb, but one of the better ones.
business.timesonline.co.uk
"Last May, Taleb published The Black Swan: The Impact of the Highly Improbable. It said, among many other things, that most economists, and almost all bankers, are subhuman and very, very dangerous. They live in a fantasy world in which the future can be controlled by sophisticated mathematical models and elaborate risk-management systems. Bankers and economists scorned and raged at Taleb. He didn’t understand, they said. A few months later, the full global implications of the sub-prime-driven credit crunch became clear. The world banking system still teeters on the edge of meltdown. Taleb had been vindicated. “It was my greatest vindication. But to me that wasn’t a black swan; it was a white swan. I knew it would happen and I said so. It was a black swan to Ben Bernanke [the chairman of the Federal Reserve]. I wouldn’t use him to drive my car. These guys are dangerous. They’re not qualified in their own field.”
Jim |
