Out of Crisis: Rethinking our Financial Markets

This article first appeared in the 14 April 2010 edition of Jamaica Observer.

OUT of Crisis: Rethinking Our Financial Markets by David Westbrook is targeted at the relatively sophisticated financial reader — which includes many readers of this newspaper, who have had a steep learning curve on this topic over the last 18 months. Although based on US financial markets, the analysis is international, and very relevant to Jamaica.

The focus is on exploring what former Federal Reserve chairman Alan Greenspan said to Congress in October 2008: “This modern risk-management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year.”

This is not just an intellectual problem. The risk-management paradigm has been taught, accepted, practised, and lived by most people in the modern economy. It has failed. We have yet to develop a new consensus on how to think about how the financial system and how economic systems should work.

As Westbrook puts it, “there is little reason to believe that this generation of policy thinkers, who were trained in the old, now largely discredited paradigm, really knows how to tackle the problems before it… The ways, or many of the ways (but which ones?) that these problems have been considered are at least compromised, perhaps simply wrong.”

The now common left-wing and right-wing attacks on the elites or “the system” play to a continuation of the old financial game, with some tinkering, rather than what is truly needed after a complete failure, a complete rethinking of our political economy overall. Westbrook suggests the following starting points:

*Markets cannot be relied upon to be efficient. (Price is not always a fair value and is not always a reasonable social judgement.)

* Financial markets need regulation.

*The information available to market actors, and their supposed sophistication, is insufficient to prevent occasional institutional catastrophe and even threats to the system overall. (“Smart money is not always smart.”)

*Confronted with the credible threat of a risk to the system (systemic risk), governments will intervene, whatever their hue. There is therefore no “moral hazard” stopping financiers taking big risks, knowing that when they succeed they get the payoff — and when they don’t the government bails them out.

* Subjective uncertainty, rather than objective risk (which many in the industry thought could be totally eliminated by mathematical models, transparency, dispersed portfolios etc.) is a major problem to be addressed, and cannot be eliminated. This is one of the key lessons of Keynes, largely ignored over the last three decades.

One of the great successes of modern finance has been the extraordinary increase in liquidity through a huge amount of financial ingenuity devoted to getting money into the hands of those who want to spend it, today. One way or another most of us have partaken of this success. However, just like with gearing (eventually many “deals” were only profitable if they were highly geared) and risk spreading (for many years the usage of derivatives was seen as something that made the financial system more robust), there is always a counter party or counterparties to such deals. So, when the music stopped (when the asset or credit bubble got out of hand or even when doubts were raised about the financial position of just one ” player” eg Lehman Brothers), liquidity vanished overnight, gearing or borrowing frequently became a nightmare or “life-threatening”, and the uncertainty about the other party to each deal froze the hyper-integrated system on the spot. The great “successes” of modern finance suddenly became its greatest weaknesses and clearly enabled and magnified the various bubbles and the subsequent crash and recession.

He makes a strong case against the “bad bank” solution — favouring nationalising and then doing an orderly liquidation through a Resolution Authority of the relevant financial institution. However, he concludes, as many governments also have, that “the nationalisation and liquidation of corporations that pose systemic risks are probably politically unrealistic”.

He thinks the “bad banks” approach will fail because it misses the forest (how do we get the financial system running properly?) for the trees (how do we “sell” toxic assets that nobody wants to buy? Or, how do we avoid declaring these insolvent banks insolvent? Or how we avoid taking the financial systems liabilities on to the government’s balance sheet?)

Westbrook provides considerable detail on the supports the US government gave to AIG, Goldman Sachs, and many of the other key financial institutions to help keep them in business when their business models failed. Much of this detail is new to me and I suspect will be new to most of his readers. That detail puts the lie to self-serving statements from such institutions that they never really had a problem at all and that their business models worked. Such continuing denial is a considerable threat to the effort to design a finance system that will not repeat the same mistakes. A definition of insanity is doing the same thing over and over again and expecting a different result.

Though short, this book contains much with which to begin to fully understand what happened and why. If I could put a copy in the briefcase of every financial regulator and executive I would. Ponder this — where institutions are judged too big to fail, is that not an open invitation to excessive risk and even corruption?

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