Out of Crisis Rethinking Our Financial Markets, by David A. Westbrook; Paradigm Publishers; Boulder/London; 154 pages; US $15.26
Westbrook sets out to understand the financial crisis and use that understanding to fundamentally rethink how our financial markets should be structured and operated . He succeeds. In doing so he challenges the financial industry on its own terms. As he puts it “this book is an internal critique of the perspective of financial policy elites”.
The book is targeted at the relatively sophisticated financial reader – which includes many of the readers of this website in view of the steep learning curve they have had to endure on the topic over the course of the last 18 months . Although based on US financial markets his analysis is international and very relevant to Europe and worldwide. (He spoke to the EU commission about financial market regulatory integration in December 2009.)
He is well equipped to adopt this approach . A professor of law at the University of Buffalo, New York, where he teaches business and international topics, much of the book was developed out of lectures on the topic in Brazil, the UK (at the London School of Economics and elsewhere), Stockholm University, and particularly in a variety of fora in China. He has also written extensively on Globalisation, The Corporation, and Ethnography, and related legal and financial matters.
En passant Westbrook makes the point that modern finance is an ideology, and one that totally failed. He does not need to make the obvious point that when ideologies fail they tend to fail big and with very nasty consequences. A well written, short, book, his metaphor comparing finance to a game will attract many. His simple explanation in those terms of how modern finance should be structured, and therefore how governments and regulators should act, is instructive: “It bears remembering, however, that the purpose is not to construct the perfect game. The purpose is to construct a game that people want to play, even when things get a little rough.”
Westbrook is clear that “the current financial crisis increasingly seems to be historically transformative, more than an anomaly.”.Westbrook supports this contention repeatedly throughout his book , referring back to the accuracy of the famous comment by the former head of the Federal Reserve, Alan Greenspan, to the US Congress on 23rd of 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 modern risk management paradigm has been taught, accepted, practised, and lived by most people in the modern economy. We have yet to develop a new consensus on how to think about how the financial system and how economic systems should work, accepting the failure of our old model. 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.”
Saying it is unprecedented or totally unexpected is a bit too convenient for these policy thinkers, these elites. Financial policy itself failed, collapsed, but many of the people dealing with it are still in place . As he puts it “the financial crisis is, in some very deep way, the fault of the very elites who are charged with rectifying the situation. Again, not to mince words, the situation is embarrassing.”
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 appropriate adjustments, rather than what is truly needed after a complete failure, a full rethinking of our political economy (as he correctly describes it) overall.
A new consensus will be difficult to achieve. It will not become politically significant until powerful parties accept it – and that demands the casting aside of their existing understanding of the world and acceptance of a new way of thinking. Establishments are conservative and not prone to self-analysis so this is a considerable challenge. To help in this endeavour Westbrook tries to chart a third way, moving on from the old left/right thinking, and “to help draw the curtain over an era of especially striking irresponsibility on the part of officials in both the so-called public and private sectors.”
A good starting point in constructing a new political economy is an understanding of the failures of the old one. Westbrook suggests that the following, at least, are clear:
- 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.[ One of the key lessons of Keynes, widely forgotten over the last three decades.]
We have all seen the irrationality of individuals and markets over the last two years. “The image of both individual and collective market behaviour as irrational – and pricing as therefore commonly inefficient – is academically buttressed by recent work in behavioural economics (psychologists have never claimed that anybody was very rational). In fact, nobody but economists ever claimed anybody was rational, and a great achievement of behavioural economics is to make irrationality cognizable in an economic idiom.”
To some extent the weaknesses noted here are the “easy ones”. What of the other traits now seen as fundamental weaknesses that proved a great boon to us all for many years and were widely appreciated and adopted?
Three traits, three great “successes” of modern finance, were the creation of greater liquidity, the availability of increased gearing or leverage, and risk spreading and mitigation through financial derivatives etc..
One of the great successes of modern finance, a great liberator in fact, 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 availed 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 some doubts were raised about the financial position of just one ” player” e.g. 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 literally froze the hyperintegrated system on the spot. This left many with no chair to sit on and a hard fall to a very rough concrete floor. 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.
The problem is actually worse than this suggests.
Dealing with strangers (individual or corporate) in a market of any type involves risk and uncertainty. Two of the key responses to such over the last three decades have been transparency (here meaning detailed disclosure to help minimise fraud and maximise investment useful information) and portfolio management, also called risk management by Westbrook, (to spread risk over different countries, investment products, asset classes, asset managers etc — all to avoid “putting all one’s eggs in one basket”.) Westbrook convincingly shows that both responses – bedrocks of modern finance- were based on a naive understanding of the world, had to fail when put under pressure, which they duly did, and were in fact antagonistic to each other.
The limits of transparency (uncertainty can never be fully eliminated just reduced, reported on, or planned for) led to the need for portfolio management. However the “success” of such eventually meant that you either did not know the other party you were dealing with (and so no transparency existed), that party was a private entity (so you were not entitled to any information – a complete lack of transparency) or when the bubble burst that other party or finance house, could not even value its own assets.[ This happened to many finance houses at the start of the current crisis — a complete failure of transparency].
The hubris was immense and the mistakes unreal. Almost all of the instruments used in our financial systems, in our markets, are legal contracts. All legal contracts are subject to inherent uncertainty because of their legal nature and for two simple reasons:
- The precision of legal contracts (and hence portfolio management) is limited.
- The legal rights of financial actors limit the possibility of transparency.[ In a networked web of contracts among discrete entities we cannot know everything about our partners partners and therefore are open to massive uncertainty and related risk of massive loss.]
His conclusion is striking. “The legal character of financial markets poses theoretical limitations on the possibility of risk management. This is a fundamental ontological [philosophical] problem: the discipline of finance has misunderstood the nature of its objects, with serious consequences for financial regulation.” Simply put the finance industry, governments, regulators, investors, consumers etc. all wrongly assumed that risk management in the broadest sense could eliminate uncertainty and guarantee our future. They were wrong.
This understanding leads to interesting and unexpected conclusions. Looked at from this perspective, markets are clearly (and always have been) social organisations, in a political context understandable only in terms of their legally-defined constituent parts. Thinking of markets as political/social entities begins to liberate us from the failed understanding of the past. In so thinking we can begin to move beyond the usual left/right responses (based on out-of-date thinking) and consider how markets can and should be constructed to meet their financial, economic, social, and political objectives.
In doing so we need to fully accept the inherent problem of bureaucratic irresponsibility generally, and particularly in financial markets, so well illustrated by the bank reserve requirements internationally established under the Basel 11 requirements. This internationally agreed approach basically left it to banks to decide what capital requirements they required to confront an uncertain future. This “decision” was made by politicians, civil servants, and bank executives worldwide. We know the result. Increasing bank reserves is now seen as the first basic step to restoring the stability of financial markets.
In focusing on how to construct markets that meet our financial, economic, social, and political needs, a good starting point is to look at where markets have performed appallingly. The best such example is of course the banking market. Westbrook pulls no punches : “One of the many infuriating things about the present crisis is that financial policy elites have not had the balls (in light of the macho rhetoric of the past few years, the gendered image is entirely intended) to admit that they, along with the rest of us, built bad markets.”
As we as citizens have pumped huge monies into our banking system, our banking market, we are entitled to see it as a public market, which should meet the public interest and be operated for the good of society. However as a market, and using the game metaphor, we should realise that there will be winners and losers, messiness (some of it creative), and as they are a way of organising people, some humane concern is required.
Designing a new system, a new market, is fun – and Westbrook enjoys the challenge. Of necessity his thoughts on how to design the market for banking and thus markets generally rely on metaphors, possibly helpful comparisons, and intellectual analysis of what is needed. In constructing a new market he is anxious to avoid falling into the trap of “fixing the unfixable” or getting stuck in old thinking.
With that background he uses four apt metaphors to help think “out of the box” to give some broad parameters on how one should construct a banking market that would meet our current requirements.
- Games: Contrary to what the right might think, detailed regulation of the entire market space is an obvious necessity. You cannot play a game without rules and regulations, or you can but no one will turn up. For the left, the game metaphor stresses the embrace of competition, not as an unfortunate necessity, but as an arena for certain sorts of life, with serious rewards , both for individuals and for society as a whole. The market, the game, must be attractive and be built on trust, or who will play/take part?
- Tensegrity: The sculptures of Kenneth Snelson provide the perfect image of a social structure made up of different parts which stands intact, but which can clearly fail, in finance called systemic risk. Although the rigid elements of Snelson’s towers are discrete, and indeed pull against one another, the structure stands so long as the cable remains taut. The building is integrated by tension, hence the term “tensegrity”.” Similarly in our banking market a “cable” (most likely credit/liquidity) must exist to handle systemic risk. Otherwise as happened in the real world, the absence of this “cable” means all the players potentially will get wiped out.
- Networked: The system needs to be as decentralised as possible, with redundancy and multiple pathways built into its connectivity. Otherwise the “too big to fail” moral hazard problem is allowed to flourish.
- Ecology: Viewing markets as an ecosystem opens up our understanding and helps shift our image from the old now out of date “jungle” metaphor to more relevant images of a garden. “Gardens are fascinating places of both planning and necessity, dependent on fortune, somewhat bounded and set apart from the broader environment, governed by the gardner, who is dependent on the garden’s produce.” Thinking of markets as more akin to a garden gives us a much more appropriate image of how they should be constructed today.
Before any such market can “take off” however, confidence has to be restored after the crash. In analysing how various governments handled the crash, he rightly points out that in many cases governments confused whole industries with individual corporations, to the cost of the taxpayer, and in many cases kept clearly incompetent management in power, and avoided taking responsibility for what were nationalised entities, keeping them “off-balance sheet”, aping the finance industry itself in much of its practices. Not surprising since all understood modern finance in a similar fashion. He makes a strong case against the “bad bank” solution as in his opinion it “was highly unlikely to work”, favouring instead 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 bank” 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?). However where we are in many countries right now, we are stuck with it, and Westbrook give some suggestions on what should work.
Interestingly 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 representatives of these institutions that they never really had a problem at all and that their business models worked. Such continuing denial, evident with a number of US institutions, and in certain respects in many others internationally , is a considerable threat to the effort to design a finance system that will not repeat the same mistakes.
When confidence is restored, one has to ensure that the finance market has been constructed well, in other words principally that it can handle systemic risk. The widely-touted approach of a government appointed regulator to help manage systemic risk is helpful, but not enough. Noting that the industry wide risk-management practices were inadequate for all finance firms, Westbrook draws the obvious but completely ignored conclusion that these risk-management practices were actually negative for the system overall. “The micro economic enterprise of risk management thus seems to be positively correlated with the macroeconomic problem of systemic risk (and government intervention) … Systemic risk appears to have actually increased in tandem with the adoption of risk-management practices. The financial system seems to have been at risk even when the economy has boomed.”
He makes some interesting broad recommendations to deal with this systemic risk, in addition to the many recommendations already widely known and “on the table”. Firstly, partnership structures (but not transparency practices) may be more appropriate for many institutions in the finance industry, rather than the current widely adopted public corporation . This is because the partnership structure is more robust, in part because it is only subject to market volatility on its assets, not also on its equity as with the public corporation. Secondly in the US, and therefore I suspect in many other countries, derivative contracts were not legally defined as securities and therefore did not fall under legislation on transparency and other legal requirements. Similarly credit default swaps were not defined as insurance contracts, and normal insurance requirements did not have to be met. Simply defining both as security/insurance contracts would reduce the risks around both these highly dangerous and volatile instruments. Such together with increased usage of insurance generally and increased counter cyclical reserve requirements, and crucially full public corporation transparency for all key market players, would lead to a significant reduction in the risk of the system itself collapsing.
His final recommendation here is to act on the “too big to fail” problem that has generated so much unclear thinking, unhelpful actions, and unhappy taxpayers.
When you fully understand how markets operate, the sheer scale of market institutions becomes a matter of critical concern. “It follows that we should limit the size of critical financial institutions … If the point of financial market regulation is to protect the financial system as a system, and the possibility of ruinous uncertainty is assumed, then institutional overconcentration, without misbehaviour, poses a danger to the system.”
“We have no qualms about regulating airlines and drug companies for safety, even though we have never had a major international economic downturn caused by drug companies or airlines. Financial institutions should also be regulated for safety, which in some cases will dictate a maximum size. If safety recommends that we divide large institutions (some, like Citigroup and AIG, are already undergoing division), so be it.” Most, if not all, governments at this time are ignoring this elephant in the room of worldwide finance systems.
Westbrook summarises the conundrum we face. “Risk has not been eliminated from this bright shiny world, but it had been identified, priced, and hedged. The financial crisis marks the swing of the pendulum away from a world in which so many of us were confident in collective wisdom, the edifice of risk management – and in which we even presumed our dealings were in some sense efficient, toward a world widely-perceived as more mysterious, where we are uncertain. And in our “new” world, we are again painfully aware that contracts may not pay, and it is prudent to save.” From this perspective “property was and is understood as a way of coping with uncertainty.”
Westbrook does not shy away from considering why much government action in the US and worldwide has attracted so much suspicion and perhaps even contempt? Much of the action taken does not make economic sense and many of the comments made, particularly by government officials, civil servants, and financiers seem self-serving and suspect.
He puts the dreaded C word, corruption, on the table, even if it is less blatant than Russian or African corruption. It still infects the body politic in many injurious ways. Stop for a moment to think through even an implicit expectation that government will bail out “too big to fail” institutions. Now they earn profits from their thus lowered risk profile (generally or through the issuance of various securities) which in essence is a transfer of value from the taxpayer to that institution, frequently then paid out in bonuses to those who “managed” us into the mess in the first place. He concludes that “not only may we be corrupt, we may be unaware of the extent of our own corruption. We may be as innocently rotten as an old barn on the edge of collapse, probably too damp for fire. It is worth worrying over.” Noting that in this environment trust, access, is everything he continues “but the sense of principled purpose, considered policy, and fundamental fairness provoked by the phrase rule of law are absent, and we are left to hope that our governing classes retain their general altruism.”
He is concerned that instead of constructing markets that meet our social, political, economic, and financial needs, we are building the type of markets we associate with weapons procurement or even kleptocracies, in which connections and influence determine success. He calls that type of market “a market of courtiers”, where people expend their energy in seeking favours and concessions and are willing to pay for the support of the powerful.
He continues “But even if we are content to take our place in the ‘courtier economy’ – this meritocratic oligarchy that seems most natural to advanced knowledge economies, we might nonetheless worry that our regulatory state has come to resemble Citigroup before its fall. Oligarchies may sometimes be durable, but is ours?… Recall that bureaucrats, meaning modern politicians, typically seek to avoid responsibility… And so important work does not get done. Risks are not actually managed. Neglected structures collapse – with luck, in slow motion, so that people have time to get out of the way, and fewer are hurt less than would be the case if the edifice collapsed suddenly. If societies’ hurt gets bad enough, public will is mobilised to tax, or inflate, and the cycle begins again.”
Drawing on his earlier writings on globalisation, Westbrook notes that this “courtier economy” is fundamentally in tension with the liberal trading regime that the US and the EU has tried to erect worldwide since the end of world War 11. [It is frequently forgotten that the alternative to globalisation which was a very deliberately constructed by elites in the US and particularly the EU after World War II, was historically the militarised nation-state that proved so effective at mass slaughter in the last century .]
There is therefore a lot to play for here, while slowly but surely, the US, China, the EU, and others erect barriers to trade and increasingly think and act in nationalistic terms. This leads to his simple conclusion of the three steps or approaches we should take to literally rethink our financial markets to ensure that operate effectively, without inordinate risk, and for the greater social good:
- Stop thinking of markets and government as antithetical. Rediscover the concept of political economy in which markets are an often preferred way of carrying on politics. See markets in more organic terms across many social structures, few of them national.
- Drop the easy bifurcation between the partisans of administration on the left and their opponents on the right, that has done so much to inhibit our thinking since the French Revolution. Adopt a less servile understanding of markets and construct them to meet our social and political as well as our financial and economic needs.
- Decide intellectually to consider the intermingling of things that had been thought separate and even opposed, “the market” and “the government” , to get a better more humane outcome for us all.
In closing, Westbrook reminds us of the need to put all these problems in perspective. “Even when financial markets fail, our economies falter, and our officials stumble, it is important to find the sweetness in society, to remember the reasons to love our world and our nation, while we think about losses and opportunities.”
There is much else in this challenging tour-de-force.It should be read by all who are interested in the current recession, and particularly how we got there and how to ensure we never repeat the same mistakes. It is essential reading for all politicians, policymakers, finance/treasury officials, central bankers, etc, all senior civil servants, all bankers and financiers, many in the broader financial services community, economists, financial and political journalists, and commentators.
If, like me, you had some lingering concerns, doubts or suspicions about how our governments are dealing with the current financial crisis, and the banks’ response to it, then this is the book for you. After reading it you will unfortunately be clear on the very tricky position we are in.
- Out of Crisis: Rethinking our Financial Markets (14 April 2010)
- Business Today: Why a Complete Rethinking of our Political Economy is Necessary (12 April 2010)