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Tiptoeing around the Anglo Disease

by Jerome a Paris Sat Jan 26th, 2008 at 04:54:27 AM EST

The FT has an editorial about The start of the great unwinding of what they call "hyperfinance." And they are actually asking the right questions, if not quite yet offering the right answers, nor moving from their position (understandable givne who their readership is) that financial markets should thrive.

If the US suffers a recession in 2008 or 2009 it will not be due to an industrial decline or an oil price shock. It will be a recession that began in the financial system. The response of the general public is confusion, tinged with horror, at how intangible finance can impinge on their daily lives. Even some bankers and traders must be struck by the chaos their business can unleash, and feel awe at just how powerful they have become.

A fundamental question therefore arises: is the financial system broken, corrupt and in need of reform; or is the system sound, yet subject to external pressures, notably heavy monetary stimulation, with which it could not easily cope? On that diagnosis rests the future of our highly liberalised financial markets.

My, my, "broken" and "corrupt"... even with question marks, this shows how far the mighty have fallen, and suggests that there is a chance right now to make the case for different policies. And in an odd way, the FT's arguments to defend financial markets help point the blame in the right place: politicians.


They suggest two scenarios:

Analysis One would begin with the actions of the Federal Reserve in 2001-02. In the wake of the internet bubble the Fed, under then chairman Alan Greenspan, cut interest rates to 1 per cent in order to stave off the threat of deflation. One result, arguably, was to create a new asset price bubble in the housing market, fuelled by the sudden affordability of mortgage loans to subprime borrowers who previously could not afford them.

At the same time, to protect against a repetition of 1997’s Asian financial crisis, China and others pegged their currencies to the dollar at undervalued rates. The only way to keep their currencies down was to buy ever more US bonds. A supply of cheap credit met its demand.

The final part of this view would be a resulting explosion in the depth, liquidity and inventiveness of financial markets that went too far, too fast. The acronyms – CDS, ABS, CDO – swarmed faster than the markets’ institutional capacity to price and manage them. Even the losses at Société Générale can be explained in this way. Twenty years ago a whole floor of traders would struggle to lose €5bn even if they were trying. Today, thanks to the deep liquidity of futures markets and the anonymity of electronic trading, one man can do so in days.

Analysis One is benign for the financial markets: they are the acted upon, not the actors.

In terms of what happened, this is a pretty accurate description, and it does not put the blame (like Martin Wolf still does) on a "savings glut" from the emerging economies, but rather from policy decisions in Washington, followed by others in Beijing and elsewhere.

While the tax cuts are not mentioned, and the general creed that "greed is good" is only implicitly suggested (the markets spontaneously took advantage to the utmost of a favorable context), the attempt to clear the markets of guilt, in saying that they are just a ruthless machine to exploit situations created by others points to two things:

  • the guilt of politicians in creating a macro-economic framework that created such huge imbalances (the combination of tax cuts for the rich, an endless push to weaken labor market rules, and a loose monetary policy which led to stagnant wages, skyrocketing debt and asset inflation);
  • the very ruthlessness of the financial machine, brutally and amorally exploiting that context for maximum immediate gain (in the way of capture of future revenues from the real economy).
These points are certainly worth flagging. But there's more:

Analysis Two would put markets’ own failings at the centre of current events.

The core of this second analysis is the vastly increased complexity of hyperfinance. Once upon a time, banks lent depositors’ money to their customers. Now, money market funds buy asset-backed securities from conduits filled by banks originating loans from brokers. The advantage of this system is that no one entity need be overexposed to any one borrower. The disadvantage is that the seller at each step has the ability and incentive to offload bad loans to the buyer.

Complexity also adds to the danger that any one part of the hyper-financial system can bring down the whole. (...)

Another conflict of interest that has become pronounced is between banks’ shareholders and their employees. This is the more cynical interpretation of Société Générale. If employees make profits they are paid bonuses; if they make losses, they are sacked. Their incentive, from graduate trainee up to chief executive, is to take more risk and so increase the potential profits. (...)

If this second view is right then regulators have failed. They will have to change the rules to try to eliminate the conflicts that imperil the financial system.

This goes even more directly to the heart of the overall culture of greed. In blaming regulators, this editorial only underlines how prevalent the permanent requirement for returns and efficiency is driving people to ruthlessly cut all corners, and go around rules - and it certainly has not helped that these rules have been deliberately weakened (a point still conspicuously absent from this article).

All in all, a ferocious, if still partly implicit, indictment of the Anglo Disease. something to build upon.

Display:
Jérôme: have a look at NBBooks diary 'No choice now but depression or hyperinflation'

You can't be me, I'm taken
by Sven Triloqvist on Sat Jan 26th, 2008 at 05:04:28 AM EST
The last time the banksters went crazy (in 1981) several of them got shot for their sins.  But they were little fish. This time around, maybe even some of the seriously guilty parties will get treated to a real hard justice.

But that is NOT the solution.  The solution is to severely restrict the power of the banksters.  They have been running things (badly) for the last thirty years.  Now they should be allowed to run nothing at all for (at least) the next 30.  The folks who gather in Davos should be recognized for who they are--low-brow criminals rather than oracles with great wisdom.

"Remember the I35W bridge--who needs terrorists when there are Republicans"

by techno (reply@elegant-technology.com) on Sat Jan 26th, 2008 at 06:23:09 AM EST
is the financial system broken

Yes, irretrievably. The mathematics of compound interest on a deficit based money supply are inexorable. Money as Debt is unsustainable in a world of finite resources.

Fortunately the credit intermediaries which create this Money are, like all other intermediaries, obsolete in a "Peer to Peer" world.

Another conflict of interest that has become pronounced is between banks' shareholders and their employees.

The "Principal/Agency problem" implicit in the sociopathic structure of "the Corporation".

Fortunately, there are new frameworks out there which enable Labour to work with Capital rather than for Capital and that realisation is beginning to sink in.

IMHO those enterprises - whatever legal form they use - which do not use these structures will be at a disadvantage to those that do.


"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Sat Jan 26th, 2008 at 06:31:19 AM EST
Money as Debt is unsustainable in a world of finite resources.

I know I'm entering a hornet's nest here, but this argument has always bothered me. First, I guess that with "Money as Debt" you mean that our current system needs growth. Loans are taken and must be repayed with interest, which requires growth, or the whole thing falls down. And yes, the world is a finite place.

But you can have different kinds of growth. Extensive growth means exploiting new resources. This cannot be done endlessly in a finite world and will eventually have to come to a stop. Second, you can have intensive growth. which means doing things in smarter and more efficient ways. Examples here might be better ways or organising production, making more of a product with the same input (or the same amount of product with a smaller input) through the use of better technology, or the discovery of an entirely new resource, earlier thought useless, that can be utilised (think uranium in the 20th century).

So, eventually we will reach the end of extensive growth, and possibly even reach the end of intensive growth, if we can't keep innovating fast enough. Growth will then have been shown to be unsustainable. But no one has any idea when this will happen, if it indeed will, so until then we might as we'll sustain our growth, which has made and is making the lives of humanity so extremely much better.

If or when we reach the end of growth and is seems it no longer can be sustained, well, then we'll deal with it. For now, making the system better is a far better idea than changing it fundamentally. Reform rather than revolution.

Peak oil is not an energy crisis. It is a liquid fuel crisis.

by Starvid on Sat Jan 26th, 2008 at 07:00:32 AM EST
[ Parent ]
I understand your argument, and it is a good one.

Money as Debt is one driver of Growth: and it is possible to imagine scenarios where "intensive growth" - built upon whatever base we are about to plumb - sets us off on a more sustainable course for a while. That is what the Kondratieff Wave is all about, as I understand it.

But the sticking point is "the Corporation". The Cooperation and transparency that is, I think, necessary for "intensification" is programmed out of Corporations in favour of "Commercial in Confidence" and the great God of "Competition" (and don't get me wrong, I'm all in favour of people competing on Quality).

The other "driving force" in the economy is the drive for "Profit" (which is, IMHO, almost by definition, one of the root causes of inflation, Money as Debt being the other). Until you replace the Corporation and a "Profit and Loss" economy with something better, then "intensification" will be difficult, if not impossible.

Within a Partnership there is no "Profit" and no "Loss", merely creation and exchange of Value ("Money's worth") in all its forms - and deficit "Money as Debt" is not Value, but a claim over it. People collaborate and share information etc in a Partnership, because they share in the gains if they do.

One of the best illustrations of the negative effect of Corporations - and the instiable appetite for Growth in Profits - is in the UK right now, where, because we have privatised Gas and electricity supply, our energy policy will always be directed down routes which do NOT lead to reduced energy consumption.

Reform rather than revolution

I prefer transformation.

The system cannot be reformed from inside.  But, as I bang on about on ET, I believe that partnership-based alternatives are emerging to the dinosaur Corporations, and that if they do not use such collaborative models they will be "out-competed" by those who do.

It's because they have the "Cooperative Advantage" of not having to pay returns to rentiers.

In a networked society there is no place for intermediaries. The defining moment of the necessary transformation is the ongoing collapse of the financial system and its transition into something else.

IMHO that will occur during the next four years. Maximum.

Napsterisation happens fast.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Sat Jan 26th, 2008 at 07:46:13 AM EST
[ Parent ]
As you found out during the conference you attended, not only there's an uphill battle to fight, but the hill is even steeper than we feared: heck, even among our fellow progressives...

You keep stating the truth (i.e. just the facts and figures from the WSJ, FT, The Economist...), but the truth is obviously no match for the thruthiness permeating your interlocutors (They call you Colbertian, they surely mean Stephen Colbert, right?).

As much as we hate to admit it, it's most likely to get worse before it gets any better.

by Bernard on Sat Jan 26th, 2008 at 07:02:27 AM EST
If this second view is right then regulators have failed. They will have to change the rules to try to eliminate the conflicts that imperil the financial system.

This is, IMO, one of the most dangerous memes and it needs serious debunking.

The implication is that regulators were "asleep at the wheel" and "failed us."

The reality is that regulators were handcuffed by lobbying and pernicious propaganda from free-market ideology economists and politicians, whose stated aim was to eventually end regulation altogether.

So, yes, regulators have been imperfect, but the blame lies with those who sought to undermine regulation in the first place. Some of those people were in fact regulators (e.g. Greenspan) but we should never lose sight of the fact that this is a disaster bred at Cato and the "Adam Smith Institute."

[To tie it to another meme, the anti-regulation people thought only of the efficiency of the market, never the robustness or resilience.]

by Metatone (metatone [a|t] gmail (dot) com) on Sat Jan 26th, 2008 at 07:15:07 AM EST
National regulation is powerless in global markets.

And some global "uber regulator" is no answer, either, because it would never be agreed upon.

Global self regulation by all market participants not just the intermediary lunatics who currently own the market asylum - is the answer IMHO with market standards agreed by governments collectively.

Market 3.0 I called it, almost seven years ago now...

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Sat Jan 26th, 2008 at 07:58:40 AM EST
[ Parent ]
National regulation can tax cross-border capital flows. Supranational regulation may have to be agreed along the lines of Keynes' International Clearing Union (updated for the 21st century) if things get much worse. And self-regulations simply doesn't work.

We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sat Jan 26th, 2008 at 08:39:40 AM EST
[ Parent ]
self-regulations simply doesn't work

Not the way it's been tried.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Sat Jan 26th, 2008 at 09:06:19 AM EST
[ Parent ]
You might as well say that deregulation/unbundling of energy markets hasn't worked the way it's been tried.

We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sat Jan 26th, 2008 at 10:50:47 AM EST
[ Parent ]
Never mind, "I might as well":  I do!

There has never been such a complete bollocks as the UK electricity market.

But then it is designed to extract the maximum short term profit for shareholders, because their agents are essentially the ones who designed it.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Sat Jan 26th, 2008 at 11:46:50 AM EST
[ Parent ]
And the Californian market (Enron, anyone?).

The point is that deregulation and unbundling is only advocated by those who stand to profit from destroying a working system. It is wasn't for them nobody would have thought of doing it, therefore it doesn't work irrespective of how it's done, because those who might "do it well" won't do it in the first place.

We have met the enemy, and he is us — Pogo

by Migeru (migeru at eurotrib dot com) on Sat Jan 26th, 2008 at 11:48:34 AM EST
[ Parent ]
That is the conventional wisdom, but as REACH showed in manufacturing, it might not be the case.

It is still the case that certain markets in the world are so important (and the US is one of these in various financial transactions) that regulations there actually filter out to the rest of the system.

Yes, there will be loopholes and yes some people will avoid compliance by moving operations to the Cayman islands. In the end however, a first step to stabilising the system is regulating the activities of savings banks, most of whom do sit in a geographical position they cannot escape.

Now I know you have no interest in measures to stabilise a system you believe to be doomed, but that's a separate issue.

by Metatone (metatone [a|t] gmail (dot) com) on Sat Jan 26th, 2008 at 09:42:35 AM EST
[ Parent ]
I think you mean decentralised multi-stakeholders regulation rather than self-regulation. In that case, I agree, regulation should take place at the relevant level, which varies with the kind of market. However global markets have to be regulated at a global level.

And to insure fairness and transparency, the rules and methods for decentralised multi-stakeholders regulation must be defined and agreed at a global level.

"Dieu se rit des hommes qui se plaignent des conséquences alors qu'ils en chérissent les causes" Jacques-Bénigne Bossuet

by Melanchthon on Sat Jan 26th, 2008 at 03:49:26 PM EST
[ Parent ]
Agreed: I did say that Governments would have to set "Market Standards" (at the appropriate level, as you say). ie set the framework within which the "multi-stakeholder" regulation takes place.

There's no difference between "multi-stakeholder" and "self-regulation" by all. It's the same holistic outcome.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Sat Jan 26th, 2008 at 04:23:24 PM EST
[ Parent ]
There's no difference between "multi-stakeholder" and "self-regulation" by all.

Yes, but most people will probably understand "self-regulation" as voluntary regulation by the industry alone (i.e. to leave the financial markets regulation to the banks themselves).

"Dieu se rit des hommes qui se plaignent des conséquences alors qu'ils en chérissent les causes" Jacques-Bénigne Bossuet

by Melanchthon on Sat Jan 26th, 2008 at 04:56:07 PM EST
[ Parent ]
Regulators failed by allowing the giants of hyperfinance to write the regulations, with the FT's approval.
Daily Kos: The dollar has lost 1/3 of its value
I was a central banker and market supervisor during some of the period of deregulation.  In retrospect it was a mistake to let Citibank and Goldman Sachs define what a good market or a good regulation might be.  But there will be lots of time to learn the lessons of the coming collapse once it is past.
No, there won't be time if the FT propagates the idea that the regulators were to blame. The time to talk about how deregulation was wrong is now.

We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sat Jan 26th, 2008 at 05:24:03 PM EST
[ Parent ]
European Tribune - Tiptoeing around the Anglo Disease
If the US suffers a recession in 2008 or 2009 it will not be due to an industrial decline or an oil price shock. It will be a recession that began in the financial system. The response of the general public is confusion, tinged with horror, at how intangible finance can impinge on their daily lives.
As usual, the Financial Times editorialists have forgotten or never knew their economic history. How about the bank panic of 1873 leading to the "long depression" or the crash of 1929 leading to the "great depression"? This time arount it'd better be short and shallow or we'll have to rename the lot.

We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sat Jan 26th, 2008 at 08:43:20 AM EST
Complexity also adds to the danger that any one part of the hyper-financial system can bring down the whole. (...)

I can't count the times I've heard it said that we were no longer in danger of a 1929-type scenario because, precisely, today's financial system was more sophisticated -- risk was distributed, the multiplicity of instruments permitted hedging of a kind that guaranteed resistance to shocks and stability.

Now none other than the FT is breezily saying the opposite?

by afew (afew(a in a circle)eurotrib_dot_com) on Sat Jan 26th, 2008 at 09:15:36 AM EST
I've also seen much reference in the FT and elsewhere recently to a "Flight to Simplicity".

This October Discussion wound up with that as a "Key Lesson".

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Sat Jan 26th, 2008 at 09:37:05 AM EST
[ Parent ]
More from Taleb on the Flight to Simplicity
The Simplicity Rule

A major rule should be taken into account: The market always tends to flow to simplicity. Complexity is generally costlier to both monitor and produce, and somehow in the long run, demand moves away from the complex in favour of the simple. New, elaborate contracts certainly attract people, but typically the novelty wanes. Operators will then try to satisfy their needs for protection by seeking the cheapest possible way.

Complex products cost more to replicate. An optimal operator becomes cost conscious and avoids enriching the financial institutions when he can satisfy his interests more economically. This becomes noticeable with the life or death of listed financial instruments. It is the recipe for the survival of exchange contracts. This rule will be discussed in the study of exotic options.

While he's writing about complex options contracts, the reasoning clearly applies to any financial instruments. Is it any wonder that the asset-backed commercial paper binge was going to end in indigestion as the more complex paper became illiquid?

We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sat Jan 26th, 2008 at 11:39:03 AM EST
[ Parent ]
Exactly.

Very annoying, especially for those of us who looked at the complexity of risk and pronounced it dangerous and were shouted down by the likes of the FT.

by Metatone (metatone [a|t] gmail (dot) com) on Sat Jan 26th, 2008 at 09:43:07 AM EST
[ Parent ]
When I telephoned one fund to ask if we could interview some of their quants, the receptionist told me that I was unlikely to get permission, partly because of the secretive, commercially sensitive nature of their work but also, because many of them in that fund are autistic.

BBC NEWS | Business | Mathematicians' role in market mayhem

What a metaphor...

We all bleed the same color.

by budr on Sat Jan 26th, 2008 at 10:22:03 AM EST
Whatever.

We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sat Jan 26th, 2008 at 11:04:30 AM EST
[ Parent ]
Sorry, mig, I wasn't thinking about the mathematicians.  I was thinking of the people who hired autistics and still don't understand why their financial models have taken leave of reality.  Is that not a metaphor for what's wrong with the whole stinking mess?

We all bleed the same color.
by budr on Sat Jan 26th, 2008 at 01:10:21 PM EST
[ Parent ]
Migeru:
I don't know what's worse: the receptionist claiming mathematicians are autistic, the journalist printing it, or you believing it and running with it.


We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sat Jan 26th, 2008 at 11:06:05 AM EST
[ Parent ]
You can't have expected them to come up with a serious discussion, though.  These things must be rushed, since there are more important issues to deal with After all, Britney Spears is having another meltdown, and Michael Bloomberg might be running for president.

Be nice to America. Or we'll bring democracy to your country.
by Drew J Jones (pedobear@pennstatefootball.com) on Sat Jan 26th, 2008 at 12:54:06 PM EST
[ Parent ]
 Of course, all mathematicians are autistic.

Pile of wank.

by Colman (colman at eurotrib.com) on Sat Jan 26th, 2008 at 12:02:26 PM EST
[ Parent ]
Well, if autistic means "Them don't bother to wear suits to work, I tell you ! some don't even shave daily !", that's not that unlikely.

Un roi sans divertissement est un homme plein de misères
by linca (antonin POINT lucas AROBASE gmail.com) on Sat Jan 26th, 2008 at 12:06:50 PM EST
[ Parent ]
Sure, and if "cancer ridden" means "has a bit of a cold" ...
by Colman (colman at eurotrib.com) on Sat Jan 26th, 2008 at 01:15:33 PM EST
[ Parent ]
Have you taken a bank health test for taking a loan recently ?

Bankers tend to be on the square side on these kind of things.

Un roi sans divertissement est un homme plein de misères

by linca (antonin POINT lucas AROBASE gmail.com) on Sat Jan 26th, 2008 at 01:20:08 PM EST
[ Parent ]
I'm sorry.  I guess my point was lost in the stereotype.  Autism is a very real, very serious mental illness, having nothing to do with mathematics.  The problem is not autistic mathematicians.  The problem is financial managers who are so obsessed with making the numbers look good on paper that they begin to believe they can evade reality if they can just manipulate the numbers enough.  If they just hire clever enough people to manipulate the numbers, they can make the reality of a mountain of bad debt look like it's something else.  If the current crisis was really caused by a bunch of autistic mathematicians in the back room, would it make the crisis any less real?

We all bleed the same color.
by budr on Sat Jan 26th, 2008 at 01:41:02 PM EST
[ Parent ]
The problem is that the financial managers can now go around blaming the mythical autistic mathematicians and people will believe them.

We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sat Jan 26th, 2008 at 01:45:04 PM EST
[ Parent ]
Migeru, perhaps it is presumptuous of me, but I think of you as a friend.  If I have offended you I apologize.  That was not my intent.

We all bleed the same color.
by budr on Sun Jan 27th, 2008 at 10:46:00 AM EST
[ Parent ]
European Tribune - Tiptoeing around the Anglo Disease
Complexity also adds to the danger that any one part of the hyper-financial system can bring down the whole.
No, it is not the complexity of financial instruments that is responsible for this, but the greater degree of interconnectedness in the financial markets. The complexity of financial instruments is a result of the pursuit of efficiency above all other considerations. Efficiency does bring complex, interconnected systems closer to "the edge of chaos" and makes system-wide crises more likely.

If capital flows were contained by national borders (as they were until the 1980's) any one part of the system could only bring down a national economy. An analogy with wildfires and the role of firebreaks is apt here.

We have met the enemy, and he is us — Pogo

by Migeru (migeru at eurotrib dot com) on Sat Jan 26th, 2008 at 11:01:52 AM EST
True, but the fact of complexity can make "risk management" effectively impossible.

I suppose I'm groping towards the idea that it may not actually be the Rating Agencies fault. We may have reached a point where it's not possible to calculate the risk involved in some of these instruments.

Of course, part of the disease is the reliance on calculation, many of us looked at various instruments and could see trouble ahead, but the "calculation models" did not...

by Metatone (metatone [a|t] gmail (dot) com) on Sat Jan 26th, 2008 at 11:30:36 AM EST
[ Parent ]
If you can't estimate the risk of something you don't stick a big fat zero in the calculations.

We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sat Jan 26th, 2008 at 11:32:28 AM EST
[ Parent ]
European Tribune - Tiptoeing around the Anglo Disease
Now, money market funds buy asset-backed securities from conduits filled by banks originating loans from brokers. The advantage of this system is that no one entity need be overexposed to any one borrower. The disadvantage is that the seller at each step has the ability and incentive to offload bad loans to the buyer.
The mistake in this case was for the regulators to allow loans to be sold to unregulated (non-bank) entities. Banks should be able to sell on the cash flows if they want, but the loan should remain in the banks' books.

We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sat Jan 26th, 2008 at 11:03:20 AM EST
European Tribune - Tiptoeing around the Anglo Disease
Another conflict of interest that has become pronounced is between banks' shareholders and their employees. This is the more cynical interpretation of Société Générale. If employees make profits they are paid bonuses; if they make losses, they are sacked. Their incentive, from graduate trainee up to chief executive, is to take more risk and so increase the potential profits. (...)
And the FT discovers this now?

This is from Nassim Taleb's Dynamic Hedging, published in 1997 and apparently sold very well in the 10+ years since.The book is peppered with things like

It is often easier to arbitrage one's accounting system than the market
But even without having to assume a failure of accounting systems, profit-based compensation is fraught with problems.
A trader with a "synthetic capital" of $10 million (i.e., the virtual capital allocated to him by the bank) has often more earning power than a manager with a higher amount of capital under him, because the manager will have to face the "diversification" - the offsetting returns from traders
This is a consequence of the lopsided performance-tied compensation: everyone profits from the upside but doesn't lose from the downside, and the individual trader has larger volatility than the manager of a team of traders.
At any rate, when the trader owns an option on his profits (i.e., gets a cut of the upside without having to share into the downside), as is the case with traders using other people's money, it is always optimal to take as much risk as possible. An option is worth the most when the volatility is highest.
Now, hasn't it occurred to anyone that the banks, who are in charge of money and credit on behalf of the economy at large, enjoy an option as well? When there are huge profits they get a cut. When the economy crashes because they inflated the money supply and ran extreme risks with it, they get bailed out or they go out of business, but they get to keep whatever fraction of their previous profit they didn't spend on oversized champagne bottles.


We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sat Jan 26th, 2008 at 11:29:17 AM EST
by asking the question - What is the PURPOSE of the financial and banking systems?

My reply to that question is "To supply capital to the physical economy." Ie, loans and equity to build new physical plant and equipment, fund research and development, and finance consumer purchases.

Anything else should either be prohibited outright (ie, program trading; I'm not sure how wise or efficient such prohibitions are) or taxed to discourage them. Ie, the Tobin Tax, which was originally proposed for forex, but which could be applied to other financial markets as well.

In The Federalist Papers (Number 15, if I recall correctly), Alexander Hamilton had a simple test: "Is private credit the friend and patron of industry?" And at that time, they understood "industry" to mean the actual production of physical goods -- they never would have called banking an "industry."

But to add to our difficulties today, at the same time we grope for a solution to this mess, we also need to be mindful of reshaping "aggregate demand generation" in a sustainable and environmentally sound direction. In my mind the past month or so I have been thinking of the concept of "malconsumption."  Malconsumption by the wealthy and the upper middle class is fairly obvious: massive homes that are too expensive to heat, SUVs that get only 12 miles per gallon. Among the poor and working class, you find malconsumption such as bad food rather than healthy food (which is usually more expensive) and an unwillingness to purchase more environmentally sound products (again, usually because  the initial purchase price of green products are more expensive, even if the life cycle cost is less). At the social level, in the U.S. at least, there is malconsumption of infrastructure, with an unwillingness to invest in water and sewer systems, for example, or the preference to build suburbs rather than more dense urban cores (an idea James Kunstler has developed at length). The political problem, of course, is how do you deal with someone who insists they have the "right" to indulge in malconsumption?

But the key question in this thread is: What is the PURPOSE of the financial and banking systems? And what incentives and penalties can be put in place to ensure those systems fulfill their proper functions?

by NBBooks on Sat Jan 26th, 2008 at 01:12:12 PM EST
the blame in the right place: politicians.

If I read you correctly, you avoid any mention of business´ responsibility in the entire disaster.  It obviously looks away from banking, finance and all the highly-placed, ethically bankrupt and overrated types.  Remember at the ´elite´ level, politicians and businesspeople are one and the same, (white) old-boys network.

It is a lot more credible and realistic to put the blame on both and their ´connection´.

Our knowledge has surpassed our wisdom. -Charu Saxena.

by metavision on Sat Jan 26th, 2008 at 04:00:20 PM EST
Politicians don't know any better and policy gets written by experts, who at best have industry experience and at worst are in the industry.

We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sat Jan 26th, 2008 at 04:02:11 PM EST
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