End of an Annus Horribilis for Finance

Here we are at the end of this "annus horribilis" that brought down the world to its knees, marking the end of a global expansion cycle which was falsely described as the dawn of a new era of perpetual growth and enduring prosperity.

In a world that has gone madoff, as this year's Nobel Prize winner Paul Krugman puts it, we are witnessing the return of the very notion of risk, whereby we start to recon that there is no such thing as "pure alpha" without some kind of "hidden beta". We have learned that everything - including liquidity - eventually comes at a price. And we are now realizing that many of the Wall Street mavericks with six figures salaries and stratospheric bonuses are not the fascinating geniuses and "beautiful minds" that we were idolizing, but a mere bunch of rogue mercenaries devoid of any sense of ethics or collective responsibility.

The emperor is naked and so are his knights, dark and white altogether. Ironically, many hedge funds, which as their name purportedly indicates were supposed to hedge against risks, were actually engaged in the same race of blind yield generation and risk complacency that sealed the fate of some of the most reputable financial institutions down the Street.

The whole financial sector turned out to be a huge ponzi scheme set out by the few with the silent complicity of the many, including politicians from all parties, regulators from all public bodies, central bankers that printed money for free, rating agencies whose reputation is now tarnished by the conflict of interest at the heart of their business, and last but not least, corporate leaders, that were more worried about their stock option plans and golden parachutes than about the viability and long term growth prospects of their companies.

In a way, we are paying now for the consequences of three decades of deregulation starting from the phasing out of Regulation Q in 1980 in the United States and going through to the subsequent endorsement of the Washington Consensus at the international level, which profoundly altered the nature and scope of the Bretton Woods institutions (IMF, World Bank). The current financial system regulation could be described at best as "the parable of the blind guiding the blind", as illustrated in the eponymous painting of Pieter Bruegel the Elder.

Take the Basel Committee which was set up in the nineties to avoid the accumulation of bad debt in OECD banks' balance sheets. It was so successful that it led to the development of a whole new generation of financial products aiming at putting all the risks off-the-balance sheet, away from regulatory oversight. The same could be said with the development of the Credit Default Swaps (CDS) which transferred credit risk attached to junk bonds from specialized investors to "main street" insurance companies, happy to earn more from this activity than from their traditional actuarial based business model. We know how the story ended, with the in extremis bailout of AIG and the fall of the so-called monoliners.

In a world of free capital flows, there is a need for a global regulation of these capital flows. The fact that this basic truth has been finally put on the global agenda at the G20 summit in Washington is an encouraging step in the right direction. But we are still far away from a comprehensive solution to the problem of regulatory loopholes and regulatory arbitrage as long as rules differ substantially depending on whether you are "legally" based in New York or in the Cayman Islands. Indeed, offshore finance is a second word for regulatory arbitrage.

Now, that the financial crisis has spread to the real economy, governments around the world are shifting their attention from the desperate calls of a handful of financiers to the much vocal ills and ires of their broad constituencies. However, it would be a dramatic mistake to let the financial reform momentum fade away. The stakes are high and yes, the time of half measures is definitively over. The world expects the new US administration to show determination and a real leadership on these pressing issues, even if it comes at the price of reining in one's own perception of sovereignty and independence.

Yes, we can. Let us do it now.

Comments

[prudentinve...:]

Great article. You seem to blame it all on deregulation, though. I'd suggest that even without regulation, free market efficiency would have prevented these distortions if markets functioned within a system of sound money.

The bubbles were enabled by interest rates below the real rate of inflation, making any asset price rise faster than the interest payments on the debt used to acquire it. Basic math will show that if you can borrow at a rate below inflation to acquire an asset, the price of that asset should rise towards infinity. A financial equivalent of a perpetual motion machine, known to be impossible to those with a background in physical science.

Thus, while it has been fashionable to blame the crisis on insufficient regulation, this is an unfair indictment. Free markets requires sound money as their basis, and it is disingenious to blame the crisis on the failure of free market principles.The central bankers who created excessive liquidity with unsound money undermined the free market, and it is they who should shoulder the blame.

2008 Dec 24 09:40 AM

[Moon Kil Woong:]

I disagree, the author is right that Base I rules allowing off balance sheet accounting encouraged banks to do things that made a lot of accounting sense but not a lot of common sense. Also coupled with a extermination of the depression era Glass Stegal laws banks, brokerages, and insurance companies were able to precipitate the same toxic mess that the laws were made to prevent.

Although, yes, if everyone remained prudent, financial catastrophe wouldn't happen. But if you look at the mindset of Wall Street the past few years, you would realize that would be the same as expecting termites to eat only the unnecessary parts of your house and not touch the support beams.

Why did the scorpion sting the dog helping it cross the river? We all know why now...

2008 Dec 24 09:56 PM