Winston Churchill once remarked, when he was chancellor of the exchequer, that he would rather have finance less proud and industry more content.
Were he still alive, Churchill would find the position little changed: industry remains frustrated by its low relative status in the British economy. But the issue with finance is now not so much its pride (although that remains considerable) as its size. Finance has grown way too big relative to the real economy. In this month’s cover story, I explore the reasons that made this—and the scale of the economic crisis it has precipitated—possible.
The statistics are certainly astonishing. In the 1960s, finance accounted for just 10 per cent of corporate profits in Britain and America. By 2006 this had risen to 35 per cent. Last year, a staggering one in five Britons earned their living in finance. As George Soros has remarked, it is manifestly an “overblown†sector, and needs to shrink. Yet this size is a puzzlement even to those who, like Soros, have done well out of it.
For a long time, academics clung to the notion that finance performed a useful role, shunting capital to its most profitable outlet. If you accepted that, more finance was inevitably a good thing, as it meant the economy was becoming more efficient. Thanks to increasing distortions in financial markets and greater frequency of crashes, this idea has come under increasing attack. Now, drawing on recent research done by Paul Woolley, I make the case that finance is not efficient but dysfunctional—and that accepting this is a vital first step if we are to recover from the current economic crisis.
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I don’t understand this article.
The writer basically maintains that financial markets make money in ways that do not really benefit the wider economy, largely due to incomplete information.
Then he concludes that it is too early do dismiss the market as a solution to over-sized finance.
The market allocates resources to things that make money, period. If you cannot guarantee that the things that money is made on are the things that bring social benefit, than the market is very likely to mis-allocate resources.
To boil it down, you argue the obvious point that the general incompleteness of information that actors have about the actions of others and the implications of their own actions mean markets consistently mis-allocate resources.
Where in this argument is there any shred of evidence that markets will get us out of the mess they have got us into?
Isn’t it interesting how we all have a different view of the markets in general and finance in particular? Isn’t it remarkable that a Labour MP remarked in 1944 that there is always enough money for war, but never enough for health, education and the environment?
Do we really have to think that the “credit crunch” happens to us just as climate change is taking place?
Following the money leads us to those who have the power, privilege and monopoly on creating currencies: central banks and governments. Unfortunately, the government share has gone down from 48% to 3% since WWII. That wouldn’t matter if the key difference was not interest. For governments create Cash which is interest-free. Why they think they have to borrow on top of that can only be revealed by those who lure them into believing that there is no alternative to borrowing and taxation.
More along this line of analysis can be found in our online petition on http://tinyurl.com/666rwd
Kind regards,
Sabine
Organiser, Forum for Stable Currencies
http://forumforstablecurrencies.org.uk
Terribly on the spot article! Factually there has been a lot of what can only be termed “Financial Engineering” going on. Which is to say, creating financial products not to boost the output of the world as say funding a new company can; rather more, products CDO come to mind which seek to game the system maximizing the concept of the greater fool.
Markets are a human construct, as such it is not only foolish, though dangerous that the markets are in fact efficient. I have never believed in at least half of what I was “taught” in business school, and my greatest profits have in fact come from practicing what is in essence a repudiation of what I was taught by my professors of Finance. I mention this because of the disingenuousness of the process. To assert validity to such an important thing as the efficient running of the world financial markets can lead to exactly the sort of failure in trust now testing the system.
As I understand the current predicament, no one is lending to anyone else, due to a breakdown in the belief of the value of any given asset. It does not aid things that the ratings agencies were promulgating a gross fraud in their pricing of the new securitized asset classes, such as with their rating of mortgage tranches which were sold out into the world at large, and whose values were based on seriously flawed models!
As the article properly posits, the growth of the Financial industry is at least in part a causal affect of the current financial debacle. It would be foolish to suggest that the growth of the industry is not to blame for some percentage of the issues affecting the world markets. More efficiency was not created. It should be noted that the aforementioned securitization process did not in fact mitigate risk, it simply spread it even further afield! Finance is in majority about Risk Management, the fact that current circumstances are far reaching as seemingly there is currently no asset class left standing whole is stark proof that the Risk Management models were seriously flawed, being as they were based on spurious assumptions. That the models were created by masters in math is yet further proof of how people will oft times improperly credit a methodology with cogency simply based on the belief that as the method was created by an MIT maths master, it is to be valued to the nth degree.
You will never read such an article in the WSJ, Americans are grand believers in the many myths of Finance.
The moment that is rarely discussed, even in an article such as this, is that it all boils down now to the strategic importance of the finance sector to the stability of the country. Financial system is now so critical to the survival of the UK, that the view of it has to change.
Armed forces, the police and the politics in itself are considered so vital for the survival of the country that they are thoroughly regulated and rarely outsourced. They are the tenets of our sovereignty. It is the same with money now and that is the reason that it cannot be left to bankers alone, as their motives are inevitably not collective-driven. As simple as that.
The main problem with financial markets was that they were looked at as just another market, instead – when they reached the size that could bring the country down – as a strategic factor in how the country is run. It is not, ultimately, the bankers that have let us down in this sad affair. It is the politicians.
The origins of academic interest in models of non-rational beliefs lie in theoretical and empirical work showing failures in the theory of efficient capital markets.
Market efficiency has always been moot; a meeting place for disputed pricing models and indeterminate econometric methods.
As primitive to behavioural finance Cootner (1964)has , “Securities prices … very sensitive,responsive to all events, both real and imagined”. While behavioural finace manifests this imagiary component, it has yet to produce tractable ex ante specifications of market behaviour
In a real and imaginary’ environment, Woolley’s Microeconomic effects cannot capture all mispricing.
Amidst the clamor for tighter regulation, what of the instruments themselves? Have collateralised debt obligations been a resounding success?
28 October 2008
The Art of Greed:
When Necessity is Not
Necessarily the
Mother of Invention
It is not the economy. It is the human being. It is unquestionably imprudent to think otherwise. Ever since 1601 when the English East India Company dispatched its first outing to the New World in search of ill-gotten gains—thus “inventing†capitalism—there has been a knee-jerk reaction to the accumulation of wealth as if it were some sanctified system, for the good of all, at the expense of workers sweating to accrue it for their persons in charge, and an arrangement, while not perfect, that is the best of all those available. Time and time again this pact has degenerated systematically into chaos and has caused immeasurable misery for hundreds of millions hoping to receive some “small change†from this frequently corrupt, obviously flawed, unsigned treaty coordinated between employee and employer—but by the employer. Economic dodos even study these cycles of stupidity pontificating, with coloured pie charts and factitious, “horoscopic†mathematical theorems, on how it is just normal that fractures in the technique of administering an economy and financing its stock market are a matter of historically recurring routine. (William H Gross, managing director of Pacific Investment Management [www.pimco.com] and Las Vegas blackjack expert, is reputed to use gaming juju when calculating stock buys; and, my uncle Lester Wood, Merrill Lynch executive in the old days, told me flat out: “Gamble the [stock] market to lose.â€) Will someone please tell me when this 400-year-old ruse used deceptively to gain another’s confidence, this swindle, will pass into oblivion for the good of all of us?
I have lived in three “capitalistic†countries: The “very rich†DisUnited States of Northamerica (1944-1975); the very poor Venezuela (1975-1983); and, the very poor “rich†Italy (1983-to the present). I am privileged to have had an eclectic view of poles apart standards of living, and I delight continually in putting them side by side. From my analyses of my assessments, I have drawn many interesting assumptions. But above and beyond the statistics, reports, studies, examinations…what have you…I have concentrated particularly so in endeavouring to comprehend the individuals breathing in these settings.
During the intoxicatingly, capitalistically-maverick Judeo-Christian democratic years (1974-1982) when some Venezuelans binged on the lucre culled from the exorbitantly high prices ($40.00!) of their liquid gold, I curried favour in an affinity with high governmental functionaries. Venezuela was in the pink of graft and corruption and Caracas was their capital. A time when all, except Venezuela’s poor, were drunk on spending and buying. All you needed was a telephone, a telex machine, and a rented room—your mini “office.†People were importing and exporting unrestrainedly. Whisky, cars, electronic equipment, clothes—even two snow ploughs! If you named it, you could buy it. Venezuelans were so “rich,†they qualified to take out billion dollar loans in the DisUnited States and Europe which they still have not been able to pay back. The feverishness was so overstated, my friend Fernando, a government official, came running into my office one morning at the Ministerio de Informacion y Turismo brandishing a copy of El Nacional with the new, higher posting of a barrel of Venezuelan petroleum, then blurted out—his eyes flooded with tears—for all, including me, within ten kilometres, this squawk in Spanish: “We’re going to fuck you gringos for good!†Fernando could not forgive and forget—as millions of his compatriots—the decades of exploitation suffered under the thumb of despotic foreigners. His hate was such that when I asked him, to calm him down, how he was going to go about “fucking†the gringos, he retorted: “We don’t know yet, but you can be sure we’ll do it, gringo!†Little did we know, at that time, a Hollywoodish actor was waiting in the wings of the White House soon to play his most eminent role, soon to bring down the curtain on the Venezuelan bacchanalia of the late 1970s and early 1980s.
The halcyon existence of this laissez-faire licentiousness was orchestrated by Los Doce DiscÃpulos—twelve mafia-like Venezuelan families who reigned heavy-handedly over the core economic sectors of their country including foods and beverages, the print and TV media, building construction materials, energy, banking and others defining Venezuela’s prominence as an underdeveloped country on its way to being developed. All of these crime syndicates possessed strong business affiliations with the DUS, Europe and other industrial nations on the economic go-go. These cliques of money lords lived in a world of their own. They were segregated from the realities of the horrible human condition that was sapping the vitality of deprived Venezuelans who were barred from them by bullet-proof glass, security guards, electronic alarms, dispensation and a disgusting haughtiness which wreaked from the disdain the “peers of the realm†held for their disadvantaged fellow countrymen. If you went to fiestas with well-to-do Venezuelans, the guests’ pearl-handled pistols were laid out on the coffee table, or, if there were children in the home, stashed high up on a China closet. They talked about how many airplanes their families’ businesses had, in what universities their lovely ones were enrolled in the DUS or Europe, in what condominiums in Miami they had purchased apartments, in what Dade County banks they had hoarded ready money ripped off their government, in what five-star hotel in Europe they had sojourned last summer…on and on and on. These nouveau riche were dressed to kill in Italian designer clothes ticketed overstatedly at up to $10,000 a part of the pack, they wore diamond rings and thick gold chains and other sparklers that sparkled with the Dom Perignon champagne served in crystal goblets. At wedding soirées where a thousand party-goers might be gathered, they inebriated themselves on imported wines and whiskies and munched on mounds of gourmet foods the leftovers of which hundreds of poverty-stricken people outside would wait to scrounge for after the splurge of gaiety had terminated. For every action there is a reaction. Hugo Chávez was the upshot to that bizarre, hedonistic lunacy of cruelty and indifference which exemplified the dog-eat-dogism of that era. None of the Los Doce DiscÃpulos ever conjured up the mere inkling that millions and millions of Venezuela’s destitute populace would spring out of their bondage and stipulate a better life, a better Venezuela. How could it be that a few thousand of Venezuela’s “upper class†made enemies of millions of their own fellows! Why were they so stupid? We’re going to fuck you gringos for good….
I know a man in Prato, Italy not far from where I live who is particularly interested in his “image†and how it is perceived by others. And I would like to tell you about him.
I became acquainted with this individual some time ago, and met him for the first time in his office. The more I came to know about him, the more I was struck with astonishment. And even as I begin to tell this story, I am tempted to pinch myself to convince myself that I am not dreaming! This true story is for me a very poignant one indeed.
The personage under discussion is a business consultant (commercialista), a very successful one at that—if one would judge by appearances only. He is always answering his cellphone. He drives an enormous white automobile equipped with the most up-to-date electronic gadgetry. His office, with three secretaries, is outfitted with computers, fax machines and other modern office accruements not always found in Prato. The room adjacent to his administrative centre is crammed with books and economic magazines and journals mostly written in English. There is a book in Italian he himself wrote and published personally but which few people have purchased but which he has given hundreds of gifts of. He represents many companies, and is often so busy in his office, he tells his secretaries to inform certain callers that he is out of town. He is twenty seven years old, uses Valium drops to calm his nerves, and is under doctor’s care for an ulcer. If you look at the left arm of his huge, expensive leather desk chair, you will see that it is worn through to the “bone†from his nervous hand rubbings. And he has told me, kidding of course, at least three times—Freudian-slipping all the way—the following: “If I don’t go crazy, I’ll go to jail!†(Kidding, of course!) Naturally, he dresses to kill. Elegance is all around him. If you enter his place of work, you will be impressed immediately with an inordinate amount of framed pieces of paper which—with the exception of one oil painting of his beautiful, childless wife—are dedications to him for some honour or other, for some diploma from one university or other, for some seminar or other he has frequented. Although he never went to university in his own country, he has testaments to his scholarly savoir faire from many institutions that seem at first to be reputable and of an inestimable quality. All of these certificates are, as might be expected, framed in very elegant, costly wooden borders which enclose them. You would be fixed deeply.
Get ready to pinch yourself…
Two of these qualifications are from a school in California where this character studied for less than two months. The diplomas state clearly that the man swotted successfully and fulfilled regularly the requirements for not only a Master’s degree in Economics, but even a Doctor of Philosophy degree in Economics. Under these two enclosed parchments is another boxed declaration, a bit smaller, written on false United States’ Department of State stationery attesting to the facts that the two degrees are in buona fide, and signed not “by…for…†but forged for the United States’ Secretary of State his very self!
Get ready to pinch yourself…
If we lean towards another wall in the room, two more sheepskins will be seen. These are from a university in Switzerland, and they proclaim that this twenty-“sevenish†someone has studied for not only the Master of Business Administration, but still—hold on!—another Doctor of Philosophy in Economics! (To date: MA, PhD, MBA, PhD!) Are you counting with me?
Get ready to pinch yourself…
One of the truths of the matter here is that this somebody, to qualify for his Swiss PhD, purchased a PhD thesis—of a student recently “doctored†at a very famous United States’ business school—from a company in Ann Arbor, Michigan and well-known throughout the degree-getting world, had that thesis translated, and then submitted it in order to receive his Helvetian documents conferring honour and privilege.
Get ready to pinch yourself…
The most recent foray by this man hungry in his extravagant quest for recognition of his adroitness in business relations, has been the enrolment in an expensive “by post†course, with audio-visuals and brilliantly designed study guides, for yet another MBA (MA, PhD, MBA, PhD, MBA!!!) granted by an English school which I was informed, by an Oxford professor, is perhaps the most respectable of its kind and which is much-touted throughout Europe. And with all of these pegs, our fox wants to return to a famous business university in his own country to—you guessed it!—TEACH!
Get ready to pinch yourself…
While he reads some English, especially economic terminology, he cannot—I swear!—communicate in English, and if you call to speak to him in English, one of his secretaries will tell you right off that he is out of town! Call again? Still out of town.
Our heavily-“degreed†perpetual student, ever on the march to nail another “HONOUR†to his wall to impress his clients, has larceny at heart. If he is to be a purloiner, he is going to be the best of sharks. His determination and verve would move you. If it is everybody’s business to steal, he will do it better. He is an artist. He does what he does because he loves its labour for its own sake. (Cannot we, at least, admire him for this?) And the joy he affords his dear mother and father, as he sits next to them at Mass every Sunday morning in his parish’s almost empty church, cannot be computed in Earthly terms.
If you ask him if he thinks what he is doing is “eccentric,†he will respond with a boyish grin—his baby face shining, his blue eyes twinkling: “Everybody’s doing it!â€
Authored by Anthony St. John in Calenzano, Italy
25 October 2008
* * *
Finding the optimal level of inflation could play a crucial role in the solution of the present international financial crisis. At the moment deflation seems the greater risk, but that time will quickly pass. I shall argue, unfashionably, that as part of the recovery strategy inflation needs to be not too little, not too much, but just right.
For a generation now it has been orthodoxy to claim that the lower inflation the greater the blessings to follow. Zero inflation is unattainable, so the developed world has lived with two to five percent for decades. Central Asia, Latin America and Russia went above that, and many argued it demonstrated how dysfunctional they were. That some countries in these area grew fast is rationalised away.
Is inflation always bad? The proposition is not a self-evident truth. Of course Zimbabwe-style hyper-inflation pauperises all but the ruling élite, and leads to shortage of goods because people hoard against the future price rises. But it has to get very bad for that to happen. In moderate inflation people on fixed incomes lose out, it is true, but in a long-term inflationary world people choose index-linked pensions and annuities, so the proportion on fixed incomes declines rapidly.
Text-books say inflation discourages saving and investment, but in fact only uncertainty about the level of inflation does that. In higher but rock-steady inflation people still save, but only for a bigger nominal return on their money to offset the inflationary loss in the value of their capital. Because over time debts melt away, bankers, who make their living lending money, hate inflation. In reality they survive it well, by increasing their interest rates to compensate for loss of real value in the debt. The rate needed depends on the taxation regime, but is easily calculable provided inflation is reliably predictable.
Some say business likes low inflation because it makes it easier to plan ahead. Wrong: what business likes is stable, predictable rates of inflation. I was at the top of a large international company through the 80s, a period of higher inflation, and we managed well enough. You read accounts differently, getting a realistic picture through discounting this year’s growth in profits and earnings by the amount the currency has lost value. In some ways inflation is helpful; it makes for flexibility. Thus if part of your business is coming to the end of its profitable life, in theory you should cut wages so that workers will seek opportunities elsewhere. It is easier to let inflation do the dirty work.
Nobody wants hyper-inflation, but a steady though higher rate of inflation, say in the range six to eight percent a year, would mean that a debt is halved in real terms in around eight to twelve years, so the debt burden fades away in a reasonable time. House-owners in negative equity who survive a few years see their problem right itself. Business can afford to pay more for money because it sees existing and prospective debts liquidating.
Of course this happens by virtue of an invisible tax on everybody with any money, as its value diminishes. How do they defend themselves? Dark holding goes out of fashion. Savers seek every practicable way to make their money earn more, which is itself a good. With inflation in this range interest rates must rise, typically by several percent, making lenders more cautious about the ability of dodgy borrowers to pay. The sub-prime mortgage fiasco seems less likely in a world like that.
When first we all moved toward minimal inflation there was a fashionable conviction, based on contestable statistics, that it promoted growth. For a while it seemed to work, but low interest rates encourage growth by increasing debt, and low inflation ensures that debts, once incurred, remain stubbornly with us. Ultimately the low-inflation scenario drowns in its own pool of debt. We see it happening now. To hope that future regulation might somehow restrain debt growth in a low inflation economy is psychologically naïve.
If the optimum rate of inflation is higher than we have been aiming for, why do we seem afraid to re-visit the question? Perhaps we cannot separate the notion of higher inflation from the volatile inflation rates that were so damaging in the past. Maybe we do not trust governments and central banks to hold inflation stable at the optimal rate that would be better for us.
In part, the pursuit of ‘sound money’ caused the Great Depression nearly eighty years ago. Now we have done it again. We must face it: the low inflation/high debt strategy has run its course. No fiddling with banking regulation will get it back into good shape. We need to move on.
Back to the article!!!!!!!!!
And a truly excellent one .
Good points by Vigil and a fair criticism by Taghioff. The author’s slight confusion about whether markets can be the solution is the only matter that gives away the likelihood that he is not an economist but relying on what they say to him.
I would like to focus on a throwaway .
‘Some economists wondered what would happen if investors couldn’t be bothered to track down all the relevant information to price stocks, but became lazy. Could efficient markets still function then? This was the Grossman-Stiglitz paradox. But all such theories forced one to move away from mainstream economics and assume that financial markets somehow obeyed different laws’.
Were this a Phd thesis , this is the point at which I would ask the author to go re-write.
There is no clash between ‘laziness’ of search and economic laws.
Search is very costly. How can an individual investor for example analyse say 100 IPO prospectuses and the situation of say 1000 listed shares in a year to sort out the best to invest in. It would be muchmore than a full time occupation.
Therefore most have to rely rationally on the research of others on the quality of potential investments or they buy at the market price because the accepted wisdom says that all information in the price.
It is quite wrong to call it laziness. It is in fact rational reality.
If the adviser/analysts/fund managers involved do not do a proper job due to conflicts or rely on the opinion of the crowd (momentum)
,……… merely grabbing their short term commissions/bonuses as described by Woolley,………………
then the system breaks down in terms of economic efficiency and appropriate allocation of resources. Add in a bit of corruption of analysts (eg the raters who rated mortgage backed securities or the analysts who rated high tech stocks in the late 90s)’ and one can have inefficiency and crisis.
As a City economist I saw all this and it made me want to get out.
I can also add the hypothesis that a high proportion in the City who deal with investors are sociopaths concentrated there by the easy pickings (as opposed to say nursing where they will be rare)
In short, the profit maximisation of individuals is in any financial systems inconsistent with optimal economic outcomes.
That is why tough regulation is needed.
It is for the same reason that accountants, lawyers, gas fitters etc are heavily regulated.
The market ideologues in Downing St and the White House have destroyed much: trust in the system and income and wealth of ordinary people. The string of regulatory initiatives turned down in the US and UK in the last ten years is very long.
That is the independent economist writing. Now I write as an economist and UK citizen
There needs to be a witch hunt. Not in blame but in restitution which does not disturb the working of the market.
If I were in charge of the UK, I would institute immediate taxation of worldwide income (eg as the US operates for US citizens) and launch a blazing attack on all tax havens to get information on any UK citizens .
Most of the wealth created in the bubble (by the culpable and those not) has been sent offshore to avoid and evade tax. It needs to be properly taxed. That tax will help to minimise the giant bill we now have.
Graham Cox
capital.connection@gmail.com
An astonishing article, but only because it is so wrong. Fund Managers do not benefit from trading activity; trading commission is paid from Investment Funds to brokers, so the point about fund managers cranking up activity is factually incorrect. (See http://farshoreswimwell.blogspot.com/2008/11/financial-times-doesnt-understand.html).
If he has muddled the opinions of Woolley it doesn’t say much. The Woolley logic seems to lead to the conclusion that competition in fund management is destroying value. Even if this were true (which it isn’t) it wouldn’t matter because it would clearly be unacceptable to have dearth of competition in pension management, mutual fund management or even hedge fund management.
It is well written. It is badly misinformed.
In my innocence I think the article is rather good, and the shock reversal at the end is a triumph! Hamlet, Lear and Macbeth live happily ever after! Snow White marries all seven dwarves!
Having dismembered and buried active financial management as both felonious and incompetent, Ford suggests we can and should help the croupier to become an honest and contributing citizen. Not consistent with his info or analysis.
Ford’s quote from Soros in the last paragraph seems closer to the truth: no market, just a regulated service selling goods like any other corner shop, with perhaps a lottery machine in the corner for the sociopaths.
If you like Ford’s approach you may find interest in David Cohen ‘Fear, greed and panic – the psychology of the stock market’. Wiley 2001. Meanwhile stay in cash and use your time to read Daniel Kahneman.
Although governments have always intervened in the banking system and caused booms and busts, the gold standard used to prevent such massive dislocations as we see today. In these presumably less enlightened times, money and credit could not be created out of thin air and financial institutions were not able to leverage to such an extent.
———————
john edwin
MLS
In 1990, MIIX hired Daniel Goldberg as president. Within a few years, he convinced his board that to remain successful the company would have to move beyond the state’s borders. By 1998, MIIX covered more than 16,000 physicians and other health professionals in 21 states. Expanding beyond the home state’s border wasn’t a novel idea; several other physician-owned carriers did so at around the same time. According to industry sources, however, MIIX achieved much of its out-of-state growth by offering low premiums to gain a share of what had become a highly competitive market. In the rush to sign up new policyholders, MIIX also may have taken on an unhealthy amount of high-risk business. In 1997, Goldberg proposed converting MIIX to a public stock company in order to raise more capital. The company needed the money, he claimed, to respond to increased competition, finance further expansion, “facilitate strategic acquisitions,” and “develop new business opportunities.”
———————–
john edwin
MLS
Great post. Really interesting view on markets there. Keep up the good work.
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