Thursday, April 10, 2008

The Economist's Brief on the Current Financial Turmoil

[The following was sent to The Economist magazine concerning their 'briefing' of current turmoil in the finance industry (22 to 28 March issue). - PEB]

Sir, - Your recent briefing on the current financial turmoil (March 22 to 28, 2008) was excellent, but solidly within the conventional wisdom. And herein lies my concern; this same conventional economic and financial ‘wisdom’ has led us all into this mess. We need to look deeper if we hope to understand its causes, and thereby avoid recurring and probably worsening repeats. In my view, at least four underlying issues have set the stage for this present mess but have not received much analysis as this crisis develops.  

First, over the past twenty-five or so years, we have seen macro-economics morphed into a sort of ‘bigger’ or ‘combined’ micro-economics. There is a radical, qualitative difference, however, between the micro and the macro perspectives. A sound macro economic view sees more than simply a repetition of micro-, or firm-level issues. The causes for the collapse of Bear Sterns’ or Enron or Barings included more than just intra-firm misconduct (chicanery, greed, accounting fraud, slipshod managerial oversight, etc.) That optic sees only the humanness of the players; whereas the dynamics of the financial sector as a whole have become flawed.
Investing has become increasingly a global casino of arcane games of chance. But it is not mathematically possible for every one to win the lottery or beat the average. When financial regulators see their role mainly as keeping the players, especially big ones, from going bust, they have lost focus on their more fundamental duty to the economy as a whole, namely ensuring an efficient and effective financial sector which fosters and assembles savings and then channels these savings into real investment and growth.

Second, the very language of financial discussions now generates more confusion than clear thinking. In the same article, we drift from ‘banking’ to ‘retail banking’ to ‘investment banking’ to ‘finance’ to ‘financial services’, with these terms being used more or less interchangeably. But they are not interchangeable. There is a real difference between ‘retail banking’ and ‘investment banking’, between a checking account and some shares of stock, between a hedge fund and an insurance policy. Unfortunately, these real differences get run together when the same firm does them all. Worse, they become increasingly less important to the regulatory authority as the process of regulation drifts more and more toward the firm or micro-level perspective. These differences are still real and still there; only, now, there is the additional problem of cross contagion - inherently risky activities undercutting the market(s) for investments which on their own merits are sound. (Observe the current situation with municipal bonds.)

Third, there is a common misconception about so-called ‘free’ markets. The function of any market is not to allocate resources but to clear supply with demand and transfer ownership. A ‘free’ market does this by (1) allowing whoever wishes to enter the market and transact, and (2) allowing the price to move up or down in order to “clear” the desires of buyers with sellers.
Resource allocation, on the other hand, concerns how a society determines what specifically to produce and, therefore, how to allocate its limited productive capacity. This is a more complex process, involving much more than buying over here and selling over there. We should not assume, therefore, that greater allocative efficiency will flow simply from more efficient markets; nor should we assume that widening access or tolerating greater price volatility will automatically make a specific market either more efficient or more effective.

Finally, the accounting practice of ‘marking to market’ has over the past decade invaded the financial world like the Spanish flu! As any one who bought Dutch tulip futures or certificates for land in Mississippi or stock in a knows so well, what goes up today may not go up tomorrow also; it may even go down!. And as the investors in Paribas’ funds found out, exit provisions can be nothing more than empty words. ‘Marking to market’ introduces fantasy into the balance sheet. As I said above, it is not mathematically possible for every one to win the lottery. It is not possible for all of us to withdraw our money from the bank. No market can clear a fundamental disequilibrium between buyers and sellers. By allowing this ‘creative accounting’ to become a standard practice in the financial industry, regulators have in effect leveraged up the herd instinct and made the whole sector more volatile.  

‘Marking to market’ also mixes up the concept of flow (income statement) with that of position (balance sheet). If I own a pork belly contract and the demand for pork bellies is on the rise, my balance sheet puffs up, but my income doesn’t change. Even when I cash in on the higher value of the contract, and then spend the new wealth, I am spending capital gains, not income! And if the price turns down, I experience a capital loss, not a fall in income.  

It is not hard to see how these issues reinforce each other. We are in a real tangle. There is no safe haven to ride it out; we’re all in it together; and we’re not likely to get through it either quickly or painlessly. It seems to me the wise thing to do, for our own sake as well as that of our children and grandchildren, is to face the facts squarely, to keep our heads clear and cool and un-ideological, and to dig down to the root causes which have got us into this mess, not just flirt about with quick-fix responses to some of the effects.  

Let’s face it. Some sort of public regulation of economic life is, paradoxically, necessary for a free society. An ideological myopia on ‘free markets’ can in its own way be as destructive as central planning. “Creative accounting” is fiction disguised as financial statements. And when discussing the economy and how to fix it, we should speak and write thoughtfully, with care and precision. This is, after all, a pretty important subject.

Paul E. Bangasser
Viejo San Juan, Puerto Rico