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Sunday 30 June 2013

Niall Ferguson, The Great Degeneration, What We Can Learn - Part 2

Follow this link to Part I


In Part II, we examine the degeneration of the institutions of capitalism, the second key component of our modern day civilization.

Regulation is not to be blamed

Mr. Ferguson argues contrary to Washington's assertion, it is regulation rather than insufficient regulation that caused the financial crisis.  He says on the contrary, the banking industry is the most regulated industry and that post deregulation economic performance was much better compared to the 1970s in US and in Britain.

In his analysis, deregulation is not the main culprit, Mr. Ferguson sites that Bear Stearns and Lehman Brothers were pure investment banks whilst Countrywide, Washington Mutual and Wachovia were commercial lenders. 

It was rather rules outlined by the Basel Committee on Banking Supervision 1998 Accord which allowed banks balance sheets to explode relative to their capital and later modified to allow banks set their own capital requirements on the basis of their own internal risk estimates.   

In government, the Federal Reserve apparent lopsided policy of controlling core inflation failed to capture house price inflation.  And the US Congress was complicit in the blow up by passing legislation designed to increase home ownership amongst the lower-income families. 

The final layer of distortion was blamed on China's export driven policy which kept the value of its currency too low relative to the dollar over an extended period of time.  China was only happy to buy US Treasuries with its huge export surpluses which kept yields low.  Mortgages which were closely linked to Treasury yields helped to further inflate an already bubbling property market.

The only area where the lack of regulation were to blame for the blow-up were the unregulated OTC markets for derivatives such as credit default swaps.  Its economic and social utility are in doubt.

Cause and Effect

While I applaud Mr. Ferguson's heroic attempt at putting most of the blame for the financial crisis on regulation, the question boils down to cause and effect.  And my views departs from Mr. Ferguson.  Indeed there are areas where legislation played a part - such as in the development of largely discredited Value at Risk (VaR) models that banks used to assess their own internal risk that lead to stupid decisions. 

But it was Wall Street that lobbied ferociously the repeal of various legislations that were intended to reign in on the predatory nature of the financial services industry starting from the Reagan-era.  And it was Alan Greenspan that was so enamoured with financial innovation that he thought risk spread around was reducing overall risk but it only increased systemic risk.  He took his eye off the ball.

The revolving door between Wall Street and Washington also played a significant part in watering down legislations intended to protect the economic interest of other parts of the economy.

Basel II Accord on bank's capital was the result of intense of lobbying to allow banks more 'freedom' - trust in ego-centric management's ability to control all sorts of risk led to the down fall.  Nothing more nothing less.

Financial innovation were mostly about increasing, disguising and hiding leverage rather than for any real good.  And therein lies the economic miracles of the 1980s and 1990s.  It was mostly a debt driven boom as the chart below shows debt have have been a fuel for economic expansion.


A Case of Bad Law or a Case of Bad Players

Mr. Ferguson quotes the Dodd-Frank Act as a case of bad law as it is overly complex. 

But Dodd-Frank came after the event, Dodd-Frank is inoperable as it currently stands because Wall Street have a hand in shaping it too.  The banking industry know precisely that by playing the complexity game, it opens up loop holes and so its social utility is diminished.

But he is quite right to observe that since the crisis, in a knee jerk reaction, US law makers have favoured complexity over simplicity; rules over discretion and codes of compliance over individual and corporate responsibility.

Unless I misread it, I think, Mr. Ferguson view industry players are all innocent bystanders is disingenuous.  Pitting regulations as a cause of the issue at heart and not the actions of individuals or groups of people in the first instance means that he is saying Wall Street is merely taking advantage of the situation.  And therefore discounts the prevalence of the revolving doors between Washington and Wall Street which I referred to earlier.  

Law makers have to take some blame as well as it has allowed themselves to be infected by corporate generosity and individual votes count for nothing. 

William K. Black a former financial regulator who put over 1,000 industry professionals behind bars during the Savings & Loans crisis in the 1980s to 1990s believes there is a an urgent need for re-regulation and criminal prosecutions.  The current crisis is at least 30 times larger in his assessment yet produced no criminal prosecutions.  You can watch a five part interview of Bill Black on this.  Rather than tightening up, regulatory watchdogs such as the FASB (Financial Accounting Standards Board) have been cornered to suspend mark-to-market accounting of financial assets and only recognize profit or loss when these assets are sold.  This has the effect similar to Japan not cleaning up its banking system of 'deadwood' which caused the lost decades.

Serengeti, The Regulation of the Natural World

Financial markets, it seems have more than superficial resemblances to the natural world.  Natural selection ensures the survival of the fittest.  Similarly, in a capitalist economy, a firm's survival is dependent on its ability to adapt and innovate in a changing environment.

It is admirable for Mr. Ferguson to highlight the similarities of the natural world.  He does so by quoting from Darwin's Essay on the Principle of Population where Darwin acknowledge his debt, in particular to Thomas Malthus the economist of his day. 

What makes it different is that while nature's evolution takes place in the natural environment which is subject to natural catastrophes, evolution in finance occurs within a regulatory framework and subject to geopolitical shocks and financial crisis.  Regulation cannot second-guess the evolutionary process so its intelligent design is flawed and therefore makes a fragile ecosystem even more fragile. 

He goes on to borrow a leaf from Nassim Taleb's book Antifragile, that the true opposite of a fragile system is anti-fragile and very 'robust' or 'strong' regulation is pro-fragile because they simply mean less fragile. 

In short over-regulation is the disease of which it purports to be the cure.

He quotes extensively from the work of Walter Bagehot's Lombard Street (1873) of the role of the Bank of England in times of financial crisis in the City of London in 1825 and a few others that followed in the 18th century.  In each case, the Bank have acted outside of its mandate to tame the markets.  Central banks then had enormous latitude to bring to task those that have transgressed not with the rule book but by powerful discretion.

In other words applied to the wild, it is similar to the baboons of Ethopia.  In that society you have an alpha male (the central bank) that utilizes its discretion and judgment to rule.  Any bad behavior is immediately put into the penalty box, cut away from the protection of the clan or even killed.

But he should have gone on further.  Animals that survive on social structures (baboons, apes, chimpanzees, meerkats etc) also have a dark side to it.  There are back room plots. Restless potential alpha male baboons jealous of their leader's power start to make alliances secretly to plot the leader's over throw. 

So if the natural world does not get a 'bailout' and have to live and die by the skin of their teeth, then the same should go for our financial institutions.  Rather the status has been perpetuated through a bailout and it is now even more unbalanced should another crisis flare up.

Discretion Not Rules

In the final analysis, Mr. Ferguson believes that Walter Bagehot have correctly outline the policy prescription to prevent further crisis:
  • Strengthen the central banks' authority on monetary and supervisory matters;
  • Act on excessive credit growth and asset-price inflation;
  • Give central banks considerable latitude in their use of monetary tools; and
  • Teach them financial history.  
He adds a fifth point.  Those that have fallen foul of regulatory authority must pay dearly.  He does not expand on it.  It appears that he had put it there as an after thought, not wanting to completely alienate those that have called for tougher sanctions on transgressors.

Sadly this is where Mr. Ferguson's whole argument falls apart because he does not go deeper to question the behavioral side of economic issues.  A point raised by Paul Volcker in his speech to the Economic Club of New York on May 29, 2013

“What is at issue--what is always at issue--is a matter of good judgment, leadership, and institutional backbone. A willingness to act with conviction in the face of predictable political opposition and substantive debate is, as always, a requisite part of a central bank's DNA.” - Paul Volcker

Firstly, the power is already there - there is no need to enact laws to strengthen authority.  The current leadership is subservient because it is also part of the problem.  The problem of alma mater and alumni networks.  And more importantly the problem of the ability to create money out of thin air.

Secondly, what does it mean by excessive credit growth and asset price inflation? How does one define it?  Is there a rule book?  If we can pay if back through means of military occupation as Britain did in 1815 when debt to GDP peaked at 260 per cent years ago.  Do we need to go through wars to so we can have access to the spoils of war - winner takes all - to pay down debt?

Thirdly, Central Banks already have considerable latitude.  If the unconventional policies of Quantitative Easing and the expansion the Fed's balance sheet by US$3.5 trillion without any oversight or audit or any form of checks and balances not a form of latitutde - what is?

Fourthly.  Teach them financial history.  Seriously?  Mr. Ferguson promoting his history classes?  Hmmmm. The point here is well intended and indeed history does repeat itself but humans are basically an optimistic lot - its really different this time round.  The events leading up to the financial crisis is already a distant memory. 

I fully support his fifth point.  But this is unlikely.  Its been over five years since the crisis began and to date only meek attempts at civil prosecutions and admonitions have been made.  Until enforcement units such as the FBI start to put some serious resource into investigating some of the crimes being committed, it is unlikely that there would be any redress.  The mainstream media by trivalising the issues as 'mistakes' rather than 'fraud' or 'corrupt criminal behavior' is not helping to mobilize public opinion at all.  And thus it is left to those at the periphery to voice their concerns.

It would be a stretch to call today's economy a capitalist model, if it were, then there would be no bailouts, no special treatment at the huge expense of the majority.  It is more corporatist or to some commentators even fascist - the marriage of governments and big businesses.  If the government were interested in helping the little guy, then it would have been cheaper just to write off their loans.  But then this would just be moral hazard for individuals but not for Wall Street. 

Survival instincts demand that players use whatever means to expand their power base and access resources - even if those means are questionable.  But we are not animals, as a species, we possess scientific knowledge, language skills, rational thought, religion and a moral disposition.  There needs to be some sort of playground rules otherwise there will be more frequent larger disruptions.

In the animal kingdom, there are the occasion big battles amongst different groups of the same species to arrest the imbalance of one group over-crowding out the others.  And this can be a foreboding of things to come if this unfairness goes on unchecked.

"The history of all hitherto existing society is the history of class struggles" - Karl Marx and Fredrick Engels Manifesto of the Communist Party

I hope we do not come to that stage.

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