Tuesday, June 08, 2010

Volcker: time is growing short

There's more about trade and fiscal balances, etc., but I thought the following was particularly good.
NY Review of Books: ... I think it is fair to say that for some time the dominant approach of economic theorizing, increasingly reflected in public policy, has been that free and open financial markets, supported by advances in electronic technology and by sophisticated financial engineering, would most effectively support both market efficiency and stability. Without heavily intrusive regulation, investable funds would flow to the most profitable and productive uses. The inherent risks of making loans and extending credits would be diffused and reallocated among those best able and willing to bear them.

It is an attractive thesis, attractive not only in concept but for those participating in its seeming ability to generate enormous financial rewards. Our best business schools developed and taught ever more complicated models. A large share of the nation’s best young talent was attracted to finance. However, even when developments seemed most benign, there were warning signs.

Has the contribution of the modern world of finance to economic growth become so critical as to support remuneration to its participants beyond any earlier experience and expectations? Does the past profitability of and the value added by the financial industry really now justify profits amounting to as much as 35 to 40 percent of all profits by all US corporations? Can the truly enormous rise in the use of derivatives, complicated options, and highly structured financial instruments really have made a parallel contribution to economic efficiency? If so, does analysis of economic growth and productivity over the past decade or so indicate visible acceleration of growth or benefits flowing down to the average American worker who even before the crisis had enjoyed no increase in real income?

There was one great growth industry. Private debt relative to GDP nearly tripled in thirty years. Credit default swaps, invented little more than a decade ago, soared at their peak to a $60 trillion market, exceeding by a large multiple the amount of the underlying credits potentially hedged against default. Add to those specifics the opacity that accompanied the enormous complexity of such transactions.

The nature and depth of the financial crisis is forcing us to reconsider some of the basic tenets of financial theory. To my way of thinking, that is both necessary and promising in pointing toward useful reform.

One basic flaw running through much of the recent financial innovation is that thinking embedded in mathematics and physics could be directly adapted to markets. A search for repetitive patterns of behavior and computations of normal distribution curves are a big part of the physical sciences. However, financial markets are not driven by changes in natural forces but by human phenomena, with all their implications for herd behavior, for wide swings in emotion, and for political intervention and uncertainties.


London Offices said...

Thanks a lot for your post. It is very interesting.
Good continuation.

LondonYoung said...

Three comments on Tall Paul:
(1) He's never quite grasped the fact that the economy is global - something which Helicopter Ben understands well. Financial profits may have been 35% of US corp profits (at the highs), but US corp profits are not the right denominator for a global industry that the US was leading. It's sorta like looking at the production of automobiles in Korea on a Korean per capita basis.
(2) He also throws out the barb that real median family income has shown no growth in decades. Of all the factors in all the world which can affect this, he betrays the importance of finance by saying this. Some sorta inconsistency in what he is saying, if you see what I mean. Like, didn't politics, demographics, the development of VLSI, the rise of China, educational patterns, manufacturing regulation, etc... all play a role too? Why so directly attribute US well being, or lack thereof, to finance?
(3) Lastly, for financial history buffs: IMHO, Volcker is pretty directly responsible for key instabilities which turned the housing bubble pop into a banking crisis. The most ancient problem in banking is the instability caused by demand deposits. People wanna earn interest on money they can take out of the bank on demand, but in order for the banks to earn that interest for them, the banks must tie up most of that money longer term (because borrowers will typically cannot make use of money that can be called away from them at any time). So, the banks keep fractional reserves and "hope" that not everybody goes to withdraw on the same day - or else they are run. One decent solution is to require that demand deposits pay zero interest - a solution that the US put into place after the crisis of the 1920's, and one which worked pretty well for decades. However, none other than Paul Volcker oversaw the dismantling of this safeguard and brought us back to the "money for nothing" practices of the 1930's. In the end the major problem with Lehman's failure was not a daisy chain of defaults on derivatives, but simply a run on demand deposit instruments - bank accounts and money market funds. Unfortunately, very few people know much of the history of finance, and very few stop to think about exactly why we think "too big to fail" are "too big to fail". If not for the money market funds, Lehman's failure would just not have been that big a deal. And to the extent it was, we can thank Paul Volcker for undoing decades of protection against paying interest on demand deposits.

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