Herd Leading, Undisclosed Conflicts, and the Euro Crisis

Just because you are paranoid does not mean they are not out to get you. And just because skepticism of Eurozone salvage operations is warranted does not mean that all of the criticisms should be taken at face value.

Andrew Dittmer pointed out a speech he correctly deemed to be “surprising” by Lorenzo Bini Smaghi, a member of the Executive Board of the ECB on “Lessons of the Crisis: Ethics, Markets,
Democracy” (and he also reports the translation is not bad either).

If you decide to read the whole speech, the first half is singularly unpromising and I recommend ignoring it (it discusses the Lehman aftermath, and argues that democracies are not good at making short term sacrifices for long-term gains. He rather underplays that the short term sacrifices entailed rescuing rich and powerful people who had caused a disaster and imposing costs on taxpayers who were often innocent bystanders.)

But then it veers off in a completely unexpected direction. Smaghi describes how media is used by private parties to amplify the profits of speculation.

Some reader may take issue with his examples, since as a member of the ECB, he seems more than a little annoyed at banks who undermined the Greek rescue efforts. But the sort of examples he gives helps explain some of the paranoid reactions I have gotten when I have run articles by those who are skeptical about the future of the Eurozone.

Smaghi cites particular instances where influential parties had poor justifications for their positions or look to have operated in a self-serving manner. While most people with an operating brain cell assume that investors would talk their book, Smaghi is targeting analysts and others who are treated by the media as objective. His discussion stands out because it is clear and detailed and ventures into terrain that most officials pointedly avoid.

From the ECB website:

A financial market participant can act as a herd leader if it can convince others that it has superior information and greater capacity for analysis so as to obtain better returns on its investments. A herd leader can thus influence, through communications either with the public or with some market participants, the behaviour of others and point the way for the herd….

Yves here. It isn’t hard to think of examples: Morgan Stanley’s Mary Meeker in the dot com era; Goldman in the 2008 oil bubble. Back to the speech:

In recent years the use of market information for “promotional” purposes has grown considerably. In the mass media, i.e. newspapers and television, the opinions of the analysts of the major banks are often sought. Since information is scarce and should have a monetary value for a financial market participant, one may wonder why it is made available to all free of charge. One hypothesis is that this contributes to the market participant’s reputation, attracting new clients. But clients should prefer insider information, the information that others do not have. The alternative, more credible, hypothesis is that with their considerable presence in the media market participants seek to steer the entire market, i.e. acting as herd leader.

Let’s look at an aspect that interests me particularly: monetary policy. The opinions expressed by analysts on monetary policy decisions often concern not only the impact of a given decision on the markets, but the substance of the decision, namely whether it is appropriate or not. The parameters according to which the analyst expresses his/her views are however not transparent. It is unclear, in fact, if the analyst is expressing an opinion based on an objective function which is the same as that of the monetary authority – price stability in the ECB’s case – or based on his/her specific interest, particularly his/her investment choices. One might ask, for example, if a decision to increase interest rates would be judged right or wrong by a financial market participant based on the outlook for inflation – or based on the speculative position that the market participant itself has taken.

What, then, should we think of the views that are expressed even before the central bank takes its decision? What are the criteria when a financial market participant expresses an opinion on what the central bank should do? Do the criteria depend on the speculative positions it has taken or on other, more general criteria?

I’ll take a concrete example, which is not related to the decision on interest rates but on the collateral the central bank accepts in exchange for funding provided to the market. On Monday 3 May the European Central Bank decided to no longer follow the rating agencies when assessing the sovereign debt of a country that has an adjustment programme with the IMF and the European Union – a programme which the ECB has judged positively. It was a logical decision for several reasons.

First, while for a company or a bank the rating agencies’ analyses may include information in addition to what the central banks have, it is less clear as regards the countries, especially those in the euro area, whose macroeconomic and budget figures are well known. The agencies – there are only three of them – have recently lost their credibility, contributing, with significant conflicts of interest, to the overvaluation of the creditworthiness of asset-back securities, particularly the sub-prime mortgages that caused the financial crisis. [5] However, the recent downward revisions of sovereign credit ratings raise many doubts. Some of these revisions were not based on macroeconomic data or new budgets, but on the assessments given by the market for sovereign bonds and the possibility of contagion. In this way the agencies have not given an independent assessment, but one linked to market’s reaction. One might even ask if they have in some cases an interest in pushing the market in the same direction that it has already moved in, contributing to the pro-cyclicality and the phenomena of distorting prices. For example, an agency reduced its rating for Greece just after the first deficit adjustment measures by over 4% of gross domestic product, indicating that, although the measures taken were adequate, the adjustment depended on the reaction of the market. Another agency reduced its rating for Greece three days before the agreement with the IMF was concluded, without knowing the contents of the adjustment programme.

Given that these behaviours are not always clear, it would have been a mistake for the ECB to continue to depend on the judgements of rating agencies. Having helped to draft the programme, the ECB – along with the IMF and the European Commission – is better able to assess the risk posed by Greece than the rating agencies.

The opinion of some analysts on the ECB’s decision was negative. Their thesis is that the ECB risks losing credibility and embarking on too lax a path. It is interesting to note that those same analysts had previously regarded the ECB policy as being too strict. Why this sudden change of opinion? Reading carefully what these analysts had written before the ECB’s decision, one notes that many had considered the support programme for Greece as inappropriate, and saw a restructuring as inevitable. In other words, they had recommended selling Greek securities and the ECB’s decision to maintain the eligibility of such securities went clearly against their interests. So it’s no surprise that their response was negative.

The media are often unaware of these conflicts of interest and report the opinions of financial institutions without clearly stating that they have probably taken speculative positions in one direction or another. This approach may undermine the credibility of the media.

The same applies to the views of many professional commentators, and even academics, who are consultants to the financial institutions from which they get information and with which they interact. It is rare to see in a footnote that Professor So-and-So – who evidently does not write for academic purposes, but to influence the opinions of specialist readers – is connected in some way with financial institutions, particularly through consultancy contracts. I was very surprised in the days before the completion of the adjustment programme for Greece to read articles by distinguished professors, many of them consultants to investment banks and – coincidentally – with very similar opinions to those expressed by the same banks, but without any reference being made to the relationship in the articles. I’m not asking for opinions to be censored, but at least there should be transparency and disclosure of any conflicts of interest, then readers are in the picture.

Doubts are raised even by some decisions to publish opinions that all go in the same direction right in the middle of periods of great turbulence, as was the case with Greece. These opinions, often with limited analytical content, were repeating the same mantra: the adjustment demanded of Greece requires too great a sacrifice, so there is only one solution: insolvency or the restructuring of Greek debt. Nobody had made clear what kind of sacrifice the insolvency of a state involved. Nobody had explained the impact on the financial system, contagion to other countries, and if that sacrifice was greater or lesser for the people than the alternative hypothesis. There was talk of a limited default, as if such a concept existed and had been tried out. Ridiculous comparisons have been made with Argentina.

Another aspect that is surprising to read in the media is the lack of precision on some news, especially when they are false and obviously put into circulation to create uncertainty. Let me offer another example related to the recent crisis in Greece. On 4 May the Greek government announced that it had hired a French investment bank, Lazard, for advice on its debt management. In the early hours of that day, the rumour spread in the markets that Lazard had been hired to restructure Greek debt. It was officially denied by both the Greek government and Lazard. It was also absurd because Greece had just received a financial support programme that explicitly excluded restructuring. Despite the denial, a leading financial newspaper ran the headline the following day “Athens calls in the default specialist”. And while sensationalist headlines are a commonplace vice, unmerited for sensitive topics, the content of the article did nothing to dispel the doubts: since Lazard has long-standing and undisputed expertise in the default field, suspicion was justified. The reasoning is absurd and raises doubts in other areas.

The payment of funds by the financial community to politicians, generally in order to obtain favourable treatment from the legislature for financial institutions, is well known. These payments are declared to some extent. It is estimated that the US financial sector spent more than USD 5 billion between 1998 and 2008 funding lobbying activities to Congress and the US administration. [6] Less is known about the payments made to other influential sectors of our society, such as the media, opinion makers and academics.

This is a subject on which our advanced societies do not have enough information and, above all, on which they have not reflected enough. In the light of what I said at the outset, we should not underestimate the risk that the consensus needed in our democracies to effectively address financial crises may be distorted in favour of special interests. The ethical question relating in particular to the operation of markets and the use that is made of information does not concern only individuals but has a broader dimension that touches on the functioning of our democracies.

In other words, it is in the general interest that the euro area countries adopt appropriate fiscal policies, reflecting not only the development of their economies but also the sustainability of public debts. However, it may be in the interest of some financial market participants for some states with budgetary difficulties not to pay back their debts and therefore fail, regardless of the impact this will have on the citizens of that country and those of neighbouring countries. It is in their interest if they have taken speculative positions in this regard and therefore can gain from the bankruptcy of a state. And since the probability of bankruptcy depends in part on the democratic process in the country itself, and on the other countries that may help the one in difficulty, it may be useful for financial market participants who bet on the failure of countries to use part of their future earnings to convince people that there is no other way possible, that an “orderly” failure that puts public finances back on track is better. The more people who are convinced of it (“As Greece is going to fail, help is useless”), the more likely becomes the outcome desired by financial market participants, although it is not in the general interest.

These issues raise ethical and moral questions that have been widely discussed, but from a limited point of view. The appeal to ethics and individual morality is an important starting point to correct the distortions that I mentioned above. But it’s not enough. The experience of recent years has shown that self-regulation and self-discipline do not suffice to prevent market distortions. This stems from the fact that the measure of individual performance, which is the economic result, can be appropriate in a theoretical context of perfect and complete information, particularly about how that result was obtained. Financial markets are, however, characterised by information asymmetries that make it very difficult to identify the source of profit, especially if it has been achieved thanks to the ability of the individual market participant (known in the jargon as alpha) or due to the risk it has taken and that may be improperly measured, precisely because of the informational asymmetries in the financial services available to the client. Other financial market participants and supervisory authorities are not always able to adequately identify the relative contribution of the two factors and therefore to punish unethical behaviour. [7]

However, not all unethical behaviour which shows a conflict of interest is directly punishable. In some cases it is considered that the reputational loss of the market participant who fails to live up to ethical principles is a sufficient incentive to ensure fairness. But if the gain more than compensates for the loss of reputation, the incentive to continue to violate the ethical principle remains, perhaps in a more effective manner. If the unethical practices make it possible to obtain higher returns, those who do not follow them are likely to be penalised. In other words, those who comply with the dictates of ethics may not perform economically so well as those who do not, and so may find themselves out of the market. [8]

Self-regulation works if everyone respects the rules and if that compliance is easy to monitor. Since the financial market information asymmetries make it very difficult to distinguish between those who observe the rules and those who don’t, the individual appeal to ethical principles is not enough. It can even penalise those who respect them, pushing them out of the market.

Yves here. Smaghi does not pretend to have any answers, but the fact that the officialdom is starting to recognize that cheating pays and can be hard to detect is a big step in the right direction.