Harvard is famous for attracting the best and the brightest, particularly in its own fund management operations (its endowment is currently over $22 billion). Mohamed El-Erian, the president and CEO of Harvard Management Company and a Harvard Business School faculty member, made these observations today in a Financial Times article, “Complex finance and the brave new world economy:”
Much of the discussion at the World Economic Forum in Davos has two themes. First, the continued robustness of the global economy as defined by sustained high growth and low inflation. Second, the steady rise in economic and financial risks.
The tendency is to treat these themes as competing and engage in an interesting but inconclusive debate about their relative merits. A better approach is to recognise that these themes are consistent with structural changes in the world and seek to recalibrate the perspective used for defining the way forward….
Consider five issues that face the public and private sectors.
First, the information content of market indicators that serve as traditional inputs for policymaking and market positioning has significantly distorted. This is true for staples such as the shape of yield curves and market measures of volatility and risk spreads.
Second, several countries must improve their policy tools to navigate their new circumstances. In emerging economies the traditional focus on liability management needs to be complemented by more sophisticated asset management capabilities.
Third, while financial innovations have enhanced risk management tools, a rise in risk efficiency does not entail a decline in risk. Rather, emboldened by new opportunities to tranche and securitise risk, many investors have moved up the risk curve. This shift is placing pressure on the infrastructure that supports settlement and operational risk management.
Fourth, regulatory efforts aimed at maintaining financial stability also need to be more sensitive to changes in the technical components of liquidity.
Finally, as recognition grows that international financial institutions are becoming less relevant, some difficult decisions face their shareholders if they wish to keep them effective and credible. At the minimum, they must agree on better representation and governance, a more sustainable income model and a sharper focus.
I found observations #1, #3, and #4 to be the most troubling. Re #1, it is an article of faith that current financial market prices reflects the best information available. That’s why, for example, most large companies use current interest rates as the basis for developing discount rates for evaluating possible investments. Yet El-Erain tells us that those prices now are disconnected from the underlying real world reality, and thus are not useful guides. Using the corporate investment decision above, if corporations are using the “wrong” discount rate because interest rates reflect speculative activity and leverage more than economic fundamentals, it means that investment decisions, and therefore the allocation of captial within the economy, are distorted and may also be incorrect, meaning inefficient. And even if there was broad-scale recognition of this issue, there is a dearth of alternate methodologies for making these sorts of decisions.
As for #3, El-Erain notes that many investors are taking on more risk. This isn’t a trivial observation either. Many of the best and brightest have been fooled into believing that their superior knoowledge of these new instruments and their trading skills meant they could profit handsomely for taking on more risk, yet also be relatively protected from serious losses. The collapse of Long Term Capital Management shows the dangers of this line of thinking.
Maybe I am reading too much into #4, but it sounds as if El-Erain is saying in a rather coded fashion that the regulators are missing the boat as far as certain aspects of liquidity management are concerned.