Herd Leading, Undisclosed Conflicts, and the Euro Crisis

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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,
” (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.

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  1. Brick

    It is an interesting article but it also concerns me. While I would agree that those with an agenda or particular position should declare their interests, there is an assumption that most opinions are strongly biased. There is clear evidence that bank analysts even within the same bank take differing view points but I might agree that contentious or sensational views tend to get favoured. Maybe the ECB and politicians are struggling to come to terms with a new age of very fast media who have to pander to a clientele which seems to have a shorter and shorter attention span. Perhaps this is a result of the ECB and politicians having not really engaged with the public over the last few decades to catch their attention.
    Firstly the argument about ratings agencies does not quite ring true. Yes they got things badly wrong but it seems to me that he is arguing that market sentiment should not be taken into account into ratings is wrong. Quite clearly a bad market reaction can alter the ability of a country to service its debt. It seems to me he is saying he does not like or agree with the market reaction and thinks it is irrational. I think it is part of a central bankers role to manage market expectations and the failure was with the ECB not communicating properly and providing clear data to the ratings agencies and the market.
    I also see a little bit of arrogance in his argument about opinions based on very limited analysis. His argument that nobody had made clear what kind of sacrifice the insolvency of a state involved concerns me also, because surely that is exactly the kind of information the ECB should be communicating. There is also an implied assumption here that macro economic analysis is the way to judge the situation which sort of suggests politics and the Greek population’s sentiment only come into it to a lesser extent. Sometimes the person on the ground has a better view than any economic analysis.
    Next he talks about the lack of precision in news and media articles and he gives the example of the Greek government and Lazard. While I do think this may have been circulated and exaggerated by those with an agenda, if governments and central bankers actually announced what they were doing and gave transparent information there would be much less imprecision in the news. I could make an argument that it is ECB and political opacity which is the root of this problem.
    Then we have the following : 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. Here I would agree and I think he gets to the root of the problem with his discussion about ethics. Perhaps he is arguing that forcing banks to have an ethical conduct and fiduciary responsibility is more important than any regulation. I also agree that those getting away with unethical conduct force others to follow the same conduct. As Yves surmises cheating and being unethical pays, but the fact that they are only waking up to this now suggests they have been too remote and failed to engage with realities in the past.

    1. Diego Méndez

      “Quite clearly a bad market reaction can alter the ability of a country to service its debt.”

      A short-term market reaction can alter the long-term ability of a country to service its debt? What are rating agencies measuring then, today’s market sympathy?

      What’s the value of such an estimate, since they can’t foresee tomorrow’s sensationalist headlines and irrational market behaviour?

  2. A. Gouvweia

    Your defense of ratings agencies makes them totally useless: if the market is going up, up!, UP! they should be total cheerleaders, right? Because interest costs are going down and there is great “apetite for risk”!
    If things are going downhill, then it’s their duty to shout fire! in a crowded theather, I guess.

    And about less transparente communication: you’re like radical goldbugs, who believe there is a worldwide conspiracy to supress the price of gold. After the rumour is in, it cannot be disproven, because every denial would just be confirmation to you.

  3. Roberto

    The argument why the ECB decided to stop following the rating agencies when accepting collateral is at best disingenuous. It basically boils down to “the rating agencies do shoddy work, so we will accept dog doo in flaming paper bags as collateral.” He is not making any argument for an alternative credit rating system, but to abandon it all together. Furthermore, if the problem is with the ratings in general, why was the decision made only for Greece? http://www.ecb.europa.eu/press/pr/date/2010/html/pr100503.en.html As far as I know, no other changes have been made in ECB eligible collateral, or the relative haircuts.

    “have in some cases an interest in pushing the market” come on! That’s a legitimate argument against the banks, but the rating agencies? If they do go bankrupt wouldn’t the agencies lose a client?

    Also, the idea that the rating agency downgrades after the aid package was approved is wrong. While the package certainly helps with liquidity in the short run, in my opinion it does nothing to solve the long-term problem. Thus, it does not materially decrease the chance of bankruptcy. The author’s lack of facts for his argument and dismissive tone suggests the he is merely talking his own while criticizing others for doing same.

    The whole rant against those who would profit from non-repayment is ridiculous, especially for a central banker, and strongly resembles the arguments against short sellers, or that evil speculators are responsible for Greek yields rising. If the sovereign is sound and solvent, there is no problem, and the speculators will be proven wrong and lose money. This is merely artifice to detract from the main problem, fiscal and structural weakness in certain economies.

    “Comparisons to Argentina are ridiculous.” Really. Personally, I would have picked Mexico/Venezuela etc. in 1982-83, but let’s not split hairs. That Greece is not a carbon copy does not mean that the comparison is not valid. In these cases you have a sovereign burdened but excessive debt that it cannot service due to high wages/rents and/or labor/products that cannot compete. I would further argue that the solution is to restructure, as Latin American did.

    I think that this extend and pretend on a national level will end badly. The ECB should get to work on building fixes, not straw men.

  4. RebelEconomist

    What a load of rubbish (from Bini Smaghi I mean). When the ECB was founded, rules on what kind of assets it could hold were established to ensure that its financial solidity and hence independence was beyond question. But to avoid the political awkwardness of having to discriminate between the government debt of different countries, the standard of creditworthiness was outsourced to the rating agencies. Yet when this constraint became binding – and whatever one thinks of the rating agencies, they are bound to take account of the effect of countries’ cost of debt service on their creditworthiness – it was relaxed. And when the relaxed constraint looked likely to become binding again, it was abandoned. Instead of casting aspersions on the integrity of market participants with little evidence, Bini Smaghi should be apologising for the ECB’s spineless retreat, and explaining why holders of euros and euro denominated debt (disclosure: like me) should trust the euro in future.

    1. Francois T

      So, the infinite shoddiness of the rating agencies in evaluating MBS, CDOs and the likes wasn’t enough for you?

      What will it take to make people understand that the rating agencies cannot have a business model such as the one they have now? They are hopelessly conflicted, and not very good at what they are supposed to do.

      1. RHS

        What they were supposed to do, is exactly what S&P did with Greece. Oh by the way Greece is the one that paid S&P for the rating. Reality of Greece flies in the face of your argument. While we are on conflicts of interest, what ministry do you work for Francois?

  5. RebelEconomist

    By the way, A.Gouvwiea above mentions gold. If the Germans, French and Italians want to demonstrate their commitment to the integrity of the euro in the face of market doubts, let’s see them sell some of their combined 8300 tonnes holding of gold into its recent price rise and use the proceeds to reduce some of their debt. Go ahead, make my day!

  6. the.Duke.of.URL

    Where is the evidence that the market is the “brains” of the economy? (Smaghi) This is nonsense.

  7. Francois T

    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.

    Dear Mr. Smaghi,

    Even when they are fully aware of said conflicts of interests, they absolutely and irrevocably do not give a nanogram of digestive remains.

    Moreover, they won’t report about it, even if one of their colleagues expose the whole charade.

  8. ddf

    A long and verbose speech to make a point that is rather cute: the financial medias are the poor quality sound boxes of people who talk their books (where have been for the past 20 years Mr Smaghi?). What this shows is that market participants (and voters) do not have the basic level of economic litteracy required to make the economic and political market places functional. That is why we are making so little progress on financial reform. I do not expect this will be resolved through a spontaneous improvement of media and financial industry integrity (at least not in this life) or through restrictions on freedom of expression (though I still cannot figure how the ratings agencies have been able to hide behind the first amendment). Rather I think it is blogs like this one, posting by posting, that are going to make a difference by improving the general understanding of how the public is taken for a ride by the financial industry/media complex. Every posting counts, this is great, in the long it will make all the difference.

  9. RHS

    In my opinion Mr. Smaghi and his fellow European bureaucrats had hoped to intimidate the rating agencies into ignoring Greece. I believe the reason why Stiglitz was hired to advise the Greeks was because he was a vehement critic of the rating agencies during the Asian crisis. Stiglitz thought the agencies were too quick to downgrade in that situation. His hiring was a warning to the agencies, that should they downgrade Greece to junk they would face a lynch mob of US liberal Keynesian economist with Stiglitz at the lead.

    But a funny thing happened, those liberal economist in the states started turn bearish on Greece. Turns out they were reality based and not the ideological hacks Smaghi et all thought they were. Further the EU ignored Stiglitz’s advise to set interests for loans to the Greeks at 3% and went for 5% which did nothing for solvency. That changed the calculus of their attack plan but they failed to realize it. Hence they came out after the S&P downgrade with talking points that had been outdated by events.

    Now his point about the agencies are of course laughable. He seems to want them to:

    1. Accept the sovereign’s economic projections as the only legitimate projections.

    2. Ignore funding costs.

    3. Not take any subjective analysis into account.

    4. Put the issuer ahead of the investor by waiting for them to present their plan.

    5. Accept that a loan at 5% would be a solution to solvency.

    The funny thing about these demands is how similar they are to what investment bankers made in regards to SF. They too wanted the agency to only go by the model, not including any subjective analysis and they wanted only their assumptions to be used. So it is ironic they would attack the agencies using what happened in SF, because they want the agencies to do exactly that.

    But back to his points, RAs have a right to do there own projections and they should. It takes time to do them so a rating action might not occur when data is released but some time after. As far as funding costs, only idiot would not use it. As it is the EU is not making anything better using 5% as the rate for the loans. Makes one think that they don’t even intend to save Greece from default and are only buying time to sure up the EU banks for an eventual restructuring. Agencies already knew from previous bailout talks what rate the loans would be when S&P downgraded Greece, the only question was size and timing. Did agencies really have to wait to make a call on this. I say no. Agencies have a responsibility not to the issuer, or even to the current investor, it is to the next investor. To wait is to screw over the next investor.

    So inconclusion Mr Smaghi is full of shit.

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