Yves here. While I agree philosophically with Richard Murphy’s belief that financial engineering should be recognized as a failed experiment, that was obvious after the 2008 blowup. Yet instead the authorities moved heaven and earth to recreate status quo ante.
One of the features of the world that produced the crisis was that regulators themselves, since the 1980s, had perversely been promoting regulatory arbitrage in the form of securitization and other approaches that reduced the need for perceived-to-be-costly bank equity. Regulators also chose to give a free pass to the growth of derivatives, when the big profits were in customized ones, generally for the purpose of tax avoidance or dressing up financial statements, as in activities with negative societal value added.
I anticipated, as Yankees are wont to say, that you can’t get there from here. ECONNED sketched out four possible responses to the crisis, and one was paradigm breakdown. From that discussion:
Recall that starting roughly in the 1870s, major European economies increasingly adopted the gold standard, and a long period of prosperity resulted. The regime was suspended in the UK and the major European powers during the war. Afterward, they moved to restore it, sometimes at considerable cost (England, for instance, suffered a nasty downturn in the early 1920s). But the aftereffects of the war meant the Edwardian period framework was unworkable. The deflationary forces they set in motion could have been countered by countercyclical measures after the Great Crash. But that was impossible with the gold standard. Indeed, as [Peter] Temin notes, “Holding the industrial economies to the gold standard last was about the worst thing that could have been done.”
Now readers may have trouble with that comparison, particularly since the conventional wisdom is that our policy responses have been so much better than those of the early 1930s. But the key point here is that the institutional framework locked the major actors into a particular set of responses. They were not able to see other paths out because they conflicted with an architecture and a set of beliefs that had comported themselves well for a very long time. It’s hard to think outside a system you grew up with. And remember, the gold standard did not break down overnight; the process took more than a decade.
Let’s use a different metaphor to illustrate the problem. Say a biotech firm creates a wonder crop, the most amazing creation in the history of agriculture. It yields far more calories per acre than anything else, is nutritionally extremely complete, and can be planted and harvested with far less machinery and equipment
than any other plant. It is tasty and can be prepared in a wide variety of ways. It is sweet too, so it can be used in place of sugar and high fructose corn syrup at lower cost. We’ll call this XCrop.
XCrop is added as a new element in the food pyramid and endorsed by nutritionists and public health officials all over the globe. It turns out that XCrop also is an aphrodisiac and a stimulant (hmm, wonder how they engineered that in) and between enhanced libido and more abundant food supplies, the world population rises at a faster rate.
Sales of XCrop boom, displacing traditional agriculture. A large amount of farmland is turned over from growing other types of produce to XCrop. XCrop is so efficient that agricultural land is taken out of production and turned to other uses, such as housing, malls, and parks. While some old-fashioned farms still exist, they are on a much smaller scale and a lot of the providers of equipment to traditional farms have gone out of business.
Twenty years into the widespread use of XCrop, doctors discover that diabetes and some peculiar new hormonal ailments are growing at an explosive rate. It turns out they are highly correlated with the level of XCrop consumption in an individual’s diet. Long-term consumption of high levels of XCrop interferes with the pituitary gland, which controls almost all the other endocrine glands in the body and the pancreas.
The public faces a health crisis and no way back. It would be very difficult and costly to put the repurposed farmland back into production. Some of the types of equipment needed for old-fashioned farming are no longer made. And with the population so much larger than before, you’d need even more farmland than before. The world population has become dependent on the calories produced by XCrop, so going off it quickly means starvation for some. But staying on it is toxic too. And expecting users simply to restrain themselves will likely prove difficult. The aphrodisiac and stimulant effects of XCrop make it addictive.
Advanced economies have become hooked on debt technology, which, like XCrop, is habit forming and hard to wean oneself off of due to its lower cost and the fact that other approaches have fallen into partial disuse (for instance, use of FICO-based credit scoring has displaced evaluations that include an assessment of the borrower’s character and knowledge of the community, such as stability of his employer). In fact, the current debt technology results in information loss, via disincentives to do a thorough job of borrower due diligence (why bother if you are reselling the paper?) and monitoring of the credit over the life of the loan. And the proposed fixes are not workable. The Obama proposal, that the originator retain 5% of the deal and take correspondingly lower fees, is not high enough to change behavior. And a level that would be high
enough to make the originator feel the impact of a bad decision would undercut the cost efficiencies that made securitization popular in the first place. You’d have better decisions, but less lending, and higher interest rates. That’s ultimately a desirable outcome, but as in the XCrop situation, no one seems prepared to accept that a move to healthier practices will result in much more costly and less readily available debt. The authorities want to believe they can somehow have their cake and eat it too.
Back to the current post, meaning now Richard Murphy.
By Richard Murphy, a chartered accountant and a political economist. He has been described by the Guardian newspaper as an “anti-poverty campaigner and tax expert”. He is Professor of Practice in International Political Economy at City University, London and Director of Tax Research UK. He is a non-executive director of Cambridge Econometrics. He is a member of the Progressive Economy Forum. Originally published at Tax Research UK
The last week has been interesting in the world of finance.
Greensill Capital collapsed. The provider of what might best be described as unusual forms of supply chain financing to what seem to have been vulnerable companies unable to offer what seem like conventional security for loans, the model ran out of steam despite the support of former Prime Minister David Cameron.
Significant numbers of companies are left vulnerable as a result, from the UK’s third-largest steel manufacturer to banks that had provided Greensill with its funding. They bet that they could fund a reward from financial engineering failed, as is so often true, and the edifice has collapsed.
Some of the same banks that will lose on Greensill, and most especially Credit Suisse, seem to also be exposed as a result of the collapse of the private hedge fund, Archegos Capital. That this was predestined to failure seems to have almost been assumed by its name, but still the banks funded it.
And as, once again, has happened before, providing funding for stock gambling has proved to be very expensive for those involved. Eventually the egos on display in these environments overrule sense. The cost is always significant. It will be many billions in this case.
Neither of these failures is the least bit surprising. Each relied on a punt that continual funding of leveraged financial positions would by itself provide the security required to make repayment. In effect, the size of the punts would, it was presumed, create growth that would yield the return to justify the risk within the differing, and yet similar in the sense that they were financially engineered, positions taken.
There is nothing new about this. The whole 2008 crisis was based on false assumptions of similar sort that by forever extrapolating a position no breakpoint would be found. Before that there was the failure of Long Term Capital Management in the 1990s. And there are ample others. The fool, whether they be technically described as a banker or not, and their money seems always to be willing to part with their money when offered returns that can only be realised if a market can continually grow.
We could, at one level, shrug this off. Both failures will be costly. David Cameron looks dodgier than ever. Some banks have been bruised. C’est la vie, it could be said. But that would be unwise.
I noted an article on inflation risk in the FT by someone called Andrew Parlin. To describe him as an inflation fetishist would be fair, but at least he had the honesty to lay bare his fear. He said:
[A]n entrenched inflation such as we have not known in decades and the need to slam on the brakes through aggressive rate tightening [is the risk that exists]. Given how inflated asset prices are, the bust that would follow would probably be unusually severe and protracted.
What he is suggesting is that there aren’t just isolated examples of excessive risk-taking on the basis of asymmetric betting right now, but that the entire financial market is currently built in it. Asset values are, as he is honest enough to admit, utterly distorted. The distortion has been created by low interest rate policy, linked to low inflation.
There is an inverse relationship between both low interest rates and inflation and financial asset prices. If financial assets pay broadly steady returns but interest rates fall asset prices rise to approximately equate the two. If inflation is also low then there is an extra boost for asset prices as lower risk discounts need not be applied. Both situations have existed for so long now asset prices are seriously over-inflated.
Parlin’s naked fear is that this situation might reverse if there was to be inflation, and that to prevent that asset price crash then the real economy must be sacrificed, in his view. Unemployment, austerity, and small-town corporate failures must all become the norm to maintain orderly asset pricing, even when it is recognised that those prices are seriously over-inflated.
Leaving aside questions of desirability (because it is patently undesirable to do this) and necessity (which is doubtful, as the inflation paranoia on display is not based on real-world risk, but on textbook ones instead, and the textbooks are wrong) what Parlin is saying is that financial markets are one entire asymmetric risky bet, all premised on the idea that interest rates will stay low in perpetuity. That may be true. But, when everything else in the economy has to be sacrificed to making good on that bet it is clear that the risk has moved from being routine to asymmetric. In other words, it can only continue to be justified by the perpetuation of the bet itself. That is the logic of the Ponzi, or pyramid selling scheme, of course. And that is where the whole of financial markets are.
Parlin wants effort to be directed to maintain this edifice. I rather suspect some self-interest in that desire. That self-interest might taint the views of many. But it should not stop us from realising that once a bet reaches this stage it is always, eventually, going to fail. It is only time before financial markets must adjust to the very obviously absurd valuations implicit in them.
That is not because interest rates need change, because I doubt there will. There is, in my opinion, almost no inflation incentive for that to happen. It is instead because the risk evaluation within markets is wrong. Most assets are being valued as if they offer near-guaranteed returns. But that is not true.
In finance, returns will fail because the bets are all wrong.
In energy, returns will fail because we have to reduce oil dependency.
In raw materials, returns will adjust to declining consumption.
In retailing, returns will fall as the shop beings increasingly irrelevant.
The same will be true in commercial property.
And the transport sector has not yet priced the adaptation to alternative energy, sufficiently.
Whilst tech has not priced changing tax rules.
Markets are going to decline because they gave mispriced risk. Oddly, inflation is not one of those risks. But that will not prevent a fall. The fall has simply been deferred by low inflation and low interest rates which have disguised the real risk of fundamental economic change.
Greensill and Archegos have failed because of mispricing risk, believing financial engineering can offset the real underlying economic factors that they chose to ignore. The signal that they provide is that the whole market is doing the same thing. But that does not mean we crash the real economy to maintain the financial edifice. We do instead invest in the real economy to create new worth.
We have to consign the era of financial engineering to history. But will we? It’s an absolutely fundamental question.