Monday, July 23, 2012
Friday, July 20, 2012
On greed
Recently at lunch with a colleague of mine we were discussing the prolonged economic crisis. As is not so very uncommon these days, he highlighted the point of greed as something that has changed historically, or at the very least the ability of greedy speculators to significantly disrupt the functioning of the system and amass massive amounts of wealth by mere speculation, not by actually producing anything concrete. One example which was mentioned was the speculation in the African bond market, of which I alas have no knowledge of.
We did agree that perhaps slightly too liberal deregulation may have been the catalyst in enabling global greed of this magnitude to materialize, but where our views diverged were the practical implications of this. Certainly, if left unchecked what we've witnessed in the last decade may destabilize the system in such a significant fashion that it would have sever consequences on the everyday lives of people who at the end of the day are merely victims, not necessarily the culprits as such. Ultimately, however, I think the systems will balance themselves out in one way or the other, but the amount of pain endured in the process will be a key question.
It is easy to also say that regulation is one potential key in ensuring that this type of mess does not come around too often. However, what that regulation in practice would be, though, is difficult to say. Certainly some things are clear, however. One thing we ought to have already learned is that if entire systems have single points of failure, the robustness of the system is significantly impaired. The global banking model which has been applied in the recent history may be one thing which causes a bit of a headache, as banks become large in size and potential conflicts of interest arise inside the banks, which I am fairly skeptical that Chinese walls can sufficiently solve.
Another fundamental learning is that of accountability. Moral hazard, the buzzword of yesteryear, if you will. If you decouple accountability from the equations, certainly you will have situations where people behave in irresponsible ways. How you bring back accountability is by not bailing out everyone who gets into trouble. You let bad decisions lead to bad consequences so that the feedback loop will ensure that the parts of the system gradually learn to avoid these types of decisions. Building off of this, think of the bond markets, which have been the focal point of discussion for too long already. The big problem is that when the environment has been injected with a fair dose of volatility, the investors who are responsible for allocating their own and possible other peoples' capital have started questioning some assumptions they've made earlier, especially in regard to the ability of governments to make good on their debts. Enter rising interest rates for some and low interest rates for others. Rising interest rates mean that countries cannot get new debt as cheaply as before, not that the debt already issued would have increasing costs. This in itself is not problematic at all: if the credit card company figures that I've lost my steady source of income, it's very likely they will feel that the risk associated with the credit that they're giving me has risen and hence either cut me off or charge me higher interest rates to compensate for the risk.
Now, where the proverbial shit hits the fan is if you have built your finances to rely on debt financing and are heavily leaning forward with it. If all of a sudden you are cut off from the ability of borrow, the house of cards comes crashing down. Is it now time for regulation? Perhaps. And not the regulation of credit rating agencies, mind you, as some have argued. But consider simple regulation and simple heuristics such as "thou shalt not build thy public sector on debt" would decouple the ability of the bond markets to punish nations, merely because nations would by definition not commit the sin in the first place of getting hooked on cheap credit, which is ultimately merely stealing from the next generation of citizens and giving to the current situation of citizens. Why is regulation and simple heuristics needed? Because the politicians running the system will always discount time so as to prefer immediate gains over longer term gains. And that is logical because without immediate gains the politicians won't be in the office in the longer term.
Interestingly enough if we move down a layer from the nation level to the firm level, we notice that the same dynamic was present in the financial crisis of 2008. Banks base a bulk of their business on the ability to borrow short term. If the credit dries up, their operations grind to a halt, making again the banking system incredibly sensitive to outside shocks and increased volatility in the environment. This is one reason why the Basel framework has been worked on; to ensure that banks have enough liquidity to survive the conditions. To be honest, I'm not an expert on the Basel frameworks, but what I have heard from some sources is that even the newer things will not most likely ultimately solve the issues. But they are working towards implementing some heuristics which may limit the ability to create profit by trading it off for a potentially more stable system and decreased mortality rates when things do go south.
The interesting question on the nation level, then, is whether or not similar heuristics should be implemented with international agreements (e.g. by increasing couplings in the scope of the EU) or should countries look to implement them on their own. The philosophical answer, at least for me, is clear, considering my skepticism of big and intricate organisms: it should be in the interest of individual nations to sort themselves out and hence no larger level coordination should be needed, as long as the voters understand that it is irresponsible of them to give the politicians the loaded gun with which to shoot the country itself in the head. Of course, that is assuming much of voters and politicians, which may suggest that in the real world someone must force this type of behavior. Unfortunately that, however, does not go well with freedom and liberty.
Regardless, the above merely goes to show that one way of decoupling oneself from the speculators' ability to harm you might not be to beat up the speculators but find ways of solving the core problem. Despite my colleague's view that we have never seen this level of greed before, I am fairly certain that the opposite is true: we've always encountered greedy people, be it (naively put) the bankers of today or the monarchs/sovereigns/conquerors of before.
We did agree that perhaps slightly too liberal deregulation may have been the catalyst in enabling global greed of this magnitude to materialize, but where our views diverged were the practical implications of this. Certainly, if left unchecked what we've witnessed in the last decade may destabilize the system in such a significant fashion that it would have sever consequences on the everyday lives of people who at the end of the day are merely victims, not necessarily the culprits as such. Ultimately, however, I think the systems will balance themselves out in one way or the other, but the amount of pain endured in the process will be a key question.
It is easy to also say that regulation is one potential key in ensuring that this type of mess does not come around too often. However, what that regulation in practice would be, though, is difficult to say. Certainly some things are clear, however. One thing we ought to have already learned is that if entire systems have single points of failure, the robustness of the system is significantly impaired. The global banking model which has been applied in the recent history may be one thing which causes a bit of a headache, as banks become large in size and potential conflicts of interest arise inside the banks, which I am fairly skeptical that Chinese walls can sufficiently solve.
Another fundamental learning is that of accountability. Moral hazard, the buzzword of yesteryear, if you will. If you decouple accountability from the equations, certainly you will have situations where people behave in irresponsible ways. How you bring back accountability is by not bailing out everyone who gets into trouble. You let bad decisions lead to bad consequences so that the feedback loop will ensure that the parts of the system gradually learn to avoid these types of decisions. Building off of this, think of the bond markets, which have been the focal point of discussion for too long already. The big problem is that when the environment has been injected with a fair dose of volatility, the investors who are responsible for allocating their own and possible other peoples' capital have started questioning some assumptions they've made earlier, especially in regard to the ability of governments to make good on their debts. Enter rising interest rates for some and low interest rates for others. Rising interest rates mean that countries cannot get new debt as cheaply as before, not that the debt already issued would have increasing costs. This in itself is not problematic at all: if the credit card company figures that I've lost my steady source of income, it's very likely they will feel that the risk associated with the credit that they're giving me has risen and hence either cut me off or charge me higher interest rates to compensate for the risk.
Now, where the proverbial shit hits the fan is if you have built your finances to rely on debt financing and are heavily leaning forward with it. If all of a sudden you are cut off from the ability of borrow, the house of cards comes crashing down. Is it now time for regulation? Perhaps. And not the regulation of credit rating agencies, mind you, as some have argued. But consider simple regulation and simple heuristics such as "thou shalt not build thy public sector on debt" would decouple the ability of the bond markets to punish nations, merely because nations would by definition not commit the sin in the first place of getting hooked on cheap credit, which is ultimately merely stealing from the next generation of citizens and giving to the current situation of citizens. Why is regulation and simple heuristics needed? Because the politicians running the system will always discount time so as to prefer immediate gains over longer term gains. And that is logical because without immediate gains the politicians won't be in the office in the longer term.
Interestingly enough if we move down a layer from the nation level to the firm level, we notice that the same dynamic was present in the financial crisis of 2008. Banks base a bulk of their business on the ability to borrow short term. If the credit dries up, their operations grind to a halt, making again the banking system incredibly sensitive to outside shocks and increased volatility in the environment. This is one reason why the Basel framework has been worked on; to ensure that banks have enough liquidity to survive the conditions. To be honest, I'm not an expert on the Basel frameworks, but what I have heard from some sources is that even the newer things will not most likely ultimately solve the issues. But they are working towards implementing some heuristics which may limit the ability to create profit by trading it off for a potentially more stable system and decreased mortality rates when things do go south.
The interesting question on the nation level, then, is whether or not similar heuristics should be implemented with international agreements (e.g. by increasing couplings in the scope of the EU) or should countries look to implement them on their own. The philosophical answer, at least for me, is clear, considering my skepticism of big and intricate organisms: it should be in the interest of individual nations to sort themselves out and hence no larger level coordination should be needed, as long as the voters understand that it is irresponsible of them to give the politicians the loaded gun with which to shoot the country itself in the head. Of course, that is assuming much of voters and politicians, which may suggest that in the real world someone must force this type of behavior. Unfortunately that, however, does not go well with freedom and liberty.
Regardless, the above merely goes to show that one way of decoupling oneself from the speculators' ability to harm you might not be to beat up the speculators but find ways of solving the core problem. Despite my colleague's view that we have never seen this level of greed before, I am fairly certain that the opposite is true: we've always encountered greedy people, be it (naively put) the bankers of today or the monarchs/sovereigns/conquerors of before.
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