Friday, January 2, 2009

Sound of inevitability

In a lightly regulated financial market, a meltdown is inevitable.

The equity markets hold corporate officers in any sector to the standards of profitability and thus stock price performance in their sector. Corporate officers of publicly traded companies who fail to deliver lose their jobs.

These incentives are short-term incentives. The executives who are sensitive to them - all executives - want most of all not to be left behind, lest they not meet the metrics for their bonuses. They measure their numbers quarter to quarter.

There are no corresponding short-term disincentives. Paper gains made today are compensated immediately irrespective of their endurance past the fiscal year.

This means that any "innovative" investment vehicle that provides strong returns will quickly spread throughout the financial sector. It doesn't matter whether it hides risk which guarantees that eventually it will hide risk. The temptation to pump is too great without the restraints of law.

The dump to come? Who cares? That's years away, and they'll have theirs. Besides, as executives, they're convinced by their own forward-looking optimism that nothing will go wrong, anyway. This business cycle is different. This business cycle is weightless.

Financial services companies also have to satisfy their clients or they'll move their capital elsewhere. This is the so-called free market mechanism for constraining risk in the market. Some clients should be more risk averse and thus should accept smaller returns for lower risk.

The irony is that these clients have less information about their risks than those who are selling them on the risk-hiding investment vehicles, and yet the free market relies on the relatively ignorant to take less money by being smarter than their professional advisers. It's human nature in any case (probably animal nature, too) to underestimate long-term risk to gain short-term reward.

Financial "innovation", so beloved by Phil Gramm and his libertarian ilk, is in fact often a path to danger for all of us with only a few reaping the benefits. The correct role for government is to make risk transparent and to constrain short-term operators from leveraging too much of it.

The consequences of having to relearn these lessons of the Great Depression surround us. Smart people are trying to figure their way out of the mire created by other smart people without too much pain - painless exits were all boarded up years ago. It's anyone's guess whether they'll succeed.

For instance, will the Chinese still have enough surplus from their manufacturing economy to lend us another trillion dollars ($1,000,000,000,000!) for use as an economic stimulus? Where are they going to get it if our consumers are cutting back?

At best, this is going to be one hell of a hangover.

Update: Common threads from Andrew Leonard in Salon, notably:

We now know that dereliction of duty ran rampant at every step of the chain. Mortgage borrowers lied about their income. Mortgage lenders failed to check the credit-worthiness of borrowers. Banks restructured loans into derivative instruments that obscured the underlying liabilities. Credit rating agencies -- dependent on fees from the very institutions whose products they were supposed to be judging -- gave the newfangled securities gold-plated ratings. Government regulators looked the other way. We now know that the incentives built into the system encouraged every individual actor to act in defiance of economic rationality.

We now know, in other words, that left to themselves, economic actors do not pursue rational, sustainable courses of action. Greed and self-interest will steer you into the ditch every time.
Yeah, I'd say that Leonard and I are on the same page.

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