Credit crunch - three views

Adam Smith gets the last laugh

P.J. O’Rourke

Financial Times February 10 2009

The free market is dead. It was killed by the Bolshevik Revolution, fascist dirigisme, Keynesianism, the Great Depression, the second world war economic controls, the Labour party victory of 1945, Keynesianism again, the Arab oil embargo, Anthony Giddens’s “third way” and the current financial crisis. The free market has died at least 10 times in the past century. And whenever the market expires people want to know what Adam Smith would say. It is a moment of, “Hello, God, how’s my atheism going?”

Adam Smith would be laughing too hard to say anything. Smith spotted the precise cause of our economic calamity not just before it happened but 232 years before – probably a record for going short.
“A dwelling-house, as such, contributes nothing to the revenue of its inhabitant,” Smith said in The Wealth of Nations. “If it is lett [sic] to a tenant for rent, as the house itself can produce nothing, the tenant must always pay the rent out of some other revenue.” Therefore Smith concluded that, although a house can make money for its owner if it is rented, “the revenue of the whole body of the people can never be in the smallest degree increased by it”. [281]*

Smith was familiar with rampant speculation, or “overtrading” as he politely called it.
The Mississippi Scheme and the South Sea Bubble had both collapsed in 1720, three years before his birth. In 1772, while Smith was writing The Wealth of Nations, a bank run occurred in Scotland. Only three of Edinburgh’s 30 private banks survived. The reaction to the ensuing credit freeze from the Scottish overtraders sounds familiar, “The banks, they seem to have thought,” Smith said, “were in honour bound to supply the deficiency, and to provide them with all the capital which they wanted to trade with.” [308]

The phenomenon of speculative excess has less to do with free markets than with high profits. “When the profits of trade happen to be greater than ordinary,” Smith said, “overtrading becomes a general error.” [438] And rate of profit, Smith claimed, “is always highest in the countries that are going fastest to ruin”. [266]
The South Sea Bubble was the result of ruinous machinations by Britain’s lord treasurer, Robert Harley, Earl of Oxford, who was looking to fund the national debt. The Mississippi Scheme was started by the French regent Philippe duc d’Orléans when he gave control of the royal bank to the Scottish financier John Law, the Bernard Madoff of his day.

Law’s fellow Scots – who were more inclined to market freedoms than the English, let alone the French – had already heard Law’s plan for “establishing a bank ... which he seems to have imagined might issue paper to the amount of the whole value of all the lands in the country”. The parliament of Scotland, Smith noted, “did not think proper to adopt it”. [317]
One simple idea allows an over-trading folly to turn into a speculative disaster – whether it involves ocean commerce, land in Louisiana, stocks, bonds, tulip bulbs or home mortgages. The idea is that unlimited prosperity can be created by the unlimited expansion of credit.

Such wild flights of borrowing can be effected only with what Smith called “the Daedalian wings of paper money”. [321] To produce enough of this paper requires either a government or something the size of a government, which modern merchant banks have become. As Smith pointed out: “The government of an exclusive company of merchants, is, perhaps, the worst of all governments.” [570]

The idea that The Wealth of Nations puts forth for creating prosperity is more complex. It involves all the baffling intricacies of human liberty. Smith proposed that everyone be free – free of bondage and of political, economic and regulatory oppression (Smith’s principle of “self-interest”), free in choice of employment (Smith’s principle of “division of labour”), and free to own and exchange the products of that labour (Smith’s principle of “free trade”). “Little else is requisite to carry a state to the highest degree of opulence,” Smith told a learned society in Edinburgh (with what degree of sarcasm we can imagine), “but peace, easy taxes and a tolerable administration of justice.”

How then would Adam Smith fix the present mess? Sorry, but it is fixed already. The answer to a decline in the value of speculative assets is to pay less for them. Job done.
We could pump the banks full of our national treasure. But Smith said: “To attempt to increase the wealth of any country, either by introducing or by detaining in it an unnecessary quantity of gold and silver, is as absurd as it would be to attempt to increase the good cheer of private families, by obliging them to keep an unnecessary number of kitchen utensils.” [440]

We could send in the experts to manage our bail-out. But Smith said: “I have never known much good done by those who affect to trade for the public good.” [456]
And we could nationalise our economies. But Smith said: “The state cannot be very great of which the sovereign has leisure to carry on the trade of a wine merchant or apothecary”. [818] Or chairman of General Motors.

* Bracketed numbers in the text refer to pages in ‘The Wealth of Nations’, Glasgow Edition of the Works of Adam Smith, Oxford University Press, 1976

The writer is a contributing editor at The Weekly Standard and is the author, most recently, of On The Wealth of Nations, Books That Changed the World, published by Atlantic Books, 2007


Do not destroy the essential catalyst of risk

Lloyd Blankfein

Financial Times February 8 2009

Since the spring, and most acutely this autumn, a global contagion of fear and panic has choked off the arteries of finance, compounding a broader deterioration in the global economy.
Much of the past year has been deeply humbling for our industry. People are understandably angry and our industry has to account for its role in what has transpired.

Financial institutions have an obligation to the broader financial system. We depend on a healthy, well-functioning system but we failed to raise enough questions about whether some of the trends and practices that had become commonplace really served the public’s long-term interests.
As policymakers and regulators begin to consider the regulatory actions to be taken to address the failings, I believe it is useful to reflect on some of the lessons from this crisis.

The first is that risk management should not be entirely predicated on historical data. In the past several months, we have heard the phrase “multiple standard deviation events” more than a few times. If events that were calculated to occur once in 20 years in fact occurred much more regularly, it does not take a mathematician to figure out that risk management assumptions did not reflect the distribution of the actual outcomes. Our industry must do more to enhance and improve scenario analysis and stress testing.

Second, too many financial institutions and investors simply outsourced their risk management. Rather than undertake their own analysis, they relied on the rating agencies to do the essential work of risk analysis for them. This was true at the inception and over the period of the investment, during which time they did not heed other indicators of financial deterioration.
This over-dependence on credit ratings coincided with the dilution of the coveted triple A rating. In January 2008, there were 12 triple A-rated companies in the world. At the same time, there were 64,000 structured finance instruments, such as collateralised debt obligations, rated triple A. It is easy and appropriate to blame the rating agencies for lapses in their credit judgments. But the blame for the result is not theirs alone. Every financial institution that participated in the process has to accept its share of the responsibility.

Third, size matters. For example, whether you owned $5bn or $50bn of (supposedly) low-risk super senior debt in a CDO, the likelihood of losses was, proportionally, the same. But the consequences of a miscalculation were obviously much bigger if you had a $50bn exposure.

Fourth, many risk models incorrectly assumed that positions could be fully hedged. After the collapse of Long-Term Capital Management and the crisis in emerging markets in 1998, new products such as various basket indices and credit default swaps were created to help offset a number of risks. However, we did not, as an industry, consider carefully enough the possibility that liquidity would dry up, making it difficult to apply effective hedges.

Fifth, risk models failed to capture the risk inherent in off-balance sheet activities, such as structured investment vehicles. It seems clear now that managers of companies with large off-balance sheet exposure did not appreciate the full magnitude of the economic risks they were exposed to; equally worrying, their counterparties were unaware of the full extent of these vehicles and, therefore, could not accurately assess the risk of doing business.

Sixth, complexity got the better of us. The industry let the growth in new instruments outstrip the operational capacity to manage them. As a result, operational risk increased dramatically and this had a direct effect on the overall stability of the financial system.

Last, and perhaps most important, financial institutions did not account for asset values accurately enough. I have heard some argue that fair value accounting – which assigns current values to financial assets and liabilities – is one of the main factors exacerbating the credit crisis. I see it differently. If more institutions had properly valued their positions and commitments at the outset, they would have been in a much better position to reduce their exposures.

For Goldman Sachs, the daily marking of positions to current market prices was a key contributor to our decision to reduce risk relatively early in markets and in instruments that were deteriorating. This process can be difficult, and sometimes painful, but I believe it is a discipline that should define financial institutions.
As a result of these lessons and others that will emerge from this financial crisis, we should consider important principles for our industry, for policymakers and for regulators. For the industry, we cannot let our ability to innovate exceed our capacity to manage. Given the size and interconnected nature of markets, the growth in volumes, the global nature of trades and their cross-asset characteristics, managing operational risk will only become more important.

Risk and control functions need to be completely independent from the business units. And clarity as to whom risk and control managers report to is crucial to maintaining that independence. Equally important, risk managers need to have at least equal stature with their counterparts on the trading desks: if there is a question about the value of a position or a disagreement about a risk limit, the risk manager’s view should always prevail.

Understandably, compensation continues to generate a lot of anger and controversy. We recognise that having troubled asset relief programme money creates an important context for compensation. That is why, in part, our executive management team elected not to receive a bonus in 2008, even though the firm produced a profit.

More generally, we should apply basic standards to how we compensate people in our industry. The percentage of the discretionary bonus awarded in equity should increase significantly as an employee’s total compensation increases. An individual’s performance should be evaluated over time so as to avoid excessive risk-taking. To ensure this, all equity awards need to be subject to future delivery and/or deferred exercise. Senior executive officers should be required to retain most of the equity they receive at least until they retire, while equity delivery schedules should continue to apply after the individual has left the firm.

For policymakers and regulators, it should be clear that self-regulation has its limits. We rationalised and justified the downward pricing of risk on the grounds that it was different. We did so because our self-interest in preserving and expanding our market share, as competitors, sometimes blinds us – especially when exuberance is at its peak. At the very least, fixing a system-wide problem, elevating standards or driving the industry to a collective response requires effective central regulation and the convening power of regulators.
Capital, credit and underwriting standards should be subject to more “dynamic regulation”.

Regulators should consider the regulatory inputs and outputs needed to ensure a regime that is nimble and strong enough to identify and appropriately constrain market excesses, particularly in a sustained period of economic growth. Just as the Federal Reserve adjusts interest rates up to curb economic frenzy, various benchmarks and ratios could be appropriately calibrated. To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across financial institutions be similarly valued. Fair value accounting gives investors more clarity with respect to balance sheet risk.

The level of global supervisory co-ordination and communication should reflect the global inter-connectedness of markets. Regulators should implement more robust information sharing and harmonised disclosure, coupled with a more systemic, effective reporting regime for institutions and main market participants. Without this, regulators will lack essential tools to help them understand levels of systemic vulnerability in the banking sector and in financial markets more broadly.

In this vein, all pools of capital that depend on the smooth functioning of the financial system and are large enough to be a burden on it in a crisis should be subject to some degree of regulation.
After the shocks of recent months and the associated economic pain, there is a natural and appropriate desire for wholesale reform of our regulatory regime. We should resist a response, however, that is solely designed around protecting us from the 100-year storm. Taking risk completely out of the system will be at the cost of economic growth. Similarly, if we abandon, as opposed to regulate, market mechanisms created decades ago, such as securitisation and derivatives, we may end up constraining access to capital and the efficient hedging and distribution of risk, when we ultimately do come through this crisis.

Most of the past century was defined by markets and instruments that fund innovation, reward entrepreneurial risk-taking and act as an important catalyst for economic growth. History has shown that a vibrant, dynamic financial system is at the heart of a vibrant, dynamic economy.

We collectively have a lot to do to regain the public’s trust and help mend our financial system to restore stability and vitality. Goldman Sachs is committed to doing so.

The writer is chief executive of Goldman Sachs

Now is the time for a revolution in economic thought

Anatole Kaletsky

The Times 9 October 2009

In my column last Thursday, I explained how academic economics has been discredited by recent events. It is now time for what historians of science call a “paradigm shift”. If we want to flatter economists, we could compare this revolution needed to the paradigm shift in physics in 1910 after Einstein discovered relativity and Planck launched quantum mechanics. More realistically, economics today is where astronomy was in the 16th century, when Copernicus and Galileo had proved the heliocentric model, but religious orthodoxy and academic vested interests fought ruthlessly to defend the principle that the sun must revolve around the Earth.
I
n this article I will outline some of the unorthodox approaches to economics which conventional economists have ignored and which might have helped to avert the present crisis — in the weeks ahead I plan to give more detail of some of these ideas.
Consider the following passage:
“Most economic theorists have been going down the wrong track. When economic models fail, they are seldom thrown away. Rather they are ‘fixed' - amended, qualified, particularised, expanded and complicated.
“Bit by bit, from a bad seed a big but sickly tree is built with glue, nails, screws and scaffolding. Conventional economics assumes the financial system is a linear, continuous, rational machine and these false assumptions are built into the risk models used by many of the world's banks. As a result, the odds of financial ruin in a free global market economy have been grossly underestimated. By using such methods there is no limit to how bad a bank's losses can get. Its own bankruptcy is the least of the worries; it will default on its obligations to other banks - and so the losses will spread from one inter-linked financial house to another. Only forceful action by regulators to put a firewall round the sickest firms will stop the crisis spreading. But bad news tends to come in flocks and a bank that weathers one crisis may not survive a second or a third.”

This uncannily precise description of the present crisis above was not written by an economist. While some economists had warned for years about global trade imbalances, escalating house prices, of excessive consumer borrowing, none of them remotely foresaw the truly unprecedented feature of the present crisis: the total breakdown of financial markets caused by the unforced blunders by investors and banks. Modern economists were inherently incapable of understanding such a problem because they assumed that investors were “rational” and markets “efficient”.
These assumptions led inevitably to disaster once they were blown apart. The author who came so close to understanding the true causes of the present crisis was not an economist but a mathematician.

Benoît Mandelbrot, a towering figure of 20th-century science, who invented fractal geometry and pioneered the mathematical analysis of chaos and complex systems, wrote the above words six years ago in his book The Misbehaviour of Markets. Mandelbrot's ideas found fruitful applications in the study of earthquakes, weather, galaxies and biological systems from the 1960s onward, but the field that originally inspired his ideas turns out, in this very readable book, to have been finance and economics. Yet 40 years of effort by Mandelbrot to interest economists in the new mathematical methods, which appear to work far better in modelling extreme movements in financial markets than the conventional methods based on statistically “normal” distributions, have been either ridiculed or ignored.

At the other end of the academic spectrum, we find economists treating ideas from sociology, psychology or philosophy with the same derision and disdain. George Soros is no mathematician like Mandelbrot, but he has repeatedly demonstrated far better understanding of how market economies work than any professional economist by using psychological and philosophical ideas. His books have explained convincingly how false beliefs among investors can create self-reinforcing boom-bust cycles of exactly the kind afflicting the world today. But the reaction to these ideas has been the same as to Mandelbrot's: a complacent refusal among academic economists, regulators and central bankers even to think seriously about approaches that challenge the central orthodoxies of modern economics: that “efficient” markets inhabited by “rational” investors send price signals which, in some sense, are always right.

Reality is very different, as everyone now admits: investors often misinterpret information and markets sometimes send price signals that are dangerously wrong. What Soros shows, moreover, is that such behaviour should not be regarded as irrational or an aberration. On the contrary, rational investors can find it very profitable to act on false premises - for example that credit will always be available without limit - if these false ideas become so widely accepted that they change the way the economy actually functions, at least for a time.

One reason why such fruitful insights have been ignored is the convention adopted by academic economists some 30 years ago that all serious ideas must be expressed
in equations, not words. By this weird standard, the intellectual giants of the subject — Adam Smith, Ricardo, Keynes, Hayek — would not now be recognised as serious economists at all.
But even if we accept the mathematical formalism of modern economics, there is vast scope for new ideas.

A control theory approach, used by serious mathematicians such as Nicos Christofides and Shahid Chaudhri, working at the Centre for Quantitative Finance at London's Imperial College, has applied advanced mathematics from aerodynamics and control engineering to analyse financial turbulence without the over-simplified assumptions, such as continuous liquidity, which have caused the recent disasters in risk management and regulation.

But the challenge that existing economic orthodoxy may find most disconcerting is Imperfect Knowledge Economics (IKE), the name of a path-breaking recent book by Roman Frydman and Michael Goldberg, two American economists. Building on ideas of Edmund Phelps, one of the few Nobel Laureate economists who rejected the consensus view on rational expectations, IKE uses similar tools to conventional economics to generate radically different results. It insists that the future is inherently unknowable and therefore that there is always a multitude of plausible models of the way the economy works.

With this obvious, but critically important, change in assumptions, IKE demolishes most of the conclusions of rational expectations. More importantly, it shows that reasonable assumptions about economic uncertainty can produce financial models that give less spurious accuracy than the rational expectations models but are statistically far closer to what happens in the real world.

These are just a few examples of the creative thinking that has started again in economics after 20 years of stagnation. But the academic establishment, discredited though it is by the present crisis, will fight hard against new ideas. The outcome of this battle does not just matter to academic economists. Without a better understanding of economics, financial crises will keep recurring and faith in capitalism and free markets will surely erode. Changes in regulation are not sufficient after this financial crisis — it is time for a revolution in economic thought.