Tuesday, November 11, 2008

Brittle Thinking and System Faults Lead to Collapse

In 2008 the American financial system imploded. This implosion is causing worldwide turmoil.

I believe it worthwhile to look in detail at this implosion to figure out how to prevent similar crises in the future. During the crisis, several financial instruments came to the fore. Notably,

  • Hedge Funds (short sells and options),
  • Credit Default Swaps,
  • Insurance (and reinsurance),
  • Fixed Wages
  • and Debt Financing.

I could have made the list longer. For example, wage labor and pensions belong in the list, but I will talk about those later. Keeping the list short makes the post succinct.

A hedge fund uses complex formulas to hedge risks. Such funds might short $30 for every $100 invested.

The goal of insurance is to pool a large number of related risks; so that people can address risks on a pay as you go basis. The goal of an insurer is to have a pool of risk large enough that the pool can handle predictable fluctuations of costs. The insurer changes a premium that gives the insurer a handsome little profit in excess of the anticipated risk.

Credit Default Swaps are a new financial innovation. These are part of a new system devised to let banks sell risks associated with loans.

A key component of the above tools is size. Hedge funds, insurance and credit default swaps all seek security in size. The reports I've read about credit default swaps indicate that they went from nothing to being larger than the Gross Domestic Product of the planet earth in less than a decade.

Perhaps the most dangerous part of our financial system is that consumers, businesses and even banks have become addict to debt financing.

We are seeing the lending and borrowing of massive amounts of money at fixed interests. Banks borrow from the Federal Reserve at prime then lend at prime plus a premium. Their goal is to loan out as much as possible. They can protect themselves with FreddieMac and credit default swaps.

Looking beyond the moral hazard arguments, what we have at the moment is a financial system flush with financial instruments set on finding guaranteed fixed rates of return on an extremely large amount of money for a preferred class of investors.

I've heard some people refer to this process of manipulating the system to give a class of investors a large fixed income as rent seeking.

When one look at this mess from a macro level, one realizes that, from the very start, the idea is untenable. The world economy does not grow at a fixed rate. Prices continually fluctuate. The economy does not grow at fixed rates, but tends to skip around.

I suspect that the proponents of the financial regime believed that they were creating a self regulating financial system. What they did in actuality is to create a brittle market with systemic flaws and deep inequities.

The hue and cry at the moment (especially from the financial sector itself) is that the system requires stricter government regulation.

However, before imposing any new regulations, I believe we should engage in a much deeper conversation about what the market is and what we want to achieve with the market.

In watching the financial meltdown, I've come to believe that the primary fault in our financial system is that the system is being driven by a desire of the financial system to give a class of investors a high guaranteed rate of income (rent seeking).

This fault exists regardless of the aggressiveness of government regulators.

Designing regulations and corporate bailouts to preserve the current financial regime might simply have the effect of institutionalizing the systemic faults in the system.

I believe that the better path is to rethink the market from scratch and to find ways to wean ourselves away from debt financing. Rather than seeking new regulations for hedge funds and credit default swaps. I believe that the wise path may be to eliminate these tools altogether.

After all, both hedge funds and credit default swaps exist solely to give one class of investors advantage over the market at large.

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