In part 2, I try without using mathematics to explain some of the fundamental problems with how the very financial tools used by financial markets underestimate risk. I also ask the question do we live in a free market economy?
Economics as a discipline was very diverse in the 1920 and 1930’s with many schools of thought and various frameworks for looking at how the economy worked. The field was also grounded in the notion that it was in-exact and was dealing with the vagaries of human herding instincts.
Economics after WWII underwent a focus on mathematical modeling. Effectively trying to use Physics as its founding paradigm the core assumptions became that the economy could be precisely studied as if it were a machine. To make the math more consistent the assumption of stability is central to all mathematical modeling in economics and finance. The primary models focused on “equilibrium states” so the profession assumes that entire economies and their components tend to be stable, or are systems that tend towards a stable state (ie: equilibrium).
Ideologically this results in the notion that government intervention is not needed as markets and economies tend to stability. Given the scope and pervasiveness of the use of government subsidies by business, the historic distinction between private companies and the state has broken down. The very definitions of free markets become ambiguous, as the Economics profession has not evolved a terminology to accurately describe the way the US and other developed economies are structured. This becomes very obvious when one looks at the financial bail-outs in the US.
The tendency towards Equilibrium really breaks down in financial markets – especially credit markets. These markets tend to boom and bust cycles- so they don’t operate in ways that can be defined in terms of equilibrium conditions. In strict mathematical terms Financial markets do not tend to equilibrium, and this is one of the key causes of the current financial crisis.
All mainstream financial models have assumptions in them that understate risk (this makes the math easy). So if you use the well-established models in managing financial risk you end up taking more risk than what the models specify. If you also assume a tendency towards equilibrium, then this further aggravates the problem.
In the last 20 years, technological advances have enabled the development of complex trading systems that effectively operationalize financial models and make decisions based on them. The development of high frequency trading has also fundamentally changed the nature of financial markets. Coupled to this is the massive derivatives overhang and it becomes difficult to call financial markets anything but casino’s as they do not perform any of the functions of financial markets other than speculation. So at many levels the profession of Economics and Finance has not really dealt with the reality of how Financial markets work, it has simply imposed an idealized set of mathematical simplification, which operates on assumptions that are clearly inaccurate.
This fact makes the debate on what to do about the current crises mired in obsolete ideology. The large wall street banks do not operate in a free market, due to the high barriers to entry required of any firm wanting to compete with them. They also effectively enjoy privileged access to capital (Again contravening free market principles). Although all financial institutions operate in a regulatory framework, the large US banks are clearly no longer constrained by market consequences.
In the overall economy through the developed world we find very few sectors in true free market competition. Yes there are portions of the economy that operate in market based competition, yet these are few and far between. Organizations that look and operate with all the trappings of Corporations exist, but just because they have boards and shareholders does not mean that they are market based institutions. The economies of the developed world are dominated by large corporations, who increasingly derive competitive advantage from government support in some way (either in research and development credits, subsidies or in tax incentives).
In 2007 $750 Trillion in derivatives were overhanging a global GDP of $50 Trillion.
What this means is that the risks created by the financial overhang of derivatives can overwhelm the real economy it is supposed to support!
Mathematically when capital markets become more like casino’s they become in-efficient at their primary function which is to allocate capital and distribute risk. At some point the question will have to be posed, do these markets merely serve the purpose of wealth extraction from the real economy?
Let us look closely at the bailouts involving sub-prime loans:
For every Triple B sub-prime bond you had 10 times the value in derivatives overhanging them (either hedging or involved in some form of side bet). That is what caused the crisis--the leverage of all of the instruments on top of the Sub prime bonds.
Their were two $750 Billion bailouts, one by Hank Paulson in 2007 and one by President Obama. This should have been enough, had the sub-prime bonds been the only problem. But what the media did not discuss, was that surrounding these sub-prime bonds were significant derivative hedges whose value was difficult to estimate.
At least another 5 to 15 Trillion in derivatives that still has to be worked through.
To be fair to the financial institutions involved:
It is difficult for many of the institutions to put accurate values on their exposures.
There is a lot of double counting; exposures are often hedged multiple times. As these markets were not regulated there was no central reporting mechanism. So there is no methodology to determine the full extent of the risks. This is why AIG and Bear Stearns were quickly bailed out as no-one new the full extent of the consequences of letting them fail.
Essentially if these companies were on one side of a hedge, and they failed then the aggregate exposure would have been considerable as there is no way for the counterparties to be hedged.
The banks are now so well entrenched in the regulatory process, that there is no way to make them accountable, and no way to recover the monies given to them. So effectively the wall street banks are not really private sector companies, but rather highly subsidized corporations that should not have survived if they existed in a free market. Ideologically this makes the whole debate rather difficult because Economics and Finance revolves around the core assumption that Free markets work.
Well free markets do work, but we do not live in a free market economy, because we have a central bank, and all of the distortions that this brings.
In part 3, I will look at Central Banks and the structure of the Global Banking system.
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