Adam Smith and the financial crisis
Posted by Dave Bath on 2008-03-20
The 2008-03-19 article "Wall Street Crisis" in The Economist says it clearly:
the world needs new ways of thinking about finance and the risks it entails.
In many respects, The Economist is maintaining Adam Smith’s love of free trade and disgust at way managers/directors avoid responsibility, and thus ruin the wealth of worlds. In the op cit, under the delightful subheading "Gordian conduits", the own-petard hoisting by an out-of-balance free market, is put plain:
The financial system, or a big part of it, began to lose touch with its purpose: to write, manage and trade claims on future cashflows for the rest of the economy. It increasingly became a game for fees and speculation, and a favourite move was to beat the regulator. Hence the billions of dollars sheltered off balance sheets in SIVs and conduits. Thanks to what, in hindsight, has proven disastrously lax regulation, banks did not then have to lay aside capital in case something went wrong. Hence, too, the trick of packaging securities as AAA—and finding a friendly rating agency to give you the nod.
Such observations are entirely consistent with Adam Smith’s distaste for the managerial classes, who mention An Inquiry into the Nature and Causes of the Wealth of Nations (1776), Smith comments on these managers and directors:
…being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. … Negligence and profusion, therefore, must prevail, more or less, in the management of the affairs of such a company.
Or, I’d add, such an economy, that cossets such brigands. Every time a central bank issues an "ego te absolvo", the mismanagers are free, indeed encouraged, to sin again, confident in their comfortable future regardless of their continued screwups.
But then, the financiers treat their opinions as holy writ, and so often with other religions, enrich themselves, going against the intent, and ignoring the details in the words of their prophet.
Capitalism is in a similar state to the church before Luther. Financial inventiveness counts angels dancing on the heads of pins, or AAA ratings on top of dodgy debt. Yet central banks offer indulgences, although without the charges imposed by the church of yesterday. Governments and central banks don’t even bother raising the possibility of imposing better regulations, the equivalent of "Go and sin no more".
It’s time to send these financiers to hell for their sins, or at least purgatory.
- "Capitalism dies of derivatoma" (2007-12-19)
- Update: Will hedge funds go down next? from The Economist "Free Exchange" that discusses (but doesn’t completely agree with Martin Wolf at the Financial Times (2008-03-18) who
thinks investing in hedge funds will soon be as popular as buying sub prime debt. I (the writer at "The Economist") agree many funds are on the chopping block. But I am not convinced the complete collapse of the hedge fund industry is inevitable or upon us.
Mr Wolf claims there are so many
bad unscrupulouslucky hedge fund managers the industry has become a market for lemons. Investors will soon realise bad ones exist, but won’t be able to spot them. They will internalise the potential downside from a bad manager and refuse to pay the high fees. Without the fees the good managers will leave the market for a better opportunity and only bad managers will remain. People will realise this and not want to invest in funds at all.
Martin Wolf’s original article includes the question
Are hedge fund managers no better than used car dealers?
These collapses are inherent in the hedge-fund model
- "Monetary policy, market excesses and financial turmoil" from OECD Economics Dept via Australian Policy Online (2008-03-25)
This paper argues that low interest rates over the period 2002-05, in combination with rapid financial market innovation, would seem to have been among the factors behind the run-up in asset prices and consequent financial imbalances that helped trigger the 2007 financial market turmoil.