December 31, 2011

Causes of GFC-1 - the death of the partner

In a short cycle on banking(I, II, III, IV), I point the crooked finger of blame for the first great financial crisis at securitization, as the contractual and markets innovation that gave the USA property bubble the legs to consume society. Now, it seems that I'm just one guy, and everyone has their favourite theory, leading to a fairly long list of hopeful causes. By way of example, Roger Garrison crooks the Austrian finger unwaveringly at central banking:

As my colleague Leland Yeager puts it, "Each cyclical episode is a unique historical event." True enough, but my attention to the central bank as turbocharger helps to keep separate the particulars and the commonalities of the different cyclical episodes.

True enough, although I think it will take a decade or two before the economists sort through the contenders and come to consensus. Garrison wrote the above in a review of a new book from Kevin Dowd and Martin Hutchinson, Alchemists of Loss: How Modern Finance and Government Regulation Crashed the Financial System, which claims to be a comprehensive treatment of the many causes. Here's one that was new to me:

As Dowd and Hutchinson make clear, the redistribution of wealth and income away from business and industrial families meant the demise of the "old partnerships" and the rise of "managerial capitalism." It meant the separation of ownership and control. In an earlier time and without the limited liability that virtually defines the modern corporation, the owners of large-scale industrial and business concerns had plenty of "skin in the game." They had a strong incentive to watch the bottom line, all things considered, and they were in it for the long run. Individual businesses, both large and small, could rise and fall with changing circumstances, but for the economy as a whole the underlying concern for preserving capital value over the long run translated into a degree of macroeconomic stability. Precisely this critical source of stability has been continuously eroded over the years by the federal tax code and regulatory schemes.

So with the atrophy of the partnership form of business enterprises, the incentives to maintain long-run profitability have been continuously weakened. It follows, almost as a corollary, that the window for exploiting short-run profit opportunities at the expense of long-run viability has been continuously widened. Managerial capitalism has given rise to a whole class of traders in securities markets and especially in derivatives markets who get in and out of markets in pursuit of short-run gains. The opportunity for these cumulative short-run gains would not have been available (or would have been available on a much smaller scale) had it not been for the absence of "old partnerships" whose vigilance and long-run perspective would have provided an effective counterbalance.

This aspect of Dowd and Hutchinson's storyline rings true. ...

My Audit cycle (I, II, III, IV, V, VI, VII) hints at the very same effect, as the entire Audit industry moved from meticulous to loss-leader in the same 2 decades that mirrored the death of the partnership model. Further, as Professor Dowd's long and prolific career in Free Banking will testify, the disappearance of robust long-term retail banking and the rise of central banking is inherently tied up with the end of partnership banking (c.f., White's Free Banking in Britain).

Why did we as society replace the owner-manager with the salaried managerial trader?

Dowd and Hutchinson date the origins of modern finance to a theorem that Franco Modigliani and Merton Miller introduced in 1958, demonstrating the underlying equivalence of debt financing and equity financing, and to Harry Markowitz's ground-breaking work (a 1952 University of Chicago Ph.D. dissertation) that formalized the relationship between risk and rate of return. Modern financial theory became operational during the 1960s in the form of the Capital Asset Pricing Model (CAPM) and allowed for significant leveraging in the 1970s after Fischer Black and Myron Scholes extended the approach to the pricing of options. Still later developments in information technology and the strategic placement of computer hardware gave rise to flash trading, putting CAPM-based trading strategies on steroids.

Outside the context of booms and busts, modern financial theory can be the basis for an overall gain to society. Apart from flash trading, which appears to have no socially redeeming features, trading on the basis of a comprehensive assessment of alternative investment portfolios allows the risks that are inherent in a market economy to be borne by those who are most willing to bear them. A risk/rate-of-return assessment more generally can help tailor an investment portfolio to an individual's risk preferences. The problem, as Dowd and Hutchinson point out, is that the risks that the CAPM takes into account do not include systemic risks. The risk metric that was widely adopted in the 1990s, called "Value-at-Risk" (VaR), quantifies the riskiness of a particular portfolio - on the assumption that the market as a whole is stable. With this metric, you may assure yourself, for example, that you have a 95 percent chance that this portfolio will suffer no greater one-day loss than the calculated VaR (Dowd and Hutchinson 2010, 113). But what if the market as a whole is not stable? And what if the use of the CAPM, the reliance on the VaR, and the proliferation of derivatives serve to leverage both short-run profits and the market's instability?

Boom! Cycle back into the volatility & ignorance theory of financial markets, and we seem to be taking our first steps towards understanding where we are today. To summarise, the elimination of the partnership allowed short-termism to dominate in the modern bonus-fuelled trading enterprises, and it was precisely this worldview that supported the rise of VaRism. Or, systemic risk ain't my problem, boss, now about that bonus...

That's a hell of a contribution. Still, it's early days yet, and to be fair, reviewer Garrison reminds us:

The dot-com crisis of the 1990s occurred because a credit expansion took place during a time when technological innovations associated with the digital revolutions created a strong demand for investment funds in that sector. The housing crisis in 2008 occurred because a credit expansion took place during a time when the federal government was pushing hard for increased home ownership for low-income families. We understandably identify these different cyclical episodes (the dot-com crisis, the housing crisis) with "what was going on at the time." The common denominator, however, is the Fed's propensity to expand credit.

At this point, we might ask, "Will the real Alchemist please stand up?"

Which brings us full circle: Systemic Risk is the central bank's problem! So where were the central banks when the partners were selling out of the investment banks and the VaRists were running rampant on bonus steroids? They were pumping up the machine in mini-crisis after mini-crisis, so setting the stage for the mother of all systemic collapses.

From an academic point of view, this is a lot of fun! Aside from the fact that we're so deep in it we can only poke our nose above the smelly brown stuff, I would suggest the next 20 years will be a grand time to be an economist.

Posted by iang at December 31, 2011 06:15 AM | TrackBack
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