SO WHAT CAUSED THE FINANCIAL CRISES? – Listen to what the gray-haired man in the tweed jacket at the bar had to say!

By KWAME MARFO

Because smart guys had started working on Wall Street”. This was the cause, according to the well-preserved, gray-haired man of retirement age in a conversation with New York Times columnist, Calvin Trillin at a Manhattan bar (see article here). While his explanation may lack the nous, intellectual heft and sophistication expressed in other quarters, it is perhaps the most compelling explanation I have found thus far.

Precisely, how did smart people cause the crises? According to the gray-haired man, as recent as the 50s and 60s, those in the lower third of his class were the ones that went to Wall Street. The smarter ones went into disciplines such as the judiciary and academia. Then things began to change in the 70s when smart kids began to descend en masse into finance. There was a confluence of two factors – college education became increasingly expensive and Wall Street, more lucrative, hence the lure of working in this sector. Those who went in earlier in the 50s and 60s (the ones without the foggiest idea of what complex financial products such as credit default swap was) soon began to run these firms, managing products that were created by their younger and often smarter colleagues. Against this backdrop, it is not hard to see why the financial system unraveled under the weight of these complex securities.

Where the gray-haired man’s explanation leaves room for perhaps a deeper analysis is how financial services became so profitable. For this, we ought to look back at geo-political trends of the 1970s and the collapse of the gold standard currency regime. Under the old gold standard, economic agents (you and myself included) did not have to worry about foreign exchange risk (volatility in currency) since exchange rates were fixed. Central banks (and by default, governments) housed these risks. In cases, where governments run loose monetary policies (viz a viz their trading partners) and generated inflationary pressures, they were almost literally compelled to “ship” gold to the coffers of the central governments of their trading partners to bring their currency back to a state of equilibrium (it was obviously a little more complicated than that). Buying gold, as you would expect, costs money. Since a country with loose monetary policies had to cough up more money to buy an equivalent amount of gold on the market due to the diminished purchasing power of its currency, as a result of inflation, this system acted as a check on countries and incentivized them to bring their financial houses in order. So when US president, Richard Nixon unilaterally opted out of the discipline of the gold standard, it had global ramifications due to the US dollar’s role as the world’s reserve currency. Managing exchange rate risk which was a responsibility of the central government was effectively privatized; outsourced to the private sector.

Policy makers acted prudently to remove barriers from financial markets to allow the private sector, championed by banks – to diversify some of these risks.  As you would expect, too much of every good thing often can turn hazardous. Egged on by a combination of fierce lobbying by now incredibly profitable banks, genuinely blind but misplaced faith in self regulating markets and a cacophony of policy blunders, politicians across the Atlantic were, at this point, falling over themselves to see who could deregulate markets even further, creating ever increasing avenues for profit making in the financial sector. Access to more markets, ably aided by technological advancements led to an increase in cross-border financial transactions. Financial players (banks, insurance, etc) now had access as never before to previously closed foreign markets. This increased supply in money led to massive reduction in the cost of capital (law of supply and demand) (see chart i).

The consequences of these dynamics was an incredibly prosperous financial sector, whose actors generously rewarded themselves, attracting an ever increasing legion of the brightest business and law students and increasingly mathematicians, physicists and rocket scientists alike. (see chart ii).

This system will be tolerable if we had assurance that the smart guys had a firmer grip of their actions. Unfortunately, evidence points to the contrary. Look no further than Fabrice Toure (who affectionately called himself Fabulous Fab), the man at the center of the US Justice Department’s inquiry into Goldman Sachs, who stands accused of having knowingly sold to presumably sophisticated yet clueless clients, the financial equivalent of ‘lemons’ – the most toxic products, hand-picked and pooled from the least credit worthy customers and designed specifically to fail. In an email to his girlfriend that was subpoenaed by the US congress, he admitted “the whole building is about to collapse anytime now… Only potential survivor, the fabulous Fab… standing in the middle of all these complex, highly leveraged exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!

That is why the debate about financial reform does not go far enough. While enhanced regulation and prudent reforms such as increasing liquidity and capital standards go a long way to making the financial system safer, it potentially misses the elephant in the room – excessive compensation schemes. One thing we know about the tools that are being put in place is they will, in a way, reduce bank profit. Banks will respond with one of two things; i) find ways to circumvent the rules (i.e. take even more risk) to make more profit and thus maintain high remuneration packages, with the knowledge that their downside risks are protected by implicit and explicit tax payer support ii) shift   activities into the shadow banking sector – the unregulated maze of interconnected web of state and non state financial actors – which by most estimates is now bigger than the more regulated formalized banking sector. Critics who argue against reining in compensation levels argue that it interferes with market fundamentals. This is disingenuous, to say the least, for the simple reason that big banks are effectively big government schemes whose profits are subsidized by taxpayers and are not governed by market forces – hence their “too big to fail” tag. Besides, curbing remuneration will go a long way to correcting the distortions in the labor market where our best and brightest math PhD students and engineers are drawn to Wall Street and the City of London to build yet again more financial models with suspect social value when they should be building bridges and solar powered aircrafts.

Copyright 2011 (April) Neo-African Consensus

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One Response to SO WHAT CAUSED THE FINANCIAL CRISES? – Listen to what the gray-haired man in the tweed jacket at the bar had to say!

  1. Jimmy says:

    Great article, Kwame. Very thought-provoking…

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