Friday, March 27, 2009

Financial Creativity

In his press conference Tuesday President Obama made reference to his dislike of the part of our economy where “AIG sells a derivative and it is considered part of GDP” or words to that effect. He contradicts that at other times by saying repeatedly that “we don’t want to stifle the creativity of our financial industry.”

I would suggest that we not only want to stifle that creativity, we want to extinguish it, and Paul Krugman wrote an editorial in the New York Times yesterday which rather supports my contention. I’ll leave you to read what he says, but he winds it up with,
As you can guess, I don’t share that vision. I don’t think this is just a financial panic; I believe that it represents the failure of a whole model of banking, of an overgrown financial sector that did more harm than good. I don’t think the Obama administration can bring securitization back to life, and I don’t believe it should try.

And what is this “securitization” to which he refers? It is, in my perception, a layer of fiction laid on top of the financial system that we once knew as capitalism, placed there by the financial industry which it has enriched, purely for the purpose of that enrichment.

At the foundation of our economy is the production of goods and the provision of services. To facilitate those things on a larger scale we formed companies, groups of people, to perform those functions on a cooperative basis. To participate in the ownership of one of those companies one gives it money and receives part ownership in return, sharing the risk of failure and participating in the gain achieved by that company. If a person decides not to keep that ownership he can sell it back to the company, or he can sell it to another party, who then becomes the part owner in that person’s place. The stock market facilitates that process. That is the basis of capitalism and it is solid and sustainable and, as Paul Krugman points out, boring. It worked very well for centuries.

Then someone decided that, while he liked the potential gain of owning stock, he didn’t like the risk. He agreed with another party to insure him against his stock declining in value so that he could participate in gains by the company of which he was part owner, but not fear any losses due to that ownership. That put a layer of financial transaction on top of the existing framework, and it opened the financial system to manipulation, distortion, deception and fraud.

Other “inventions” came along one after another. The owner of the stock could borrow money based on the fact that he owned that stock. Then he could borrow based on the insurance that he had on the ownership of that stock. Then his debt could be sold to another party as if it were an asset. The more “creative” these financial instruments became the more they became vulnerable to manipulation, distortion and outright fraud. It is notable that, six months into the financial crisis, we are still trying to calculate just what is the financial standing of the banks and financial houses which are involved in it.

To the Administration’s credit it is pressing hard for reregulation, although the nature to the proposed rules is very murky at this point. But I would suggest that a mere set of new rules falls far short of what is needed.

First, the whole “creative” layer needs to be eradicated to the greatest possible degree. Our economy needs to be brought as close as it can be to the production of goods, provision of services, the unleveraged sale and purchases of stock, the insurance of individuals, investments which serve as savings, demand deposit functionality and nothing else.

Second, the “big banks” need to be broken up as to both size and function. The business of financial investment, acceptance of demand deposit, and issuance of insurance need to be isolated into separate companies with no common interests of any description. No banking, investment or insurance operation should be allowed to exist, or have ties to any other operation with existence in, any more than six states. Economy of scale is very real, but you cannot convince me that beyond a six-state scope of operation the economy of scale produces sufficient savings to offset the power of size.

It may not need to be this radical, but I stand by the principle.

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