What just happened?

December 6, 2008

An editted version of this article appeared in the December issue of Boss magazine:

What Just Happened?

Accept, for arguments sake, that the Global Financial Crisis is an epoch-shifting event.

Ignore the view that it is just the latest in a long line of economic crises – according to one recent study, it is the 149th crisis in which a country’s GDP plummeted by 10% or more since 1870 – that will continue, and are, in fact, integral to the progress of capitalism. Ignore the fact that two-third of recessions in the last hundred and fifty years have lasted less than 1 year.

Don’t compare it to the events of the last decade or so, the Asian financial crisis, LTCM, the Russian default, the bursting of the dotcom bubble, Argentina, 911, all of which were seen as huge epoch-changing shifts in global capitalism at the time, all of which have faded from memory much faster than anticipated.

Accept, instead, that this is a huge dislocation, an earthquake that has cracked the landscape apart so the freeway of progress must take a different route. Imagine that the wholesale socialisation of finance across the US and Europe will be more than a short-term detour, but a more permanent redirection. Accept that the financial markets will be utterly transformed, that trust between counterparties will need to be rebuilt using new and yet-to-be-invented structures, that the way we do business in the future will be different to that of the past.

If that’s the case, and there is no saying it isn’t, what ideas will we be using to build the new world, and who are their most articulate proponents in the English-speaking world today?

Over the last three months, column inches devoted to analysis of what happened and where to now would reach the moon and back. But through all this, several strands of thought have emerged as having strong explanatory power and providing ideas for leaders concerned with both risk management and regulation.

Clever sentimentalists

There are two things you need to remember about the financial markets. The first is that the markets are made up of very sharp and sophisticated people, our greatest minds. The second is that markets are driven by sentiment.
- John Bird, of comedy duo Bird & Fortune

If you are still unclear about how the financial markets could have got themselves into such a mess, watch this. This classic exposition by two avuncular British comedians, broadcast over a year ago, explains the growth and sudden pop of the finance balloon clearly and hilariously by pointing out two interconnected facts about the capital markets.

On the one hand, cutting edge finance is disproportionately populated by intelligent people with powerful tools. They are good at growing their business. On the other hand, they are just people.

Rational self interest
In 2007, finance took up four times the proportion of the US economy than it did in the 1960s (up from 10% to 40%), but doesn’t actually produce anything. In The Ascent of Money, a timely exposition of the rise, and now crash, of finance Harvard economic historian Niall Ferguson puts it this way: “In 2006, the measured economic output of the entire world was around US$47 trillion. The total market capitalisation of the world’s stock markets was $51 trillion, 10 percent larger. The total value of domestic and international bonds was $68 trillion, 50 percent larger. The amount of derivatives outstanding was $473 trillion, more than ten times larger. Planet Finance is beginning to dwarf Planet Earth.”

The rise and rise of Planet Finance is in great part due to the capability of those who work in the financial markets in looking out for their own interests. According to Dr Paul Woolley, it is this “agency problem” that has been a major driver of finance’s growth, as well as its subsequent collapse.

A former fund manager and IMF economist, Woolley has funded two institutes for the study of financial market dysfunctionality at the London School of Economics and the University of Toulouse. Researchers will be focussing on the fact that those who work in the markets know more about what they are selling than those who do not. Woolley says this issue causes misallocation of capital on a massive scale and a disproportionate grab on the gains of growth by financial intermediaries.

These intermediaries include corporate executives, who, according to Standard & Poor’s in the US claimed stock option based remuneration in 2002 equivalent to 20 percent of reported profits. They also include investment bankers, fund managers, trading commissions, fees and the rest. According to Woolley, by the time the money gets to your super account, returns have shrunk to less than 1%, and financial intermediaries have managed to get their hands on between 40 and 80% of the returns that should have been the shareholders.

It is no surprise then that politicians are looking at ways to reign in this excess, from Kevin Rudd’s bold pronouncements on executive remuneration to the wholesale reregulation of banking across the globe.
All is not lost for the free marketeers, however. Bill Emmott, former Editor of The Economist, believes the swing towards state intervention has been overblown, if only because the cost of intervening in the financial markets has been so high that Governments won’t be able to extend themselves any further. He points to the Japan experience – when Japan’s property bubble burst in 1989, the collapse of its banking system was so expensive to fix that the Japanese government had to become proportionally smaller. The great deleveraging now underway may do a great deal more than governments can to shrink the size of Planet Finance.

Irrational self interest
The growth of Planet Finance might be less of a worry (and there would certainly be less schadenfreude directed at newly-unemployed investment bankers) if its rise had corresponded with smooth gently upwards growth, if in fact, more people making more decisions about price and value led to better overall calculation of risk, capital allocation and a tempering of speculative excesses, if, in other words, markets were efficient.
But if 2008 provided clear evidence that this is not the case, that large numbers of people can make really bad decisions as easily as good ones.

In recent years, many influential thinkers have put forward theories as to why the financial markets don’t work quite as they are supposed to. Billionaire George Soros puts much of it down to reflexivity – the idea that markets react to what has happened in the markets themselves, rather than to any underlying analysis of value.

Joseph Stiglitz won the Nobel prize in part for showing that, with plenty of others doing the work, investment practitioners have little incentive to actually do any original research themselves, relying on the wisdom, or madness of others. In the business, its known as momentum investing. Kahneman and Tversky, a psychologist and an economist, won the Nobel prize for showing that people have a lopsided and perverse approach to risk-taking: we are risk averse for positive prospects, but risk seeking for negative ones.
As John Bird put it, markets are driven by sentiment. Planet Finance, in other words, is populated by human beings, all of whom have their well-documented quirks which distinguish real human beings from the Dr Spocks of classical economics.

In recent years researchers have shown that people have numerous biases in the way they think about the future. We base decisions on facts we remember or data that is close to hand, rather than information that might actually have a bearing on the issue. We look back and think events were predictable, when really, they were not. We look around for confirmation of our biases, accept confirming data and reject things which speak against our prejudices. As humans we are subject to a host of fallacies, heuristic biases, overconfidence issues and logical missteps. All of these speak against the base assumption that drives the capital markets: that the aggregate decisions of a large number of people are a more or less accurate indicator of value.

Economists such as Pete Lunn, author of Basic Instinct: Human Nature and the New Economics (Marshall Cavendish, 2008) thinks that issues such as these undermine the very assumptions on which economics, and thus everything from regulation performance management is based. “Orthodox economic models are not wrong, as such,” he says, “but rather sloppy, biased approximations of how our economy works. They present a cartoon characterisation of economic life, greatly exaggerating one side of our nature at the expense of others.”

But modelling and regulating a world based on an assumption of rational self interest is challenging enough, modelling it on irrational quirks may be nigh on impossible. Add to that the fact that those irrational, quirky beings live in a world that is inherently uncertain, and it is a wonder that regulators and risk managers don’t just give up and go home.

The world of Black Swans
Australia’s highest profile claim to fame during the current financial crisis may be the contribution of the black swan. Not the theory of black swans made so famous by Nassim Taleb in his recent bestseller The Black Swan: The Impact of the Highly Improbable, but the actual black swan. Before Australia was discovered, western philosophers had only ever seen white swans, the kind that live in the northern hemisphere. It was beyond the realm of probability that black swans existed, because noone had ever seen one, a bit like a unicorn. When Australia was discovered, and black swans were seen flying about, that idea went out the window – black swans are now part of reality.

Noone could argue that a financial crisis, of one sort or another, was unforeseeable. Many did foresee it. It is the precise circumstances, the chain of events, and the implications and severity of those events – the all important details – that are the black swans. The assassination of Archduke Ferdinand was an unlikely event to cause a world war, but it did. The housing boom of the early twenty-first century was an unlikely trigger for the collapse of capitalism as we know it, but it was.

In this view, the tools that we use to predict the future, from weather models to revenue forecasts to capital markets trading systems are inadequate, because they are unable to take into account what their creators never imagined. But the unimaginable happens far more often than we give it credit for.

Our propensity to rely on yesterday as a predictor for tomorrow is built into just about every form of analysis western business uses every day.

Corporate quarterly profit forecasts, banks daily value-at-risk models, insurers earthquake and hurricane models, strategic plans and budgets, performance and remuneration systems, whether or not tomorrow will be a good day for a picnic, each of these uses techniques developed to extrapolate the future from the past. But what if the future is much less predictable than the depth of faith we have in these techniques will allow? This is Taleb’s Ludic fallacy, or “the misuse of games to model real-life situations”.

Still, statistically, the best predictor of tomorrow’s weather is today’s. It may be that the only tool we have is the rear view mirror, and all we can do is invent innovative ways of using it.

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