Financial folly: A (meager) defense of the nationalization of banks.

The famous John Bogle, founder of Vanguard Mutual Fund group, reminds his readers in Enough of an epigram from 18^th century Britain:

Some men wrest a living from nature and with their hands; this is called work.

Some men wrest a living from those who rest a living from nature and with their hands; this is called trade.

Some men wrest a living from those who wrest a living from those who rest a living from nature and with their hands; this is called finance.

Of course some people have always been skeptical of the real value finance holds. Tim O’Reilly, who, while being a very smart guy, is certainly not a finance guy, and about a month ago put out an essay on his blog likening our global economy to a Ponzi scheme in itself. Tim cites former World Bank economist Herman Daly, who was griping about the global crisis back in October last year.

As Daly puts it “Real wealth is concrete; financial assets are abstractions—existing real wealth carries a lien on it in the amount of future debt.” And while Daly made this statement to set up an obvious argument about how debt works, this point is illustrative for a different reason – why are financial assets abstractions?

Gao Xiqing, the president of China Investment corporation, a SWF that manages $200billion of China’s foreign assets, and makes the most newsworthy of China’s foreign investments (Blackstone, Morgan Stanley, etc), described financial assets in a recent Atlantic article this way:

First of all, you have this book to sell. [He picks up a leather-bound book.] This is worth something, because of all the labor and so on you put in it. But then someone says, “I don’t have to sell the book itself! I have a mirror, and I can sell the mirror image of the book!” Okay. That’s a stock certificate. And then someone else says, “I have another mirror—I can sell a mirror image of that mirror.” Derivatives. That’s fine too, for a while. Then you have 10,000 mirrors, and the image is almost perfect. People start to believe that these mirrors are almost the real thing. But at some point, the image is interrupted. And all the rest will go.

These assets are nothing more than contracts, and are conceived in acts of financial wizardry as quickly as they can be sold. Daly addresses this point head on:

Can the economy grow fast enough in real terms to redeem the massive increase in debt? In a word, no. As Frederick Soddy (1926 Nobel Laureate chemist and underground economist) pointed out long ago, “you cannot permanently pit an absurd human convention, such as the spontaneous increment of debt [compound interest] against the natural law of the spontaneous decrement of wealth [entropy]”. The population of “negative pigs” (debt) can grow without limit since it is merely a number; the population of “positive pigs” (real wealth) faces severe physical constraints.

Fine. We get it. These things can be dangerous. Dividends in particular are financial weapons of mass destruction, as Buffet put it like a million years ago. But our economy creates a lot of really valuable stuff that only exists as an idea, as bits of information, not in any warehouse. Through an accountant’s eyes, how are derivatives fundamentally different from software, or insurance, or a new drug? Leverage is a complex and value-adding technology; one must know how much of it, of what type, and how and when to re-position it. Our problem with leverage was not that we had too much, but that we didn’t understand it. As entities de-lever, they are returning to positions where they won’t be in as much hot water the next time they get it wrong. This is akin to releasing a drug too soon, and finding out that it has a chance of killing people.

What’s the solution? Well, we can start with improving our financial regulation, which has proven pretty soundly that it is less than useless – it’s dangerous. I don’t have the time in this article to discuss the many things we should probably be doing to fix regulators and rating agencies, but I do want to address one concern: complexity. The GAO (Government Accountability Office) had this to say in a recent report entitled A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System:

As new and increasingly complex financial products have become more common, FASB and SEC have also faced challenges in trying to ensure that accounting and financial reporting requirements appropriately meet the needs of investors and other financial market participants. The development and widespread use of increasingly complex financial products has heightened the importance of having effective accounting and financial reporting requirements that provide interested parties with information that can help them identify and assess risk. As the pace of financial innovation increased in the last 30 years, accounting and financial reporting requirements have also had to keep pace, with 72 percent of the current 163 standards having been issued since 1980—some of which were revisions and amendments to recently established standards, which evidences the challenge of establishing accounting and financial reporting requirements that respond to needs created by financial innovation.

CFO Blog mentioned this report two weeks back (it’s where I found that quote), and elaborated:

Accounting rulemakers have struggled to keep pace with financial innovation… But missing from this statement of the bleeding obvious is the fact that many of the 'financial innovations' in question were innovative because they were slick end-runs around accounting rules. Structured finance, by definition, is some form of leverage whose structure is complex enough that the letter of accounting rules does not apply. Ditto for hybrid securities, intended to win preferential accounting and tax treatment.

What does this issue have to do with nationalizing our banks? Nassim Taleb, recently stated on Charlie Rose that banks should be treated as utilities. The entities that take the real risks, the sophisticated investment vehicles like hedge funds, will still have role, albeit significantly smaller, and under the explicit understanding that they will never be bailed out again. Could this stronger control restrain us from making big bets on complexity that we do not yet understand? Could government oversight allow for economists to have a greater sense of how finance works, and allow for us to design better models for control? Perhaps, although we can probably be just as certain of the inefficiencies and restrained growth that comes with bureaucracies and government oversight.

Should we nationalize banks? Should bank holding companies just be plain-vanilla utilities? I have no idea, but I do know that we don’t seem to understand how the modern capital markets really function. And even if we do, we definitely don’t have the transparency and the appropriate control systems in place to organize this system to our predictions and analysis will be relevant. Would having our government oversee these capital markets help our economists develop the appropriate theories to understand our world? If so, it sure sounds a lot like communism. Not that we’re not pushing that envelope anyway.

Bringing it all back to Tim O’Reilly and Daly’s arguments, they promote a “steady state” economy. With the arguments I have made in this post, I will continue this week to discuss the merits and the issues with a steady state model as I see them.