Tuesday, January 20, 2009

The Hope For A New Financial Order

On this day that Barack Obama is inaugurated, I would like to talk about the need for big ideas for the world’s financial future. As the U.S. and the world is in a state of hope for a better future, now is the time to think big, and to think fundamentally about how we can move forward. What we need is a truly global effort to change our financial system for a sustainable future.

The financial crisis is getting worse every day, and there are some very good reasons for this. As a result of the developments of the last 20-30 years, the world’s financial state is worse than most people realize. I usually don’t list a heap of numbers on this blog, but this time, a bit of a reality check is called for. The current crisis actually has a pretty straight-forward cause, which is a rather simple question of plus and minus. Consider the following facts:

The GDP for the entire world in 2007 was around $54 Trillion.

The outstanding value of financial derivatives is currently over $200 Trillion

At least $100 Trillion of these financial derivatives are estimated to be so-called toxic assets, by several independent estimates. In essence, these assets are worthless, but someone has to take the hit…

So there is a slightly delicate question of $50 Trillion that needs to be resolved. I recently had a conversation with a plumber about the economic crisis. He was, understandably, confused about the crisis. He couldn’t understand how there could be more debts than there was money in the world. Though he was more familiar with plumbing than the world of high finance, his reasoning about the economy was positively more profound than that of any Wall Street trader.

The answer to the plumber’s question has to do with what is known as credit expansion. In essence, when speculators borrow money to bet on all sorts of different things, a bubble is created that will make it seem as if there is more money than there actually is. A speculator can hence own lots of “fantasy money”. However, the catch is that, if things go bad as they have now, the speculator cannot pay his debts back with fantasy money; he has to pay them back with real money (because the fantasy money is now worthless). Since there is considerably less real money than there is fantasy money, something’s got to give. That is why Lehman Brothers, Bear Sterns and all the other institutional speculators no longer exist, and that is why we are in a global financial crisis right now.

So, how do we deal with this problem? In society there are many rules. If rules were gotten rid of, does anyone really believe that everyone would behave responsibly anyway? If we took down all the road signs and got rid of all the traffic rules, would everyone drive safely down the road at an appropriate speed? I don’t think so, and the same is true for high finance.

Commerce is truly global again today, which it was not 30 years ago, and hence the same regulations as those that were gotten rid of in the 1980:s (which led to the crisis) cannot be applied today. The new legislation doesn’t necessarily need to be more draconian, but it needs to be comprehensive, simple, uniform as well as prohibitive.

I think it’s time for the U.N. to get involved in financial regulation. We need an International Treaty of World Commerce. We need clear and well thought out rules that will prevent a global meltdown like the one that we are seeing today. Here are some suggestions of what should be included in an International Treaty on World Commerce:

Prohibition on overly leveraged speculation - in other words, a prohibition on borrowing 20-30 times more than you own, in order to make financial bets. Leveraged speculation is what leads to credit expansion and asset bubbles, the cause of this crisis. In many countries, it is illegal to buy lottery tickets or place bets with a credit card (borrowed money). This law would be in the same spirit.

Tax on stock market investments - this would discourage small-scale investing by vulnerable individuals and also breed prudent investment strategies among institutions. Less volatility and less vulnerability would be the outcome. The tax money could go to a reserve fund of the IMF to fight economic crises wherever they occur.

Uniform accounting standards - these standards would be constructed so that hiding assets away from, or within a corporation’s balance sheet, would be next to impossible. The tactic of hiding bad assets or large liabilities, pioneered by Enron and perfected on Wall Street, is also an important cause of the crisis.

Prohibition on complicated derivatives - most financial derivatives were intentionally constructed in such a complicated way that the buyers were not meant to be able to understand what was in them or how they worked. The food industry could serve as inspiration for more transparency, and any financial product would have to have a strict declaration of its “ingredients” as well as the exact plan for growth and how that makes sense.

There are many more things that could be added. Readers are encouraged to add their own suggestions in the comment section.


Anonymous said...

You have essentially made the case for the scraping of 99% of MBA programs in America, especially Harvard's program.

These people are not engineers. They are being taught to produce nothing and sell nothing and it's like a mass whodini act.

Thank you for helping me understand that economics, at it's base is very simple:

You need to make something that people need and you then you need to sell it. that is economics in a nutshell. Why don't people like krugman get it?

Jacob said...

Business schools should be teaching business ADMINISTRATION, which is the A in MBA. So, you're right; administration is different from production, especially when that production is a whole lot of nothing (which can nevertheless become a whole lot of losses...)

A lot of the losses today stem from the theory by two Nobel Prize winners (now bankrupt) about so-called "quants". This is essentially an analysis of what happened to stocks in the past, in order to find out what will happen to them in the future. The first problem is that they only went back 5 years, and the second problem is that it wouldn't have worked even if they had gone back 100 years.

The prize winners' hedge fund, Long Term Capital Management, was the first victim of these toxic assets that everyone owns today, back in 2000.

Quants could potentially be used in the field of economic history if data is missing in a historical series, but should not be used for much more.

Anonymous said...

I'm waiting for an article from you on Britain's collapsing economy: Read below


With the rising use of technology, administrative work is soon going to become obsolete. I'm seeing it every day at work.

you cannot study "business" in a school setting and remain honest. If MBA programs were honest, they'd would have to boil down business education to a 5 minute course.

business - One makes something people need and one sells it.

As people begin to realize this phenomenon, investment banking will become obsolete.

Jacob said...

Good idea, it shall be done