21st century finance: too complex to exist?

As we push on through the recession, one thing that we haven’t seen enough of is solid original thinking about the causes of the crisis and what can be done to stop such a systemic disaster ever happening again. However Duncan Watts, writing in the Boston Globe, has a bold idea. Not only were banks to big to fail but the system as a whole is simply too complex to exist.

Rather than waiting until the next cascade is imminent, and then following the usual modus operandi of propping up the handful of firms that seem to pose the greatest threat, it may be time for a new approach: preventing the system from becoming overly complex in the first place.

It’s well known that few in the financial sector (let alone regulators) understood the instruments that were being used. Risk assessors refused to believe that a firm like Lehman Brothers could ever fall so easily and as a result, the consequences of such a collapse were not accounted for in risk models. In an ever more interlinked world, the danger of contagion effects means that everyone has an interest in the way the system works. If only a few people understand it, so much the worse for the rest of us.

An alternate approach is to deal with the problem before crises emerge. On a routine basis, regulators could review the largest and most connected firms in each industry, and ask themselves essentially the same question that crisis situations already force them to answer: “Would the sudden failure of this company generate intolerable knock-on effects for the wider economy?” If the answer is “yes,” the firm could be required to downsize, or shed business lines in an orderly manner until regulators are satisfied that it no longer poses a serious systemic risk. Correspondingly, proposed mergers and acquisitions could be reviewed for their potential to create an entity that could not then be permitted to fail… Perhaps what we need is an “anti-systemic risk” law that would aim to avert systemic risk before it is too late.

Watts concedes that this degree of intervention in the market is concerning, but one thing that everyone seems to agree on is that the era of market fundamentalism is over. If we’re willing to allow the state to intervene in bailing out failed banks, why not intervene to prevent them becoming unmanageable in the first place? Think of it as bonsai banking. As E.F. Schumacher said, ‘small is beautiful’.

Clarke to Cameron – Get Real

David Cameron thinks an IMF bailout for the UK is on the cards:

If we continue on Labour’s path of fiscal irresponsibility, at some point – and it could be very soon – the money will run out. Then you will see the return of what happened under Labour in the 1970s, including emergency cuts to many of the public services on which a progressive society depends.

Ken Clarke, his new minister, thinks such talk is unrealistic and irresponsible:

ANDREW MARR: So let’s return to the main matter then: the economy. Is it possible that this country would go bankrupt, would actually be back in the 1970s position of having to go cap in hand to the IMF?

KENNETH CLARKE: I don’t think it’s a realistic possibility, though I mean I’m as gloomy as most people. I just think 2009 is going to be a dreadful year. And actually I don’t want it to be. I think it’s very important to realise the constraints of a responsible Opposition.

Personally, I think the chances that the IMF will have any money left to rescue the UK are vanishingly small. Jules has much much more on this…

Get us out of this mess…

I’ve been in Japan today, speaking at ‘Reforming International Institutions – Meeting the Challenges of the 21st Century’,  a seminar organized by the United Nations University and the British Embassy in Japan.

You can download my talk here (with pictures, references etc) – or the text only is available below the jump. There’s a webcast too.


  • It’s going to be a tough year. The financial meltdown has a long way to go, and the downturn is risking turning into a global depression.
  • Trade is a bell wether. Protectionist pressures are already on the rise. If they gain traction, take that as a warning of a wider loss of confidence in global institutions.
  • The unravelling of global economic imbalances could prove corrosive to the international order. If countries start to devalue to protect exports, expect a tit-for-tat dynamic to kick in.
  • Scarcity issues (energy, water, land, food, atmospheric space for emissions) remain the key medium term driver of global change. Commodity prices will spike again as soon as there’s recovery.
  • The downturn has stemmed the uncontrolled growth of emissions, but also lessened the chance of a robust global deal on climate.
  • Economic bad times could well drive increased conflict. A major new security threat might be the fabled black swan – hitting just when the global immune system is already overloaded.
  • If we experience a long crisis (or a chain of interlinked crises), we are likely to see either a significant loss of trust in the system (globalization retreats), or a significant increase in trust (interdependence increases). 
  • You need to stretch time horizons to get the latter – shared awareness (joint analysis of risks and challenges), as a basis for shared platforms (loose coalitions of leaders), which can lobby for a shared operating system (a new international institutional architecture).
  • 2009 sets a challenging agenda for the G20 (financial reform and economic recovery – but framed by a broader vision on climate, resources, security etc.)…
  • …the G8 (caucus of rich countries able to tee up Copenhagen and kick start development assistance if developing countries begin to teeter)…
  • …the UN (especially Ban Ki-Moon’s proposed high level ‘friend’s group’ on climate, but also as a fora for getting to grips with scarcity issues)…
  • and the Bretton Woods institutions and the WTO (first of all ensuring they keep their heads above water, then looking to ‘save globalization from itself’).
  • Oh and be ready for the backlash – people are angry and rightfully so, but that may well lead us down some populist blind alleys.


Markets punish UK for saving markets

It’s been another terrible day for the pound as markets punish the British government for stepping in to prop up… the markets:

Analysts said the [latest bailout]… shone a particularly unflattering light on the state of the British government’s finances as it was forced to take an ever-increasing role in the private sector.

James Hughes at CMC Markets said: “Any support seen through yesterday’s session for sterling is looking to be little more than wishful thinking as currency markets take on board the fact that the UK government is risking looking like a huge bank with some legislative functions attached, as RBS now seems to be teetering on the brink of full nationalisation.”

Credit ratings agencies are also enjoying the party, despite being utterly discredited. When they downgrade the UK’s credit rating, the current devaluation (which has upsides) may turn into a rout (which won’t):

The Commonwealth Bank of Australia lowered its forecast for the pound to $1.50 by the end of June from a previous estimate of $1.60, citing a high risk of a cut to the UK’s credit rating outlook. Richard Grace, CBA’s chief currency strategist, warned in a note on Tuesday that UK debt may now be greater than forecast due to the government’s additional bank bailout plans and cited the “high risk” of a downward revision to the ratings outlook for the UK.

Any downgrade wil force many investors to sell their UK government debt, raising the government’s cost of borrowing. The FT’s Lex thinks there’s one thing that will stop a run on the pound – all the world’s other major currencies are screwed too…

The genius of Larry Kudlow

Optimism is in short supply at the moment, so I was psyched to read that Larry Kudlow – the National Review’s economics editor and (in his owns words) “a renowned free market, supply-side economist armed with knowledge, vision, and integrity acquired over a storied career spanning three decades” – has read the tea leaves and seen clear signs that the US economy is now bottoming out from a recession that hasn’t been “that big a deal”.

Phew. We can all stop worrying then. After all Kudlow’s stunning track record proves he really has his finger on the pulse of US economic performance. Let’s review some of the highlights from his analysis over the past couple of years:

Feb 2007: Praises Ben Bernanke for “laying the groundwork for what is virtually a runaway bull market” – one he assures us a few months’ later has guaranteed the US’s role at the epicentre of a “a global boom, marked by a spread of free-market capitalism like we’ve never seen before.”

Sept 2007: Warns us that “it’s very easy to be totally pessimistic and bearish right now, but that’s precisely why I will avoid falling into that trap. Optimists are winners. Pessimists are losers.”

Sticks to this creed throughout the quarter in which the recession got underwayOctober (“if things are so bad, why are they so good?”), when he says growth is accelerating…November (subprime is “just not that big a deal”)…and December (“the prophets of recessionary doom…have been proven wrong once again”)

In Feb and March 2008, admits that a mild recession is possible, but assures us that “Bernanke’s emergency machinations to fight the recession in housing and housing-related credit are starting to show very positive effects.” There is no “genuine, across-the-board credit crunch,” he tell us in April. As a result, any slump “could be over by late summer.”

In September (with summer a memory and the economic clouds darkening), swoons for Henry Paulson who has embraced the gales of creative destruction and promised “no more federal bailouts. Not for Lehman Brothers. Not for global insurer AIG.”

Three days later, however, swoons for Paulson again, this time for preventing what would have been an “unfathomable” – an AIG collapse. Bailouts, it turns out, are a simply wonderful idea – not only will they save capitalism from doom; for taxpayers they’re a “win-win-win-win.” The government is sure to get its money back – even better it’s highly likely to make “a handsome profit” – enough to “pay down the national debt.”

October 2008: Is appalled by the “fear and panic” that have gripped the economy. “It is one of those moments in history when people feel helpless, frustrated, and bewildered about what’s going on and why it’s happening.” But still assures us that “much good may ultimately come of this terrifying correction.”

November 2008: Is cock-a-hoop at the “economic-primer” George Bush has left for his successor-elect Barack Obama, who apparently now has “an outsized responsibility [eh?] to mend and revive the economy.” Obama needs to access Bush’s wisdom and follow his economic-growth model, one “that has worked so well and so long for this country.”

Yes – that’s right. Bush (“the top economic forecaster in the country”) and his administration have left the US poised for recovery. If it all goes wrong, we’ll all know who to blame – that “extremely liberal-left” guy who is just about to take over. But as long as the new President tries to do what Bush would have done, then everything – my friends – will be alright.