The failures of the western financial models

The worst outcome of the current financial crisis would be a return to the status quo ante that produced the pathologies, anomalies and contradictions that are its root causes.

I believe that the Western model of financial capitalism - a convex combination of relationships-based financial capitalism and transactions-based financial capitalism - has, in its most recent manifestations (those developed since the great liberalisations of the 1980s), managed to enhance the worst features of these two ideal-types and to suppress the best. This period has been characterised by a steady increase in the relative dominance of the transactions-based financial capitalism model in the overall financial arrangements of the world, most spectacularly in the US, the UK, and such smaller countries like New Zealand and Iceland, somewhat less in most of continental Europe and elsewhere. (more…)

Mr Greenspan’s apologia pro vita sua in the Financial Times of Monday, April 7 2008 fails to convince.

1. The Greenspan Fed (August 1987 - January 2006) did indeed contribute, through excessively lax monetary policy, to the US housing boom that has now turned to bust.
2. The Greenspan-Bernanke put is real. It is an example of an inappropriate monetary policy response to a stock market decline.
3. The Greenspan Fed focused erroneously on core inflation, rather than using all available brain cells to predict underlying headline inflation in the medium term.
4. The Greenspan Fed failed to appreciate the downside of the rapid securitisation during the first half of this decade and acted exclusively as a cheerleader for its undoubted virtues.
5. The Greenspan Fed displayed a naive faith in the self-regulating and self-policing properties of financial markets and private financial institutions.
6. The Greenspan Fed, by enabling the rescue of Long Term Capital Management in 1998, acted as a moral hazard incubator.
7. The failure of the Greenspan Fed to press, before or after LTCM, for a special insolvency resolution regime with prompt corrective action features for all highly leveraged private financial institutions that were likely to be deemed too big and too systemically important to fail, demonstrates either bad judgement or regulatory capture.
8. During his years as Chairman of the Federal Reserve Board, Mr. Greenspan’s statements reflected a partial (in every sense of the world) understanding of how free competitive markets based on private ownership work. This partial understanding guided his actions as monetary policy maker and financial regulator. Mr Greenspan’s theories have been comprehensively refuted by the financial crises of 1997/98 and 2007/08. (more…)

This blog is a comment on Martin Wolf’s Column in the Financial Times of Friday April 4, 2008, “Four falsehoods on immigration”.

Martin and I have crossed swords before on the issue of immigration. Our disagreement is fundamental and based on different ethical premises. Martin believes that existing residents of a country have a right to control who enters their country. The House of Lords select Committee shares this view, as is clear from their Report, The Economic Impact of Immigration, which asserts that the criterion to be used to assess the costs and benefits of immigration for the UK is the impact on the existing resident population.

I reject that view. The wellbeing of the existing resident population is no more, and no less, relevant than the wellbeing of any potential immigrant to the UK, wherever in the world he or she may be. I recognise private property rights. My home is my castle and I can deny entry into it to anybody at any time. I don’t recognise national property rights. A country is not like a private home. A country is an open club.

(more…)

At last a local outbreak of common sense. The Advisory Council on the Misuse of Drugs, an independent expert body established under the Misuse of Drugs Act 1971 that advises government on drug related issues in the UK, has come out against UK government proposals to reverse the 2004 downgrading of cannabis from a class B substance to a class C substance.

I don’t know what irks me more about this government - the puritanical, kill-joy zeal with which it tries to hunt down and eradicate every vice, even those that do not impose material harm on third parties, or its inability/unwillingness to get its brain in gear once its emotions are engaged/the smell of elections is in the air. (more…)

My friend Professor Avinash D. Persaud recently gave a speech to the Committee of European Securities Regulators (CESR) on why bank risk models failed and are bound to fail. It is today’s guest blog. Avinash is a trustee of the Global Association of Risk Professionals, Chairman of Intelligence Capital Limited and Emeritus Professor of Gresham College.

**********************************************************

Sir Alan Greenspan, and others have questioned why risk models, which are at the centre of financial supervision, failed to avoid or mitigate today’s financial turmoil. There are two answers to this, one technical and the other philosophical. Neither is complex, but many regulators and central bankers chose to ignore them both.

The technical explanation is that market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them. This was not a bad approximation in 1952, when the intellectual underpinnings of these models were being developed at the Rand Corporation by Harry Markovitz and George Dantzig. This was a time of capital controls between countries, the segmentation of domestic financial markets and to get the historical frame right, it was the time of the Morris Minor with its top speed of 59mph. (more…)

The coming and going of Good Friday and the imminence of Easter has prompted some musings about sanctity. Sanctity is the quality or state of being holy or sacred. I run into a lot of sanctity when engaged in political debate with serious-minded people. For free-market economists there is the sanctity of contracts and of property rights. For right-to-lifers there is the sanctity of life. We hear of the sacred bond of matrimony. We all know of the Holy Land. Holy cities are a dime a dozen: for Muslims it includes Mecca, Medina and Jerusalem. For Christians and Jews, Jerusalem. For Hindus Varanasi - Benares – Kaasi. There are holy rivers, from the river Jordan to the Ganges. Roman Catholics used to have holy water (I don’t know whether they still do). There are, God forbid, holy wars. There are reputed to be holy men and women, although I have never encountered any. There are sacred oaths and sacred honour.

Permit me this spontaneous outburst of self-righteousness, delivered from a simplistic protestant perspective: a pox, pest and plague on all those who claim holiness, sacredness or sanctity for any cause, anyone, any being or anything other than the One God. All other claims to sanctity and holiness are blasphemous. Nothing is sacred, except the One God. (more…)

My friend and former colleague, Uwe E. Reinhardt, James Madison Professor of Political Economy at the Woodrow Wilson School of Public and International Affairs and the Economics Department of Princeton University, has written the following lovely reflection on the role of the government in the US economy. Its applicability to current discourse in the financial markets throughout the North Atlantic area should be obvious.

Start of Uwe Reinhardt’s guest blog

To provide a proper backdrop for my lecture on “The Government’s Role in the Economy” in Econ 100, I always preface it with the question: “Who in this class has a mother?” In a good year, as many as 25% of the students raise their hand. The rest won’t admit it, because regulating mothers, like regulating government, are the ultimate buzz kills in the human experience. (more…)

In today’s Financial Times Economists’ Forum, Michael S. Barr and Laura D. Tyson present proposal to deal with the problems of the American residential housing market and the housing finance market: “Foreclosures: How to save America’s family equity”.

Under their achingly preciously acronymed SAFE (Save America’s Family Equity) loan plan, the US Treasury and the Federal Reserve would run auctions, in which Fannie Mae, Freddie Mac and Federal Housing Administration originators would purchase mortgages from current investors at discounts determined by the auction process. The FHA, Fannie Mae, and Freddie Mac would work with “responsible originators” to restructure the loans they acquire to stem defaults, foreclosures, and liquidations.

This is a terrible proposal: distortionary, unfair and except in the shortest of short runs so beloved by political opportunists, a threat to macroeconomic and financial stability because of the moral hazard and other perverse incentives it creates for reckless borrowing and reckless lending in the residential home finance markets. The FHA, Fannie Mae and Freddie Mac are, of course, the vehicles through which the US has since the Great Depression pursued its unique brand of socialism for the middle class. This proposal widens and deepens that role and extends it to include socialism for the upper-middle class. (more…)

The Chancellor hasn’t had much luck since he took command of the good ship Britannia. Some of the back luck was of his own making and the criticism of his (in)actions has been partly deserved. As Martin Wolf has pointed out, even when he has done the right thing, he has at times done it for the wrong reasons and clumsily. The taxation of non-doms is an example. The Tories came up with the clever populist wheeze of taxing non-doms and using the (overestimated) proceeds to pare back death duties. The immediate ‘me-too’ reaction of the Labour government lead to the hasty introduction of a two-part proposal.

Non-doms would remain exempt from UK income tax on foreign earnings not remitted to the UK for seven years. After seven years, they would either pay a yearly £30,000 fee per capita to retain their non-dom status, or pay UK income tax on their worldwide earnings, regardless of whether they are remitted or not - like the poor doms have had to do all along. There would also be some tightening up on the legal definition of repatriation of earnings, to close some glaring loopholes.

A second, rather fuzzy part of the proposal involved (or appeared to involve) greater reporting obligations for non-doms on assets held in foreign trusts. Many of these foreign trusts are off-shore vehicles located in tax havens.

The explosion of indignation that greeted this proposal was deafening and largely bereft of logic other than the financial self-interest of those non-doms who would be adversely affected by the proposal. The fact that the UK government’s introduction of the non-dom proposal was motivated by a knee-jerk opportunistic response to an opposition initiative, and that the details of the proposal were hastily cobbled together and ill thought out, ought not to obscure the fact that the proposal makes moral and economic sense. It is fair and just that those who are resident in this country be taxed on their worldwide income; they are the beneficiaries of the public goods and services financed through this country’s tax system. The very existence of the resident but non-dom category is an outrageous sop to a small number of highly vocal and well-connected rich folk and their lobbyists. The unequal treatment of equals introduced by the creation of the non-dom (resident but non-domiciled for the purpose of income tax and inheritance tax) category undermines respect for the law among the tax paying public at large. (more…)

After a 49-year rule, Fidel Castro has decided to give up the presidency of Cuba, although he will continue to lurk in the background exercising influence as and when his failing health permits, through his position as first secretary of the ruling Communist Party. The most likely successor as president is his younger brother Raúl Castro, essentially Fidel without the charisma and without the beard. He represents perhaps a minor improvement in administrative competence, but no change in anything of substance.

Even during the late sixties-early seventies, when almost every western male is his late teens or early twenties sported a poster of Che and/or Fidel on his wall, that particular cultural bacillus passed me by. I was fortunate that my father took the time to explain to me that this duo stood for a repressive, totalitarian regime. My father spent his entire life fighting totalitarian regimes at home and abroad. This started in earnest when he was 18 and the Nazis rolled into the Netherlands, but like much of his vintage of European and American democratic socialists, his political education began with the Spanish civil war. After World War II he was, as a Dutch trade union official for the Metal Workers, then as Secretary General first of the European Trade Union Confederation and later of the International Confederation of Free Trade Unions, involved in resistance to communist dictators in central and eastern Europe and in China, fascist dictators in Spain and Portugal, fascist Colonels in Greece, military dictatorships throughout South America and in Indonesia, white racist regimes in Rhodesia and South Africa, black dictatorships throughout Sub-Saharan Africa, repressive regimes in North Africa, the Middle East and elsewhere in Asia.

(more…)