Market squares without a clue
The Lunacy Of Modern Finance Theory and Regulation By Les Coleman Routledge, 171pp, $72.99
The Queen acutely inquired during a 2008 visit to the London School of Economics why none of the experts saw the global financial crisis coming. The professors she directed this question to noted that everybody relied on somebody else and thought they were doing the right thing. In one fell swoop the cream of Britain’s economic intellectual elite revealed they were emperors with no clothes.
The hapless professors failed to note to Her Majesty that systemic failures in the economic and financial theories they had spent a lifetime teaching rendered them incapable of spotting an incipient crisis. Les Coleman in this short, lucidly written book pillories the structural weaknesses of economic and regulatory models that have proved inept at forecasting or dealing with the financial crises that break out every seven years or so. After reading this book one is left with the sense that business economics is not only a dismal science but one ruled by mumbo-jumbo.
Coleman had a long history of working for international firms before joining the staff at the University of Melbourne, where he teaches the theories that underpin the finance industry. And in The Lunacy of Modern Finance Theory and Regulation he brings to bear all his rich experience straddling the world of finance and academia to give an insider’s account of the misguided theoretical framework of the discipline he teaches.
Coleman’s aim is not to dismantle the extant business structure. He simply wants the defects of finance theory exposed to the disinfectant of sunlight and new paradigms developed that are “more robust to real-world influences”. Right at the outset Coleman forthrightly declares, “A moment’s thought shows that financial prediction is a mug’s game and little more than guesswork.”
Guided by this observation, he establishes a series of themes that empirically highlight the “nature and causes of crippling deficiencies in finance research and practice”.
Coleman explores the best that finance research has to offer, and at each step concludes that the army of researchers employed in the private finance sector and universities is working with models that have no practical application in the market.
He advances through a range of finance theories, including some that have bagged their creators Nobel prizes, and concludes that the investment market has in practice found them little more than irrelevant speculation. Their only concrete role is to provide complex formulas that foster the belief among the gullible that richly rewarded market analysts are not voodoo specialists but instead really are equipped to pick the shares that will bring the optimum return.
In particular Coleman anatomises an asset pricing model that is the benchmark finance theory taught in all tertiary investment courses. It scooped a Nobel prize for its architect. It asserts that “there is a linear relationship between expected return and risk”. In brief, the guiding principle of this theory is that the higher the risk taken by an investor, the greater the reward.
After years of practitioners trying to breathe life into this theory, its poor empirical record in achieving the mooted high share returns was quietly accepted in the inner circles of finance. However, the fact the model proved to be completely useless at the coalface has not stopped it being taught as a centerpiece of finance theory. Also, investment houses wheel it out in their publications to assure the less economically literate that they are managing risk in the best rational maximising fashion to optimise returns.
Coleman draws a parallel between the mori-
bund models of finance theory and the flawed ideas of orthodox economics. He suggests both these disciplines depict the market as a world of harmony and equilibrium. Fixated by the concept of rational calculation and efficient markets acting as an automatic regulator of prices and growth, there is no account taken of dynamic changes that produce economic fluctuations and the upending of elegant maxims.
In our market society a disjuncture between theoretical niceties and practice assists in producing cyclical financial shocks, and thus there is a role for a regulatory cop on the beat. Yet according to Coleman the corporate watchdogs charged with monitoring and constraining risk are of symbolic value only: “[F]inancial regulators lack either the ability or willingness to prevent crises.”
They not only fail to stop or limit risk, but are also outgunned by corporate whales who “find back doors in regulation, read the legislation differently and get it approved in court”.
In a world where financial theories are empty window dressing and economic crises abound — along with regulators captured by vested interests — Coleman thinks getting tough with corporate directors will cure governance issues. He believes that if a large firm files for bankruptcy, this outcome will suffice to make directors guilty of an offence. He argues giant firms provide smaller returns to investors than the small fry of the system and this is one of the chief reasons for going in hard against their managers. He sidesteps the voluminous bankruptcy figures for small firms.
Coleman has a “small is beautiful” fixation that blinds him to the reality that large firms emerged from free competition. They emerged victorious because they outflanked others in the battle to increase productivity and reaped cost advantages in scale and unit costs of production. The systemic logic of market laws is that if you falter in the competitive race you will eventually be toppled, no matter how big you are. Creative destruction is an integral part of the reproduction of a market economy and it acts to provide space for new forms of business.
In sum, to reconfigure corporate law in the punitive fashion prescribed by Coleman would be to overlook the fact that bankruptcy is not always due to venal management. In many cases it involves a business model that has been pursued in good faith, but which the tide of history has cast on the rocks.
Coleman’s corporate reform program smacks of magical thinking — thinking exactly of the type he believes most human beings en- gage in, and which he holds responsible for making them unable to see that finance theory is rarely able to survive contact with the real world. His resort to it is a disappointing coda to an otherwise sober analysis of modern finance theory and regulation.
The Queen, at the LSE in 2008, felt experts were caught napping; top, a man walks past a share prices display amid rain in Tokyo