Mar­ket squares with­out a clue

The Weekend Australian - Review - - Books - Frank Car­ri­gan

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

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