Capitalism works but not that way

IN ITS MODERN FORM, the packaging of the first CDO can be traced back to 1983, though the idea of a CDO originated earlier, i.e. in 1980. It is contemporaneous with the advent of Reagan and Thatcher, the period identified squarely with neo-liberalism in many circles. It changed the whole structure of Western Capitalism, and ended the social compact of Roosevelt. This period caused an incredible increase in wealth and income distributions, though CEO paychecks inflate the wage bill and make it appear less dramatically twisted than it actually is, and accelerated financialization to such a dramatic scale that de-industrialization became the hallmark for at least two decades after 1980. The service sector grew by leaps and bounds, traditional industries shrank, and financial markets became almost totally unfettered despite the SEC and other regulatory entities.

A THEORETICAL GLIMPSE

In a model with linear real assets, budget constraints are homogeneous in prices ( jointly in asset and commodity prices) so prices can be defined up to normalisation. This is the usual Arrow-Debreu story. Furthermore, as in the context of Arrow-Debreu regular economies, we obtain generic local uniqueness results. In the case of nominal assets, however, there is a continuum of equilibrium allocations. In the absence of a well-defined “monetary system” indeterminacy may occur. One implication is that the indeterminacy of equilibria translates into that of asset prices.

Against this, the neoliberal argument is two-fold. First, there is a conjecture harbouring the possibility that private equity will diversify risk away. It argues that private owners may discretely transfer risk to counter-parties; if markets tend to become ‘complete’ markets, that is if the argument for market-clearing at infinity can be cast away, managing or otherwise diversifying away those risks arguably becomes a lower cost substitute for traditional risk capital. The argument aims at discrediting any transfer to the public in the presence of constrained inefficiency to remedy one specific curse of incomplete asset markets. We know that with an incomplete span of assets, competitive markets do not function optimally even within the restricted subset of existing markets. Could this mathematical argument be overturned? If risk management can substitute for risk capital without requiring a transfer of ownership, then why would we need regulation at all? This first part goes against the whole literature of general equilibrium theory with regards to incomplete markets and restricted participation developed between 1985 and 2000.

Second, there was Lehman, and the global financial crisis, and the secular stagnation that followed. We all understand that from a technical viewpoint, many financial institutions fueled the downturn of the credit cycle with heavily invested asset portfolios, overheated real estate markets, private equity/LBO, and structured credit products entailing a number of L-geared risks: longer duration, lower credit quality, larger positions, leverages, less liquid assets. It is also clearly understood that, despite the examples cited above, people do not seem to have taken seriously the myriad warnings against bearing potentially unbearable risks. Was it all about “fat tails”, i.e. non-linearity and non-Gaussianity, or was it also about the macroeconomic framework, a framework that casts its shadow on the finance world via monetary and credit channels?

SKEWNESS AND KURTOSIS

Cyclical risks are low-frequency/high-impact events characterized by their negatively skewed and “fat-tailed” loss distributions. This means investors incurring such risk can expect mainly small positive events but are subject to a few cases of extreme loss. Consequently, they are difficult to understand. The difficulty stems from two factors. First, there is insufficient data to determine meaningful probability distributions. Second, and perhaps more importantly, infrequency clouds hazard perception. Risk estimates become anchored on recent events. This leads to disaster myopia, whereby we ignore low-frequency, remote events. Overemphasis on recent events can also produce disaster magnification immediately following an adverse event. These facts lead to risk mispricing and the pro-cyclical nature of risk appetite. The other problem is correlation within a portfolio. That is, among the asset returns that form it. In this respect, using long-memory data sets has been of no avail, since such a practice only augments the parameter space because co-variation matrices can grow very large.

THE LI NON̞SOLUTION

Then, Li came up with a convincing idea, a Black-Scholes equivalent device that all investment houses could easily use and hedge against portfolio correlation risks. Li, a Chinese exchange student originally, who

went on to earn a Ph.D. in actuarial science in Canada, ended up on Wall Street. The Gaussian copula he used supposedly allowed financial institutions to separate marginal distributions from their joint dependency. Not only is correlation contoured within the asset portfolio, let’s use a CDO as an example, but it is also possible to compute the default time of a company if the asset value falls below some threshold. Gone were all the risks, gone were the incomplete market hypotheses that no longer mattered, and revived was the stubborn belief that markets always provide the best solution. John Geanakoplos, at Yale, concisely put forth the theoretical and, hopefully, practical implication back in 1990: “The automatic association of the existence of competitive markets with some kind of intuitive notion of efficiency in the mind set of practicing economists has now no theoretical validity whatsoever.”

FINANCIAL CAPITALISM DOESN’T WORK THAT WAY

Now, both arguments are incorrect. Securitization serves nothing in terms of mitigating market and portfolio correlation risks; a mere Gaussian copula cannot handle all the complexities of asset markets; private equity cannot pass for diversified publicly hold risk slices. Have we not yet learned – so painfully – that this kind of irrational exuberance and market fundamentalism only leads to financial & real crises? Securitization is a bad idea, and it is particularly bad if you are pre-set to pack up all eventualities in anticipation and market securitized credit chunks to a central bank. This argument amounts to accepting –so many years after the crisis and with the benefit of hindsight – that asset-backed securities that banks are pushed to issue have such a high probability of going sour that the CBRT has better buy them immediately, from day one. This is not only wrong on all counts, but it has a signalling effect that is self-defeating. Are we so desperate that we should strongly (and wrongly) incentivize banks, giving them security guarantees that go far beyond what a well-designed credit guarantee fund would entail, and induce them to extend credits at all costs?

THE FUTURE̞AT̞RISK

Capitalism hasn’t worked in the myriad ways it was supposed to work after 1980. It isn’t optimal. It isn’t fair. It isn’t fair in terms of intra-state statistical profiles and it isn’t fair in comparisons between countries. The convergence hypothesis doesn’t hold: regions, cultures, countries continue to diverge. The “big divide” of the 19th Century has already been carried over to the 21st Century. From a financial viewpoint, it is irrationally exuberant more often than not. Risks are constantly being downplayed. And it isn’t predicated on the use of “soft power” in international politics. Modern capitalism has at least one merit though: technological innovation is continuous. This is despite the fact that the international system is similar to what one might call neo-feudalism. Hence, two or three divergent dynamics are at work under the guise of modern capitalism. Exuberant finance and excessive risk-taking characterizes the first layer. The use of sheer force in the quest for control over global energy supplies is another facet. A clear trend for technological innovation is the last layer, and therein lies hope.