Tuesday, 5 January 2010

Avoiding crashes — a word from the wise

       I am instinctively sceptical of big government—whether it be authoritarian national government, or regional or global governance. Big government rarely, if ever, properly understands the problems it claims to address—witness the global financial crash.

However, the opposite alternative—allowing economic activity to proceed without monitoring or check—also has its downside: witness the global financial crash.

So what is the solution?

I'm not sure I have one. But the answer must lie closer to the factors of economic production than the factotums of authoritarian government. It's only at the sharp end of economic activity that true knowledge lies and practical observation takes place.

However, how do we encourage those involved in economic generation to regularly report on their businesses. And how can we trust what they say?

Government has many select committees that invite senior representatives to comment on their, often troubled, industries. But what imminent pre-crash truths could have been learned from the CEOs of Lehman Brothers or RBS? Certainly very little indeed, since they were totally ignorant of the dangers they were in, or were in denial, or would have simply remained economic with the truth to protect their positions.

Other bodies in UK, such as the BofE, FSA, ONS, etc., seek to obtain real-time data on economic activity to inform policy-makers. But as we see from the financial crash, such data can be insufficient, unreliable or misunderstood—or the facts simply get ignored.

I've been reading a narrative* about the financial crash in the US, seen from the inside viewpoint of a financial trader at Lehman Brothers. This particular guy worked in the distressed bond department, where the skills required were to anticipate corporate financial disasters and take timely action for the benefit of the bank's clients and the bank itself.

This department began to notice worrying signs about the US financial economy back in 2005. They were concerned about the growth of unregulated credit default swaps (CDSs), which became disembodied bets against corporate collapses, and the vast expansion of the housing mortgage market, led by brokers not deposit takers, which generated collateralised debt obligations (CDOs), packaged and quickly sold by banks like their own with the active assistance of the major US credit rating agencies.

While the specialist derivatives traders, egged on by the management board, raked in profits hand over fist, without apparent risk or applied banking skills, the guys in the traditional trading departments who dealt daily in value and risk watched this phenomena with growing concern but were unable to be heard against the tide of profitability and the belief that the holy grail of a self-generating financial nirvana had finally been found.

Suffice to say, the guys on the lower deck were right, the profit-crazed management supporting the derivatives traders were wrong.

But how do governments, regulators, and the public who are put at risk, obtain the right information from the right people to be able to make wiser judgements than in the recent past?

It may sound like another aspect of intrusive big government, reaching in to the rivers and streams of the land, but perhaps some communication forum needs to be found that regularly enquires into the temperature of industry and particularly finance. The unique feature of this forum would be that its participants would be middle managers rather than the leaders of industry. In other words, those who deal directly with the trades, the clients and the finances that make the cogs of our economy work. Difficult to achieve, particularly where whistle-blowing is involved, but possibly worthwhile for the result.

Given the experiences we've recently been through, there is a self-interest in coal-face managers revealing trends and potential risk. At Lehman Brothers, the 'distressed traders' group took its own action—taking massive short positions against the activities of its own bank. Sadly, this could never match the colossal debts that finally stuck on Lehman's books. Nor did it affect the $14 trillion dollars of toxic debt that Lehmans and other Wall Street banks had already spread throughout the US and then the globe.

If only these wise, traditional, but actively engaged managers had had a way to speak to someone with ears to hear—it might all have been so different.

* The book is: A Colossal Failure of Common Sense by Larry McDonald

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