The Big Swindle

The collapse of the Berlin wall in 1989 attested to the untenability of socialism as a way of organising productive forces in society. In the West, a similar decline in Keynesian economics had been taking place. The emergent paradigm came to be known as the Washington Consensus (WC), a term coined by John Williamson referring to the ten universal principles for encouraging growth and prosperity.

These principles were anchored on a faith in unfettered markets and a reduced role for government through liberalisation, privatisation and macro-stability. While they were intended to form the lowest common denominator for policy prescriptions, as Williamson later observed, they became a panacea, sufficient in and of themselves to cause economic transformation.

As it later became evident from the experiences of Russia, Sub-Saharan Africa and Latin America which had experimented with "market fundamentalism" or neoliberalism in the 1990s, the link between these reforms and economic growth seemed to be weak or untenable at best.

Meanwhile, economies like China and India which had used a hybrid approach involving private joint ventures with town and village enterprises (in the case of the former) or had engaged in selective deregulation (in the case of the latter) did extremely well. Decades earlier, Japan, Korea and Taiwan had engaged in industrial policy and currency devaluation, clearly distorting product and money markets, and saw their populations rise out of poverty within a generation.

What is worse, capital market liberalisation, an important WC tenet, apparently made Southeast Asian economies vulnerable to speculative attacks as demonstrated in 1997 with the Asian financial meltdown. In order to rescue the reputation of the economic doctrine, a renewed focus was placed on the role of governance, institutions and corruption something that the WC had hitherto ignored.

Ten additional principles covering these areas rounded out what was termed the Washington Consensus Plus. Never mind that an earlier financial crisis had erupted in Scandinavia where countries have an unrivalled reputation for transparency in government or that bureaucratic corruption had not prevented Korea or China from developing quite rapidly.

If the thesis had previously hinged on "getting the price right", it now depended on "getting institutions right" to deal with "noise" in the form of non-productive transactions costs that prevent markets from functioning properly. Institutional determinants (property rights, contract law, juducial capacity) were given the same level of concern that political considerations had earlier occupied (democracy v authoritarianism). It was observed however that no matter what developing countries did, the list of reforms and explanations for why they did not subsequently grow just kept getting longer and longer*.

The one democratic country that had comprehensively applied the principles of the Washington Consensus Plus and had developed from it was Australia. Since the 1980s, successive governments instituted reforms in the economy and governance. When the dot com crash of 2001 and global financial crisis of 2008 hit, local banks were innoculated from it through prudential regulation and supervision. By adapting the book title of one famous Peruvian author, this episode could be called, "Why the Washington Consensus works in Australia and fails everywhere else" for even America had resisted the need for transparency in exotic derivatives markets or prudential regulation over its banks.

When the bubble that was the US realty-derivative market burst, weaknesses were exposed in its political economy. As Simon Johnson noted (Johnson being part of the trio including Acemoglu and Robinson or "AJR" that first highlighted the importance of institutional determinants), Washington had become captive to Wall Street in a manner that was characteristic of many developing countries. This would suggest that the US ought not grow as fast into the future, something that recent developments seem to confirm.

It is interesting to note that from Australia, the jurisdiction that provides the ultimate case for the successful and bi-partisan application of neoliberalism its leader should have screamed the loudest for an alternative social democratic paradigm with protestations that "the Emperor has no clothes". In practice it has meant adopting a kind of Millenium Challenge approach through its domestic social and labour market policies enforced through a "cooperative Federalism".

One could challenge this approach as an alternative to the Washington Consensus, but the problem is what else would one then substitute it with? Development economists are in a state of confusion about the way forward. There are it would seem many paths to prosperity, not just one. But for countries already on that road, a key question is how to build on it.

An important study that illuminates this question was performed by Gustav Ranis in 2000. He showed that countries pursuing economic growth as their paramount objective may wind up in a development rut, but for those countries that pursued human capital development, a virtuous cycle that involved both growth and improved human well-being ultimately occurred.

Although it would seem straight-forward and self-evident to take the conclusions of the study and recommend investing a greater share of GDP to human services as what Jeffrey Sachs and the UN Millenium Challenge Project would prefer, the same old questions crop up. Namely, would not improvements in governance be more helpful? How would local institutions, cultural and social norms interact with the resulting programs? Should governments or private markets take the lead?

Just as the "death" of god led to his resurrection in the form of "structure", the decline of neoliberalism is bringing about its rebirth in other deterministic forms.

* Perhaps instituting structural reforms is not the answer if it eventually weakens the legitimacy and capacity of governments to function especially if local conditions prevent reforms from producing material differences in outcomes.

Dishonest or Incompetent?

The broad contours of two competing narratives on the origins of the GFC are what David Brooks brilliantly outlines in his op-ed piece for the New York Times. Dubbed as"Greed and Stupidity" or alternatively as I have framed it, dishonesty and incompetence. In any principal-agent relationship, there are always two problems to look out for: dishonesty, in which case the need is for the principal to motivate the agent to take his view of things; and incompetence, in which case greater monitoring is required. Policy, to be on the mark, has to address these agency costs.

This is how the greed narrative is broken down. It is essentially an amplified version of the situation faced by most emerging markets where the dominance of a certain class of moneyed elites, or oligarchs, holds sway over political or ruling elites. With their entrenched interests in keeping things the way they are, any attempt at reform will simply wither at the vine. The most coherent expression of this is encapsulated in "The Quiet Coup" by Simon Johnson in The Atlantic. In essence, it is a moral hazard problem, one of "keeping the bastards honest."

Johnson uses statistics covering the last three decades to illustrate the growth of the finance industry in the US. From a low of 16 per cent at the outset, its share of corporate profits rose to 41 per cent in the last decade, and with this came a rapid wage disparity between average workers in the finance industry and other sectors. With increased wealth and prestige came influence and power. The revolving door between Wall Street and Washington produced an incestuous relationship which spawned lax regulation and increased risk-taking.

A nuanced and slightly more convincing explanation is offered by the incompetence argument. Its takeoff point is the increased diversity and complexity of bank operations and the ignorance of senior bank executives with regard to the nature of assets they were handling. It is essentially an information problem. The mutation of investment banks from partnerships to publicly listed companies and their subsequent merger with commecial banks bred a lack of transparency and accountability. Yet with all this centralisation of authority, why were the captains of industry asleep at the wheel?

The basic answer is complacency. They thought that they had figured out a way to manage and diversify away systemic risk. As Felix Salmon points out in his riveting article for Wired Magazine, they were enamoured and gradually seduced by the elegance of a mathematical formula, known as the Gaussian copula developed by an actuarian by the name of David X. Li working at the time for JP Morgan Chase, which was published in The Journal of Fixed Income back in 2000. The fact that this theoretical model was not subjected to more scrutiny and empirical evaluation really says something about "group think" and herd mentality in the so-called Information Age.

The analysis of Li sought to simplify the manner by which to estimate the corelation of undesireable events like defaults occurring in two separate loan contracts. He used the prices of an instrument known as a credit default swap in lieu of actual default histories to determine the coefficient of corelation. Using this approach, it was possible to bundle junk bonds together and still come up with triple-A rated instruments known as collateralised debt obligations or CDOs.

Nevermind that the coefficients actually may change as circumstances on the ground become fluid. Though elegant, the brittleness of the solution became evident once it was tested by the hard reality of unforeseen external circumstances such as the rise of China and the flooding of the financial sector with fresh capital seeking safe yet solid returns.

Financial innovations based on the Li formula spawned complex instruments too opaque to comprehend or monitor since doing so required intimate knowledge held by the mathematicians closely linked to the models used for underwriting such contracts. On top of that was a system based on the "cult of accountability", the search for standardised measues of achievement with which to rate the performance of financial executives who were paid according to the amount of such contracts they had floated and not on how well the instruments performed thereafter.

In other words, these numerical methods did not square with real performance on the ground, and they could be "gamed" by the executives whose activities they were meant to control. This created a pseudo-objectivity which as Jerry Z Muller writes makes this the first epistemologically driven recession the world has seen (epistemology being the study of the limits of knowledge, or how we know what we think we know).

Policy Prescriptions
If the greed narrative is to be followed, then the obvious solutions to the crisis have to do with curbing dishonesty among the bankers. How do you reduce the power of entrenched interests? Well, to take an extreme case, Vladimir Putin's approach was to prosecute the dishonest crooks, takeover their operations, break-up their monopoly. Curb their excesses by putting a tight rein on the level of compensation they are allowed to have. A softer version would be that held by McCain. Say "no" to government bailouts. Let them have the "freedom to fail" as the recent White House announcement over General Motors tried to signal.

If on the other hand the incompetence narrative is to be followed, then the solution would entail simplifying contracts, making them easier to subject to regulatory supervision and managerial control, not substituting due diligence for diversification, gaining a better handle on what it is that forms the underlying value of assets. In other words, improve the quality of information being transmitted.

Finally, whatever narrative you subscribe to, there is one conclusion that both will support. This is the need to reinstate rules that prevent banks from getting "too big to fail", "too complex to manage" which was what the Glass-Steagall Act of 1934 was designed to do following the (last?) Great Depression. Unfortunately, the opposite has happened with Goldman Sachs and Morgan Stanley becoming bank-holding companies like the bailed-out Citicorp to be monitored by some supervisory body yet to be named. The question now is whether the authorities will be sophisticated enough to stay on top of these large complex organisations, or will we be substituting market failure with government failure in the not too distant future.

The Social Insurance of Private Risk: Executive Compensation and the Merits of Government Intervention

The ire for Wall Street that has been the hallmark of anti-globalisation activists has become mainstream as evidenced by the notorious name recall of such entities like AIG and Pac Brands in Australia. The legitimacy of government bailouts for firms that have turned around and paid their senior executives hefty bonuses has been called into question. Legislators and responsible governments that approved such dole outs have scorned these practices citing the fact that the social insurance of private risk-taking has occurred.

They have not realised that it was government policy that set them on this course to begin with by encouraging such dubious lending practices in the housing market to the so called ninjas ("no income, no job, no assets"). AIG merely sought to manage away such risks through credit swaps and other financial derivatives. The lack of oversight into these contracts did not help them hold back when times were good.

System dynamics heralded as the science of unintended consequences tells us that when prolonged feedback loops are present policymakers will often fail to connect the dots that link their actions with such perverse outcomes. They may instead associate adverse consequences with near-term causes (in this case "greed") and formulate their responses based on them.

Insuring executives against risk is not a bad practice per se. In fact, it is desireable to some extent. To use a sports analogy, every club guarantees its "star players" an incentive to "go for it" in the field, even though they risk injury that could jeopardise the rest of their careers in the process. What would happen if a player "held back" at crucial moments in a championship match for this very reason? Salaries remain fixed whether the player is fit for the entire season and are not dependent on the team winning the tournament (although renewal of contracts might).

In the case of David Beckham, when he transferred to the LA Galaxy franchise, his prominence allowed them to maximise receipts from footbal matches held at their stadium. This alone made his outrageous salary worth every penny. For the same reason, some executives may focus on generating short-term growth in market share or profits to the detriment of long-term sustainability.






David Beckham's outrageous salary was worth every penny for LA Galaxy.


But even if their remuneration were based on some long-term metric such as growth of value in the company's stock, there would be no reason for the firm to stick to the contract once it has established that an executive decision (say outsourcing of production overseas) sets the firm on good financial footing. Some savings may in fact be derived by paying him out if he is nearing retirement (could this be the case with Pacific Brands?) and makes the setting of executive pay a tricky business because a long-term contract merely becomes the starting point for renegotiation later.

On the one hand, if they are not insured against failure, CEOs may become too averse at taking investment decisions if there is a possibility for large losses. On the other hand, critics have turned to the mechanisms for setting pay and the way it can be captured by corporate executives.

Board members who are meant to be independent in making decisions covering this area often share an affinity with their Chief Executives by virtue of having been nominated by him (or her) in the first place. So called compensation experts suffer the same fate as external auditors, often screened by CEOs before getting hired by the board. The difficulty here is in designing good corporate governance practices to avoid these forms of capture.

In the end, if the attainment of desirable social ends, such as a more equitable distribution of property or the protection of jobs in an uncompetitive industry, was offered in promoting risky projects in the private sector, society should not balk at insuring these social experiments from failure. The problem is that when these programs were formulated, they may have been designed with an eye at preserving the short-term electability of a politician, but that merely leaves us where this discussion began.