Greenspan and Rubin maintained then, as now, that Born was on the wrong track. Greenspan, who left the Fed job in 2006 after an unprecedented three terms, also insists that regulating derivatives would not have averted the present crisis. Yesterday on Capitol Hill, a Senate committee opened hearings specifically on the role of financial derivatives in exacerbating the current crisis. Another hearing on the issue takes place in the House today.
The economic brain trust not only won the argument, it cut off the larger debate. After Born quit in 1999, no one wanted to go where she had already gone, and once the Bush administration arrived in 2001, the push was for less regulation, not more. Voluntary oversight became the favored approach, and even those were accepted grudgingly by Wall Street, if at all.
In private meetings and public speeches, Greenspan also argued a free-market view. Self-regulation, he asserted, would work better than the heavy hand of government: Investors had a natural desire to avoid self-destruction, and that served as the logical and best limit to excessive risk. Besides, derivatives had become a huge U.S. business, and burdensome rules would drive the market overseas.
The core of the problem is that most economists believe extremes of risk operate according to Gaussian (bell curve) distribution, whereas the evidence is increasingly clear it is in fact a power function of some sort. That’s how you get several “once in ten thousand year” events in the space of merely ten years, not ten thousand.
I also wonder to what extent computers and calculators got us into this mess. I’m old enough to have done all my undergrad work, and much of my post-grad studies on a slide rule.
The true beauty of a slide rule is that it keeps you honest about significant figures. In other words, we now have at least a generation of market quants who fundamentally do not understand the profound difference between precision and accuracy. The digital thermometer reads a very precise 74.361 degrees F, but when you turn it over the small print says ±3 degrees!
Competition for higher yields led to the construction of some absolutely bizarre financial instruments for the simple reason that they couldn’t be copied or commoditised by competitors.
So the market quants cobble together a three-way cross-currency deal hedging the Argentine Peso–Japanese Yen exchange rate against the relative performance of India’s Sensex versus the Nikkei, all allegedly underpinned by 180-day sovereign Argentine debt and a bunch of second-order calls against the MerVal close on 19 September, all of it geared out at about 20-to-1.
It’s calculated to pay off big time on a positive swing of 0.02% … except nobody noticed that Argentine economic data are not even accurate to ±2%. And we’re surprised it all blows up? Much of what has been happening is the highly foreseeable product of the intersection of ignorance with hubris.
Unfortunately, those monstrosities could not be sufficiently analysed and rated by people charged with that task … or even figured out by those investing in such Kafka-esque excrescences of any reasonable financial behaviour.
I’m just a small business owner trying to protect my business, my customers, and my family from other people’s pathological stupidity … and [i]cu[/i]-pidity. There are, quite unfortunately, no longer any collective solutions, only individual ones.
It is an environment I absolutely detest because it has punished prudence while rewarding hubris, greed, and stupidity. Our family has attempted to creep towards prosperity, while others have pocketed immense (and unjustified) short-term profits in the course of trashing the very system upon which normal commerce — our business included — depends.
I must confess I’m becoming somewhat bitter about it all.
“I . . . wonder to what extent computers . . . got us into this mess” —Bart Hall [#1]
Without computers, we couldn’t have derivatives (too complex to calculate) but we also couldn’t have mortgage-backed securities (too much record-keeping).
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You make good point about how slide rules (something outside my experience) bring home the difficulty of assessing the probability of improbable but disastrous outcomes.
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The real problem is not technology, of course, but the hubris of computer-model builders who believe they have eliminated or precisely quantified the risk of extreme events.
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That sort of hubris underscores the wisdom of having some basic prudential regulation of banks and insurance companies—the sort of financial institutions on which ordinary folks depend. No matter how impressive its value-at-risk models, an FDIC-insured bank must still have $4 in shareholders’ equity for each $100 in total assets (and thus cannot have more than $96 in liabilities for each $100 of assets). That’s a reasonable constraint. No matter how impressive its models, an insurance company must still establish reserves under systems that should pass your slide rule test.
Basic rules (although not sufficient guarantees of financial soundness) help control the natural human temptation to keep up with the Enrons.
[i]computer-model builders who believe they have eliminated or precisely quantified the risk of extreme events. [/i]
That is, er, precisely what they did. It was quite simply inaccurate and wrong as it was precise.
I’d far prefer to be approximately right than precisely wrong.
“I’d far prefer to be approximately right than precisely wrong”
Building on that sentence, I’d propose this summary of your comment #1:
“Better approximately right and realistically humble than catastrophically wrong.”
[b]”How did the world’s markets come to the brink of collapse?”[/b]
The world may never know…
http://www.youtube.com/watch?v=3fGTUFqPJo4
Then again, some folks seem to me to be on the right track…
http://www.youtube.com/watch?v=pAF6vNtEgGA
Of course, fingers can point in both directions…
http://www.youtube.com/watch?v=6rpoYvsc3ho
A different perspective that doesn’t exonerate either political party can be viewed here…
http://www.youtube.com/watch?v=d73KlhUq1W8
So, in the end, I think that this is the best answer to the question in a new and improved format…
http://www.youtube.com/watch?v=TtEPkRK1tlo
Once the truth sank in, this is about the only thing that helped…
http://www.youtube.com/watch?v=yjnvSQuv-H4
I especially agree with number #1’s second paragraph, implicit question. The geek friends I ask don’t have ready answers for me.
Before attempting to comment on this very interesting and revealing connect-the-dots article, I thought it good to find out more about Brooksley Born:
http://www.arnoldporter.com/attorneys.cfm?u=BornBrooksleyE&action=view&id=557&CFID=3362370&CFTOKEN=79413125
The last two sentences in particular are revealing.
More later.