Bill Totten's Weblog

Sunday, February 10, 2008

This reckless greed of the few ...

... harms the future of the many

The government must act firmly to control an industry that destabilises all our lives with its naked pursuit of huge profits

by Will Hutton

Observer (January 27 2008)

Never in human affairs have so few been allowed to make so much money by so many for so little wider benefit. Across the globe, societies and governments have been hoodwinked by a collection of self-confident chancers in the guise of investment bankers, hedge and private equity fund partners and bankers who, in the cause of their monumental self-enrichment, have taken the world to the brink of a major recession. It has been economic history's most one-sided bargain.

Last week's financial panic was further evidence of the extreme foolhardiness with which global finance has been organised and managed. There was the biggest one-day fall in Wall Street since 11 September, which spilled over into every world stock market and the largest single cut in American interest rates for 25 years as an emergency attempt to stop the rout. A new crisis emerged in an obscure American insurance business (monoline, it is called). To cap it all, there was the GBP 3.7 billion bank fraud at Societe Generale.

The growing realisation of how exposed the financial system is - and from transactions that should never have taken place - is reinforcing the mounting credit crunch, which, in turn, is spooking stock markets. The US economy is weakening while in Britain new mortgage lending is at a ten-year low. The staples of a settled life - jobs, pensions and house prices - are all under threat.

The availability of credit is one of the fundamental pillars of any economic system. Like the delivery of gas, electricity and water, finance should be regarded as a utility and after the credit-crunch disasters of the 1930s, following the free-market 1920s, it was regulated as one. But Anglo-American financiers have used the theories of the free-market fundamentalists to argue that it should be liberated from such regulatory 'shackles' and again run as a business like any other.

Yet finance is not like any other business. When a bank makes a mistake, the ramifications for the rest of the financial and economic system are so severe that it has to be bailed out - witness Northern Rock. Because of this truth, financiers have organised themselves so that actual or potential losses are picked up by somebody else - if not their clients, then the state - while profits are kept to themselves. An industry that socialises losses while privatising profit, and that has the capacity to create booms and busts alike, has to be as closely regulated as any utility.

I was reminded of the system's proclivities by a consultant friend who was hired to arbitrate over a performance bonus between a hedge fund and one of its asset managers. The individual in question was paid a base salary of some $100,000, but the investment funds he managed had done well over 2007, rising in value by more than $500 million. His bonus was $206 million and he felt that to conform to industry norms, his bonus should be nearer $250 million - the cause of the dispute.

What, I asked, would happen in 2008 if the assets he managed fell in value? He would get paid his base salary and no bonus came the reply. And would he be required to repay any of the $250 million he had pocketed this year? Of course not.

This is the one-way, short-term bet that is endemic in the way the financial services industry rewards itself and which incentivises recklessness. Raghuram Rajan, former chief economist of the IMF, differentiated between two sources of wealth generation in the financial markets in an insightful article in the Financial Times earlier this month. There is run-of-the-mill 'beta' value created because stock markets and the economy are set fair and going up; then there is special 'alpha' value generated by investors such as American billionaire Warren Buffett who see opportunities others do not.

The problem is that while we know a priori that there are only one or two Buffetts around who deserve alpha-style pay, this has become the way the entire financial system's executive class rewards itself - being paid as if just one year's performance revealed them to be alpha superstars when, in truth, most are ordinary beta performers. It takes longer than a year to reveal who is alpha and who is beta, whatever executives like the hedge-fund manager in dispute over his bonus may claim.

The remuneration structure is a disaster. One of the reasons why rogue trader Jerome Kerviel faked a stunning GBP 3.7 billion of transactions at SocGen may have been because he regarded himself as being paid as a beta when he should have been paid as an alpha like everybody else. Moreover, he was able to fool the bank by trading in the daffy instruments that the financial system created to persuade national governments that it is not running excessive risks, an insurance that laid off risks to others. Hence the casino character of many new financial markets, which essentially operate as bookmakers accepting differing bets on future prices. Underneath their technical names - monoline insurance, derivatives, debt securitisation - lies little more than bookie principles and practice.

But selling off bad risks doesn't mean the catastrophe won't occur. And when the balloon goes up, the financial system screams for government intervention - to cut interest rates aggressively and to bail out stricken banks and insurance companies. Indeed, better still for the financiers, a gullible government can be persuaded to assume the risk, the exact principles of the Goldman Sachs-devised bail-out of Northern Rock - lubricated by excessive fees to the partners.

Thirteen years ago, I tried to blow the whistle on financial market liberalisation in my book The State We're In. It was obvious then what is even more obvious now: financial market freedom embeds short-termism, guarantees lower investment, works against business building and innovation, generates booms and busts, inflates house prices, creates system-wide risk and excessively rewards those who work in them. I thought the Germans and Japanese were better than the British and Americans in the way they organised and regulated finance and that while Britain and America might look good in the short term, their economies would eventually come back to earth with a bump.

New Labour threw a protective mantle around the financial markets in a way it never would for industry and sceptics were patronised as backward-looking, Old Labour know-nothings. Let's hopes these new crises will prompt a root-and-branch rethink. Of course, like the Americans, the British need to respond by aggressively cutting interest rates, cutting taxes and lifting public spending.

But more, we need to regulate closely how the financial system deploys its capital, develops its loans and how its people are paid, an initiative that requires global support. We need the financiers to serve business and the economy rather than be its master.

This is not a question of helping the financial system better to understand the risks it runs through more 'transparency', the friendly diagnosis deployed by both the Governor of the Bank of England and the Prime Minister in speeches last week. This is about reworking the one-sided bargain between finance and our economies. Only then can we lay the foundations for recovery and bring some semblance of fairness and rationality to the way these plutocrats behave.

Guardian Unlimited (c) Guardian News and Media Limited 2008,,2247583,00.html

Bill Totten


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