Wednesday, January 21, 2009

The Financial Crisis: A Question of Perspective

One of the big problems in figuring out the nature of the present financial crisis is that it is very difficult to adjudicate between different perspectives on the facts of the case. These do not speak for themselves. And, there are various parties, with opposing agendas, who are crowding in to speak on their behalf.

This problem is tackled in the book I have been working on, as I mentioned in the last posting. The conclusions I am edging towards are: (1) there may be no neutral ground from which we can decide between different perspectives on the facts, (2) we may have to work backwards from conceptions of the kind of society we want to live in and the sort of people we want to be, adjusting our interpretation of the facts accordingly, and (3) in the end, we may only be able to deal with the crisis by means of what the late Richard Rorty called 'cultural politics'.

Tampering with 'the facts'? Sounds like idealistic, wishful thinking. But, it is actually a useful form of pragmatic realism. Dogmatism, the inability to see that facts have multiple, self-consistent interpretations, is what makes us lose touch with reality. If you have qualms about all this, then consider the problem of making good on talk about facts without appealing to interpretations. For how do we deal with the reality corresponding to the facts directly, on the outside of any interpretations, as it were? Hmmm,.... I hope you get it, but maybe, I should be able to think of a better way of expressing that last point.

In the case of high finance, there are many examples to illustrate the issue of 'perspective'. But, let me just pick one that recently stood out in my reading and research. It involves the complex financial instruments called derivatives. These do not show up on balance sheets, and are shielded from regulatory control and investor scrutiny. Trillions of dollars have been notionally involved in transactions based on derivatives. And, there have been some spectacular losses by organisations that, on the face of it, should not be carrying out high cost, risky transactions.

Enter our old friend, the father of modern finance theory, Merton Miller. In countless speeches and articles, he robustly defended derivatives on grounds of their social benefit, reinterpreting the spectacular losses accordingly - they provide no convincing evidence that special purpose regulatory control is required. Take the bankruptcy of Orange County. Its investment pool filed for bankruptcy in December 1994, reporting losses on leveraged purchases of derivatives-based securities of $1.5bn. Miller defends derivatives even in this case, and his strategy, as usual, is to view things from the economic heights so that only the overall flow of monetary wealth shows up, and the economic distress of individuals, not to mention the negative effects on social life, are bleached out.

However, let's not question this general approach, but look instead at a matter of factual detail that helps drive home the claim about 'perspectives'. Miller acknowledges that Orange County's approach to investment was risky: "That strategy had risks to be sure, but those risks would have been clear to treasurer Robert Citron - and, for that matter, to the people of Orange County who re-elected Citron treasurer in preference to an opposing candidate who was criticising the investment strategy." Miller's faith in the financial savvy of the good people of Orange County is touching, but strangely optimistic.

Here is his own, relatively clear, explanation of the heart of that strategy: "Most of the investments involved leveraged purchases of intermediate-term securities and structured notes financed with 'reverse repos' and other short term borrowings". So the good people understood and voted for that? There's a whole background story about the flaws in how finance theorists, and economists in general, treat voting preferences and other decisions. But, again, let's leave that aside. Let's look instead at Robert Citron himself, the person who was found guilty of violating state investment laws, the person the Orange County folk so shrewdly voted for, the person who Miller claims was well aware of the risks. Here's a different take on Robert from Frank Partnoy, a former derivatives broker and now law professor and best-selling author: "The sentencing inquiry revealed that not only was Citron a college drop out, he had the maths skills of a seventh grader. Psychologists put his ability to think and reason in the lowest 5 per cent of the population."

Now this may look like a simple stand-off over the which account is factually accurate, and hence an example that actually goes against my main point. But, that is because we have viewed these 'perspectives' in isolation. If we start to describe each one in more detail, which involves links with further interpretations of the facts, then we end up with two very large, empirically rich, internally consistent outlooks between which it is impossible to choose from neutral ground. Different perspectives. Enough said?

References: 'Value at Risk: Uses and Abuses', C.Culp, M.Miller, and A. Neves; in The Revolution in Corporate Finance, 4th Edition, J.Stern and D.Chew, Jr. (eds), Blackwell: Oxford, 2003, p.423
F.I.A.S.C.O. Guns, Booze and Bloodlust: The Truth about High Finance, Frank Partnoy, Profile Books: London,2007, p.173.

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