Friday, January 22, 2010

The Financial Crisis, Yet Again

When I talked previously about the current financial crisis, I was very concerned about the lack of insightful and informative analysis of its causes and consequences. Since then, the situation has improved, with commentators such as Paul Krugman, Joseph Stiglitz and Robert Shiller, in particular, making some very useful contributions (though the crisis deniers tend not to listen to them: regarding any reformist suggestions as 'socialist'). Nevertheless, the overall situation still concerns me greatly. And here, very quickly, are some of the reasons why (I will expand on these on another occasion).

Clearly, those most responsible for creating the crisis have failed to seize the opportunity to radically rethink their approach to business and finance in order to help build an international financial system that avoids such problems in the future (if you think about it, the government bailouts, though necessary, provide a strong disincentive to do this). Most seem to have reverted to type by resolutely defending the dogmas that encouraged grossly irresponsible risk-taking.

Unfortunately, their critics follow suit by voicing simplistic anti-business views that fail to engage with those dogmas in a realistic or fruitful manner. This negative stance yields little by way of practical recommendations for improving financial behaviour and institutions.

For some of the lead actors, such as Goldman Sachs, it seems to be "thanks for the leg-up, but now it's back to business as usual". In a letter to the Financial Times, the CEO candidly admitted "complexity overwhelmed us" - presumably, with huge (perhaps record) profits, the company has solved that problem. No doubt its fear of losing the competitive advantage prevents it from sharing the secret to the greater good (just to be be clear: I am being ironic - they have no 'solution', but have adroitly found ways of cashing in on the crisis, and in the finance world, 'cashing in' is, by definition, socially beneficial).

Here, the entrenched thinking of those in the first category above is the most worrying. One fears that their views lack any rational foundation - if only because no evidence is allowed to refute them. The finance theory (e.g. the efficient market hypothesis, and so on) that sparked the creation of fancy financial gift-wrappings for risk and guided the behaviour of powerful financial institutions was subjected to a giant experiment. Powerful lobbying ensured that perceived regulatory obstacles were removed or forestalled, oversight bodies were conveniently complicit, and ethical interference of any kind was at a minimum. Under these hugely favourable conditions, with large amounts of capital swishing around, the finance community should have been poised to work some magic to the economic benefit of all. But, the end result was a gigantic screw up. And, apart from some token apologies, the main actors have shown no real remorse, and many have scrambled to invoke ad hoc conjectures that blame 'less than ideal' conditions for the crisis - as if the experiment would have worked if only the government hadn't .... or whatever. Recall, there are Marxists who discount the fall of the Soviet Empire and insist that the communist experiment has yet to be carried out.

At this point, those in the 'critics' category mentioned earlier might interject: "Yes, but this is because you have a naive conception of business motivation. When you said that the finance theory-based beliefs behind the crisis were not held on a rational basis, you were ignoring the individualistic bias that infects the thinking of the finance community. The beliefs may have failed in the social arena, and they may have harmed others, but most of the individuals concerned emerged, not just unscathed, but much richer. For them, the experiment did work, and that shows that their views were held on a rational basis. For what could be more rational than making lots of money, especially when wealth creation is automatically good for everyone and not just the immediate beneficiary? By the looks of the profits now being made, the finance community is setting things up for another economic flare-up." More on the ethical implications of all this next time.


  1. HI Alan. Delighted to read this astute analysis of the situation. I agree with everything you are saying here.
    I hope you will forgive me for cheekily mentioning that I argued a similar line when you gave your talk on Finance Theory to UEA several years ago now: your response at that time was very different. When I claimed that Finance Theory was built on sand, and that crude mistakes in the philosophy of science (in particular, broadly Friedmanian assumptions about abstracting from the humanity of participants in the economy, and about equilibrium, markets, deregulation, etc) were perpetuating the illusion of an escape from the tendency of speculation and deregulation to lead to bust, you demurred and claimed that I hadn't understood how sophisticated the new Finance Theories were! At least, that is my recollection of the meeting. I'm glad to see how you have changed your tune! ;-)
    [My recent work on this may be of interest to you: see my pieces in IJGE and Eco-politics, for instance. And my persistent arguments across the blogosphere and media for real nationalisation of the banks as the only genuine long-term solution.]

  2. Good to hear from you. Yes, I remember that talk well - mainly because I was concerned that a new kind of business person was emerging: a person for whom morality has no value except as something to be paid lip-service to when necessary - exactly the kind of person who was capaable of creating the crisis we now face. As for finance theory, I haven't changed my view - at that time I was simply trying to get people to recognise that it had great (and highly dangerous)causal power because of its scientistic trappings of mathematical elegance and quasi-empirical stability(though I too thought it was built on sand). I doubt whether you did 'understand' the irrelevance theorem, for example, or the internal significance of option pricing theory - but that, as you rightly said, was actually no big deal.