End of an epoch?

This is an article by Con Keating, reproduced with his kind permission. It’s hard but it’s worth it- Con is the cleverest man in town.

The demise of the Bretton Woods system in the 1970s was epoch-defining; it constituted a massive shift of financial risk-bearing from the public to the private sector. One aspect of this was the progressive international financial liberalisation that followed, and a by-product of that, the ever increasing ‘financialisation’ of our economies. This shift also marked a fundamental change of economic philosophy.

The Bretton Woods institutions, the IMF and IBRD, survived but did so by adopting the role of leading advocates of the new religion. These institutions have demonstrated an ability to change and are doing so again.

This is well-illustrated by their attitude to free international flows of capital. Though the original articles of the IMF never advocated such liberalisation, by the late 1990s they were part of every “solution” advanced by the IMF and culminated in the (rejected) attempts to modify those original articles. This was the new orthodoxy.

Regulation of the private sector moved from the control regulation of Keynes and White, to the risk-based (self) regulation with which we are all familiar; a process of regulatory capture by common philosophy, which greatly benefited regulated financial sector insiders. The exponential growth in credit, financial market activity and contractual complexity, the increased ‘financialisation’ of our economies, which accompanied this, can be only partially justified by the increase in risk faced by the private sector. It was also notable that these inside financial institutions also changed character by merging and incorporating within a single institution many of the traditional activities of distinct categories of financial institution, notably insurance and banking.

The Asian crisis of 1997/1998 was, perhaps, the turning point. The excoriating criticism of Dr Mathahir Mohamad and Malaysia on their introduction of exchange and capital controls in crisis response verged on demonization. Hindsight places those controls in a very different and positive light. The 2010 Seoul G20 declaration and numerous recent IMF and other official publications have now thoroughly legitimised this behaviour. The debate is now not over minor detail of the phasing and sequence of capital account liberalisation but, rather, of more fundamental questions, including the optimal size of the financial sector, the role of international capital flows and their appropriate control mechanisms.

Though it is trivial to demonstrate that capital account controls can be used to manipulate exchange rates and the terms of trade, the current debate is not about trade and globalisation, or even protectionism, but about financial stability and the economy. International trade can be expected to continue to increase, perhaps reaching 40% of global GDP in the coming decades. It is notable that the empirical evidence in support of the theoretical economics of free international capital flows was always rather mixed and ambiguous. The development arguments of the liberalisation philosophy were certainly confounded by the observation that, for the decade prior to the crisis, the capital flows were from the less-developed to the developed world.

The current problems of the Eurozone can also be seen in this light; free movement of capital (even within a common currency area) without concomitant co-ordination of fiscal policy (including taxation) can be profoundly problematic.

Re-evaluation of the financial system, its role in the economy, and society more generally, has been proceeding apace; amidst a literature which is often confused and confusing, Michael Sanders’ “What Money Can’t Buy” and the Skidelskys’ “How Much Is Enough” are notable for their lucidity.

Alongside unprecedented official actions to resolve the problems arising from the crisis and its lingering effects, we have seen numerous regulatory proposals, littered with technical jargon such as procyclicality, with an apparent ambition of “never again”. In academic circles, these have been broadly divided into micro-prudential extensions and alterations of the pre-existing regime and new macro-prudential regulation concerned specifically with stability. One related manifestation:  the various examinations under way of the short and the long-term: the Kay Review, a forthcoming EC Green paper, an ECMI/CEPS task-force, the Long Finance Initiative and many other influential private groups.

Until recently the financial services lobby was apparently having considerable success in delaying, obstructing and watering down many of these proposals.  However, with the public travails of JP Morgan, HSBC, Barclays and many more, it seems that this lobby is now more than ever likely to be ineffectual. The financial world is changing and the recently unthinkable now requires consideration.

This is nowhere more relevant than in the asset management industry. The vocal, and often exaggerated, claims of excessive costs and fees are just one symptom of this need.

Risk acquired a surprising centrality in financial regulation, even though ex ante, it is unobservable and ex post, it is disputable. Indeed the very feasibility of its estimation or measurement is questionable. The risks of financial markets differ in material ways from those of natural hazards. Insuring against flood or earthquake is a game against nature; we really cannot affect the likelihood of the event. Mitigation may be important in terms of the total loss incurred, but carrying an umbrella does not change the likelihood of rain, though it may save our clothes from ruin. Financial markets, by contrast, are predominantly games against others. In describing markets as places where “men meet to deceive”, Democritus was not entirely wrong. In other words, most of the risks of financial markets are of our own collective creation, rather than naturally occurring hazard, and, perversely, all too many of the ‘solutions’, the hedges to these financial risks are yet more financial contracts.

To be perfectly clear, the only perfect hedge of a financial asset is its sale. This makes immediately obvious the central flaw of this now-dominant management style; it reduces the investment fund to cash. This is entirely inconsistent with any idea of investment and deferred consumption.

Until the crisis, liquidity did not figure in any meaningful way in banking regulation. The argument of the liberalisation school was that liquidity was always available from the central bank in its role as lender of last resort; experience has entirely discredited that canon, along with much else. If we use the ultimate source of liquidity to define and distinguish between investment and speculation, we can advance the discussion and resolve a few conundrums.

We shall define speculation as reliance upon a market for its future liquidity. This is sale in a market, reliance upon the market price at some future date. By contrast, we will define investment as reliance upon a specific obligor under the terms of a contract. In this view, the saving deposit placed in a bank by an individual is investment. The treasury bill bought and held to maturity is investment. The equity bought and held solely for the collection of dividends is investment. Time, or the holding period, is material here. The return performance of an equity held for a few microseconds is determined entirely by price. That same equity’s returns when held for a hundred years or more will be predominantly determined by the income received from it. This has long been known to the asset management industry – it usually takes the form of statements to the effect that asset allocation is the most important management operation for performance (Beebower, Brinson et al is the usual citation. However, the dissonance of this with the long-term is rarely commented upon, though its academic credentials are also impeccable (Dimson, Marsh and Staunton – Triumph of the Optimists). This point warrants emphasis – the long term is about income and income growth while the short term is about price movement.

Hedging is immediately obviously a form of speculation concerned with movement in price – as is most of the risk management that we observe in markets. This is fuelled and exaggerated by ‘fair value’ or mark-to-market accounting, which can be seen as another strand of the liberalisation philosophy. If I have purchased a gilt strip as an investment so that I hold this to maturity, any intermediate price is immaterial to the liquidity I will receive at maturity. If I purchase a coupon paying government my income yield is not determined by the intermediate prices, but rather by the initial price at which I purchased the security. In fact the total return achieved increases as prices decline and intermediate reinvestment yields increase. Declining prices are the friend of the investor, they offer better opportunities and higher returns, but they are inimical to the speculator (unless short).

The consequence of a mark-to-market accounting regime and regulation based upon that for investors is that the stabilising influence of these investors is diminished and market stability impaired as the speculators come to dominate. In this circumstance, markets cannot perform their critical economic resource allocation role. The market itself becomes a source of procyclicality that has so troubled the regulatory authorities.

There is another related disjunction – in the academic liquidity literature. In the macro-economic analysis liquidity is costly and harmful, but in the market microstructure it is desirable. Now it is obvious that liquidity must have a cost; if it did not all assets would be liquid. This runs contrary to much analysis where, incorrectly, it is illiquidity which has a cost. In markets we are concerned with instruments which are negotiable, which contain an option on liquidity. A bond which is non-negotiable yields more than a bond which is tradable. This has long been exploited by sovereign debt management offices, which go to great lengths to maximise the negotiability of their securities, lowering their issuance costs.

If we consider the risk-free rate of financial theory to be a pure liquidity preference rate, then it is immediate that this rate lies above the rate on the zero-coupon government of the term of interest, since that security is negotiable, as it contains an embedded option on liquidity. Contrary to popular belief low rates do not provide information about future returns, what these low rates are telling us is that future liquidity is expected be high (in relative terms).

The implicit terms of the liquidity option of a negotiable security are fixed at the time of purchase of that instrument; the costs are realised when it is exercised on sale. A buy and hold strategy never exercises this option, but the option still has a cost to the strategy. The security had a higher price at acquisition, which lowered the income yield and this liquidity option is a pure sunk cost. When current market liquidity is low, the implicit cost of the option is low. When current market liquidity is high, the implicit cost of the liquidity option is high. We really do make the worst of deals in the best of times.

The liquidity available in a market is principally exogenous to that market; it is determined by the level of savings and the real investment demands in the economy. The liquidity provided by financial intermediaries, such as dealers, is limited to their capital employed. There is an efficiency dimension in the velocity of this inside liquidity but that is merely an intermediate step in the transfer of liquidity from saver to investor user. It appears that under financial liberalisation, the inside sector has grown far beyond anything necessary merely to smooth the flows from savers to users of capital and that the rents extracted for these intermediation services are material drags on the economic performance of savings.

As the philosophy of market-based financial liberalisation loses influence, we may expect the financial sector to shrink, and with that lower inside activity to occur, which suggests lower use of derivatives. As the developments in the US, Holland and Scandinavia have shown, the use of fair value accounting and regulation based on that is beginning to be rolled back. Solvency II is clearly the swan-song of the old and discredited school.

As for fund management, the future is not about asset allocation and ever more clever and complex strategies for the management of assets and liabilities, nor is it about ever more sophisticated risk management, but rather of the management of cash-flows.  In this world, performance and skill will be concerned with the improvement to the income yield. Here, transparency of costs and fees are the friend of the investment manager.

This is a world in which fund managers will be far less concerned with second and third guessing the behaviour of markets and others than previously and far more concerned with the actions of the authorities. It will become necessary to consider the recently unthinkable; taxes, controls and many other interventions are now possible, and many even likely. If, as many argue, these are extensively evaded or even just avoided, we should not be surprised by an official response of ever more draconian changes in regulation. Even such shibboleths as the tax-deductibility of corporate interest payments on debt capital are being revisited.

The relevant quotation now is not James Carville’s wish to be reincarnated as the bond market but rather another of his aphorisms: “(Republicans) want smaller government for the same reason crooks want fewer cops: it’s easier to get away with murder.”

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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