Devil in the Detail: Demystifying Global Economics
Ben Friis-O’Toole argues for the simplification of the global economic order.
When the solvency of a local council in suburban Sydney is threatened by a collapse of the U.S. housing market, it is not merely an inevitable if regrettable outcome of globalisation: it is absurd. More importantly, though, it demonstrates a great failure of the global financial system that first became obvious in 2007 and continues to spiral out of control – a failure rooted in excess generally, but triggered and exacerbated by the excessive complexity of modern finance. As The Economist has argued, if the price of financial sophistication is instability, something is amiss.
Much has been written on the global financial crisis since the credit crunch first took hold approximately 18 months ago. Economists, central bankers, and even Prime Ministers have dealt with the issue extensively. Yet, despite the vast amount of information, analysis and opinion available, no coherent and comprehensive consensus has emerged in relation to its causes.
Of course, that is not to say that no dominant theme is apparent; certainly there is broad consistency in terms of the identification of specific factors. Look beyond unhelpful explanations that are simplistic (such as bankers are greedy) and quixotic (such as free markets are evil), and factors such as the availability of excessively cheap credit, lax regulation, reckless lending, avaricious securitisation, and poor rating and risk evaluation combine to explain most aspects of the current world economic situation.
A satisfactory explanation, however, which accounts for the suddenness, rapidity and severity of the crisis, requires more than observing that the unsustainable debt-fuelled asset bubble which developed over the last few decades has finally burst. Indeed, even more arcane explanations centered on the impact of underlying global capital imbalances are inadequate inasmuch as they, too, fail to provide justification for the timing of the crisis. Perhaps, however, the very fact that it has proven so difficult to explain the crisis may be the key to understanding it.
Complexity is not inherently bad. Indeed, it is wrong to fear something merely because you do not understand it. But the price of financial sophistication has been global economic instability. Complexity can evidently be dangerous. It is, therefore, not only eminently sensible but absolutely crucial to be cautious of things that even the best and brightest of the financial world do not and likely cannot understand.
Derivatives and other financial products are not intrinsically iniquitous. Indeed, they are an integral part of the modern global economy, and play a crucial role in risk management among other things. However, as instruments such as the now-infamous Collateralised Debt Obligations (CDOs) and credit default swaps (CDSs) illustrate, such products can be dangerous.
One of the central tenets of finance is the risk-return relationship: the notion that investors should be compensated for taking on risk by way of higher returns. Although simple, the idea is profound, and the failure of numerous institutions and organisations to observe it lies at the root of the current crisis. Of course, such failure is partly due to the greed of sections of the finance industry, and, as Robert Shiller argues, to the wilful ignorance of investors. However, it is also due to the sheer complexity of products such as CDOs: if it is practically impossible to assess the risk of a CDO, how can a fair value (and therefore an appropriate return) be determined?
“It is absolutely crucial to be cautious of things that even the best and brightest of the financial world do not and likely cannot understand.”
As a result of the miscalculation of risk associated with excessively complex financial products, the capital of many institutions has been decimated by the crisis. And if the enormous problems associated with the valuation of CDOs are not enough, there is another, potentially more devastating result of the excessive complexity of the financial architecture. As Warren Buffett pointed out, the ‘web of mutual dependence’ created by instruments such as CDSs can be incomprehensibly dangerous, especially in times of economic crisis. Even ostensibly robust companies can suddenly become exposed to very large and unexpected liabilities.
In a paper published by the Boston Consulting Group in 2008, it was noted that the global financial system rests on three interdependent pillars: capital, liquidity and confidence. Each of these has been attacked, either directly or indirectly, in the wake of the current crisis. For the real economy, the result has been devastating. Complexity has led to an extreme lack of transparency and the erosion of confidence, which in turn has led to the drying up of the lifeblood of the world economy: credit. The financial system has failed in its critical function of efficiently and effectively allocating capital.
The global financial system is unavoidably and perhaps necessarily complex; yet it has proven far too complicated for its own good. While the roots of the crisis run deep, involving numerous micro- and macroeconomic factors, policymakers must act to rein in excessive complexity and ensure the world does not find itself in this situation again. The global financial system must be better regulated so as to support the three pillars of the modern financial system, because as John Kay made clear, a functioning and vibrant financial industry is essential for a prosperous world economy.
