Saturday, 8 December 2012

The Future of Finance


 
 
THE FUTURE OF FINANCE: And The Theory That Underpins It, London School of Economics Press, UK, 2010

Preface by Richard Layard; with contributions by Adair Turner, Andrew Haldane, Paul Woolley, Sushil Wadhwani, Charles Goodhart, Andrew Smithers, Andrew Large, John Kay, Martin Wolf, Peter Boone and Simon Johnson.

This compilation of papers by Britain's best and brightest addresses the structural weaknesses and questions the social utility of the global financial system. These deeper issues are not addressed by the new US 843-page Dodd-Frank Wall Street Reform and Consumer Protection Act signed by President Obama. The Future of Finance (downloadable) exceeded my expectations, and it will be required reading at central banks and ministries, in academia and by institutional and pension fund trustees, their consultants, portfolio managers, as well as retail broker-dealers and their clients.

The Future of Finance, the brainchild of banker turned academic Paul Woolley, is the first bold shot across the bows of mainstream conventional finance from Woolley's new Centre for the Study of Capital Market Dysfunctionality at the venerable London School of Economics.

From the Preface of Richard Layard, author of Happiness: Lessons from a New Science (Penguin Group 2005) and the magisterial lead chapter by Adair Turner, head of Britain's soon-to-be-abolished Financial Services Authority, to the final warnings of the next crises by Peter Boone and Simon Johnson, author of 13 Bankers, this book will shake up the business-as-usual, outdated theories and models --- from Wall Street, London's City, the world's other financial centers and sovereign wealth funds to every retail broker and banker. The authors put financial sectors back in thir places – as intermediaries between savers, producers, lenders and borrowers in the real economies of the world.

These authors cover the many causes of the 2007-2009 financial collapse: the reasons financial sectors outgrew their usefulness to real economies and their reliance on outdated economics and its now-discredited theories of "efficient markets." The authors critique such models, including "rational actors" and the entire intellectual apparatus and the range of models which it spawned: MPT, VaR, CAPM, Black-Scholes Options Pricing. They explore the skewed incentives, the rush to benchmarking and indices, all seeking alpha, and the huge ballooning of dysfunctional financial sectors and their predation on real economies. Many identify the famous but flawed Arrow-Debreu Theorem (for which Kenneth Arrow won the Bank of Sweden Prize in Memory of Alfred Nobel in 1972) as the justification used by market players for this "financialization" in the theorem's assumption of "market completion."

Most of the authors share the view that structural reforms are needed as well as better regulatory transparency if the world is to be spared new crises. All point to systemic risks and offer reasons why those risks (about which I have written since the early 1990s!) were overlooked by market players, regulators and politicians. Only Adair Turner mentions the obvious remedy to curb flash trading and speculation: the below 1% financial transaction tax proposed in the 1970s by James Tobin and in 1989 by Larry Summers, now US President Obama's chief economic advisor. Traders defend these markets as providing liquidity – but as we saw in the "flash crash" May 6th, 2010, on Wall Stret, such "faux liquidity" provided by robots disappears rapidly. Remedies for TBTF banks, avoided in the new US law, are those of Simon Johnson (break them up), and Laurence Kotlikoff's and John Kay's equally sensible proposals for limited-purpose, narrow banking as "public utilities." Many acknowledge the goals of Paul Volcker and the 1930s Glass-Steagall Act which separated retail deposit-taking banks from speculation and proprietary trading. These still continue to dominate today's global casino.

Most innovative and viable for immediate application are Paul Woolley's proposals to reform institutional and pension funds, based on his new financial model which takes into account the principal-agent problem so endemic in legal, corporate and academic literature. Woolley points out that this has never been applied to finance! It has even been missed by behavioral science approaches now fashionable in economics. These illustrated how markets were governed by "herd behavior" (recognized by Keynes and my own writings (Henderson, Building a Win-Win World 1996; "What did the Asian Meltdown Teach Us About Conventional Economic Policies?" Journal of Futures Studies 1998; "Information: the World's New Currency Isn't Scarce" World Business Academy PERSPECTIVES 1994).

The behaviorists overlooked the obvious principal-agent problem wherein investors (principals), for many reasons including information asymmetry, rely on agents: brokers, advisors, consultants and portfolio managers. This principal-agent problem leads to a host of conflicts of interest, opaqueness, rent-seeking, which skew markets, prices and incentives. Woolley demonstrates how these can be overcome, starting with his sensible 10-point Manifesto for Giant Funds (institutional and pension funds) and his 5-points of Supportive Actions for Policy-makers that are all already available.

My only addition to Prof. Woolley's proposed GDP-linked bonds for institutional portfolios is that he needs to emphasize the ways in which GDP itself is due for a drastic overhaul. Many corrections have been outlined by me (Paradigms in Progress 1991, 1995), the European Parliament at their Beyond GDP conference (www.beyond-gdp.eu) and the Stiglitz-Sen Commission's tweaks. Sovereign bonds can be linked to corrected GDP measures as well as to new Quality of Life Indicators (www.calvert-henderson.com) and those of ecological sustainability, (such as the TEEB model and Ecological Footprint) as well as asset valuation models beyond MPT. These include ESG, "triple bottom line," blended value and other responsible and ethical investing models promoted by the UN Principles of Responsible Investing, representing $20 trillion of institutional and pension fund assets of which my company, Ethical Markets Media, is a signatory. We all share Woolley's concern with how to retrain portfolio managers and all agents in shifting to the new asset valuation models.

Prof. Woolley has performed a huge service and The Future of Finance is a worthy start to his new Centre at the LSE. We can hope that this work, the best that can be done within the economics paradigm, will be complemented in the future with all the "beyond the economics box," multi-disciplinary work based on systems integration. Multiple metrics from ecology and the physical sciences will be needed to incorporate pricing of ecosystem services and thermodynamic models of efficiency about which economics is ignorant, as I, Herman Daly, TEEB's Pavan Sukhdev, and early pioneers Kenneth Boulding, Nicholas Georgescu-Roegen and Nobelist Frederick Soddy have documented for over a century.


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