Professor Feiger of Aston University inhabits a world of dark pools, hidden dominoes, conceptual conundrums and economic fallacies, circulation and velocity, hypothecation and re-hypothecation, interlinked systems and sadly for many of us mere mortals in his audience, too little equilibrium.
At his inaugural Professorial lecture given last week he outlined the straightforward matter of, 'understanding systems dynamics in economics: the villains and the heroes'.
He said, rather ominously, that it was the end of macro economics as we know it - because these economists and their understanding of 'how systems fit together is way too limited'.
As is so often the case the efforts made to 'buck the existing orthodoxy' were facing a rearguard battle from 'the economics of status quo'.
Whilst we needed, in his view, to 'fundamentally reconstruct the system' there was something of a repair job going on since the economic crash.
In outlining the 'repair men's' view of what went wrong in 2008 Professor Feiger felt it could be summarised through a confluence of four factors --
1) Unfortunate ideological pressures : "Ideology has been allowed to distort the reality," said Professor Feiger. He explained that according to the 'Efficient Market Hypothesis' it was impossible to make money without risk and that the market always priced risk correctly. This theory had been proposed by the neo classical economist, Eugene Fama, whilst simultaneously being opposed by Robert Shiller, leader of the behavioural school, with both economists being awarded the Nobel Prize for economics this year for their opposing views - reflecting the deep-seated schisms at the heart of economics thinking.
"The efficient market hypothesis has been used to justify a hands-off approach to regulation and by the EU to justify a single currency embracing the whole economic zone in spite of the degree of indebtedness of the various economies, the lack of labour market cohesion and a multiplicity of tax variations."
Even though they had pressed ahead with the project he warned that the Eurozone might still come unstuck due to the deep fault lines that had been 'papered over'.
2) Flawed Economic Structures : There were no real owners in stock market capitalism as it was currently operating around the globe. Companies were owned and traded by pension funds, mutuals, indexes - with none of these holders having any long term interests. The goal of making money quickly was their primary motivation. It was, said Professsor Feiger, a situation where, "Quarterly earnings dominate. Complex structures of international institutions add to the overall complexity. Too often there is an inadequate understanding of the risks that enterprises are running." People were, he said, unlikely to know the personal skills and qualities of 30,000 global partners in an accounting practice, for example. Applying rules to the management of discretionary risk was a fundamental structural problem.
3) Markets were littered with hidden dominoes : There was a great multiplicity of legal and regulatory environments. This often led to problems arising as a surprise which no one had expected or anticipated.
4) Being Done : The repair men of the financial system were saying that too many people didn't know what they had been doing which had amounted to 'Moral hazard' - or the unwanted happening alongside incentives which had led to people do things which were ultimately 'bad'. These had come about through three main issues:
1) Securitization : Banks had originally made loans and kept them on their books. But in the '90s banks had started creating structures for pooled loans. Loans were originated, fees paid for each loan made, and the loans sold on into pooled loan facilities generating bonuses. There was a strong incentive to go for volumes and to let quality of loans slip to build volumes.
2) The Greenspan 'Put' : Whatever trouble capital markets got into the Fed Reserve would bail them out.
3) Fallacy of composition : This theory implied that the aggregate behaves as individual parts behave. For example, Keynes had stated that if everyone saved output would fall. However, the collateral underpins of global credit systems had not functioned in this way - if all houses came up for sale at the same time, the collateral value collapses and all the dominoes fall simultaneously.
The new Governor of the Bank of England had said recently that with proper regulation we could look forward to good times and growth.
It was therefore worth considering 'What is 'Proper Regulation? '
The following had been proposed -
1) Tougher and Smarter regulators : There were, observed Professor Feiger, some challenging practicalities associated with implementation of this...It was possible to earn around £75k at the Bank of England or one of the regulators, or around £1m at a typical commercial bank. In fact many traders went to work in the Bank of England first or one of the regulators before going to work for a commercial bank which had in turn become a 'revolving door' practice and led to the development of a 'cosy bunch'.
2) Companies should focus on long term earnings , not quarterly earnings - difficult to implement, observed Professor Feiger, when the market still expected earnings in the short term.
3) Outlaw bonuses at regulated institutions : This had already led to the flight of people and capital into non-regulated areas of financial activity, commented Professor Feiger.
4) Force Banks to hold more capital : In 2007 US banks held 0.5-0.6 cents of equity or assets to loans or were leveraged 16 times. In the EU banks had been leveraged 15 times assets. However, whilst regulators might want banks to hold more capital, and to target 20% capital requirements - there was still a long way to go to get there.
At the same time money market funds, structured equity and leveraged funds already had more capital than the banks so business was leaking into these areas. Banking was the 'four horseman of the apocalypse' said Professor Feiger. "Given this, I don't believe we can tinker with regulation and do away with the 'crisis'".
Reconstructing our view of the financial system.
The Keynesian approach suggested that through the application of economic, financial and fiscal tools we could put all the pieces back into place; and that market economies always reverted after periodic of bouts of self cleansing through the Equalibrium theory.
However, Central banks and macro economic models had always, without fail, missed every turning point in every economy across all time. This was, he said, an "Incontestable point. A Pure act of faith."
"We need to move from conventional views to a more path dependent economic system, something like weather forecasting. We need to develop a model of an interlinked system, grown from path dependent formations."
1) Model of the interlinked system
In 2007 when Lehman Bros collapsed the Primary Reserve Fund held lot of Lehman shares, so they were unable to pay out to holders $1 owed per share. This caused a run on Reserve Funds and on US Treasury Bonds. When bank customers started pulling funds out the asset ratio was so low that the forced reductions in credit worsening the position of the banks and business. Government, in turn, had been so grossly indebted that bailing out the banks had resulted in them becoming even more indebted. Path dependent expectations were in play in this situation.
"Economic theory, as outlined above, anticipates a stationary distribution of outcomes which would be unaffected by previous outcomes. If the movement of securities prices were drawn from a stationary distribution it would be possible to calculate value of risk. However this is not the case. The value of what happens next is in fact affected by what happened earlier. When off balance sheet loans received margin calls on garbage then banks had to pay up bad loans. By leveraging the funds of safe assets we had pushed good assets to poor values - and in some instances institutions were getting 0.50c on a $ for these deals."
In 2007 US government had been criticized for saving Bear Sterns and for favouring Wall Street. However prior to Lehman Bros collapse, no one had bothered to check the web binding Lehman Bros to other institutions outside of New York. Banks on Wall Street were unaffected by the Lehman collapse as Wall Street had prepared itself for the next collapse and were ready for it. But the regulators had not checked outside of Wall Street. It was there that the real impacts of the unwinding of the Lehman loans portfolio was felt.
2) Re-hypothecated loans - post collateral. "A broker treats your collateral as his own and is able to lend on the back of it." In US this could only be done 1.5 times the amount of the collateral taken. In UK brokers could lend against this collateral, remarkably, unlimited amount of times.
"The Fed had calculated a notional figure for re-hypothecation at 4 times across the world. But it was in fact much higher.
"The real research agenda for finance and economics is based around these issues and expectations. It is based around leakage and think back and what people actually are going to do in these situations.
"We need to develop some sensible and realistic policies we can learn from them, follow them and in turn get smarter about how to deal with these situations. At present there are no viable models of expectations formulation."
"When look at underlying structural situation there is huge level of debt - public and private and within households. The ratio of household debt to income is the highest it's ever been and we can't expect this to continue. Professor Feiger predicted that the 'debt supercycle was coming to a close'.
There were, he said, only three ways out -
i) Default
ii) Growth
iii) Inflation
It was difficult to see default for the bulk, but not all, Western economies; growth was also difficult to see at higher than trend levels, which left inflation as the most likely option.
3) Velocity and Circulation
"The concept of money was vague", he stated... "What is money? Something someone else will accept in lieu of something they want. Money as a concept was becoming even more elusive through the increasing digitisation of transactions which might even do away with money as we know it.
Under the system of Quantitative Easing (QE) the velocity of circulation had fallen pro rata in relation to the assets created.
Money had ceased to be something understandable. The function of credit was to allow the time displacement of consumption. There was a need for greater understanding about the formation of expectations in economies.
Off Balance Sheet investment pools didn't appear on any balance sheets, were not recorded in any public registers as loans or stocks, or in any known places. Where the labels were, how they were recorded and interpreted remained a challenge. So much so, that even physicists were writing about economics and path dependent systems.
In conclusion he noted that linkages and expectations were a problem of epidemiology, which suggested we needed to make the linkages much more visible. We needed more trades to be OTC rather than in 'dark pools'. However, there had been a huge increase in 'dark pool' trading. Which meant it was impossible to know who is connected to whom.
We needed to stop off balance sheet trading completely.
We needed to ban re-hypothecation. "This isn't only about disclosure, we also need to ringfence certain trades. There was no one brilliant idea in the short term.
So what was the moral, or the meaning of all this, if I can hazard an attempt at one?
In my view in order to understand George Feiger's arguments you have to be critical of financial services, of how bad debts were wrapped up with good ones and how off balance sheet debts, whatever you call them, were used excessively.
Despite his protestations about the 'concept of money' being vague, he has assumed that there is a fundamental set of values to which we have all subscribed. When the financial system gets out of kilter with these real values, disaster ensues, no matter how clever we are about it.
Perhaps we have in fact been too clever and lost sight of reality, or at the very least equilibrium between real assets in existence and attributable value in pursuit of the 'fast buck' that democracy so often demands.
Maybe the reality we need to pursue is growth. Rather than assume this is not possible for more mature economies, why do we not tilt all our efforts through entrepreneurial endeavour, towards creating the real output required to grow at unprecedented rates, rather than inflating our way out of this crisis.
* Beverley Nielsen is Director of Employer Engagement at Birmingham City University
