Prudence and Risk Awareness Go Together

Risk Reduction Leads to Speculative Booms

Capital markets, like all markets, are bi-polar. Periodically they go through a boom/bust phase. If this is unpalatable, the only other option is state control (ownership) of capital and labour. This was tried in the Soviet Union where it resulted in distortions and shortages for nigh on seventy-five years--all of which was blamed on serial and relentlessly bad weather.

Surely there has got to be a middle way, someone will opine. Surely if you keep capital in private hands (that is, out of government control) but regulate the worst excesses of private capital markets, keeping those markets on an even keel, so to speak, or within the railway tracks, the train of unending growing prosperity can ride off into the sunset in perpetuity. Boom and bust will no longer apply.

This sort of solution of regulation, controls, maintaining moderation, keeping the system working within reasonable bounds--all of this may work reasonably well when it comes to transport systems, which explains why the railway analogy is appealing. But the analogy breaks down when applied to capital markets.

A capital market is an exchange of capital where folk, who have some surplus money, supply it (at a cost) to those who need it. A market is, by definition, a decentralised decision making institution. Markets, in order to get transactions taking place, must be implicitly free, because value, worth, needs, goals, aspirations and ambitions vary amongst human beings. What is sauce to the goose is not necessarily sauce to the gander. One person may choose to invest his surplus capital in electricity producing windmills because that it highly valued by him. Others may choose to invest in Vegemite because it pays a regular dividend. Different strokes for different folks.

But all participants in capital markets tend to have one common concern: they implicitly measure the risk of their capital being wasted or destroyed. Implicitly providers of capital are reckoning up the likelihood that the return they are wanting would not transpire, were they to entrust their spare capital to a bank, or a windmill company, or a food conglomerate, or whatever. The vast majority of capital investors seek a monetary return on their capital. They want their original capital returned, plus some gain.

When does the boom occur? Booms always occur when perceptions of risk become cloudy. Simply put, when people believe they are investing in a "sure thing" they will be comfortable with investing. Booms occur when it is believed that not only is an investment a virtual guaranteed gain, but that the gain will be substantial and quick. When you see around you friends and acquaintances, colleagues and business rivals enjoying these gains--when everyone is doing it--the boom is on. It is not just that the potential returns have to be seen as substantial, but that they have to be understood as virtually certain. No doubts. No worries.

Here is where regulations and rules can indirectly cause booms. Instead of preventing booms and busts more often than not regulations and government controls cause them. Why? Because regulations are supposed to reduce risk. They implicitly are supposed to make returns more certain. A recent article in Foreign Policy magazine provides a telling picture of how regulation and inappropriate governmental interference actually indirectly caused the collapse of 2008. The author, Paul Seabright argues that we face a paradox in the matter of capital market regulation: the more clever the regulation, the more likely it will distort markets, and the bigger the collapse will be.

There are important lessons to be learned from the crisis. But we'll learn them better if we realize that the intellectual and political architects of the system that failed us were not naive at all, but immensely clever and subtle; it was their cleverness and subtlety that undid them. And that is bad news for all of us, for naivete can give way to learning, but cleverness has no obvious higher state.

The more people believe that central banks can control bubbles and deflate them before bursting, the more a truly destructive collapse will happen. Why? Because providers of capital think that the authorities have effectively removed risk from the investing equation. Therefore they are prepared to take huge risks, telling themselves the risks do not really exist.

In effect, the second and third lines of defense came down to this: trusting the other to do more of the work than either was prepared to shoulder. The better the central bankers performed, the more everyone else was content to rely on them to sort out the obvious tensions in the system, such as the fact that real U.S. housing prices rose nearly 150 percent from 1995 to 2006. Everyone knew it couldn't go on forever, but if Greenspan had taken care of the crises of 1987, 1991, 1998, and 2000, surely he would be on hand if there were a crisis this time. Not everyone agreed there was a bubble, but the danger lay not with those who didn't believe in bubbles. It lay instead with those who thought there might be a bubble but that we could handle it.

Here is the paradox: the more a financial system is engineered and regulated to reduce risk, the more likely systemic risk will break out causing a collapse of the system. The less regulation, the more risk is controlled and booms less likely to occur.

Banking creates the illusion -- the necessary illusion -- that there exist islands of stability in a sea of risk. Depositors who settle payments with a check need not worry -- most of the time -- whether a check drawn on one bank is worth the same as a check in the same nominal amount drawn on another. As the economist Gary Gorton has put it, banking does for the nonexpert in finance what the electricity grid does for the nonexpert in electricity: allowing one to use the system and benefit from its technical sophistication as reliably as the expert can. How? By enabling most who ultimately bear the risk not to have to worry about it on a day-to-day basis.

But as we discovered once the crisis broke, it was not just nonexperts who had stopped worrying about risk on a day-to-day basis. Most professional investors had also gotten into the habit of not worrying about it either, including those who had money invested in the repo markets and other parts of the vast shadow banking system. Before we rail against their stupidity, we should remember that not worrying about risk is precisely what a modern banking system enables its customers to do. That the lack of worrying had gone too far is now undeniable, but it happened precisely because of how impressively the modern banking system works when it is working well.

There is one egregious component in the most recent debacle, however. Governments stepped in as the liquifier of last resort: the cost of capital loss was cast forth upon future generations. This left most of us solvent. In terms of behavioural economics, this sets us up for a much bigger collapse to come--because, once again, the regulators have prevented loss; they have reduced our risks. The moral hazard mounts.

Reaffirming the need to take responsibility will require not just that individuals who are exposed to risk should realize that fact and act on it, but also that individuals who create risk bear more of the consequences. The fact that creditors have borne so little of the cost of recapitalizing failing banks is one of the great scandals of modern times. It is a scandal due to panic and not only to capture by special interests -- policymakers bailing out creditors were rightly terrified of the consequences if the bailouts failed -- but it is no less unacceptable for that. This massive bailout of imprudent creditors will matter for many reasons, not least of which is that crises will recur in the future and we shall need to anticipate how to manage the bailouts that will be needed when they do.

A risk-aware market is a prudent market. In capital markets there is a lot to be said for "caveat emptor". If it fails, you are on your own. Rules and regulations should focus upon honesty, integrity, and disclosure and not on ensuring safety. Risk-reducing regulations and bail outs perversely create far more systemic risk over the long term.