Friday, January 25, 2008

Take It On Faith - The Markets Will Heal Themselves

Today David Brooks gives us another of his "there are two types of people" columns, this time in relation to the financial markets. As usual, one type of person agrees with David Brooks and is correct, and the other type of person disagrees with him and is wrong. The latter group accepts a "greed narrative" of the financial markets, in which:
The financial markets are dominated by absurdly overpaid zillionaires. They invent complex financial instruments, like globally securitized subprime mortgages that few really understand. They dump these things onto the unsuspecting, sending destabilizing waves of money sloshing around the globe. Economies melt down. Regular people lose jobs and savings. Meanwhile, the financial insiders still get their obscene bonuses, rain or shine.
Smart people like Brooks know better, and endorse an "ecology narrative":
It starts with the premise that investors and borrowers cooperate and compete in a complex ecosystem. Everyone seeks wealth while minimizing risk....

Hedge funds have proliferated to help investors manage risk. These things exist precisely because investors want to smooth out volatility. In the old days, a blow to, say, the Texas economy could have dried up lending in Texas, but now funds flow globally, and money from one part of the world can shore up weakness in another.
The problem with the ecology narrative, according to Brooks, is not greed, but is inexperience:
When a new instrument enters the market, it takes a while before people understand and institutionalize it. Whether the product is high-yield bonds or mortgage-backed securities, there’s a tendency to get carried away.

In the first stage of this adolescence, investors look around and see everybody else making money off some new instrument. As Nicholas Bloom of Stanford notes: “They assume they are fine because they see everyone else buying it.”

Brooks assures us that this rush into the new and unknown isn't driven by greed - it's just inexperience. There is no "greed" to be found when an extremely well-compensated investment banker or financial professional pours investor money into an investment vehicle that he doesn't understand. He's like a teenager who gets to drive a muscle car - he may get a little bit carried away, wrap the car around a tree, and cause a great deal of anguish for the owner, but what can you expect from a teenager? I mean, an investment professional earning six or seven figures a year.
Then, finally, maturity sets in. Those who have lost great gobs of money get fired. People still find the new product useful, but within parameters and with greater safeguards.

The lesson of the Ecology Narrative is that, in most cases, the market corrects itself.
Whence the parameters and "greater safeguards"? Voluntary self-regulation? Government regulation? Either way, why is it necessary? Brooks has already told us that investors only crashed the car because of their inexperience - under his "ecology model", after the instrument is understood and institutionalized, why would they make the same mistake again?
People who embrace the Ecology Narrative don’t like the offensive bonuses that get handed out on Wall Street. They just don’t see any way the government can curtail them without rending the fabric of the ecosystem. They don’t like the periodic crises, but don’t see how government can prevent them without clamping down on innovation.
Yet they have no qualms about having the government pour billions into a failing company to subsidize up a failing industry, pour billions upon billions into failing savings and loans to prop them up, pour billions upon billions into a "stimulus package" to offset a recession brought on in part by the way adolescent investment professionals crash their new fiscal vehicles. The "fabric of the ecosystem" is only rendered when the government tries to prevent calamity or, Heaven forbid, put responsibility for righting the mess on the shoulders of the recipients of those "offensive bonuses".

Perhaps I should have saved some typing and simply pointed out that Brooks regards the two narratives, greed and ecology, as polar opposites. In fact, they can and do coexist in the markets. It's foolish to pretend otherwise.

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