Sensible finance for a dynamic economy

<p><em>Romesh Vaitilingam interviews Professor&nbsp;Amar Bhid&eacute;&nbsp;for Vox</em></p>
<p><em>October 2010</em></p>
<p><em>Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5723]</em></p>
<p><strong>Romesh Vaitilingam</strong>: Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam, and today's interview is with Professor Amar Bhid&eacute; from the Fletcher School at Tufts University. We met in London in October 2010, where we spoke about his recently published book, &quot;A Call for Judgment: Sensible Finance for a Dynamic Economy.&quot; I began by asking Amar to explain the central thesis of his book, about the mismatch between what the financial sector does and the needs of the real economy.</p>
<p><strong>Professor Amar Bhid&eacute;</strong>: In my view, the real economy is a vibrant, dynamic place, most of it. It's constantly changing, and it's constantly changing because of autonomous decisions made by myriad producers and consumers. These decisions are made on the basis of judgment. And ultimately, most demands for finance arise from a judgment made by an individual, looking at his or her circumstances and making some leap about what he or she expects the future will be like. So, if I am borrowing money to buy a house, I have looked around my neighborhood. I have determined that prices are not about to collapse. I have then thought about my own income, and I've figured out that I can carry such and such mortgage, because my income is secure, that I have a job that will not seize in the foreseeable future. It's a set of on the spot judgments that inform my decision to apply for a mortgage loan.</p>
<p>Same thing with a business applying for a working capital loan. I think I want to expand my business. I think my competitive position is sound. I think I have enough of an equity cushion. Therefore, I ought to apply for a larger line of credit to finance my venture, to finance my working capital.</p>
<p>Since what I'm doing is a case by case judgment, prudent finance also demands that such case by case judgments be made by the financier, and that it's the mortgage lender's job to understand and poke holes into, if necessary, my reasonings and my data which went into my decision to apply for a loan.</p>
<p>And in many sectors of finance, these kind of case by case, boots on the ground judgments are still made. So venture capital which finances the most advanced companies in the world continues to be done in what one would think of is a rather primitive way, of people showing up, kicking the tires, having extensive discussions with you. Small business lending continues to be done in this fashion.</p>
<p>But the big growth in finance for the last 20 or 30 years has not been case by case. It has been this robotic, mechanistic form of finance, which has a curious resemblance to the kind of mechanistic central planning that Friedrich Hayek talked about.</p>
<p>Friedrich&nbsp;Hayek said that the problem with central planning is that the information that can be communicated to a central planner is fairly limited. He can only communicate five or six items of information, and that wipes out the hundreds of pieces of information that the man on the spot, as Hayek said, needs to take into account.</p>
<p>So, similarly, mortgage loans are made on the basis of five or six variables. These variables ignore important distinctions. So, as far as a mortgage lending model is concerned, income is income is income. And it doesn't matter whether it's a federal judge's income, which is secure for life, or whether it's the income of an automobile worker, who works for a plant whose closing has been announced. The model simply doesn't take this into account. But that's where most of the growth in finance has been.</p>
<p>We have also seen enormous growth of finance in the derivatives market, particularly in over the counter derivatives. We went from virtually nothing in the early 1980s to about $100 trillion by 2000, and between $6-800 trillion by 2006. None of this would have been possible if people writing these derivative contracts, buying and selling them, hadn't relied on mechanistic models, which simply ignored anything real deep about the counter parties or about the kinds of risks underneath.</p>
<p>This, in my view, both leads to a misallocation of capital. The federal judge may be turned down for a loan because his income is slightly lower than the automobile worker. It leads to a misallocation of capital because bank CEOs get attracted to those parts of finance which can be most easily mechanized mortgage lending, derivatives and disregard the kind of finance that does require this labor intensive, boots on the ground stuff. So we get more money going into derivatives and more attention to derivatives and housing and less to the real economy, as it were.</p>
<p>And it's also highly unstable because, instead of having a large number of individuals making case by case judgments, we have one or two highly similar models. If these models are wrong and they almost inevitably are in some important way these mistakes can, and have periodically, led to systemic collapses.</p>
<p><strong>Romesh</strong>: Amar, you're a great believer in innovation.</p>
<p><strong>Professor Bhid&eacute;</strong>: Right.</p>
<p><strong>Romesh</strong>: But you don't like financial innovation.</p>
<p><strong>Professor Bhid&eacute;</strong>: That's correct.</p>
<p><strong>Romesh</strong>: Can you explain why you think &quot;bad finance&quot;, as you term it, evolved in this way, why we had financial innovation, as the innovators of finance call it but which you don't really think of as an innovation?</p>
<p><strong>Professor Bhid&eacute;</strong>: If financial innovation had taken place purely through a free market process, then I would not quarrel with it. So I do not quarrel with pet rocks. Willing buyers, willing sellers. I may think it's idiotic, but it's an innovation. Somebody, God bless his soul, made a fortune selling pet rocks, because somebody on the other side thought that there was value to it. I don't think innovation in finance has had this character. It hasn't had this character principally because the banking system is one of those activities in the economy which simply cannot function without extensive regulation.</p>
<p>And in the 1780s, when virtually nothing in the American economy was regulated, banks were tightly regulated, with good reason, and this regulation increased progressively. And the basic banking functions of taking short term deposits and making long term loans would be impossible and did not, in fact, occur till we had deposit insurance.</p>
<p>This is an industry which simply cannot function in a sensible way without regulation. And therefore, it is the regulator's job to figure out whether the innovations that are proceeding under its umbrella are valuable innovations or not.</p>
<p>As a society, we may not care about pet rocks, because we don't subsidize the production of pet rocks and, as far as I know, pet rocks don't have any negative externalities.<br />
As a society, we subsidize the banking system. Then it becomes necessary for society to look at whether these are worthwhile innovations or not. And then the onus falls on the innovator to demonstrate, beyond reasonable doubt, that the subsidy is worthwhile.</p>
<p>Regulation in the 1930s made possible a great innovation, which was called a term loan. Till the 1930s, there were no term loans because banks were supposed to make very short term loans, because their deposits were volatile. A new technology developed in the 1930s, which was the term loan, which is fantastic. We all love it. It made possible a great expansion of commerce and a great expansion of consumption.</p>
<p>I don't believe a similar argument can be made about derivatives. Certainly, I would not put a nickel in the bank which had a trillion dollar derivative book, because I'd say it's much too risky for me. If I'm going to get one or two percent on my deposits, why do I want JP Morgan to do this stuff? And therefore, it is also then the responsibility of the regulator to figure out whether JP Morgan's derivative book, this innovation, is (a) prudent, because ultimately it's the taxpayer who is picking up the pieces when things go wrong.</p>
<p>Prudence, to a large degree, lies in the eye of the beholder, and it should. JP Morgan won't let any of its borrowers build up a huge derivatives book, in part because it's very hard to monitor. If regulators cannot easily monitor a derivatives book, then, on that basis alone, they should forbid it.</p>
<p>These vast increases in innovation have taken place largely because of the subsidy provided by the state; provided by regulators, and I can see no corresponding economic value. Bernanke asserted in 2006 that the banking system had been made fantastically safer through all these great advances. But any reasonable person would look at it and make exactly the opposite determination, that it had been made less safe.</p>
<p>So I'm not against all financial innovation. The yardstick I would use is, if this innovation depends on a public subsidy, then (a) is there clear and demonstrable public benefit from it? And if it's ambiguous, then I want to begin to ask myself the questions, is it congruent with the structures of the real economy? Is it based on case by case analysis?&nbsp;So, term loans were based on case by case analysis. A banker did do the boots on the ground analysis before extending a term loan.</p>
<p>One of the other innovations which people are very fond of talking about is preferred stock, which helped finance the railroads. That, too, was based on case by case innovation. There was a clear economic need on the other side.</p>
<p>I just don't see what the value of securitized loans is. They could just as easily be made by your local bank. And the process of securitizing these loans is fundamentally incongruent with the idea of a decentralized, case by case, judgment based economy.</p>
<p><strong>Romesh</strong>: Amar, you talk in the book a great deal about the evolution of the field of academic financial economics, about which you have a generally negative view. Can you elucidate that idea about the contribution that the academic world made to the development of bad finance?</p>
<p><strong>Professor Bhid&eacute;</strong>: It's made a large contribution, but the sign is negative. Modern finance involves a fundamental misrepresentation of risk, at its root.</p>
<p>We all take risky decisions every day - what shirt should I put on? what tie should I wear? what I should order off the menu? And so forth. Perhaps once every 10 years, we reduce these decisions to a probability distribution, even if we have been through many, many statistics courses and we've been taught about base theorem and so forth. Yet even the professors who teach about base theorem never use it in their daily lives. This cannot be because they're stupid. This must be because the kinds of decisions that they make are not amenable to being reduced to quantitative risk measures. Yet the assumption of modern finance is that all risks can be reduced to these one or two variables.</p>
<p>For further convenience, it is assumed that there are no differences of opinion. This is palpably wrong. It's also incongruent with the idea of decentralized decision making, where each person is looking at situations in their own idiosyncratic way and making their own choices.</p>
<p>It also assumes that not only are there no differences of opinions; it assumes that this all knowing probability distribution is the right one. Again, false.</p>
<p>And finally, and I think worst of all, it assumes that the world is stationary, that it doesn't change, that it changes only on the margin. I was talking to a well known economist, who shall remain unnamed at this point, and he said, &quot;Yes, yes, yes, it's all very well to talk about judgment. That's the stuff you only need on the margins of the economy, which are innovative.&quot; And I said, &quot;This is a fundamental misrepresentation of what a modern economy is really like.&quot; It's not just the stuff that's happening in the R&amp;D labs, which is dynamic. Everything is dynamic.</p>
<p>We're sitting in a restaurant. That restaurant is facing new threats to its existence and new opportunities every single day. You wouldn't lend to it, if you were a banker. You would take these constantly changing facts about this restaurant into account before you did anything.</p>
<p>But modern finance assumes the other way. It assumes that everything is a draw from an urn, and it's the draw from the same urn. This is extremely convenient for the mass production of financial instruments, for strategies which allow you to make multi billion dollar investments in stocks and build up trillion dollar derivatives books. It's just wrong, and we have eaten the results, as it were.</p>
<p><strong>Romesh</strong>: Can we turn to possible solutions, what we want to do in the future? You've described what the dynamic economy is, one that we're facing in our daily lives. But your subtitle is &quot;Sensible Finance for a Dynamic Economy.&quot; What do you think sensible finance looks like?</p>
<p><strong>Professor Bhid&eacute;</strong>: I have no hope that academic finance will be reformed. My only hope is that it can be made irrelevant. Academic finance came into its own because of the encouragement of regulators, principally banking regulators, and if we take away that underpinning, it would naturally shrink. Global warming is a really hard problem. Health care is a really hard problem. Fixing the financial system is a really easy problem, or fixing most of the financial system is a really easy problem.</p>
<p>I say, first of all, the principles should be case by case, boots on the ground, not top down edicts. So I have no faith in Basel, I have no faith in capital requirements, these top down solutions. I want brakes to be examined. I don't want people to mandate thicker airbags.</p>
<p>Now, brake examination is labor intensive which means that there are only so many things that you can hope to accomplish through case by case analysis. So I would focus just on maintaining a sound depository and payment system. If you did this then many of the other good things that come out with a sound banking system you'd get automatically.</p>
<p>So I would go back to really an 1835 law which didn't try to forbid banks from doing this, that or the other. It took the opposite approach which said, &quot;You will only be allowed to do this, this, and this and nothing else.&quot;</p>
<p>In my view, banks should only be allowed to do basic lending and simple hedging. And the standard ought to be simply activities that someone with a basic accounting or college degree can understand and hope to examine. If it's not examinable by someone without a PhD in economics then it should not remain in the depository system.</p>
<p>Perhaps we need something like a prudent lender rule when the stuff ever comes up for litigation you have to persuade the jury that this is the kind of law you would pay if it were your own money. Beyond that, I would not attempt to regulate the rest of finance at all. Let them do what they want.</p>
<p><strong>Romesh</strong>: But without the government guarantee backing the money?</p>
<p><strong>Professor Bhid&eacute;</strong>: But, and that's a really important &ldquo;but&rdquo;, with no credit risk and no counterparty risk. We think that there are some cars that are so dangerous that we deem them to be non street legal, but we allow them to race on Formula One race tracks. If financiers want to create these high powered stuff and race them around on Formula One race tracks under the rules which they privately determined, as long as these cars don't come near the public highways, that's fine. I think by the similar process you would pretty much require JP Morgan, Goldman Sachs, the five banks who have between them about $200 trillion in derivatives to get rid of these derivatives because nobody else can look at them.</p>
<p>This doesn't mean that I would ban derivatives, but let it happen outside the depository system, and I would bet a lot less would happen.</p>
<p>I also think perhaps the time has come to assert a full government monopoly over money. Until 1862, there used to be privately-issued bank notes. This is chaos. And then we nationalized paper currency. Then we found that an alternative medium of exchange arose which would kind of nationalize through deposit insurance, but we didn't do it explicitly and we sort of pretend that only parts of it would be protected and other parts wouldn't. And then we let alternative forms of money develop.</p>
<p>Let's sort of get rid of the pretense. Let us say that all short term deposits (we can argue about what is a short term deposit whether it's one week or a month or whatever) are explicitly the liability of the government. The United States has something called &quot;TreasuryDirect Accounts&quot; where symmetry didn't come with the treasury.</p>
<p>So why shouldn't all transactional accounts, whether those held by individuals or by companies, be TreasuryDirect accounts? We would in one fell swoop end the problem of banks not trusting each other and companies not trusting the checks written on other banks and the kind of paralysis that we saw in 2008, and then correspondingly the government is going to take on all these liabilities and it ought to explicitly equip itself to regulate those entities who will act on its behalf.</p>
<p>We could easily clean up the financial system or at least rid it of its most dangerous parts without actually adding to the manpower and the regulatory agencies. We've passed the 2300 page regulatory bill which creates body after body and demands rules after rules, and it's a hopeless task because you'd have to hire every single PhD coming out of every PhD program to have any chance of imposing these things and it's too broad.</p>
<p>People talk about regulatory capture. I think what we have is regulatory asphyxiation, smothering the regulators with so many responsibilities that they can't perform. So let's narrow their responsibilities and make sure that they can do it.</p>
<p><strong>Romesh</strong>: Well, I was going to ask you how far away you think we are in terms of the current regulatory discussion, whether on a national level or on a global level. You don't have much time for Basel, you say. Dodd Frank?</p>
<p><strong>Professor Bhid&eacute;</strong>: The one good think about Dodd Frank is the Volcker Rule and it's a good stock. The rest of it is worse than useless. By throwing all these responsibilities at regulators, it virtually ensures that none of them can be properly performed. We have the oversight council, an inter agency body that's somehow going to sniff the systemic risk coming down to pipe. We have the Fed and it couldn't see the housing bubble. This whole thing is whitewash.</p>
<p>But I think the good thing that has come out of the crisis is the public has become extremely skeptical of the experts, and angry. I think that anger and skepticism is an important first step.</p>
<p>One of the big differences between financial debates now and financial debates as used to occur when the Federal Reserve Act was passed and the Banking Act was passed in 1935 is that it was Senators and Congressmen who were front and center of these debates. They informed themselves of the issues. They had the self confidence to have a view. There were many members of the public who had the self confidence to have a view.</p>
<p>We have now allowed a small number of people all subscribing to theories which, as I said, I think are wrong to monopolize the debate. They have been proven to be wrong. So the debate can be opened up, if we can actually have a genuine public debate of what kind of financial system we need and should have, and this is a debate which, if not the average citizen, but at least the listeners to your program the readers of The Economist can participate.</p>
<p>If we could get back to people like Senator Glass and the representative Steagall, who had views as opposed to simply being mouthpieces for either special interests that funded them or academic theorists who provided them with position favors, that's the only way I think we are going to solve this.</p>
<p>These things take an awful lot of time. Deposit insurance was first proposed in the 1860s or 1870s, and it was finally passed in 1933. In a democracy, that's not necessarily bad.</p>
<p>So I hope we reach the peak of the madness and we are going to slowly go the other way. It's fine if the first bill was a bad bill, but at least Congress felt the heat. What I'm afraid of is that things would go back to normal, and say &ldquo;we&rsquo;ve solved the problem&rdquo;, and they'll wait till the next crisis before we begin to resume this debate.</p>
<p>The debate shouldn't stop. If a law is passed next year or a year after, I don't care that much. But it's time that the average person understood the issues and got engaged.</p>
<p><strong>Romesh</strong>: Amar Bhid&eacute;, thank you very much.</p>
<p><strong>Professor Bhid&eacute;</strong>: Thank you very much.</p>