Wednesday, October 01, 2008

The system suffers when everyone has somewhere to hide

This global financial crisis is testing to extremes every idea and tool economic regulators possess.  But regulators don't demonstrate any understanding of a major cause of instability.  It's an idea that sits outside economic orthodoxy.

The problem is that the legal, managerial and psychological processes of employment diminish the transparency so necessary to healthy economies.  This has been at play in this crisis.

A key objective of economic regulators is to smooth out the cycles of boom and bust and to target steady, sustained growth.

Regulators have strong but limited tools.  They manipulate interest rates and cash liquidity and impose regulatory oversight on companies.

Yet the human factor of unrestrained greed seems to overwhelm them.  Greed creates economic bubbles when transparency is low.

It's not unexpected that the FBI is investigating potential fraud in Fannie Mae, Freddie Mac, Lehman Brothers and insurer American International Group (AIG).  Given even recent history, it's reasonable to assume that fraud will be found and executives jailed.

Less than 10 years ago, parallel scenes were witnessed with Enron, WorldCom, Italy's food giant Parmalat and Australia's own HIA, Bond and Qintex.  It was greed at its worst.

What beats the regulators is that it's impossible to control or predict the behaviour of every executive in every business, every day.  Sensible economic management would say "don't try!" -- attempts to micro-manage business kills business and economic activity.

It's a difficult balance.  Free-market economies need minimal regulation to maximise economic outcomes.  But leave business to itself and eventually "smart" managers conjure financial trickery to give stupidity and even criminality the appearance of respectability.

Look at the essence of this crisis.  US housing loans were made en masse to people who clearly could not afford the payments.  They were conned into loans that began with

very low interest rates but locked in higher rates several years down the line.  Now, at the end of the line, they can't afford the higher payments and are loan defaulters.  Poor people are now destitute people.

The lenders who initiated the loans, were loan traffickers.  They packaged the loans, masked them and on-sold them.  They knew the loans were duds.  At each level, traders pocketed profit.  Reputable institutions wound up owning worthless loans.  The con became globally systemic.  Then it crashed.

The loans bubble was always ethically poor, but was probably also fraudulent.  It certainly required lots of people to ignore that the loans were destined to fail.  But why would people in business be willing to do such bad business?  Here's the question:  what is it about the free-market approach that makes economic success so possible, yet economic crisis so repetitive?  There's systemic failing here.

An answer is in understanding that free-market systems are not fully applied.  The problem is at company level, and the link with employment.

Economic theory says that companies cannot and must not function like free markets.

They allegedly need strict command-and-control systems to operate.  Employment is the legal contract that delivers managerial control, it locks in each employee's subservience to the people above.

It's called loyalty, and it's thought that this enables companies to capture value.

Consequently, a company operates like a socialist state.  Individuality is suppressed.  Moral reasoning is distorted.  Subservience is supreme.

Accountability belongs to the collective and not the individual.  When senior people behave badly or illegally, the command system sends signals that people beneath them must comply.  Only the very brave "blow the whistle", and they are rarely rewarded.

The outcome is that individual common sense and ethics must overcome the system, rather than be supported by it, and the result is the systemic suppression of transparency.  Under these circumstances, when businesses trade with each other, the incentive is to trade in low transparency.

This was the core problem with the dud US housing loans.

Achievement of temporary "fools' gold" profit induced the suppression of the financial truth.  Long-term accountability for the inevitable harm was never taken on by individuals.  Everyone had an incentive to ignore reality.  The contagion spread, rotting the integrity of the entire financial system.

Successful free-market economies depend on transparency and the allocation of individual accountability.

It's the millions of little things that matter.  Buy the wrong clothing and you'll be a fashion disaster.  Buy the wrong car and you'll spend too much on petrol.

Reliable information helps our decisions.  With individual accountability, we change our behaviour because we must accept reality.

The system of employment fails in this respect.  Accountability is not individual and truth can be ignored.  Applied throughout an economy, transparency is reduced, corrupting market signals and allowing speculative bubbles to grow.

If regulators fail to recognise that "employment" is a primary contributor to economic instability, they risk merely tackling symptoms of crisis, rather than root causes.


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