Alchemists of Loss

How Modern Finance and Government Intervention Crashed the Financial System

Kevin Dowd, Martin Hutchinson

• Publisher: Wiley
• Year: 2010
• Print ISBN: 9780470689158
• eBook ISBN: 9780470689967
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

An engaging look at how modern finance almost destroyed our global economy

Over the last thirty years, capital markets have been restructured through the tenets of modern finance. This has been enormously profitable for the financial services sector. However, these innovations, coupled with unsound risk and regulatory practices have proved disastrous for the global economy.

In a clear and accessible style, ex-investment banker and financial journalist Martin Hutchinson, and highly respected academic, Kevin Dowd show how modern finance combined with easy money threatened to bring down the world financial system. At the heart of the book is modern finance as a U.S. invention, the theories and practices associated with them, and the changes they made in business models and risk management on Wall Street and other major financial centers.

• Breaks down the events involved in the 2007-08 financial collapse
• Reveals how botched policy response made a bad situation worse
• Focuses on lessons that the practice of finance must learn from recent events

The Alchemists of Loss will help you to understand how our financial system crashed and show you what it will take to make sure this won't happen again as we move forward.

Part One

Past Successes and Disasters

1

Introduction

Towards the end of his General Theory of Employment, Interest and Money, published in 1936, John Maynard Keynes wrote that:

“… the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.”¹

In this book we suggest that the key to understanding the recent financial crisis is to appreciate the impact of two belief systems, at first sight unconnected. Both of these belief systems originated from economic theories propounded by “defunct economists.”

The first of these is Modern Finance. At its broadest level, Modern Finance consists of a set of attitudes and practices, perhaps best understood by comparing it to what went before. In the past, finance emphasized old-fashioned values: the importance of trust, integrity and saving; the need to build long-term relationships and invest for the long term; modest remuneration for practitioners and a focus on the interests of their clients; and tight governance and a sense of harmonized interests and mutual benefit. All of these dovetailed together into a coherent whole.

Modern Finance emphasizes the opposite: a focus on marketing and sales, form over substance, and never mind the client; an obsession with the short-term and the next bonus; a preference for speculation and trading over long-term investment; stratospheric remuneration levels for practitioners, paid for through exploitation of clients and taxpayers, or “rent seeking”²; the erosion of the old governance mechanisms and out-of-control conflicts of interest.

Underpinning much of Modern Finance is a vast intellectual corpus, the formidable mathematical “Modern Financial Theory.” This includes Modern Portfolio Theory developed in the 1950s; the Efficient Market Hypothesis and the Capital Asset Pricing Model developed in the 1960s; the weird and wonderful universe of financial derivatives pricing models, including notably the Black-Scholes-Merton equation for valuing options, developed in the early 1970s, and its many derivatives; and financial risk management or, more accurately, the modern quantitative theory of financial risk management, which emerged in the 1990s.

Modern Financial Theory soon became widely accepted; those who questioned it were, for the most part, drummed out of the finance profession. It became even more respectable with the award, to date, of no fewer than seven Economics Nobels, ample proof of its scientific respectability.

Modern Finance was big on promises. We were assured that it would provide us with the ever-expanding benefits of “financial innovation” and sophisticated new financial “services,” and not just at the level of the corporation, but trickling down to the retail level, benefiting individual savers and investors in their everyday lives. The evidence for this was, allegedly, the much greater range of choice of financial services available and the expanding size of the financial services sector as a percentage of GDP. At the same time, improvements in financial risk management meant that we could sleep easily in our beds, knowing our hard-earned money was safe in the hands of financial institutions working on our behalf. Or so we were led to believe.

Yet, intellectually impressive as it is, most of this theoretical edifice was based on a deeply flawed understanding of the way the world actually works. Like medieval alchemy, it was an elegant and internally consistent intellectual structure based on flawed assumptions.

One of these was that stock price movements obey a Gaussian distribution. While the Gaussian distribution is the best-known distribution, it is only one of many, and has the special property that its “tails” are very thin - i.e. that events from outside the norm are truly rare, never-in-the-history-of-the-universe rare. History tells us that’s not right; markets surprise us quite often.

Among some of the other common but manifestly indefensible claims of Modern Finance are that:

• modern “free markets” ensure that financial innovation is a good thing, which benefits consumers and makes the financial system more stable;

• risks are foreseeable and, incredibly, that you can assess risks using a risk measure, the Value-at-Risk or VaR, that gives you no idea of what might happen if a bad event actually occurs;

• highly complex models based on unrealistic assumptions give us reliable means of valuing complicated positions and of assessing the risks they entail;

• high leverage (or borrowing) doesn’t matter and is in any case tax-efficient; and

• the regulatory system or the government will protect you if some “bad apple” in the financial services industry rips you off, as happens all too often.

The invention and dissemination of Modern Financial Theory is a startling example of the ability to achieve fame and fortune through the propagation of error that becomes generally accepted. In this, it is eerily reminiscent of the work of the Soviet biologist Trofim Denisovich Lysenko, a man of modest education whose career began when he claimed to be able to fertilize fields without using fertilizer.

Instead of being dismissed as so much fertilizer themselves, Lysenko’s claims were highly convenient to the authorities in the Soviet Union, and he was elevated to a position of great power and influence. He went on to espouse a theory, “Lysenkoism,” that flatly contradicted the emerging science of genetics and was raised to the level of a virtual scientific state religion. Those who opposed his theories were persecuted, often harshly. Lysenko’s theories of agricultural alchemy in the end proved highly damaging and indeed embarrassing to Soviet science, and Lysenko himself died in disgrace.

Of course, the analogy is not perfect: proponents of Modern Financial Theory did not rely on Stalin to promote their ideas and silence their opponents, nor did they rely on the prison camps. Instead, their critics were sidelined and had great difficulty getting their work published in top journals, so ending up teaching in the academic “gulag” of less influential, lower-tier schools. But what the two systems share in common is a demonstrably false ideology raised to a dominant position where it inflicted massive damage, and an illusion of “scientific” respectability combined with a very unscientific unwillingness to listen to criticism.

For its part, the financial services industry eagerly adopted Modern Financial Theory, not because it was “true” in any meaningful sense (as if anyone in the industry really cared!) but because the theory served the interests of key industry groups. After the investment debacles of 1966-74, investment managers wanted a scientific-seeming basis to persuade clients to entrust their money to them. The options and derivatives markets, growing up after 1973, wanted a mechanism to value complicated positions so that traders could make money on them. Securities designers wanted mechanisms by which their extremely profitable derivatives-based wrinkles could be managed internally and sold to the public. Housing securitizers wanted a theory that reassured investors and rating agencies about the risks of large packages of home mortgages, allowing those packages to get favorable credit ratings. Back-office types and proprietary traders wanted models that would provide plausibly high values for the illiquid securities they had bought, allowing them to be marked upwards in financial statements and provide new profits and bonus potential. Most of all, Wall Street wanted a paradigm that would disguise naked rent seeking as the normal and benign workings of a free market.

With this level of potential support, it’s not surprising that Modern Financial Theory was readily adopted by Wall Street and became dominant there, even though crises as early as 1987 demonstrated that it was hugely flawed. It didn’t hurt that, in parts of the business, the universal adoption of Modern Finance techniques tended to validate them, as options prices arbitraged themselves towards their Black-Scholes-Merton value, for example. After 1995, the loosening of monetary conditions for a time created an apparently eternal “Great Moderation” bull market environment in which Modern Finance techniques appeared to work well, but then broke down completely when they were really needed.

Nevertheless, for those with open eyes, it has been apparent for some time that Modern Financial Theory wasn’t delivering what was promised on its behalf. The industry was benefiting, to be sure: its remuneration skyrocketed, and perhaps that had something to do with its expanding share of GDP. But what about everyone else? What exactly were these new financial services that were benefiting us all? More credit than we could afford to repay? Subprime mortgages? Unwelcome cold calls at dinner time from our bank pestering us to buy expensive “products” we didn’t want? Or, at the corporate level, credit derivatives perhaps? And if risk management was working so well, why were there so many risk management disasters over the last two decades? Something was going wrong.

For a long time the problems were explained away or swept under the rug, and critics were dismissed as coming from the fringe: if you held your nose and didn’t look too hard at what was going wrong, you could perhaps still just about persuade yourself that it really was working. Occasional problems were, after all, only to be expected.

But there eventually came a point where denial was no longer an option: as institution after institution suffered unimaginably unlikely losses in 2007 and 2008 and much of the banking system simply collapsed, the edifice of Modern Financial Theory (and especially Modern Financial Risk Management) collapsed with it.

And, to any flat-earther who denies what is self-evident to everyone else, we would ask: if the events of 2007-08 do not constitute a failure of Modern Financial Theory, then what exactly would?

Yet, even after this debacle, Modern Financial Theory remains in daily use throughout Wall Street. Its models are still used to manage investments, value derivatives, price risk, and generate additional profits, just as if the crash had never happened. Needless to say, this refusal to recognize reality is deeply unhealthy, although the costs will probably be borne yet again by taxpayers and the global economy in general rather than by Wall Street’s denizens themselves. A new paradigm is urgently needed.

The second belief system that led to financial disaster is one which celebrates the benefits of state intervention into the economy. Of course, there are many such belief systems, but the one most directly relevant when seeking to understand the current financial crisis is Keynesian economics. The “defunct economist,” in this case, is Keynes himself.

Keynesian economics came to dominate economic thinking in the 1930s, as people tried to come to terms with the calamity of the Great Depression. It maintained that the free market economy was inherently unstable, and that the solution to this instability was for the government to manage the macro economy: to apply stimulus when the economy was going down, and put on the brakes when it was booming excessively.

In his General Theory, Keynes explicitly put himself in the dubious tradition of the monetary cranks, the “funny money” merchants of old, who had been dismissed before then. He sneered at the Gladstonian notion that the government should manage its finances like a household and instead offered a macroeconomics founded on paradox - in particular, the “paradox of thrift,” a notorious idea infamously espoused by Bernard Mandeville in his Fable of the Bees: or, Private Vices, Publick Benefits (1714) that caused great offence when it was first suggested and was aptly described later as a cynical system of morality made attractive by ingenious paradoxes. The gist of it was that we can somehow spend ourselves rich. Keynes not only resurrected the idea and made it “respectable,” but enthroned it as the centerpiece of his new theory of macroeconomics.

Keynes liberated us from old-fashioned notions about the need for the government to manage its finances responsibly, inadvertently perhaps also paving the way for the more recent belief, widespread before the current crisis, that we as individuals didn’t need to be responsible for our own finances either.

Keynesianism ruled the roost for a generation or more. In practice, Keynesian policies almost always boiled down to more stimulus, typically greater government spending and/or expansionary monetary policy.

The result was inflation, low at first, but by the late 1960s a major problem. Keynesianism never really came to terms with this problem, and its most significant attempt to do so - the treacherous Phillips curve, interpreted by Keynesians as a trade-off between inflation and unemployment - was refuted by Milton Friedman in his famous presidential address to the American Economics Association in 1967. In the long term, no such trade-off existed.

Yet policymakers were reluctant to embrace Friedman’s position that bringing inflation down required tight monetary policy - lower monetary growth and higher short-term interest rates - which was likely to produce short-term recession as a side effect. Policymakers were hooked on “stimulus.” In any case, if inflation ever did get out of hand, they could always apply brute force or wage and price controls to contain it, and they ignored the warnings of Friedman and his monetarist followers that controls wouldn’t work either.

Keynesian economics reached the apogee of its influence after World War II in both the United States and Britain, then ran into serious trouble in both countries after 1970. After the 1970s’ Keynesian-driven stagflation, a move towards much tighter money eventually worked. Inflation was brought down and seemed to be conquered for good.

Yet slowly, quietly, Keynesianism made its comeback. Most economists and policymakers had never entirely given up on the idea that policy should have some element of “lean against the wind,” even if they acknowledged that “old” Keynesianism had gone too far. Moreover, as the memories of past inflation horrors began to dim, the Federal Reserve in particular slowly began to squander the inflation credibility it had earned with such difficulty and cost in the Paul Volcker ³ years of tight money in the late 1970s and early 1980s. In the meantime, Volcker had been replaced by Alan Greenspan,⁴ who began in the mid-1990s to pursue the easy-money policy demanded by politicians and the stock market. For over a decade the Fed pushed interest rates down, and its ‘accommodating’ - that is to say, expansionary - monetary policy fueled a series of ever more damaging boom-bust cycles in asset markets, the worst (so far) of which culminated in the outbreak of crisis in the late summer of 2007.

More ominously, the policy response to the most acute crisis since the Great Depression was massive stimulus - deficit spending on an unprecedented scale; even more accommodating monetary policy, with interest rates pushed down to zero; and massive taxpayer bailouts of financial institutions and of the bankers who had led them to ruin. Keynesianism was now back with a vengeance. Thus, in another one of those Keynesian paradoxes, the Keynesian medicine that had helped fuel the crisis was now, in huge doses, the only solution to it. The irony was lost on most policymakers.

One of the few exceptions who didn’t lose his mind in the panic was the social democrat German finance minister, Peer Steinbrück. In December 2008, he expressed the bewilderment of many when he observed how

“The same people who would never touch deficit spending are now tossing around billions [and, indeed, much more]. The switch from decades of supply-side politics all the way to a crass Keynesianism is breathtaking. When I ask about the origins of the crisis, economists I respect tell me it is the credit-financed growth of recent years and decades. Isn’t this the same mistake everyone is suddenly making again …?” ⁵

Indeed it is.

Both these ideologies, Modern Financial Theory and Keynesian economics, have proven themselves vulnerable to the revenge of the gods of the Copybook Headings, in the words of Rudyard Kipling’s poem. Kipling wrote it in 1919, at a time of sadness and disillusionment after losing a son in World War I. Its central theme is that whatever temporary beliefs we may acquire through market fluctuations or fashionable collectivist nostrums, eventually the old eternal truths of the children’s copybook return to punish us for having departed from them:

“Then the Gods of the Market tumbled, and their smooth-tongued wizards withdrew

And the hearts of the meanest were humbled and began to believe it was true

That All is not Gold that Glitters and Two and Two make Four

And the Gods of the Copybook Headings limped up to explain it once more.” ⁶

Kipling was an instinctive economist; this verse of the poem describes exactly how the wizards of the tech boom and the housing boom withdrew at the peak of the market, when the gods of the Copybook Headings reawakened and took their revenge. Traditional truths about the market that had been thought outdated and irrelev...

Table of contents

• Title Page
• Copyright Page
• Acknowledgements
• Foreword
• Part One - Past Successes and Disasters
• Part Two - The Modern Financial Theory Engine
• Part Three - Interactions with the Real World
• Part Four - Policy Accommodates Modern Finance
• Part Five - Götterdämmerung
• Part Six - Charting a New Way Forward
• Bibliography
• Index