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Moral Hazard, part ten

Blog entry posted by anciendaze, Aug 17, 2011.

The latest financial news seems to be that the U.S. economic system isn't as bad off as it seemed; paradoxically, this is because Europe may be in a bigger mess than previously thought. A meeting between leaders of Germany and France did not produce dramatic results, which markets were hoping to hear.

Hidden by other excitement we now learn that German economic growth has been flat for months. This wouldn't upset anyone, if this wasn't Germany. France has a different problem. Despite rumors, their bonds appear to be able to keep their AAA ratings. For many French a belief in sound money takes the place of religion. Don't expect this background to produce a unified Eurobond for sovereign debt.

Neither country is thrilled with the idea of weakening their own position by rescuing Italy and Spain, (added to the list of Portugal, Ireland and Greece). Coupled with weak growth, this suggests the wrecker called to pull several economies out of the ditch has arrived in the form of a lawn tractor.

A kind of behaviorist stimulus/response paradigm for economic emergencies isn't going to solve deep-rooted problems. Someone must think.

My own efforts at thinking about economics, and the crisis which made news in 2008, has proceeded to another level. To explain this I will need an idea or two from graph theory.

This isn't about graphs like charts of prices over time, it is about diagrams composed of nodes (or points) connected by links (or edges). All they look like are a bunch of dots with lines between them. The shape is not important, but the connections are essential. (A popular book about the way ideas about graphs and networks are changing our understanding is "Linked" by Albert-Lazlo Barabasi.)

In my mental picture of Wall Street, I started with a graph where the nodes were firms and the links were credit default swaps (CDS). This was introduced as a measure to spread risk, reducing the probability a single failure would destroy anything else. Each CDS is a contract between two firms swapping risks associated with particular assets in the belief this will make a simultaneous default less likely. Details of these contracts are not widely publicized, so even close competitors may not know how the opposition is connected.

The problem I see is that everybody wants to accumulate assets, but no sane investor wants to accumulate liabilities. Attempts to diffuse risk tend to be like encouraging water to flow uphill.

In fact, many forms of interconnection between big firms produce graphs showing that every major firm is directly connected to every other. In graph theory this is called a clique. If you were to replace the entire clique with a single node having the same connections to other parts of the economic network you could treat this as a single 'supernode'.

This is also familiar to me. Most of the time networks where things flow back and forth efficiently do form this kind of structure, even when nobody plans it. I've seen this in electrical power grids, telephone systems and computer networks. You can even see it in ecological food webs, where a few 'keystone species' make the whole thing possible.

The fundamental difficulty here is that every more-or-less rational investor who assumes a risk keeps a corresponding asset to cover that risk. Expecting risks to flow one way, and assets another, should be an obvious non-starter. In this light, you should expect those companies most successful at accumulating assets to attract risks. That clique I described did attract risks.

Only a fool would use a pair of CDS with the same counterparty in the expectation that this would cause both risks to vanish. Make things a little more complicated, and foolishness is not so clear. The network of CDS contained short circuits which returned risks to the point of origin.

Complicating matters until nobody has a handle on the big picture, plus natural human desire to believe you've finally hit the mother lode of endless wealth, is a sound recipe for disaster, should that be what you desire.

The natural antidote is clarity, especially for the public. If the public loses confidence in finance, and starts trading pullets directly, the vast majority of notional money simply evaporates.

Another aspect of this is the problem of insider dealing. There is a highly-specialized definition used by the SEC and criminal attorneys. I'm less concerned about this than the more general sense of making money from the ignorance of others. An economy based on stupidity and ignorance does not appeal to me as a long-term proposition.

One approach to preventing this would require tapping every telephone and constantly monitoring anyone who might be up to something, which sounds like '1984'. There is also the problem of where you find incorruptible people to listen to all this financial information without using it themselves. Prosecution takes us to a new level of complexity. It all looks like another non-starter.

The best answer I can see is to reduce the value of inside information. Speculators make big profits from those surprises which catch other people unaware. Increase transparency, make the workings comprehensible, and the remaining big surprises are much easier to police.

Ask yourself to what extent we have rewarded people who hid or distorted information and increased complexity.

There is an economic maxim called "Gresham's law", approximately stated as "bad money drives out good." (Why pay bills with gold when you can use script?) To my jaundiced eye, this seem to extend to financial information -- indeed information in general -- but that is another story.
anciendaze

About the Author

As the name suggests, I am old and dazed. The avatar illustrates my rule of thumb: "Hang on! This ride isn't over."