India should not let Finance become a Frankenstein monster

On January 20th, I read in THE HINDU that Indian stockbrokers wanted the Securities and Exchange Board of India to roll back its new risk management norms for derivatives. I was both amused and not amused. Along with Praveen Chakravarty and Ajit Ranade, I had written about the need for tightening risk management norms for derivatives exposure in Indian stock markets. Prior to these op.-eds., in our co-authored book, ‘Economics of Derivatives’, Dr. T.V. Somanathan and I had highlighted that derivatives were almost wholly used for speculation (=gambling) rather than for hedging.

That does not mean they needed to be banned but the losses from such speculative activity should be borne wholly by the participants who engage in them and that they should not have systemic consequences.

Based on the news-story, one does not get the impression that the brokers have provided any solid arguments or evidence that the proposed margining requirements would do zilch to reduce risk. In fact, their very protest is solid indication that it would. If it resulted in a lower volume or transactions in the derivatives markets, it is good for systemic stability.

This is a classic example of the case of socially useless finance. India, at this stage of development, does not need to go out of its way to facilitate such financial market activities. Instead, it should do what SEBI is trying to do now.

My co-author Gulzar Natarajan and I have finished our manuscript, ‘The Rise of Finance: causes, consequences and cures’ and we have received the first proof from the publisher. We hvae a special chapter on India. India needs to avoid repeating the mistakes that the West made with respect to Finance. The West allowed Finance to become a Frankenstein Monster and India does not have to repeat that mistake.

The myth that secondary market trading facilitates efficient capital allocation in primary markets has been persisted with, for too long, without being subject to the burden of proof. Shrinking investment horizons alone should have let that theory be put to rest permanently. It has not.

Buttonwood, in its penultimate column in ‘The Economist’ last year had written on the ‘Flaws in Finance’. There was a link to his earlier article published in May 2015. Both the short piece from May 2018 and the long essay he had written from May 2015 are thoughtful and make for good reading. But, his conclusions are vague. Here are two samples:

For all their criticism of mainstream economists, the challenge for the behavioural school is to come up with a coherent model that can produce testable predictions about the overall economy. [Link]

Here is the second one:

For too long economists ignored the role that debt and asset bubbles play in exacerbating economic booms and busts; it needs to be much more closely studied. Even if the market is efficient most of the time, we need to worry about the times when it is not. Academics and economists need to deal with the world as it is, not the world that is easily modelled. [Link]

In contrast, witness the most practical suggestion from Cliff Asness:

Making people understand that there is a risk (and a separate issue, making them bear that risk) is far more important, and indeed far more possible than making a riskless world. And if I may go further, trying to create and worse, giving the impression you have created, a riskless world makes things much more dangerous. [Link]

Honestly, the call for new models, etc., are either diversionary or distracting. They are not needed. One does not have to have new behavioural models that incorporate human irrationality. In fact, all that is needed is for policymakers to be reasonable.

(1) You may believe that markets are mostly or, for the most part, efficient. I do not. But, you can accept that humans can and do make mistakes. That is reasonable assumption.

(2) That one does not ignore empirical evidence is a reasonable thing to ask of policymakers

(3) That one requires policymakers to be able to see through the self-interested demands of the financial sector is not such a onerous demand either.

(4) Policymakers simply have to stop writing CALLS and PUTs for the financial sector. That is what Cliff Asness is saying in the quote above. Central banks do not have to remove risk from the lexicon for the financial sector and, in the process, encourage them to take excessive risks that put the economy and their goals for the economy in peril.

The fear of surprise, volatility and the realisation that policy will not be beholden to the financial sector even if there is short-term pain need to be inculcated in the financial sector.

What India’s brokers ask of SEBI is what the American financial sector has been asking of the Federal Reserve in the last thirty years and been getting, up to yesterday.

India does not have to walk the American way in this matter.

Minding the banana skins and not the manholes

On Tuesday, I had written my MINT column on the Powell PUT now reinforcing the trend of Greenspan, Bernanke and Yellen PUTs. I knew that the Fed Meeting was due to conclude on Wednesday. The Federal Reserve Open Market Committee (FOMC) did vindicate me. It is a huge letdown. This FT article calls the FOMC U-turn ‘momentous’. It, indeed, is. But, for the wrong reasons. The article cites somone from Barclays calling it a Powell PUT. Powell says NO. But, it is difficult to give him the benefit of doubt.

Narayan Kocherlakota is outdoing himself calling for a Fed rate cut now. The notion that there is a financial economy which will only be helped such mindless monetary easing, resulting in excessive risk-taking seems to escape him totally. Such excessive risk-taking, in turn, will result in a collapse or crash somewhere causing economic activity to slump and remain slumped for long, defeating the very purpose of monetary easing that he is calling for, now. Just recently, what is happening in Australian property market is an example. Stubbornness in the face of evidence to the contrary is not conviction. It is stupidity. Mr. Kocherlakota is keen on and proud to avoid the banana skins and never mind the manholes of finance!

The header of this post is a take-off from the short and sensible article in ‘The Economist’ on the overextension of finance in Australia. That is what I had mentioned in my MINT column too – a long cycle or an economy running well above capacity will spawn excesses.

Mike Mackenzie in FT cites an analyst/economist from Brown Brothers Harriman:

“We believe the Fed gave in too quickly and too completely to market demands that it pay more attention to market tantrums. By doing so, the Fed changed its message by a whopping 180 degrees from the December meeting. This goes back to our complaints about the extreme swings in Fed messaging over the last few months. Markets would have been happy with ‘patience’ and ‘flexibility’ but instead, the Fed went ahead and gave away the family silver.” [Link]

In the same spirit, John Authers wrote:

This begins to look like an example of the market leading a new Fed chairman by the nose. [Link]

Read this comment on the monetary policy stance of the European Central Bank:

Draghi had warned that the euro zone would slow this year, but things looks worse than predicted. This raises questions about the wisdom of stopping quantitative easing. He committed to this step in June last year, but a little more patience might have avoided the potential embarrassment of this turning into a policy mistake. [Link]

Comments such as this betray lack of elementary commonsense. If, after several years of unprecedented asset purchases, zero and/or negative interest rates, one withdrew the policy tentatively and the economy slowed down considerably, then what does one make of the efficacy, the durability or the desirability of such a policy medicine? Isn’t it normal to ask if that was the right policy at all? It is hard to believe that journalists cannot get themselves to ask such an elementary question.

The world lacks leaders with the right sort of convictions and spine to see them through. If not, they should even have the courage to resign and use their resignation as a bully pulpit.

Feel sad and let down.

[No, not because, as you might think, I have short positions on the equity market. I don’t.]

The credit rating agencies of higher education

In dealing with the philosophical aspects of conflation of ‘means’ and ‘ends’ by humans, I had also dealt with the same malady in higher education, in my column in MINT last week. With individuals, the most obvious example is that of money. Money is initially seen as the means to happiness or comfortable lives but it becomes an end in itself.

In higher education, ranking, accreditation are all signals of quality education which is the ultimate goal and ought to be the eternal goal. But, ranking and accreditation become ends in themselves. This is what I wrote:

An institution accredited by a reputed accreditation body signals a certain quality and standard of education to students and their parents. Over time, accreditation becomes an end in itself. Institutions figure out how to “game” or do well in the game of accreditation while its main purpose—signalling quality—becomes more and more divorced from the process. Accreditation agencies too have become prescriptive in practice. More on that later.

The emphasis of research over teaching and PhD-qualified faculty over practitioner-faculty are also cases of means supplanting ends. The purpose of any educational institution is to educate. In primary and secondary schools, education is about teaching. In higher education institutions, it is not about imparting knowledge but about showing a path to knowledge. It is about giving students the tools—skills and attitudes—that will help them learn.

There is clearly a case for “research for its own sake” in institutions of science, medicine, etc. Pure research leads to discoveries and outcomes that eventually benefit humankind. Until the outcomes are achieved, they may appear esoteric but the society has to indulge them for the sake of serendipitous outcomes. But, in business or management schools, the aim is to prepare students to become effective managers and leaders of social or commercial institutions or even of nations. Research has to be seen as an instrument for aiding the process of preparing or producing such managers or leaders. But, in reality, research takes on a life of its own.

Some obscure question with only peripheral utility, if at all, for the society or for businesses, is pursued and if it is published in so-called prestigious journals (another instance of conflation of “means” and “ends”), then the prestige of the individual and that of the institution is enhanced. But, to what end? The question of for whom the institution exists is lost in the process. Is it just an arrangement of, by and for academics with students and social purposes of higher education peripheral to it?

In the words of a thoughtful academic, “(accreditation agencies) propagate a model of business school that unmistakably values research over teaching, theory over practice, esoteric journal papers over pedagogical innovations, lectures over cases, PhD-qualified faculty over practitioner-faculty, among other puritanical biases. This is essentially a caste-system, in which an elite community of research scholars, taking turns as accreditors, remake business schools in their own image.” [Link]

On the related topic of accrediation, I was happy to note that my friend and professor at IIM, Kozhikode, Rudra Sen Sarma had written about the bane of Indian Institutes of Management now seeking accreditation from foreign agencies. His piece can be found here. It is over a year old. He makes some valid arguments.

The accreditation agencies have made it difficult to talk about yourself positively unless you have been accredited. Rudra makes a very good point about ‘surrendering’ autonomy to foreign accreditation agencies when they fight for autonomy from the Government.

It is exactly how central banks curse the financial wrath on the governments for eroding their autonomy but willingly surrender theirs to financial markets!

He is right that IIMs should have evolved their own standards for accreditation and set a benchmark for emerging economies.
Pity, yet again and frustrating yet again. 

So many opportunities to show that we are self-confident, self-assured and that we can set the standards yet we capitulate!

Everybody talks inequality

Raghuram Rajan has a piece in ‘Project Syndicate’ in which he echoes Paul Tucker on central bankers but stops of advising them to not to go to Davos, as Paul Tucker did. In any case, if this FT story is true, there won’t be much tears shed. How times have changed?!

An extract from Raghuram Rajan’s article on central bankers:

And, of all elites, central bankers seem to have the most strikes against them. Most have doctorates and speak in a language that nobody else understands. The quintessential “citizens of nowhere,” they meet periodically behind closed doors in faraway Basel, where they discuss global financial conditions and the systemic effects of monetary policies. What they do not talk about, many believe, is Main Street, except when it factors into discussions about inflation.

No wonder there has been such a decline in public trust. It is bad enough when average citizens can scarcely understand the complicated tradeoff between inflation and unemployment. It is worse when one adds in public grievances over Wall Street bailouts and the perception that central bankers are focused on global conditions instead of domestic concerns. Yes, it is every central banker’s job to think about such things; but that job is increasingly being met with suspicion by those who aren’t in the room. [Link]

Overall, the piece tries to cover too many grounds and offers too little by way of answers. His piece, however, triggered my interest in the inequality topic and I re-hashed some of the recent pieces I had read in the last twelve months or little longer. The links are here:

https://washingtonmonthly.com/2017/11/06/how-the-rich-rig-regulations/

https://www.nytimes.com/2017/11/17/upshot/income-inequality-united-states.html

https://www.nytimes.com/interactive/2017/12/14/business/world-inequality.html

https://www.livemint.com/Opinion/sMRTHlLePT4cfXTkjM7JOM/Angus-Deaton–How-inequality-works.html

I had blogged on the topic here and I think that remains an answer!

Consistently inefficient

When I read the following in FT, I could hardly suppress a smile:

Chinese economy gets a shot China’s central bank injected a record Rmb570bn ($84bn) into the country’s banking system on Wednesday in the latest effort to boost liquidity and promote increased lending. Global markets responded favourably. (FT)

Stock markets react positively whenever major economies boost liquidity. It is not that stock markets reacted negatively much when the bad news out of China was pouring out. Perhaps, other central banks were pushing liquidity then!

But, they are into lazy investing. Low interest rates and liquidity are what they care about. If you are in doubt, read this interesting article published in New York Times on 10th January and download the original paper too. Investors just do not read annual reports even if they contain information (hints) of bad or good tidings to come. They react only when the actual news breaks out months later. So much for the market’s informational efficiency. 

It is breathtaking that someone got a Nobel Prize for calling the stock markets efficient populated as they are by humans who are anything but. May be, the efficiency of the Swedish Riksbank’s selection committee has to be questioned!

Bolsonaro should beware the asymmetry

This story in Bloomberg on the new Brazilian President’s plans to relax the country’s strict gun-control laws reminded me of the note I had written with my friend and co-author Gulzar Natarajan on asymmetry in economics and in public policy.

His claim is that the country’s strict gun-control laws have not really ended violent crimes. May be. But, relaxing them might well raise them substantially. That is the asymmetry that he should be mindful of.

Finance and Federal Reserve

In my first column for MINT for 2019, I dealt with the issue of the Federal Reserve backtracking on its rate hike trajectory. Methinks it is sustained pressures from ‘financial market types’ that led the Fed chairman to cave in. I don’t buy the argument that he is tightening on two fronts: federal funds rate and quantitative tightening. So what? One acts through the banking channel (from the overnight lending rate to bank loan rates) and one acts through the capital markets channel – through the yield curve. All the rates, across the yield cuve, were depressed extraordinarily – in magnitude and for an inordinately long time. So what if all points in the yield cuve were rising? Financial conditions still remained accommodative.

This was the burden of my column. I was not impressed with the arguments of Stanley Druckenmiller and Kevin Warsh nor was I impressed with the arguments of John Mauldin. My friend Gulzar Natarajan had urged me to read his ‘Thoughts from the Frontline’. I read the last four of them last evening. You can read two of them – pertaining to the discussion of Fed monetary policy – here and here.

Nor did Gavyn Davies impress me with his arguments. So what if the Federal Reserve were triggering an economic recession? Recessions must be welcomed after excesses have built up in so many areas – from corporate debt to leveraged loans to market concentration in tech firms

‘Wrath of the financial markets’ that Viral Acharya (RBI Deputy Governor) invoked in a speech in October is felt more by central bankers than governments and that too not in public interest but in self-interest of the financial community.

Dean Baker has a list of ‘facts’ or resolutions to improve debates on economic policy in 2019. Item no. 6 is about finance. His list is about the ‘facts’ that are often obscured in economic policy debates:

6) A large financial sector is a drain on the economy
The financial sector plays an important role in a modern economy. It allocates capital from savers to those who wish to borrow. A poorly functioning financial sector is a drag on growth. The same is true of a bloated financial sector.

The financial industry is an intermediate sector, like trucking. This means that it does not directly provide benefits to households, like a housing, health care, or education. For this reason, we should want a financial sector that is as small as possible for carrying through its function, just as we would want the trucking sector to be as small as possible to deliver the goods in a timely manner.

Over the last four decades the narrow financial sector (securities and commodity trading and investment banking) has more than quadrupled as a share of the economy. It would be difficult to argue that capital is being better allocated or that savings are more secure today than 40 years ago.

This means we have little to show for this enormous expansion of the financial sector. It would be comparable to seeing the size of the trucking sector quadruple with nothing to show in the form of faster deliveries or reduced wastage. Finance is of course also the source of many of the highest incomes in the economy.

These facts make for a strong case for measures that reduce the size of the sector, like financial transactions taxes, reduced opportunities for tax gaming, and increased openness in pension fund and endowment contracts. In any case, it is important to recognize that a big financial sector (as in Wall Street) is bad for the economy, not the sort of thing that we should be proud of.

Reducing the size of the financial sector will also mean that its influence on monetary policy will come down. About time.