Dec/Jan 2011

Uncertain Embrace

Arguing for a system free of omniscient financiers

Reihan Salam


The decades-long boom in financial services has created tremendous wealth for a handful of people. The once-stodgy banking sector became a Xanadu for the quantitatively gifted, attracting talent that might have once been drawn to industry or academia. But has this transformation contributed to the growth of the real economy? In A Call for Judgment, economist Amar Bhidé argues that it has not. Rather, it has undermined the foundations of free-market capitalism by encouraging a dangerous centralization of financial decision making.

Unlike Simon Johnson and Joseph Stiglitz, economists who've also been sharply critical of the US financial system, Bhidé is an unapologetic classical liberal. In his 2008 book, The Venturesome Economy, he offered a brilliant critique of "techno-nationalism"—the view that innovation is driven by large public and corporate investments in research and development. Rather, Bhidé argued, the most important kind of innovation in a modern economy is the incremental, ground-level kind that's driven by consumers and the entrepreneurs who serve them. Yet as Bhidé writes in his new book, this dynamism—this perpetual cycle of economic reinvention—must rest on a financial system founded on the principles of forward-looking, case-by-case judgment. Decades of misregulation have, in his view, given us instead what he calls a system of "robotic finance," and the consequences have been nothing short of catastrophic.

To make his case, Bhidé draws on the work of Friedrich Hayek and the lesser-known Frank Knight, both of whom were central to the midcentury revival of economic liberalism. Though often identified as one of the founding fathers of the Chicago School, Knight was as much a philosopher as he was an economist, and one of his chief preoccupations, as illustrated in his Risk, Uncertainty, and Profit, was the fact of pervasive uncertainty.

Risk, in Knight's account, refers to quantifiable probabilities, such as the odds of getting three heads in a row in a fair coin toss. And with the aid of carefully crafted actuarial tables, a life-insurance company can be fairly sure of the number of claims it will face in a given year. But life is also shaped by uncertainties that can't be quantified, which Bhidé calls, for the sake of simplicity, "one-off events." A dynamic economy is continually generating one-off events. Every new business investment takes place in a world that is different, subtly or otherwise, from the world that came before it. One can attempt to construct a mathematical model of which businesses will succeed and which will fail, or for that matter which children. But doing so would require that the future be much like the past, and that is hardly ever the case.

Uncertainty means that actors in a dynamic economy must pay close attention to new information. And as Hayek argued in his celebrated essay "The Use of Knowledge in Society," the information needed to make sound economic decisions is dispersed among many individuals. A functioning economy requires constant, small-scale, on-the-spot adjustments that can't be anticipated, a fact that's always foiled the best-laid centralized plans.

Consider the venture capitalist evaluating a new investment. She can certainly use her knowledge of the industry, the players involved, and the fate of similar start-ups. Yet statistical probabilities are of little use in a world shaped by countless confounding variables. Rather, the job of the venture capitalist is to construct narratives and weigh them against the available evidence, not unlike a juror in a criminal trial. This process involves plenty of number crunching, as investors estimate rates of return and much else. But it is very different from simply plugging numbers into a mathematical model.

In Bhidé's account, the US financial system has relegated the case-by-case judgment of the venture capitalist to the margins as securities have grown more tightly regulated and banking has grown less so. Until the New Deal, securities regulation in the United States was all but nonexistent. Large business enterprises in the US, like their counterparts in Germany and later Japan, were financed by investors who made long-term commitments to oversee and, when necessary, fire and replace managers. Regulations designed to protect small investors—which the New Dealers saw as essential to restoring confidence in the stock market—made it difficult for large investors to develop and maintain relationships with the managers of business enterprises. As a result, the owners of public corporations lost their ability to exercise real oversight.

Under this system of arm's-length finance, capital moves quickly and for the most part anonymously. The supposed benefit of this hyperactivity is its creation of very liquid markets for securities. Yet Bhidé suggests that this unnatural liquidity encouraged carelessness on the part of corporate executives, who could safely ignore their fiduciary responsibilities to footloose stockholders. And so tough securities laws designed to curb recklessness might have actually cultivated it.

While Bhidé questions the wisdom of securities regulation, he sees the tight regulation of depository institutions as necessary. Banks had been regulated long before the New Deal, even when the consensus behind economic laissez-faire was at its strongest. Decades of bank runs, suspensions, and failures led to extensive trial-and-error regulation that by midcentury resulted in a more or less stable banking system, defined by deposit insurance, tough supervision, and strict limits on the risks banks enjoying government guarantees could take. For instance, commercial banks were barred from investment banking under the Glass-Steagall Act.

But after successive waves of deregulation, that hard-won stability was lost. Long before the 1999 repeal of Glass-Steagall, the barriers to new forms of risk taking were steadily dismantled. At the same time, deposit insurance remained in place, guaranteeing that taxpayers would be left to pick up the pieces in the event of a bank failure. As Bhidé makes clear, not all the deregulation was unwise. For example, the end of restrictions on interstate banking abetted a consolidation that allowed for a larger and more stable deposit base. But deregulation also coincided with a sharp turn away from decentralized, case-by-case judgment, as mechanistic models and exotic securities came to the fore.

The new megabanks promised to lower the cost of capital in part by doing away with expensive armies of meddlesome small-town bankers, who made their money by placing long-term bets on families and businesses they knew well. Instead, a generation of math-savvy financial wizards replaced the hunches of those bankers with algorithms that drew on past experience from thousands if not millions of loans, supposedly perfecting a process that had long been governed by guesswork. Bhidé calls this the development of "judgment-free finance." When those models failed, as in the housing bust, they failed in synchronized fashion.

The fundamental insights of Knight—that uncertainty is real and deep—and Hayek—that knowledge is dispersed—counsel against a financial system that depends on the omniscience of financiers, regulators, or, for that matter, algorithms. For Bhidé, the most important goal of financial reform should be to nurture long-term relationships between bankers, business owners, and homeowners, founded on old-fashioned due diligence. He thus calls for limiting insured depository institutions to making loans to households and nonfinancial firms, to simple hedging transactions, and that's it.

With one stroke, banking would once again become a conspicuously unsexy industry. No more lucrative derivatives dealing, no more exotic asset-backed securities, no more gambling with taxpayers' funds and guarantees. Slowly but surely, would-be quants would gravitate away from banking and toward more exciting and lucrative corners of our dynamic market economy, like designing video games or manufacturing hoverboards.

Reihan Salam is a policy advisor at Economics 21.

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