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Back to basics

By Andrew Sheng (chinadaily.com.cn)
Updated: 2008-11-17 10:23

Special Coverage Exclusive: An Asian view of the global financial crisis

Contents:  Preface  A historical inflexion point  The macro question  The micro origins  Lessons for China and Asia  Back to basics  One world, three paths  Status quo  The rise of regional markets  Romance of the three regions  Conclusion

The first is that crisis is the natural outcome of human excesses. It is the most Darwinian of collective human action – it creatively destroys the irrational exuberance and brings everyone back to reality that there is no free lunch. Schumpeter was right to say that out of crisis comes rejuvenation.

Crisis actually accelerates the exit of weak and fraudulent institutions that should have been the function of effective regulation over a normal period of time. Accordingly, we cannot forget that crisis is an event, whereas reform, restructuring and regulation are continuous processes.

Crisis only concentrates the mind on what we need to do to fix what is wrong with society and the economy and what we did not do or could not do because of vested interests. There is in fact only a short window of opportunity of reform before memory fades and vested interests again capture the need for reform. If we do not reform while the sun is shining, crisis like the next tsunami is an inevitable consequence.

The second is that derivatives carry leverage and therefore risks. Risks are transferred but do not disappear. Indeed not understanding the nature of derivatives is itself a major risk.

Basic finance theory will tell you that a derivative is a representation of an underlying asset that is essentially linked through leverage. The advantage of derivatives is that one can easily subdivide an indivisible underlying asset (such as a large piece of immovable land) and make the property right transferable at lower transaction costs.

Real products require labour and real assets to make. Financial derivatives require imagination. There can be multiple derivation of the same underlying asset. For example, equity stock is a derivative of the assets of a company. A stock option is the second order derivative of real assets and a swaption (swap on option) is the third order derivative and so on.

The trouble is that the higher the level of derivation, the more complex (and more opaque) the relationship with the underlying and the greater the leverage, making the derivative pyramid dynamically profitable and risky at the same time. As we see from experience, if the underlying asset gets into trouble, the derivative pyramid can come crumbling down very rapidly.

The instability of the financial pyramid is precisely why finance should be fettered or regulated heavily. Left to pure market forces and no constraints, the financial derivative game can be exploited at great moral hazard – increase leverage and opacity for private gain at eventual social cost.

At the purest conceptual level, there is therefore no principal difference between state planning and unfettered finance – both consume or waste at great social loss. The crux is the golden mean – how to utilize the efficiencies of market forces and yet regulate it to prevent excesses and instability. Herein lies the uncomfortable relationship between the government and the market. Too much government is bad and too much unfettered markets is also bad.

The third fundamental is that if finance is a derivative of the real economy, no financial structure is strong unless the real economy is strong. We cannot allow monetary theory to dazzle us from the common sense fact that finance must serve the real economy, rather than to drive it.

If this is so, then it does not make sense that Wall Street should be paid more than Main Street. We must ensure that the incentive structure is even-handed – financial wizardry cannot be rewarded irrespective of performance. The corporate governance structure must be transformed so that there can be no golden parachutes and pay must be aligned with long-term performance.

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