"What interferes with rationality? It's ego. It's greed. It's envy. It's fear. It's mindless imitation of other people"
- Warren Buffett, 1998
The financial services industry is in disarray once again. Economist John Kenneth Galbraith once joked that Wall Street meltdowns seemed to occur once in a generation, after everyone who experienced the previous disaster has retired and the next generation gets to learn the hard way that banking is not a party.
Until recently, financial crises were indeed once-in-a-generation events. In the 100 years from 1883 to 1983 there were four significant financial crises in U.S. financial markets: two severe global depressions lasting a decade or more (the Long Depression of 1873-1893 and the Great Depression of 1929-1939); the Panic of 1907, which resulted in the creation of the Federal Reserve System, and the crash of the exuberant "go-go 1960s" in 1970.
But in the past 25 years we have had five major crises in the U.S. financial markets: 1987's "Black Monday," in which the Dow Jones industrial average index fell nearly 23 percent in one day after computerized "program trading" spiraled out of control; the savings and loan crisis of the late 1980s, which cost taxpayers an estimated $125 billion; 1998's Long Term Capital Management collapse, in which a hedge fund founded by several Nobel Prize-winning economists nearly sank the global financial system with its esoteric bad bets; the dot-com bubble bursting in 2000-2001; and the current subprime mortgage/derivatives debacle.
So crises of financial speculation are now occurring every five years on average, rather than every 25 years. What steps should an economy addicted to financial speculation take to lengthen the intervals between the inevitable spasms? Here are eight guiding principles for a healthier 21st century global financial system:
• Admit we have a problem. When the dot-com bubble burst in 2000, followed by the terrorist attacks in 2001, investors did not lower their expected return on investment as in past downturns. The bubble mentality remained, and the speculative activity merely shifted to real estate.
• Oil the wheels, don't grease the train. In a capitalist system, a certain amount of financial speculation is beneficial, creating liquidity to enable the growth of new businesses. But too much lubrication will send the train flying off the tracks.
• Don't fight the need for regulation. Even free-market purists must acknowledge that conscientious regulation is critical to a healthy financial system. Using an automobile metaphor, a free market means that you can drive where you want, not that you can run red lights or speed.
• Value investing or speculation? The desire to get something for nothing is hard-wired into our nervous systems. But value is built slowly, and benefits buyers as well as sellers. Financial speculation, even if successful and legal, is a zero-sum game -- only one party can win. To distinguish value creation from esoteric pillaging, apply Warren Buffet's ownership test and visualize whether you would want to own 100 percent of the investment.
• Beware quants bearing algorithms. A key factor to the expansion of esoteric financial products on Wall Street has been the hiring of "quants," often doctorates in quantitative sciences such as math and physics, who built intricate formulas to profit from minute market "inefficiencies." The algorithms became increasingly divorced from financial reality, masked by complexity and greed.
• Stick to reality. In a domain as dangerous as derivatives, the burden for regulation and accounting rigor should be higher, not lower, even if the inherent complexity makes that difficult.
• Form follows function. Firms that engage in financial speculation should be privately held partnerships, not publicly held investment banks. A partnership structure would have encouraged Lehman Brothers executives to manage their 158-year-old firm as caretakers of a valuable legacy, rather than drive it into bankruptcy with dangerous short-term investments.
• Keep politics out. Easier said than done, of course. Fannie Mae was created decades ago to support the American Dream of homeownership.
But the success of Fannie (and Freddie Mac, who followed her in 1970), was based on artificially inexpensive money enabled by its quasi-government status. When Fannie and Freddie executives sought to expand in the 1990s, they had an unfair advantage over competitors who were not "quasi government entities." They compounded their insulation from market realities through a blizzard of constituent lobbying and campaign contributions to congressmen and senators.
Exotic financial instruments are the nitroglycerin of the financial world, valuable but highly dangerous.
Closely regulating their use is a legitimate purpose of government -- if we wish to avoid blowing ourselves up in a cloud of basis points.