The lessons of LIBOR

"We've lived through a period of mass financial delusion."

-- author Michael Lewis

For those who hoped the financial industry had put the era of short-term profits at the expense of the systems' stability behind it, this summer's LIBOR scandal is cause for pessimism.

LIBOR, the London Interbank Offered Rate, is the interest rate set nightly in England that underlies more than $350 trillion in assets globally. Those assets include adjustable-rate mortgages, credit cards and financial derivatives.

LIBOR was established about 25 years ago at the dawn of the age of financial derivatives to reduce friction in these new markets by creating common standards for what major banks estimated it should cost to lend money to each other the next day.

The system's accuracy was questioned in the years since the financial crisis of 2008, culminating in June of this year, when Barclays, the British-based global bank founded in 1690, pleaded guilty to manipulating the LIBOR standard, partially for trading speculation, partially to mask the increasingly high cost of its own borrowing from investors.

In a Sept. 28 column entitled "Taking the Lie out of LIBOR," the Economist describes the steps being recommended to reform LIBOR (www.economist.com/blogs/schumpeter/2012/09/interest-rates). They include making any manipulation of the LIBOR numbers a criminal offense and appointing an outside agency to crunch the numbers.

These solutions seem sound enough, but they are addressing the symptom, not the root cause. Why are we fooling ourselves with such greater frequency than our predecessors? Major financial emergencies are now erupting several times a decade, rather than once in a generation, as in the previous century. Shouldn't the Information Economy be smarter about bubbles? Yet events continue to demonstrate the need to adjust our financial system to the massive potential for fraud inherent in knowledge-based economies.

The 21st century is the Age of Abstraction, much as the 20th century was the Age of Electricity, and the 19th was the Age of Machines. Abstraction is an esoteric engineering concept, poles apart from the colloquial usage of "abstract" to describe unstructured art or music. The engineering version refers to organizing and summarizing complicated technologies or procedures into symbols, allowing a non-expert to benefit from their use without understanding the underlying complexities.

Probably the most important abstraction in our lives is money. Paper and plastic representations of wealth are the foundation of Western economies, though few of us understand the macroeconomics underlying the monetary system.

In some sense, human history is the history of increased abstraction. Specialization is the basis of historical civilization, and the increase in people using tools they didn't make themselves, wearing clothes they didn't weave and eating food grown by others. Abstraction makes specialists more efficient and allows the use of specialized tools by people who don't understand their inner workings. (Think Windows or the iPhone operating system.)

There is a dangerous side to abstraction. It can easily be a force multiplier for fraud by those taking advantage of people's natural potential for delusion. The financial bubbles of the last several hundred years were all based on people overbidding for overvalued or nonexistent abstract assets -- tulips in Holland, pyramid schemes, dot-com startups, collateralized mortgage obligations.

The ability to deceive is universal, among people, animals and even plants. But opportunities to deceive in the physical world are finite. The automation of information collection, generation and collaboration has created unlimited opportunities.

The history of dynamic capitalist economies, with their potential for creativity and fraud, can be seen as a back-and-forth dynamic between structurally encouraging the former and inhibiting the latter. At its best, abstraction simplifies the complex. But it can be used to obscure the truth with complexity, or to deceive.

Healthy societies recognize how dangerous it is to corrupt critical abstractions, which is why currency counterfeiting is punished as a serious crime. A specialized society is ultimately built on trust, without which it would revert to a simpler, cruder existence. And trust derives from transparency and predictability, which are hard to build and easy to destroy.

We need to structure our financial markets so that harmful bubbles become rare, rather than the norm.