Monday, December 27, 2010

Finance - what is it? Who really understands it?

I have been reading about Finance and its importance in the modern day economy.

I am generally eager to know what is happening in Finance, as I believe that along with technology this is one of the defining curves of the present consumer culture.

After all, the share of the financial sector in American corporate profits was almost 40% in 2007- this was before the present crisis well and truly set in.And its share of the market was around 23%.

What astounds me more is the fact that this sector at its peak employed only 5% of the workforce! This explains why so many of the bankers that we knew were criminally rich. After all 40% of Corporate America's profits were accruing to just 5% of the people!!!!

Though the technical reason being bandied around for the present economic crisis (its not just limited to the financial sector anymore) is that it was precipitated by sub-prime loan originations and securitizations, the larger cause is of course unbridled human greed and the fact that no body really understood how big the risk was and where exactly did it lay....

Two writers whom the world is kind of rediscovering come to notice.

The first is Dr John Kenneth Galbraith-Keynesian and an economic theorist. I say economic theorist because I believe that he was right in asserting the Economics has to make sense withing the larger social and cultural framework of the society, and not completely tethered to the Neo-classical strands that it is now.

The second is a former economist with the Fed, Henry Kaufman. Now, Kaufman's concerns about the excesses of debt and the nebulousness of new financial instruments is nothing new.

I have been following him for quite some time and I reckon that he was so prescient about leveraged buyouts, securitizations and floating rate financing, as early as the 80s. And how far away the Fed's Establishment was from the truth can be gauged from the fact that as late at August 7th 2007, the Fed said that it worried more about the inflation than about a weakening economy.!!!!

May be it was because of the strong libertarian strands within the workings of the American economy, led by Fed and personified by none other than the belief and ideology of Mr Alan Greenspan. I still believe like many others that Mr Greenspan blundered by believing almost devoutly in the "incorrigibility of the markets".

Marcus Nadler was right when he said, that "no schoold of economic thought has a monopoloy on wisdom." And that "financial institutions must balance entrepreneurial drive with fiduciary responsibility."

I have tried to de-construct this blind pursuit of "the market can never go wrong" kind of thinking that has defined American Capitalism in the post war years.

One of the reason could be that the contemporary economic thinking in United states was almost completely defined by people who came in from either the Russian empire or pre war Europe - places where centralized planning was the dominant paradigm.

And its no surprise that most of them, often cite the Ricardo-Hayekian legacy as the intellectual force that defind their thinking. Hayek's "The Road to Serfdom" holds special signifiance in the heart of many such grandees.

Galbraith's "The Affluent Society" and "The Great Crash" is again flying off the shelves.

Gillian Tett's latest book "Fool's Gold" also postulates about the evolution of modern day finance.

One of the far reaching aspects of this evolution is the securitization of credit-the conversion of non-marketable assets like credit card receivables or mortgage obligations into marketable assets that are priced and subequently marketed.

This has created a dangerous arrays of derivative instruments. A very questionable innovation in finance, as it perpetuates the belief that credit risk could be reduced if the instruments became marketable!

And along the way, the public perception of liquidity has changed- from the one based on assets (what you can profitably sell) to one centred on liablities (how easily one can borrow)

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