Friday, March 6, 2009

"maybe we ought to have a two-tier financial system,"

From Justin Fox:

"Myron Scholes, intellectual godfather of the credit default swap, says blow 'em all up

Myron Scholes, whose Black-Scholes option pricing model provided the intellectual underpinning for modern derivatives markets, thinks one particular derivatives market—that for credit default swaps—is due for a Red Adair style rescue. Or a Fred Adair style rescue.

Red Adair put out oil well fires by setting off gigantic explosions at the wellhead. "My belief is that the Fred Adair solution is to blow up or burn the OTC market in credit default swaps," Scholes said this morning. What that means, he elaborated, is that regulators should "try to close all contracts at mid-market prices" and then start up the market anew with clearer rules and shorter-duration contracts.

This was at a conference at New York University occasioned by a new collection of papers on how to fix the financial system, authored by a bunch of NYU Stern School faculty. Scholes kept saying Fred Adair. Sometimes he'd notice and correct himself, sometimes he wouldn't. The FT's John Gapper, who was on a panel with Scholes, finally speculated that this was because the government response to the financial crisis has been such an unwieldy mix of Fred Astaire (dancing around the problems) and Red Adair (doing something to fix them). Scholes did not disagree.

The blow-up-the-CDSes option is intriguing, and I'm going to check in with Scholes later to see if he wishes to elaborate. But for now, a few more notes from the panel, which was moderated by Paul Volcker and also featured NYU finance professor Matt Richardson:

Some would say Scholes is partly to blame for this whole mess, and Volcker dropped a couple of hints in that direction. Scholes didn't exactly accept responsibility, but neither did he give a blindered, Chicago-style defense. For one thing, he cited John Maynard Keynes—still a nonperson to many of Scholes's fellow Chicago Ph.Ds—arguing that we're currently stuck in a situation where the financial system needs to deleverage, but its current deleveraging is causing asset values to plummet, meaning that it's not succeeding in deleveraging at all (that is, debt is down, but so is the value of everybody's capital, so leverage ratios aren't declining). For another, he seemed to agree with one of the main criticisms of the Wall Street risk models that evolved in part from Black-Scholes—that they have some ability to capture the risks faced by one investor operating in a financial market that the investor is too small to influence, but aren't much good at capturing the risks faced by the entire market. "Risk aggregation is not linear," he said. "It's nonlinear." (This is what Chapter 13 of The Myth of the Rational Market is about. Doesn't that sound exciting?)

As the moderator, Volcker didn't say all that much. He did talk for a bit, though, about how "maybe we ought to have a two-tier financial system," with a heavily regulated "core part that I will for purposes of simplicity call commercial banking" and a less-regulated outer realm of hedge funds, proprietary trading desks, and such. Hmmm, said Gapper, that "reminds me of something I once heard of called the Glass-Steagall Act." This Glass-Steagall revivalism is happening all over. I'm even beginning to feel the spirit. But Gapper had an interesting question: "If you wanted to set up a new Glass-Steagall, where would you draw the line?"

Scholes finally got his free-market Chicago dander up over the possibility of synchronized global financial regulation—something that Volcker has been advocating as chairman of the Group of Thirty project on financial reform—sparking this entertaining exchange:

Scholes: If we internationalize everything, we end up with rules that stifle freedom and innovation. Mr. Sarkozy and others say our system has failed and we should adopt theirs. Do we want to become French?

Volcker: I'm not an acolyte of Mr. Sarkozy.

Gapper: Actually, the French banks are big derivatives users.

Volcker: The U.S. is no longer in a position to dictate to the rest of the world."

  1. donthelibertariandemocrat Says:

    In my mind, the Glass repeal was a mistake, but not an obvious one at the time. Now it is. I'm going to bring up the S & L Crisis again. In that crisis, you had a kind of faux free market deregulation, that was built, paradoxically,upon government guarantees. This ended up being a bad brew.

    In this crisis, the Glass repeal and other faux free market deregulation, we now know, was built upon government guarantees. When these faux free market plans pass, there's a kind of implicit assumption that the businesses affected will live and die on their own without government intervention of any kind. That's what free market usually means to most people. Since there was no explicit policy about government guarantees or even insolvent large banks, many people assumed that taxpayers were shielded from any problems caused by this deregulation. We were wrong.

    If there are going to be government guarantees, then I believe that we should have narrow banking, which is guaranteed, and another financial sector which is not guaranteed, but supervised. The key to me is the extent of possible government involvement.

    My main point is that we should no longer accept ambiguity in these areas.

    Richardson also has a good essay on nationalisation, in which he said this:

    "In a recent conversation, Myron Scholes told me he was also in favour of nationalisation – as long as it lasts just 10 minutes."

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