Think Twice Finance

The G7 Plans a Financial Reform – The Market Plans Another One.

On March 8, the G7 announced that it is forming a plan – a plan that would put an end to the crises that seem to plague the post-OPEC world financial system. They’ll plan. The plan won’t work.

The G7 – the United States, the United Kingdom, Canada, France, Germany, Italy and Japan – have proven unable to cooperate beyond an elaborately superficial level; and the individual countries have proven unwilling to discipline their own financial systems – let alone the global system as a whole. Any G7 plan for a financial pact is a waste of resources.

It’s OK by me if the G7 waste these resources making useless plans for new financial systems. It’s a vast improvement over the centuries the countries spent wasting resources making war on each other. Now they waste resources making war in less populated places and building immense bureaucracies. Not good, but better. I’d rather pay outrageous taxes than burn at the stake.

Getting back to the G7’s plan, why will it fail? It will fail because it is based on transparency. Governments love transparency. Accountants and lawyers exist to help governments achieve transparency. The public is told that transparency protects their investments. But transparent financial institutions do not succeed, because they cannot innovate. And while the system that generated the crisis was unbelievably complicated (by design of banks colluding with bank regulators) it was transparent. Given the time and interest, it was always possible to find the important misleading banking decisions and irresponsible regulatory decisions that led to the crisis lying around in the public domain. In the information age, you deceive the public by drowning them in detail and ennui.

The reality of the crisis is that it is the result of two government commitments that simply cannot be kept. They have never been kept since they were made in the 1970’s and they will not be kept in the future. The government can keep a promise to protect investors from losing their money. The government can keep a promise to create conditions consistent with high returns to investors. But the government cannot do both simultaneously. It is this false promise, bought by a credulous public, which eventually falls apart with a resultant crisis.

That the crisis itself was largely experienced by the most heavily regulated institutions is an unattractive, politically inconvenient fact. The fact was acknowledged by Secretary Paulson in a speech early in the crisis, but since, has become a victim of a flurry of contrived publicity, focused on the failure of the smaller and less regulated Bear Stearns, publicity focusing little attention on regulatory blessings conferred on heavily regulated JP Morgan Chase. (JP Morgan Chase has been among the least profitable global banks since 2000. Watch that change now, for five years or so.)

The conflicting promises of no risk and high returns will not be achieved. What will be achieved is another, less publicly promoted banking reform, occurring spontaneously in financial markets as the public reacts to reality learned the hard way. What may also be contrived is a new regulatory magic act, also well under way. Put them together, and we are about to relive the last 20 years. The events of the past were coincidence, but now, I maintain, are destined to be a part of a semi-coordinated plan for the future. I call it “Hide the Banks.”

The regulatory part is to expand the tax subsidy provided to financial institutions’ risk-taking. When the money market mutual funds first mushroomed into prominence during the first oil crisis, there may have been truth to the rule that says such funds are not protected from default by the government. But today, so many firms have told so many customers that money market mutual funds are safe, and the likelihood of a genuine run on these funds sufficiently dangerous, that these mutual funds are protected. Ergo, the firms that offer these funds will soon fall under the regulatory umbrella. And hedge funds, when they threaten the system as with Long Term Capital, are protected. Together, all these institutions will be considered banks for regulatory purposes. What they will really do, as did the banks according to the old regulatory definition of the past 20 years, is transfer funds from taxpayers to investors at the point the fiction of safety unravels.

But for banking to progress, needs must be met in new and better ways. So “The Banks” will be reinvented. And with the floodlights trained on the investment banks, obviating new technology of the important paradigm-changing kind, intellectual property is going to migrate away from these investment banks. My candidates for new homes are Private Equity, the two important investment banks, Macquarie and Babcock & Brown (hiding in Australia) and others not yet appearing on the radar.

Meanwhile, the newly regulated, like the currently regulated, institutions will get in line for the dole, and we will have creative new “innovative” ways to subsidize these institutions – by giving new names to old activities that create false security among investors being misled by elements of the entire system, including regulators.

It’s a cynical system, and unnecessarily unstable, but it beats the guaranteed 3% savings returns of the old post-depression system.