Welcome to the latest in our In Conversation series, between risk analyst and author Satyajit Das and Kevin Davis, Research Director of the Australian Centre for Financial Studies.
Satyajit Das is an internationally-known specialist in financial derivatives, risk management and capital markets, who has written extensively on the causes of the global financial crisis and, most recently, of his deep concern about Europe’s sovereign debt crisis.
Just today, the latest chapter is being played out in Greece as private sector creditors agree to a debt swap that it is hoped will mark a turning point in the fortunes of the beleagured nation.
Das’s 2006 book, Traders, Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives, anticipated many of the problems which led to 2008’s global economic meltdown. His latest book is Extreme Money: The Masters of the Universe and the Cult of Risk.
In this thought-provoking interview, Davis and Das discuss:
how Europe’s untested sovereign debt problems make them an economic microcosm for the rest of the world to follow
the fracturing of the fragile social contract between our trust in governments and economic growth
the global rise of the Occupy movement
how financial innovation - dubbed Weapons of Mass Destruction - is back, because it never really went away.
Kevin Davis: You’ve said in the past the situation in Europe worried you more than ever before in your professional life. What’s going to happen?
Satyajit Das: The first thing you’ve got to understand is that it’s not the detail and minutiae; it’s about what this means at a deeper, fundamental level. When the GFC started, the governments around the world essentially used their own balance sheets to issue debt; they used central banks to print money or provide other sorts of monetary accommodation, to manage the system. What we are now seeing in Europe is the limits of that strategy being reached, with the solvency of countries being questioned.
This is a completely different to the insolvency of individual companies or financial institutions. The underlying assumption of modern society is always that at the end of the day, if all else goes wrong, governments can save the day.
The question now being posed - and by no means is the answer yet in - is whether countries will go down in this crisis. Greece, in my view, has already defaulted - a write-down of $100 billion is synonymous with default. To put it into context, (Greek sovereign debt) is six times the size of Argentina’s debt, which was the world’s largest sovereign default till now.
It is also shows how difficult it is to deal with the problem, both in terms of the availability of economic tools and our understanding of the cause and effect of certain actions we take.
It shows you in a microcosm the problem the world will face in dealing with the whole issue. It is going to be very difficult to convince the body politic of the sacrifices and adjustments in living standards that need to be made. Europe is a very good experiment. It will have far reaching consequences for everybody.
Kevin Davis: Talking of social and political consequences, if we return to Australia we have the current dispute going on between Wayne Swan and various mining magnates. The question is, can we reach any sort of consensus on implying sensible policies?
Satyajit Das: Well, leaving the debate between the Australian government and the miners to one side - which to my mind is a very narrowly focused fight about whether something should be taxed - I think the democratic process and the politics of the world relies on a very fragile construct. One is trust. And trust relies on economic growth.
Basically, the political process in the post-war era has delivered us prosperity with a few notable and relatively short periods. Our wealth and our well-being has improved. Now we are reaching a very interesting inflection point where maybe our models don’t work any more, or don’t work as well. We are ushering in a period of low growth - or maybe no growth - and in some countries like Greece, Spain and Italy, we are going to see a regression in living standards.
Under those circumstances, how can the politicians manage the electorate and its expectations? A concrete example is Greece, where the two major parties are now collectively polling less than 40%. Assuming those numbers are realised in the election in late April or May, no party will be able to form a government without a cumbersome coalition.
That creates a different tension, especially when 60% of the population is anti-Euro or certainly anti-austerity and anti-bailouts.
And you even have strange things even in Germany, where a party called the Pirates Party, whose only platform seems to be opposition to internet censorship, is polling 10%. This fragmentation is occurring because some of the assumptions of normal society are breaking down. People forget the underlying growth framework has been related to the democratic framework. If one breaks down, the other goes as well.
Kevin Davis: Do you see those issues as relevant to the growth of things like the Occupy Wall Street movement?
Satyajit Das: I’m not really sure what Occupy Wall Street stands for. I can see disparate strands. There are a bunch of people who have worked very hard and done all the right things and expected to get some rewards in life. Instead, they find they’re not going to get what they thought they were going to get. Then there is a deeper discontent with the system. Perhaps not so much in Australia, but you can see that at work in Occupy Wall Street.
A few are highly trained bankers and lawyers, who have written the most dazzling critique of the Dodd-Frank Act’s Volcker Rule. It is over 300 pages and it is a point-by-point refutation of the arguments of the different groups who have lobbyed for different changes.
But Occupy Wall Street points to a breakdown in the trust and consensus we have previously shared. While we have always had Occupy Wall Street in some degree, it became global very quickly, which suggests a deep discomfort with what has happened. The Indignados in Spain have occupied the centre of Madrid for a long time. The protests in Greece and Italy are significant because they’re not made up necessarily of what I call “professional activists” or professional anarchists.
They’re ordinary middle-class people who feel they have been disenfranchised, who have lost their livelihoods, their houses and become street people, in just a year or so, due to the adjustment mechanisms being forced on these countries.
There is a very ugly undercurrent in Europe - because of the divide between northern and southern Europe - that this is very much a German-led imposition which, given the history of the Euro, is inflammatory.
And what I really fear is at some stage, maybe soon, is that a German tourist who inadvertently ends up in the middle of one of these (protests) is hurt or killed, or a Greek or other nationality gets physically manhandled in a protest in Germany or northern Europe.
Kevin Davis: As you say, the Occupy Movement has broadened out into big social protests, but at least initially I thought of it as being directed at the finance industry and the finance sector. In the past, you’ve certainly written about what have been called Weapons of Mass Destruction, the financial innovation, and excessive development of financial products. Are we seeing a return or a regrowth of that happening now?
Satyajit Das: To some extent they never went away. I think of financiers and financial products a bit like locusts. They lie dormant in the ground until the conditions are right and then they emerge.
There was an opportunity after 2008 for Western regulators to ask the right question. What do we want the financial system to do? The contribution these instruments to the global financial crisis provided an opportunity for reform and review. I honestly don’t think they were the only cause of the crisis. I think the basic problem was over-indebtedness, amplified by some of these instruments.
Instead, we lurched into a few regulatory patches, rather than addressing the real issues.
In March, The Economist published a fairly uncontrite view of financial innovation. The idea was that everything is fine, and a few things going wrong can be justified. You have to break a few eggs to make an omelette. That misses the point. I personally think that the financial system has become too large. It’s become too central to the way we drive economies.
In my view, financial systems should do three things: match savers and borrowers, provide safe payment mechanisms and provide rudimentary risk management instruments. And that’s all it should do.
And we should have a debate about how we get the financial system back to doing that. But the problem here is finance and debt has become a driver of growth, so there’s an unwillingness on the part of the regulators and the politicians to tackle them.
It’s a bit like an old Woody Allen joke. Woody Allen says to the psychiatrist, “my brother thinks he’s a chicken,” and the psychiatrist says “well, bring him to me and I’ll have a chat with him and we’ll see if we can fix the problem”. Woody Allen says, “I’d like to, but we need the eggs.”
Eisenhower wrote about the Defense Industrial complex. From the 1990s onwards, we developed the Finance-Government complex – “Government Sachs” in short. Their lobbying power has become a real issue. People like Simon Johnson have written very very powerfully about this financial oligarchy. And I think like oligarchies everywhere, they are not necessarily compatible with a democratic society.
Kevin Davis: Their lobbying hasn’t stopped a huge amount of financial regulation. Are the regulators going down the right track, are they being sidetracked, are they getting it right?
Satyajit Das: Having participated in financial lobbying and financial regulation for most of my life in different guises, I think there are many ways you fight new regulation.
The first line of attack always is self-regulation. You basically say, “Well, you don’t understand, it’s too complicated, we can regulate ourselves”. But self-regulation has the same relationship to regulation that importance has to self-importance.
The next strategy is “We’ll try and cut it down to areas [where] we’ll manage it”; sort of like a phase-by-phase strategy.
The last, what I call the nuclear option, is that you let them regulate. But you make it so complicated and so detailed that there are loopholes everywhere and it’s unmanageable. And you know the regulators won’t have the resources or the actual expertise to regulate you properly, so the whole thing will crumble under its own weight.
I think that is particularly the case with Dodd-Frank, which was over 2000 pages and complicated. To give you an idea, the Volcker Rule is about eight paragraphs, and the actual detailed regulations run to is several hundred pages. I had a conversation with a derivatives US lawyer about the Volcker Rule. He said to me: “As a lawyer I’d be embarrassed if I couldn’t make sure that you could continue to do everything that you were doing, under available exemptions.”
There has been a lot of activity, but little improvement in regulation, I am very, very sceptical. We’re still relying on some very hoary chestnuts such as disclosure and more capital.
A different model would be what I call the Drug Administration model: there are certain things which are so toxic we just don’t let you have, and certain things which can only be prescribed by a doctor, there’s only a limited number of things you can just go to the pharmacists and buy.
There are different models but we never debated that. I think that was a great missed opportunity.
Kevin Davis: One last question, do you think the academics are contributing, sufficiently and appropriately, to the analysis of financial sector development growth problems and the linkages with the real sector?
Satyajit Das: That’s a very loaded question, but I’ll give you an honest answer. There’s a group of people who’ve now congregated around this finance-government complex.To some extent academics are a part of that.
And I think Inside Job (the Oscar winning documentary) pointed towards some important conflicts of interest. Frederic Mishkin actually mislabelled one of his reports in his CV to avoid drawing attention to the fact that he had been paid by Iceland to do a report which endorsed the stability of the Icelandic banking system, which was obviously not quite correct. [Editor’s note: Read Mishkin’s response at the time here.]
There’s a huge conflict of interest, in terms of people who do this type of work, although I will leave that to one side, because I wouldn’t class that as pure academic endeavour.
In terms of the academic debate, what I’ve found is it’s like a train line, where there are two parallel tracks: one where the real business of practical finance goes on and a parallel line which is academic research. They no longer seem to intersect.
I’ll give you a very honest example of what I did with academics in terms of my professional training career. We used to have people who did quantitative models and so forth and they were useful up to a point. We used academic economists for advice.
But basically, they very quickly became sales gimmicks. So we would give quantitative research to our clients, whether we believed in it or not, because it afforded us face-time with the client, and to some extent the more eminent the economist, especially if we could trot along a Nobel Prize winner, so much the better, so we’d turn up with that.
I don’t think anyone really expected any earth-shattering research or contribution to the world of business, but it was kind of a parallel world. And the best way to do it I think is the academics became the pianists in the whorehouse. Some of the academics, however, were smart enough to cut themselves a share of the action along the way.
We saw people like Myron Scholes and Robert Merton turn up at LTCM with somewhat indifferent results. I think the two groups pursue parallel and different interests. There’s not a lot of intersection between that. Except when it’s convenient, I suspect, to both parties.