Reforming the Financial Casino By Ross Jackson , Fall/Winter 2008

Ethical MarketsReforming Global Finance

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public. – Adam Smith, author of The Wealth of Nations (1776)Adam Smith’s principle of the “invisible hand” is often used as a justification for corporate deregulation by the neo-liberals who have brought about the financial crisis of 2007/08. Smith’s principle states that an individual acting in his self interest will also be benefiting the greater society.

This was a reasonable theory in the 1770s of England when capital was local, businesses were relatively small and decentralised, and agriculture was the major industry, characterized by many small producers who were unable to affect market prices, and who operated under a set of government regulations which Smith deemed “just and equitable”. Adam Smith was very conscious of the human and social impacts of his economic theories, and of the morals of the merchant class, having no confidence whatsoever in their ability to regulate themselves. He would never have approved of the deregulation regime of the last quarter century. Indeed, he warned of the dangers of relaxing government regulation of the private sector, which he feared would lead to abuse of the public interest and inequalities of wealth that would be socially unstable.

What we have experienced in the “free market” regime of 1980-2008 is a direct consequence of ignoring Adam Smith’s warning. The modern economy is very different from 18th century England, particularly regarding the concentration of capital in enormous oligarchies, whose owners are able to affect not only prices, but the whole political process, including how they themselves are regulated. But the morals are the same. It is not surprising then that this political leverage was used in the 1980s to push the neo-liberal Reagan/Thatcher governments and their successors to deregulate private business to an extent never seen before. The most glaring example of this was George W. Bush’s policy of letting the foxes guard the chickens, as he filled leading positions in government agencies, which are supposed to protect the public from corporate abuses, with campaign-contributing cronies from the industries to be regulated.

Thus the major cause of the crisis can be summed up in one word—deregulation.

Deregulation
In my opinion, a major tipping point of the crisis was the repeal of the American Glass-Seagall Act in 1999. This act was passed back in 1934 to prevent the kinds of irresponsible and unregulated speculation that was identified at that time as a major cause of the 1929 stock market crash. The effect of the original act was to separate normal retail banking functions from all other financial activities such as asset management, investment advising, trading on own account, stock brokerage and insurance, and to introduce a stricter regulative regime in all these sectors. When this Act was repealed in 1999 after pressure from the neo-liberals, the way was opened for unregulated speculation, often off the banks’ balance sheets. The post 1999 financial world became a casino unrelated to the underlying economy. The use of highly-geared derivates like options and credit default swaps (CDS), which did not exist in the 1930s, made the risks even higher than in those days.

Credit Default Swaps
Take the example of Credit Default Swaps. A CDS resembles an insurance policy between investors in a particular company’s corporate bonds and an insurance company, which will cover any deficit if the company defaults on its debt. However, A CDS is not classified as insurance, and therefore is unregulated. On a small scale, this is not a big problem. But what happened historically from 1995 on was that CDS contracts were entered into between speculators (the deregulated financial institutions) on many major companies’ corporate bonds even though neither party had any connection to the companies involved. These contracts, entered into on an individual basis via the largest commercial and investment banks, might as well have been bets on a horse race. They play no role in the real economy. There is no limit to how many contracts might exist for any particular company. It was recently estimated that CDS contracts for over $60 trillion are in circulation, greater than the total GDP of the entire world. The major players in the speculation are unregulated hedge funds, private equity funds and the world’s largest commercial and investment banks, most of which have sold risky

CDS contracts on very low margin.
As long as the economy evolved without any major shocks, both the sellers and buyers had a common interest in doing CDS deals. The sellers could see a steady inflow of premium income with only a small deposit as margin and an apparently low risk, while the buyers could inflate their current profits and management bonuses by immediately revaluing their bond holdings to par value (and thus exploit their investors), since they were now guaranteed, while the costs would be booked in later years (somebody else’s problem). The whole structure was very fragile due to the enormous positions taken on very low margin—an accident waiting to happen.
The collapse of the over-geared US housing market was the trigger that started the avalanche. Many CDSs included contracts on packages of subprime debt, resulting in enormous unrealized losses on and off many balance sheets. To make matters worse, the ability of the sellers of CDS contracts to pay up in case of a default was often unknown to the buyers. This was one of the major reasons for the “freeze-up” where financial institutions were reluctant to deal with each other due to the lack of transparency and unknown off balance sheet risks. Super investor Warren Buffet correctly called this type of geared derivative a “financial weapon of mass destruction”. A chain reaction started by the bankruptcy of a major bank or corporation like troubled General Motors could wipe out trillions of dollars of capital and send the real economy into a long depression. This is the background for all the rescue packages.

Local Banking Undermined

One of the results of the consolidation of different financial services in the same institution has been the weakening of traditional regional banking. Without their knowledge and approval, the savings of many local citizens was being siphoned off to far away financial behemoths that used the unsuspecting local citizens’ money for speculative ends rather than for productive loans to citizens and real businesses.

The Rich Get Richer
A by-product of deregulation has been an explosion of salaries and bonuses in the private sector, especially in financial institutions. The “greed is good” mentality went to extremes. The numbers became grotesque. In the 1950s the typical ratio of a CEO salary to the average worker was about 12:1. Today, in the USA it closer to 400:1 and the trend is the same everywhere. Such large differences are socially unstable and have historically often been the trigger for revolution. Obscene bonuses encourage managers to take unnecessarily high risks with other people’s money. In addition, the system attracts the wrong kind of people to jobs which require prudence and a sense of social responsibility.

But it is not only CEOs that have benefited. The general result of a quarter century of so-called “free markets” (that are not at all free) and deregulation has been that the gap between rich and poor has widened dramatically, not only within the Western industrial states, but between the rich and poor countries. This too was predicted by Adam Smith if government regulations should be relaxed.

Recommendations
The following recommendation should be adopted by an international group such as the G-20 and implemented world-wide on an urgent basis.

1. Every country should implement a new Glass-Seagall -type law in an updated form, this time to include hedge funds, private equity funds and derivative trading. We must separate financial activities once again and regulate them closely to protect the public interest.

2. Purchases of geared derivates should be limited in practice to investors who have a direct underlying interest. Speculators with no direct interest should be required to put up much higher margin, even up to100% (Today they typically put up less than 10%, which makes speculation too tempting.) This would decimate risky speculation with other people’s money without harming the hedging activities of legitimate businesses.

3. The enormous 2008 taxpayer rescues of major banks across the world due to uncontrolled speculation has demonstrated once and for all that banking is too important for the health of society to be left to the whims of bank managers bent on taking high risks for personal gain at the expense of taxpayers, who end up paying the bills when things go wrong. The lesson learned is that TOO BIG TO FAIL (TBTF) means TOO BIG TO PRIVATIZE (TBTP). In future the state should have a “golden share” in all banks, bestowing the right to a seat on the board and a veto right over any board decision. The state’s representative should have the obligation to protect the public interest, including vetoing any non-transparent or potentially dangerous speculative scheme at an early stage.

4. The concept of “off balance sheet” risk must be eliminated. All exposure and potential losses must be reflected in the standard accounts.

5. All US hedge funds and private equity funds should be required to register with the SEC and become taxable under domestic laws. Similar laws should be implemented in all other countries. Incorporation in tax havens should be as a rule be considered tax evasion by the owners unless proven otherwise (e.g. local businesses).

Two additional reforms should be considered on a less urgent basis:

1. The importance of local retail banking should be re-established. Tax incentives should be granted to banks which are owned locally and which lend over 80 percent of their funds locally. Complementary currencies should be legalized and encouraged to promote the building of local wealth.

2. To get control of greed, the principle of “mandatory philanthropy” should be considered. Anyone earning more than, say,12 times the average worker wage would be taxed at 100%, however with the condition that the person can have an influence on how his tax money is used by prioritizing a list of government approved projects, which need funding. These could be environmental restoration projects, fundamental research, charitable activities, etc. In this way it might be possible to shift status in society away from an “earnings scorecard” and towards personal contributions to the greater society. A more egalitarian society would be far a far more stable and enjoyable place for the great majority.

Conclusion
The 2007/08 financial crisis demands the adoption of urgent reforms that will minimize the likelihood of a repetition. If reforms similar to those recommended above are not taken, we can expect new crises to appear every few years, each one differing from the past (as the financial community is very innovative), but always due to the same underlying cause—a lack of adequate financial regulation and supervision.

Ross Jackson is an economist, founder/chair of Gaia Trust, Denmark and majority shareholder in organic foods wholesaler Urtekram A/S, Denmark.