[This is a fairly long post attempting to examine derivatives from a relational perspective. Fun, huh! It’s becoming evident, three hours into it, that I ain’t an economist! And that there’s more to say.]
Why weren’t derivatives regulated?
In the comments of Saturday’s post Nick told me about Brooksley Born, former head of the Commodity Futures Trading Commission. Back in 1998, having become increasingly concerned with the lack of transparency of over-the-counter derivatives, and in particular ‘swaps’, the Commission issued a “Request for Comments” report. The report is a first step towards new regulations. One day later, strong objections to the report were made by the chairman of the Federal Reserve (Alan Greenspan), the Treasury Secretary (Robert Rubin) and the SEC Chairman (Arthur Levitt) strongly objected to the release of the report.
So the three most powerful people in US finance opposed a preliminary investigation into the derivatives market. Born, apparently, wasn’t even permitted to take a closer look, let alone issue new regulation.
Why regulation should be a tool of last resort
[UPDATE: the original heading was “Why regulation sucks”, a hastily invented and unfortunate choice given the reaction “regulation” talk causes.”]
Now, I don’t honestly know what “Regulation” means when someone says the word. But it seems like people want it used like a very blunt and unimaginative hammer for constraining any excessive human nail. And even if it’s successful at that, it is ill-designed to foster virtuous innovation, creativity and trusting relationships. “Law” does have a place in fostering trust, I guess, by letting everyone know where the boundaries are. But by placing the locus of moral restraint on the law rather than in the human heart and in human relationships, one underestimates what the human heart is capable of and opens up a Pandora’s box of deceitful ingenuity that requires more law.
Regulation and a lack of transcendent moral authority
I’m so sorely tempted here to make an argument for God, or rather an argument for the inevitable trajectory of a society that rejects God or a transcendent moral authority. [And please, if you’re atheist, don’t get bent out of shape about that proposal. I would guess and expect, if you’re reading this, that you’re a person of high moral sensitivity and fortitude (not to mention a person with exceptional taste in blogs!).] But I speak about those for whom the absence of a transcendent moral authority is license to … well, create fraudulent, exploitative, derivatives. I mean if the accepted norm in a society is that morality is self-determined, that’s fine if what you self-determine is righteous and good (namely, you, dear reader!), but for everyone else? What then? More laws, more regulations (that affect everybody, even the righteous) ironically taking us back to something akin to the religious legalism from which we thought we’d liberated ourselves. Most claims for human enlightened progress assume a level of goodness and righteousness that empirically does not exist even in the best of us, and even if it does, it’s only in those who make the claim. [Oh man, looks like I did make an argument. I think I’ll be in for some fire for this paragraph.]
Regulation as “oversight”: observation of actions
The key word for the role of the CFTC, and for regulation in general, is ‘oversight‘. Over. Sight. Looking over … someone is watching! Regulation does provide specific permissions and prohibitions (the creative spirit killer), yes. But the main thing seems to be about disclosure, as with Sarbanes-Oxley for example. That’s what screams “you can’t be trusted with each other!”. No gentleman’s handshake for you two! The authority needs to know, for the sake of everyone else.
Relational analysis of derivatives.
So the big question I want to ask is: how do we create a different form of oversight that is built right into the financial relationships embedded in entrepeneurial activity and human exchanges of labor, material and time? First we have to examine the system relationally.
From Wall St to Farmer Bob. Or, Financial Risk Management made easy (for me to understand)
Farmer Bob wants to harvest a field, but he can’t afford a tractor. A friend has some money to lend him, but with a few other friends they pool it together to help the farmer. Suddenly the farmer’s productivity sky-rockets, he’s even employing more people, developing better farming techniques, trying out organic methods. Only he doesn’t, the tractor blows up. All his friends lose their money. Except they don’t. They get together with yet more friends so that some of the bigger pool of money goes to this farmer, some goes to a milliner, some goes to a guy who’s invented something called a yPed. Two out of three succeed so the larger group still receive a return on their investment. Except they don’t. A tornado rips the local economy to shreds so they lose everything. Except they don’t. They get together with another group of folks out west and pool money to share in even more diverse enterprises: the confidence that a failure at one farm or one town won’t make them bankrupt encourages more people to invest their money in helping more people farm and make hats and yPeds.
And so it goes, the world of financial risk management and economic expansion. Through the eyes of a non-economist.
Financial risk and relational proximity.
In this whole scenario, you can see the possibility of accountability between the people with money and the people who use money to do something creative, productive. There’s a relational proximity between them, though growing more mediated and distant the bigger the pool becomes. There’s no ‘derivative’ pool of money that’s speculating against potential future scenarios. There IS financial speculation, but it’s “invested”, it has a stake in the end product.
Directness. It seems the greater the distance between the lender and Farmer Bob, the greater the chance that the lender will forget there’s a human being trying to make something good at the other end, and will instead only think, “how am I going to make money?”. Equally, there’s a greater the chance Farmer Bob won’t remember there’s a human being who’s risked their money with them. Purpose/Commonality. In other words, there is no longer a shared understanding of the source and purpose of the money. So relational distance (what I’ve called elsewhere, mediated relationships) contributes to a lack of mutual, intrinsic moral accountability – so now you need ‘oversight’, the law, from someone who’s not invested in either party or the relationship. There’s even greater relational distance now because the people ‘with the money’ (e.g. Wall St traders) are not even using their own money, they’re using money invested by millions of people. The traders stand in between million’s of other people and Farmer Bob.
Power. That shift in moral accountability and sense of relational investment is made more problematic by this big pool of money now being concentrated in fewer hands (e.g. Wall St traders). There’s now an enormous power asymmetry. The people with the money, who now have a lesser sense of moral accountability to Farmer Bob, can now dictate terms. The distance means their only purpose is “make more money”. The fact that Farmer Bob needs a tractor is irrelevant to them now (especially because there’s just no way ALL tractors would fail at once, or that ALL resale prices of tractors would drop at once, that would NEVER happen!). The only way to redress the power imbalance in this case is for all the farmers, and everyone else who needs money to buy houses or tractors, to get together as a community (consumer action? social media?). Or else there’s regulation.
So relational distance (directness) causes a loss of shared purpose (purpose!) and a greater possibility of power imbalance (parity).
And I think I’m done.
Except I’m not.
None of this horrid scenario would have been possible if there was no interest charged on loans. An interest charge essentially enables the lender to make money out of money. They’re being paid to lend money. So interest creates a loss of shared purpose right at the get go. If, however, the lender received money from the success of the business, THEN, lender and Farmer Bob have shared interest. Bob gets his tractor, lender gets his money because Bob is successful. Yes, pool money with others, pool with even more others, spread the risk. But keep the source of investment income in the form of business productivity, dividends. Not interest.
Now I’m done. For now.