Stability of the financial system: perception, reality, and leadership

As this recent article in the FT put it, “When it comes to managing sovereign debt crises, perception is all.”

We might add, “perception [not reality] is all”.

The latest update on this situation is that the UK government’s borrowing costs have now fallen to historic lows, as investors seek safety from the perceived risks of Italy and the eurozone. Just as Italy was once a safer haven than Greece.

Continuing turbulence in Europe is also increasingly affecting emerging economies. In the ‘flight to safety’, emerging market currencies have “plunged”, stock markets have fallen, and consequent low interest rates are driving up inflation.

And as the situation worsens, falling perceptions are hampering our ability to address the crisis. It has become harder for governments to raise the cash they need to solve the problem.

Capitalism, it seems, is a self-fulfilling prophecy. Growth or recession creates the expectation of more of the same. Stability is not possible.

This explains the calls for a ‘big bazooka‘ solution: not necessarily because a bazooka is what is needed, but because a ‘big bazooka’ event is the only thing that will change investors’ perceptions.

With each weakening of a part of the system, the remaining stress is concentrated into a smaller and smaller area — like rats clambering together onto the highest parts of a sinking ship.

The ‘theory of constraints’ puts it this way: imagine a large factory, with many related processes and activities converting raw materials into intermediate parts and then into finished products. Somewhere in the factory there is a bottleneck. But it you increase capacity at that point, the bottleneck will simply move to another part of the factory.

Solve the bottleneck in one part of the eurozone (Greece) and it simply shifts to another part (Italy).

Like the power systems of the USA, which experienced blackouts when one section was hit by electrical storms, part of the solution lies in linking the pieces together, to create a bigger system that has spare capacity.

This is what our newly-globalised financial system has done. We have linked together our different financial institutions, bringing huge benefits, but we have taken it too far. Entities now hold so much of each others debt that there is very little differentiation between them. Instead of being different institutions linked in a network, they have become essentially similar institutions, all part of a larger entity. Removing the separation between investment and retail banking has made the situation worse.

To solve this we need to reintroduce separation and differentiation. Reintroducing distinctions between retail and investment arms will help, as will merger of similar entities.

We also need to ensure that each part of the remaining system is inherently stable. This is what all the talk of ‘firewalls‘ is about. But the long term solution lies in ensuring stability of each part, rather than fencing it off from the others. This is what re-introduction of higher capitalisation requirements would achieve.

In other news on the same theme of perception being more important that reality, France is said to be furious that the Standard & Poor ratings agency ‘mistakenly’ downgraded its debt rating. But as comments on the article pointed out, professional bond investor will have their own opinions about the risk involved with different instruments and will pay little heed to a ratings agency’s opinion, especially when agencies a few years ago were rating subprime mortgages as AAA.

Italian bond yields also fell below the “psychologically important seven per cent“, helped by a successful €5bn bond auction at 6.09 per cent. (Or did a perception shift drive the success of the auction?) This article explains how the real struggle going on inside Italy is a cultural one. Italy’s problems, it says, lie in an “undemocratic system of self-referential capitalism” — for which I read ‘crony capitalism’. As Berlusconi said this week of one politician no longer supporting him, “It’s incredible. I am the godfather of his daughter and he betrays me.”

Cronyism can work in the short term, but the point comes where the outside world moves on and the right thing to do for the daughter is to face and address the new reality.

In this situation what we need is leaders, not managers (and definitely not playboys or cronies). We need leaders who can understand physical realities, and shape them into a compelling perception — of where we are, where we need to get to, and first steps to get there.

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