Wednesday, October 14, 2009

High Innovations and Misdemeanors

"The market can stay irrational longer than you can stay solvent."
- John Maynard Keynes

As a card-carrying taxpayer I thought I should check in on my blindsides and trundle into the sense-making machine. I would hear the analysis needed to talk the next pendulum swing into a softer landing than the dead stop of last fall's meltdown. Something well-argued, reasonable. Unlike climbing out of a recession with unemployment cresting past 10 percent. On the day the Dow resurfaced above 10,000 I'm thinking -- better revise my reasoning downward -- and buy oil futures before tanking up for my next trip to Western Mass.

According to Paul Krugman his brethren (mild-mannered B-school professors) were launched into rocket science stardom by their serious math-making and sparkling financial models. Rare was the request for the macro-perspectives they were schooled in -- an assessment to compare asset prices to real world fundamentals, e.g. reality-based earnings?

Instead they did what any investor or CEO or Rotisserie League Commissioner would do. They compared assets to other assets (and the more you pay, the more it's worth so bubble-up, econ man...) How do you know it's overpriced? Whenever the appraiser's fees are set by the appraisal. Put another way -- the market holds a monopoly on what to price things. This is not just a blinking black eye for a job poorly done. It's an abdication of the job itself by a profession that prides itself in standing apart from fiscal gravity -- not from being pulled in by it.

What's that awesome and universal self-policing curb on prices? It's fear that trumps greed and pushes demand off the price-setting tables. This is not advanced macroeconomics talking. This is primordial worst case behavior kicking in at no extra charge.

When their macroscopes were placed under the full light of day and here's what Krugman saw:

* They concocted new recipes (fuzzy math, real dividends) to feed a hungry market. Their ratio-making rode atop the eyebrows of Greenspan as works of genius that perfected a recession proof set of market forces and pacified the social forces that might disrupt this state of perpetual growth.

* They rationalized away the insatiable appetite (the savage force of our material natures). So what if this equilibrium nudged the distribution of wealth off a precipitous ledger? The middle class still held down a job, even if it was two jobs. Now there is no easy credit. There is no steady work. And the world economy is learning how to run clear of the maxed-out American consumer, XXL edition.

* Trouble is, when your insights are underwritten by the too-big-to-fail team the too-precious-to-share scheme loses its luster. The bubble pops and the tent comes crashing down. Fear beats greed senseless in a race to zero sum as old as scarcity and as artificial as the house of cards built on the edifice of self-correcting markets.

Cool rationality was the temptation that seduced investors into back-to-back decades of buy orders on efficient, friction-free markets -- the zipless f*ck of wealth creation. I would like to see even-handedness return to the notion that economies are not casinos, that winners don't take all, and that the goal is not to create more rich people but a stable social order. Maybe if I swap out sustainable for stable I'll sound like less of a socialist-fascist and more like the great silent desperation majority now forced to choose between pitchfork populism and disenfranchised resignation.

However, if you read the latest HBR on risk you find that aspiration to be romantic, impractical, and dissed by the enduring power of unfettered innovation. A roundtable of risk elites assure each other that the standard risk return is measured in corporate balance sheets and that the needle must nose up to systemic levels where "firms and markets intersect" and the institutional deer and environmental buffaloes play. Regulation anyone?

Harvard B-school professor Peter Tufano says that we have too many club-footed regulators overstepping on overlapping jurisdictions. "Quite a lot of risk falls in the gaps," Tufano observes with the circular transparency of one who robs banks (because that's where the money is) or frequents K Street fundraisers (where the arms of the law end and the loopholes take over).

Robert Kaplan of Balanced Scorecard fame hints that the law will always be a step behind the law-breakers. Are the expectations that low? Could a step-behind be a step-ahead of asleep-at-the-switch? It's not even clear where the moral lies within the hazard when Kaplan assures us that "regulators will always be behind innovation -- certainly in finance -- and they're always going to be regulating the previous innovation." Ouch.

So the next innovator laces a derivatives bomb to the bottom of their shoes. Sounds like we're in for some barefooted banking. No liquidity exceeding 3 ounces of gold per inflation hedge? If Kaplan is right and regulators lack imagination as much as enforcement tools then maybe the government needs to fire a spoiler salvo at the alter of next cycle innovations. Given that: (1) the Dow is up 53% for the year, and (2) that Goldman's investment banking division is responsible for much of that a pre-emptive strike might be in order.

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