Inequality

[Razgovory]

I dunno, 19th and early 20th century the balance of wealth was fairly stratified.

[MadImmortalMan]

Yeah, but the disconnect we're discussing is in labor productivity vs worker compensation, not relative wealth between rich and poor.

[alfred russel]

In my view the deregulation of the financial sector is largely what is responsible for the innovation which occured.  And, in my view deregulation was largely ideological.  The early 80s in America were all about cutting out all the red tape that was holding business back. Then when the financial markets began to "innovate" and take advantage of its new found freedom there was a political judgment made not to regulate the new financial products that were being created.

I recall a discussion around derivatives and the "whiz kids" that created them.  To some extent the debate was whether or not to regulate but there was also an aspect of how one would do such thing because very few people really understood what the heck they were or how they worked.

Outside of options (which have a long history and aren't colloquially referred to as derivatives in any event), by far the two most ubiquitous types of derivatives among American companies are foreign currency swaps and interest rate swaps. There wouldn't have been much demand for the former in the Bretton Woods world. The rise in demand for the latter is more difficult to explain, but certainly they require a threshold of large companies offering debt to both cover the overhead and create enough demand to allow intermediaries to avoid accumulating risk. At the same time, the stable interest rate and inflation world of the 1950s and 1960s broke down with the stagflation of the 70s and early 80s. There was a heightened awareness of interest rate risk.

For academics, swaps aren't exotic and complex. Their use is going to be taught in any risk management class in B school when interest rate risk and currency risk comes up. It isn't as though "whiz kids" on wall street have come up with products few understand and managed to pawn them off on almost every company in America: if companies want them to mitigate the risk associated with a newly volatile currency and interest rate environment, and academics are saying their use makes sense, it doesn't seem likely for the government to get in the way.

[crazy canuck]

For academics, swaps aren't exotic and complex. Their use is going to be taught in any risk management class in B school when interest rate risk and currency risk comes up. It isn't as though "whiz kids" on wall street have come up with products few understand and managed to pawn them off on almost every company in America: if companies want them to mitigate the risk associated with a newly volatile currency and interest rate environment, and academics are saying their use makes sense, it doesn't seem likely for the government to get in the way.

I doubt you rather sweeping statement that derivatives are not complex - even for academics today.  But for sure they were exotic and complex when they were first introduced.  I think you are probably a bit too young to remember that.

[PDH]

Who cares?  As long as I get mine...

[Admiral Yi]

I can't recall ever reading about "complex, difficult to understand derivatives" before the subprime meltdown.

[DGuller]

I can't recall ever reading about "complex, difficult to understand derivatives" before the subprime meltdown.

I do.    It was mainly in articles predicting the financial meltdown (I refuse to call it a subprime meltdown, because it deliberately marginalizes the true nature of the meltdown).

[dps]

Part of the problem I'm having with trying to apply economic theory to explain the changes in the last 30 years or so is that all of the proposed explanations would seem to be things that in theory should cause increased unemployment, not wage stagnation for those who still have jobs.

[Oexmelin]

Its just that well intentioned people got sucked into the notion that paying the executive suite incentives would maximize shareholder value.  That was a genuinely held belief.  It wasnt something cooked up to "swindle" everyone.

That has nothing to do with what I wrote, though. I am not talking about nefarious conspiracies of evil-doers. I am talking about some basic group sociology forces. One the one hand, people reward "people like them" all the time. Sometimes it is a somewhat explicit ideology (old boys networks, patronage, shared ethnicity); most of the time, it is an implicit ideology, with lots of unspoken asumptions ("we reward merit"). On the other, bureaucracies are filled with people who genuinely hold beliefs about what they do, that they do it for the best of the society/the shareholders, and few ever think that what they are doing is there to swindle anyone.

What I meant by lack of accountability is at its most basic sense: giving accounts of what you do - and this happens when you are forced to explain things to people from "outside" the system, because sometimes you realize you are also explaining them to yourself. Deregulation removed one incentive from that kind of rendering accounts. The very, *very* closed society of high flying managers with few incentives to explain what they are doing is another. The bureaucratization of both firms, and accounting bureaus is yet another (and, again, by that I don't mean evil bad government, but the increasingly routine, increasingly compartimentalized structure of financial institutions). And perhaps the financiarization of the economy in general with its dissolution of shareholders into faceless forces might be another.

[alfred russel]

For academics, swaps aren't exotic and complex. Their use is going to be taught in any risk management class in B school when interest rate risk and currency risk comes up. It isn't as though "whiz kids" on wall street have come up with products few understand and managed to pawn them off on almost every company in America: if companies want them to mitigate the risk associated with a newly volatile currency and interest rate environment, and academics are saying their use makes sense, it doesn't seem likely for the government to get in the way.

I doubt you rather sweeping statement that derivatives are not complex - even for academics today.  But for sure they were exotic and complex when they were first introduced.  I think you are probably a bit too young to remember that.

Interest rate swaps and foreign exchange swaps aren't complex--the concepts are probably standard fare in undergraduate coursework for accounting and finance majors, and the agreements basically boilerplate with a dozen or so customizable terms. The risk management for an investment bank acting as an intermediary for a bunch of these is very complex, and how to regulate them a nightmare (neither is really the concern of a corporation, though maybe counterparty risk should matter more). At the outset the legal environment was also less resolved.

I am too young to be working with derivatives in the mid 70s-early 80s, you have me there. 

[Admiral Yi]

I do.    It was mainly in articles predicting the financial meltdown (I refuse to call it a subprime meltdown, because it deliberately marginalizes the true nature of the meltdown).

It's interesting that people were able to predict the meltdown without knowing how the instruments worked.

[alfred russel]

That has nothing to do with what I wrote, though. I am not talking about nefarious conspiracies of evil-doers. I am talking about some basic group sociology forces. One the one hand, people reward "people like them" all the time. Sometimes it is a somewhat explicit ideology (old boys networks, patronage, shared ethnicity); most of the time, it is an implicit ideology, with lots of unspoken asumptions ("we reward merit"). On the other, bureaucracies are filled with people who genuinely hold beliefs about what they do, that they do it for the best of the society/the shareholders, and few ever think that what they are doing is there to swindle anyone.

What I meant by lack of accountability is at its most basic sense: giving accounts of what you do - and this happens when you are forced to explain things to people from "outside" the system, because sometimes you realize you are also explaining them to yourself. Deregulation removed one incentive from that kind of rendering accounts. The very, *very* closed society of high flying managers with few incentives to explain what they are doing is another. The bureaucratization of both firms, and accounting bureaus is yet another (and, again, by that I don't mean evil bad government, but the increasingly routine, increasingly compartimentalized structure of financial institutions). And perhaps the financiarization of the economy in general with its dissolution of shareholders into faceless forces might be another.

Even though I disagree with you on a lot of stuff, I think you have a point here, only I would expand it beyond class. There is an adage to "stay close to the executives," whether you are a secretary or a senior manager. The idea is that when there is a pool for bonuses or other rewards they go to the people and groups the executives see on a daily basis, not the faceless people and groups around the world.  I've seen it said in the business press that you know a company is serious about cost cutting when they start layoffs within the home office rather than just field locations.

But Oex, I think you should take into account that if you are talking about just the executives, at larger companies $20 million  a year just isn't going to show up in the bottom line, but executive performance will.

[alfred russel]

I doubt you rather sweeping statement that derivatives are not complex - even for academics today.  But for sure they were exotic and complex when they were first introduced.  I think you are probably a bit too young to remember that.

Maybe only CC would care (and maybe not him), but a brief description of one of the most common derivatives-a currency swap-would help.

CC, lets say you own a Canadian business and I own an American one. You make a significant in the US, and I do in Canada. Both of us are worried--we need the income from our cross border investments to pay debts (or pay dividends, fund operations, meet earnings expectations, etc) in our home countries, but while we are confident the income streams will be sufficient at current exchange rates, we are concerned they won't be if there are significant changes in exchange rates.

[to keep the rates straightforward lets assume that the US Dollar (USD) and Canadian Dollar (CAD) are at parity and expected to stay there for the foreseeable future] You are confident you will get $1m USD from your US operations, and that is how much you need to bring back to Canada. I am confident I will get $1m CAD from my Canadian operations, and that is how much I need to bring back to the US.

So you and I enter a deal. I will give you payments of $1m CAD for each of the next three years and you will give me $1m USD for each of the next three years. In effect, each of us has been protected from the risk of currency fluctuations over the next few years, though we are now exposed to counterparty risk (one of us may not be able to pay the other, and the swap agreement may thus become void).

That is a very idealized version of a currency swap. The real world differs in a few ways. First, neither of us would find each other--we would both go to an investment bank. Second, we wouldn't exchange cash flows with the investment bank--we would likely just have a net cash settlement feature at the end. For example, I would go to the investment bank and tell them I have $1m CAD coming in the next 3 years that I want to lock into USD at current rates (parity, in this example). We would enter a swap agreement, and the only time cash would change hands is at the end of the agreement: basically if the CAD cash flows I described would have been converted to USD at less than $1m, the investment bank will pay me the difference. If they would have been more, I will give the investment bank the extra benefit.

[alfred russel]

There are different types of derivatives, and some can get complex, but I don't think that led to any problem (credit default swaps aren't conceptual complex either, but seem to have caused some trouble).

Where there is complexity is with counterparty risk. Derivatives are everywhere: I would guess every company in the S&P500 has some. If an investment bank goes down, that means a lot of companies could be owed a lot of money that they were counting on (for the in the money derivatives). But where the real complexity comes in is the risk management of an investment bank. Derivatives are generally customizable agreements, so if I want an agreement to protect my CAD to USD cash flows you aren't going to find a perfect counterparty for that. The investment bank is going to be left with some exposure. I really don't know how they manage that risk. For a regulator coming in to a company that they don't know with literally trillions in the notional value of derivatives outstanding (and perhaps a company staff not inclined to help them understand everything), the challenge is worse.

There is also trouble in that they can allow speculation because of the way they are valued. If I enter a bet on a coin toss, putting $1 in, and winning $2 if I lose, until the coin is flipped you can't recognize a loss (my expected gain is $1 after all, what I put in). However, if I bet all my company assets on the coin toss, an investor could be misled and not understand there is a 50-50 chance the company won't be around tomorrow. If we disclosed that we had bet all our money on a coin toss, this likely wouldn't be a problem, everyone would understand what was going on. But if we ran the speculation through derivative agreements, of which we already had thousands, probably no one would notice. AIG, for example, was a massive insurance company that decided to make massive bets that the housing market wouldn't collapse. I went back and read their financial filings--they actually highlighted the risk that they were very exposed to the housing market. Their auditor took the very unusual step of indicating a risk regarding financial controls in this area. But I think most investors were shocked to find out that the insurance company they thought they were investing in had become a wild real estate speculator.

[crazy canuck]

I can't recall ever reading about "complex, difficult to understand derivatives" before the subprime meltdown.

Then you were not reading carefully enough.

Also, I am not just talking about the periold before the meltdown.  I am also talking about the period when these things were first introduced which coincided or at least closely followed deregulation in the early 80s.