Do Not Ignore the Need for Financial Reform


". . .financial markets always present a distorted picture of reality."

The philosophy that has helped me both in making money as a hedge fund manager and in spending it as a policy-oriented philanthropist is not about money but about the complicated relationship between thinking and reality. The crash of 2008 has convinced me that it provides a valuable insight into the workings of the financial markets.

The efficient market hypothesis holds that financial markets tend towards equilibrium and accurately reflect all available information about the future. Deviations from equilibrium are caused by exogenous shocks and occur in a random manner. The crash of 2008 falsified this hypothesis.

I contend that financial markets always present a distorted picture of reality. Moreover, the mispricing of financial assets can affect the so-called fundamentals that the price of those assets is supposed to reflect. That is the principle of reflexivity.

Instead of a tendency towards equilibrium, financial markets have a tendency to develop bubbles. Bubbles are not irrational: it pays to join the crowd, at least for a while. So regulators cannot count on the market to correct its excesses.

The crash of 2008 was caused by the collapse of a super-bubble that has been growing since 1980. This was composed of smaller bubbles. Each time a financial crisis occurred the authorities intervened, took care of the failing institutions, and applied monetary and fiscal stimulus, inflating the super-bubble even further.

I believe that my analysis of the super-bubble offers clues to the reform that is needed:
  1. Because markets are bubble-prone, financial authorities must accept responsibility for preventing bubbles from growing too big.

  2. To control asset bubbles it is not enough to control the money supply; you must also control credit. The best known means to do so are margin requirements and minimum capital requirements.

  3. Because markets are unstable, there are systemic risks in addition to the risks affecting individual market participants.

  4. Financial markets evolve in a one-directional, non-reversible manner.

  5. The Basel Accords made a mistake when they gave securities held by banks substantially lower risk ratings than regular loans: they ignored the systemic risks attached to concentrated positions in securities.

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