May 21, 2012

Trusting trust

Like an invisible cloud waiting to develop in a storm, the financial sector’s unsolved problems have been lingering above us since the economy fell to pieces after the 2007/2008 financial crisis. Some saw the cloud developing behind the horizon, and pushed for substantially reforming the financial sector. Others stopped well short of the horizon, and seemed to have been guided only by the financial markets’ immediate reactions. The latter’s stand is, in my opinion, often the result of a thinking deficiency: it’s about trust (in the long run) and not about whether financial markets are in favour of reform or not.

Recently I watched an interesting documentary about the financial crisis and its aftermath, titled Money, Power and Wall Street, in which this became once more evident. In episode three, the documentary focuses on the decision-making in Obama’s government shortly after it came to power. Faced with a huge crisis, and a financial sector that had been bailed out beyond imagination, there was the wish and opportunity to reign in the big banks. But it didn’t happen! Why not? Because the deficiency thinkers, under the leadership of Timothy Geithner, got the upper hand – among others Larry Summer had an opposing view, focusing more strongly on forcing extensive new regulation on the financial sector. Geithner seemed haunted by the Lehman ghost of the disastrous unintended consequences of strong interference (or the lack of it, in Lehman's case), and feared financial markets would disapprove of profound change.

The fear for a Lehman-like scenario was an understandable but equally wrong one. The unintended consequences of Lehman’s demise were largely the result of a lack of trust that surfaced with a vengeance. Banks didn’t know what crap was on the books of their counterparts, and because the government’s safety net now wasn’t a sure think anymore trust evaporated. Financial markets reacted immediately, though negatively. Now that the unlimited faith that had existed before had been cracked, uncertainty prevailed.

In the follow up, financial markets first reactions have unfortunately become the gauge for the soundness of (proposed) policies, and issues like too-big-to-fail, derivatives and risky investment have not been seriously addressed (JPMorgan Chase’s recent disaster clearly illustrates this). This line of thinking prevents one to look beyond the horizon, and ask the question whether financial markets are driven by a lack of trust or a fear for the ending of profitable business models. The latter is often the case, and should largely be ignored if the main priority is a more equal and stable economy. Players in the financial markets may not like reform that jeopardises profitability, and they will certainly object. But if it’s a clear message trust will quickly resume. What matters is whether they can trust their counterparts and make assumptions about the future, even if they earn less than before. After the first shock and disapproval of the financial markets, financial players will pick up their trading and business - they can't sit and moan, if they want to make a living.

If only there were more people looking beyond the horizon we may face a sunny future instead of a gloomy one.