Rik And Uncertainty (PDF)

Paul McCulley of Pimco very eloquently describes the mechanics (and contradictions) of the ongoing government orchestrated asset bubble from the Bond market’s perspective.

He also muses about the future of finance, declaring the efficient market hypothesis all but dead and describes the dawn of behavioral finance. Bond guys continue to be, so it seems, much more attuned to the risks we run in our system.

One big unanswered question remains: how do we best frame our financial system to most efficiently handle risk and uncertainty to optimize the stability of our capitalistic financial system?

Correctly, finally, the efficient market theory seems to become recognized as the poison it is. Toxic it is especially in the hands of universal financial superstores who, with the help of this dubious theory have crowded out an atomistic and entrepreneurial institutional landscape. Much of finance needs to be much nimbler, quick footed and the incentive of ownership to handle the all-important but somewhat elusive influence of uncertainty. Of course adequate and independent regulative oversight is important but that is an issue for another time.

Equally, and as repeatedly impressed upon us throughout history, the ability to “handle” uncertainty is strongly correlated with leverage. The higher the leverage, the more volatility and destructive reflexive potential is allowed to grow in the system. This is quite the opposite of what is being portrayed by the risk models inherent the efficient market theory. As Paul McCulley explains, this seeming paradox can be observed live in today’s bond and equity markets. Additional liquidity reduces volatility and the perception of risk in the system. Risk can be handled by government to behave as it likes it to (at least for a while and sometimes for a long while).

On this count both the Fed and our large commercial banks (and not so much the non-bank financials who are in governments’ cross-hairs) are responsible for building up unprecedented leverage in the system. Thereby they increased risks, those real and more long-term risks, and directly reduced the ability of the financial system to deal with the system’s inherent uncertainty.

Now, in 2009, governments around the world (led by the Fed) have decided that there is only one way out of it: push on, accelerate, “guns” blazing, i.e. pumping liquidity (leverage) even if it means putting the entire financial system and governments’ financial position at risk. Even when it means that the systemic maltreatment of risk is allowed to continue; even when it means to contradict the steady advice of history. The path taken is not to re-establish markets’ proper functioning but to broaden its unholy suspension.

Unfortunately, this irresponsible policy is not simply a domestic US problem. Global monetary policy is under the leadership of the Fed and a certain Ben Bernanke. Despite grave doubts and resistance, in particular from mainland Europe, there is not much they can do in the current system where the dollar is the reserve currency and most everyone has built a US export dependency. Willingly or not, they all are compelled to follow Big Ben’s lead, a man whose academic rigor and credentials as a central banker are more than just questionable. (Fred Sheehan, Marc Faber on Ben Bernanke. I am not sure whether this global liquidity experiment will be to the advantage of the more timid participants such as Europe; they may end up with the short end of the stick.

One thing is sure; we are not dealing with the origins and root causes of this crisis. Instead we are moving farther and farther away from being able to handle the risks and uncertainties in our system.

Buckle up!