Friday, 24 July 2009

Simon Johnson on Peak Finance

As is often the case Simon Johnson has a way of distilling complex financial ideas into simple and digestible nuggets. In an article from his blog which is re-published at SeekingAlpha Johnson lays out the case for what he terms Peak Finance . It is exemplified by, in his opinion, the inability of financial luminaries and policy makers such as Larry Summers to grasp the big picture and structural implications of the systemic bubble which burst ingloriously last year.

He distinguishes three kinds of bubbles in the article:
1. A short-run bubble. Think about 17th century Dutch Tulip Mania: spectacular, probably disruptive, but not a major reason for the decline of the Netherlands as a global power.
2. A distorting bubble. In this case, the increase in asset prices contributes to a reallocation of resources across sectors. Think of the Dot-com Bubble: fortunes were made and lost, the collapse was scary to many, and – at the end of the day – you’ve built the Internet and some good companies.
3. A political bubble. Here rising asset prices generate resources that can be fed into the political process, through bribes, building politicians’ careers, and lobbying of all kinds. Bubbles in Emerging Markets often generate resources that impact the political process, sometimes in good ways – but most often in bad ways, which eventually contribute to a collapse.

Summers seems to think that bubble #1 is a satisfactory explanation for the events of Q4, 2008 and Johnson believes that a proper explanation discards the transient nature of #1 and vitally requires inclusion of elements from both his second and third characterization of bubbles.

This leads him to conclude that the mindset which Summers personifies and its incapacity to see the underlying dynamics is indicative of a dysfunctional view of the role of finance in the economy. A sea change will be required in the status currently afforded to the role of the financial technocracy and one positive consequence of this would be a relative diminution of the size of the finance sector in terms of total GDP. This would mark the passing of the era which has given rise to too many bubbles and the term Peak Finance becomes appropriate for this, in a similar manner to the way that the term is used with respect to the transformations ahead for the energy sector.

I concur with this line of reasoning but doubt whether we will witness the sea change required in the philosophy of finance in a timely and undramatic fashion. Here is the comment that I have made in connection with the article.
The inability of Larry Summers to fully see the big picture reasons behind the collapse of the credit bubble highlights the dissonance that is endemic amongst this generation of the financial elite.
Assuming that we don't have another meltdown like experience (which is by no means a wise assumption to make) we will require another generation of differently educated individuals to provide better financial policy and leadership.

The question however is - are there enough educators at the top business schools who see the bigger picture and structural reasons behind asset price bubbles and can amend the curricula accordingly?

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