THE TEMPTATIONS OF MODERN FINANCE A Critical Yet Sympathetic Analysis of U.S. Financial Policy

1. THE TEMPTATIONS OF MODERN FINANCEA Critical Yet Sympathetic Analysis of U.S. Financial Policy David A. Westbrook The University at Buffalo The State University of New York

2. An Influential Statement of the Problem Former Chairman of the Federal Reserve Alan Greenspan told the U.S. Congress that “the modern risk management paradigm held sway for decades” but “the entire edifice . . . collapsed in the summer of last year.”

3. Without a Paradigm . . . • How do we begin thinking about financial regulation? • How do we begin to address the current crisis? • How do we conduct financial regulation going forward? • Most broadly, what do we believe about the relationships between “government” and “markets”?

4. A Global Question • Markets are global • This is an intellectual crisis with a non-national frame • As evidenced by my talking to you today 

5. Three Eras of Financial Policy • The Era of Transparency • The Era of Portfolio Management • The Era of Constructed Markets (that I hope is being born)

6. The Temptation of Finance • Finance gives individuals and institutions tools with which to confront the future. • Financial markets present their own dangers. • Finance is therefore tempting (but sometimes we should give in to temptation).

7. Transparency • Transparency approaches to financial regulation respond to marketplace danger by giving investors information. • Much financial regulation – particularly the mandatory disclosure regime of the securities laws in the United States – is based on transparency. • Information – truth – is difficult to achieve. Actual disclosure regimes cannot live up to the ideal of transparency. • “Put all your eggs in one basket – and watch the basket!”

8. Portfolio Management • Based on theoretical work done in the 1950s • Understands investment in terms of risk; embraces risk. • Marketplace danger is managed through strategies of diversification and hedging • “Don’t put all your eggs in one basket”

9. Portfolio Management is • Synthetic • Speculative • Virtual • Modern • Social

10. Needle TowerKenneth Snelson, 1968Hirschhorn Museum and Sculpture Garden, Washington, D.C.

11. Needle Toweraluminum & stainless steel60 x 20 x 20 feet18.2 x 6 x 6m

12. Marketplace danger is ignorance Addressed through information Assumes a (naively) descriptive function of language In U.S., roughly 1933-1974 Marketplace danger is risk Addressed through construction of sound portfolio Assumes a (naively) contractual and analytic function of language In U.S., roughly 1974- September 2008 Transparency vs. Portfolio Management

13. Weaknesses of Portfolio Management • Diversification does not work against systemic risk • Models may not represent reality (but be legally binding all the same) • Integration of portfolios tends to increase uncertainty (and hence counterparty and even systemic risk)

14. Tragic Structure of Current Crisis • Crisis results, in immediate sense, from success and global adoption of portfolio management. • At deeper level, crisis results from the antagonism between incommensurate virtues, those of transparency and portfolio management. • Financial regulation – like much of politics – is business of managing such tensions, and as such, incapable of perfect solution.

15. Managing Temptations (and the Resulting Crises) through Law • Recent decades have seen, at the heart of financial regulation in the U.S., a superficial understanding of law, and therefore of markets • Financial regulation might be vastly improved by understanding that markets are constituted by law. • It is wrong – too simple – to think of law merely as a “response” to financial markets. Markets are always already legal. • Markets are a form of social organization, and in that sense, inherently political.

16. Some Recent Oversights (Tough Lessons) • Corporations do not self-regulate. • Contract terms are not perfectly determinate, especially under conditions of insolvency. The precision of pricing models are therefore limited in principle. • Privity (the inability to obligate third parties) imposes fundamental limitations on disclosure and hence transparency.

17. General Lessons for Financial Regulators in the Era of Constructed Markets • Financial regulation should be unapologetic, because good minds may disagree about the essentially political question of how markets should be constructed. • Market failures (and regulatory failures) are to be expected. • Bureaucratic judgment is inescapable, and responsibility should be taken.

18. A Few Specific Thoughts About Responding to Crisis • Even when supporting an industry, care must be taken not to throw good money after bad, and give undue support to badly run institutions • Safety may be sought in separation (often legal or artificial) of risks, even though unnecessary as a matter of financial theory. • There is safety in a diversity of institutions, analogous to biodiversity. • Scale. Too big to fail is one thing; too big to rescue is another.

19. Intellectual History, Then and Now • Financial policy has been naïve about the nature of language, and the social. • Financial policy has not thought seriously about the laws at its core. • It is time for financial policy to take the turn to interpretation that has marked the rest of the humane sciences. • Thus the turn from the era of portfolio management (modeled on physics) to constructed markets implies a parallel turn to a more interpretive understanding of financial scholarship.

20. Conclusion In a time of interconnected discourses, not least of all financial confidence, worldly philosophy can – and should – become a far friendlier enterprise!