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The LIBOR Manipulation, Who’s To Blame: Bankers Or The Process?

ImageThe LIBOR (London Interbank Offer Rate) is currently the centre of attention after the City Regulator ordered its biggest ever fine – £290 million penalty – to Barclays for manipulating the LIBOR rate.

Indeed, the recent revelations of the alleged manipulation of the LIBOR by most of the major banks have made this interest rate the top topic in the news around the world. However for me, the ultimate question is (as it has always been since April 2008 when the LIBOR stopped being in line with the UK base rate) to know whether the issue was actually the operator (i.e. the bankers) or the way the LIBOR is calculated/consolidated (i.e. the process).

Since 2007 at the beginning of the global financial crisis , I have been following the LIBOR rate. In April 2008, I started questioning the way the LIBOR was calculated as it started falling dramatically (at 2.48% from 4.22% in January 2008 and 5.27% in September 2007) and was no longer in line with the UK base rate (which was at 5% in April 2008). Although it must be said that the LIBOR does not necessarily always have to be in line with the base rate, I am however increasingly vindicated in my concerns with regards to the way Thomson Reuters (on behalf of the BBA) gather and consolidate data in order to reveal the daily LIBOR rate. Source of data: http://www.bbalibor.com/bba  

In practice, Thomson Reuters calculates and distributes LIBOR on behalf of the BBA. The BBA names the panel banks that submit the rates to Thomson Reuters and also sets the methodology Thomson Reuters follows for the calculation. Every morning Thomson Reuters receives the contributions electronically from the panel banks. It performs a series of high-level validity checks following the criteria set and agreed with the BBA. The rates contributed by the panel banks are meant to answer the question: “At what rate could you borrow funds …?”

Not too bad as a method of calculation but could it be more accurate & transparent?

Indeed, instead of relying on a panel of surveyed banks that provide data on their prospects of borrowing along with their forecast of liquidity which later are consolidated by an agency, would it not be more sensible to have a system where the actual rates of borrowing between banks are automatically recorded as transactions take place? Banks / financial institutions lending to each other at different rates …, the consolidation would ultimately and automatically takes place when financial markets close, thereby producing a rate that would be the market’s opening price?

I can already hear some critics arguing that the LIBOR rate is different from other rates or index values as this is solidly linked to the level of liquidity in circulation. But wait a minute, the same principle applies: if the rate falls below its real value, this will mean that there was plenty of liquidity in such a way that it became cheap … the rate will progressively appreciate as liquidity will become rare and the cycle will start again.

I can hear some others arguing that not all banks will be on the automated electronic system, thus some transactions will be missed out and therefore jeopardise the accuracy of the LIBOR. Hang on; does the current method include all banks? Is it not just a panel of banks set by the BBA?

Other critics suggest that the separation of the retail and investment banking is the ultimate solution. I have to admit that, although this would be a giant step towards resolving the current banking crisis, it would not however help to strengthen the current system in terms of the calculation of the LIBOR. Indeed, most of the so called retail banking products such as mortgages rely on the LIBOR rate; thus being able to manipulate the LIBOR will definitely impact both investment banking as well as retail banking.

With the current system, banks have been manipulating the Libor so as to get funds at a cheaper rate and to lift up gains on trading positions they hold. At this defining moment where we are still in the economic & financial tornado started in 2007 and generated by banks / financial institutions and where there have been some financial scandals (the alleged mis-selling of PPI & Interest Rate Swaps), we cannot really expect Imagebank professionals to suddenly change and no longer be greedy, no longer try to manipulate figures etc, can we? That would be very naïve. At the end of the day bankers are made to make money!  On top of all this, the recent IT issue that prevented millions of banks users (not only RBS/NatWest users – some other bank users could not receive payments as they were paid from a RBS/NatWest bank account) from accessing money has not helped to restore trust.

It is therefore pretty clear that bankers are not likely to deviate from their “raison d’être” that is “making money”. The only way to get this fixed is by making the process as robust as possible.

This paper is a first step of an article that I am preparing on the LIBOR System. This is a first thought aiming to raise questions. For example, is this the time to think about another process of calculating the LIBOR or should we stick to the current system expecting that the FSA (the first to blame in my opinion), the BBA and to some extent the Bank of England and the SFO would finally start doing their job properly?

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July 8, 2012 Posted by | Articles In English, Economics, International Business, International Finance | , , , , , , , , , , , , , , | 2 Comments

Floating Regime: Myth or Reality?

As you might be aware, The Swiss National Bank decided yesterday 06/09/2011 to peg the Swiss franc against the Euro (CHF 1.20 per Euro) in an attempt to weaken its currency and protect its economy. The SNB has also pledged to buy foreign currencies to force down the value of the Swiss franc and has warned that it would no longer allow 1 CHF to be worth more than € 0.83.

For me, this implies a high level of intervention into markets and thus raises a lot of questions: with American, China, and now Switzerland setting fixed values for their currencies by strictly monitoring it, are we still within the floating regime where market forces were supposed to determine currency values? We know that even in normal circumstances, Central Bank normally intervenes to stabilise its currency; but to this extent? Having a goal of a fixed rate set by a central bank?  Are we about to witness a currency war as Japan also recently revealed their plan of selling the yen and pledge to inject liquidity? Should we therefore rename the “floating regime” to a “managed float regime”?

To be continued …

September 7, 2011 Posted by | Articles In English, Economics, International Economics, International Finance | , , , , , , , , , , , , | Leave a comment

We Live Longer…Should We Work Longer?

With increasing public debt and budget deficit across countries, governments around the world have been under serious pressure to simultaneously reduce public debt and not jeopardize global recovery.

This tricky situation has led to many debates, among them the one about the average pension age.

Having followed discussions & arguments on the topic, I would summarise the issue as follows: should there be a default age or an arbitrary age limit to work? Should all workers be treated in the same way, regardless of the nature of their job?

Before going into details with arguments, I should point out that my answers to these questions would be motivated by the sense of freedom that I believe everybody should be entitled to.

In the UK, the coalition is proposing to increase the average pension age to 66 by 2016. In France, public sector workers were recently on strike again (not big news) because the government is proposing to increase the average pension age from 60 to 63. In Greece, the government was forced to acknowledge that the country was living beyond its means and that people were expecting everything without working hard; therefore among some harsh measures that were imposed on the Greek government by the EU & IMF, was the increase of the average state-pension age from 60 to 63. But the Greek labour minister Andreas Loverdos has been facing tough industrial actions from civil service organisations and trade unions.

My question to those strikers and protesters would be: what is the point of living longer with no money or a miserable pension?

In France for example, the official average retirement age is currently 60. If in past decades, the life expectancy was around 72 years old and the government could thus take care of retired people without creating a big hole in the state budget, this is no longer the case. Nowadays, with people living up to 80-85 years, how can we expect the same funds to cover, not 10 years of retirement but 20 years?!!!

Unquestionably, the standard of living is changing & improving around the world, people are living longer and better. So, should we amend labour legislation accordingly or should we stick to old rules and expect some kind of magic to happen in order to prevent budget deficit? Also, from a business standpoint, would it not be good to keep this experienced labour force active? To illustrate my thoughts, I will quote the British Secretary of State for Work and Pensions Iain Duncan Smith, who recently said: “people are living longer and healthier lives than ever, and the last thing we want is to lose their skills and experience from the workplace due to an arbitrary age limit” I would add to this quote “particularly when they are willing to work”.

To be honest and fair, if someone, regardless of whether he has worked as a farmer or a banker, would like to carry on working in order to contribute more and then have a better retirement, why shouldn’t he /she be allowed to do so? On the other hand, it should be clear that, if someone chooses to retire earlier – just because he/she does not want to work anymore- then he/she must not expect to receive the same money as people who used to retire at 60 then live up to 75, especially as he/she might live up to 85 years, if not longer.

I can hear some critics saying that, instead of asking older people to work longer, we should be giving those jobs to young jobseekers. Well, this raises the question on how we perceive “labour”. For me, work & the labour market are more likely to be infinitely elastic than like a fixed entity that would be divided among the available labour force. In other words, the more you work, the more it creates other jobs. So, stopping the elderly from working would not necessarily make the jobs available for younger jobseekers…it might even have a contrary effect.

So, let’s all adapt to this new challenge and stop limiting people due to their age…by the way, can someone check the average retirement age in the USA? 67 years old and 5% of the active population is over 70 years old!

“[Forced retirement] makes you feel pretty rotten, 

as if you’re stuck on the shelf and put to one side”

John White, 70 retired postman.

Source: http://www.bbc.co.uk/news/business

August 14, 2010 Posted by | Articles In English, Economics, International Economics, Uncategorized | , , , , , , , , , , , , | 2 Comments

Déficit Public Annuel Inférieur À 3% du PIB, Un Luxe Pour La Zone Euro ?

1ier janvier 1999, c’était parti, la zone euro était lancée ! Et pour faire comme les grands, elle s’était dotée d’un parterre de conditions spécifiées dans ce qui convient d’appeler le « Protocole sur les critères de convergence ». Critères de convergence dont l’un des piliers centraux est le rapport entre le déficit public annuel et le produit intérieur brut (PIB) qui ne doit pas dépasser 3 % à la fin du précédent exercice budgétaire.

Vous avez dit 3% ? Bien !

Alors, comment expliquer les chiffres ci-dessous ?

Grèce, déficit public 2009, 12,7% du PIB

Espagne, déficit public 2009, 11,2% du PIB

Portugal, déficit public 2009, 8% du PIB

France, déficit public 2009, 7,9% du PIB ….

………. Belgique, déficit public 2009, 5,9% du PIB; Italie, déficit public 2009, 5,3% du PIB et Allemagne, déficit public 2009, 3,4% du PIB.

Source : Commission européenne

http://www.touteleurope.fr/fr/actions/economie/euro/presentation/comparatif-le-deficit-public-dans-la-zone-euro.html

Plus grave, des révélations récentes font état des chiffres truqués publiés par le gouvernement grec sur la situation de ses finances publiques. En effet,  et je me prononce avec réserve, il semblerait que les chiffres officiels avancés jusqu’à présent par le gouvernement grec étaient tous faux. L’exemple le plus patent est le déficit public qu’il avait annoncé être à 6% du PIB pour 2009, alors qu’en réalité il se trouvait à 12,7%. Un ancien dirigeant de la banque centrale grecque, Mr Panayotis Thomopoulos pour ne pas le citer, déclarait même récemment et je le cite : « Ici, la fraude est un sport national » bon, au moins un qui est honnête !

C’est à se demander à quoi servent les institutions statistiques européennes en l’occurrence Eurostat, la Banque centrale européenne et la direction générale des affaires économiques et financières de la commission européenne ?

Mais par-dessous tout, ce qui a surtout retenu mon attention dans cette affaire euro-européenne,  c’est la prétendue solidarité bilatérale et / ou institutionnelle  (française et allemande) promise lors du sommet qui s’est tenu très récemment le 11 février 2010 à Bruxelles et dont l’objectif était de sauver la Grèce. Franchement, la France ? Parle t- on du pays dont le déficit public devrait s’envoler à 8,3% du PIB en 2010 ? Non seulement donc bien au delà des 3% requis, mais pire que 2009 !

Franchement, ne faut-il pas plutôt pour l’euro-zone penser à une dévaluation de leur monnaie? Vous me répondriez sans doute qu’il ne s’agit pas du Peso de l’Amérique latine ou du franc CFA de l’Afrique francophone dont les déficits publics atteignent les 30, 40, voire souvent 50% du PIB. Je vous le concède !

Bien que comparaison ne soit pas raison, et toute proportion gardée, admettons quand même que les situations sont similaires : déficit budgétaire, endettement public, taux de chômage élevé, balance commerciale déficitaire, mauvaise gestion des finances publiques, avec comme cerise sur le gâteau,  fricotage des données publiques !!!

Sérieux, si c’avait été le Mexique, l’Argentine ou le Burkina-Faso qui présentait de tels manquements, Monseigneur  FMI (dont les décideurs ne sont autres que princesse zone-euro et Prince USA) préconiserait déjà une dévaluation « compétitive » et des programmes d’ajustement structurel afin de rétablir les finances publiques.

Alors Sa Séniorité FMI, qu’en est-il du cas grec ? Ou mieux encore du cas zone-euro ?

J’entends parler qui de souveraineté européenne, qui d’interventionnisme américain si le FMI venait à s’y impliquer… alors on préfère ne pas faire appel à ses services.

Oh chère Europe, « ce qui arrive aux autres commence déjà à nous arriver » !

February 23, 2010 Posted by | Articles In French, Economics, International Economics, International Finance | , , , , , , , , | 6 Comments

GOLD STANDARD: YES OR NO?

Well, before answering this question, let me start by confessing something. This question has been on my mind for a while now; and to be honest, for me, there has never been a second of doubt with regards to the answer to this. Thus, there was no need for a debate or an article about the question. But, considering the number of papers and commentaries from economists, businesses, politicians and civil society organisations, calling for or rejecting the idea of a return to a Gold Standard system, I felt the need to write something.

Should we start with some fundamentals? Okay.

The Gold Standard is a monetary system in which the standard economic unit of account is a fixed weight of gold. Under this system, paper notes are convertible into pre-set fixed quantities of gold; any issuance/creation of money is counterbalanced and guaranteed by gold reserves. Parity between two different currencies is therefore set through gold and the exchange rates are stable if not fixed between them.

This definition leads immediately to some questions:

First of all, who would decide on the weight of gold that would be allocated to currencies? Would the weight depend upon the current monetary strength of each country’s economy? What would determine the monetary strength or simply the strength of an economy? Would it be its ability to repay debts, its growth rate or the trust placed in its currency by international investors? Would the current quantity of a currency including treasury bonds (issued to pay debts) count towards determining the strength of an economy? Would all currencies be convertible into gold? If no, which currencies would be convertible and based on what criteria? If under the Gold Exchange Standard started in1922, only the U.S. Dollar and the British Pound were convertible into gold and other currencies were pegged to them, could this be the case today with new currencies such as the Euro and emerging economies such as China?

If there are so many questions raised with a potential Gold Standard system, why are some “famous” people calling for its return?

I must acknowledge that there are some advantages with such a system taking place. For instance, the Gold Standard would limit the power of governments in issuing fiat currency through central banks without counterpart in the real economy (quantitative easing, anyone?). The ultimate effect of financing debt through bond issues is to destabilise other economies who buy debt without gold collateral.

The Gold Standard also tends to reduce uncertainty in international trade by providing a fixed pattern of international exchange rates. Indeed, under a Gold Standard, disturbances in price levels in one country would be partly or wholly offset by an automatic balance-of-payment adjustment mechanism called the “price specie flow mechanism.”

Let’s take the example of a country with a negative balance of trade. Gold would flow out of that country in the amount that the value of imports exceeds the value of exports. This would mean reduction in the money supply in that country since the creation of money would be indexed to the quantity of gold held by the central bank. This fall in money supply would in turn, generate the drop in prices of products in that country. The lower prices would cause exports to increase and imports to decrease, which will improve the balance of trade. Inversely in countries with positive balance of trade.

Having said that, the idea of going back to the Gold Standard does sound really rustic to me owing to the high speed and complexity of today’s monetary and financial transactions around the world. Under such a system based on pre-determined, fixed exchange rates between currencies, there would be a need to review these fixed parities between gold and currencies every time that there would be a significant fluctuation on commodity, stock, financial or monetary markets. Furthermore, if a country decided unilaterally to devalue its currency, it would produce sharper changes on a global scale than the smooth declines seen in fiat currencies since the exchange rates are fixed. How? As its currency would become cheaper to obtain with less gold, economic agents would rather acquire it and later exchange it at the same exchange rate for a more powerful currency.

Also, in such a system where coins, paper notes, electronic funds and any other form of money are automatically convertible into pre-set fixed quantities of gold, what would happen if a country like China calls in all their debts including treasury bonds owed by western countries to be repaid immediately in gold?  With the vast quantity of dollars worldwide laying claims to the U.S. Treasury, an overnight transition to gold convertibility would certainly create a major discontinuity for the U.S. financial system.

People might respond that there is no need for the whole block of current dollar obligations to become an immediate claim. Well, no comment!!!

What about the bilateral debt owed by developing countries to developed nations? Would this be claimed in gold?

Finally, the idea of a Gold Standard could be suicidal for emerging economies. You would probably ask why?

Let’s have a look.

Indisputably, emerging or developing economies need to spend in order to finance their growth and their development. Most economists would also agree that when a country creates a budget deficit designed for public investment (infrastructure, education, basic research or public health), such a deficit is bearable, beneficial and even necessary in the case of emerging economies. Therefore, restricting these economies to spend in proportion to the quantity of gold produced would be anything but understandable. Indeed, budget deficit can help emerging nations to stimulate their economies by creating a market for business output, creating income and encouraging increases in consumer spending, which creates further increases in the demand for business output. As a consequence, the real GDP of the country raises and the unemployment rate decreases, leading to more tax income for the government.

The restrictions of gold convertibility could therefore profoundly jeopardise the development of some emerging economies.

I can hear some Gold Standard advocate voices responding that, they are not referring to the previous or old “Gold Standard”. Instead, they are referring to a new “fractional reserve system”, under which the gold reserve will indirectly affect the amount of currency circulated in countries and around the world.
Well, during economic crises like the current one, the “fractional reserve system” could meet the currency supply in countries such as U.S.A and E.U., and would not hinder the development of their economy. However, for emerging economies, the lack of gold reserve would not meet the monetary supply of rapid economic development.
But above all, being under a more traditional Gold Standard or a so called new modern one, developing countries, particularly those without enough gold, would have to purchase gold with their foreign exchange reserves. In that way, U.S. and Euro-zone could decide to withdraw dollars and Euros in order to protect their leading positions in international financial system.

To conclude this paper, and for those who have not yet noticed it, to the question on “Gold Standard: yes or no?” my answer is without doubt no. However, I must admit that the current global financial system, which predominately relies on the U.S. Dollar as a reserve currency by which major transactions such as the price of gold itself are measured, must change. Especially as U.S.A do not issue their currency with proper real economic counterpart.

But instead of going back to a strict Gold Standard system, the idea of having a more diversified reserve currency system based on market baskets of currencies or commodities including gold would be more sensible.

Related Article:

Towards a new global reserve currency…the end of the U.S. dollar?

January 2, 2010 Posted by | Articles In English, Economics, International Economics | , , , , , , , | 10 Comments

OUI OU NON A L’ETALON-OR?

Veuillez vous référer à la version anglaise pour le moment.

https://lambertmbela.wordpress.com/2010/01/02/gold-standard-yes-or-no/

 

January 2, 2010 Posted by | Articles In French, Economics, International Economics | , , , , , | Leave a comment

Is The Free Market Era Over?

Stock market

Are we moving back to the Keynesian economic approach with all these bailouts around the world, or should we define a new paradigm for economics after the world financial crisis has demonstrated the limits of the free market with its invisible hand?

The failure of economists, businesses and politics to predict and manage the recent catastrophic crash of the world’s financial system has triggered a re-evaluation of the whole basis of current economic theories.

Since the end of the 20th century, economics has been dominated by the classical paradigm based on notions of rational consumers making rational choices in a simple supply/demand world of finite resources, with prices constrained by decreasing returns; all driving the economy to an optimal equilibrium point.

So far, this classical economic approach, initially conceived by Adam Smith, has been working well. Indeed, in normal circumstances people are generally rational. The market automatically allocates resources and controls excesses in an optimum way with minimum oversight or outside regulation required. Under this model, the economy has been working as an equilibrium system; a system that moves from one equilibrium point to another, driven by shocks from external disruptions – technological, political, cultural etc- but always coming to rest in a natural equilibrium state.

But in extreme or complex circumstances, people and the system tend to behave/react differently including consumers, banks, financial institutions, stock market traders and governments. And perhaps the most critically flawed assumption of this classical model has been that economic agents are generally rational. Whereas, we observed recently insolvent households taking mortgages that they could not afford, banks lending to insolvent households without conditions etc. leading us to the subprime crisis …we know the result.

From this flawed assumption, the following question is raised: is it the theory that should be questioned or is it one of its hypotheses (namely the rationality)? Some would argue that questioning the hypothesis is questioning the theory. Anyway…

To tackle this current crisis, Some voices have been suggesting more regulations as this would frame the rationality of economic agents and force them to behave in a more sensible way; some others have been calling for more government intervention in order to set rules and monitor  the whole system (with a big bailout here and there when necessary).

Wait a minute, if I am not mistaken, this would mean going back to the Keynesian approach of economics?

Indeed, according to Keynes, Excesses or deficiencies in aggregate demand are the rule and not the exception. Therefore, for Keynes, government intervention is needed to eliminate recessionary and inflationary gaps: laissez faire, laissez passer policies should be replaced with an active interventionist policy by the central government.  Keynesians believe that monetary and especially fiscal policies are required; otherwise disasters like the Great Depression that followed the First World War or the crisis that we are facing now would certainly reoccur.

There we are! Was Keynes right? Or should I say, is Keynes right?

Not so sure. If the Keynesian prescription for active government involvement in the economy was warranted after the World War I, in the past few decades, government intervention has become less desirable…and some argue, less necessary. Indeed, since the World War II, we have experienced six decades of growing competition. The once oligopolistic market structures in autos, telecommunications, services, etc. have become very competitive, and government policies increasingly have impact across borders. Furthermore, nowadays, banks, financial institutions, manufacturers, energy suppliers are increasingly internationally managed; following Keynesian policies with their fundamentally collectivist, centralized approach would just lead to more trouble. For instance, if a multinational that has networks over the world is centrally managed in the way Keynes suggests, the collapse of one element of the network in one country would easily make the whole system topple like dominoes around the world as we have just experienced.

In short, if the Keynesian approach was likely to work after the First World War, the crash that we are facing now is far more serious than the Great Depression of 1929 as it can not be contained within borders or so easily solved by mass bailout, mass lending or big government investments/ job creation programs.

The need of an evolutionary or new economic model…

Instead of going back to the Lord Keynes School of thought, maybe we should rather think of a new model that would fit with the globalisation of markets, and that would -to some extent- set some global regulations to frame agent behaviours around the world, but ultimately leave the market free.

This new paradigm should be based on the principle that economies, markets, regulations, globalisation, as well as the internet (a new and very important component), consumers, enterprises and the brain all form complex adaptive systems in which agents dynamically and rationally interact, process information and adapt their behaviour to a constantly changing environment- but always reach a final equilibrium.

In this new model, and unlike the strict distinction between the too much and the too little government approach, the market should rather be a combination of an “invisible hand” and necessary regulatory elements (government that would not impede competition and risk) with the mindset that the market is henceforth a small village that needs to adapt to the constantly changing global environment.

To conclude this paper, I strongly believe that free market still has a future, and markets are still perfectly self-regulating systems. They are only becoming enormously complex adaptive networks – too complex and interdependent for economists and governments to control or even understand.

Ultimately, every individual/company is continually exerting himself to find out the most advantageous employment for whatever capital he / it can command. Therefore, by pursuing our own interest we benefit society more than when we directly attempt to benefit society. According to Adam Smith, we are all led by an “invisible hand” to benefit society even as our intent is to benefit ourselves.

Invisible Hand Theory proposed by Adam Smith in the 18th century, really helps to explain how the market economy works even with its chaotic nature.

Personally, I view the Invisible Hand theory as the economic counterpart of democratic theory. Just as, in a democracy, people are supposed to choose the best leaders for themselves, the Invisible Hand theory presumes that people chose to produce and consume in the most efficient manner when given a free hand.

So in practice, markets may still end up being little bit chaotic due to the irrationality of agents or inadequate information shared within the system, but that is not because the Invisible Hand theory or the free market model is inaccurate.

October 3, 2009 Posted by | Articles In English, Economics, International Economics, International Finance | , , , , , | 3 Comments

Towards An Economic Recovery?

Do the big profits of Barclays and HSBC (almost £3bn each) revealed today, prefigure the end of, if not the economic crisis, at least the financial crisis?

August 3, 2009 Posted by | Articles In English, Economics, International Economics, International Finance | Leave a comment

Vers La Fin De La Crise Economique?

Les énormes profits (près de 3 milliards de livres chacune) annoncés aujourd’hui par Barclays et HSBC, préfigurent-ils sinon la fin de la crise économique, du moins celle de la crise financière?

August 3, 2009 Posted by | Articles In French, Economics, International Economics, International Finance | Leave a comment

Are we moving back to the Keynesian economic approach? The need of a new Model?

keynes

Are we moving back to the Keynesian economic approach with all these bailouts around the world, or should we define a new paradigm for economics after the world financial crisis has demonstrated the limits of the free market with its invisible hand?

The failure of economists, businesses and politics to predict and manage the recent catastrophic crash of the world’s financial system has triggered a re-evaluation of the whole basis of current economic theories.

Since the end of the 20th century, economics has been dominated by the classical paradigm based on notions of rational consumers making rational choices in a simple supply/demand world of finite resources, with prices constrained by decreasing returns; all driving the economy to an optimal equilibrium point.

So far, this classical economic approach, initially conceived by Adam Smith, has been working well. Indeed, in normal circumstances people are generally rational. The market automatically allocates resources and controls excesses in an optimum way with minimum oversight or outside regulation required. Under this model, the economy has been working as an equilibrium system; a system that moves from one equilibrium point to another, driven by shocks from external disruptions – technological, political, cultural etc- but always coming to rest in a natural equilibrium state.

But in extreme or complex circumstances, people and the system tend to behave/react differently including consumers, banks, financial institutions, stock market traders and governments. And perhaps the most critically flawed assumption of this classical model has been that economic agents are generally rational. Whereas, we observed recently insolvent households taking mortgages that they could not afford, banks lending to insolvent households without conditions etc. leading us to the subprime crisis …we know the result.

From this flawed assumption, the following question is raised: is it the theory that should be questioned or is it one of its hypotheses (namely the rationality)? Some would argue that questioning the hypothesis is questioning the theory. Anyway…

To tackle this current crisis, Some voices have been suggesting more regulations as this would frame the rationality of economic agents and force them to behave in a more sensible way; some others have been calling for more government intervention in order to set rules and monitor  the whole system (with a big bailout here and there when necessary).

Wait a minute, if I am not mistaken, this would mean going back to the Keynesian approach of economics?

Indeed, according to Keynes, Excesses or deficiencies in aggregate demand are the rule and not the exception. Therefore, for Keynes, government intervention is needed to eliminate recessionary and inflationary gaps: laissez faire, laissez passer policies should be replaced with an active interventionist policy by the central government.  Keynesians believe that monetary and especially fiscal policies are required; otherwise disasters like the Great Depression that followed the First World War or the crisis that we are facing now would certainly reoccur.

There we are! Was Keynes right? Or should I say, is Keynes right?

Not so sure. If the Keynesian prescription for active government involvement in the economy was warranted after the World War I, in the past few decades,  government intervention has become less desirable…and some argue, less necessary. Indeed, since the World War II, we have experienced six decades of growing competition. The once oligopolistic market structures in autos, telecommunications, services, etc. have become very competitive, and government policies increasingly have impact across borders. Furthermore, nowadays, banks, financial institutions, manufacturers, energy suppliers are increasingly internationally managed; following Keynesian policies with their fundamentally collectivist, centralized approach would just lead to more trouble. For instance, if a multinational that has networks over the world is centrally managed in the way Keynes suggests, the collapse of one element of the network in one country would easily make the whole system topple like dominoes around the world as we have just experienced.

In short, if the Keynesian approach was likely to work after the First World War, the crash that we are facing now is far more serious than the Great Depression of 1929 as it can not be contained within borders or so easily solved by mass bailout, mass lending or big government investments/ job creation programs.

The need of an evolutionary or new economic model…

Instead of going back to the Lord Keynes School of thought, maybe we should rather think of a new model that would fit with the globalisation of markets, and that would -to some extent- set some global regulations to frame agent behaviours around the world, but ultimately leave the market free.

This new paradigm should be based on the principle that economies, markets, regulations, globalisation, as well as the internet (a new and very important component), consumers, enterprises and the brain all form complex adaptive systems in which agents dynamically and rationally interact, process information and adapt their behaviour to a constantly changing environment- but always reach a final equilibrium.

In this new model, and unlike the strict distinction between the too much and the too little government approach, the market should rather be a combination of an “invisible hand” and necessary regulatory elements (government that would not impede competition and risk) with the mindset that the market is henceforth a small village that needs to adapt to the constantly changing global environment.

To conclude this paper, I strongly believe that capitalism still has a future, and markets are still perfectly self-regulating systems. They are only becoming enormously complex adaptive networks – too complex and interdependent for economists and governments to control or even understand.

Ultimately, every individual/company is continually exerting himself to find out the most advantageous employment for whatever capital he / it can command. Therefore, by pursuing our own interest we benefit society more than when we directly attempt to benefit society. According to Adam Smith, we are all led by an “invisible hand” to benefit society even as our intent is to benefit ourselves.

Invisible Hand Theory proposed by Adam Smith in the 18th century, really helps to explain how the market economy works even with its chaotic nature.

Personally, I view the Invisible Hand theory as the economic counterpart of democratic theory. Just as, in a democracy, people are supposed to choose the best leaders for themselves, the Invisible Hand theory presumes that people chose to produce and consume in the most efficient manner when given a free hand.

So in practice, markets may still end up being little bit chaotic due to the irrationality of agents or inadequate information shared within the system, but that is not because the Invisible Hand theory or the free market model is inaccurate.


May 3, 2009 Posted by | Articles In English, Economics | , , , , , | 1 Comment