International Finance - A systemic weakness?

In my last post, I mentioned that wealth concentration exposed the financial systems to risks. The risk is compounded by inherent weakness of the financial system that  were not designed to accommodate. These systems are weak and plagued by complicated issues.

• Firstly, these were created as a subset of national governance systems. Consequently the flexibility of these systems are limited by the overall governance infrastructure in each nation.
• Also, unlike the capital movements, these standalone national regulatory systems are not inter-connected in any meaningful manner. Meaning any response to international financial crises will be subject to foreign-policy-like ambiguities and negotiations and, therefore, delays.
• The regulations are patchy - unable to control global momentum.

Popular, informed expert opinion is also weighing in on this shortcoming.
You can read Michael J. Panzner

in the modern global financial system, where many participants are either unregulated or are monitored by a patchwork of country or sector-specific regulatory overseers, chances are that a derivatives-related catastrophe will see a similar lack of coordination that will produce a far more devastating outcome than if it was a purely domestic affair.

It is one thing for a central banker to summon the heads of various financial firms into a room to sort out the mess at hedge fund LTCM, as the New York Federal Reserve chief reportedly did in 1998. Despite the fact that the Fed had limited statutory authority in the matter, it is not hard to see why none of those who were asked to attend turned down the "invitation."

However, if a derivatives time-bomb is set off by the failure of a large London-based hedge fund, will a banker in the Cayman Islands, an investor in Japan, an insurer in Germany, and a regulator in France feel similarly inclined to respond, or even to take the lead? That is assuming, of course, that those affected even understand what is going on or why it may be relevant to their own interests. Overall, there appears to be little, if any strategy in place for dealing with cross-border financial upheaval.

And Marshall Jevons linking to Davos

At the World Economic Forum in Davos, Mr Knight said the “major challenge” for regulators was the “the Balkanisation of regulation – fragmented across market segments, across national jurisdictions and yet we want to have a global financial system”.

And Dani Rodrick

How do you deal with capital flows when they are so prone to boom-and-bust cycles and generate (roughly once a decade) financial crashes with painful economic consequences?  The mainstream answer is that you do not regulate capital flows directly--through capital controls such as financial transactions taxes or deposit requirements--but you rely instead on prudential regulation of financial intermediaries. The best way to avoid crashes, this argument goes, is not to "throw sand in the wheels of international finance" (as Tobin famously put it), but to make sure that intermediaries do not take excessive risks.

In Sum...
A system so designed will be prone to momentum effects. The momentum is aggravated by wealth concentration. International finance needs to evolve beyond the free capital movement to counter this risk. A system of seamless regulatory response needs to be developed. Hopefully the thinkers at Davos will lay the first stone of a potent globalized interlinked system.

Market behaviour - Is Wealth Concentration a risk?

The world markets have taken a beating for a few trading sessions. We are all confounded by the speed, breadth and uniformity in the correction. As usual, yours truly already expressed it long ago (!) with loads of hypotheses and un-correlated facts. So lets start looking at one out of those - my favourite - Wealth Concentration!

Wealth concentration has increased
The past two decades has created lot of substantially wealthy and globally connected individuals/families. Their numbers were always increasing, but they may have crossed a certain potency threshold in terms of numbers and size of wealth available with each.

And they are connected - creating a super machine!

Thanks to information age, these individuals are now better connected globally. This new found strength enables investors to create companies, investment vehicles, repatriate profits and in general take more risks, faster. This is, in part, the source of complex corporate structure and ever-more complicated investment products.

Financial System, Infrastructure is old

Financial sector infrastructure, designed along national lines in a non-globalized era, is not able to grasp the increasing complexities of the newly globalized investment playground. The regulators still have to develop a "court sense". The current systems cannot control the high velocity international money movements generated by these investors.

The investors themselves don't know the risks

While these investors are (Wall) street smart, they are not the smartest! They are faced with unfathomable complexity - posed by globalization of products, services, capital and concurrent nationalisation of labour, consumption, markets (since driven by national regulators with nation-based systems).

We have just realised US housing markets, Australian banks, Chinese regulators and European central bankers are lot closer than we could have anticipated.

In Sum..

Globalisation has brought forth new set of complexities that are still difficult to gauge. Further wealth concentration have created high mass (volume) - high velocity monetary movements accentuated by innovative structures that can compromise the current financial systems. High velocity, high volume money flow can create "Shock-and-Awe" impact on many asset markets. Consequently, risk has increased many-fold.

The layout of poverty

I mentioned in a previous post why certain people stay poor. In the meanwhile, there have been lots of articles on poverty I have highlighted those below as well. Yet, I don't think enough work has been done to classify and understand different types of poverty. I believe the efforts in classification will help devise better solutions to the problem. I do not claim to be an authority on the subject but I am trying my best to think through the issue.

A different poverty - volatility induced poverty
I have highlighted two broad levels of classification i.e. transient and structural. Under structural poverty, we have a type off poverty that arises out of high net-income volatility combined with adequate average income. This kind of poverty is induced by volatility -in gross incomes and in expenses - both on unpredictable time scale (un-seasonal). Day-laborers, artisans etc suffer this kind of poverty more often. Farmers dependant of rain-water also suffer this kind of poverty. Dean Karlan and Sendhil Mullainathan have explored this here.

The unpredictability of expenses leads to in-debtedness. The flow of credit to this sector comes at high costs hence in-debtedness tends to be self-reinforcing - particularly with higher expense volatility. Hence cash-flows are directed towards life-sustenance rather than investments. In other words - expenses for healing, medicine, food, essential tools etc tend to be favored against education, savings etc. Such people find themselves caught in a structural poverty. I suspect healthcare is the most critical expense of the rest. It reduces income and increases expense at the same time! Also healthcare costs tend to be higher as nutrition is not proper. For them snakes-and-ladder game of scaling the income pyramid seems hopelessly crawling with snakes of healthcare costs denying them the ladders of savings and education.

Framework for solution
A first principles approach suggests that anything that reduces volatility (both income or expense) will be of great benefit. We can also easily conclude that smoothening incomes comes first, before smoothening expense is important. Next, it is absolutely essential to reduce expenses - particularly healthcare, food (proper nutrition) and education (for future). Yet most solutions to their problems tend to addressing volume not volatility. These solutions are likely to fail unless they add an element that suppresses volatility.

Income diversification
The growth in rural incomes in India has come from income stream diversification. Farmers have used tractors, pick-ups for transportation thereby leading to stable earnings and alongwith highly volatile agri-income. This resultant reduction in income volatility has set them on path of prosperity.


Expense smoothening Credit?
Simply throwing credit at this kind of poverty problem is not a solution. Credit repayments impose a smooth addition on their volatile expenses making their situation worse. (Hence farmer suicides in India). Indian rural banking is abound with stories of farmers wanting to pay two months installments together when they have money - and not being able to pay even one months installment in distress times. If their loan repayment schedule were to match the income generation schedule they will have much less to worry about.


In sum
Poverty reducing initiatives need to appreciate the differences in poverty. Volatility induced poverty can be tackled by addressing income volatility first, then expense volatility and then quantum of income and expenses. Expenses on healthcare, food and education are critical and need to be reduced.

Must read links:
Innovation for Poverty Action
MIT poverty action lab -
Is microfinance too rigid?
Marshall Jevons highlights course on poverty and some other links
Poverty in pictures -
Does poverty kill PSD blog links to some important conclusions