When Models Crumble, the Need to Rethink Them

The current financial and economic crisis has brought enormous strain in the industrialized world, in Europe in particular. The healing will take quite a while, for much is damaged economically. And adjustments and repairs, at macro and micro levels, are time consuming. The current crisis has also questioned cognitive and operational models that organizations, big and small, private and public, have used in the pursuit of their goals. The rethinking of models/paradigms is either deliberate, or it will be forced upon organizations by forces and pressures from outside; it will take place at micro, macro and international level, be it in a forceful, or a protracted and circumvoluted manner.

Much of the rethinking of models is induced by the role played by finance in the current crisis. For instance, Cyprus has captured much attention lately in view of the attempts to work our a bailout plan for it. Whatever comes out in the end, Cyprus, like Ireland, Iceland and UK, epitomize a fragile model for economies. This model has favored the expansion of finance, of the banking sector, at the expense of other sectors (manufacturing), which has resulted in an over-dependency on the financial sector. Once the crisis hit, the fragility of this model has come vividly into the open. A downsizing of the financial sector makes sense, though it will not be easy at all to achieve it. Not least, because there are vested interests which would oppose it. The Cyprus crisis should also fuel the discussion on whether tax havens (and off-shore banking) should be accepted in the eurozone (in the EU), apart from money laundering and tax evasion considerations.

Another model under question is linked with an insufficient attention paid to tradables in the overall functioning of economies. This model relies on the tenet that markets know best and their failures are negligible. The boom and bust dynamics in the eurozone and in some New Member States indicate that public policy has a role to play in mitigating destabilizing capital flows and in enhancing better resource allocation. If that is possible under the rules of the Single Market is something to be seen because the free flow of capital is a key rule in the European Union and EU level policies are quite weak in this respect (structural and cohesion funds are useful, but not a sufficiently powerful instrument). Some say that the downhill capital flows model has been validated in the EU in terms of economic convergence. This is the gist of a recent World Bank study (Regaining the luster of the European Model). And it is correct to notice that Spain, Ireland, Portugal have achieved substantial catching up after they joined the EU. Some catching up has happened with NMSs too. But this conclusion has, nevertheless, to be nuanced considerably. For threatening divergence in economic performance has taken place in the eurozone after the introduction of the euro. And boom and bust dynamics did happen in several NMSs, which has caused a major setback in their convergence trajectory. This remark is not meant to favor the uphill flow model, which has been practiced by Asian economies after their 1997-1998 crisis. Instead, it is an invitation to see things in the wider picture of pluses and minuses of international finance, of the organizational and policy rules in the eurozone, and of the need to improve governance structures in the EU as a whole.

The questioning of the models mentioned above are to be judged together with the need to overhaul the regulation and supervision of financial markets. The light touch regulation has brought havoc in the financial industry and in economy/society at large. Business models have proved inadequate on a massive scale, with their overemphasis on trading and speculation, the use of fancy (toxic) derivatives, the neglect of risks and of complexity as a trait of nowadays systems. Likewise, regulators and supervisors succumbed to the reasoning that a low inflation rate is equivalent to financial stability and that the spread of derivatives is a means to diminish risks throughout the economy body. As a matter of fact, we ended up with rising inter-connectedness that, in conjunction with the consequences of light touch regulation, has crippled the robustness and resilience of both large and small organizations. Moreover, systemic risks have skyrocketed and have compelled central banks and governments to come to the rescue of banks as a means to avert a financial meltdown.

The very model of regulation and supervision of financial markets is questioned. There is a process under way now to overhaul the regulation and supervision of financial markets, of financial organizations. Facts show that an integrated model (like in the UK) was not superior to sectoral, or “twin peaks” models (that distinguish between macro-prudential oversight and supervision of business conduct) in preventing the financial debacle. Sure, contagion was favored by the break up of Chinese walls between investment and retail operations and by increasing cross border transactions. But, what has brought all these organizational patterns into disrepute, more or less, in the end, was a blatant misunderstanding of risks --as the latter were entailed by expanding financial markets. The problem, therefore, is to deal with the very object of regulation and supervision, and not think that nothing can be done about it.

The business models of financial organizations is also questioned. A while ago, many extolled large, integrated entities, with the capacity to provide a full range of services and engage in all kind of operations. The mood has changed. Not only that “too big to fail” (and “too big to save”) is a formidable challenge to governments and central banks, but complexity and size itself are a challenge to management. Complexity and size are not a given, and they can be tackled in order to enhance the robustness of organizations, of economies. More simple and smaller organizations (by using anti-trust legislation and splitting large organization, by ring fencing retail from trading operations) would be a step in the right direction, arguably. More own capital and less reliance on debt (as against the Modiglian-Miller theorem that where capital comes from does not matter), lower leverage, rules that prohibit the use of depositors’ money for the own trading of banks (The Volcker’s rules) would also contribute to making systems more robust. The demarche to align incentives and to limit pay, to link it with performance and the interests of shareholders is part of these reforms.

Banks’ and other financial entities’ risk modeling needs to be made more trustworthy and transparent. The current VAR (value at risk) enables banks to fudge numbers and assume too high risks. The way large banks have been fiddling with their risk positions and evaluations, with reporting to regulators, even years after the eruption of the crisis, is quite telling (JP Morgan’s treatment of its big trading loss in London comes into one’s mind). This would suggest that Basel III, too, is overtaken by events and the very logic of VAR is weak. At the same time, it shows that misreporting to regulators, shareholders and investors is a serious challenge. This challenge goes beyond banking, for there are hedge funds, brokerage houses, etc that were in breach of trust, that provided incorrect information to and used their clients’ resources unlawfully. Compliance rules and supervision need to be much strengthened in the financial industry.

A McKinsey recent study notes a substantial reduction in cross border financial flows during the crisis years. Some decry it as a sign of reversal of globalization, with a malevolent foreboding. But it would be, arguably, better to see it as a healthy phenomenon to the extent we acknowledge that: a dangerous overexpansion of financial flows took place in many regions; that there are limits to openness (which is not the same as limiting an open society, in Karl Popper’s terms) and there may be an optimal degree of openness and of reliance on external supplies of goods and services (as a means to control vulnerabilities); that rediscovering home and closer to home markets is a way to regain robustness in view of the risks entailed by proliferating tail events and chain links disruptions, etc.

Cognitive models are also reexamined. The current crisis is, quite likely, the big watershed, wake up call, which tells that quantitative models which underestimate tail events and rely on linearity are flawed. It appears that the golden boys, the “quants”, in building increasingly high octane models, had brought about unintended bad effects. They made their bosses turn a blind eye to the need to never put qualitative analysis, nose-metrics on the shelf. But this was clear since the LTCM (a hedge fund) episode, when the models concocted by two Nobel prize laureates were made irrelevant by unexpected events. One can argue that what hedge and private equity funds use in their modeling is their exclusive business; that banks and insurance companies are in a different league, which would/should make them objects of public scrutiny and regulation when it comes to risk modeling. But hedge funds and other asset management funds, the shadow banking sector in general, do create systemic risks through their operations, that can be huge and can destabilize markets. And therefore they, too, should be regulated and supervised. When it comes to economy as a whole, to systemic risks, financial stability comes prominently to the fore. Monetary policy is bound to pursue price stability, but this goal cannot be divorced from the stability of financial institutions. And even if overall financial stability would be under the oversight of a special body, central banks’ modeling would have to internalize it.

Models which explain relations among countries are under scrutiny too. The eurozone crisis provides plenty of evidence that its design and policy arrangements were inadequate, that a one size fits all monetary policy should have been accompanied by a fiscal union from the start. That this policy combination would have precluded some current member states from membership is a different matter for debate. The fact is that the eurozone is more a single currency area than a monetary union. The way it operates is more rigid than the gold standard regime of the interwar period, in spite of the existence of automatic stabilizers. And when we know where that international policy regime has led into we should be quite worried. It is fair to remind that not a few economists warned, before its inception, that its sub-optimality as a currency area was a major weakness of the eurozone. But more to blame are its design and policies. The banking union may be an exit out of the current troubles to the extent fiscal arrangements are mended and a fiscal capacity (as Herman van Rompuy put it) will come into being.

Against the backdrop of the financial crisis and of the welfare state crisis the eurozone turmoil has widespread social and political reverberations. The rejection of traditional policies, rise of extremism, erosion of the social contract, all are begging an overhaul of public policies, a redesign of the relations between the public and the private sector, the fostering of more individual self-reliance simultaneously with preserving social solidarity. Democracy can be undermined, as a model of society, by the disconnect between politics and citizens and the distortions caused by over-financialization and a simplistic economic paradigm.

The rules of the international regime are also under review When the IMF, which, years ago, was a staunch promoter of unimpeded capital flows, makes a turnaround and says that capital controls may be useful, one needs to take a pause. Students of finance and international relations know that to achieve simultaneity of exchange rate stability, free capital flows, and monetary policy independence is quite impossible (the so called “impossible trinity”). The experience of the eurozone shows that the relinquishing of monetary policy by member states is not sufficient and that it needs to be accompanied by fiscal integration. In world finance, it may be the case to revisit the Bretton Woods arrangements for the sake of preserving a relatively open trading system. And this can happen if financial markets are tamed.