Goodbye Financial Engineers, Hello Political Wonks

This week marks the fifth anniversary of the global financial crisis. Five years ago, the world of finance was shocked when BNP Paribas announced a freeze of three of its money market funds that were undergoing a deadly run of withdrawals. At that moment, a huge pyramid of complex financial assets—then sustained as collateral accepted by banks and the “shadow banking system”—hedge funds and money market funds—started to crumble.

What a party had ended for finance! An era in which asset values typically moved upwards, and one in which the realm of finance was taken as an accurate reflection of the underlying real side of the economy, was over. Not by chance “reading the financial tea leaves” had become a fashionable expression.

Fast-forward five years and one now sees the hands of governments and central banks all over the place in finance, sustaining markets with their maneuvers upon quantities and prices of assets available. Central banks’ balance sheets in the countries at the core of the crisis have expanded dramatically because of purchases of domestic assets to ease monetary conditions and avoid asset fire sales. Yield curves have flattened through several types of intervention in order to maintain long term yields close to their current historic low levels. Support to banks via bail-outs or broad liquidity facilities have avoided the collapse that funding costs imposed by private creditors would lead to. Regulatory requirements of liquidity have been tweaked, and in practice, have created a captive demand for government bonds, pushing down their yields. Currency markets have been subject to systematic interventions by heretofore hands-off governments, no longer comfortable with free floating under current conditions.

This is not the first time in history that public money extends itself in order to occupy the vacuum left by the destruction of the “private money” created during a previous phase of euphoria. And things would have been worse in the absence of such a provision, as investors rushing to swap private money for public funds would have otherwise provoked a liquidation of private assets, markets and institutions even more dramatic than the one that took place. The real sector would of course have been dragged deeper down—as happened during the Great Depression of the 1930s.

An open “politicization” of finance came out as a consequence of governments and central banks stepping in, in the sense that the dynamics of financial asset prices is now determined directly in the political sphere. Think of the Eurozone. Policy makers in those member countries under financial stress, currently implementing national programs of fiscal austerity and structural reforms, hold the view that the chances of success would rise if they had the support of supplementary creation of public money by the European Central Bank (ECB). On the other hand, the ECB’s actions are constrained by the political view predominant in other Eurozone countries according to which such a support would undermine the political willingness to reform. Financial markets now move on a daily basis between the poles of collapse and stability in accordance with signals of where the balance of those political views tilts.

Think of the US. The fiscal retrenchment—the so-called “fiscal cliff” —poised to be reached next year has not been created by private investors requiring sky-rocketing yields, but rather as an outcome of the battle between political views in Congress. As monetary easing by the Federal Reserve can be effective only to some extent without a concurrent fiscal stimulus, a precocious fiscal adjustment may well harm the prospects of economic and financial recovery.

During the apogee of the belief on the prescience of financial markets, armies of engineers, physicists and mathematicians were hired by financial institutions to develop quantitative models to decipher what the “financial tea leaves” were saying at each moment in time. One may wonder whether now the search is being taken over by political wonks.

6 Responses to "Goodbye Financial Engineers, Hello Political Wonks"

  1. barf   August 9, 2012 at 7:36 pm

    the cornerstone of this "financialization" was the media not "financial engineers." to extend this amount of liquidity without a "plan" is simply not plausible. the fact of the matter is after 9/11 the deployment of the "internet weapon" was accelerated to such an extent it's hard to imagine such a so called "bubble" not being created. A "Brave New World" was underway based upon the belief of a "Vanity Fair of the Ages" was upon us. Madness of course…but all these speculations are. The irony that there could even be a bubble in "single family home real estate" still has not been adequately explained to me. to me it's impossible actually…but hey, "tell it to Wall Street" cuz that was what blew up in 2008 not some mythical "real estate bubble" but a SECURITIZATION of debt bubble. amazingly folks have been talking "real estate recovery" ever since the collapse. "bad ideas to begin with" die hard. the fact of the matter is unless and until laws relative to privacy start being created AND ENFORCED there will be no true recovery from the collapse. the fact that the authorities still have no clue what is even going on says to me "expect further blow ups"…though not in equities of course because 'too much is never enough" when it comes to information in that space. does give new meaning to the term "naked capitalism" of course. Perhaps "capitalism naked" is where we're at now…

  2. ThomasGrennes   August 10, 2012 at 10:45 am

    EU authorities and governments in troubled debtor countries are naturally troubled by the
    size of interest rate spreads on sovereign bonds relative to German bonds. However, actual and anticipated intervention by governments makes it more dificult to extract useful
    information from the spreads. Does a reduction in the spread between Spanish and German sovereign bonds mean that economic recovery in Spain has increased the probability that Spain will service its debt, or does it just mean that market participants
    expect a greater probability of a bailout of Spain by EZ institutions? Politicization of financial markets has made it more difficult to disentangle these two effects.

  3. Schofield   August 10, 2012 at 11:06 am

    For the second time within eighty years an out-of-control financial sector imposed a massive debt burden way beyond the real economy's capacity to support it and triggered a second Great Stagnation. Irrational belief in Market Fundamentalism and abandoning our hunter gatherer ancestor's egalitarian code was the cause of this continuing stupidity.

  4. NIFTY   March 12, 2013 at 1:45 pm

    but which has actually been invested or implemented. This is so true when Buying Investment Properties.

  5. Collin Thomas   May 7, 2013 at 9:55 pm

    I just hope the government knows what it's doing. So many companies and businesses have folded over the last 5 years. The country can't really afford to keep losing more for another 5.

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