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Post details: Waiting for a Financial Einstein

Waiting for a Financial Einstein

Towards the end of the 19th century, the towering edifice of science, by then well grounded in Newtonian mechanics, seemed consummated, plausible and self-consistent. But as the ever restless gang of physicists started plowing the elusive electromagnetic field, hairline fractures started showing up in its polished walls. The mathematical development of the underlying theory spurred by the barrage of high precision experiments began exerting significant strain on the foundations of classical mechanics. Soon it became clear that in order to reconcile the old with the new, the fundamental notions of space and time will need a serious adjustment. However, tweaking the statements and definitions within the existing schema created more problems than it solved. Scientists educated in the classical ways could not divorce themselves from the shadows of status quo. Lots of duct tape was expended to hold the teetering structure together but none was good enough to provide permanent relief.

Fast forward to 1905. Enter 27 years old clerk from the Swiss Patent Office named Albert Einstein. Unencumbered by the previous dogma, his mind could freely set sail on the vast ocean of imagination, guided only by the positions of the stars rather than by man made navigational structures. In his Special Relativity he boldly demolished the increasingly confusing labyrinth of ad hoc fixes and empirical constants and based his overall vision on two simple principles.

The Principle of Relativity - the laws of physics should be the same when expressed in coordinate systems that move with respect to each other with constant velocity.

The Principle of Invariant Light Speed - light propagates in empty space with a fixed and definite velocity which is independent of the motion of the body which emits it.

There. Instead of hectic, chaotic and mutually contradicting scribbles, two masterful strokes of a brush. Armed with only these two simple propositions and some relatively straightforward geometry Einstein laid foundations to of all of the 20th century physics. The survival of his theory on the boisterous seas of modern science (hundred years and counting) is the best testimony to the effectiveness of his sleek logical design.

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These days, the banking system is floundering in a quagmire similar to the one physics was stuck in 100 years ago. Bound by the regulatory straight jacket, constantly undermined by rampant greed, conflicted by competing interests and helplessly overwhelmed with complexity, the system is on the verge of crumbling under its own weight like a bridge made out of reinforced corn flakes. Things are not helped by the fact that the central pillar of the whole structure, the US Federal Reserve Bank, was designed just a few years after Einstein published his ground breaking paper and it is not clear whether it still reflects the needs of the highly interconnected world or whether it was hijacked to serve the needs of a few. Viewed from the ground, the global financial system looks like a giant plumbing fixture whose sole purpose is to transfer wealth from productive sectors to financial centers.

Over the past few centuries, economists managed to create a veritable Babel tower of capital ratios, credit derivatives, currency swaps, collateral obligations and other obscure mumbo jumbo. No one - and that clearly includes CEOs of major banks - can even begin to understand all of its implied feedback loops. A brand new paradigm is obviously needed. Not a patchwork of regulations and exceptions which are being piled on top of each other without regard for consequences, but rather a clearly formulated framework which would benefit most citizens of this planet.

Something like this.

The Core Business of Banks is Lending - the primary purpose of banks is to match people who have extra money (i.e. capital) with entrepreneurs who have solid business ideas (i.e. people who can put that money to the best use).

People control the money - every now and then it may happen that existing money stock needs to be expanded. In such situations the power to print money rests with the people and they are the primary beneficiaries of such action

The first postulate defines the purpose of the financial sector. At least of the part that is protected by the central banking system. Banks are merely matchmakers. That is the function that is socially useful and as such should be protected. And if a group of wizzards - whether from Goldman Sachs or JP Morgan - wants to have fun in the cassino and do some proprietary trading on the side - sure - they can create their own hedge fund and gamble away to their heart's content but without implicit or explicit backing by taxpayers.

The second one refers to the crucial issue of who exactly has the power to print money. If Joe Sixpack prints or copies a $100 bill in his garage, he goes to jail, because he has to earn that money. So why would give a small group of financiers and bureaucrats a license to counterfeit our currency for their own purposes? The power to create money out of thin air can lead to enormous wealth whether it is implemented directly though the actions of the central bank or indirectly through a sleight-oh-hand known as Fractional Reserve Lending. In a democratic system, one would expect that any unbacked expansion of the money stock would be done in a way that supports all participants of the economy, and by extension all people. Not just those who managed to elbow their way into positions closest to the monetary spigot.

Bankers are not humanitarians and they are not supposed to be. They have a legitimate business and are perfectly entitled to make money off of it. It is up to us - or more precisely up to our elected representatives - to set up a system which will not only prevent abuse but also ensure that the evaluation and assessment of risks can be done in an efficient way. But instead of searching for the grounding principles, we are drowning in a sea of random details and expedient measures which are only good for creating thousand page monstrosities such as the Dodd Frank Financial Reform.

Now I am obviously not an expert, so I am not saying that the two postulates above should be at the heart of the new financial charter. What I am saying is that someone knowledgeable should come forward and lay out a simple and clear blueprint for a system that would respect the principles of fairness and functionality. Perhaps we could even have several competing visions. But the important point is that those visions should be formulated through a small set of transparent principles, rather than amendments to the current financial jungle. Which - as anyone knows by now - is neither fair nor functional.

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