The financial sector is widely blamed for the financial crisis, with banks and their investment vehicles considered responsible for the products at its epicentre.
By contrast, investors who bought these products are seen as having played a largely passive role. In fact, demand-side pressures were the main driving force behind the growth of these products. As a result, governments will be unable to prevent crises if they restrict themselves to changing the global financial architecture.
The scale of demand for securities (see appendix, table1) helps to explain the fall in treasury yields and the tightening of yield spreads after 2001. Psychological factors are typically invoked to account for these developments: infected by the atmosphere of optimism and confidence in the real economy, investors also became over-confident and hence overly willing to accept lower risk premiums. However, it is more likely that yields fell after 2001 mainly because governments and large corporations were unable to supply securities with a sufficient wealth storage capacity to accommodate the surplus capital pools.
Without any one of the main components of the global demand for securities, yields would not have fallen as far as they did; nor would the ‘search for yield’ phenomenon have become as pronounced as it did.
The question is: which demand component can we subtract? That exercised by the institutional investors? Or by the banks? Or by governments? In each case, there is justification or plausible explanation for the size of the demand for securities that was exercised.
However, this hardly applies to the high net worth individuals, of whom there were 9.5m in 2006. HNWIs may have had little or no direct involvement in the collateralised debt obligations market, but their indirect involvement was substantial in that they were the leading providers of finance to hedge funds (see appendix, figure 1). These hedge funds were in turn the leading buyers of CDOs (see appendix, figure 2).
This last fact is easily explained. The basic task of hedge funds is to generate above average returns for their clients, for which these clients pay above average fees. This task became increasingly difficult in the low-yield environment of the early to mid- 2000s. The problem was that no matter how sophisticated were the investment strategies used to generate yield, there were limits to how much could be squeezed out of the securities and other available asset classes. So the hedge funds found themselves in a dilemma: on the one hand, more and more assets were placed under their management because other investors were finding it difficult to generate yield; on the other hand, the hedge funds were themselves finding it difficult to generate yield.
It was hedge funds’ need to resolve this dilemma that led them to the search for alternative financial products that could give higher yields, and, when finding that the CDOs fitted this description, led the demand for them. Hedge funds pressured suppliers into providing these products at an ever-increasing rate. As Gerald Corrigan, a managing director of Goldman Sachs, told British MPs recently: “To a significant degree it has been the reach for yield on the part of institutional investors in particular that goes a considerable distance in explaining this very rapid growth of structured credit products”.
Financial crises will not be avoided merely by reforming the financial system. Regulators can make the system as transparent and accountable as they like, but as long as there remain external pressures on it to create products or to indulge in harmful practices, such products and practices will continue to be introduced and financial crises will continue.
Only a significant re-distribution of wealth will remove these external pressures. This requires globally coordinated action in three areas of tax policy:
(1) Tax havens: these need to be closed to prevent trillions of dollars from disappearing off governments’ radar screens;
(2) Tax structures: these need to be harmonised to prevent mobile sections of global capital from encouraging a tax competition ‘race to the bottom’ with the result that domestic tax burdens fall on those who cannot operate across borders;
(3) Tax rates: these need to be re-aligned so that the tax burden is again distributed on a progressive rather than regressive basis.
A globalised version of Keynesianism is needed to help to prevent future crises and to help finance the resolution to the present one. As governments pile more claims on their future revenues through bond issuance, the lower will be their credit ratings and the higher will be the risk-adjusted returns that investors will demand.
From where will these returns come? Since there are limits to how much can be raised from average income households, small businesses and other immobile taxable units, there will have to be, in the absence of serious tax reforms, deep cuts in many areas of government expenditure.
It will be difficult for governments to institute the necessary tax reforms, and thus prevent them from making those cuts, given the pressure exercised by the very wealthy.
However, it can be done providing strong countervailing pressure is brought to bear on governments. If ever there was occasion and opportunity to exercise that countervailing pressure, it is now.
Photis Lysandrou is professor of global political economy, London Metropolitan Business School, London Metropolitan University
Appendix: Table 1
| Major Holders of Securities, 2006 (US $Trillions) | Total Assets | Securities | Alternative Investments (inc. Hedge funds) | Other Assets (cash, real estate, etc.) |
| 1. Institutional Investors | ||||
| (a) PFs | 21.6 | 17.3 | 1.3 | 3 |
| (b) MFs | 19.3 | 17.4 | 0.8 | 1.1 |
| (c) IC's | 18.5 | 14.8 | 1.1 | 2.6 |
| 2. Banks | 74.4 | 37.2 | ||
| 3. Governments | ||||
| (a) Reserves | 5.4 | 4.9 | 0 | 0.5 |
| (b) SWFs | 1.9 | 1.5 | 0.2 | 0.2 |
| 4. HNWIs | 37.2 | 19.3 | 3.7 | 14.1 |
References
Bank of England (2008), Financial Stability Report, October
Capgemini (2007), 11th World Wealth Report, June
Conference Board (2008), Institutional Investment Report, September
House of Commons (2008), Treasury Committee, Report on Financial Stability and Transparency, 26th February, 2008,
International Monetary Fund (2008), Global Financial Stability Report, April
McKinsey Global Institute (2008), Mapping Global Capital Markets: Fourth Annual Report, January
Sovereign Wealth Fund Institute (2008), Asset Comparison -Investor Classes and Asset Classifications, August
No comments:
Post a Comment