Joseph Schumpeter is honored in many ways today. His name is even used as the seer of wisdom, giving stature to the Schumpeter business column in the Economist. In the ongoing debate over “regulation,” his name is inevitably invoked to define the creative side of the capitalist model matched with the equally important ability to shed unproductive resource allocation errors by the market. This process of “creative destruction” is one of the hallmarks of the assertion of the efficiency of markets over institutional or governmental allocation of resources. In his model, competitive profitability in laissez-faire competitive markets maintains the availability of resources for each individual firm over time. This process, first identified by Schumpeter, is not just a nice wrinkle in the market model. It is an essential element of the argument for free markets and a rejection of regulatory interference. Since regulators neither can pick winners nor can they effectively force out losers in a market, “creative destruction” is a mechanism of efficiency that ranks with the Adam Smith’s “invisible hand” as a self-regulating attribute of the market process.
What could go wrong with this approach to allowing markets to manage themselves? First we need to look at assumptions. In Schumpeter’s model, the markets are competitive which means there is no barrier to entry into the market or exit from the market. The market is independent from other markets and competes between markets by being either a substitute or complement to other products. Finally the market in question must not have a systemic impact on other markets expectations. A change in the price in a perfect Schumpeter market leads to reallocation of resources not to systemic market failure. Thus, all of the information in a Schumpeter market is conveyed by the price of the product.
To the extent that the above assumptions are violated, the information we receive from such a market is not necessarily creative nor will the appropriate destruction occur.
JPMorgan Trading Loss May Reach $9 Billion: “Snatching Defeat from the Jaws of Victory”
JP Morgan and Jaime Dimon were considered the “creation” that survived the “destruction” of the 2007-2009 crash of the financial markets. They absorbed Bear Sterns and moved on with successful moves out maneuvering the market. Yet time and the continued presence of the credit derivatives market has reversed that outcome for JP Morgan to where they are being “destroyed” by the very instruments that Schumpeter would have predicted would be eliminated in his model. They are now in a “destructive creation” trap.
“The growing fallout from the bank’s bad bet threatens to undercut the credibility of Mr. Dimon, who has been fighting major regulatory changes that could curtail the kind of risk-taking that led to the trading losses. The bank chief was considered a deft manager of risk after steering JPMorgan through the financial crisis in far better shape than its rivals.” Specifically the authors describe the problem “the losing trade, made by the bank’s chief investment office in London, was an intricate position that included a bullish bet on an index of investment-grade corporate debt. That was later combined with a bearish wager on high-yield securities.”
The market we’re looking at here is for exotic financial instruments as well as insurance products that are the result of risk management at “too big to fail” financial institutions. The most recent example of this is JPMorgan’s $2 plus billion plus loss in the derivatives market. Of course, this is very small compared to the trillion dollar losses sustained in the recent massive recession. Yet it remains instructive. Also the fact that exotic financial instrument markets such as mortgage derivatives, credit derivatives and structured instruments remain in existence after the debacle of 2008 through 2010 suggest the destructive part of Schumpeter’s model is not working.
First of all, the market for derivatives and hedge fund products is a market restricted to the financial sector at its highest most noncompetitive level. The investment banking sector is where no realistic entry is possible in the short run. Secondly, this market has a unique supply characteristic since the members of the market create the product for each other, as they are engaged in a continuous process of risk avoidance. It doesn’t take a lot of sophistication to recognize that the primary business of investment banks is risk transfer rather than risk taking when they create these instruments. On a worldwide scale there are just a few investment banks engaged in creating and selling insurance products to each other in magnitudes that are in the hundreds of billions of dollars. They are essentially playing a game of musical chairs. The last one standing is the one unable to transfer risk, and thus, they become the target for default. When JPMorgan became the market the music stopped, it had no chair, nowhere to sit. It took the market losses leftover from its rivals risk avoidance actions. Jessica Silver-Greenberg and Susanne Craig, note this in the following investigative report;
“Hedge funds and other investors have seized on the bank’s distress, creating a rapid deterioration in the underlying positions held by the bank.”
Furthermore they report “Essentially, JPMorgan has been operating a hedge fund with federal insured deposits within a bank,” said Mark Williams, a professor of finance at Boston University, who also served as a Federal Reserve bank examiner.”
This problem of risk management at the scale of investment bank operations, relative to the real economy, was not anticipated by Schumpeter. In addition, Schumpeter never considered the Macro Economic, thus systemic, nature of modern markets. Importantly, the inability to consider macro issues fails to allow the analyst touting this process to consider whether or not “creative destruction” is affected by operating in an excess liquidity or inadequate liquidity setting. In the time Schumpeter was writing, the problem generally was inadequate liquidity and resource scarcity requiring very precise allocation of resources and efficiency to avoid wasting resources. Today the problem is excess liquidity and management of large but, at the margin, useless financial instruments when they are evaluated for their role in efficient resource allocation. These financial instruments exist because of excess liquidity and are the fuel for bubble markets.
Today’s world is one of historically low interest rates. These interest rates are often negative in real terms and create massive excess liquidity (excess reserves at the banks) due to quantitatively expansive monetary policies of the US Federal Reserve (and now parts of the Euro area and China). As noted by Binyamin Appelbaum,
“Concerned about waning economic growth, central banks in Europe and China announced measures Thursday to increase borrowing and spending by businesses and consumers, a response that was all the more striking because it was uncoordinated.” http://www.nytimes.com/2012/07/06/business/global/markets-look-to-europes-central-bank-for-action.html?ref=business
Those dollars when used to create credit derivatives such as by JP Morgan etc. move through the financial markets detached from any connection to the output of goods and services. They were created, not by making loans the old fashioned way, but by huge investment banks creating derivatives that move dollars into the exotic markets with no connection to real output. The dollars in the financial sector can still, however, be used to outbid buyers dependent on earnings from goods and services production. This process, measured on an income basis, explains a good deal of the current increase in the inequitable distribution of income measured over the past 10 years.
Paying fees (the earnings of hedge fund managers and derivative market sales officers) to sell derivatives rather than basing payment on the performance of the products further detaches income from productivity. The market for the derivatives becomes quantity rather than price driven and the volume of sales is the road to high earnings for the creator of the instruments. Prices do not convey risk or signal shortage or excess supply in the market.
In the case of rating agencies (Fitch, Moody’s, Standard & Poor’s) that priced derivatives of equal average risk together, without regard to the variance (dispersion) of risk each instrument embodied, we see pseudo-technical driven misinformation. This meant that risky instruments with high-risk mortgages mixed with very secure mortgages and risky instruments that included just moderate risk mortgages were both given the same rating if they had the same average score. As a result the ratings were not a guide to internal risk of each instrument failing. In addition, the rating agencies designation was seen as the sole measure of comparative risk. As a result, no measure of systemic risk was taken into account either by the market, or the insurance instruments generated to facilitate risk transfer schemes. Not only were housing prices seen as rising to meet the collateral value needed to justify the mortgages, but this was a general assumption for income as well. We now know that this was not true in reality.
The observations recounted so far show that the conditions under which Schumpeter’s “creative destruction” process would operate that did not exist in the time before 2007-8, and do not exist yet in today’s financial markets. The market became a quantity adjustment not price adjusting market and the supply was extremely responsive at low prices (interest rates) and demand was in excess at these prices continuously in the pre-crash markets. The excess demand was fueled by attempts to keep growth maximized by providing massive growth of liquidity (money supply) by the Greenspan Federal Reserve. As a result disturbances tended to not converge toward equilibrium, just the opposite. This is the inverse of the famous “hog cycle.” I would call it the “fat Hog Cycle” Here the pun is intended and appropriate.
In the “hog cycle” excess supply is destroyed (killing hogs) reducing supply excessively thus, raising prices in the next period above equilibrium continuing in a process where quantitative overreactions move the market away from equilibrium.
In the reverse case excess demand causes supply (derivatives) to be created at lower than correct prices (no systemic risk and underestimated failure rates) so that the demand does not raise prices it just leads to more supply of underpriced derivatives. This market moves away from equilibrium not toward it. This destructive activity is particularly true when fees are paid on volume of sales encouraging additional creation of “sure to fail” mortgages and their derivatives. The fees prompt sales efforts even when the underlying mortgage instruments may ultimately fail. If the price reflected risk, the price would be so relatively high that sales would dramatically fall. This information problem in quantitative adjustment processes is asymmetrical or at least incomplete when sellers know that the prices are not valid and buyers don’t.
As you might recall in the run-up to the 2008 financial crisis, Main Street banks were making loans, which clearly would never pay off, to people who had no income. The famous Ninja loans: No income, no job, no assets. They made loans because they could sell those mortgages in the secondary markets knowing they were going to be pooled with good mortgages. It would be a long time before anyone discovered there were rotten mortgages in the derivatives. The reason this occurred was in part due to the rating agencies averaging of risk.
Ultimately this was not profitable for the investment banks. Of course, the fees were paid based on volume so the loan officers in the banks didn’t care about the future. They were making money now. Here is where Wall Street made money by aggregating thousands of mortgages into derivative instruments that could not be understood, which added considerable systemic risk as an insult to the injuries to the market begun by Main Street incompetence and rating agency hubris.
Many bankers and financial analysts thought this was just smart portfolio management. Tobin’s portfolio theory was about balancing holdings among different risk instruments, all of which were viable. Portfolio theory did not suggest taking on instruments that were not viable to balance them off against viable instruments. The mathematical models used to handle thousands of mortgages were fundamentally flawed. Whatever mechanics were involved would fit the famous Kenneth Boulding dictum that mathematical models are often supported by the articulation of theory which amounts to “the celestial mechanics of a nonexistent universe.”
In Schumpeter’s world, supply was not driven by demand. If products were not profitable, production was reduced making the market convergent toward equilibrium or where supply and demand were equalized at a specific price. The derivative markets today are not competitive. Prices are not reflective of supply and demand conditions and do not convey risk differentials between like products. The supply function is dependent on the fees paid to the creator of the instrument not on the viability of the instrument, which is assumed to be certain. It would be like placing bets on fights based solely on weight. Experience, training, the ability to see, conditioning and the ability to walk would count for nothing. And very importantly the markets are interdependent. This means that failure of the instruments in one market would spread risk through all markets so that the sum of the downturn losses will exceed the expected losses in each market added up individually. This is what is called a negative sum game. But this is no game. There will be unanticipated risk strewn throughout the banking sector raising risk premiums not only in the financial sector but in the real sector, with declining expected demand leading to retraction in the production of goods and services. We call that a recession in the short term and a depression over longer periods.
The Markets for Derivatives and Other Illusions of Risk Management: “Creative Destruction” becomes “Destructive Creation”
Had Schumpeter been here today, my guess is he would have coined a new phrase to describe the process that fails to correct itself when none of the information generated by the market system is diagnostic of the problem. I will entitle this situation, “destructive creation” applied to contemporary financial derivatives. They have prices that do not convey information about what is thought to be purchased in the market for these instruments. This would be risk management and risk transfer. The product is produced essentially out of thin air based upon the false belief that the instrument manages risk by insuring bets placed on the purchase of credit default swaps, for example. The insurance instruments price is based on the possibility that aggregated mortgage based instruments will fail. The failure rate is supposed to reflect the underlying probability of the mortgages failing to be paid by the original buyers. However this approach does not account for systemic failure.
Though we want to believe that Schumpeter identified the experimental process in the market which is self-contained, he did not contemplate a situation which was not self-contained. The one market type he missed takes off and explodes through the entire economy. Since it is not self-contained, the creation of the instruments themselves is related to market actors operating on false assumptions regarding the virtual product, which they like to think of as a risk transfer tool. The phony derivatives create macro-dynamic risk; they do not transfer or manage risk in the economy as a whole. This fiction is just in the delusional minds of his investment bankers unwilling to see conflict of interest, are blinded by the fees pouring into their personal bank accounts they normally have at commercial banks.
Ironic as it may seem, these financial wizards, who exist because of deregulation, usually put their money in FDIC government insured accounts.
What micro market players do not contemplate is that though they can rearrange risk exposure in the market, the macro economy responds to this movement of risk up the hierarchy. As they push risk up the market ladder forces emerge from the assessment by skeptics who see the house of cards and act focusing on the contrarian moves created by systemic risk as this aggregation occurs. The market will not correct this until a threshold is reached where the false assumption is illuminated by a real-world event such as a sudden switch to falling housing prices or more subtly incomes not growing sufficiently to support mortgages that are being created to meet the volume salable in the derivative creation market.
The derivative market goes on, leading to the creation of more and more derivatives despite the fact that the market is collapsing underneath this exotic market. This is like someone who’s built a beautiful foundation for an elegant house, who then decides to construct a magnificent chimney by taking stones from the foundation and wonders why the foundation, the house and eventually the chimney collapse into the basement.
“Destructive creation” is a process where a product is produced that is priced to sell but its price is unrelated to the systemic risk it creates and thus is produced in excessive quantities relative to its real cost. The market based on that price may think it measures the risk of failure for that instrument, but it clearly does not, as we saw in 2007 and 2008. Inability to assess nonmarket characteristics of a particular financial product destroys a market’s ability to measure and evaluate, because the price is unrelated to market characteristics.
These unquantifiable properties of market miscalculation include the possibility of systemic failure due to macro adjustments, no precise measurement of long-term profitability based on undecipherable market aggregation actions defining the derivatives. This makes present valuation of the instruments impossible. Also, quantity based supply incentives that are perverse relative to price, where demand is based on interactive gaming behavior. Additionally a couple of subtle distortions appear, changing expectations based on misinformation, or the creation of products that are not measured by risk but exhibit qualities associated with uncertainty. The derivative as a product is ephemeral.
This blind market will continue in operation because it is misinformed. Reality bites. The sellers have no stake in future outcomes when they are paid immediately and strictly on volume sold. The situation is profoundly wasteful and the magnitudes are an astonishing distortion of any aberration we would expect in a properly functioning financial market. Part of the waste comes from people who produce nothing having huge claims on goods and services. “The unit at the center of JPMorgan’s $2 billion trading loss,” reports The Financial Times, “has built up positions totaling more than $100 billion in asset-backed securities and structured products — the complex, risky bonds at the center of the financial crisis in 2008. These holdings are in addition to those in credit derivatives which led to the losses.”
In Schumpeter’s model of,” creative destruction,” in the marketplace value is created because it is competitively profitable and survives and that which is not as profitable is destroyed. Resources are mobilized in productive directions.
In today’s financial markets, “destructive creation” creates products that destroy themselves while diverting resources to their creators and putting at risk the entire financial system. The destruction remains long after the creation is exploited. Resources are diverted to those who produce nothing but destruction. These “bankers” consume what others produce since there is hardly anyone who can outbid them in the “free” market.
Once a bubble bursts Investment Banks may have been “too big to fail” but failed anyway. Examples like Bear Sterns are instructive because they failed and were absorbed by JP Morgan which is now at risk of failure by not being prevented from making the same mistake in assessing risk all over again. How many times do we need to see this error repeated? When JP Morgan is rescued or fails, we need to go back, following Paul Volker, to the era of Glass-Steagal where “destructive creation” was prevented.