The qualitative crisis

The US invented, and has largely succeeded with, quantitative management techniques.  Rightly so:  measurement is the basis of reasoned discovery.  But as a result, we have a tendency, when faced with a complex problem, to focus on the parts that are easiest to measure, rather than the parts that are obviously most important.

It appears the financial crisis is such a problem, whose root causes are essentially non-quantitative.

Let’s back up a few months, to summer 2007, before demand had collapsed.  What was the problem then?  The cost of borrowing was exploding, putting firms at risk, and financial firms in particular.  Why did that happen?  Two reasons.  First, the credibility of bond rating agencies was destroyed by the mortgage crisis.  No one trusted a triple-A bond to stay triple-A, so no one wanted to buy bonds.  Second, investors began to realize that various firms had vast exposure off the balance sheet, and there was no way to estimate risk.

Both of these problems, it would seem, can be traced to what governance expert Daniel Kaufmann calls “legal corruption,” which basically means blatant conflicts of interest that are not explicitly illegal.  These are rife in the US financial system, too many examples to list — refer to Kaufmann’s recent Forbes article for more.  Perhaps because they cannot easily be measured, these activities are getting almost no attention.

This is, one hopes, what the current administration means by the pursuit of “transparency,” which could be construed to mean the following:

  1. Force big auditing firms and banking regulators to require clear disclosure of off-balance-sheet exposure by public firms.
  2. Regulate the bond rating agencies, which have demonstrated they cannot regulate themselves.

These two things alone would go far to restore investor trust, which would by itself stabilize markets.  I suspect these would accomplish more than any fiscal stimulus.

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