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Thursday, 9 April 2009

The Tragedy of the Financial Commons

The Sumerian Dilemma

Way back in the mists of barely historic times, down in the then fertile crescent of Mesopotamia, the Sumerians ceased their nomadic wandering, started cultivating wheat and barley and settled down to form the world’s first civilisation. The easy availability of food – at least compared to hunting vicious animals with nasty pointy teeth - allowed them to grow their society but also created a deadly dilemma. To maintain the population nearly all the Sumerians – apart from a few priests and so forth – needed to spend all of their time processing grain. A people that can’t generate a surplus of food are destined to spend eternity on the treadmill of maintenance.

Sadly the Sumerians, acting in their own interests, exhausted the resources needed to maintain their society and in so doing destroyed it. In a similar manner our financial industry is exhausting the world’s fiscal resources. Unfortunately it’s unlikely that the individuals responsible will care too much because they’re too busy spending their loot.

The Tragedy of the Commons

In 1968 Garret Hardin's paper on the Tragedy of the Commons expressed the problem faced by both Sumerians and twentieth first century humanity. At root the issue is the asymmetry of gains and losses in the use of “commons” – resources with shared ownership. What he pointed out was that if, in these circumstances, we apply Adam Smith’s principle of the invisible hand, where each person acts in their own interests on the basis of market economics, then the inevitable consequence of this is destruction of the shared resources.

His analogy was with herdsmen grazing common land. Individually it was in each individual’s interest to maximise their profit by adding another head of cattle to their stock. As a group, however, if they all did this the net result was the overgrazing and destruction of the commons. In such cases, argued Hardin, the idea that individuals should seek out the best results for themselves and let the markets take care of the result for the betterment of all simply doesn’t work.

Agricultural Futures

Over a hundred years before Hardin a financial innovation which too had its genesis in the arena of agriculture was born in Chicago, an idea which was to lead to the greatest destruction of the commons we’re yet seen. The smart idea this time was the concept of the future.

A future as applied to agricultural commodities is relatively simple to understand. It gives the seller the right to sell something – their grain supply or their beef herd, perhaps – at a specified price on a future date. It gives the buyer the equivalent right to buy the grain or beef. Both participants in the exchange lock in the price which means that they have guaranteed their profits or their expenses and can plan accordingly.

This was the origin of derivatives – tradable securities whose price is derived from some other underlying item of value. Using futures in this way allowed both buyer and seller to ensure that their profits and costs were known in advance. Basically futures originally were tools to allow people to manage their risks. Such concepts have a long history – at least as far back as the Roman Empire.

Derivatives with Everything

Of course, if you give the modern financial industry an idea they’re bound to push it to extremes. So it was with derivatives which eventually spread beyond the physical products of agriculture to the more ephemeral and less tangible outputs of the financial services sector. It became possible to buy derivatives based on the price of stocks or property. Then it became possible to buy derivatives based on the price of the derivatives based on the price of stocks or property. Then it became possible to securitise all of these things so that they were chopped up into little bits, repackaged and sold on as low risk investments.

By this point the meaning of the securities being traded was lost on everyone apart from a few experts who no one understood anyway. Their managers didn’t care as long as the money kept flowing. Their managers’ managers – our modern day equivalent of the Sumerian priests – cared even less, they were too busy performing human sacrifices. Sorry, I meant “raking in their bonuses”. Silly mistake.

All of this was compounded by using huge amounts of gearing. Warren Buffett called derivatives “Weapons of Mass Financial Destruction”. Everyone nodded sagely and then gleefully added another couple of steers to the land.

Financial Security is a Commons

Somewhere along the way the divorcing of the underlying things being bought and sold – mortgages, shares, etc – from the risk associated with them generated an all too modern version of the commons. It was in the interests of everyone involved to keep them cattle grazin’ regardless of the destruction that was going on. In unique twenty first century style, we’ve managed to create a worse situation than Hardin ever imagined.

At least in his version of the tragedy the people responsible for the damage also suffered from it. In our version those responsible have got to flee with the rewards generated while leaving the cost of it in the hands of others. Us and our children mainly, through the current debt and later taxation that’ll be coming our way. The commons in this case – the financial security most of us rely on – have been grazed to death and the herdsmen have vanished with their gains.

Regulating the Regulators

We’re now seeing a slow motion replay of the eventual scenario that Hardin forecast. If the market can’t manage the commons effectively – and Hardin showed logically that it couldn’t – then the only option is to regulate it. This, as he pointed out, means making hard decisions none of which can ever be satisfactory. The alternative, though, is ruination for all. It’s like inheritance – it’s clearly unfair that some talentless, self-preening sponge should inherit a fortune through an accident of birth but all the alternatives are worse. It’s the least bad option.

Once you rely on administrators to regulate banks and the financial services industry then you’ll run into the inevitable issues of corruption. Who regulates the regulators?

Food, Population and Pollution

The Sumerians ended up self-destructing as the crops they depended on exhausted the fertility of the soil. A society founded upon everyone working dawn to dusk to process grain left nothing over for the creation of the kinds of intellectual capital that’s powered our civilisation for the past four hundred years. It’s our technological and financial innovations that have ensured we live lives of unbelievable comfort compared to our ancestors.

Yet the experience of the financial markets over the first decade of the twenty first century should be a loud and clear warning that we ignore the risk of abusing our commons at great peril. In financial markets the challenge, now, is not whether to regulate but how to regulate. The danger is that the regulators self-interest may outweigh our joint welfare. Innovation can only take us so far.

Hardin’s analysis isn’t just applicable to the financial commons. It also governs some of the other major issues that confront us. Today the United Nations estimates that nearly a billion people go hungry every day. Maybe this is more about politics than production but in a world of finite resource we must eventually run into a situation where the world cannot support more people without either a reduction in living standards or mass starvation.

Meanwhile we as individuals continue to contribute to the pollution of the planet and the global warming that goes with it. The immediate loss to each of us individually may be tiny but the eventual loss to all of us will be immeasurable. For proof just look at the value of our pension funds.

Filters Against Folly: How To Survive Despite Economists, Ecologists, and the Merely EloquentThe Devil's Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street . . . and Are Ready to Do It AgainCollapse: How Societies Choose to Fail or Succeed: Revised Edition

Related Posts: Hedge Funds Ate My Shorts, The Death of Homo economicus, Newton's Financial Crisis

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