FT interview of Trichet

The president of the ECB engages in a rather candid video interview with the FT. In my opinion some good some bad some neutral.

The Good.
Around minute 5 Trichet says clearly that the amount of risk in the system was not known, the risk was mispriced and that regulation should focus on amplification of cycles.

On the first point, I still personally have trouble understanding the total level of money in the system. M3, it seems, does not capture all of the private debt issued by bank. He is probably calling for a better monitoring of total monetary levels in the system. That means re-regulation of the capital ratios. Good luck controlling the debt levels. I would argue that letting the invisible hand fine-tune the debt levels may not be a bad thing but it needs to be measured, otherwise things can get a little out of hand (pun!).

The mis-pricing of risk is very interesting one. Risk in an on itself is not a bad thing if debt is adequately priced so that defaults never destroy capital. However structures like CDO's clearly obfuscated the risk and a lot of capital has been destroyed as a result. If every year a tenth of your debt is bad debt then minimal payments of 10% should cushion that. If you get paid ten but the default is 20 then capital gets hit. Models will improve with the lessons learned from this crisis.

Pro-cyclicality. The reporter thinks Trichet is talking about counter-cycle measures of easing capital requirements during stress times and tightening them during boom times, as was done in Spain, but he is talking about something else. He says that our own actions should NOT amplify normal market cycles. Take the CDS as side bet as I talked about a couple of blogs ago. The speculator doesn't own the underlying bond, but takes out the CDS. These clearly amplify risk as a default is multiplied by the number of bets taken. A CDS as a hedge, does not amplify risk but merely moves it around. The CDS market should not be killed as Dizard called the other day, just regulated in its risk amplifying aspects. I believe this is what Trichet means. Great minds think alike :)

The Bad.
The last 2 minutes where he talks about lack of flexibility: stick to the rule. Navigate within the framework. His argument is that it is important to maintain faith in the system by respecting the rule book. I have seen this too many times in Software. The belief that your "framework" IS THE framework and that it has anticipated every scenario. There is a little bit of intellectual arrogance and dogmatism in this statement. Whatever mighty framework you can come up with was designed with partial information and when the context changes, the most important thing is TO LEARN QUICKLY. THROW THE RULE BOOK OUT OF THE WINDOW IF NECESSARY.

Don't get too high on your own fumes. Intellectual certitude can only exist in mathematics, a field whose objects only exist in our minds. Not even Physics can afford this dogmatic rectitude when confronted with Nature. Physics advances because observed facts contradict our precious little models. But when it gets to the science of the living, Biology and Economics, one should treat their frameworks and models with the utmost distrust. I believe economists, like doctors, should take the oath of "FIRST DO NO HARM". Then be very careful in applying your model. It works until it doesn't. Third stay nimble and be quick to change your stupid little models.

The Neutral.
On a lighter note, I chuckled at the question asked at the end "where do you think we are, the end of the beginning, the beginning of the end?" and you get to see Trichet dancing around the question and basically answering nothing for 45 seconds. Kind of a French Mime Marceau impersonation of Greenspan. Hilarious.

Comments

So true about the framework and throwing out the books... I mean how good is the framework if one guy (Madoff) can cook the books for 20 years for 50B and nobody seems to notice...?
I mean do people remember how Enron shook the world? This is Madoff scam is of Enronic proportions. (Enron was worth $60B at some point, the bankruptcy a few billions....) Yet in a world of trillion dollar bailouts people shrug. European banks announcing losses today in the billions because of this. Did it really make a difference in the market? Hardly. Amazing. Everyone is numbed out...

Same faults - same scams. "Not a hedge fund', computer trades, whatever. Make it so complicated that people don't understand but give people what they want to hear.
Greed over ratio. Powerful human impusle, like all the other pleasures we're hardwired for.
adt43wt342 said…
Some speculate that the markets have priced in a recession of 1929 proportions... which is why you don't see dips on bad news. I have no idea if that is true, but I tend not to buy it :)
Alex said…
"Marcf said...
Some speculate that the markets have priced in a recession of 1929 proportions... which is why you don't see dips on bad news. I have no idea if that is true, but I tend not to buy it :)"

The markets are not even that optimistic.

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