Wednesday, September 2, 2009

Buiter: most finance is socially nefarious

The more I read Willem Buiter, the more I like him. This morning in the FT he denounces the financial sector as a harmful sector in some instances.

I believe that efficient financial intermediation and a dynamic financial sector are essential for the proper functioning of any decentralised market economy; I also believe that too much financial sector activity is not only socially worthless, but actually harmful. Take financial derivatives. A financial derivative is a bet created by the issuer whose payoff depends on some aspect of the performance of an underlying financial instrument. If the bet pays out when the buyer of the derivative is worse off, we call it insurance. If the bet pays off when the buyer of the derivative is no worse off, we call it speculation. Speculation need not be a problem; it is a necessary feature of the efficient allocation of risk, as long as only one party to the transaction is engaged in it. To tame the rampant excessive speculation in the derivatives markets, it is sufficient to require that at least one of the parties involved in a derivatives transaction has an insurable interest. The Tobin tax does nothing to achieve this. An example: credit default swaps (securities that pay the holder when a bond defaults) can be issued in amounts much larger than the value of the underlying bonds. Anyone who owns CDS in excess of the value of the bonds he owns benefits when the debt defaults, creating obvious moral hazard. The issuer of CDS whose value is much larger than the underlying bonds has the opposite moral hazard: there is an incentive artificially to reduce or eliminate default risk. The simplest solution is to require that CDS pay out only if the same amount of the underlying bond is presented.

Which is a long winded way to say "Ban naked CDS!". Interestingly I think his analysis of moral hazard is incomplete. Namely even if you hold the bond your interest is to see the company completely default in some way to see your CDS pay out in full.

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