Our crisis is a crisis of knowledge. We witness a remarkable market failure in creating high quality financial research for the global economy.
There is plenty of evidence. The lack of adequate modelling framework for the global economy results in the absence of effective asset valuation; the lack of price anchors lead to major bubbles in boost times, and a downward asset-price-spiral in bad times. The standard answer has been to blame rating agencies and the lack of 'deep-thought' on the part of investors. Calls for more or different regulation are ample.
The cause for the problem:
1. Investors were looking at a new horizon with the old set of tools. Their coverage grew from local to global in a very short time, and thus there was, and is, a complete lack of adequate in-house research capacity in most investment houses, especially outside the main financial centres.
2. There is a significant incentive compatibility problem with the bulk of the external investment advisory services. The investment banks do offer global and universal research coverage, but the advice provided is often superficial, and despite the Chinese wall regulations, is still broadly in line of the interest of the banks; at the same time the business model of rating agencies further amplifies the incentive compatibility originated distortions.
Alternative source of modelling innovation has so far failed to deliver:
The upgrade of the in-house research capacities of global investors has so far lagged due to the very large cost of building up global modelling centres, coupled by the uncertainty of the pay-offs due to the lack of adequate modelling framework. Furthermore, the induction of such build-up might lead to major concentration of investors on the global scale, creating a new set of problems.
State-provided research has been entirely inadequate in providing the necessary innovation, while academic research has been lagging, probably due to data availability reasons.
The small set of independent research houses are struggling for being driven out of the market by the large amount of low quality free research published by investment banks: as a consequence, most of the major independent global research houses are politics centred.
The consequence is a market failure without an obvious regulatory solution.
There are three main non-regulatory solutions:
Solution: reputation. Deal with the problem from a reputation angle. The argument goes like this: the market learns from its mistakes, this is ultimately a reputation game. This argument suggests that investment banking research is a product with asymmetric information problem, where credibility collapses in one-off games, and a reputation based equilibrium emerges in the repeated game.
Solution: refined regulation. Recognise that the core of the problem is a regulatory failure, and seek a solution through the refinement of the regulatory system. The burst of the dot-com bubble resulted in a wave of regulation that tried to tackle the incentive problem inherent in the investment banking research. The refinement of this regulation may result in increased efficiency, especially if accompanied by a global regulatory umbrella ensuring coordination and some universal standards.
Solution: global economics. The core of the problem is that the emergence of the global economy has not been accompanied by the rise of a new, global level socio-economic modelling framework, and thus the solution is ‘global knowledge leadership’. The basis of this argument is the assumption that the knowledge and theoretical underpinning about the socio-economic universe around us is essentially a public good. Thus, although arguably the monitoring of the movement of the system given the availability of the data and the framework is delivered most effectively in a competitive framework, we cannot expect the same institutions to provide an innovation in the framework itself. As the new organisation level, the global economy, emerges, the existing toolbox becomes obsolete, the data inadequate. Consequently, the creation of the new framework is a global quasi public good, with manifest policy implications.
It is not going to be a surprise that I’d go with the third version...