Corrupting risk on top of the surplus pyramid

If developing countries take on debt that is stolen, spent on patronage or simply poorly invested, the debt increases, not decreases, their economic and financial vulnerability. The contrast with ordinary business and household debt is marked--a loan which was likely not to improve the capacity to pay the loan back, whose only likely effect was to increase the financial vulnerability of the borrower, would not be regarded as a good commercial risk. Loans which increased vulnerability were also a feature of US mortgage markets, making the similarities between the corrupted public debt market and the corrupted US mortgage market even clearer.

Unstable irresponsibility

Anything which systematically shields agents only from downside risk increases instability in the system. (And do so even if they only believe they are shielded from such--see any asset bubble of your choice.)

If risk-managing firmsmove from being (pdf) full-liability partnerships to limited liability corporations, that shields the actual managers of risk from downside risks. If the state makes deposit insurance compulsory, or otherwise guarantees deposits, that shields managers of risk from downside risks.

Such shielding of agents from downside risk tends to increase the private return to risk management while increasing the social costs. The obvious way to correct such systematic imbalance in downside exposure to risk is to have compensating prudential regulation. The argument for full deregulation of prudential regulation rests on firms as decision-agents-bearing-risks, but modern corporations separate risk and decision-making, leading to perennial corporate governance problems. It is actually rather foolish to analyse firms' risk management without paying attention to their internal structures, since what institutional incentives exist will clearly affect patterns of behaviour.

There are wider grounds for prudential regulation of financial institutions, due to such considerations as herd behaviour in highly liquid markets being a rational response to limited attention resouces and to uncertainty. Uncertainty, information limitations, fluidity and the existence of financial assets meaning that demand is not an immediate function of supply (of non-competing products, to state Say's Law [pdf] correctly)--since transacting can be deferred, leading to the "general gluts"/transaction crashes we call recessions and depressions--all make financial markets crisis-prone and crisis-generating.

Too big to fail is just an invitation to fail bigger (pdf). Unless there is compensating prudential regulation. For anything which systematically shields agents from downside risk increases instability in the system.

The great fraud of the current global financial system is that quantifying risk largely eliminates it-if you are managing enough of it.

Worse, to be shielded from consequences is to be shielded from responsibility. To be shielded from responsibility fundamentally undermines moral constraints. It is, in a quite direct sense, morally corrupting. In the sense, and for the reasons, that Lord Acton meant.

If a system of financier privilege is corrupt at its core, it is hardly surprising if it generates even more blatant signs of moral corruption. Such as the Barclays Bank scandal where it systematically lied to manipulate market information, leading to scathing comments from the Governor of the Bank of England. Barclay's corrupted social processes in quite a direct fashion, a society and economy those engaged in the corruption of are premier beneficiaries of (particularly its information flows). In the words of Lord Turner, Chair of of the Financial Services Authority:

There is a degree of cynicism and greed that is quite shocking. I think we would be fooling ourselves if we thought that some of the behaviour and culture evidenced in Libor fixing are not found in some other areas of trading activity as well.

Possibly it is shocking, but it is only surprising if you have not been paying attention to the incentives being created in financial markets for some decades now. (You can call it blowback, if you like.)