Financial System Reform: Just Do It

For 11 years between 1976 and 1998, I worked in Chinese-speaking Asia. Many of my deeper insights into the dark side of human nature came from my experiences there. Not because Chinese society (in its many forms) is darker than American society, but because the darkness is in plain view. It is not a taboo.

Chinese matter-of-factness also makes some conversations easier. In the most awkward of moments one can always agree that things are indeed 很复杂, very complicated, and gloss over the unspeakable. One need not parse exactly who or what is complicated.

Last Thursday morning (2012 1206) I was asked to talk to senior-level officials from the PRC Ministry of Industry and Information (MIIT) about whether our post-Crisis financial reforms can power up the real economy. With responsibility for regulating and developing telecommunications and the digital economy and promoting the national knowledge economy, these delegates came with a fairly well-developed point of view about the efficacy of our reforms (negative). They came to hear the thinking of U.S. academics.

Nominally I am an academic, an Adjunct Associate Professor of Finance at Hong Kong University of Science and Technology. But that is not why I was on their agenda. In the ’80s and ’90s, I worked with Chinese economic reformists; knowledge of the long and winding road to marketizing the Chinese economy gives my presentations a certain caché.

Here were my thoughts:

  1. The main point of our reforms is a renewed focus on financial system design. It may work out all right but in the short run, most measures are weak.
  2. A solid debt capital market architecture has three interlocked cornerstones:
    1. Well-articulated market infrastructure, where information parallels the flow of capital
    2. A consensus theory of value that allows people to debate risk and value with the same set of meanings without stifling independent thought
    3. A public, unified, consistent set of benchmarks on which to convert valuation to wholesale quality grades, also known as a credit rating scale.
  3. Our fractured financial regulatory systems–the de jure ones to be sure but also the de facto system that keeps credit ratings separate from pricing, and from benchmarks of intrinsic cash value separate–gave rise to the Credit Crisis.
  4. The structured finance market will not revive again until we allow the credit rating function (designed as primary market function that leads to price formation) to enter the 21st Century and merge with secondary market pricing and valuation.
  5. The unification of these three facets of the asset valuation problem–credit grading, pricing and liquidation value–can only come together in a modern information economy. If they did come together, the easy money would disappear and growing companies could claim more of the value they create. This fact makes banks reluctant participants in this process. But, without these incentives, intellect (the source of all capital) has no incentive to produce value in the real economy. Not when the regulations make it so easy to plunder it via the financial economy.

How self-defeating our greed is, and how to move past it: this conversation is a national taboo. This taboo makes us weak, not strong. It is an opportunity for China, which is still Marxist, and whose values are still aligned with promoting the real economy, to leapfrog the U.S. while we are in denial.

And frankly, I don’t care who moves first. As the Nike slogan that encapsulated the can-do American spirit said,

Just do it.