Expert View: A sledgehammer to crack excess

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The Independent Online

My grandmother told me that the whole world knows your financial risk aversion reduces as your wealth rises. Quite a lot of academic work backs her up. As the latest financial bubble grew, so did the risk-taking behaviour of those caught up in it. When risk-taking no longer sustained the heightened expectations, some executives tried less ethical ways of achieving their goals – a process seen many times in previous bubbles. Armed with this knowledge, presumably we should have a structure that helps to prevent such occurrences.

My grandmother told me that the whole world knows your financial risk aversion reduces as your wealth rises. Quite a lot of academic work backs her up. As the latest financial bubble grew, so did the risk-taking behaviour of those caught up in it. When risk-taking no longer sustained the heightened expectations, some executives tried less ethical ways of achieving their goals – a process seen many times in previous bubbles. Armed with this knowledge, presumably we should have a structure that helps to prevent such occurrences.

Instead, we see the ebb and flow of legislation and opinion that always comes after the event, reactive and overdone. My fear is that the current obsession with deregulation has become so ingrained that when the pendulum swings back, as it will, to greater regulation, it will go far too far. The question is, how did we get here in the first place?

The current environment has been produced by the response to the excessive inflation of the 1970s. This involved a tight interest-rate policy and a move to deregulation and labour flexibility. Though unpalatable to many at the time, these measures brought results: 1981 to 2000 was a period of generally very good returns in financial markets. Capital was applied to where returns were available and the efficiency of the free market became clear. The theory of deregulation became received wisdom.

One example of this shift in thinking was the Glass-Steagall Act, introduced in 1934 to bring order to the chaos in the banking sector produced by the bubble of the 1920s. In essence it set out to ensure commercial and investment banking were kept separate. Many felt it was flawed, and, rather than being improved, in 1999 it was repealed as big business carried on the fight against regulation. The rhetoric used in the run-up to repeal was that markets were democratic and didn't need to be regulated. This idea probably found its epiphany in Walter Wriston's 1992 book The Twilight of Sovereignty. Markets, he said, were "global plebiscites that pass democratic judgement day and night".

In the US, this type of thinking gained force to the extent that by 1997 commentators were predicting that deregulated markets and technological development would together deliver "an economic expansion without end that will eventually solve just about every known social problem".

But a belief in the democratic powers of markets is flawed because they are amoral. If they had an inherent morality, then alcohol and defence companies would have a much higher cost of capital than other companies. They don't. This doesn't make markets bad; it merely highlights that their job is to apply capital to wherever returns are attractive. It is the imposition of a regulatory backbone that provides the moral structure.

The US government has been quick to address problems raised by the bubble, but these problems run deeper because deregulation remains the received wisdom. The whole question of an appropriate level of regulation needs to be addressed, especially in the international financial markets, and with an eye to the future rather than as a reaction to the past.

As an example, we are now undergoing a downward revision of expectations, the corollary of which is attacks on those who seem to have gained most from the excess. The truth is that being "overpaid" extends way beyond business (how about sport?), but if the issue is not addressed, then aggressive regulation will be the result. Such an environment will be tougher for companies and bad for investors. Early, but sensible, action is desperately needed.

Dominic Wallington is pan- European equities fund manager, Invesco Asset Management.

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