A Bankruptcy Lawyer’s Blog

First Looks: The Squam Lake Report: Fixing the Financial System

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In the fall of 2008, fifteen of the world’s leading economists–representing the broadest spectrum of economic opinion–gathered at New Hampshire’s Squam Lake. Their goal: the mapping of a long-term plan for financial regulation reform.

The Squam Lake Report distills the wealth of insights from the ongoing collaboration that began at these meetings and provides a revelatory, unified, and coherent voice for fixing our troubled and damaged financial markets. As an alternative to the patchwork solutions and ideologically charged proposals that have dominated other discussions, the Squam Lake group sets forth a clear nonpartisan plan of action to transform the regulation of financial markets–not just for the current climate–but for generations to come.

Arguing that there has been a conflict between financial institutions and society, these diverse experts present sound and transparent prescriptions to reduce this divide. They look at the critical holes in the existing regulatory framework for handling complex financial institutions, retirement savings, and credit default swaps. They offer ideas for new financial instruments designed to recapitalize banks without burdening taxpayers. To lower the risk that large banks will fail, the authors call for higher capital requirements as well as a systemic regulator who is part of the central bank. They collectively analyze where the financial system has failed, and how these weak points should be overhauled.

Combining an immense depth of academic, private sector, and public policy experience, The Squam Lake Report contains urgent recommendations that will positively influence everyone’s financial well-being–all who care about the world’s economic health need to pay attention.

Review:

The problem with this book is that it was written completely by a group of economists who accept the standard underlying Benthamite Utilitarian philosophy of Maximizing Utility.The updated version,expressed in modern mathematical terms,is called Subjective Expected Utility (SEU).THe SEU model assumes that risk assessment analysis ,based on the Ramsey-De Finetti-Savage personalist approach to probability,allows its users to make careful and sophisticated reward-risk tradeoffs based on the assumptions that the probabilities or decision weights are linear and additive.This allows one to use the normal(log normal) probability distribution to quantify risk assessments and make safe risk-reward(return) tradeoffs using the variance or variance -covariance matrix.This approach is ,in fact, a special case of a much more general theory of decision making outlined by Keynes in his A Treatise on Probability that demonstrated that nonlinearity and nonadditivity were the general case.This means that the normal (log normal )distribution fails to represent the risks resulting in stock and money markets, especially from speculative stock market activity where debt leverage ,using bank loans, is used in an attempt to greatly increase the returns.Specifically ,the belief that a normal distribution can be used to assess the risk of the use of derivative contracts and credit default swaps is completely erroneous.
Four philospher- economists ,Adam Smith,John Maynard Keynes,Benoit Mandelbrot and NN Taleb, recognized ,in one way or another,the severe dangers that can result from the creation of new speculative instruments,which is misleadingly called financial innovation,financial engineering or securitization,involving the banking industry over time.None of these four are mentioned in this book.

Another shortcoming involves the discusssions on page 5 of the link between AIG and Goldman Sachs .THe discussion completely fails to state that the credit default swaps were purely speculative trading arrangements that served no economic function relating to the provision of any real good and/or service.

I will close this review by quoting Warren Buffett’s 2002 warning about the grave dangers of using financial derivatives.” The rapidly growing trade in derivatives poses a ” mega-catastrophic risk…derivatives are financial weapons of mass destruction that could harm not only the buyers and sellers,but the whole economic system”.(2002 Annual Report,Berkshire Hathaway).

This is precisely what happened.The whole economic system has been severely damaged by the Wall Street ,supply side ,casino capitalism approach which is built on the SEU approach .Unfortunately,this book’s conclusions, concerning the need for both more severe regulation and the regulation of the use of financial derivatives ,wants to keep the current systems’s major flaw intact.The major flaw in the current system is that it is built on a few large maga banks.Smith recognized that a very small number of very large banks endangers the financial system. What is needed is Adam Smith’s suggested use of regulation to prevent projector firms like Goldman Sachs and AIG from getting bank loans combined with a very large number of small banks.