If only more of the world’s financial markets were actually markets

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The Curious Capitalists spent last week visiting the Getty Center, the San Diego Zoo, and various other Southern California attractions. All the while I was getting bits of information here and there about the strange state of global financial markets, and feeling very out of it and confused. I’m still nominally on vacation today, but have no major excursions planned and am in a place (my Dad’s house) with a reliable Internet connection. So I read the WSJ and the FT online this morning, and now feel slightly less out of it but even more confused.

The main impression I get is that nobody has the remotest grasp of how much trouble is out there, how long it will last, etc. Which explains why markets have been so jumpy, why banks have been scared of lending to each other, etc.

This would seem to be the natural consequence of building giant global financial markets on a largely over-the-counter basis. That is, the securities causing all the problems at the moment aren’t traded on any kind of organized market with clear rules of conduct and disclosure requirements (U.S. stocks, which are, were up 0.4% last week). It’s all make-it-up-as-you-go-along.

As you’ll hear all the time from Wall Street and its partisans, this free-for-all encourages all sorts of swell financial innovation. They’re surely right about that, but it also encourages all sorts of really stupid financial innovation like the sort that swept through the U.S. mortgage market over the past couple of years. And when the stupidity of a particular innovation begins to dawn on people, it can take months to figure out just how bad the damage is because there’s no real market with regular trading and regularly posted prices on which to work things out. Then, when things get so scary and uncertain that the Federal Reserve and European Central Bank feel the need to jump in with barrels of cash, the stupid innovators get bailed out along with the smart ones.

So here’s a thought, and it’s not well enough informed to be more than just a thought: Maybe the world’s central bankers should be doing more to encourage the creation of formal markets in all these weird new securities being traded around the globe. They could say ahead of time, for example, that when they do one of their periodic bailouts (liquidity infusions, if you prefer) they won’t accept as collateral securities that don’t meet prearranged standards of transparency, liquidity, etc. Investment banks would still be free to come up with strange new products to buy and sell, but always with the idea that if the things took off they’d eventually have to be moved to some sort of formal derivatives exchange or risk getting completely wiped out in a liquidity crunch like last week’s.

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