The world has become more insecure – and that insecurity may last a generation.
That’s the issue underlying Martin Wheatley’s investigation into Libor, which published an interim discussion paper oday.
Granted, that’s rather more profound than the immediate issue prompting this review – namely, how can one remodel the Libor market which, as most people, including Mr Wheatley agree, is not fit for purpose?
But leaving aside for a moment the possibility of criminal behaviour by traders in fixing the Libor rate, the scandal is a reminder of one of the big issues we are still grappling with in the wake of the financial crisis.
The world is inherently rife with uncertainty. Whether that’s uncertainty about whether a firm will be bust in the next month; uncertainty about whether someone will lose their job and hence not be able to pay their mortgage; uncertainty about the rate of inflation, or interest rates.
But investors hate uncertainty – they want to be able to put money into something in the fullest knowledge of its prospects.
So we rely on whatever metrics are out there to try to measure those prospects: whether it’s a simple price measure, like the gold price, a broad-based interest rate like Libor (the London Interbank Offered Rate) or a credit rating to measure the likelihood of a country, or a company, defaulting.
Those metrics then become a part of the wider system which helps the financial markets function: Libor becomes the basis for other interest rates around the world (at least $300trn, according to the Wheatley Review); credit ratings are linked to a whole range of functions, including the kinds of collateral central banks accept when they carry out their essential monetary activities.
The problem today is that it’s not merely that the world economy is in trouble, and that there is a crisis of confidence in the solvency of banks and countries: those very metrics we have relied on to tell us that story are broken as well.
We can no longer be sure that Libor really reflects borrowing costs for banks. It is hard to be fully confident in the reliability of credit ratings, given the agencies’ spectacular failure to spot the sub-prime crisis – even measures like the inflation index are now coming under question.
All of which is why this is a time of such strife for the financial system: it’s facing both instability and, if you will, meta-instability.
And what if it’s not merely that the measures we’re examining today – whether Libor, credit ratings or, as namechecked by Wheatley today, the spot price for gold – need fixing? What if they never really did the job we thought they did in the first place? What if there isn’t really a decent comparable rate of interbank borrowing? What if there is no decent measure of a country’s solvency?
What if trillions of dollars worth of investments out there are based on something that can never properly be measured?
As Sir Mervyn King said earlier this week (emphasis mine): “There is a real problem that people need to face up to which hasn’t been faced up to, which is that before the crisis it was reasonable to suppose that there did exist something called an interbank unsecured rate, in other words the interest rate at which banks would lend to each other for three or 12 months…
“But since the crisis what’s become very apparent is that there is no such thing as the interbank borrowing rate… I think the fundamental question that people have to face up to is, does it make sense to base hundreds and billions of dollars and pounds of transactions on linking to something that doesn’t actually exist?”
It all goes back to a natural human inclination: we do whatever we can to minimise insecurity in our lives.
Some would say that’s the function religion originally performed: helping provide an ordered framework for living in an inherently chaotic and unpredictable world; and that’s what science does in the modern era. Measures like Libor and credit ratings performed a not-dissimilar function in financial markets.
Either we need to replace them with better measures – even if we suspect that such measures are chimerical – or we must try to live without them, and tolerate a lot more uncertainty. Which means a period of instability that will last well beyond this Libor crisis.