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August 29, 2012

A word on LIBOR

Up until a few years ago, I had no idea what LIBOR was. (Probably no worse than 99.9% of the country's population.) But 2007 and 2008, LIBOR became The Thing To Follow, so I looked up what it was.

And I thought: What? Why would anybody pay one second's attention to this?

But then I thought: What the heck do I know about finance? It must be a sound, smart practice to pay attention to it.

Well, score one for initial impressions:

At its heart, it is an honor system. . . . [How well do honor systems usually work?]

But if LIBOR's rates can be so easily manipulated, why use them? After all, the financial world offers a cornucopia of rates that are set by the marketplace and are therefore virtually impossible to rig. Rates on government and corporate bonds, for example, are governed by supply and demand and can be tracked through trading data, while LIBOR rates cannot.

"It's surprising that LIBOR has become so important, because of the imprecision and the lack of verification" by regulators of the rates that banks report, states Wharton finance professor Jeremy Siegel. . . .

"This may be another good example of Goodhart's Law: Whenever you focus on a rate for policy purposes, you will set up incentives to manipulate the rate," Herring notes.

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