Invisible hand of morality

I enjoyed writing my MINT column for Tuesday on the rise of socialism among millennials and how capitalism – both ‘arms-length’ and ‘arms-around’ varieties – brought about this love for socialism. The MINT column was triggered by ‘The Economist’ cover (16th February 2019) and the ‘leader’ on the topic. While researching for the topic, I came across a paper by Amar Bhide titled, ‘An accident waiting to happen’ written in 2009. It is a well-written paper – both cogently and passinately argued.

In my MINT column, I argue that both arms-length capitalism and relationship capitalism (citing an example from India) had failed and the common reason for that failure is that morality has disappeared from both forms of capitalism. The common belief stemming from a faulty reading of Adam Smith’s ‘Wealth of Nations’ was that morality was not required. Self-interest was both necessary and sufficient to drive collectively beneficial outcomes. It is quite possible that Adam Smith never meant it that way. I had covered that in an earlier blog post. The visible hand of morality was the foundation or pillar of capitalism. My argument and Amar Bhide’s arguments are not mutually exclusive.

In his paper, Amar Bhide argues that the crisis of 2008 was a case of humans lacking in humility (excessive belief in mathematically determined probabilities) and failing to factor in the law of unintended consequences. He argues that tight securities market regulations (investor protection laws; insider trading rules, etc.,) created arms-length capital markets in which nobody had a stake and hence, managers looked after themselves. No single shareholder was powerful enough or interested enough to stop excesses of managements.

Similarly banking or financial deregulation, he says, enabled banks to take on risks that they otherwise would not have. He cites abolition of inter-state banking, repeal of Glass-Steagall, proprietary trading, etc. Federal Deposit Insurance encouraged banks’ excessive risk-taking: moral hazard. Ho brw come economists ignored moral hazard in this matter? With deposit insurance, depositors were not interested in monitoring risk-taking by banks.

He writes:

In the narrative offered by Rajan and several other economists, exogenous technologies played a deterministic role, inexorably forcing changes in regulation and financing arrangements. But technology might, instead, have facilitated relationship banking…. The outcome was not predetermined. In fact, in the story that I have told here, the increased share of securitized financial assets was driven mainly by the beliefs of financial economists and regulators. [Link]

His conclusion is pithy, sharp and correct:

Economics has underpinned securitization through its embrace of mathematical models to the exclusion of other perspectives, and through a complementary tendency to ignore the downside of liquidity and arms-length relationships. Regulation has brought this way of thinking into the world of practice in two paradoxically related streams: by increasing the scope and effectiveness of the New Deal securities acts and subsequent rules that fostered the growth of arms-length transactions in corporate control; and the progressive dilution of New Deal banking acts, which nurtured and protected long term relationships. This is the complicated story that may explain why developments in mortgage banking, of all things—traditionally the plodding, conservative bread-and-butter of depository banking—should have led to the implosion of the world economy.

I also chanced upon two of his op.-eds. One calls for the end of the Federal Reserve (as we know it) and the other faults the IMF for encouraging reckless lending by banks in foreign currencies to emerging sovereigns. Who, in their senses, could disagree with his (and his co-author’s) arguments?

Notwithstanding all of these, I could not resist pointing out in my column that the love of socialism is misguided and that humans were once again falling back on lazy answers. In this regard, the article I had cited in my MINT column on the case for wearing fur and leather was very thoughtful. The costs imposed on societies by misguided and/or uninformed do-gooders are substantial. I encourage you to read it.

I would also like to recommend reading a blog post I had written little less than six months ago.

Whose sufferance?

This is not a long article but makes some important points. It is about technology taking over our lives. AS always, it is an outcome of ‘means’ becoming the ‘end’. Technology was the means to a comfortable life. But, because we chased it too hard, technology has become the ‘end’ in itself and it is now dominating our lives.

IF you are not convinced about the conflation of ‘means’ and ‘ends’, read this paragraph by George Dyson:

The search engine is no longer a model of human knowledge, it is human knowledge. What began as a mapping of human meaning now defines human meaning, and has begun to control, rather than simply catalog or index, human thought. No one is at the controls. If enough drivers subscribe to a real-time map, traffic is controlled, with no central model except the traffic itself. The successful social network is no longer a model of the social graph, it is the social graph. This is why it is a winner-take-all game. Governments, with an allegiance to antiquated models and control systems, are being left behind. [Emphasis mine; link]

This warning by a MIT professor in 1970 was very prescient:

While Minsky believed that A.I. might solve the world’s problems, he also recognized how it could all go drastically awry. In an interview with Life magazine in November of 1970, Minsky warned: “Once the computers get control, we might never get it back. We would survive at their sufferance.” In one of his more famous premonitions, he posited, “If we’re lucky, the [machines] might decide to keep us as pets.” [Link]

The reference to the work of Arthur C. Clarke, ‘Childhood’s End’ is interesting. One should check it out.

Perhaps, this tribal community in Nagaland, in its own way, is showing us the way?

Michael Jensen’s legacy

(1) This link takes us to the work by Alex Edmans of London Business School, showing how CEOs release news in the month in which his share sale takes place. He and his co-authors do control for many other factors.

(2) This paper shows corporate stock buybacks and executives’ share sales are linked.

I got the link to the article by visiting his home page. Click on the Jan. 18 paper. A good summary of the paper is here.

(3)  In turn,  I was led to the HBR article from this blog post.

(4) While you are at it, do not miss this FT Alphaville post which is also linked in the above blog post by Jesse Felder.

In a way, this shows up the inadequacy of Michael Jensen’s work. Or, to put it differently, the law of unintended consequences is always operational and tha the road to hell is paved with good intentions.

Or, third, it proves my point that whatever starts as MEANS to an END becomes the END in itself. That is what Sapiens always do.

Postscript: let us not forget what makes debt-financed share buybacks feasible: ultra-low interest rates of central banks done in the name of supporting the economy

India should not let Finance become a Frankenstein monster

On January 20th, I read in THE HINDU that Indian stockbrokers wanted the Securities and Exchange Board of India to roll back its new risk management norms for derivatives. I was both amused and not amused. Along with Praveen Chakravarty and Ajit Ranade, I had written about the need for tightening risk management norms for derivatives exposure in Indian stock markets. Prior to these op.-eds., in our co-authored book, ‘Economics of Derivatives’, Dr. T.V. Somanathan and I had highlighted that derivatives were almost wholly used for speculation (=gambling) rather than for hedging.

That does not mean they needed to be banned but the losses from such speculative activity should be borne wholly by the participants who engage in them and that they should not have systemic consequences.

Based on the news-story, one does not get the impression that the brokers have provided any solid arguments or evidence that the proposed margining requirements would do zilch to reduce risk. In fact, their very protest is solid indication that it would. If it resulted in a lower volume or transactions in the derivatives markets, it is good for systemic stability.

This is a classic example of the case of socially useless finance. India, at this stage of development, does not need to go out of its way to facilitate such financial market activities. Instead, it should do what SEBI is trying to do now.

My co-author Gulzar Natarajan and I have finished our manuscript, ‘The Rise of Finance: causes, consequences and cures’ and we have received the first proof from the publisher. We hvae a special chapter on India. India needs to avoid repeating the mistakes that the West made with respect to Finance. The West allowed Finance to become a Frankenstein Monster and India does not have to repeat that mistake.

The myth that secondary market trading facilitates efficient capital allocation in primary markets has been persisted with, for too long, without being subject to the burden of proof. Shrinking investment horizons alone should have let that theory be put to rest permanently. It has not.

Buttonwood, in its penultimate column in ‘The Economist’ last year had written on the ‘Flaws in Finance’. There was a link to his earlier article published in May 2015. Both the short piece from May 2018 and the long essay he had written from May 2015 are thoughtful and make for good reading. But, his conclusions are vague. Here are two samples:

For all their criticism of mainstream economists, the challenge for the behavioural school is to come up with a coherent model that can produce testable predictions about the overall economy. [Link]

Here is the second one:

For too long economists ignored the role that debt and asset bubbles play in exacerbating economic booms and busts; it needs to be much more closely studied. Even if the market is efficient most of the time, we need to worry about the times when it is not. Academics and economists need to deal with the world as it is, not the world that is easily modelled. [Link]

In contrast, witness the most practical suggestion from Cliff Asness:

Making people understand that there is a risk (and a separate issue, making them bear that risk) is far more important, and indeed far more possible than making a riskless world. And if I may go further, trying to create and worse, giving the impression you have created, a riskless world makes things much more dangerous. [Link]

Honestly, the call for new models, etc., are either diversionary or distracting. They are not needed. One does not have to have new behavioural models that incorporate human irrationality. In fact, all that is needed is for policymakers to be reasonable.

(1) You may believe that markets are mostly or, for the most part, efficient. I do not. But, you can accept that humans can and do make mistakes. That is reasonable assumption.

(2) That one does not ignore empirical evidence is a reasonable thing to ask of policymakers

(3) That one requires policymakers to be able to see through the self-interested demands of the financial sector is not such a onerous demand either.

(4) Policymakers simply have to stop writing CALLS and PUTs for the financial sector. That is what Cliff Asness is saying in the quote above. Central banks do not have to remove risk from the lexicon for the financial sector and, in the process, encourage them to take excessive risks that put the economy and their goals for the economy in peril.

The fear of surprise, volatility and the realisation that policy will not be beholden to the financial sector even if there is short-term pain need to be inculcated in the financial sector.

What India’s brokers ask of SEBI is what the American financial sector has been asking of the Federal Reserve in the last thirty years and been getting, up to yesterday.

India does not have to walk the American way in this matter.

Everybody talks inequality

Raghuram Rajan has a piece in ‘Project Syndicate’ in which he echoes Paul Tucker on central bankers but stops of advising them to not to go to Davos, as Paul Tucker did. In any case, if this FT story is true, there won’t be much tears shed. How times have changed?!

An extract from Raghuram Rajan’s article on central bankers:

And, of all elites, central bankers seem to have the most strikes against them. Most have doctorates and speak in a language that nobody else understands. The quintessential “citizens of nowhere,” they meet periodically behind closed doors in faraway Basel, where they discuss global financial conditions and the systemic effects of monetary policies. What they do not talk about, many believe, is Main Street, except when it factors into discussions about inflation.

No wonder there has been such a decline in public trust. It is bad enough when average citizens can scarcely understand the complicated tradeoff between inflation and unemployment. It is worse when one adds in public grievances over Wall Street bailouts and the perception that central bankers are focused on global conditions instead of domestic concerns. Yes, it is every central banker’s job to think about such things; but that job is increasingly being met with suspicion by those who aren’t in the room. [Link]

Overall, the piece tries to cover too many grounds and offers too little by way of answers. His piece, however, triggered my interest in the inequality topic and I re-hashed some of the recent pieces I had read in the last twelve months or little longer. The links are here:

https://washingtonmonthly.com/2017/11/06/how-the-rich-rig-regulations/

https://www.nytimes.com/2017/11/17/upshot/income-inequality-united-states.html

https://www.nytimes.com/interactive/2017/12/14/business/world-inequality.html

https://www.livemint.com/Opinion/sMRTHlLePT4cfXTkjM7JOM/Angus-Deaton–How-inequality-works.html

I had blogged on the topic here and I think that remains an answer!

70% top marginal tax rate and other links for the weekend

Alexandria Ocasio-Cortez favours 70% marginal top tax rate to pay for climate change. Something to think about?

When Wall Street firms behave in this fashion, Alexandira Ocasio-Cortez’ proposal does not seem so outlandish or outrageous. The story is about Goldman Sachs with 1MdB in Malaysia and Credit Suisse in Mozambique:

According to the International Monetary Fund, the loans Credit Suisse and others arranged effectively doubled the cost of servicing the country’s debt. …

Mozambique defaulted and then restructured its debt. Last year, the country’s economy was due to grow at the slowest rate in 18 years — a burden that its citizens will be left to bear. 

Whatever the outcome of these cases — no doubt, risk controls will be tightened and new standards set — the bitter taste of these experiments with market capitalism will linger. [Link]

On climate change, these lines should strike fear in Indian hearts. It is about Yemen:

“The civil war in Yemen seems to be a politically-motivated competition for power among many actors with varying motives,” he wrote in his paper. “But underlying all other motives is the ongoing need by all parties to secure access to the diminishing water supply.” [Link]

Staying in the desert, let us read Noah Smith’s article on Saudi Arabia. The drastic fall in the fertility rate in the country is remarkable.

This FT article on how investors are pushing companies to look at all stakeholders’ welfare rather than maximise profits as Milton Friedman advised in 1970 was not impressive because it did not have any other name than Larry Fink, as the investor doing it. In other words, institutional investors are not exactly forcing companies to look at a bigger picture than shareholders, much as the FT writer would like to believe or have us believe.

But, it was good to see that the now-departed chairman and founder of Southwest Airlines walked his talk on profits and employee welfare too. Remarkable story, written well by Joe Nocera.

“Should a self-driving car kill the baby or the grandma? Depends on where you’re from.” That is the header of an article in MIT Technology Review. The article presents results of a voluntary survey in which millions participated from different countries. Responses varied from country to country.

This is a re-statement of the old trolley problem (I did not know about it although I had seen variants of it) in the era of artificial intelligence and self-driving cars.

Greg Ip begins the New Year with an optimistic take on how the world is getting relentlessly better. It is true but it is also true that it is a partial analysis.

Greg Ip has a more penetrating take on the US-China trade dispute. The observations by Senator Dan Sullivan, cited in the article, are pertinent:

Dan Sullivan, a Republican senator from Alaska, personifies these broader forces reshaping the U.S. approach to the world. Mr. Sullivan has followed the rise of China for decades—as a Marine sent to the Taiwan Strait in 1996 in a response to Chinese provocations; as an official in George W. Bush’s National Security Council and State Department; and for a time as Alaska’s commissioner of natural resources.

As companies moving goods from China to the U.S. face heftier tariffs, some have developed creative techniques to avoid paying them. The WSJ’s Steven Russolillo takes to the field to explain how some businesses sidestep import duties.

When Mr. Xi visited the U.S. in 2015, Mr. Sullivan urged his colleagues to pay more attention to China’s rise. On the Senate floor, he quoted the political scientist Graham Allison: “War between the U.S. and China is more likely than recognized at the moment.”

Last spring, Mr. Sullivan went to China and met officials including Vice President Wang Qishan. They seemed to think tensions with the U.S. will fade after Mr. Trump leaves the scene, Mr. Sullivan recalled.

“I just said, ‘You are completely misreading this.’” The mistrust, he told them, is bipartisan, and will outlast Mr. Trump.

The Guardian has an unsurprisingly condescending piece on the new Brazilian President. I think he is interesting and India needs to build its ties with him closely before China does.

This NYT profile article on Bob Lightheizer is a good one. More strength to him.

A colleague of mine pointed to this CATO Institute policy analysis titled, ‘Nostalgia and the Liberal Order’. Yet to read it. I like the sound of it, though. It was published in June 2018.

Klarman vs. Friedman

I thought I blogged on it but I had not. On November 11, I had read a good piece by Luigi Zingales in FT on maximising shareholder welfare and not shareholder value. That did appear somewhat incomplete to me. What he was trying to say was that maximising shareholder welfare over the long-run means attaching less importance to shareholder value in the short-run.

I forwarded it to the students at the IFMR B-School with the following message:

As you have access to FT and WSJ, you should read more such articles. 

In the class, you can also discuss whether what Boeing did – withholding information – is correct, even if it maximised profit and shareholder value in the short-run.

Sometimes, one does not have to change one’s goals. It can be still profit maximisation and shareholder value but having a long-enough horizon will make all the difference.

I was happy to find that Seth Klarman echoed my thoughts in his address at the Harvard Business School at the inauguration of the Klarman Hall on October 1. HBS Alumni Association carried that speech two months later in December:

Consider corporate time horizons. It’s a choice to attempt to maximize corporate results over the very short run and a different and sometimes harder decision to take a longer-term view. I’m convinced that one of society’s most vexing problems is the relentlessly short-term orientation that manifests itself in investing, in business decision-making, and in our politics. Educational and philanthropic endowments, for example, with institutional time horizons that necessarily span centuries, invest their funds with monthly performance comparisons.

This is the same as what I had told my students in my brief email to them. In fact, the running theme of Seth Klarman’s speech was about short-term vs. long-term horizons. It is short and well worth a read.

In fact, in his speech, Seth Klarman questions Milton Friedman’s credo that the social responsibility of a business was to maximise profits. Recently, I read somewhere that Milton Friedman had caveated it. But, I do not think that the caveat was adequate. This was his caveat:

I have called it a “fundamentally subversive doctrine” in a free society, and have said that in such a society, “there is one and only one social responsibil ity of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception fraud.” [Link]

This is too narrow. It does not include ethics. Not to be deceptive is not the same as doing the right thing. This is almost legalese. To engage in open and free competition is not as forceful as arguing that businesses should not actively smother or kill competition by buying them out and then killing the business. Milton Friedman also did not anticipate how humans would interpret him to their convenience.

He did not have a long-enough horizon himself to think of how humans, with short-term horizons, would interpret him!