The Rise of Finance

The article is an extract from a forthcoming book. It is thoughtful and thought-provoking.

Some paragraphs are exactly in line with the sentiments expressed in ‘The Rise of Finance: Causes, Consequences and Cures’ and those were the sentiments that motivated our book:

Jensen and his co-author, William Meckling, proposed a series of measures to correct then-prevailing ideas about corporate governance. They argued that the owners of stocks and bonds should push corporate management to attend very closely to the price of their company’s shares and less closely, if at all, to the needs of society.

It’s always tempting to think about the way things turned out as having been inevitable—as the only possible response to vast, irresistible forces—but history is always contingent.

But there was a problem. The shareholder revolution and the rise of finance made the kind of social vision that Berle, Drucker and others were promoting for post-World War II America impossible to sustain.

Just as political systems a century ago had to adjust in response to the social dislocations produced by industrial capitalism, today they are adjusting to the social consequences of the financial revolution of the late 20th century.  

This became the theoretical accompaniment to a great remaking of the relationship between corporations and finance, which put finance in a much more empowered position.

We are at an inflection point in the world. The Conservative movement in the UK is in disarray. The Labour Party has radical (but unviable) ideas. In the USA, the Democratic Party’s balance of power has shifted decisively to the Left.

To a large extent, the rise of finance and the corporate greed that rose along with it are to be blamed for this.

Postscript: it appears that Binyamin Applebaum’s book also mentions ‘financial liberalisation’ as one of the bad ideas to have emerged from ‘free market’ economists. I have not read the book but here is a review of the book (ht: Rajeev Mantri).

Sovereign dollar bonds

Many of you might have noticed that the Indian government announced a plan to borrow in dollars in international capital markets. It will be India’s first foreign currency sovereign borrowing from capital markets.

In one short sentence, it is ill-advised. If you thought that the issue of ‘Masala’ bonds (rupee bonds issued for foreigners to subscribe) were safer, that is wrong too. Happy to elucidate. Have done so here.

I wrote about it in my column on the budget published the day after the budget was presented:

One headline that grabbed attention pertains to the government announcing its intention of issuing sovereign debt in foreign currencies. Apparently, India thought of it in 2013 but did not go ahead as the macro fundamentals were deemed dodgy then. But, probably the best time to borrow would be when the domestic currency is undervalued. The Indian rupee in the second half of 2013 was close to being undervalued. Right now, India’s macro fundamentals are not weak, although big question marks remain over the economy’s growth rate, its sustainability and vulnerability to a global stock market correction. In other words, the risk is tilted towards further weakness of the Indian rupee. In 2013, it was tilted towards its strengthening after a hefty correction.

On the other hand, the timing is opportune in another sense because global central banks are back to considering further crazy monetary easing moves. To that extent, raising foreign currency borrowing now is a case of good timing. Another upside is that the government would not be crowding out domestic savings, which have declined in recent years and show no signs of reviving. That is a good thing. [Link]

The above two paragraphs only focused on the micro issue of timing the bond issuance in foreign currency. But, the argument in favour of issuing foreign currency denominated bonds in terms of it not crowding out domestic borrowers is not entirely correct, I admit, because Dr. Y.V. Reddy had pointed out lucidly as to why it is no help to domestic non-sovereign (private sector borrowers).

The argument is this: if India’s safe current account deficit is 2% of GDP and if Government of India borrows from foreigners (it is part financing of the CAD), then the amount available for other domestic borrowers in foreign currency is going to be reduced by that amount. The ‘ceiling’ is unofficially set by the ‘safe’ current account deficit for the country.

Then, on July 9, I wrote more extensively for MINT on the dangers of the Indian government borrowing in foreign currency. [Link]. It might open the door, together with other measures announced in the budget, for greater financialisation of the economy at a time, when its macro-economic health and performance are brittle.

Besides Dr. Y.V. Reddy’s piece, one of the best comments on this subject came from Sanjaya Baru. It is well worth a read.

In this piece, Shankkar Aiyar suggests alternatives to raising dollar resources through sale of sovereign bonds:

Yes, India must raise additional resources and in dollars to finance the aspiration for high growth. Why not raise dollar resources by listing LIC? Why not aggregate surplus land with government into a land bank and call for bids? Why not transfer government ownership of public sector banks and enterprises into an exchange-traded sovereign fund?

The broken world of finance or Does Capitalism need enemies?

I was startled to read these two stories and contrast them with the picture below.

This image file came via courtesy of this website.

This article in Bloomberg gamely tries but fails to make sense of the craze for negative yielding bonds.

Wework floated a debt before filing for IPO! It has been losing money ever since it was founded and it is valued at USD47.0bn!

In contrast,

Regus owner IWG , founded in 1989, has a similar business. It booked revenue nearly twice as high as WeWork did last year yet it has an enterprise value a bit above $4 billion. [Link]

Wework co-founder has reportedly cashed out US$700 million from the company through stock sale and borrowings against shares of Wework. JP Morgan advised him on his sales and it is also advising the company on its debt offering. His shares hold 10 times the voting rights of standard shares. He has properties that are leased back to Wework and he collects millions in rent from Wework! Source: Link

Evidently, he could cash out so much because the company had the chutzpah to issue USD4.0 billion of debt

What a model of ethical capitalism!

It is into this loss-making company with co-founder cashing out such a large sum before IPO that Softbank decided to invest USD 16.0 billion including USD 6.0 billion of new money! The amount was eventually scaled back after partners opposed it.

Blame central banks and their policies for money losing its value and investors losing their heads and eventually, their shirts and trousers.

For a new agency theory?

Private equity firms have also taken advantage of benign credit conditions to cut risk and realize gains sooner. They’ve saddled the companies they invest in with more debt to pay themselves dividends. Issuance of leveraged loans for distributions to equity holders reached the highest in six months in April, according to data compiled by Bloomberg.

Sycamore Partners, a private equity firm know for aggressive bets in the retail sector, pulled a staggering $1 billion out of Staples Inc. last month through a recapitalization that increased the company’s interest expense by $130 million annually. A few weeks later, Hellman & Friedman and Carlyle sold one of the riskiest types of junk bonds from drug research company Pharmaceutical Product Development LLC to help pay for a $1.1 billion dividend. The bond, which allows the company to delay interest payments, was the largest of its kind since 2017. [Link]

I guess I am too old-fashioned to figure out why private equity funds invest in good companies. I thought it was to help them grow and accrue returns for oneself in the process. I realise I am too naive.

Tribal war of hypocrisy and not morality

The paragraph below in the article by Rana Foroohar sums up the hollowness of the Democrats’ idealism and ‘moral outrage’ rathr well:

What’s more interesting and also murkier is why Democrats would list Kraft-Heinz as their most favoured company. As both myself and my colleague John Gapper have written, this is a corporation that exemplifies many of the most problematic aspects of capitalism today, including short-termism and financialisation. And that tells you a lot about the challenges for Democrats today. The Clintonian move towards a “market knows best” approach, which dominated the party’s approach to economics until quite recently, created many of the legislative changes that have driven companies like Kraft-Heinz into the ground — not to mention helping to brew up the financial crisis and create a generation of “socialist” millennials. [Link]

What we are witnessing is not a battle between the ‘ideal’ and the cynical nor between the ‘ethical’ and the ‘unethical’. It is a tribal war between two sets of competing interests, cultures and values. If anything, for one side to clothe itself in the vestiges of morality, ethics and higher values is downright hypocritical. At least, with the other side, what you see is what you get.

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.