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.

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

Pre-announcement of our new book

I have some good news to convey:

Our (Yours truly and Gulzar Natarajan) co-authored book, ‘The Rise of Finance: Causes, Consequences and Cures‘ has been accepted for publication by the Cambridge University Press. It is now ‘syndicated’ for publication. Have to deliver the manuscript before I go on a holiday end of this month. Will provide further updates on the timing of the launch of the book.

The Thiruvadanthai trilemma

Although my friend Srinivas Thiruvadanthai did not mean to pose the question as such, I thought I would credit him with a ‘Trilemma’ that, I hope, will remain for posterity! His blog post triggered the following thoughts:

Another thoughtful and thought-provoking post as usual, Srini. The last paragraph of the post has been the rallying cry of BIS economists from White to Borio (including Cecchetti or not?).

I found the paragraph on the ‘ex-post criticism’ of the Fed not being easy enough in mid-2008 to be particularly insightful. Hindsight is a gift for critics that is denied to policymakers in real time!

The blog post can be considered a formulation of ‘Thiruvadanthai Trilemma’ between free-market finance, financial stability and economic stability. You can have two of the three but not all of them.

Notice that I have taken interest rates out of this trilemma. That is deliberate. In other words, the problem that there is no one single interest rate that stabilises the financial economy and the real economy at the same time disappears if (a) we remove the paradigm that ‘markets know best’ particularly for the financial sector and for financial markets (in a sense, I believe, the comments by Ms. Carolyn Sissoko reflect that) and if (b) the relevant horizon to evaluate the correctness of the monetary plolicy setting was long enough.

Let me take up my point (a) above. The question is whether regulating finance alone is both necessary and sufficient to enjoy both financial and economic stability at the same time. Yes, some would say.

That is what Ms. Caroline Sissoko has said in her coments on his post. But, is that really the case? We will never know because two things were at work in the post-Great Depression period and, in particular, in the post-WW II period. Economic growth was a low-hanging fruit. Therefore, it is possible that, regardless of how the financial sector or financial markets behaved, sustained high growth would have washed away all sins – with or without tight regulation. We will never know.

Therefore, it logically follows that in the era of slower growth that we face now, the case for financial sector and financial market regulation becomes stronger and not weaker.

Critics would object that this would further jeopardise the already lower growth. Well, the IMF has the answer. In a paper that is now a book, ‘Too much Finance’, the authors argue that financial development in advanced nations has already crossed the theshold at which it is beneficial for economic growth.

So, financial sector/financial market regulation will take care of the ‘Thiruvadanthai Trilemma’.

Fortifying that will be a monetary policy setting that chooses its relevant horizon more carefully than what central bankers have done in the last three+ decades. It should be longer than the business cycle so that it encompasses the financial cycle. I am merely paraphrasing the arguments made regularly by BIS economists. That is my point (b) above.

In a long enough time horizon, the dilemma, of fixing a high enough rate that handles financial market exuberance without hurting real economic activity or a low enough rate that allows financial intermediation to repair or to resume while the economy is overheating, solves itself.

In recent times, I beleive that the former dilemma has imposed much bigger long-run costs on the economy and on the society than the latter dilemma, in the above paragraph.

If unelected and technocratic policymakers optimise their decision over a reasonably long time frame, then the need for (or, the impossibility of) multiple policy rates is avoided or obviated.

If they cannot do that in practice that easily, then another approach is to have the domestic economy counterpart of ‘unremunerated reserve requirements’ that is applied to regulate capital flows. There can be a counter-cyclical credit surcharge (or discount) that the central bank, in its capacity as a banking regulator, prescribe for credit allocation, on the top of the policy rate. There can be times when this surcharge (negative or positive) can be zero. In that case, the policy rate works both for the financial economy and for the real economy. This can be on top of (and not in lieu of) countercyclical capital buffers that regulators now want to impose on banks.

Only one firm matters

An extraordinary proportion of people with training and experience in finance have worked at the highest levels of every recent presidential administration. Four of the last six secretaries of the Treasury fit this description. In fact , all four were directly or indirectly connected to one firm: Goldman Sachs. This is hardly the historical norm : of the previous six Treasury secretaries, only one had a finance background .

In 2001, following revelations of accounting irregularities, Enron verged on collapse, which meant that Citigroup, a major lender, would lose a significant amount of money. Fulfilling a request made by Michael Carpenter, head of Citigroup’s investment banking unit, Rubin called Peter R . Fisher, then undersecretary of the Treasury and asked him to consider advising the bond – rating agencies against an immediate downgrade of Enron’s debt. In other words , Rubin (a Democrat ) lobbied Fisher (a Republican ) to help bail out Enron. ( So much for Washington’s ideological divide.)

What Rubin did was technically legal, as The Economist explained, only because Bill Clinton , in his last days as president , had canceled an executive order that barred top officials from lobbying their old departments for five years after leaving office.

Source: Zingales, Luigi. A Capitalism for the People: Recapturing the Lost Genius of American Prosperity (p. 68). Basic Books. Kindle Edition.

Today, of course, there is far more money riding on the models than in the 1980s – and when it comes to positive feedback, size matters. Indeed, another example of positive feedback is the relationship between the financial sector and regulators. As the sector increases in size, it gains more influence over the government; this allows it to change regulations in its favor, which allows it to grow even larger, and so on, until it becomes Goldman Sachs.

  • Sometimes called Government Sachs, because of the remarkable ability of its alumni to go straight into senior levels of government, perhaps related to the fact that the firm is a leading corporate donor to political campaigns (Baram, 2009). It is even better represented at central banks. Four of the Federal Reserve’s 12 regional banks  are currently headed by former Goldman Sachs executives. Only five banks have voting power, in a rotating fashion, and in 2017 ex-Goldmanites will hold four of these votes. Together with Mark Carney at the Bank of England and Mario Draghi at the European Central Bank, this means that interest rate decisions for much of the world’s economy are made by people who came from a single firm. Nothing to see here, move along.

Source: Wilmott, Paul; Orrell, David. The Money Formula: Dodgy Finance, Pseudo Science, and How Mathematicians Took Over the Markets (Kindle Locations 4524-4527). Wiley. Kindle Edition.