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.

Stuff that caught my attention (STCMA) – 15th February 2019

Who would have thought that ‘The Economist’ would be forced to write a leader on the love of the millennials for socialism. I think, once again, the diagnosis is correct. But, the solutions are hackneyed. Capitalism has gone to extremes. Share buyback, financed by debt, and its brazen link to executive compensation are just an example.

Pity that an astute observer like James Mackintosh twists himself too much to exonerate or minimise share buyback. It is hard to understand how one has to be mutually exclsuive about these things. That is, one can be critical of share buybacks and one can also be critical of the other stuff that he writes. Why does it have to be EITHER/OR?

This is incredible. The story is about how some of the corporate bonds that the European Central Bank bought went bust barely a year later. Had it happened in India, all hell would have broken loose and the Reserve Bank of India would have either had to close down and then be reinvented or the entire management and the Board would have had to resign. But, there is barely an eyelid batted in Europe. They preach governance to us. Read these extracts:

Scores of banks and bond investors were freely lending to investment-grade rated companies on not particularly onerous terms back in 2016. Yet the ECB determined that jostling its way to the front of this queue would boost investment and create jobs. What it did create were immediate pricing distortions, with companies able to issue negative-yielding bonds for the first time — charging investors for the privilege of lending to them. …

This QE bezzle was sometimes dramatically revealed even while central bank bond-buying was in full swing. Months after the ECB bought Steinhoff’s bonds in 2017, it had to dump the position at half face value amid an accounting scandal at the retailer. [Link]

I do not think Indians are paying attention to what is happening in Italy although folks of Italian origin continue to make the news in Indian politics. Mateo Salvini, one of the two Italian Deputy Prime Ministers,spoke about seizing the gold reserves from the Bank of Italy. Again, had the Government in India spoken like this, the so-called elites will have concluded that India was doomed forever.

In the meantime, the other Deputy Prime Minister did meet anti-government protesters in France:

Italy’s Deputy Prime Minister Luigi Di Maio said he met leaders of France’s “yellow vest” anti-government movement on Tuesday, an encounter likely to further test already strained bilateral relations. [Link]

Interesting, isn’t it?

For economists who see ominous patterns in the world of numbers, one figure — 18 — is giving pause for thought. Last year, China, the world’s second-largest economy, accounted for 18 per cent of the global economy — just like Japan on the cusp of a decade of stagnation, and just like the Soviet Union shortly before it collapsed.

“In different ways, the USSR and Japan both stumbled when they faced the need to generate growth from more bottom-up, entrepreneurial, service- and network-oriented activities,” says Arthur Kroeber, managing director of research company Gavekal Dragonomics. “Despite a strong record of bottom-up dynamism, China is now moving in a much more statist direction.” [Link]

That leads to interesting political battles too:

Last month, the son of 1980s reformist leader Hu Yaobang warned that the USSR’s demise was due to overly centralised power and over-reliance on a planned economy, in a pointed swipe at Mr Xi. The son of reformist leader Deng Xiaoping has similarly warned that the country’s aggressive international stance could lead to danger. [Link]

The Free Exchange blog in ‘The Economist’ argues that a world without Facebook will be a better place. It might be hard to quarrel with that, even for FB users.

Recommended reading – 10th Feb 2019 edition (part 2)

We need positive change to avoid climate hell. Can we? Colour me sceptical.

This is grim stuff:

Total student loan debt rose 161% for people aged 60 and older from 2010 to 2017—the biggest increase for any age group, according to the latest data available from TransUnion.

Between 2010 and 2017 people in their 60s, like most other age groups, accelerated their borrowing in nearly every category, according to the TransUnion data.

Seniors are finding they have to work longer, holding onto positions younger adults might otherwise receive. They’re relying on credit cards and personal loans to pay for basic expenses. People 65 and older account for a growing share of U.S. bankruptcy filers, according to the Consumer Bankruptcy Project; unlike most consumer loans, student debt is rarely dischargeable in bankruptcy. [Link]

The DNA kit can and did unravel families. What will happen if it becomes ubiquitous in India? Absolutely fascinating reading.

A fiction explores the dark side of Sweden. FT has a book review on it.

A friend forwarded this Brookings blog post on ‘joyless growth’ in India, China and in America. I think it is mostly right.

Jason Gay thanks Katelyn Ohashi for her perfect and joyful 10 in the floor gymnastic exercise. She deserves it every bit. Watch the 2 minute video embedded in the article.

Consistently inefficient

When I read the following in FT, I could hardly suppress a smile:

Chinese economy gets a shot China’s central bank injected a record Rmb570bn ($84bn) into the country’s banking system on Wednesday in the latest effort to boost liquidity and promote increased lending. Global markets responded favourably. (FT)

Stock markets react positively whenever major economies boost liquidity. It is not that stock markets reacted negatively much when the bad news out of China was pouring out. Perhaps, other central banks were pushing liquidity then!

But, they are into lazy investing. Low interest rates and liquidity are what they care about. If you are in doubt, read this interesting article published in New York Times on 10th January and download the original paper too. Investors just do not read annual reports even if they contain information (hints) of bad or good tidings to come. They react only when the actual news breaks out months later. So much for the market’s informational efficiency. 

It is breathtaking that someone got a Nobel Prize for calling the stock markets efficient populated as they are by humans who are anything but. May be, the efficiency of the Swedish Riksbank’s selection committee has to be questioned!

Finance and Federal Reserve

In my first column for MINT for 2019, I dealt with the issue of the Federal Reserve backtracking on its rate hike trajectory. Methinks it is sustained pressures from ‘financial market types’ that led the Fed chairman to cave in. I don’t buy the argument that he is tightening on two fronts: federal funds rate and quantitative tightening. So what? One acts through the banking channel (from the overnight lending rate to bank loan rates) and one acts through the capital markets channel – through the yield curve. All the rates, across the yield cuve, were depressed extraordinarily – in magnitude and for an inordinately long time. So what if all points in the yield cuve were rising? Financial conditions still remained accommodative.

This was the burden of my column. I was not impressed with the arguments of Stanley Druckenmiller and Kevin Warsh nor was I impressed with the arguments of John Mauldin. My friend Gulzar Natarajan had urged me to read his ‘Thoughts from the Frontline’. I read the last four of them last evening. You can read two of them – pertaining to the discussion of Fed monetary policy – here and here.

Nor did Gavyn Davies impress me with his arguments. So what if the Federal Reserve were triggering an economic recession? Recessions must be welcomed after excesses have built up in so many areas – from corporate debt to leveraged loans to market concentration in tech firms

‘Wrath of the financial markets’ that Viral Acharya (RBI Deputy Governor) invoked in a speech in October is felt more by central bankers than governments and that too not in public interest but in self-interest of the financial community.

Dean Baker has a list of ‘facts’ or resolutions to improve debates on economic policy in 2019. Item no. 6 is about finance. His list is about the ‘facts’ that are often obscured in economic policy debates:

6) A large financial sector is a drain on the economy
The financial sector plays an important role in a modern economy. It allocates capital from savers to those who wish to borrow. A poorly functioning financial sector is a drag on growth. The same is true of a bloated financial sector.

The financial industry is an intermediate sector, like trucking. This means that it does not directly provide benefits to households, like a housing, health care, or education. For this reason, we should want a financial sector that is as small as possible for carrying through its function, just as we would want the trucking sector to be as small as possible to deliver the goods in a timely manner.

Over the last four decades the narrow financial sector (securities and commodity trading and investment banking) has more than quadrupled as a share of the economy. It would be difficult to argue that capital is being better allocated or that savings are more secure today than 40 years ago.

This means we have little to show for this enormous expansion of the financial sector. It would be comparable to seeing the size of the trucking sector quadruple with nothing to show in the form of faster deliveries or reduced wastage. Finance is of course also the source of many of the highest incomes in the economy.

These facts make for a strong case for measures that reduce the size of the sector, like financial transactions taxes, reduced opportunities for tax gaming, and increased openness in pension fund and endowment contracts. In any case, it is important to recognize that a big financial sector (as in Wall Street) is bad for the economy, not the sort of thing that we should be proud of.

Reducing the size of the financial sector will also mean that its influence on monetary policy will come down. About time.

Keynes and Krugman

The ideas of economists and political philosophers, both when they are right and when they are wrong are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct economist. [Link]

Most people who know of Keynes and economics would have heard of or read the above quote.

But, these days, it has been more appropriate to reword it the other way around: most economists are usually slaves of some defunct political ideology. Or, they disgrace themselves by allowing themselves to be enslaved by some defunct political ideology or policy idea.

Krugman defending Alexandria Ocasio-Cortez’ proposal for a 70% top marginal tax rate in an indefensible manner is an example of that.

That forms the subject matter of my MINT column tomorrow.

A lumpy error by Tim Harford

By lumping Fed, BoE and RBI in one article, Tim Harford missed out the nuances. Trump’s sniping at the Federal Reserve is unfortunate. America needs a return to normal monetary policy because ultra-accommodative policies have created a lot of imbalances – social and economic. Asset price bubbles are back in many asset classes if not in real estate. Excessive leverage caused the problems in 2008 and leverage ratios are higher now. Eight years of near-zero interest rates and bond buying might have hidden risks in places that would be revealed only later. Therefore, normalisation of monetary policy in America is long overdue. Trump is wrong.

The Bank of England (BoE) inserting itself into the debate on Brexit has been ‘condemned‘ by Mervyn King himself, a long-standing former BoE Governor. Well, he was ‘saddened’. BoE eased pre-emptively in 2016 but the worst macro-economic consequences of Brexit have not materialised.

In India, the story is different. The Reserve Bank of India (RBI) is a creation of Parliament. It is not an independent organ of governance established by the Constitution of India. In the Westminster system of governance India has adopted, institutions created by Acts of Parliament are answerable to the Parliament through the Executive. The Ministry of Finance is answerable and accountable to the Parliament for RBI’s performance. Therefore, the MoF must have authority too, over RBI.

It had ceded the monetary policy function to a committee constituted by RBI and the Government together. The Government has signed an agreement with RBI for inflation targeting and hence the committee is responsible for setting the interest rate. The Government is not commanding the RBI to cut interest rates or intervening in this function. The previous Finance Minister in the previous government did so. He once directed the government-owned banks not to raise their interest rates when the central bank raised rates. That is blatant interference with the transmission mechanism of monetary policy.

The present Government had not acted to curb any institution that has been set up independent of the Executive, by the Constitution. Hence, the question of eorsion of institutional independence does not arise. Nor has it interfered with the monetary policy mandate of RBI which it has ceded to the central bank. One can argue on whether the central bank has excessive capital and whether there is a macroeconomic need for additional liquidity support by the central bank, etc. but the charge of ‘sniping’ is weakly founded.

Further, those who bat for central bank autonomy (independence is illusory except in the case of the Bundesbank and now the European Central Bank) should also bat for central bank accountability. In the West, central banks must be held accountable for their role in the rise of political and economic polarisation (wealth and income inequality and concentration of market power). Arguably, the former is the consequence of the latter.

In India, RBI must be held accountable for its failure to detect and take timely action on the rise of bad debts, on its monitoring of banks’ risk and compliance management systems with respect to frauds and on its regulation of non-banking finance corporations. With respect to monetary policy too, there is a reasonable case that it has been guilty of a doctrinaire approach to inflation-targeting. So, there is really no need to shed too much tears for the exit of the previous RBI Governor.