In his usual straight-to-the-point way, Peter Schiff of Euro Pacific Capital has summarised the recent financial split at the G20 meeting, in the style of the great Jonathan Swift describing the divide between the Lilliputians and the Blefuscudians:
Despite the apparent deficit-cutting solidarity that emerged from this weekend’s G-20 meeting in Toronto, it is clear that the great powers of the industrialized world have not been this philosophically estranged since the end of the Cold War. Ironically, in this new contest, the former belligerents have switched sides – the capitalists are now the socialists, and vice versa.
We now are witnessing a struggle between two camps that I playfully call the “Stimulators” and the “Austereians.” Both warn that a worldwide depression will ensue if governments now make the wrong choices: the Stimulators say the danger lies in spending too little and the Austereians from spending too much. Each side also has their own economic champion: the Stimulators follow the banner of Nobel Prize-winning economist Paul Krugman, while the Austereians are forming up behind the recently reformed former Fed Chairman Alan Greenspan. (It is cold comfort to witness “The Maestro” belatedly returning to the hard-money positions that characterized his earlier years.)
In a recent Wall Street Journal editorial, Greenspan argued that the best economic stimulus would be for the world’s leading debtors (the United States, UK, Japan, Italy, et al) to rein in their budget deficits, a strategy dubbed “austerity” by the press. Greenspan explains that because lower deficits will restore confidence, diminish the threat of inflation, and allow savings to flow to private-sector investment rather than public-sector consumption, the short-term pain will lead to gains both in the mid- and long-term. Rather than redistributing a shrinking pie, this approach allows the pie to grow. Greenspan’s Austereian view has been echoed loudly in the highest policy circles of Berlin, Ottawa, Moscow, Beijing, and Canberra.
Meanwhile, in several articles for his New York Times column, including one today, Krugman has argued that those who push for austerity in the face of recession are either doing so for political expediency or out of a “crazy” fealty to archaic economic views. Krugman has apparently judged inadequate the trillions of dollars worth of deficit spending unleashed by the United States and European governments in the last 24 months. He believes our only remedy is to spend more – no matter how much debt results. Absent this, he claims, millions of workers “will never work again.” Unfortunately, Washington has clearly aligned itself with Krugman and the Stimulators.
Reading straight from the Keynesian playbook, Krugman argues that cutting government spending now will simply send the economy back into recession. He asserts that by flooding the economy with money, i.e. “stimulus,” governments can encourage consumers to spend. Once the spending creates better conditions, so the argument goes, the economy will be better positioned to withstand the spending cuts, tax hikes, and higher interest rates necessary to address the staggering deficits left behind.
Krugman proposes an enticing argument that is nevertheless built on rubbish. Economies do not grow because consumers spend; consumers spend because economies grow [for a detailed explanation of how this works, read my latest book: How an Economy Grows]. Investment capital comes from savings, and when governments borrow, savings are diverted from private investment. While it is possible for governments to invest as well, it is much more likely that the money will be spent on entitlements or “invested” in projects that may be politically advantageous but economically useless.
Any money spent by governments is not available to the private sector to invest. The Stimulators don’t make this connection because they believe money grows on trees and that a printing press is a legitimate creator of wealth. However, printing money merely encourages people to spend their savings now rather than wait for it to lose value through inflation. This is okay to Stimulators, because stimulating “demand” by any means necessary is the only goal they can see.
What really grows an economy is not more demand, but more supply [also explained in my book]. The Austereian argument is that reductions in government spending will allow the private sector to generate the additional supply of goods and services. Europe seems to understand this; unfortunately, the US does not. Judging by the recent weakness of the dollar – not only against gold, but other fiat currencies, including the pound and the euro – the markets are coming to the same conclusion.
As sovereign-debt worries initially spread throughout Europe, the dollar benefitted. However, now that Europe has demonstrated a willingness to reduce its debts, while we have committed to make ours even larger, the sovereign-debt worries are moving west.
If Greenspan and the Austereians are correct, the stimulus will fail and leave us in a much deeper hole. As long as governments create bigger deficits, we will never have a sustainable recovery. Instead, we will be chasing our tail, and wearing ourselves out in the process. When we finally realize the folly of this approach, the austerity measures that we will then be forced to adopt will make those currently proposed by the Europeans seem relatively painless.
My guess is that before year-end, our stimulus-induced recovery will falter, prompting Obama and Congress to administer even more stimulus. After all, the Stimulators have no other answer. However, given the adverse reaction this will produce in the currency and debt markets, this next jolt will likely vindicate the Austereians, as the world witnesses its greatest power careen into inflationary depression.
Sean Corrigan has been interviewed by the Frankfurter Allgemeine Zeitung. German readers can view the original article.
For the sake of the rest of you, here’s a translation:
Germany is the scapegoat of the world for its austerity measures (there is no real austerity because debts are high and rising dramatically). Even Soros and Krugman are lamenting about the “hair-shirt politics”. Your take?
This all presupposes that if the government does not prop up activities which by virtue of that very government support are not viable, all the consequences are bad. It forgets that if the service provided is really valued by its consumers, someone, somewhere will step in to offer it privately – probably more reliably and at a better price, too! It also neglects the fact that if the government borrows less, there is more room for capital formation in the wealth-creating sectors; that less government demand means lower costs for entrepreneurs and end consumers; that greater budgetary discipline means more money left in individuals’ pockets to use as they see fit – not as some distant bureaucrat decides.
If ever more government was the answer to the problem of prosperity, why were the guards and machine guns not on the Western side of the Berlin Wall for all those years?
How is it possible that the debtors are the good guys and the savers the bad guys?
Because the mainstream is still far too heavily influenced by Keynes’ theories of under-consumption and perpetual slump. After all, these are the same people who argue that World War II had its plus-side in that it finally ‘ended’ the Great Depression, by carting the nation’s youth away from the jobless lists and off to the front and by destroying untold capital so as to remove an imagined ‘surplus’!
The only ‘fault’ of the savers is that they had – perforce – to lend more and more money to their worst customers – but we can blame not only too low interest rates (i.e. the Fed and its friends) for that, but also the fact that once the single currency removed FX risk from a periphery all too used to borrowing at double-digit rates, nobody bothered with the remaining credit risk when they gave out their loans at what must have seemed give-away levels to their unbelieving recipients.
Where will the American debt spiral lead us to?
Well, this is part of the irony of the present assault on Europe – that the US arithmetic is hardly less scary than anything the PIGS may have to offer. In the end – and who knows how long this will take to come to its bitter fruition – the US will have to renege on the promises its politicians have offered all too freely to its people – either by a drastic reform of the tax and welfare system (and here the scale of the adjustment is so frightening as almost to rule it out), by repudiation of its debts, or by naked inflation.
How long will the markets tolerate the American strategy of big government spending and what will happen if a critical tipping point is reached?
This is hard to say. After all, we have the present paradox of seeing people buying US government debt at, in some cases, negative real yields at the same time that they are buying gold – simply as a safe haven trade. But, as long as central banks – both at home and abroad – either buy this debt directly or offer nearly free money to the commercial banks who buy it for them, these ludicrously low yields can persist. But, once again, it is a sign of the dysfunction of our system of finance, not something of which to be proud. We are again misallocating capital and distorting the key price signals in the economy and this can only destroy more wealth.
What has to be done to return to a sound economic system (in the States and elsewhere)?
All the things no-one wants to do. Balance budgets, shrink the state, promote enterprise by leaving it in peace and making sure that the tax code fosters capital formation, make money as hard as possible, apply accounting rules properly, and outlaw fractional reserve banking. The adjustment would no doubt be very painful for a generation which has spent its whole lives being forced to act as over-borrowed speculators when its members buy their houses or save for their retirement, but it could also lead to a new Wirtschaftswunder.
Your take on bail-outs and regulation – (what will happen if the Volcker-rule will be watered down)?
I am sure that whatever final form the legislation takes, it is not going to be more than an inconvenience for the financial oligarchy whose members presently enjoy so much influence. Even if we do a Standard Oil or a Ma Bell and split the banks into some ‘non-universal’ units, I am sure that they will grow just as monstrous over the course of the next cycle – and will prove just as adept at gaming the regulations. No one will repeal deposit insurance, back money with a hard, scarce asset, and insist that banks hold 100% reserves – and, maybe even ban them from holding government debt! – until we do, we are not addressing the root of the problem
What do you expect from the G20-meeting? Will Tim Geithner and Larry Summers succeed with their obtrusive “spend now, consolidate later” message?
I am sure Chancellor Merkel’s team will be every bit as strong willed as their American counterparts!
What should G20-leaders do?
Insist on proper accounting, stop intervening, get their own finances in order, and stick rigorously to the rule of law. A very slim hope!
How to behave as investor?
Cautiously. I think the economy is on the verge of losing a good deal of its recent upward momentum. Whether that means an outright decline is too early to say, but it does look like the ‘stimulus’ is beginning to wear off with many problems left unresolved – and even, in some cases, made worse. Hence, things are very fragile. If markets take fright once more and trade and production begins to suffer, I would anticipate another wave of central bank money printing. We may not light the inflationary flames just yet, but we will certainly put a lot more wood on the bonfire if the recovery falters.
“[Government] is apprehended, not as a committee of citizens chosen to carry on the communal business of the whole population, but as a separate and autonomous corporation, mainly devoted to exploiting the population of the benefit of its own members… The intelligent man, when he pays taxes, certainly does not feel he is making a prudent investment of his money; on the contrary, he feels he is being mulcted in an excessive amount for services that, in the main, are useless to him, and that, in substantial part, are downright inimical to him”
— H.L. Mencken, ‘More of the Same’, American Mercury 1925
Imagine a country unfortunate enough to have succumbed in conflict to a foreign enemy and now subject to a thorough-going military occupation by the forces of their victorious foes.
Young men, who have been conscripted in a vast profusion, are marched in to pacify the vanquished nation’s populace, to patrol its streets, watch over its borders and constantly to patrol its coastlines – though, in truth, much of their activity soon palls into a dull routine, being merely work for work’s sake, meant to deny the devil too many idle hands for mischief, rather than because the doing of it fulfils any useful purpose of itself.
Some of these warders of the conquered realm are barracked in camps where their basic material needs are catered to in large, centralized facilities specially built for the purpose, while others are billeted on civilian householders in their homes – whether or not these latter show any willingness to have their property used, their provisions divided, and their privacy violated in this way.
Aside from the fighting force itself, there is an even larger host of administrators, technicians, and other support staff abroad in the land, many of its members busy overseeing the activities of the conquered – issuing requisitions to the factory owners; commandeering resources; ordering farmers what to grow and where; and generally re-organizing a significant part of the people’s economic lives in order to serve the needs of their new masters in place of those of their own.
War, after all, had best be made to pay for war and all those martial souls need to be fed, shod, clad, sheltered, and even re-armed if they are to maintain their military effectiveness.
Finally, however, the glad day dawns when the war is ended and blessed peace takes its place. Bested on some far distant battlefield, the invader negotiates a peace, its armies meekly surrender their arms and the erstwhile Hectors and Horatios shuffle apprehensively off to wire-strung detention centres, there to await their fate. Meanwhile, the bells ring out in carillons of joy and young and old alike take to dancing in the streets in a great celebration of regained liberty.
As it soon transpires, large numbers of the former garrison have no wish to return to a homeland many can scarcely still remember. Besides, they have grown to love their new surroundings and many of them have found wives and sweethearts there, to boot. They plead to be allowed to stay and – at first with reluctance, but gradually with a laudable hope for reconciliation (for this occupation, while not without its share of accompanying evils, was not marked by wholesale rapine or blemished with overmuch outright atrocity) – the authorities accede to more and more of these very human requests.
Even amid the rejoicing, however, there are one or two grumblings to be heard. Will all these former soldiers not still be have to fed and clothed at our expense, some ask or – worse to some – finding productive work at last, will they not represent a drug on the market for labour, depressing the wages of us, the long-suffering natives?
Not so, reply the wiser heads. For we should see them not as a surplus, but rather as a vital human resource and each, eager to earn his keep and ply again a peaceful trade, will have to give as much value as he gets, in future, if he is to earn the goods he formerly took simply by merit of his uniform. This can only be to the benefit of all.
But, there are others, too, whose feelings of relief are decidedly mixed – the sutlers and the swordsmiths, the bar-keepers and the bawds, the munitions-makers and the mule-breeders – for all those who supplied the enemy have lost the greater part of their custom, even though their conscience must have told them that their living was being made at the final expense of those unconsenting fellow citizens whose wealth and income were being tapped to make up the soldiers’ pay and quartermasters’ drafts.
At length, they, too, still their complaints and resign themselves to seeking out another kind of clientele; to producing ploughshares not poniards or pikestaffs, all the while consoling themselves that, now the exactions of war have been stopped, the majority will have more money in their pockets and that, in the general hunger for the things long denied them during the grim, grey years of subjection, trade and industry will soon be booming once more and commerce will again flourish.
Some good while may pass before they see it this way, but certainly, no-one among even those who flourished most – or languished least – will so rue his temporary loss of business that he will advocate striking up a quarrel with some other likely nation, in order to capitulate as abjectly as possible and so refill the deserted camps and cantonments with another batch of loose-pursed intruders!
So far, the verdict here seems indisputable. The end of the occupation – though occasioning a measurable difficulty for the few, as well as a by no means trivial challenge of readjustment for the many – will overwhelmingly redound to the common weal: a truth which will be instinctively recognized in an intuition of good to come which almost everyone will later find to have been a correct one.
A Continuation of Policy by Other Means
If all the foregoing seems unobjectionable – and we fully trust that it will – then consider how little the argument changes if there is no foreign occupation, but instead the imposition of martial law by those in power domestically.
We still have the same diminution of the private sphere; still the same tyranny over people’s lives, however softly velveted is the mailed fist which holds the nation down. We still have the same forcible redirection of employment and still the same sequestration of income and arbitrary denial of property as we did when the perpetrators spoke a foreign tongue – and, on that account, we will be just as glad to be rid of all their impositions when the laws are at length repealed or the regime is toppled in the dust of despots past.
Finally, even where the intent is in no way overtly malign – where the nation has been put on a purely defensive war-footing in order to deter the aggression of a hostile neighbour – the very same conditions will apply and the very same relief will be felt when the Dogs of War are finally put back on their slips and ‘Havoc!’ no longer cried.
So, if you are with me this far, tell me why it is any different when the Home Army carries few actual arms and when most of those who fill its ranks wear no obvious uniform, or bear no fluttering pennons, but whose stormtroopers and Sonderkommandos nonetheless boss us and direct us; telling us what we can and cannot do; relieving us of a good portion of our income to pay their keep and to enact their schemes of domination; and hemming in our natural rights to property with rules and regulations which we ourselves pay for them to conjure up and to impose upon us?
What if this occupying army is in service to – nay, if it actually constitutes – the governmentitself?
What if comprises a host grown fat and bloated and officious as it siphons off the best milk from our herds and swipes the choicest fruit from our orchards in order to satiate its vast, pestilential, multi-million array – its troops of tax-gatherers and health-and-safety tinpots; its platoons of permit peddlers and planning panjandrums; its ranks of red-tapers, rubber-stampers, and rubbish recycling-bin riflers; its columns of closed-circuit televoyeurs and carbon credit cozeners; its divisions of dole deceivers and disability dissemblers; its junta of jobsworths, Jacks-in-Office, and gender outreach counsellors; its cohorts of Cultural Marxist commissars, and clipboard commandants; its echelons of egalitarian engineers, its squadrons of subsidy-suckers – and all the other plunderers who make up this Legion of the Damnable?
A Set of Lies Agreed Upon
Why, then, should we listen to the hand-wringing of the punditocracy when they tell us that to disband even the most ineffective and ill-disciplined section of this rapacious army of permanent occupation is somehow to condemn ourselves to ruin?
Why should we heed the brow-beating of the leader writers when they insist that to reduce even some of the country’s unsustainable deficit – not even, you will note, to try to eradicate the whole of the annual shortfall, much less to address the noxious legacy of debt accumulated over long years of easy profligacy – is for the Emperor to condemn all of us to his former nakedness if foregoes his customary non-attire (one cut by his charlatan couturiers from the virtual cloth of spending what he routinely does not earn) and dons, in its place, a debilitating hair shirt of ‘austerity’ ?
No! Better that we stop our ears to the insidious wheedlings of all the Philosopher Kings – the Stiglitzes and Soroses, the Krugmans and Kaletskys and all the other intellectual Vichy who would perpetuate our subjugation – and press on with the attempt to demobilize as many of these battalions of bad husbandry as possible.
Nor should we be persuaded that, without the reckless dollops of Other People’s Money which the vote-buying minions of the State dish out in all their counter-productive billions, the real economy will crumble and blow away in the wind: that shops will empty and factories shutter; that the lights of enterprise will dim, and flicker, and fade – any more than they would if a foreign conqueror were to relinquish his pitiless hold upon those who own them and allow them to take charge, once more, of their own destinies.
Rather, we should steel ourselves for the challenge ahead in a frame of resolute self-reliance and, to show our true intent, we should first make plain our utter rejection of the doom-mongers’ vision of a people grown too servile and enervated under the heels of the horde which strangles their growth and saps their strength that they dare not greet their own liberation with the utmost, unqualified, clarion jubilation.
Otherwise, this will be a long, protracted war, and, as Sun Tzu himself noted all those centuries ago, no country has ever benefited from such a calamity – to which aphorism, we might add, all too few have emerged with even their money, much less their wealth, intact, either. It may also be true that ‘there’s a great deal of ruin in a nation,’ but keep in mind that when Adam Smith penned those words, at a bleak moment in British history, he was making an observation, not a policy recommendation.
Last week I presented a book review of Alchemists of Loss[1]. Now I seek to explore the errors of Modern Financial Theory in more detail and provide some insights based on an understanding of entrepreneurship that is missed by the authors. I hope this will add to the impressive firepower mustered by Dowd and Hutchinson, and allow us debunk the myths of the Alchemists once and for all. The Alchemists’ ideas, like those of Keynes, have zombie-like quality; they return, undead, like something from a cheap cult Hammer House of Horror movie. I aim to provide another stake to impale them with. The Great Austrian economist Dr Frank Shostak will also be deployed, as he placed an almighty stake into the Zombie in 2000, in an article I will reproduce in full. In an appendix to this article, I reproduce the names and profiles of the Alchemists of Loss.
MFT, MPT, and EMH
Let us begin with an overview of Modern Financial Theory, as explained by Dowd and Hutchinson:
In essence, Modern Financial Theory can be summarized as the application of the theories of mathematical statistics to finance. The techniques involved soon became known colloquially as “rocket science”, although in fact real rocket science is a lot simpler. [2]
Nobel Prizes for its principal developers, including (among others) Harry Markowitz in 1990 and Robert Merton and Myron Scholes in 1997. By the mid-1990s it was said that there were more PhD physicists working as “quants” in the research departments of investment banks than were working in physics itself. [3]
A good starting point and one of the key pillars of Modern Finance is the 1958 Modigliani-Miller Theorem, developed at Carnegie-Mellon by Franco Modigliani and Merton Miller. This stated that under a set of hypothetical conditions – which included (i) no taxes, (ii) no difference between the rates at which individuals and corporations could borrow, (iii) zero transactions costs, and (iv) the complete absence of agency costs (no conflicts of interest) – then the value of a company is invariant as to its capital structure. In other words, capital structure, the balance between debt and equity, is irrelevant.
The Theorem was quickly extended to take account of the taxdeductibility of debt and the double taxation of equity dividends in the US system to show that, for a US company, the theoretically optimal level of leverage was infinite and the optimum dividend payout from earnings was zero. [4]
As with most of Modern Financial Theory, the flaws in Modigliani/Miller were primarily in the assumptions. [5]
Modern Financial Theory gave rise to Modern Portfolio Theory, which the authors describe as follows:
The underlying ideas were simple; the application of those ideas, however, was anything but straightforward. Imagine an enterprising trader who runs a market stall by an English seaside. Our trader can afford a certain outlay and has to choose which of two goods to sell, but is concerned about the day-to-day fluctuations in his income.
He begins by selling ice cream and sunglasses. This works really well when the sun is shining and everyone wants ice cream and protection against the sun: on such days, sales of both boom. However, this being England, there are many days when it rains, so on those days people want neither and he sells nothing. So he either makes a lot of money or he makes nothing, depending on the weather, and the English weather is very uncertain.
He then has the bright idea of switching from sunglasses to umbrellas. When he does so, he then finds when the sun comes out, he does well on the ice cream but not on the umbrellas; and when it rains, he does badly on the ice cream but well on the umbrellas. His income is now much steadier, even though the weather is as unpredictable as it was before. Our trader has diversified his risks.
In the one case, the lines of business had a strong positive correlation, meaning that if one did well, the other was also likely to: both depended on the sun being out. In the second case, the two lines of business had a strong negative correlation: one did well if the sun came out, and the other did well if it rained.
The lesson is to search for lines of business that are negatively correlated and so have risks that offset each other [6]
As mentioned in my review, Hutchinson and Dowd show how these negative correlations are worked out statistically with sublimely beautiful maths. The probability of each standalone investment going bust is also worked out, and voila: a “black box” can objectively calculate your optimum portfolio strategy. Man has been removed from the investment process; the maths do the work of portfolio allocation. All man has to do is find clients to whom to sell the black box.
This faith in objective measures is rooted in the Efficient Market Hypothesis:
Its essence was the claim that market prices were “efficient” in the sense that they “fully reflected” all available information: markets are “efficient” because they get prices right. This hypothesis was the perfect embodiment of the notion of “rational economic man” that ruled the economics textbooks: efficient markets was rational economic man in the stock market.
Large amounts of empirical evidence were soon being collected that seemed to support the Efficient Markets Hypothesis. Doubts and evidence against it were generally ignored and academics who opposed it were railroaded [7]
The Efficient Markets Hypothesis goes beyond the self-evident truth that, on average, you can’t expect to beat the market. It is one thing to say the market is hard to beat, as good investment gurus had maintained since at least Benjamin Graham, another to say that market prices are, somehow, “right.”
Yet the Efficient Markets Hypothesis was clearly inadequate. This was especially so for the “strong form” of the Efficient Markets Hypothesis, which maintained that prices fully reflect all information, both public and private. For one thing, how exactly does the information in one person’s head become instantaneously known to everyone else in the market? And, if the strong-form Efficient Markets Hypothesis does hold, then what incentive would anyone have to collect any more information? If prices fully reflected the information available, then it would be economically irrational to spend resources collecting it. In that case, the investment advice industry shouldn’t exist at all. But it did. There would be little reason to trade either.
There was also the awkward implication, usually glossed over by its proponents, that if markets were truly efficient, then why do market prices move so much? If markets are efficient, then changes in market prices must reflect new information becoming available to the market.
If so, what was the information that became available on October 19, 1987 that caused the New York Stock Exchange to fall by 23% that day? [8]
Dr Frank Shostak, an eminent economist and noted econometrician himself demolishes this point of view and provides us with the seeds of a correct and subjective view of portfolio allocation:
“According to the efficient markets hypothesis, stock market prices move in response to new, unexpected information. Since, by definition the unexpected cannot be known, it implies that an individual’s chances of anticipating the general direction of the market are as good as anyone else’s chances.
It is thus suggested that since the future direction of the stock market cannot be known and that the only way of earning above average returns is to assume greater risk. This is described by the modern portfolio theory (MPT). It is accepted by the practitioners of this theory that risk is associated with the degree of dispersion of returns around the average of returns.
A security whose returns are not expected to deviate significantly from its historical average is termed as a low risk. A security whose returns are volatile from year to year is regarded as risky. MPT assumes that investors are risk averse and they want high guaranteed returns. To comply with this assumption the MPT instructs investors how to combine stocks in their portfolios to give them the least possible risk consistent with the return they seek. MPT shows that if an investor wants to reduce investment risk he should practice diversification.
Consider the following simple example:
Activity A
Activity B
Cold Weather
20%
-10%
Warm weather
-10%
20%
Let us assume that on average, half of the time the weather is cold and half of the time it is warm. According to the table, investment in activity A will yield a 20% return in cold weather and in warm weather will produce a loss of 10%. On average the return by investing in A will be 5%. The same outcome will be obtained with regard to investment in activity B.
The MPT then suggests that if the investor diversifies and invests one dollar in A and one dollar in B then he will be guaranteed a 5% return regardless of weather conditions. Thus in warm weather, one dollar invested in B will produce a 20% return, while one dollar invested in A will produce a 10% loss. Investors total return on two dollars invested in A and B will be 5%. Exactly the same result will be obtained for cold weather conditions. This example illustrates that through the magic of diversification regardless of weather conditions one can obtain risk free 5% return on investment.
This must be contrasted with the fact that the two investments A and B are highly risky, because the frequency of a cold or a warm season in a particular year cannot be always ascertained. All that we know is that on average, over a prolonged period of time, half of the time the weather is cold and half of the time it is warm. This however, doesn’t mean that every year this will be so. This example shows that as long as activities are affected differently by given factors there is a place for diversification, which will eliminate risk.
The basic idea of MPT is that portfolios of volatile stocks, i.e. risky stocks, can be combined together and this in turn will lead to the reduction of the overall risk. The guiding principle for combining stocks is that each stock represents activities that are affected by given factors differently. Once combined, these differences will cancel each other out, thereby reducing the total risk.
However, the theory indicates that the risk of various stocks must be broken into two parts. The first part is associated with the tendency of returns on a stock to move in the same direction as the general market. The other part of the risk results from factors peculiar to a particular company. The first part of the risk is labeled systematic risk, the second part, unsystematic. Through diversification only unsystematic risk is eliminated, systematic risk cannot be removed through diversification. Consequently it is held that return on any stock or portfolio will be always related to the systematic risk, i.e. the higher the systematic risk the higher the return.
The systematic risk of stocks captures the reaction of individual stocks to general market movements. Some stocks tend to be sensitive to market movements while other stocks display less sensitivity. The relative sensitivity to market moves is estimated by means of statistical methods and is known as beta. In this regard beta is the numerical description of systematic risk. If a stock has a beta of 2 it means that on average it swings twice as much as the market. Thus if the market goes up 10% the stock tends to rise 20%. If however, the stock has a beta of 0.5% then it tends to be more stable than the market.
Does it make sense?
The MPT framework gives the impression that there is a difference between investing in the stock market and investing in a business. However, the stock market doesn’t have a “life of its own”. The success or failure of investment in stocks depends ultimately on the same factors that determine the success or failure of any business. Consequently an investment in stocks should be regarded as an investment in business as such and not in stocks. By becoming an investor in a business an individual has exercised an entrepreneurial activity. In other words he has committed his capital with a view to supply the most urgent needs of consumers.
For an entrepreneur the ultimate criterion for investing his capital is to employ it in those activities that will produce goods and services that are on the highest priority list of consumers. It is this striving to satisfy the most urgent needs of consumers, that produces profits and it is this alone that guides entrepreneurs. The entrepreneurs focus and main consideration while investing his capital is to secure the highest possible profits, not to minimise risk as the MPT suggests. If entrepreneurs strived after what they considered to be the safest investment while neglecting consumers wishes they would render the entire investment unsafe.
The size of an entrepreneur’s return on their investment is determined not by how much risk they assume, but whether they comply with consumers’ wishes. The fact that entrepreneurs appear to be practicing diversification by investing in various businesses over time doesn’t necessarily mean that they do so in order to reduce their investment risk, they may diversify in order to boost their chances of earning profits.
The moment the primary consideration of investment becomes the reduction of risk rather than the attainment of the highest possible profit, then all kind of strange decisions may emerge. For instance, strictly following MPT, one may deliberately invest in an asset that offers a negative return in order to reduce the overall portfolio risk. However, no sane investor deliberately chooses a badly performing investment. It is only the emergence of conditions not properly forecasted by the investor that leads to a bad investment.
According to Mises:
A capitalist never chooses that investment in which, according to his understanding of the future, the danger of losing his input is smallest. He chooses that investment in which he expects to make the highest possible profits. [9]
Furthermore, in an attempt to minimize risk, practitioners of MPT tend to institute a high degree of diversification. However, having a large number of stocks in a portfolio might leave little time to analyse the stocks and understand their fundamentals. This could raise the likelihood of putting too much money in bad investments. This way of conducting business would not be an entrepreneurial investment but rather gambling.
One of the world’s most successful stock market investors, Warren Buffett, argues that investor’s financial success is in direct proportion to the degree to which he understands investment. This understanding, according to Buffett, is what separates investors with a business consideration from gamblers who merely buy stocks. Buffett says that investors are better served if they concentrate on locating a few spectacular investments rather than jumping from one mediocre idea to another. John Maynard Keynes expressed a similar view:
As time goes on, I become more convinced that the right method of investments is to put fairly large sums into enterprises which one thinks one knows something about and in management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little.
Proponents of modern portfolio theory argue that diversification is the key to the creation of the best possible consistent returns. We argue that one must focus on the profitability of the investments in a portfolio, before one considers their contribution to the portfolio’s diversification. Consequently, whilst we agree with the general principle of diversification, we believe that the profitability of an individual investment should be the primary consideration for the investor.
The Missing Link in Portfolio Management : The Entrepreneur and the (boring but smart) Bank Manager
The Neoclassical School of thought (anything other than the Austrian School) seems to absent the entrepreneur from all of economics. To them, economics is about the dispassionate, efficient allocation of resources, rather than a dynamic (ongoing) and creative process of discovery and capital allocation. This is why such otherworldly investment strategies can gain traction with otherwise very intelligent men, with such horrendous consequences for our economy.
The Three Stages of Entrepreneurship
Our starting point is the initial discovery of information. For example, the simple observation I have in my business that people want their meat and fish delivered, cut to a bespoke specification, packaged in a certain way, and sold with local provenance that floats their boat. Each of these factors makes the consumer want to buy from me rather than my competition.
Then, by my actions, I seek to train highly skilled people to do the bespoke cutting, go to inventors of packaging and get modifications here and modifications there, and source meat and fish from the desired locations: the farms and seas nearest to me. I signal out to other entrepreneurs that there are opportunities to provide me with these things to help me stratify my ex novo idea.
Other entrepreneurs then respond and supply me in the knowledge that things they might not have thought of as being valuable are now actually valuable.
Note that the co-ordination of my ex novo thought or idea then causes a trickle through the economy of further co-ordination to others and a new alignment of resources is propagated.
Others may well have the same idea and different patterns of co-ordination arise, which causes capital to be realigned to the new set of needs. This is a constant and ongoing process of creation, discovery, and co-ordination. IT CAN NEVER BE SUMMED UP BY EQUATIONS AND MODELLED BY ANY MATHEMATICS. It is a process driven totally by subjective decisions.
The role of a fund manager is to understand what entrepreneurs are tailoring their business to and why. They do not have to have the initial creative idea; the fact that they are employed as a fund manager probably indicates that they do not have this skill. Their skill is to understand the opportunity the entrepreneur has seen, then understand how he is seeking to meet this need. Is the opportunity real? Is the plan realistic? As I said in the original book review,
if a portfolio manager is so dull that he can’t look for companies with at least some of the following traits, then perhaps he is in the wrong business:
Strong balance sheet with good equity and retained profits for a rainy day,
Ongoing investment,
Inspiring entrepreneurial leadership,
Good executive management,
Sensational, functional product,
High or strong barriers to entry
The unique and economically vital role of the fund manager is not to look at a black box, “quantifiable” system and deploy “objective” mathematical equations to determine what stocks he should pick and who he should allocate capital across his portfolio to, but instead to exercise some judgement about the merits of the entrepreneur’s own creative talents and his ability to actually make what he sees happen in a solid and profitable way.
This, of course, is what the bank manager used to do. This elusive member of our species certainly did exist when I started business, but by the early 90’s he was replaced by “relationship managers” who were never there for more than 18 months at a time. His care was to facilitate this co-ordination process of matching capital with successful entrepreneurs to help facilitate the ongoing, creative and dynamic co-ordination of the market. This should be the purpose of portfolio management.
It is little wonder that the whole house of cards has fallen down if capital has been allocated over the last 30 plus years less under the subjective guidance of entrepreneurship and more via objective Modern Financial Theory.
Appendix: The Alchemists of Loss Named
Courtesy of Dowd and Hutchinson, here are the names and profiles of the Alchemists of Loss:
Appendix 1: Some Leading Financial Alchemists …
Louis Bachelier (France, 1870–1946)
Grandfather of modern financial alchemy. A mediocre student at the Sorbonne, his 1900 PhD thesis “Theorie de la Speculation” laid out a mathematical description of Brownian motion (the motion visible under a microscope through vibrating molecules randomly bashing dust particles), but applied it to stock market prices rather than particle physics, as would have been natural. In spite of patronage by his instructor Henri Poincaré, France’s leading mathematician, the thesis only drew the grade of “honorable.” Albert Einstein later improved the Brownian motion mathematics, publishing it in 1905 with its proper physical application. Bachelier later had an academic career that might be politely described as peripatetic, interrupted by service as a private on the Western Front.
By applying a perfectly good physics model to finance, and assuming Gaussian randomness of prices and zero net expectation in markets, Bachelier was inadvertently the creator of a new discipline that ultimately led to multi-trillion dollar losses more than a century later. His work was obscure but not entirely forgotten, influencing the Soviet mathematician Andrei Kolmogorov (1903–87) and then becoming a source for the work of Benoit Mandelbrot and Franco Modigliani, both of whom studied in Paris in their youth.
A third of the Black-Scholes-Merton options valuation equation. Degree and PhD in applied mathematics from Harvard, after which he spent some time at Arthur D. Little. Joined the University of Chicago in 1971, where he did some interesting work on the theory of moneyless monetary systems and propounded the remarkable theory that monetary policy was irrelevant to the economy’s movements.
His most famous work, with Myron Scholes, the eponymous option valuation equation, was published in a paper “The pricing of options and corporate liabilities” in January 1973. This was just in time for the explosion in options trading, and enabled him to move to a lucrative position with Goldman Sachs in 1984. He was unlucky enough to die of throat cancer two years before the work leading to his equation was honored with the 1997 Nobel Prize.
Robert F. Engle (1942–)
Inventor of Autoregressive Conditional Heteroskedasticity (ARCH) methods of volatility forecasting, initially applied to the UK inflation rate; this subsequently generalized by his former student Tim Bollerslev to create the GARCH model, which was then widely applied to financial volatilities. Co-founder of the Society for Financial Econometrics. BS in Physics (Williams, MS in Physics, PhD in Economics (Cornell). Professor at UC San Diego, 1975–2003. The co-inventor, with Clive Granger, of the theory of cointegration, which models equilibrium relationships between trended variables.
Eugene Fama (1939–)
Propounded the Efficient Market Hypothesis in his 1965 doctoral thesis “The behavior of stock market prices.” PhD in Economics from University of Chicago, with Benoit Mandelbrot as doctoral supervisor.
He also played a leading role in the development of the Capital Asset Pricing Model, before putting it out of its misery a generation later in a landmark paper with Kenneth French. Apart from Black, Bachelier, and Gauss (all dead), he is the only leading Financial Alchemist not to get the Nobel. It is unclear why he has been snubbed in this way; it’s not as if any of the other financial alchemists’ theories worked either.
Carl Friedrich Gauss (1777–1855)
Son of a gardener in Brunswick, Germany, he is ranked in the “objective scoring system” of Charles Murray’s Human Accomplishments as the fourth greatest mathematician of all time. He was reputedly the last mathematician to know all of the mathematics of his day. Inventor of the famous Gaussian probability distribution, often mislabeled the “normal distribution,” which is a lot less normal than its proponents normally suggest. Also invented modular arithmetic and proved the fundamental theorem of algebra showing that any polynomial in a single variable has at least one root. His calculations enabled astronomers to identify Ceres, the first identified asteroid. Identified a method for representing the unit of magnetism (the Gauss). Disliked teaching and was not a prolific writer.
Gauss married twice and had six children, but maintained poor relations with his two sons, whom he would not allow to become mathematicians “for fear of sullying the family name.”
Gauss would have rejoiced in the practical and lucrative uses to which his probability distribution has since been put. However, as a highly rigorous yet intuitive mathematician, he would undoubtedly have spotted the fundamental flaws underlying Modern Financial Theory the moment he saw it.
Inventor of Modern Portfolio Theory, published in the Journal of Finance in 1952. PhD, University of Chicago in Economics. Developed the Markowitz frontier, under which the risk/expected return function of all securities in an optimal portfolio lies on a single Markowitz Efficient Frontier curve, which helped pave the way for the later Capital Asset Pricing Model. Worked at Rand Corporation, founded CACI International, pioneer in computer simulation and a well-read and open-minded polymath. Professor at UC San Diego. Awarded Nobel Prize in 1990 for development of portfolio theory, along with Merton Miller and William F. Sharpe.
Generalized the Black-Scholes options valuation equation and then produced an inter-temporal version of the Capital Asset Pricing Model.
Hailed by Paul Samuelson as the Isaac Newton of Modern Finance, which, since Newton was a keen alchemist, is only appropriate. Professor at MIT Sloan School of Management, 1970–88, Harvard Business School, 1998–. Spectacularly eventful consulting career. With MyronT. Scholes, was a Director of Long-Term Capital Management, which slid famously into collapse in 1998, causing a major crisis and triggering a panicked bailout led by the Federal Reserve. Chief Science Officer of Trinsum Group, a financial advisory firm that filed for bankruptcy protection in January 2009. Awarded Nobel Prize jointly with Myron T. Scholes for their work on options valuation.
Co-author with Franco Modigliani of Modigliani-Miller theorem, which proposed the irrelevance of debt-equity structure. PhD in Economics from Johns Hopkins University, 1952. At Carnegie-Mellon in 1958, jointly authored paper “The cost of capital corporate finance and the Theory of Investment” propounding the Modigliani-Miller theorem, which was sometimes used to give a spurious respectability for grossly excessive leverage in US financial and corporate systems, and among US consumers. A leading advocate of the benefits of financial derivatives – he often claimed that financial derivatives made the world a safer place rather than a more dangerous one – and free financial markets.
Professor, University of Chicago, 1961–93. Nobel Prize, 1990 with Harry Markowitz and William F. Sharpe.
Primarily a macro-economist. Co-author with Merton Miller of Modigliani-Miller theorem, allegedly after he and Miller had been assigned to teach corporate finance at Carnegie-Mellon to business school students, and as good economists determined that the existing texts were internally contradictory. Modigliani also propounded the life-cycle theory of saving in the economy, in parallel to Milton Friedman’s “permanent income” theory, which supposed that consumers would aim for a stable level of consumption through their lifetime, saving in early years to fund their retirement. Left Italy in 1939 for France, then came to US in 1942. D.Soc.Sci., New School for Social Research. Professor, Carnegie-Mellon, then MIT 1962–2003. Nobel Prize, 1985.
Co-author with Fischer Black of Black-Scholes option valuation model. BA Economics McMaster University, PhD/MBA, University of Chicago. Professor, MIT 1968–73, University of Chicago, 1973–81, Stanford, 1981–96. Director of Long-Term Capital Management with Robert F. Merton, which collapsed in spectacular fashion in 1998. From 1999, Chairman of Platinum Grove Asset Management, $5 billion hedge fund which was forced to suspend withdrawals in October 2008 after a 38% loss, then lost another 11% in March 2009 and by October 2009 was in a Special Rebalancing Situation, bankrupt in all but name. Nobel Prize 1997 with Robert F. Merton for the European call option valuation model.
William F. Sharpe (1934–)
Devised the Capital Asset Pricing Model, published as “Capital asset prices – a theory of market equilibrium under conditions of risk” in the Journal of Finance in 1964. MA, PhD in Economics from UCLA. Professor, Stanford, 1970–89. Also devised the Sharpe ratio measuring the return of a security in relation to its risk. One of his doctoral students Howard Sosin founded AIG Financial Products, whose activities in the CDS market were a major contributor to the recent financial crisis.
Co-founder of the consulting firm Financial Engines, which encourages its clients to save more for the retirement that, thanks to Modern Finance, many of them will never live to see. Nobel Prize, 1990 with Harry Markowitz and Merton Miller
Appendix 2: … And Some Non-alchemists
Augustin Louis, Baron Cauchy (France, 1789–1857)
Father of the Cauchy distribution, the ultimate long-tailed risk. Born into a Royalist family and spent his first five years hiding from the French revolutionaries deep in the countryside. Educated at the new Bonapartist École Polytechnique, where he objected to the military discipline, then became an engineer. After a few years of engineering, he returned to Paris in 1812 and switched to mathematics. Three years later, when Napoleon fell and the Bourbons were restored, as a well known Royalist he was appointed a professor at the reorganized École Polytechnique in December 1815 and a member of the Academie des Sciences the following year.
As a professor, he was not entirely successful, since he took his students through higher mathematics at a brisk, rigorous trot that baffled all but the best of even the École Polytechnique’s elite. He designed the Cauchy stress tensor, central to the theory of elasticity, and Cauchy’s integral theorem, which led to the development of the theory of complex functions and his proof of Taylor’s theorem, central to calculus. In mathematical papers produced, he was second only to Leonhard Euler.
Then in 1830, disaster struck. The reactionary Charles X was overthrown and Cauchy went into exile, refusing to swear an oath of allegiance to the new regime of Louis Philippe. In exile he was for five years tutor to the legitimist heir Henri d’Artois, Duke of Bordeaux, an exercise that left the Duke with a lifelong hatred of mathematics and Cauchy with a legitimist (and therefore, alas, legally unofficial) barony.
He was only readmitted to the École Polytechnique after Louis Philippe was himself overthrown.
Cauchy was an eccentric reactionary, but a very great mathematician; he ranks eighteenth all-time among mathematicians (above Fibonacci and Archimedes) in Charles Murray’s Human Accomplishments.
Benoit Mandelbrot (France/US 1924–)
Should be thought of as the Robert Boyle or Antoine Lavoisier, who began to move the world of finance beyond alchemy. PhD, Mathematical Sciences, Paris. Centre National de la Recherche Scientifique, 1949–57; Institute of Advanced Study, Princeton, 1953–54. Moved to US in 1958. Fellow, IBM Research Centre, 1958–90. Also taught as Visiting Professor at Harvard and Yale. Mandelbrot discovered as early as 1962 that financial market prices did not follow a Gaussian distribution: cotton prices in fact followed a Levy stable distribution with constant of 1.7 instead of 2 as in a Gaussian.
Mandelbrot invented fractal geometry, which he named in 1975, publishing The Fractal Geometry of Nature in 1982, Chapter 37 of which is “Scaling and price change in Economics.” His 1997 book Fractals and Scaling in Finance and his 2004 book The (Mis-) Behaviour of Markets exploded many of the axioms of Modern Finance, without posing a wholly satisfactory alternative paradigm.
The only possible excuse the Nobel people have for not having awarded him one or two Nobel Prizes is the lack of a Nobel Prize for Mathematics. Even so, he is a gap in the Economics Nobel line-up.
Alternatively, it might be more appropriate if the Sveriges Riksbank would end the Economics Nobel Prize as a failure: strictly, it is isn’t a true Nobel at all; it was not part of Alfred Nobel’s legacy, but a much later add-on to pander to the economics profession’s vain pretensions of scientific respectability. If we judge a science by the hallmark of predictability, then the predictions of economists are no better than those of ancient Roman augurs or modern taxi drivers; alternatively, we can judge it by its contribution to “scientific” knowledge, in which case the contribution that financial economics has made makes us wonder if the agricultural alchemist Lysenko shouldn’t have got a Nobel himself; or we can judge it by its contribution to the welfare of society at large, in which case the undermining of the capitalist system, the repeated disasters of the last twenty years, the immiseration of millions of innocent workers and savers, and the trillion dollar losses of recent years surely speak for themselves. [10]
[1] Alchemists of Loss (AofL)How Modern Finance and Government Intervention Crashed the Finance Systemby Kevin Dowd and Martin Hutchinson, Published by Wiley 2010
The small but determined worldwide movement to reform global monetary policies, based upon Austrian School economics, took a blip upwards last week when Peter Schiff announced on his radio programme that he is now officially a candidate on the ballot for election as the Republican party candidate for the US Senate. This ballot will take place on August the 10th against fellow Republican, Linda McMahon; if Schiff wins that intra-party vote, he will then be up against the Democrat’s candidate, Richard Blumenthal, on November the 2nd, in a general election for the US Senate.
After collecting 13,000 signatures, Schiff reported that approximately 1,000 of these signatures failed to reach various Republican party offices due to difficulties associated with unusual office opening hours and other shenanigans. Of those signatures that did make it, 30% were then disqualified for various complicated or even inexplicable reasons. However, Schiff still made the cutoff point by 400 votes, despite all the best efforts of the establishment to stop him, as the only candidate who has ever got himself onto a Connecticut party ballot via a petition; this was required after a successful backstairs campaign by the extremely wealthy wrestling promoter Linda McMahon, at the recent Connecticut Republican party convention, which managed to get Schiff initially excluded from the August vote.
These establishment Republicans in Connecticut must really dislike Peter Schiff now; he just refuses to lie down on the McMahon wrestling mat and die like it says in the script! If you’re interested, you can hear all the details yourself on Mr Schiff’s latest hour-long radio show:
On the show, Peter also announced that Euro Pacific Precious Metals is open for business (http://www.europacmetals.com/), to help bring a healthy gale of competition into the US retail bullion market. I’m unclear as to whether this new company will be supplying Europeans with gold and silver bullion bars and coins, however any North American readers of the Cobden Centre may want to check the company out to see if Schiff can offer them better deals than their current physical metal suppliers.
In his usual fifteen-minute monologue, Schiff spoke about Alan Greenspan’s refusal to take culpability for inflicting inflation and mass money printing onto the United States; he also pointed out to Paul Krugman that if debt grew an economy then the Greek economy would be the envy of the world; he then made the point that eastern european communist governments had maximum government stimulus for decades, just like Krugman is insisting upon for western european governments, but the only real growth that occurred in eastern europe was when all these communist governments collapsed in the 1990s. (This reminded me of a pair of Doug Casey allegories in which the head of Casey Research likened the Dark Ages to a centuries-long depression and the seventy years of soviet rule in Russia as a seventy year depression.)
In the subsequent Q&A session with his callers, Schiff then tackled questions on; (1) Silver investments versus gold; (2) Emigration and expatriation away from the United States and towards South America, in which Schiff also spoke about the removal last week of the Australian prime minister who proposed a super-tax on mining; (3) The US government’s handling of the gulf oil spill, in which Schiff feared that Washington may benefit from its own incompetence, such as its regulation to limit financial damages to deep-drilling companies, and take the opportunity to pass further damaging laws to drive oil prices much higher; (4) The state-run nature of China and how this runs against the grain of free-market economics, where Schiff argued that despite its socialist faults, there is more capitalism going on in China than there is in America and more freedom in China than in America.
When pressed on a possible Chinese property bubble, Schiff stated that although he didn’t agree with the interference, the Chinese communist government insists that you put 40% cash down on your first property before borrowing the rest and also insists that you put down at least 50% cash on all other subsequent properties, without guaranteeing any mortgages you take out; Schiff is therefore sceptical about the much-debated general Chinese property ‘bubble’.
Schiff also added that although Chinese property may be shooting up in terms of dollars and the partially-peg-linked Chinese renminbi, it is not going up in terms of gold.
(5) Schiff then spoke about inflation in Canada and predicted that it will be lower in Canada than in the US, but that Canadian property prices have risen too high against gold so will need to come back (which is something Doug Casey is also strong on, particularly in the Vancouver region). Schiff also claimed that Canada will become a primary destination for American refugees dodging future US inflation, taxes, and regulations.
(6) Schiff was asked why he thought Germany had done well despite having more employment regulations than the United States. He replied that before the ECB it had possessed a strong independent central bank which kept deficit spending and inflation in check, and promoted high savings. He claimed Germany’s record would have been even better with less socialism, but as a net creditor nation, Germany was still much better off than the United States, which is a net debtor nation.
Further questions discussed the nature of why a recession is necessary to cleanse out the malinvestments of the preceding spending boom phase and how the US government is turning a hard necessary recession into a much worse inflationary and completely unnecessary depression.
All in all, a thoroughly informative radio programme.
Let us hope that the David of Peter Schiff can put aside the Goliaths of Linda McMahon and Richard Blumenthal and get that seat in the US Senate. If he does this remarkable thing, the other 99 senators may then pretend that they are unable to hear him, but however hard they shove their fingers into their ears, I am sure he will be giving it to them good and hard just the same, especially on the question of monetary policy reform.
On this website Toby Baxendale presented his plan for monetary reform. He offered a reward of £1000 for anyone who can provide a logical reason why it won’t work; naturally this provoked a lot of discussion. In my opinion Toby’s plan has a major problem, and I discussed this with Toby and the Cobden Centre team over email. Toby doesn’t agree that I’ve found a major flaw in his plan. However, we both think that the debate should be opened up. This article summarises the discussion we’ve had so far.
The Cobden Centre recognize the need for monetary reform, as do I. Reform of money and banking is urgently needed to avert future economic crises. I also agree that Austrian Economics provides a sound understanding of the issues. However, I doubt that the Baxendale plan could be successful. In my opinion if the plan were enacted there would be a burst of price inflation immediately after. The reasons for my concern come from simple economic theory.
What Task Does Money Perform?
Ludwig von Mises described the job of money as follows:
“What is called storing money is a way of using wealth. The uncertainty of the future makes it seem advisable to hold a larger or smaller part of one’s possessions in a form that will facilitate a change from one way of using wealth to another, or transition from the ownership of one good to that of another, in order to preserve the opportunity of being able without difficulty to satisfy urgent demands that may possibly arise in the future for goods that have to be obtained by way of exchange. So long as the market has not reached a stage of development in which all, or at least certain, economic goods can be sold (that is, turned into money) at any time under conditions that are not too unfavourable, this aim can be achieved only by holding a stock of money of a suitable size.” [1]
What Tasks Do Bank Accounts Perform and How Do They Work?
The economics of banking is important here because bank accounts are pivotal to the Baxendale plan. A balance in a bank account that provides on-demand payments and transfers provides services that are similar to those of note and coin money. Again, Mises gives a good description of the situation:
“The cash balance held by an individual need by no means consist entirely of money. If secure claims to money, payable on demand are employed commercially as substitutes for money, being tendered and accepted in place of money, the individuals’ store of money can be entirely or partly replaced by a corresponding store of the substitutes.” [2]
In Mises’ terminology notes and coins are money-in-the-narrower-sense. A bank balance in an on-demand account is a money-substitute. Money-in-the-broader-sense is the sum of money-in-the-narrower-sense and money-substitutes such as bank account balances.
A balance in a bank account is a debt that the bank owes to the account holder. As Toby writes in his article “… your bank-statement is a mere IOU”. Banks invest the money deposited into accounts, often in loans and mortgages. Banks keep only a small amount of “reserves” of money-in-the-narrower-sense. The diagram below shows the situation:
Entries marked in blue on the diagram are money-substitutes. Entries marked in green are money-in-the-narrower-sense.
The Baxendale Plan
Toby Baxendale’s plan is based on a similar plan by Jesús Huerta de Soto, an economist of the Austrian School from Spain. The essence of the Baxendale plan is that it makes all money-substitutes into money-in-the-narrower-sense. Lorry loads of notes are shipped to banks to make this happen. After the plan is enacted a bank statement that says £550 means that the bank is holding a corresponding £550 in notes and coins. The legal relationship between the customer and the bank is altered, after the plan the customer is no longer lending to the bank, instead the bank is acting as custodian of the customer’s cash. The bank becomes a “money warehouse” [3]. Since the balances of on-demand accounts become possessions of the customer, not debts, they no longer appear on the bank’s balance sheet. So, after the plan the banks will have an asset surplus. Rather than allow the banks to profit from this Toby intends to use these assets to pay off the national debt. Specifically, Toby proposes that the asset surplus be removed and put into a mutual body to pay off the national debt.
Bank Services and Interest Payments
A balance in an on-demand account isn’t just a money-substitute, it entitles the account holder to extra services from the bank. In Britain banking services such as payments and transfers are free, some on-demand accounts also pay interest. A balance in an on-demand account provides the holder with two things. Firstly, it provides a reserve of wealth that may easily be exchanged, just as notes and coins do. Secondly, it provides access to banking services and in some cases interest payments. Toby plan is that the banks’ assets will be used to pay off the national debt. That should lead us to ask: what role are those assets currently employed in? The answer is that they provide the income that is used to provide free banking services and interest.
It’s the income from a bank’s assets that funds free services and interest-bearing accounts. If the Baxendale plan were enacted then this stream of income would dry up. Banks would have to start charging fees for services and stop paying interest on balances in on-demand accounts. It’s difficult to estimate what the effect of this change would be. Some people would be indifferent to the change, those who use few banking services and don’t qualify for interest-bearing accounts, for example. It’s doubtful though that every account holder will fall into this category — if they did then these extra services would never have been commercial successes in the first place. Many other account holders will be sensitive to this change. I myself have been a user of interest-bearing on-demand accounts for more than a decade; I’ve always used a portion of my balance as savings.
Let’s suppose the plan is enacted and interest payments cease. Those savers like me who hold balances in on-demand accounts in order to receive interest will have to change our ways. The change will be permanent: the type of saver who once held a large balance in an on-demand account as an investment can no longer exist. Consequently, there will be a fall in the demand for these accounts’ balances when the plan is enacted. This is a fall in the demand for money. The savers in question will invest elsewhere, in interest-bearing bonds for example. Banks today offer notice accounts where the account holder must give a few weeks notice before they can withdraw. The Baxendale plan doesn’t extend to timed savings, so these accounts will operate as before; they are the obvious alternative to on-demand accounts.
Higher charges for banking services will also have widespread consequences. Businesses and individuals will have an incentive to avoid using banks for payments and transfers. Alternative methods of payment will become more attractive. Businesses will be more likely to use debt agreements and reciprocal cancellation. Suppose two wholesale companies A and B regularly trade with each other. Before the plan they make payments using bank services. After the plan they decide this method is too expensive, so they each keep a record of the debt that is owed to them by the other. Then at a regular interval they settle the net debt using money or bank transfer [4]. This will also cause a reduction in the demand for money.
The purchases of alternative investments will trigger what is called an injection effect. The type of saver I mention above will withdraw a part of his or her balance and put it into other investments. That extra demand will raise the price of such investments. The sellers of these investment products will receive that money and spend it themselves causing further price rises elsewhere. The sellers of these investments are not required to store the money they receive, they can spend it on investment projects. In time the money will spread through a large swath of the economy and price inflation will result. It’s a very similar situation to an injection of money by the central bank. These price rises will impair the planning and economic calculations of all individuals and businesses.
To recap, my opinion is that the Baxendale Plan would lead to damaging price inflation. By removing the extra services that bank accounts provide the plan will cause a fall in demand for money. If the stock of money remains the same while the demand for it diminishes then the value of each unit of money will fall.
Toby Baxendale’s Responses
Toby doesn’t agree with my criticism, we discussed this by email. Toby gave four counter-arguments:
Bank Services
Toby suggested that after the plan banks will use free services and possibly interest payments to attract customers. Toby wrote:
“Banks should charge for services rendered, why not? Maybe they will choose to subsidise the custodianship of cash storage. I sell fish for a living and to get hotels and restaurants to buy all of our fish species we sell, we have to discount the fastest moving lines, for example the salmon, and sell for virtually nothing. We are happy to do this as we work our margin in on the less important lines to our customers. Tesco sell cans of beans at £0.07p. This can not be even covering direct costs, but it gets people to walk into their store to buy other things that they make a full and sustainable margin on.”
This is called “loss leading”, a business offers a product or service at a loss in order to attract customers and build up a relationship with them. This hopefully gives the business an opportunity to sell them other products and services that are profitable. I agree that banks are likely to do this.
But, on-demand accounts attract customers to use other banking services now under the existing banking laws. What we should examine is the change: how would things change if the Baxendale plan were implemented? The situation at present is that a bank gains in two ways from offering on-demand accounts. Firstly, the bank can lend out the funds it receives from account holders, secondly, the account services can be used to attract customers towards other services. If the plan were enacted then afterwards only the latter incentive would apply. So, I think that if the plan were enacted then the provision of free banking services would decline, all other things being equal.
The Scale of the Problem
In Toby’s opinion the size of the effect I’ve described here would be small. If the total sum of balances in interest-bearing on-demand accounts is small then the cessation of interest would not have a great effect on the wider economy. Toby found some statistics on this from the Bank of England [5], these show that in March there was £386 billion in on-demand accounts that pay interest. As discussed above quite a large proportion of that amount would remain in on-demand accounts after the plan is enacted, though it’s impossible to accurately predict the proportion. However, I think it’s still useful to compare this figure to the stock of money-in-the-broader-sense. Anthony Evans and Toby Baxendale have made a measure of the UK money stock that’s consistent with the concepts of Austrian Economics [6]. By this measure the money stock is presently about £1 trillion. So, interest-bearing balances make up approximately a third of the total. The Bank of England use a different measure – “M4″ – which is based on different principles. According to that measure the money stock is about £2.2 trillion. I’ll concede that if the arguments put forward by Austrian economists against the M4 metric are wrong then I’m wrong about interest-bearing accounts. But, I think the arguments make by Frank Shostak [7] against the M metrics are persuasive.
However, interest payments are only one part of the issue, the cost of banking services is the other. If the banks were to significantly raise the fees for their services then the demand for balances in their accounts would fall. This depends, to some extent, on how the banks decide to charge. If the banks were to charge a monthly storage fee proportional to the account balance then that would be akin to a negative interest rate. That would be a strong incentive not to hold a large balance, but other charging schemes would have a similar albeit lesser effect. There are several historical precedents for this, Irving Fisher wrote about some of those in his booklet “Stamp Scrip” [8]. Fisher thought that reducing “hoarding” of money could be economically beneficial, I disagree. But, he provides evidence that charging for storage of money reduces the amount of it that people hold.
Price Deflation Afterwards
Toby writes:
“With a fixed money supply, the ongoing productivity gains by the entrepreneurs means that more goods will be offered for sale at better prices, this means the purchasing power of money has gone up. As this is the only way that we have economic progress with a fixed money supply, people will be more fixated on what their money buys rather than what the numerical value is supposedly going up by.”
In the long run Toby is correct, but, in the short run the purchasing power of money is affected by the demand for money. Steady price deflation could occur in the long run after the short term effects I’ve discussed here have played out. But, the stumbling block is the period directly after the plan is enacted. If I’m right and price inflation occurs then the government may call a halt to the plan and reintroduce the current banking system.
Effect of the Plan on Production
Toby writes:
“I concur with you that price realignments will take place as people adjust to the brave new world. This is wholly right and good, as what consumers want will be more aligned with what producers produce. What producers produce will correspond more closely with what savers want to buy when they spend their money. Only bubble based activity will be deprived of credit.”
Here Toby is referring to the Austrian Theory of the Business Cycle. That theory indicates that if the quantity of money and the demand for money remain stable then unsustainable bubbles become much less likely to form. But, like the price deflation argument this is a long term theory. It can’t tell us what will happen while the demand for money is settling down from the initial disturbances caused by the implementation of the plan.
Further Discussion
I’m sure lots of people will have opinions about this, and there are many more questions that remain to be explored. I think it’s likely that there is no way of transitioning to a better monetary regime without disturbances. However, we should endeavour to predict what disturbances may occur and plan for them. For now we can continue the discussion in the comments thread below.
References
[1] Ludvig Von Mises “The Theory of Money and Credit” Liberty Fund Edition, p.170.
In reference to Sean Corrigan’s latest piece on the problems that Ben Bernanke is facing, Cobden Centre readers may want to refresh their background to this story by watching a nicely produced YouTube video first broadcast seven months ago, featuring Ron Paul, Peter Schiff, and Marc Faber:
For those of you who have read AEP’s latest Armageddon story in the Telegraph, though the details of his ‘monetary’ analysis are, of course, suspect, the truth is that US money supply – properly measured – has slowed alarmingly of late, making the deceleration from last year’s peak one of the largest in the record. Regular readers will know that we set great store by such indicators and that we have been saying for some time that the real economy should be starting to feel the effects by the end of the third quarter.
I attended an interesting lecture at Civitas, on Wednesday night (23rd of June), given by Dr Paul Woolley on the title above.
Dr Woolley’s main contention was that the financial services system is clearly broken, particularly by the principal-agent problem where the agents (traders, fund managers, financial advisers) are milking the investment gains of the principals (that’s you, me, and everyone else with a retail pension), mainly through technological financial innovation, moral hazard, leverage, and the general opacity of the financial system.
The other main problem, he relayed, is the reliance of most people within the financial services system upon the Efficient Market Hypothesis (EMH), first proposed by Professor Eugene Fama in the 1960s and based upon the mathematical theories of the lognormal random walk, in which a single stock price perfectly reflects all the knowledge the market has about that stock at any given moment; without further information, the chance of today’s stock price going up or down tomorrow — or staying the same — can be predicted by a random variable drawn from a mathematical model; there is no historical pathway which can successfully predict tomorrow’s price movement!
To generate this randomness you can use a Martingale Brownian motion process using a Mersenne Twister algorithm, or a Black Swan Monte Carlo engine using a Latin Hypercube, or even a fairy cake using a really nice hot cup of tea, but however you predict tomorrow’s price movement, you cannot use historical chartism or technical analysis.
Obviously, virtually everybody in the City of London is using, or is at least aware of, the success of chartism, the Elliot Wave, and the other major tools of technical analysis, with constant talk about breakouts, support levels, and ceilings. At the same time, even chartists use the EMH model to price all of their structured products, to derive stock volatilities, and to generate their Values at Risk (VaR), whether they are using the weak, the semi-strong, or the strong forms of Fama’s EMH model (which use market information, all public information, or all public and private information, respectively, to define how accurate EMH pricing should be).
There is something within this dichotomy, observes the good doctor, which is dysfunctional. Everyone is acting rationally and yet we still had the Nasdaq bubble, the Housing bubble, and we have the ongoing financial crisis whose second part is ready to step back in from the wings, once the quantitative easing stimulus has worn off. If Adam Smith was right, then everyone acting in their own self-interest should produce the best of all possible worlds, and yet everyone in the financial services system acting in their own self-interest has led to a bloated monster which has sucked the productive sector dry, consuming both human talent and all other resources along the way. What has gone wrong?
As a former value-fund manager of some repute and one of the first to use quantitative methods, with some time also spent working alongside the IMF, Dr Woolley clearly possesses an impressive CV and knew of what he spoke.
His approach to a remedy consists of several elements. First, he is funding several centres, including one within the London School of Economics (LSE), to research what is going on under the hood of the financial system as it stands. Second, he outlined an initial plan where pension fund managers should be precluded from investing on a short-term momentum basis; they currently turn over each stock within their portfolios at about an average of eight months each.
Dr Woolley contends that this average period of stock turnover should be much longer, if real value is to be extracted from a stock (Charles Lee, the originator of fusion investing, thinks that it takes at least three years for a ‘fundamental’ value to materialise within a stock price). To prevent this high stock turnover of alpha-seeking fund managers, the plan is to cap stock turnover to 30% per annum; to preclude pension funds from investing in hedge funds, derivatives, and commodities; and to use GDP as a basic benchmark to compare pension funds against.
If his plan is implemented, Dr Woolley thinks that an extra 1.5% per annum of growth would be raised by pension funds, but only over the longer-term rather than theshorter-term.
I asked Dr Woolley whether or not his plan was just another set of regulations that the agents in the City would be able to skip around, taking us back to square one; others also asked whether or not this was an intrusion upon property rights.
Faced with a plethora of such questions, Dr Woolley’s multiple answers kept coming back to the overriding idea that however we do it, we need to introduce (or re-introduce) a culture of long-termist thinking into the minds of pension fund managers and that we need to get them away from their focus on the annual Christmas bonus round. A specific answer to one questioner included tax exemptions for those pension funds which stayed within the turnover cap plan (or tax penalties for those that didn’t).
As any regular readers of the Cobden Centre will know, we have many objections to the further imposition of yet more government regulations, taxes, and other central plans onto free people, and my own general solution to the principal-agent problem would not be to impose more rules of good behaviour, administered by a hopefully benevolent central planner, but simply to let Schumpeter’s unfettered creative destruction process execute itself properly by letting the market work; bad agents should be allowed to go bankrupt and taken to court to have their assets re-allocated by their contractual creditors, rather than these bad agents being bailed out with other people’s money, by the state, to cause yet more waste of yet more resources.
That will focus the agent’s mind, as it does in the rest of the free market; this engagement of Schumpeter’s weapon of creative destructionism will either make the agent think beyond next year’s bonus or it will put them back on the street alongside all the other working Joes.
At the moment, however, if the risk-return levels go south, the taxpayer principals are forced by government to pick up the socialised losses of the finance agents; if the risk-return levels go north, the finance agents get to keep the privatised gains extracted from the pension investments of the taxpayer principals.
As to the human capital that is being expended on this, if you have ever witnessed the mass-exams of the finance profession, where thousands of bright young energetic people subject themselves to gruelling financial tests of all kinds, then you will have witnessed the same examination fervour which aspirant mandarins put themselves through to achieve the higher echelons of economic success in imperial China.
If you have the mathematical ability, the motivation to do the hours required, and no particular bent as to what you should do with your life, then given a choice between working in a car factory in Sunderland generating useful consumer products or working in a Docklands bank generating collateralised structured financial products for pension fund managers, for ten times the money, it becomes what the Americans call a no-brainer.
I should imagine there are now even people who acquire doctorates in physics, not so much to help humanity reach the stars or to fuse the hydrogen atom safely to provide us with inexhaustible energy, but merely to get their first role within the quantitative finance function of a major money-centre bank, before moving on a few years later to a sexy hedge fund in St James.
To heck with colonising Mars; what’s my bonus going to be this year?
In my eyes, the moral hazard of the state backing risky behaviour, with virtually-guaranteed bailouts and bank account protections, along with legal tender laws and other fractional-reserve finaglings, all administered by a central bank which generates currency out of thin air as a ‘lender of last resort’, have created all of the problems that we currently face. It is central planning which is the problem, not the solution.
However, I did find it highly refreshing that even among what you might call the mainstream of financiers and economists, many of whom were in the room at Civitas, there is the genuine beginnings of a general recognition that something is broken and that something needs to be fixed; this is without even examining the reasons as to why the state has so gamed the system towards the financial sector, though we can come back to that enormous subject another day.
We have a different solution from Dr Woolley, here at the Cobden Centre, as to how we can fix this ragged something, based upon the Austrian Business Cycle Theory. But let us hope that we can all come together one day, before it is too late, and fix our monetary and financial system before the whole thing disappears into the liquid quicksand of Keynesian economics.
How Modern Finance and Government Intervention Crashed the Finance System
by Kevin Dowd and Martin Hutchinson , Published by Wiley 2010.
This book is a page turner. It is a must for anybody who has an interest in what has gone wrong with our financial system and thus the economy, and what can be done to fix the problems created.
It is an unparalleled tour de force of the last 300 years of modern finance with special focus on the last 30 years and microscopic focus on the last 30 months. In years to come this will be a book that our children and our grandchildren refer to when studying “The Great Crash” of the last years of the last decade. Sensible lesson are learnt from the Japanese 20 year recession rather than the 30’s. The various stimulus packages and failed deficit spending should be there in your face for anyone with above room temperature IQ to learn what not to do, but hey ho — every generation, like monkeys, we seem to have to re learn everything in economics all over again. The short sharp shock of the Savings and Loan crisis of the early 80’s could well show us a way forward on the 00’s.
The alchemists in the title are 7 Nobel Prize winners, investment bankers, the political class, other economists, and regulators. They exploit the frailty of the human condition — our impulse to believe that “this time, things are different.”
Dowd and Hutchinson show beyond all reasonable doubt how the financial centre of the economy has become one massive rent extraction machine where gains are privatised and the losses are socialised — paid by the likes of you and I, the hapless taxpayer. The bailouts are unquestionably the biggest examples of this. No other industry on the whole planet would get this treatment. Smaller examples of rent seeking are the successes of the industry in achieving light touch regulation and non-domiciled tax status for over 100,000 UK financial service workers. Indeed, unbeknown to most, the UK is one of the biggest tax havens in the world.
The authors also conclude, like I do, that excessive bails outs funded by deficit spending leads to government debt crises, which is “solved” by either monetisation of the debt (inflation), or straight forward sovereign debt default.
We must remember that in 2008, one quarter losses of the financial system cost us taxpayers, one quarter of a century of profits! Read that again. It is so staggering a figure that anyone who even believes these Alchemists should be allowed even near their own money, let alone ours, occupies a different planet to me.
My in-depth review follows. I am inviting the authors to critique it. There is much good debate to be had. I start with their conclusions that will give you a flavour of the book and you may well stop at that. If you want to delve deeper, I explore some of the issues more. However, this is no substitute buying the book. I hope the compelling policy recommendations will be taken up and the book itself will be a major historical book that will last the test of time, and be read by generations to come.
How to Exit this Mess
No more bailouts just bankruptcy and a realignment of capital to those who are more prudent.
Make debt for equity swaps if need be with over leveraged banks. Ironically, this is the policy the banks themselves are forcing on companies that they deem to be too highly leveraged. What is good for the goose is good for the gander.
Abolish deposit insurance.
Remove failed management in the banks and in the regulators.
Abolish the regulators and put the individual back in change of his/her risks.
Move to historical cost accounting and not mark to market.
Move back to partnership banks with open-ended liability. Like doctors who have an open-ended liability to you in the advice they give and medicine they administer, they are professional experts and you are not. They have a fiduciary duty to you. So too should the bankers go back to having this fiduciary duty to you.
If mathematical models are to be used at all in risk management, they suggest the “Expected Shortfall” or the “Probable Maximum Loss” model. I personally have reservations about any mathematical models as I favour sound entrepreneurial judgment. If you do not have this, you should not be playing, thinking you are investing, with savers’ money.
My view on Maths in banking is that Bayesian or non Bayesian, Cauchy not Gaussian, fuzzy logic or good old fashioned Aristotelian logic is all by the by — if you don’t have a talent for matching the needs of savers and borrowers, you should not do banking. No mathematical system will aid you in this. This alternative model outlined by Dowd and Hutchinson is new as far as I am aware, and needs to be debated. It is certainly better than our Alchemists of Loss failure model. Personally, I favour entrepreneurial judgement by bankers with open-ended liability.
Scenario planning should become a major factor in banks’ internal risk assessments. I agree, predictions are binary and assumption-laden. Scenario planning, especially if it is ongoing, is like musical chairs — you always have an eye on a seat should the music suddenly stop!
Rating agencies should be compelled to remove conflicts of interest by not being paid to assess a security by the issuer of the security!
CDS instruments should only be allowed to be sold to you if you have an “insurable interest” in the underlying asset. See more in the article about this very interesting proposal.
Use the language of investment and not speculation. If you use the latter, you are a gambler, if you use the former, you are a banker.
Let judgement rule over the mathematical models. Do not diversify for the for the sake of the model.
If you do not understand it, do not buy it.
The recommendation they make to set up Zombie banks, I take it to read as simple saving and lending, plain vanilla banks like Jimmy Stewart / George Bailey in “It’s a Wonderful Life” would have run, as opposed to the Zombiefied state owned banks that we see today that are very challenging to deal (as anyone in business will testify).
Root money back into a commodity standard such as gold. This would require no central bank support (i.e. the central bank could be abolished).
If a central bank does exist, go for the hard money Volcker-style monetary control or hard currency control like the early Bundesbank.
They suggest a tax on assets to make the very large banks shrink. Personally I would suggest that if that is the way they want to go, they can just lawfully enact legislation to break them up. If free competition in banking with no central bank and no legal privilege is allowed, then the Behemoth banks would wither on the vine anyway.
Concerning the ad valorem tax, should we keep the existing banking system, it will only push up the prices for the products sold. I do not know how this will achieve their desired objective of limiting excessive trading.
Equalisation of taxes on dividends and interest as a foil against excessive leverage sounds a plausible reform should we stay with the existing banking system.
Abolition of the non dom tax breaks which allow 100,000 people in the City of London to work in the biggest tax haven in the world and pretend that most of their income comes from elsewhere should be abolished.
Establish a monetary constitution via legislation like the 1994 New Zealand Fiscal Responsibility Act sounds like a very good move to prevent the governments from going back to their old ways of monetising debt.
Abolish the IMF and the World Bank, as these just perpetuate the international bureaucrat class that feathers its own nest and gives bad advice for recipient countries they lend to.
Stop crony capitalism where bankers become politicians with ease, then go back to banking again. Make a mandatory time separation required should anyone want to move between the two, as has become fashionable during this period.
Abolish any estate duties / inheritance tax so families can once again be the primary owners of banks and long term shareholders encouraged, often on an intergenerational level which is lacking today. Wealth confiscation by these taxes has created the big unaccountable beasts we have today. Let us go back to shareholder capitalism and not institutional crony capitalism.
Above all bin Modern Financial Theory – it has utterly failed us.
For me I say amen to pretty much all of the above.
Modern Financial Theory
The authors see the current mess we are in as a blend of two very wrong belief systems. The first is what is called Modern Financial Theory and its offspring of the Efficient Market Hypothesis, Capital Asset Pricing Model, Black-Scholes equation for option valuation, Modern Financial Risk Management. The intellectual edifice of the above was spawned by 7 Nobel winners, the lead Alchemists of Loss. I find these distinguished mathematicians to be great builders of elegant mathematical models, but they are abstract and do little to help us study and understand the human condition.
A good start point for Modern Financial Theory is the 1958 seminal Modigliani-Miller Theorem. Believe it or not, this Theorem states the following: the value of a company is invariant to its capital structure; or simply put, the capital structure, the balance between debt and equity, is irrelevant!
Gloriously the theorem assumes;
No taxes,
No difference between the rates at which corporations can borrow,
Zero transaction costs,
The complete absence of agency costs
This gave academic credence to equity light, heavily laden, debt leveraged companies. With assumptions like the above, it is hard to imagine what relevance this has in the real world that we live in. It has always alarmed me that such mathematical economics with its unrealistic, otherworldly assumptions should be taken seriously as tools with which to govern our lives.
Modern Portfolio Theory came along around this time as well. You have a steady income if you diversify your risks. Ideally you want to have an investment portfolio with negatively correlated companies so if one is tanking seasonally, there is another over performing etc. The volatilities are labelled as a sigma and the higher the sigma the more volatility. A portfolio manager should not worry about individual sigmas but about the sigma of the whole portfolio. I would add a further point: if a portfolio manager is so dull that he can’t look for companies with at least some of the following traits, then perhaps he is in the wrong business:
Strong balance sheet with good equity and retained profits for a rainy day,
Ongoing investment,
Inspiring entrepreneurial leadership,
Good executive management,
Sensational, functional product,
High or strong barriers to entry
Modern Portfolio Theory
In enters Harry Markowitz, another Alchemist of Loss, he claimed to be able to fix this problem of capital allocation in an investment portfolio by using statistical methods. Assume a Gaussian distribution of return from all investments — i.e. a Bell Curve and know the sigma and plot the correlations between them — and there you have it: capital allocation choices are no longer subjective, but objective and quantifiable. Now you could just take your pick of your preferred tradeoff between risk and reward.
Furthermore, you could now mathematically determine if a new share was added, its riskiness (beta) or its potential for reward (alpha). So the search was on for low beta and high alpha. My points one to six mentioned above never seem to get a mention.
The Gaussian curve (think Bell Curve) clusters most sigmas in the bell of the curve with the lip tailing off to the most improbable sigma events. To give you a flavour, 5 sigma loss is a 14,000 year event. A 23 sigma event is measured in many millions of years. In 1987 we had one when the stock market crashed, and we had one again in 2008. The authors quite rightly question the sanity of anyone who can believe in this nonsense:
So when Goldman Sachs Chief Financial Officer David Viniar famously admitted to being puzzled by a sequence of “25-standard deviation moves” in August 2007, it might have occurred to him and others that Wall Street’s risk management methods even at the best-run institutions where hopelessly inadequate.
Efficient Market Hypothesis
This was the claim that market prices were efficient, i.e. they fully reflected all available price data . This fitted in nicely with the homo oeconomicus of the Neoclassical School: that perfect all-seeing, all-knowing, rationally acting man.
The Blend with Keynes
The Keynesian system of state intervention and deficit spending, via gigantic monetary pumping is the other trend line that has rollercoasted us into a brick wall. Even though they all accept that credit is the creator of the boom and the bust, they see more credit as its cure. I call these economic practitioners witch doctors and mystics; the politeness of Dowd and Hutchinson does not allow them to use this language, but I am sure they agree with my sentiment.
The Emergency of Crony & Managerial Capitalism
With the advent of Modern Financial Theory, we have seen the explosive growth in institutional ownership of shares and the demise of the private share owner. There has also been a shift in the investment horizon from the long term to the short term. In the 1950’s institutional ownership was some 15% of shares in the USA. Death duties and other measures such as a pro inflationary policy had extracted wealth from the long terms savers and by the 1980’s , over 50% of shares were held by institutions, where it remains today. The family owners who controlled their shares have been usurped by the middle manager, a salaried man commonly incentivised by a short term bonus and not the underlying shareholder gains.
Modern Financial Theory also has suggested that the management are perfectly aligned with their shareholders if they are given options to effectively make them mini owners, the reality is most hold options for the shortest time period and sell for gain as soon as they can. If there is no gain, they lobby their senior manager to have their sunken options re-valued again so they can have another go until they hit the cash-in jack pot.
CEO salaries from the 1980’s in the USA have grown from 42 x average worker earnings to 520 times. The Theory would work if shareholder value had risen accordingly. Sadly, this annual growth of over 8.5% in CEO salary corresponded with a 2.9% annual growth in profits. Management somehow managed to get rewarded when shares went up, but never had to return their bonuses when the share value went down. The dice now seem to be loaded in favour of the manager rather than the owner.
Management while in control can push down dividends (now yielding 1% on average in the USA), load up debt, and thus push the share price but not the net value of the company up, forcing more events to run through the extraordinary line and not the income statement. Practices like this are more prevalent now than ever.
The authors conclude that our system of capitalism is little better than the corrupt crony capitalism of the new Russia, where only a handful of people gouge the majority.
One statistic that shocked me is that fees to financial management account for $620bn in the USA or a full 4.5%of their GDP. Once you take into account the need to pay these fees before you even earn a dime, it is little wonder that it is hard to get a return while the “croupier” is always winning!
Hedge funds regularly charge “2 and 20” i.e. 2% management fee each year and 20% of the upside. They never give 20% of the downside back when the shareholders suffer loss, it is almost a one way bet for the fund manager.
Derivatives
Outstanding trades are 10 times larger than global GDP at $512 trillion. With global GDP at $50 trillion, they estimate that only $2 trillion is actually used for some genuine hedge purpose. The liquidity that we actually need to facilitate transactions is only a fraction of the hedge value, so why the need for all of these trades? To me they are just bets, mere gambling. The authors do not spell this out, but I suspect they would agree. They label these trades as just plain rent seeking, another way for Wall St et al to extract more and more wealth from the system.
If it is gambling, I say let them gamble, but like a gambling contract, give it no enforceability in law. Make them do it in casino companies and not banks that should have a fiduciary duty to its stakeholders!
The Ticking Time Bomb Securitization
If you can package up your mortgage book and sell the income stream to some third party for a profit on the income stream, even though you have not had to wait for the full 30 years of the mortgage income to come through to you, you can a) hold less capital in place to cover defaults on these loans and b) book all the income into the income statement in one year. This means big bonuses being paid on profits that have not even materialised! I personally would love to book 30 years hypothetical profits of my business into one year and take and mother of all bonuses. Also, being a simple seller of fish and meat, this opportunity does not offer itself up. Being a banker however and way-hey, you are in the money big time! No wonder there has been a rush to securitize assets in banks like this. With the backing of Modern Financial Theory giving you the academic basis to stretch your capital as far as possible, and leverage, leverage, leverage, in the knowledge that high numbered sigma events are a 1 in 10 thousand or million year events, you are off to the races with sure fire certainty that this is the right thing to do.
Needless to say, you can see the moral hazard in being able to sell mortgages in the knowledge that you will never have to see them through to the end of their life. Unless you are really unlucky and have some very early month defaults, you will never see a default as it is not your problem.
The rating agencies that are complicit in this process are paid by the bank that is selling the security – no conflict of interest here then!
The Community Reinvestment Act 1977
This act was a push to force lending to minorities and poorer families, well intentioned I do not doubt, but the sad fact was, for the sake of box ticking with regulators and with the sure fire knowledge that you could lend to sub optimal borrows and remove it from your balance sheet AND book profits for the whole duration of the loan to your current year P&L via securitisation, and the time bomb of subprime was set. The only wonder is how long it took to explode!
The Unbalanced Economy
At the start of the 80’s in both the UK and the USA, the finance industry was around 5% of GDP, now it is close to 30%. The authors point out that whilst the croupier can feed on us for a while, what indeed are we going to feed ourselves on in the future? The authors are correct to point out the dire straits that both economies (USA/UK) are in and rightly question what the long term survival of both is going to be predicated on.
Credit Default Swaps
These were created in the 1997 and from nothing reached $62 trillion by 2007. They allow the owners of the swap to manage their risk exposure to a particular credit default (“going bust”) event. Consider this as an insurance policy against an underlying asset going bust on you. You could now own a bond in a company and hedge your bets by taking out a CDS and now bet that the company could fail. This was a perverse incentive when the CDS became more valuable that the bond itself. The authors liken this to a spectator shouting “jump, jump” when some poor desperate soul is contemplating suicide. You did not even have to have any relation with the company insured against as we saw with Lehman as CDS positions were compelling the quick death of this company.
Life Assurance Act 1774
The authors make a very important point. The above act introduced the concept of “insurable interest.” Before this a life policy could be taken out by anybody over anybody. There was presumably a high incidence of death for no apparent reason and the concept that you must have an insurable interest to have the policy came into existence. A move to establish the insurable interest equivalent for the CDS is certainly a way forward worth investigating.
The reality is, with Modern Financial Theory and its faulty mathematics predicting very remote possibilities of loss, the selling of CDS to support securitisation, that biggest of all money spinners was easy money for all in the finance sector. The horn of plenty continued to gush forth money for all involved in these operations. AIG was one of the biggest counterparties. They loved the fee income and with Modern Financial Theory saw the risks to be negligible.
Mark to Market Accounting
The move from “historical cost” or “lowest realizable value” is lamented by the authors as the finance sector has moved to “mark to market”. This allowed the ever rising valuations in the balance sheet, from which income that was not earned could be extracted in the form of bonuses. Naturally if the valuation went the other way, nobody was ever asked to put their bonuses back.
Deposit Insurance
Because banks lend more than they have in the vaults (i.e. they maintain a fractional reserve, unlike every other kind of commercial entity, which needs to keep its creditors whole), the USA introduced deposit insurance in the early 30’s to assuage the rational fear that people have of a bank run. The Alchemists, Diamond and Dybvig show in their abstract model of 1983 that if you include this policy in your banking systems, you stabilise the system so it can on lend as much as it likes. There is no surprise to anyone that more risk is thus taken and capital driven to its lowest possible number so all capital is working efficiently!
Investor Protection
Dowd and Hutchinson show how this moves the onus of protection from the individual to a whole array of government bodies that end up not protecting you. Never has there been a bigger system wide banking failure with tens of thousands of regulators. In my industry with have fish quotas and controls set on scientific measures undertaken by the EU. No one believes their data on sustainability so new organisations in the private sector have been created to fill this gap giving sustainability information such as the MSC and the British Soil Association. If we all have a stake in our industry we manage to provide for the long term. Shift the responsibility to a third party to look after us (or be forced to be looked after via the government) and it is no surprise that the whole house of cards has toppled down.
The Regulators
The story of the incompetence of the FSA and the SEC is told, and it would be funny if it were not such a telling bit of real financial history with us as the victim.
Bankruptcies
Bankruptcies have been made easier to undertake, and to recover from. We should go back to the old bankruptcy laws.
Basel I, II & III
If you wish know in detail how the Alchemists’ VaR (Value at Risk) modelling has made this juicy bit of regulation positively dangerous then I believe Dowd and Hutchinson make a compelling case indeed. The banks working under their partnership model with open ended liability would not have historically countenanced such mathematical abstractness to justify massive risk taking.
Some History
All historic recessions are shown to have been caused by either just one of these five causes or a combination of them:
Rampant speculation,
Government involvement,
Misguided monetary policy,
Misguided regulation or legislation,
New financial technology
All five were present in the 2007/08 Crash!
Values Lost
Partnership and open ended liability was the way forward for most of the great names in banking historically. Limited liability was something that you had to apply to parliament for. The knowledge that you could lose your entire wealth as a bank partner historically kept you from undertaking risky acts. You were prudent, your reputation was everything. This ethical and commercial stance was no hinderance on the creation of wealth in society as Modern Financial Theory will tell you; indeed we must remember that the whole industrial revolution was built on very solid financial foundations. The authors give ample evidence for this.
Although Dowd and Hutchinson do not explicitly mention it, the language of banking was of the fiduciary and now it is that of gambling.
The authors mention that the during the period of partnership-led banking there was also the establishment of such organisations as the Accepting Houses Committee in 1914, which you would not be allowed to join if not of a certain reputation, and you would not be allowed to have your trade bills “accepted” by the Bank of England.
The Financial Services Act 1986 swept all of this away. I remember being very supportive of this liberalisation as a child, but in hindsight it was ill thought out legislation. My personal view is that instead of a banking system based on bankers holding fractions of deposits in reserves against liability claims, we need 100% reserve free banking to produce a robust system. No amount of good practice can ensure the system stays solid when it is inherently illiquid by any normal commercial accounting standard. The authors suggest that a fractional reserve free banking system similar to the Scottish system in the early 1800’s would be the model to follow with all of the reputational and partnership ethic strengthening up the system. This however is a small quibble about their reform program and not with what they have to say about what has got us into this mess.
Buy the book, it is a sensational read.
Afterthought
Dowd and Hutchinson on Economics
They hold the view espoused by Friedman and Schwartz that the problem with the 1930’s was that the Fed did not keep the money supply at the levels seen in the build up to the 1929 crash. They hold a conventional monetarist position. They do not discuss or entertain the possibility that the massive uplift in money supply from 1913 – 1929 may well have been the direct cause of the asset inflation, i.e. excess credit created the boom that led to the bust.
By advocating that during this bust stage we should not do what other monetarist inspired economists have done (such as Bernanke, who flooded the market with liquidity), they take what I would call a hard monetarist view and suggest a route of keeping money supply growing only at the rate that productivity and the needs of trade demand. They do not discuss the Austrian Theory of the Business Cycle, which I think is the most useful theory for explaining the boom and bust. This is puzzling.
The official launch for Alchemists of Loss will take place on Wednesday 30 June 2010. Contact the IEA if you are interested in attending.
