Thursday, August 11, 2011

Why is the Invisible Hand in My Pocket While China Grows Unchecked?

Devotees of Rapture Theory are likely wondering why they got left behind during the Tribulation.  More worldly, modern persons, who eschew eschatology might nonetheless be worrying about TEOTWAWKI (which is, ironically enough, the same thing).  Devotees of Cyclical Theories of History (Kondratiev, Strauss and Howe, Hinduism) are likely seeing the end of a K-wave, the Fourth Turning, or the coming of Shiva, respectively.

Was it just a little over a decade ago that the New American Century was dawning?  History itself, according to some, was ending.  With free markets across the globe open 24 hours a day the invisible hand was sure to make our future bright.

Then the invisible hand started picking pockets, crashing the Tech market in which many had invested, and foreclosing on houses in which even more had not only invested but lived.

What happened to the invisible hand?  Was it always just a scam- a means to shift income to an increasingly select few?

Back when Francis Fukuyama was proclaiming the End of History, faith in the free-market inspired invisible hand's virtue was hard to challenge publicly.  A few years ago, echoes of that faith still resonated, as was evident when the presumed bastions of free markets, the banks, were saved from the effects of their own unwise speculations and lending.  Today, the natives seem a bit (in London, a lot) more restless.  It might, given current conditions seem a bit odd to resurrect that rapidly fading totem so let me try to explain.

Recently I've been reviewing the work of Mancur Olson, particularly the role of interest (or ownership, if you wish) in fostering an invisible hand effect, or in the US' case of late, the lack thereof.  In The Economics of Autocracy and Majority Rule: The Invisible Hand and the Use of Force Martin McGuire and Mancur Olson argue persuasively (in my view): that whenever a rational self-interested actor with unquestioned coercive power has an encompassing and stable interest in the domain over which this power is exercised, that actor is led to act in ways that are, to a surprising degree, consistent with the interests of society and of those subject to that power.  In other words, for the socially virtuous invisible hand to manifest some person or group has to think they own now and will in the future, their domain- that they are part of the realm. 

McGuire and Olson's argument begins with a hypothetical discussion of a bandit's transition to a benevolent dictator: Consider the interests of the leader of a group of roving bandits in an anarchic environment. In such an environment, there is little incentive to invest or produce, and therefore not much to steal. If the bandit leader can seize and hold a given territory, it will pay him to limit the rate of his theft in that domain and to provide a peaceful order and other public goods. By making it clear that he will take only a given percentage of output – that is, by becoming a settled ruler with a given rate of tax theft – he leaves his victims with an incentive to produce.

According to this view, free markets, which were apparently considered a condicio sine qua non- a necessary condition- of the virtuous invisible hand are rather simply a medium for aligning interests, which can be either those of a bandit or of a long term owner.  Multiple financial crises over a relatively short period of time are a sign that banditry, not long term ownership are the aims of large players in our free markets.  What long term owner wants multiple crises over a short period of time?

For a real world example of the difference between a bandit and an owner, consider the case of JP Morgan.  Whatever his initial designs as a young man, from his mid-50s until the creation of the Fed in 1913 Mr. Morgan had great power over (owned, some rightly argued) American finance.  As McGuire and Olson argue, the more control he gained the more he seemed to care about systemic solvency, of course, not without expecting great gains for himself.  Morgan knew that long term American financial difficulties were not at all in his interests.  A growing American economy was a condicio sine qua non for a wealthier JP Morgan.  While hardly a benevolent dictator, I hold to my view expressed here I’m confident if JP Morgan were running the Fed, credit growth would have been restrained long ago.  There is some merit to having someone "own" an issue- unlike Greenspan, Geithner, Rubin et alios, who claim no responsibility.

These days, American finance is run and regulated by people who have much less "skin in the game."  As I argued previously (here): It's apparently much better to work in a senior position at a money center bank than to own one.  For JP Morgan, risking insolvency to make Wall St. analysts happy would have been absurd.  The benefits accruing to him (higher dividend pay-outs for a few quarters- selling bank shares was considered silly then) would have been overshadowed by the potential loss in corporate stock value.  Today's money center bank CEOs, whose compensation is heavily skewed towards cash can run a bank into the ground and, in the event a bail-out isn't forthcoming, retire in luxury. 

Consider the case of Dow Kim, detailed in the aptly titled NYTimes article, On Wall Street, Bonuses, Not Profits, Were Real: For Dow Kim, 2006 was a very good year. While his salary at Merrill Lynch was $350,000, his total compensation was 100 times that — $35 million.....But Merrill’s record earnings in 2006 — $7.5 billion — turned out to be a mirage. The company has since lost three times that amount, largely because the mortgage investments that supposedly had powered some of those profits plunged in value.  Richard Fuld, ex-CEO of Lehman Brothers, earned some $45M in 2007, one year before that firm went bust.

Had Mr. Kim or Mr. Fuld held large stakes in their respective firms would they have been so reckless?  Would the real sector in the US be starved of cash, as is currently the case, if the reckless behavior of those like Mr. Kim, Mr. Fuld and others hadn't required their and other financial firms to be bailed out?  The large additions to public sector debt caused by the recent bail-outs are one of the main reasons the US debt rating was recently downgraded.

Meanwhile, over in ostensibly communist China, the invisible hand seems to be working just fine.  China's political leaders think like owners and through, at times, admittedly coercive policies, impose that view on others.  While China's middle class grows by leaps and bounds the American middle class is shrinking fast.

What can be done?  Assuming there is something to the views of McGuire and Olson, and I do so assume, the US needs leaders who think like owners instead of hit and run bandits.  Cash pay-outs and easily converted stock-option grants need to be replaced by long term equity holdings- players need to be forced to have "skin in the game".  Regulators too might perform better if their compensation was tied to disaster avoidance (imagine if FDIC regulators received bonuses if no banking crisis occurred not only during but 5 years after their tenure). 

In short, the US would be well served by reviving faith in the virtue of ownership.  Large public companies with diffuse ownership structures have been treated as disposable ATMs by senior officials.  Forcing people to have "skin in the game" before allowing them to make policy decisions seems like a good idea.  Even my local bank, of which I'm a shareholder, requires Directors to have a reasonably large stake therein. 

Sunday, August 07, 2011

Them's Fighting Words

As the war of public words between the US and China escalates, the old adage- When you owe the bank $1Mil, you owe the bank.  When you owe the bank $10Bil, they owe you - springs to mind, with a nasty twist. Chillingly, both parties are nuclear armed with significant standing armies.

Following S&P's downgrade of US debt China's Xinhua news offers the following wise economic advice:

China, the largest creditor of the world's sole superpower, has every right now to demand the United States to address its structural debt problems and ensure the safety of China's dollar assets.

To cure its addiction to debts, the United States has to reestablish the common sense principle that one should live within its means.

S&P has already indicated that more credit downgrades may still follow. Thus, if no substantial cuts were made to the U.S. gigantic military expenditure and bloated social welfare costs, the downgrade would prove to be only a prelude to more devastating credit rating cuts, which will further roil the global financial markets all along the way.

Alas, sometimes economic wisdom clashes with political reality.  Chinese calls for US military expenditure cuts will prick US hawks' ears the wrong way.  I can hear them now- this has been China's goal all along.

I fear the world just took a step closer to the abyss of war.

Thursday, August 04, 2011

A New (and most interesting) Blog

NewPopulationBomb by historian  Jack Goldstone whose Revolution and Rebellion in the Modern World was an enlightening read.

Today's post, La Grande Revolution, Encore is quite pertinent for modern America.

To wit:  Is there a lesson here for today, or is this ancient history?   In fact, the parallels are remarkable.   Just as today, the elites in the US are confusing their self-interest with principles of freedom from taxation, when in fact the critical principle is that the country must have sufficient revenues to cover its necessary expenses and service its debts.  As to the deficit, conservatives blame it on Obama just as 18th century French elites blamed their deficit on the king. But just as in France, the greater portion of the the long-term deficit in the US is being driven by population change, which the President cannot affect.  The number of Americans over 65 will double over the next forty years, from 50 to 100 million.  The increases in medicare and social security costs that this will bring cannot be covered by simply cutting spending unless we decide to toss out these programs altogether

Wednesday, August 03, 2011

When is a Non-Default a Default?

'When I use a word,' Humpty Dumpty said, in rather a scornful tone, 'it means just what I choose it to mean — neither more nor less.'

'The question is,' said Alice, 'whether you can make words mean so many different things.'

'The question is,' said Humpty Dumpty, 'which is to be master — that's all.'

The US Government, according to most press reports, has, by virtue of a last minute- a self-designated limit, it seems worth noting- deal, avoided default.  Amazingly, both the process and situation are even more confusingly convoluted than my opening sentence. 

Imagine a world in which the debtor determines whether or not he is in default.  In that world defaults would be rare events indeed.  Alas for the debtors, but fortunately for the solvent, our world doesn't work that way, no matter how things might appear. 

In our world, debtors don't determine default, creditors do. 

Here's what some important US Government creditors have recently been saying:

1) China: (Xinhua News) With its debt already almost equaling its gross domestic product, the United States, as a major anchor of the increasingly globalized world economy and the issuer of the dominant international reserve currency, needs to roll out more responsible and effective measures to balance its budget and restore the economic health of itself and the world.

2) Russia: (Reuters) They are living beyond their means and shifting a part of the weight of their problems to the world economy...They are living like parasites off the global economy and their monopoly of the dollar. - Russian Prime Minister Vladimir Putin

3) China: (RawStory) China's foreign exchange reserves will continue following the principle of diversified investment, enhancing risk management and minimising the negative impact of volatility in global financial markets," People's Bank of China governor Zhou Xiaochuan said in a statement.

"Large fluctuations and uncertainty in the US treasury bond market will affect the stability of international monetary and financial systems, which will hurt the global economic recovery."

Also on Wednesday, the Chinese ratings agency Dagong downgraded the United States for the second time since November, with a continuing negative outlook.

Meanwhile my preferred measure of US credit worthiness (and market in which nations of less military prowess might express their views more safely), the value of Gold in US$s continues to set new records.

With combined holdings on some $1.28T of US Treasuries, China and Russia are, unlike the US, in a position to declare the US in default, which brings us back to the big egg.  Humpty Dumpty's great fall might prove prophetic (and hopefully, beneficially cathartic) but it's his words that haunt me.

The question is, which is to be the master- that's all

Once words (like default, creditworthy, war, ally, etc.) lose their agreed upon, dictionary meanings, might is eventually used to make right.  The US Kabuki Play that was the debt ceiling debate has apparently failed to convince our militarily armed creditors we have jumped back from the abyss.  They seem to think our non-default still looks like a near default, and are taking action.  Will we continue our dance, putting off hard (but oh-so-necessary) decisions hoping to distract our creditors with drama, or will we make honest strides towards resolving our debt issues, which, first and foremost, must include growth policies (of the non-rent-seeking kind)? 

As an aside, the notion that our debt problems can be solved simply through broad spending cuts or tax increases is absurd to me (and likely to our creditors).  If the US economy does not resume growing fast the Washington crowd can crow about avoiding default all they want, but the rest of the world will know otherwise and act accordingly. 

If the Washington crowd chooses the former "more of the same" option, we might have to have a contest (a.k.a. War) to answer Humpty Dumpty's question- which is the master?

In hindsight, it might have been better to self-declare default and immediately start picking up the pieces instead of watching and waiting while the big egg teeters on the precipice.  After all, we know how the rhyme ends.

Luckily, capitalism doesn't require putting the pieces back together again.  Indeed, capitalism works best when the broken pieces are used to make newer, better things than a silly egg on a wall, destined to fall.

Full Disclosure: Long Gold