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. 


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