Dangerous Economic Territory - The Globalist

Summary:
David Smick ("The World is Curved") thinks that the politicization of globalization is putting a quarter of century of amazing prosperity and global poverty reduction at risk, potentially sending the US back to Seventies-like period of economic devastation. Globalization, free trade and liberalized financial markets have been a bipartisan success story (Reagan and Clinton). Was a tool to break away from the economically suffocating 70s. But this period of political consensus is at risk of coming to an end. Part of the financial market turbulence, and dollar weakness, in recent times stems not only from subprime-related credit uncertainties, but also from uncertainties about the direction of U.S. politics. Growing belief that the financial world, politically speaking, has entered uncharted political waters. Today’s voters look at globalization’s downsides with not enough appreciation of its tremendous upsides, and the political community is at risk of creating the conditions for a global financial disaster. Urgent need to expand the base of financial capital ownership and reduced the wealth gap. (Published: 09/09/08)

Notes:

• last quarter century
  
• relatively seamless, bipartisan political consensus in favor of free trade and liberalized financial markets
• globalization neither a Republican nor Democratic phenomenon
• not much difference in economic policymaking between Bill Clinton and Ronald Reagan
• both Reagan and Clinton grabbed on to globalization as a flawed yet essential tool to break away from the economically suffocating 1970s
• quarter-century of amazing prosperity and global poverty reduction
• period of policy consensus is at risk of coming to an end
• both political parties in the United States backing away from the pro-globalization policies championed by Bill Clinton
• part of the financial market turbulence, and dollar weakness, in recent times stems not only from subprime-related credit uncertainties
• also from the uncertainties about the direction of U.S. politics
• US politicians engaging in populist attacks on capital formation, entrepreneurial initiative and wealth creation
• problem with politicizing globalization
• world financial markets until now have set the price of U.S. financial assets, including the price of stocks
• at relatively high values
• based on the assumption that the Clinton-Reagan model of free trade, liberalized capital markets and long-term robust growth will remain largely intact
• new political universe emerging: less patience for freely liberalized trade
• questions of the hour are:
  
• How will markets in coming years reprice the changing nature of the political environment?
  
• Will an aggressive downward repricing of financial assets happen in a climate of panic?
• threat for financial markets of unwise political change is very real
• growing belief that the financial world, politically speaking, has entered uncharted political waters
• today’s voters look at globalization’s downsides with not enough appreciation of its tremendous upsides
• helped U.S. economy pull itself out of the 1970s period of economic heartache
• 1980s and 1990s produced a renaissance of American confidence and optimism about the future
• level of global wealth creation and poverty reduction that would have seemed far-fetched, verging on pure fantasy, in the late 1970s
• return to the seventies?
• economically devastating period
• politicians flirting with protectionist, class warfare policies that would unravel economic success that a broad international coalition worked desperately to achieve
• in rejecting the free-trade, liberalized financial market agenda of Bill Clinton, political community is at risk of creating the conditions for a global financial disaster
• first we’ll see a steady loss of global investor confidence in the US
• followed by shrinking of liquidity and credit availability
• then a protracted period of stagnant economic growth far below potential
• weaker growth will beget even more protectionist, class warfare rhetoric and policy
• will further shrink confidence in the US throughout the international system
  
  
• need to expand the base of the investor class
• future of globalization is politically unpredictable fundamentally because the base of financial capital ownership is so small
• wealth gap is widening
• as a result, globalization’s political base of support remains tenuous at best

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Ownership vs markets - Stumbling and Mumbling

Summary:
Chris Dillow argues that the traditional capitalist ownership structure is responsible for the credit crunch, not free markets as others have argued. Banks lost money on mortgage derivatives because of principal-agent failings, i.e. bosses (principals) don't know what the traders (agents) are doing. Traders have an incentive to take risk: life-changing bonus; gains exceeds benefits of prudence. Also, little pressure upon banks' executives to be prudent because when shareholding is dispersed, no individual shareholder has much incentive to rein in management. There has been more "bad" financial innovation that good ones. With good financial innovation it is very difficult for anyone to own its beneficial effects, it's a public good. Gains from “bad” financial innovation are more appropriable, hence we get more of it. Finally, banks' reluctance to lend to each other stems from the inability of management of such complex organisations to know everything. Banks should become more like venture capitalists, i.e. using an internal market, allocating capital to semi-independent divisions, which put in their own capital. (Published: 12/09/08)

Notes:

• Samuel Brittan and Anatole Kaletsky: credit crunch is undermining the case for free market capitalism
• but: crucial distinction between free markets and traditional capitalist ownership structures
• credit crunch does more to highlight the failing of the latter than of free markets
• Four reasons
• Banks lost money on mortgage derivatives because of principal-agent failings
• principals (banks’ bosses) didn’t understand what agents (traders) were doing,
  
• traders had incentives to take on excessive risk
• because the gains from doing so - a life-changing bonus - exceeded the benefits of prudence.
• Banks have been reluctant to lend to each other
  
• not so much because each bank fears its counterparty will not repay the money
• but: because they fear they’ll need the money themselves
• because banks just don’t know what sort of losses they are sitting on
• it’s impossible for managers of such complex organizations to know everything
• Banks are under-capitalized because chief executives have traditionally had incentives to maximize earnings by using leverage
• pressure upon them to be more prudent has been absent partly
  
• because when shareholding is dispersed, no individual shareholder has much incentive to rein in management
• [note: is shareholding too dispersed? 70% of all stock in America is now owned by financial institutions; as John Bogle said, in relation to Enron-type scandals, "the problem is that shareholders aren't owners anymore, they're agents of owners, and they do not actively engage in corporate governance, making sure that companies are managed for their shareholders etc.; instead they are more actively engaged in trading pieces of paper back and forth and they don't seem to care much about anything except whether the CEO meets the earnings expectations he's promised or doesn't; sometimes these expectations are met by fair means, but sometimes by foul ones" - like Dillow, Bogle also focuses on the ownership, but he blames it on the traditional owners capitalism having been replaced by managers capitalism]
  
• Good financial innovation has been lacking
  
• because it’s very difficult for anyone to own its beneficial effects;
  
• it’s a public good
• gains from “bad” financial innovation are more appropriable.
  
• so we get more of it
• e.g. overly complex mortgage derivatives
• solution
• not nationalization
  
• bad way of solving principal agent problems
• perhaps instead, banks should make more use of internal markets
• i.e. should become more like venture capitalists
• allocating capital to semi-independent divisions, which put in their own capital
• would restrain traders’ risk-taking
• as they can not so easily hide behind the fact that losses are spread over the whole firm
• would reduce the problem of asymmetric information between banks’ senior managers and trading desks
• as there’s a simpler test of how well the latter do: whether they can hand over enough hard cash to cover their required returns

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Falling Down - The New Republic

Summary:
Jospeh Stiglitz blames the current crisis are the financial system's latest innovations, fee structures that were often far from transparent. Imperfections of information (resulting from the non-transparency) led to imperfections in competition. Allowed banks to generate enormous profits and private rewards that were not commensurate with social benefits. Worst problems (e.g. subprime mortgage market) occurred when non-transparent fee structures interacted with incentives for excessive risk-taking. Too much effort has been devoted to increasing profits, creating financial products that enhanced risk, and not enough to increasing real wealth. Financial markets frequently fail to do what they are supposed to do in allocating capital and managing risk. Painful lesson from the 1930s and today is that the invisible hand often seems invisible because it's not there. (Published: 10/09/08)

Notes:

• Adam Smith: the market leads the economy, as if by an invisible hand, to economic efficiency and societal wellbeing
• Great Depression
• 1 in 4 Americans out of a job
• Smith's self-regulating markets a fallacy?
• some economists: in the long run the market's restorative forces will take hold, and we will recover
• Keynes's retort: In the long run, we are all dead.
  
• i.e. could not afford to wait
• today, 75 years later: another shock
• unofficially in recession
  
• more than half year since jobs were created
• "If the Great Depression undermined our confidence in macroeconomics (the ability to maintain full employment, price stability, and sustained growth), it is our confidence in microeconomics (the ability of markets and firms to allocate labor and capital efficiently) that is now being destroyed."
• resources were misallocated and risks were mismanaged so severely that the private sector had to go running to the government for help, lest the entire system melt down
• cumulative gap between what our economy could have produced and what we will produce over the period of our slowdown estimated to be more than $1.5 trillion
• had we invested in actual businesses
• rather than e.g. mortgages for people who couldn't afford their homes
• financial markets rightly blamed
• it is their responsibility to allocate capital and manage risk, and their failure has revived several old concerns of the political (and economic) left
• increasing dependence on service sector
• including financial service
  
• decreasing reliance on manufacturing
• is the whole thing was a house of cards?
  
• i.e. aren't "hard objects" the "core" of the economy? And if so, shouldn't they represent a larger fraction of our national output?
• the food we eat, the houses we live in, the cars and airplanes that we use to transport us from one place to another, the gas and oil that provides heat and energy
• answer: no
• live in a knowledge economy, an information economy, an innovation economy
• because of our ideas, we can have all the food we can possibly eat with only 2 percent of the labor force employed in agriculture
• even with only 9 percent of our labor force in manufacturing, we remain the largest producer of manufactured goods
• better to work smart than to work hard
• our investments in education and technology have enabled us to enjoy higher standards of living than ever before
• we would do even better if we had more resources in these sectors
• but: our recent success may based on a house of cards
• in recent years financial markets created a giant rich man's casino, in which well-off players could take trillion dollar bets against each other
• weren't just gambling their own money
• were gambling other people's money
• were putting at risk the entire financial system, indeed, our entire economic system
• now we are all paying the price

• financial markets as the brain of the economy
• supposed to allocate capital and manage risk
• when they do their job well, economies prosper
• when they do their job badly everyone suffers
• financial markets are amply rewarded for their work
• in recent years, they have received over 30 percent of corporate profits
• standard mantra in economics was that these rewards were commensurate with their social return.
• i.e. financial wizards might walk off with a great deal of money but the rest of society is better off
  
• because our capital generates so much more productivity than in societies with less well-developed--and less rewarded--financial markets
• part of the rewards that accrue to financial markets are thus for encouraging innovation
• through venture capital firms and the like

• financial innovation to blame
  
• financial system's latest innovation was to devise fee structures that were often far from transparent and that allowed it to generate enormous profits
• private rewards that were not commensurate with social benefits
• imperfections of information (resulting from the non-transparency) led to imperfections in competition
• helps to explain why the usual maxim that competition drives profits to zero seemed not to hold
• the worst problems (e.g. subprime mortgage market) occurred when non-transparent fee structures interacted with incentives for excessive risk-taking
  
• financial managers got to keep high returns made one year, even if those returns were more than offset by losses the next
• had those in the financial sector allocated capital and risk in a way that fueled the economy, they would have had handsome profits
• but they wanted more
• so established incentive structures that encouraged gambling
• if they gambled and won, they could walk away with a share of the profits.
• if they gambled and lost, the investors would bear the consequences

• current woes in America's financial system are not an isolated accident
• more than one hundred financial crises worldwide in the last 30 years or so
• in each of these instances, financial markets failed to do what they were supposed to do in allocating capital and managing risk
• e.g. in the late '90s, for instance, so much capital was allocated to fiber optics that, by the time of the crash, it was estimated that 97 percent of fiber optics had seen no light
• problem with the U.S. economy is not that we have allocated too many resources to the "soft" areas and too few to the "hard" (i.e. services/knowledge vs. manufacturing)
  
• not necessarily the case that we have allocated too many resources to the financial sector and rewarded it too generously
• but:
  
• too little effort was devoted to managing real risks that are important
• i.e. enabling ordinary Americans to stay in their homes in the face of economic vicissitudes
• too much effort went into creating financial products that enhanced risk
• too much energy has been spent trying to make an easy buck
• too much effort has been devoted to increasing profits and not enough to increasing real wealth
• whether that wealth comes from manufacturing or new ideas
• painful lesson from the 1930s and today:
  
• The invisible hand often seems invisible because it's not there.
  
• at best, it's more than a little palsied.
  
• at worst, the pursuit of self-interest--corporate greed--can lead to the kind of predicament confronting the country today

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Profit-maximization as the sole goal of a corporation - Creative Capitalism

Summary:
Martin Wolf on the nature of the firm. "What is the goal of the limited liability, joint-stock company, the core institution of the contemporary capitalist economy?" Important distinction between the role of the firm and its goal. Role is to provide valuable goods and services, whereas its goal is to maximize profit. Different views of the firm: as a bundle of contracts, as a social organism, as having culture and history, and as having/offering meaning. Big differences between Anglo-American capitalism and capitalism in rest of the world. Differences focus on the nature of ownership of the firm, the existence of a market for corporate control, and whether or not a firm can be bought and sold. Implications for relationship with employees, efficiency and creativity. Room for enduring divergence in the forms of capitalism is bigger than those working in the Anglo-American intellectual tradition appreciate. Evidence on the (in)effectiveness of takeovers and the recent sad experiences in financial markets rather suggests Anglo-American capitalism may be on the way out. (Published: 17/08/08)

Notes:

• What is the goal of the limited liability, joint-stock company, the core institution of the contemporary capitalist economy?

• distinction between goal of the firm and its role
• role of companies: to provide valuable goods and services
  
• i.e. outputs worth more than their inputs
• great insight of market economics is that they will do this job best if they are subject to competition
• goal of the firm: profit-maximization
• or shareholder value maximization
• its more sophisticated modern equivalent
• goal of profit-maximization drives the firm to fulfill its role

• market in corporate control
  
• competitive market for corporate control forces companies to maximize shareholder value
• or at least behave in ways that the market believes will lead them to do so
• if companies fail to oblige, the company will be put “into play."
  
• thus, in Anglo-American shareholder-driven capitalism, maximization of shareholder value (as perceived by the market) must perforce be the goal of the company
• not the case in countries where a market in corporate control does not exist
• in such countries, companies must earn a high enough return on capital to survive
• but this need not be a shareholder value-maximizing return

• views of the firm
  
• company as a bundle of contracts
• Anglo-American view of the company
• contracts between the company, its employees and, quite often, its suppliers and even distributors
• many contracts relational
• cannot be written down in any precise form
• companies are hierarchies in which people engage voluntarily
• they necessarily work on the basis of trust in what is often a very long-term relationship:
  
• "I work extra hard to meet a deadline now, in return for consideration when I need to look after my elderly mother later on."
  
• for many companies, trustworthiness is an essential ingredient in their long-term success.
• company as social organism
  
• companies are social organisms created by a highly gregarious mammalian species with a unique capacity for large-scale co-operation over time and space
• companies have cultures and histories
• companies have/offer meaning
• for many of those most closely associated with them
• committed workers in successful companies do not work in order to maximize shareholder value or even to earn the largest possible living
• indeed, it is impossible to direct most companies solely by the goal of profit-maximization
• they have to be aimed at the intermediate goal of producing and developing goods and services that people want to buy and are worth more in the market than they cost to produce
• company is an entity that can be freely bought and sold
• Anglo-Saxon view
• not shared by rest of the world
• for many cultures, a company is viewed as being an enduring social entity
• e.g. for many Japanese, one can no more sell a company over the heads of its workers than one can sell one’s grandmother
• in this view, goods and services can be bought and sold.
  
• companies, like countries (or, as we all now agree, people), must not be
• if companies can be freely bought and sold, relational contracts are hardly worth the paper they are (not) written on
• relational contracts depend on continuing interaction among specific people inside the business
• rational employees will act opportunistically
  
• because they will always expect their company to do the same
• the longer and more reliable relationships are expected to be, the less likely such opportunistic behaviour is to emerge
• not necessarily the case that companies which operate under the assumption that they can be bought and sold (like GM) will operate more successfully in terms of maximizing shareholder value than those which do not
• e.g. Toyota is a better car company than GM in almost all dimensions.
  
• the failure of Japanese capitalism to achieve the highest level of productivity and sustained dynamism may have far more to with
  
• repression of domestic competition in many markets for goods and,
  
• above all, services, rather than with the absence of an active market for corporate control.
• ownership of the firm
  
• Anglo-Saxon view: shareholders are the owners
  
• rest of the world: core workers are the owners
  
• shareholders are not genuine owners
• they are merely an (ever-shifting) group of people with a claim to the residual incomes
• contribute nothing of value to the competitive strengths of the firm
• enjoy the benefits of limited liability
• are well able to diversify the risks they run
• core workers have the biggest (undiversifiable) investment in the firm
• and thus the greatest exposure to firm-specific risks
• the interests of the core workers are, therefore, paramount
• capital-market arrangements (and associated views of the firm) that enforce shareholder value maximization may make companies work less efficiently than otherwise, in terms of their primary role, by precluding a range of potentially valuable relational contracts inside the firm
• such restrictions may have powerful effects on comparative advantage
• by shifting countries away from those activities in which companies that benefit from long-term relational contracts are likely to be most effective
• room for enduring divergence in the forms of capitalism is bigger than those working in the Anglo-American intellectual tradition appreciate
• without an active market for corporate control, managements rule companies
• they also acts as a trustee for a range of stakeholders, of which core workers are the most important
• Anglo-American capitalism gives primary direction of companies to capital markets
• because these companies cannot be forced to maximize shareholder value, they can indeed undertake a range of costly “charitable”activities
• provided they do not threaten the company’s ability to survive
• one of the most interesting questions over the next generation is whether the Anglo-American form of capitalism will flourish and expand, or not
• some of the evidence on the (in)effectiveness of takeovers and the recent sad experiences in financial markets rather suggests not
• but: active financial markets do bring big benefits
• particularly in financing new companies and enforcing greater discipline on badly run businesses
• the more “Anglo-American” capitalism becomes and so the more shareholder driven
• the less “creative” it is likely to be
• the less concerned with wider social results it is likely to be

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