The merits of Anglo Saxon capitalism
As we all know one of the differences between the Anglo-Saxon variant of capitalism and others such as Rhineland such is the way in which economic activity is financed. They tend to use banks to finance both the debt and equity portions of a business, we tend to use markets to do so. For us large companies tend to issue shares, bonds, commerial paper, and even small companies don't get their equity from banks, only their debt financing.
As an aside it has hugely amused me the way in which recent events have had everyone spitting at the banks, insisting that they be cut down to size. And then the very same people (yes Mr. Hutton, we're lookin' at you) insist in the next breath that we must have Rhineland capitalism, the one in which the banks loom even larger in the financing of industry.
But that is an aside. What we really want to know is which is the best method of financing industry?
The nature of the firm and its financing are closely interlinked. To produce significant net present value, an entrepreneur has to transform her enterprise into one that is differentiated from the ordinary. To achieve the control that will allow her to execute this strategy, she needs to have substantial ownership, and thus financing. But it is hard to raise finance against differentiated assets. So an entrepreneur has to commit to undertake a second transformation, standardization, that will make the human capital in the firm, including her own, replaceable, so that outside financiers obtain rights over going-concern surplus. I argue that the availability of a vibrant stock market helps the entrepreneur commit to these two transformations in a way that a debt market would not. This helps explain why the nature of firms and the extent of innovation differ so much in different financing environments.
It would seem that the draw of being able to float a company increases the incentives to make it truly independent of the original guiding force, the entrepreneur. And as is mentioned, we very much want companies to both outgrow and outlive their founders. So it would appear that it is the Angoo Saxon variant that wins this little part of the battle then.
So rah rah for The City then, eh?
Hester's bonus
I was on Sky News earlier today talking about Stephen Hester’s £1m RBS bonus. To tell the truth, it isn’t a subject I relish tackling – there’s more nuance there than it’s easy to communicate in a short TV debate. For one thing – and I made sure to stress this upfront – I don’t believe that RBS should exist today, at least not in its current form. Bailing it out in 2008 was a big mistake, and if we’d let it go to the wall, we’d be much better off now.
And then there’s the point Gordon Kerr made in his recent Adam Smith Institute report The Law of Opposites, that bonuses are sometimes driven as much by the flaws in the International Financial Reporting Standards, which allow banks to recognise years of very uncertain future income as current profit, as they are by genuine performance. I decided not to bring this up. Nor did I get the chance to nail the real corruption at the heart of the financial sector – the central bank and its constantly expanding balance sheet.
Like most libertarians, I am ambivalent about the financial sector: on the one hand, the government should not interfere with free enterprise or use Britain’s most important industry as a political punchbag; on the other hand, there’s more than a whiff of crony capitalism around parts of the financial world, and I hate having people assume that everything that happens in the City must, by definition, be the product of the free market. That just ain’t so.
All that said, the furore over Hester’s bonus makes for a truly unedifying spectacle. The fact is that the taxpayer has been lumbered with 82 percent of RBS, and is on the hook for billions of pounds of liabilities. I’d never had put us in this position, but we are where we are and if we want our money back we’d be well-advised not to run RBS into the ground. The company needs top-quality leadership, and in the banking world that costs something. Moreover, we need to remember that this bonus is being paid entirely in shares, which seems a good way of aligning executive interests with shareholder (i.e. taxpayer) interests. That’s no bad thing.
My opponent, The Guardian’s Philip Inman, made the usual point that (a) nobody deserves to be paid that much and (b) bankers shouldn’t get such big bonuses when they’re already paid seemingly enormous salaries. My answer to the first point was a simple one: who are we to determine how much someone ‘deserves’? As soon as you interfere in the market here, everything becomes a deeply politicized value judgement. The second point is, I think, based on a lacking of understanding of the way financial firms operate. The reason so much of bank pay comes in the form of bonuses rather than fixed salary is that bank revenues are unpredictable and volatile. In that context, a (relatively) low basic salary with a large variable component makes perfect business sense. Not everything bankers do is a conspiracy against the public interest.
Ultimately, the point I want people to take away from my appearance is this: if taxpayers own 82 percent of a company, it is right that the government closely scrutinizes the executives on their behalf. I’m all for giving more power to shareholders. But in doing this, it is vital that the government pursues taxpayers’ economic interests, not their own political ones.
The fiasco of state financial regulation
In August 2010, the Institute of Economic Affairs published a monograph “Does Britain need a Financial Regulator?” .Written by Professor Philip Booth and myself, with a particular focus on Stock Exchanges around the world, our conclusion was no, it does not.
Within days of publication we were vilified by several commentators, including a barrage from readers of my blog article on the website of Conservative Home.
Given the subsequent performance of the Financial Services Authority in several areas perhaps we can now hope for a little more support. Take, for example, the fiasco of the FSA report on the demise of the Royal Bank of Scotland (the latest trick being the appointment of the insider Sir David Walker), or the FSA veto (yes, veto) of a proposal to put all RBS directors up for re-election, thus ensuring that Sir Fred Goodwin stayed for another six months and a doubling of his pension. Or take the FSA’s own almost unbelievable empire building, supported by the government and heavily driven by levying unlimited fines of its own choosing. Or its clampdown on communications between journalists and their city contacts. And, of course, its complete failure to foresee the financial crisis because of its total lack of nous. (I have kept an interesting e-mail exchange between myself and Hector Sants on this but that had better stay private.)
Financial entities and in particular Stock Exchanges, would be far better left to their own devices – as they once were, making their own rules which had to attract both corporate listings on the one hand and buyers and sellers on the other, thus leading to a race to the top; emphatically not a race to the bottom which State regulators everywhere would have us believe.
As an example of possible rules for a private Stock Exchange, take the contentious case of insider trading. There is no reason why such a feature should be a criminal offence. As the US lawyer Richard Epstein wrote, “for a company to legitimize insider trading all it needs is a provision in its charter saying “if you want to deal in shares with this company, please understand that every employee and every director is entitled to trade on insider information to their heart’s content. If you do not want to trade with us you are free to buy shares in our competitor which does not allow that option”2.
I can just imagine Lord Turner shouting the odds here; “Make insider trading a matter for contracts between the company and its investors? You must be joking. You’ll be suggesting that companies have control over their Memorandum and Articles next!”
In fact the criminality lies with the regulator. There are clear reasons why insider trading would often be helpful; under free markets, there is a raft of devices which would enable shareholders to control insiders. Not the least of these is a thriving takeover market. It is all of a piece that the FSA looks upon such a market as necessarily hostile. In the majority of cases any hostility is directed at incompetent management, where a takeover would enable shareholders to dismiss the incumbents in favour of a new and better management. In other words the FSA protects incompetence at the expense of shareholders.
Another incontrovertible point is that an insider not trading may be just as important a signal as trading, but naturally it can’t be spotted!
The activities of successful speculators in short-selling have many similarities to insider trading. In both cases the essential point is that such activities get market prices nearer to where they should be faster, so that those profiting, far from making a quick buck at the expense of others, are effectively sharing their knowledge with the rest of the world. It is the unsuccessful speculators and insiders that we should worry about, but fortunately they don’t last long!
It is true that for the present the FSA has nothing on the USA’s Securities and Exchange Commission. Formed in the early 1930s, it is even more scary, and the IEA monograph referred to herein highlights some dreadful abuses of power. For example, our research suggests strongly that at least two of the most notorious jailed insider-dealers (Martha Stewart and Kenneth Lay) were not guilty even as charged. But that’s cold comfort at best for those of us on this side of the pond.
Anthony Evans on low interest rates and QE
Professor Anthony Evans, of ESCP Europe, the Cobden Centre, and Kaledic Economics, has the given the following comment to Management Today, as part of their feature on whether the Bank of England should engage in more quantitative easing. I think he is absolutely spot on:
'The Bank of England’s policy rate has been historically low for some time now and this cannot continue indefinitely. The aim of low interest rates is to boost the economy by creating incentives to borrow money and invest. But higher capital requirements and policy uncertainty create counter forces that restrict bank lending.
'In these circumstances the purported "benefits" of low interest rates fail to materialise, but the costs certainly do. These include the lack of an incentive to save (and actually rebuild banks' balance sheets through voluntary lending), distortions to the capital structure of the economy (making white elephants like the HS2 line appear profitable) and the erosion of people's savings.
'The fact that real interest rates (the difference between inflation and the return you get on your savings accounts) is negative is a harmful confiscation of wealth.
'When interest rates are close to zero policymakers look to alternatives, and quantitative easing has emerged as their favoured tool. However grateful banks and the financial community are in general to have an injection of freshly-printed money, it’s not clear how much this is helping the real economy. The aim shouldn’t be to preserve the status quo, but to find ways to allow banks to fail without exposing the general public to the fall-out.'
It wasn't the Efficient Markets Hypothesis wot did it
It's been a common enough trope, that it was the Efficient Markets Hypothesis (EMH) that led to the crash. Usually put forward by those who don't understand what is being claimed, true. What it actually says is that markets are efficient at processing information about what prices should be in markets. What some seem to think it says is that "markets are efficient". Which may even be true but that's not what is being claimed by the EMH. However, there are those slightly more clued up who do know what EMH means and blame it for the finanacial woes. Because everyone thought that markets were efficiently processing information no one was doing their own processing to see if they were right.
Thus dodgy mortgage bonds got rated AAA, everyone bought too many of them and thus we had collapse. However, via Tyler Cowen, we've a new paper which makes a very interesting point.
The first statement (ie, that the EMH is to blame-Tim)is at odds with the fact that prior to 2007,collateralized debt obligations (CDOs),3 the mortgage-related bonds at the
center of the financial crisis, were offering much higher yields than straight corporate bonds with identical ratings, apparently for good reason.4 Disciples of efficient markets were less
likely to have been misled than those investors who flocked to these instruments because they thought they had identified an undervalued security.
Those bonds were more risky, those bonds were lower priced (had higher yields) to reflect that risk. Those who actually believed the EMH would therefore not have been mislead as to the calculating value of the EMH. It was those who did not believe the EMH who got biffed then.
There are a couple of other excellent insights like this in the paper and I recommend reading it all. For over and above those specific points, it really is an excellent over view of the various explanations that are being bandied about.
The law of opposites: Illusory profits in the financial sector
An Adam Smith Institute report released today (Wednesday) claims that the failings of the International Financial Reporting Standards (IFRS) allows banks to overstate their profits by recognising years of often very uncertain future income as current profit. As well as having the potential to deceive investors and lead to misallocations of capital, this overstatement of profits benefits company executives whose performance is typically measured and rewarded on this basis. Recent developments in accounting rules have encouraged, rather than tried to prevent this. In addition, the latest developments of the Basel international rules specifying banks capital and liquidity minima only exacerbate the problem.
Though standardised accounting standards effect many sectors, any unintended consequences they throw up are especially problematic for banks, since such failures are magnified by banks taking exposure to each other. Moreover, in the case of banks attracting state bailouts, real transparency is clearly needed to protect the taxpayer.
The Adam Smith Institute report is structured around six shortcomings in the rules governing bank profit and capital reporting, which must be addressed:
- Uncertain future cashflows can be recognised as certain by purchasing a credit default swap (CDS) or similar “protection”, even though the supplier of the protection is likely to default if the insured event occurs;
- Profits can be recognised from the increased value of assets, or decreased value of liabilities, on the basis of a market price, even though the totality of revalued assets or liabilities could not be sold at that price;
- Profits can be recognised from the increased value of assets, or decreased value of liabilities, even when the revaluation of assets is estimated, not by market prices, but by a model built by bank employees. This is the so-called mark-to-model approach to valuation;
- The net present value of uncertain future cashflows can be recognised as profits even when they are estimated using implausibly optimistic forecasts. (This is a variation of the mark-to-model problem listed above);
- The EU’s IFRS accounting system, voluntarily adopted by UK and Irish banks at the banking company level, is inconsistent with UK law
- Banks need not make provision for expected losses when calculating their profit.
With much of the activity in the banking sector aimed at nothing more than exploiting these accounting rules, the report suggests the introduction Steve Baker MP’s bill to bring about simple legislation to reveal the extent of mark-to-market and mark-to-model banking activity.
Author Gordon Kerr adds: “Accurate accounting is at the root of the legal and scrutiny framework; without accurate accounts basic laws are incapable of enforcement. As this report shows, banks have been using loopholes in these rules to inflate their accounts and create illusory profits, which pay for bonuses and short-term gains for their shareholders, but give a very misleading view of their real financial health.
"The accounting regulation system needs radical reform so that banks are not encouraged by the rules and regulations to invest in risky assets to make themselves seem more profitable than they really are. Honest balance sheets are the cornerstone of a healthy financial system – right now, we don't have the transparency we desperately need to avoid a repeat of 2008.”
The impossibility of financial regulation
Samizdata's Brian Mickelthwait has done a great job capturing Jamie Whyte's appearance on Radio 4 last night to discuss the failings of the Financial Services Authority (FSA). Jamie's analysis is, I think, spot on:
"[The FSA] did fail. But I don't blame it on the individuals of the FSA. I think that they have an impossible task. What's happened in banking is that because of government guarantees to those people who lend money to banks, explicitly in the case of retail depositors – you and me with our ordinary money in the bank, and implicitly and pretty reliably in the case of wholesale lenders to banks. Because they're government guaranteed, there is no price mechanism any longer in the banking market for risk. So banks can take as much risk as they like and without paying a price for it. Normally what would happen in a free market is that it would become more expensive for banks to borrow money. And that doesn't happen. There's no risk premium for banks taking larger risks, because the people lending the money realise that the government will bail them out.
"Now the effect of this is that basically the government is subsidising bank risk taking on a massive scale. And the job of the FSA is to counteract that. There are these rules – the Basel rules and so on about capital requirements. And then there are supervisors, regulators, people who go into the banks and check they're complying, and their job is to counteract the massive incentive towards risk taking that the government has already provided. Now the question is: can they do it? They obviously failed to do it. Can they, if they do a better job? And I think they can't.
"And the reason they can't is that there are almost infinitely many ways that banks can take risks. The rules will always specify some particular ways, and regulators will go in, looking at that stuff. Are they doing this or that? But the bankers are very clever and they can always come up with other ways of taking risks, and I just think it's a hopeless task that they've been given."
It’s official: the BoE’s money printing achieved almost nothing
By taking away from one side of the economy to stimulate another, Keynesian economics is smoke and mirrors at the best of times. But now it transpires that our own most recent example, Quantitative Easing, was more akin to a volcanic ash cloud and a one hundred mile-long mirage.
The BoE claimed that the £200 billion it printed in 2009 onwards, resulted in the yields on five and ten years gilts being 100 basis points lower than they would otherwise have been. It claimed that growth was boosted by between 1.5 and 2%. On the basis of this, it enthusiastically decided to print another £75 billion this October.
Not so, says the highly authoritative (and not personally interested) Bank for International Settlements in its latest quarterly report. The real effect was about a quarter of what the BoE claims. Yields were on average 27 points lower.
The BIS also doesn’t agree with the BoE’s belief that new stimulus will have a similar effect. “It may be harder to achieve the same degree of effectiveness as with the initial programmes once the surprise or novelty element wanes”, it states in its conclusion. This basically means that financial movers realise that the money printing results in inflation, and that they therefore add that future inflation into their behaviour.
Will Sir Mervyn now review the decision of the 6th of May to print another £75 billion?
Paper Money Collapse (300 word version)
As I wrote on Thursday (and repeat in a 'rapid response' to City AM this morning), the deal reached by EU leaders last week doesn't change a thing. Here's Detlev Schlichter on the ongoing crisis:
"The problems around the world are essentially the same. After decades of ongoing and generous expansion of the fiat money supply, of artificially low interest rates and cheap credit, banks are hopelessly overextended, asset markets are distorted, and sovereign states are bust. I sometimes get pushback on the last point. Are they really bust? – Yes, most of them are. They have acquired debt loads and spending habits – now very deep-rooted and practically impossible to eradicate – that require constant new borrowing at fairly low interest rates – cheap credit forever. Obviously, that is not going to happen. The end of the forty-year credit boom has arrived. The private sector is no longer playing ball.
"What needs to happen? The overextended credit edifice needs to be cut back to a size that is commensurate with the underlying pool of real voluntary savings and with underlying real income streams. Money printing and the constant attempt to manipulate lending rates down have to stop. The market has to finally be allowed to set interest rates that reflect the true cost of available savings, and to liquidate what is not sustainable. Deleveraging, default, and debt deflation are necessary to bring the economic structure back into balance. Is this painful? – You bet. It is also unavoidable. There is no other solution. Yet, the solution is deemed politically unacceptable and it is thus being fought tooth and nail. Not only in the US and the UK, also in Europe.
"The entities that are most under stress in this scenario are the banks and the debt-addicted states. You know my forecast: the central banks will be asked to underwrite the states and the banks directly with the help of the printing press on an ever-larger scale, and this will ultimately lead to higher inflation and finally to paper money collapse: the end of our present fiat money system, the latest experiment in the sad history of unlimited and fully elastic state money systems."
Read the whole thing or, better still, buy Detlev's book. You can also watch his recent Adam Smith Institute lecture here.
The end of fiat money?
It feels redundant to recommend Allister Heath's Editor's Letter, because it's consistently excellent and should already be on the reading list of this blog's readership. But today's piece has a particularly tantilizing closing paragraph:
If anything, today’s problem is even greater than that: it is clear from the global government debt crisis that fiat money – currencies entirely detached from any commodity or anchor and produced entirely at the discretion of government agencies – has failed. Its adoption has abolished all restraints on governments and has meant that currencies keep being devalued and inflated away. Eventually, we will need a new monetary system more in tune with the principles of capitalism and sound money – until then, expect tensions between central bankers and governments to rise and rise.
I wonder if Heath has read Paper Money Collapse yet. As we approach the endgame for the euro, the epitome of all fiat currencies, we may start to see more people coming round to Heath's view as well.
