Other people’s money

Catching up with post-holiday stuff has slowed me down, but I finished John Kay’s new book, Other People’s Money: Masters of the Universe or Servants of the People? on a flight back from his native Edinburgh yesterday. It is characteristically excellent, drawing the main threads out of the complexities of modern financial history and the post-crisis consequences, and writing with beautiful clarity and style. It’s up there  with John Lanchester’s Whoops! as a guide to understanding what has happened in finance. I agreed with every word. I don’t suppose he’d want the job, but it would be marvellous if we could put John in as Chancellor to sort things out.

The book tells the story of the financialisation of the British and global economies in its first section, and the transition from relationship-based financial services focused on customers and the real economy to transactional and trading-based financial entities.This progressive shift in behaviour, values and institutions affected the whole of the corporate sector. The book offers a telling contrast between the 1987 and 1994 annual reports of ICI:

“ICI aims to be the world’s leading chemical company, servicing customers internationally through the innovative and responsible application of chemistry and related science. Through achievement of our aim we will enhance the wealth and well-being of our shareholders, our employees, our customers and the communities which we serve and in which we operate.”

versus

“Our objective is to maximise value for our shareholders by focusing on businesses where we have market leadership, a technological edge and a world competitive cost base.”

This has happened across the whole of the business sector throughout the west. It’s tragic. Risk taking at the expense of others, bonus culture, income inequality, short termism, declining business investment, overly-detailed regulation having utterly adverse consequences, and the taxpayer still in line to prop up the whole edifice if – or rather when – the financial sector gets hit by another tail risk it can’t cope with. As Kay underlines, and as Admati and Hellwig pointed out so clearly, and even Alan Greenspan now admits, the banks have far, far too little equity capital and too much leverage. The summary here of Deutsche Bank’s balance sheet is terrifying.

The book is particularly clear about the inadequacy of banks’ current levels of shareholder capital vs debt on their balance sheets, and the nonsense of the Basel risk weightings, and banks’ claiming they can achieve 15% return on equity – always done by reducing the amount of equity in the denominator. Kay writes: “Return on equity is an inappropriate performance metric for any company, but especially for a bank; and it is bizarre that its use should have been championed by people who profess particular expertise in financial and risk management.” Bizarre, or perhaps just cynical.

So what to do about it? Especially as financial markets start displaying the kind of declines that could, potentially, wipe out a frail bank’s mimimal equity? The book has good answers. Kay starts with a set of principles for reform, including shorter chains of intermediation before the final customers, more focused and specialist financial institutions, a prioritisation and demonstration that the financial institution has its clients’ interests at heart (hello, Goldman Sachs), criminal and civil penalities applied to individuals (not fines on institutions), simpler regulation. Above all, politicians should abandon the illusion that the finance sector is special compared to other sectors of business. After all, the numbers don’t make sense; it has certainly not contributed as much to the economy as is claimed, and is not financing industry or serving the needs of investors.

In detail, the book favours structural remedies, not more and more regulation of behaviour – that is an arms race between banks and regulators that the former, with their ability to extract vast rents and hire lawyers/lobbyists will always win. Kay sees ring fencing of retail activities from investment banking as a ‘first step’. I agree: the too-big-to-fail-subsidy will always be too big for as long as there are any links. There needs to be a structural separation, and deposit guarantees only for utility retail/small business banking. He also puts great weight on individual civil and criminal responsibility.

Towards the end of the book comes one of many eye-popping quotations from Goldmans executives:

Sen C Levin (D, Michigan): When you heard that your employees in these emails and looking at these deals said, “God, what a shitty deal!)… do you feel anything?

Mr D.A.Viniar (CFO, Goldman Sachs): I think that is very unfortunate to have on email.

No wonder Kay concludes: “The finance sector of modern western economies is too large.” Spot on. It takes too many of the best graduates, distorts pay across the corporate sector, fails to innovate on behalf of its customers, and exposes taxpayers to unsupportable risks. Financial conglomerates need to be broken up, banks need to hold much higher levels of equity capital.

Financialisation has even damaged unfairly the standing of the role of markets (and economics): “The intellectual misconception behind the thought that prosperity might be enhanced by trade in baseball cards has been associated with an economic model that misunderstands the (important) role that markets play in enabling complex modern economies to manage information,” Kay writes. Prices are important signals – just not the prices on the trading room screens.

Shrinking the finance sector takes the book in its final pages to the influence of money and lobbying on politics. Which politicians are going to serve the people instead of the masters of the universe? Unfortunately I haven’t heard even the Labour leadership candidate my Tory best friend has renamed “The Gift that Keeps on Giving” addressing this. As for the American system, utterly bought by big money, beyond hope.

Meanwhile, I hope lots of people will read Other People’s Money and then send it on to their elected representative with suitable passages highlighted, saying – if you want my vote next time, act on this.

 

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Phoolish economists

On a day of equity market plunges around the world, it seems timely to recommend the new book from George Akerlof and Bob Shiller, Phishing for Phools: The Economics of Manipulation and Deception. Princeton University Press have put the introduction online for free.

It explains the basic concept, introducing the gap between the standard equilibrium where people know their preferences and select to maximise utility, and the phishing equilibrium where they also maximise but do not know what their preferences are – either because of behavioural psychology or information asymmetries of one sort or another. The book gives a coherent and highly plausible explanation of why markets – although usually beneficial – can lead to undesirable outcomes: the powerful force of competition in a market will not leave profit opportunities unexploited.

As you would expect, it’s a very clearly written book with tons of examples. And it makes a simple and powerful point about the fragility of the normative, welfare economics conclusions economists tend to draw.

Prof Shiller will be in London and in Bristol (at the Economics Festival as the keynote speaker in the RES session) in November.

Life beyond shareholder value

The peerless Izabella Kaminska (@izakaminska) of the FT linked this morning to this Andy Haldane speech, which I’d only skimmed when he made it. The speech discusses the consequences for corporate governance of the way the limited liability corporation has evolved, giving primacy to a narrow view of shareholder value. It cites en passant some terrific books both recent – Anat Admati and Martin Hellwig in The Bankers’ New Clothes, Colin Mayer’s Firm Commitment – and less recent – Berle and Means’ The Modern Corporation and Private Property and Schumpeter’s Capitalism, Socialism and Democracy.

The speech looks at the historical context of the emergence of limited liability, especially in banking. The need to which it responded was of course the increased capital requirements of the time, the Industrial Revolution getting well under way. With either partnerships of unlimited liability, banks in particular were unable to respond to crises by raising new capital. (Not that it proved straightforward in 2008-9 even with limited liability.) The speech ends with a discussion of potential corporate governance reforms, including clawing back bonuses, and modifying company law to reflect wider stakeholder interests, in addition to shareholders’ interests.

The history made me ponder, however, whether the limited liability public company largely ought to go the way of the megalosaurus? Already the growth of private equity suggests there are other financing channels chipping away at the monoculture. Perhaps when legislators ever get around to doing something, one of the corporate governance reforms needed is to reduce the role of limited liability public companies in the economy.

Meanwhile, I’m reading John Kay’s latest, Other People’s Money, an excellent read which follows up on his short-termism review, to which the Andy Haldane speech refers. A review to follow.

On not skipping over facts

I read recently Sarah Bakewell’s delightful book, How to Live: A Life of Montaigne in one question and twenty attempts at an answer. Then by chance today (possibly via @Storythings?) came across this quotation from his Complete Essays:

“I realize that if you ask people to account for “facts”, they usually  spend more time finding reasons for them than finding out whether they  are true. … They skip over the facts but carefully deduce inferences.  They normally begin thus: “How does this come about?” But does it do so?  That is what they ought to be asking.”

Quite so. The more time I spend thinking about it – and it’s quite a lot already – the more puzzling economic facts seem to be.

 

History and imagination

The last of my holiday reads, albeit finished this week, was Sapiens: A Brief History of Humankind by Yuval Noah Harari. I was a bit disappointed, as it had absolutely glowing reviews. After reading Ian Morris’s Why The West Rules For Now and his more recent Farmers, Foragers and Fossil Fuels, and Jared Diamond’s Guns, Germs and Steel, and his later Collapse, not to mention Joseph Tainter and Walter Russell Mead, I suppose it’s hard to describe anything completely new looking through the long lens on the history of civilisation. It’s quite a crowded terrain.

That isn’t to say I didn’t enjoy reading Sapiens. It’s eloquently written. I liked the emphasis on human social agency, and absence of technological or ecological determinism: “The ability to create an imagined reality out of words enabled large numbers of strangers to co-operate effectively.”

He writes of ‘imagined order’ (echose of Benedict Anderson): “We believe in a particular order not because it is objectively true but because believing in it enables us to coperate effectively and forge a better society.” He has a nice example using Peugeot, the car company. It doesn’t consist in the cars it makes, or its assets, or the people working for it – it has an existence beyind any of them, and a longevity too, kept in existence by the imagined order of the French legal system, the French state, the idea of nation states, and so on. The ‘rules of the game’ as an institutional economist might put it, are a set of Russian dolls.

It drove home for me the point that for individuals the agricultural revolution was an adverse development, although it was great for spreading Homo Sapiens genes. I liked the discussion of natural and unnatural – a distinction that pre-supposes the existence of a higher purpose, and since evolution has no purpose it is a distinction that comes from religion.

I very much enjoyed the contrasting portraits of Louis XIV of France and Barack Obama: “Dominant men have never looked so dreary as they do today. What happened to the wig, stockings, high heels?”

The book tails off a bit towards the end – the economics chapters seemed weak to me, although perhaps they wouldn’t to a non-economist. They cram the whole history of world economics with an emphasis on credit (Graeber-style) into three chapters.

Anyway, that’s it for summer paperbacks. Back to the serious reading now. Next up is John Kay’s Other People’s Money. Four pages in, and I think it’s fabulous.