Note to the impatient: this is a long post and it only gets to free software ecosystem dynamics towards the end. The short version is that we need to empower software companies to participate in the GNU/Linux ecosystem, and not fear them. Rather than undermining their power, we need to balance it through competition.

Church schools in apartheid South Africa needed to find creative ways to teach pupils about the wrongs of that system. They couldn’t actively foment revolt, but they could teach alternative approaches to governance. That’s how, as a kid in South Africa, I spent a lot of time studying the foundations of the United States, a system of governance defined by underdogs who wanted to defend not just against the abuses of the current power, but abuses of power in general.

My favourite insight in that regard comes from James Madison in the Federalist Papers, where he describes the need to understand and harness human nature as a force: to pit ambition against ambition, as it is often described. The relevant text is worth a read if you don’t have time for the whole letter:

But the great security against a gradual concentration of the several powers in the same department, consists in giving to those who administer each department the necessary constitutional means and personal motives to resist encroachments of the others. The provision for defense must in this, as in all other cases, be made commensurate to the danger of attack. Ambition must be made to counteract ambition. The interest of the man must be connected with the constitutional rights of the place. It may be a reflection on human nature, that such devices should be necessary to control the abuses of government. But what is government itself, but the greatest of all reflections on human nature? If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary. In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself. A dependence on the people is, no doubt, the primary control on the government; but experience has taught mankind the necessity of auxiliary precautions.

When we debate our goals, principles and practices in the FLOSS community, we devote a great deal of energy to “how things should be”, and to the fact that “men are not angels”. I think the approach of James Madison is highly relevant to those discussions.

The conservation of power

Just as energy, momentum, charge and other physical properties of a system are conserved, so in a sense is power. If your goal is to reduce the power of one agency in government, the most effective strategy is to strengthen the position of another. We know that absolute monarchies are bad: they represent unbalanced power.

Within a system, power will tend to consolidate. We have antitrust agencies specifically to monitor the consolidation of economic power and to do something about it. We setup independent branches of government to ensure that some kinds of power simply cannot be consolidated.

Undermining power in one section of an ecosystem inevitably strengthens the others.

Since we humans tend to think the grass is greener on the other side of the fence, and since power takes a little while to get properly abused, you can often see societies oscillate in the allocation of power. When things seem a little out of control, we give more power to the police and other securocrats. Then, when they become a little thuggish, we squeeze their power through regulation and oversight, and civil liberties gain in power, until the pendulum swings again.

The necessity of concentrated power

Any power can be abused. I had a very wise headmaster at that same school who used to say that the only power worth having was power that was worth abusing. This was not a call to the abuse of power, you understand, merely a reflection on the fact that power comes with the real responsibility of restraint.

So, if power can be abused, why do we tolerate it at all? Why not dissolve authority down to the individual? Because the absence of power leads to chaos, which ironically is an easy place to establish despotic authority. Power isn’t seized – it’s given. We give people power over us. And in a state of chaos, all it takes is a few people to gain some power and they have a big advantage over everyone else. That’s why early leaders in new ecosystems tend to become unbeatable very quickly.

Also, power clears the path for action. In a world with no power, little gets done at all. We are better off with large companies that have the power to organise themselves around a goal than trying to achieve the same goal with a collection of individuals; try making a Boeing from an equivalent group of artisans, and you’ll see what I mean. Artisans form guilds and companies to increase their reach and impact. Individual volunteers join professional institutions to get more effective: consider the impact of handing out food yourself, versus helping sustain a network of soup kitchens, even in the purely non-profit world. Having some clout on your side is nothing to sniff at, even if you have purely philanthropic goals.

Power and innovation

If you have all the power already, there’s no spur to innovate. So kingdoms stagnate, eventually.

But power makes space for good things, too. It’s the powerful (and rich) who fund the arts in most societies. Innovation needs breathing space; companies with economic power can incubate new ideas to the point where they become productive.

Too much competition can thus limit innovation: look how difficult it has been for the Windows-based PC manufacturers, who live in a brutally competitive world and have little margin, to innovate. They are trapped between a highly efficient parts supply ecosystem, which feeds them all the same stuff at the same price, and a consumer market that requires them all to provide PC’s which run the same stuff the same way. As a result, they have little power, little margin, little innovation.

The trick is not to fear power itself, but instead, to shape, balance and channel it. You don’t want to aim for the absence of power, you want the Goldilocks effect of having “just enough”. And that was James Madison’s genius.

Verticals, competition and the balance of power

Of course, competition between rivals is the balance of power in business. We resent monopolies because they are either abusing their power, or stagnating.

In economics, we talk about “verticals” as the set of supply dependencies needed for a particular good. So, to make an aircraft, you need various things like engines and alloys, and those suppliers all feed the same pool of aircraft manufacturers.

In order to have a healthy ecosystem, you need a balance of power both between suppliers at the same level of the stack, and vertically, between the providers of parts and providers of the finished product. That’s because innovation needs both competition AND margin to stimulate and nurture it.

In the PC case, the low margins in the PC sector helped reinforce the Windows monopoly. Not only was there no competition for Microsoft, there was no ability for a supplier further down the chain to innovate around them. The only player in that ecosystem that had the margin to innovate was Microsoft, and since they faced no competition, there was little stimulus to embrace their own R&D, no matter how much they spent on it.

Power in the FLOSS ecosystem: upstreams and distributions

So, where do we stand in the free software and open source ecosystem?

The lines between upstreams and distributions aren’t perfectly clear, of course. Simplistic versions of that picture are often used to prove points, but in fact, all the distributions are also in some sense upstreams, and even derivative distributions end up being leaders of those they derive from in some pieces or markets. Nevertheless, I think it’s worth looking at the balance of power between upstream projects and distributions, as it is today and as it could be.

Also, I think it’s worth looking at related parties, companies and institutions which work a lot with FLOSS but have orthogonal interests.

If one uses margin, or profit, as an indicator of power, it’s clear that the distributions today are in a far stronger position than most individual projects or upstreams. The vast majority of software-related revenue in the FLOSS ecosystem goes to distributions.

Within that segment, Red Hat claims 80% market share of paid Linux, a number that is probably accurate. Novell, the de facto #2, is in the midst of some transition, but indicators are that it continues to weaken. Oracle’s entry into the RHEL market has had at best marginal impact on RHEL economics (the substantial price rises in RHEL 6 are a fairly clear signal of the degree to which Red Hat believes it faces real competition). The existence of “unpaid RHEL” in the form of CentOS, as well as OEL, essentially strengthens the position of RHEL itself. Ubuntu and Debian have large combined levels of adoption, but low revenue.

So clearly, there is work to do just to balance power in the distribution market. And it will take work – historically, platforms tend to monopolies, and in the absence of a definitive countervailing force that establishes strength outside the RHEL gravity well, that’s what we’ll have. But that’s not the most interesting piece. What’s more interesting is the dynamic between distributions and upstreams.

Today, most upstreams are weak. They have little institutional strength. It’s generally difficult to negotiate and do business with an upstream. In many cases, that’s by design – the teams behind a project are simply not interested, or they are explicitly non-profit, as in the case of the FSF, which makes them good leaders of specific values, but difficult to engage with commercially.

As a result, those who need to do business with open source go to distributions, even in cases where they really want to be focused on a particular component. This greatly amplifies the power of the distributions: they essentially are the commercial vehicles for ALL of open source. The weakness of individual upstreams turns into greater strength for distributions.

You can imagine that distributions like it that way, and it would be surprising to see a distribution, or company that backs a distribution, arguing for stronger upstreams. But that’s exactly the position I take: FLOSS needs stronger upstreams, and as a consequence, weaker distributions.

Stronger upstreams will result in more innovation in FLOSS than stronger distributions. Essentially, like Microsoft, a distribution receives cash for the whole platform and allocates it to specific areas of R&D. That means the number of good ideas that receive funding in our ecosystem, today, is dependent on the insights of a very few companies. Just as Microsoft invested a lot in R&D and yet seemed to fall behind, upstream innovation will be strangled if it’s totally dependent on cash flow via distributions.

It’s not just innovation that suffers because we don’t have more power, or economic leverage, in the hands of upstreams. It’s also the myriad of things beyond code itself. When you have a company behind a project, they tend to take care of a lot more than just the code: QA, documentation, testing, promotion. It’s easy, as a developer, to undervalue those things, or to see them as competing for resources with the “real work” of code. But that competition is necessary, and they make a great contribution to the dynamism of the final product.

Consider the upstream projects which have been very successful over the long term. Qt and MySQL, for example, both had companies behind them that maintained strong leverage over the product. That leverage was often unpopular, but the result was products available to all of us under a free license that continued to grow in stature, quality and capability despite the ups and downs of the broader market, and without being too dependent on the roving spotlight of “coolness”, which tends to move quickly from project to project.

There are of course successful upstream projects which do not have such companies. The best example is probably the Linux kernel itself. However, those projects fall into a rather unusual category: they are critical to some large number of companies that make money in non-software ways, and those companies are thus forced to engage with the project and contribute. In the case of the kernel, hardware companies directly and indirectly underwrite the vast majority of the boring but critical work that, in other projects, would be covered by the sponsoring institution. And despite that, there are many gaps in the kernel. You don’t have to dig very hard to find comments from key participants bemoaning the lack of testing and documentation. Nevertheless, it gets by quite well under the circumstances.

But most ecosystems will have very few projects that are at such a confluence. Most upstream projects are the work of a few people, the “coolness” spotlight shines on them briefly if at all. They need either long term generosity from core contributors, or an institution to house and care for them, if they want to go the distance. The former rarely works for more than a few years.

Projects which depend on indirect interests, such as those sponsored by hardware companies, have another problem. Their sponsoring institutions are generally not passionate about software. They don’t really need or want to produce GREAT software. And if you look at the projects which get a lot of such contributions, that becomes very obvious. Compare and contrast the quality of apps from companies which deeply care about software from those which come from hardware companies, and you see what I mean.

We FLOSS folk like to tell ourselves that the Windows hegemony was purely a result of the manipulations of its sponsor, and the FLOSS as we do it today is capable of doing much more if it only had a fair chance. I don’t think, having watched the success of iOS and Android as new ecosystems, that we can justify that position any longer. I think we have to be willing to think hard about what we are willing to change if we want to have the chance of building an ecosystem as strong, but around GNU/Linux. Since that’s my goal, I’m thinking very hard about that, and creatively. I think it’s possible, but not without challenging some sacred cows and figuring out what values we want to preserve and which we can remould.

Power is worth having in your ecosystem, despite its occasional abuse

There’s no doubt that power created will be abused. That’s true of a lot of important rights and powers. For example, we know that free speech is often abused, but we nevertheless value it highly in many societies that are also big contributors to FLOSS. You probably know the expression, “I disagree with what you are saying entirely, but I will defend to the death your right to say it”.

Similarly, in our ecosystem, power will be abused. But it’s still worth helping institutions acquire it, even those we dislike or distrust, or those we compete with. At Canonical, we’ve directly and indirectly helped lots of institutions that you could describe that way – Oracle, Novell, Red Hat, Intel and many others. The kneejerk reaction is usually “no way”, but upon deeper thought, we figured that it is better to have an ecosystem of stronger players, considering the scale of the battle with the non-FLOSS world.

I often find people saying “I would help an institution if I thought I could trust it”. And I think that’s a red herring, because just as power will be abused, trust will be abused too. If you believe that this is a battle of ecosystems and platforms, you want to have as many powerful competitors in your ecosystem as possible, even though you probably cannot trust any of them in the very long term. It’s the competition between them that really creates long term stability, to come back to the thinking of James Madison. It’s pitting ambition against ambition, not finding angels, which makes that ecosystem a winner. If you care about databases, don’t try to weaken MySQL, because you need it strong when you need it. Rather figure out how to strengthen PostGRES alongside it.

How Canonical fits in

Canonical is in an interesting position with regard to all of this. As a distribution, we could stay silent on the issue, and reasonably expect to grow in power over time, on the same basis that Red Hat has. And there are many voices in Canonical that say exactly that: don’t rock the boat, essentially.

However, perhaps unlike other Linux distributions, Canonical very much wants to see end users running free software, and not just IT professionals. That raises the bar dramatically in terms of the quality of the individual pieces. It means that it’s not good enough for us to work in an ecosystem which produces prototype or rough cut products, which we then aggregate and polish at the distribution level. Unlike those who have gone before, we don’t want to be the sole guarantor of quality in our ecosystem, because that will not scale.

For that reason, looking at the longer term, it’s very important to me that we figure out how to give more power to upstreams, so that they in turn can invest in producing components or works which have the completeness and quality that end-users expect. I enjoy working with strong commercial institutions in the open source ecosystem – while they always represent some competitive tension, they also represent the opportunity to help our ecosystem scale and out-compete the proprietary world. So I’d like to find ways to strengthen the companies that have products under free software, and encourage more that have proprietary projects to make them available under free licenses, even if that’s not the only way they publish them.

If you’ve read this far, you probably have a good idea where I’m going with this. But I have a few more steps before actually getting there. More soon.

Till then, I’m interested in how people think we can empower upstream projects to be stronger institutionally.

There are a couple of things that are obvious and yet don’t work. For example, lots of upstreams think they should form a non-profit institution to house their work. The track record of those is poor: they get setup, and they fail as soon as they have to file their annual paperwork, leaving folks like the SFLC to clean up the mess. Not cool. At the end of the day, such new institutions add paperwork without adding funding or other sources of energy. They don’t broaden out the project the same way a company writing documentation and selling services usually does. On the other hand, non-profits like the FSF which have critical mass are very important, though, which is why on occasion we’ve been happy to contribute to them in various ways.

Also, I’m interested in how we can reshape our attitudes to power. Today, the tenor of discussion in most FLOSS debates is simplistic: we fear power, and we attempt to squash it always, celebrating the individual. But that misses the point that we are merely strengthening the power elsewhere; in distributions, in other ecosystems. We need a richer language for describing “the Goldilocks power” balance, and how we can move beyond FUD.

So, what do you think we could do to create more Mozilla’s, more MySQL’s, more Qt’s and more OpenStacks?

I’ll summarise interesting comments and threads in the next post.

We made some mistakes in our handling of the discussion around revenue share with the Banshee team. Thanks to everyone who helped make sure we were aware of ‘em ;-)

Money is particularly contentious in a community that mixes volunteer and paid effort, we should have anticipated and been extra careful to have the difficult conversations that were inevitable up front and in public, at UDS, when we were talking about the possibility of Banshee being the default media player in Ubuntu. We didn’t, and I apologise for the consequential confusion and upset caused.

The principles from which we derive our policy are straightforward:

The bulk of the direct cost in creating the audience of Ubuntu users is carried by Canonical. There are many, many indirect costs and contributions that are carried by others, both inside the Ubuntu community and in other communities, without which Ubuntu would not be possible. But that doesn’t diminish the substantial investment made by Canonical in a product that is in turn made available free of charge to millions of users and developers.

The business model which justifies this investment, and which we hope will ultimately sustain that effort for the desktop without dependence on me, is that fee-generating services which are optional for users provide revenue to Canonical. This enables us to make the desktop available in a high quality, fully maintained form, without any royalties or license fees. By contrast, every other commercial Linux desktop is a licensed product – you can’t legally use it for free, the terms for binaries are similar to those for Windows or the MacOS. They’re entitled to do it their way, we think it’s good in the world that we choose to do it our way too.

We know that we need a healthy and vibrant ecosystem of application developers. We think services should work for them too, and we’re committed to sharing revenue with them. We want to be entirely aligned in our interests: better code means a better result for both of us, better revenue means more resources to do what we love even better. Our interests, and upstream interests, should be perfectly aligned in this. So we have consistently had the view that revenue we can attribute to a particular upstream should create a revenue share for that upstream. We support Mozilla in this way, for example. The numbers are not vast, but nor are they insubstantial, and while we are not obliged to do so, we do so happily.

Those are the principles, the policy is straightforward: Canonical seeks to earn revenue from services delivered to Ubuntu, and we will share a portion of that revenue with relevant projects who help make that possible. Our interests, and those of the projects, should be aligned to the greatest extent possible.

In engaging with Banshee leads at UDS, we should have been absolutely clear about our expectations and commitment. Apparently, we weren’t, and for that I apologise. There was certainly no conspiring or maliciousness, it apparently just never came up. But it was my expectation that we would share revenue with Banshee, I mentioned it briefly to someone closer to the conversation, but I failed to follow up until I heard rumours of a potential disagreement on the subject in recent days.

We also made a mistake, I believe, as this blew up in private conversations, when a well-meaning person presented a choice to the Banshee developers, who then of course made a choice. But our position isn’t at all what was communicated. Our position is that we’ll deliver the best overall experience to users, we’ll derive services revenue from that, and we’ll share it with upstreams where we can attribute it efficiently. It wasn’t in the mandate of that person to offer a choice outside of that framework, but it was an honest mistake.

So, every free software project out there should be confident of a few things:

Canonical would like you to succeed, would like to make it as easy as possible for many, many users to adopt your software, and is willing to share the benefits of that with you. Whether your software is promoted as the default in Ubuntu, or simply neatly packaged for easy consumption, we’d like our interests to be well aligned. We have a bug tracker that helps us pass issues to you if they are reported in Ubuntu first, we have a revenue model which matches that with passing through a share of revenues, too. And that goes for any kind of revenue that we can attribute to your project; for example, if we offer a support service specially tailored to people using your code, you can reasonably expect to agree a revenue share of that with us.

Canonical invests heavily in creating a big, addressable ecosystem that you can easily reach. That’s worth something. We also want a big, vibrant upstream community that innovates and makes its own investments. We know that contributions come both from volunteers and paid staff, and it’s good to be able to have a bit of both in the mix, for the sake of both the volunteers and the paid staff!

Documenting this position is obviously a priority; we should have done so previously, but we just relied on internal precedent, which is a dumb idea when you’ve grown as quickly as we have in the past few years. So we’ll do that.

As for the revenue share we’ve offered the Banshee team, I would love to see them use that to make Banshee even better. That’s what it should be for. Don’t be shy, don’t be nervous of taking the money and using it for your own project. Canonical has already provided much more in the way of funding to the Gnome Foundation than this is likely to, through initiatives like the bugzilla.gnome.org work that we funded, and many other forms of support. I think money generated by an app should go towards making that app rock even harder. But the offer stands for Banshee devs to take up if they’d like, and use as they’d like. If they don’t want it, we’ll put it to good use.

This certainly won’t be the last word on the subject. I expect these situations to become more common, not less. But I think that represents a great opportunity to see sustained investment in desktop free software, which we have been sorely lacking. I think our model gives projects a nice, clear roadmap: build awesome stuff, partner with Canonical and be confident you will share in the success of Ubuntu. This is the model which catalysed the founding of Ubuntu, seven years ago, this is what we’re here to do: make free software available freely, in the best quality, to the widest audience we can. That’s an opportunity for every project that cares about how many people get to use their stuff, and under what terms.

This is not the end of capitalism

Tuesday, November 4th, 2008

Some of the comments on my last post on the economic unwinding of 2008 suggested that people think we are witnessing the end of capitalism and the beginning of a new socialist era.

I certainly hope not.

I think a world without regulated capitalism would be a bleak one indeed. I had the great privilege to spend a year living in Russia in 2001/2002, and the visible evidence of the destruction wrought by central planning was still very much present. We are all ultimately human, with human failings, whether we work for a state planning agency or a private company, and those failings have consequences either way. To think that moving all private enterprise into state hands will somehow create a panacea of efficiency and sustainability is to ignore the stark lessons of the 20th century.

The leaders and decision makers in a centrally-planned economy are just as fallible as those in a capitalist one – they would probably be the same people! But state enterprises lack the forces of evolution that apply in a capitalist economy – state enterprises are rarely if ever allowed to fail. And hence bad ideas are perpetuated indefinitely, and an economy becomes dysfunctional to the point of systemic collapse. It is the fact that private enterprises fail which keeps industries vibrant. The tension between the imperative to innovate and the consequences of failure drives capitalist economies to evolve quickly. Despite all of the nasty consequences that we have seen, and those we have yet to see, of capitalism gone wrong, I am still firmly of the view that society must tap into its capitalist strengths if it wants to move forward.

But I chose my words carefully when I said “regulated capitalism”. I used to be a fan of Adam Smith’s invisible hand, and great admirer of Ayn Rand’s vision. Now, I feel differently. Left to it’s own devices, the market will tend to reinforce the position of those who were successful in the past, at the exclusion of those who might create future successes. We see evidence of this all the time. The heavyweights that define an industry tend to do everything in their power to prevent innovation from changing the rules that enrich them.

A classic example of that is the RIAA’s behaviour – in the name of “saving the music industry” they have spent the past ten years desperately trying to keep it in the analog era to save their members, with DRM and morally unjustifiable special-interest lobbying around copyright rules that affect the whole of society.

Similarly, patent rules tend to evolve to suit the companies that hold many patents, rather than the people who might generate the NEXT set of innovative ideas. Of course, the lobbying is dressed up in language that describes it as being “in the interests of innovation”, but at heart it is really aimed at preserving the privileged position of the incumbent.

In South Africa, the incumbent monopoly telco, which was a state enterprise until it was partially privatized in 1996, has systematically delayed, interfered, challenged and obstructed the natural process of deregulation and the creation of a healthy competitive sector. Private interests act in their own interest, by definition, so powerful private interests tend to drive the system in ways that make THEM healthier rather than ways that make society healthier.

Left to their own devices, private companies will tend to gobble one another up, and create monopolies. Those monopolies will then undermine every potential new entrant, using whatever tactics they can dream up, from FUD to lobbying to thuggery.

So, I’m a fan of regulated capitalism.

We need regulation to ensure that society’s broader needs, like environmental sustainability, are met while private companies pursue their profits. We also need regulation to ensure that those who manage national and international infrastructure, whether it’s railways or power stations or financial systems, don’t cook the books in a way that lets them declare fat profits and fatter bonuses while driving those systems into crisis.

But effective regulation is not the same as state management and supervision. I would much rather have private companies managing power stations competitively, than state agencies doing so as part of a complacent government monopoly.

Good regulation is very hard. Over the years I’ve interacted with a few different regulatory authorities, and I sympathise with the problems they encounter.

First, to be an effective regulator, you need superb talent. And for that you need to pay – talent follows the money and the lights, whether we like it or not, so to design a system on other assumptions is to design it for failure. My ideal regulator is an insightful genius working for the common good, but since I’m never likely to meet that person, a practical goal is to encourage regulators to be small but very well funded, with key salaries and performance measures that are just behind the industries they are supposed to regulate. Regulators must be able to be fired – no sense in offering someone a private sector salary and public sector accountability. Unfortunately, most regulators end up going the other way, hiring more and more people of average competence, that they become both expensive and ineffective.

Second, a great regulator needs to be independent. You’re the guy who tells people to stop doing what will hurt society; it’s very hard to do that to your friends. A regulatory job is a lonely job, which is why you hear so many stories of regulators being wined and dined by the industries they regulate only to make sure they don’t look too hard in the back room. A great regulator needs to know a lot about an industry, but be independent of that industry. Again, my ideal is someone who has made a good living in a sector, knows it backwards, can justify their high price, but wants to make a contribution to society.

Third, a great regulator needs to have teeth and muscle. It has been very frustrating for me to watch the South African telecomms regulator get tied up in court by Telkom, and stymied by government department inadequacy. Regulators need to be able to drive things forward, they need to be able to change the way companies behave, and they cannot rely on moral suasion to do so.

And fourth, a regulator has to make very tough decisions about innovation, which amount to venture capital decisions – to make them well, you have to be able to tell the future. For example, when an industry changes, as all industries change, how should the rules evolve? When a new need for society is identified, like the need to address climate change early and systemically, how should the rules evolve? Regulators need to move forward as fast as the industries they regulate, and they need to make decisions about things we don’t yet understand. And even when you regulate, you may not be able to stop an impending crisis. It’s very easy to criticize Greenspan for his light touch regulation on hedge funds and derivatives today, but it’s not at all clear to me that regulation would have made a difference, I think it would simply have moved the shadow global financial system offshore.

So regulation is extremely difficult, but also very much worth investing in if you are trying to run a healthy, vibrant, capitalist society.

Coming back to the original suggestion that sparked this blog – I’m sure we will see a lot of failed capitalists in the future. Hell, I might join their ranks, I wouldn’t be the first ;-). But that doesn’t spell the end of capitalism, only the opportunity to start again – smarter.

The term “credit crunch” is very misleading for the current crisis. It suggests that the problem is merely one of confidence, that calm will return if liquidity is introduced to the system.

My view, though, is that the real issue is one of solvency. This is the systemic bankruptcy of 2008.

Mortgages are just the beginning.
At real rates of interest, with real expectations of a reasonable rate of return, many of the deals which have been done since 2003 just do not make economic sense. Thus far, the spotlight has been on one piece of that problem – bad mortgage loans – but I think we’ll see the problem areas expanding rapidly to include a lot of the private equity deals which were done on the basis of free money between 2003-2007. I remember a fatuous statement by some private equity genius that “everybody’s rushing to do the first $100bn deal”. Well, the chickens are coming home to roost. Expect a steady flood of announcements of setbacks, restructurings and bankruptcies as companies that were bought with borrowed money turn out to be unable to service their debt.

Lower interest rates will ease the symptoms only.
Dramatic easing of interest rates will help to slow down the pace at which we have to deal with the bankruptcies, but they won’t change the cold reality of the situation, and they run the very real risk of making things worse by encouraging another round of speculation based on free money. We are once again in a situation where the US discount rate is effectively a negative real rate of interest, as a gift to the banks, but staying there for any length of time puts us back into a state of addiction.

Interventions must target bank equity and leverage, not liquidity.
The latest move from the UK to buy equity stakes is the best response yet, I think. It dramatically improves the capitalisation of those institutions, it keeps the upside of that move in taxpayers hands (they are taking the pain and funding the bailout, it seems right to preserve the upside for them) and it dilutes the existing shareholders who allowed their institutions to become insolvent. Personally, I’d be inclined to do more than dilute those shareholders.

I don’t see the current $700bn deal making a real difference to US banks. I would expect the US to announce a deal similar to the UK deal soon, but the numbers would have to be larger. Scarily large. Much better for the US to make that move, than to wait for Asian and Middle-eastern sovereign wealth funds to step into the breach.

Depositors in regulated banks should be protected by the governments that run the regulators. Shareholders not so much. Bondholders… maybe.
I think the Irish and other countries who have guaranteed the deposits of individual users have done the right thing. Governments setup regulatory authorities, and banks advertise that they are regulated. The people who appoint those regulators need to stand by the approach they take – they should offer a guarantee that they will stand by their product, and when it fails, they will stand by the people who trusted in them. Depositors at banks in the UK really should not have to worry that the bank might fail – such a failure should at most affect the interest rate they receive, not the safety of their capital. Shareholders in those banks, however, should be very worried indeed. There’s an interesting question about bondholders and institutional depositors. By one argument they are sophisticated investors and should be responsible for their bonds. By another argument, they are the very people who can cause massive shifts in funds from bank paper to T-bills, and hence worth keeping pacified. I would lump them in with individual depositors too.

Executive compensation should be structured not fixed.
There has been a lot of discussion about limiting executive compensation. That’s just an invitation for armies of consultants and lawyers and accountants to work around whatever compensation limits are put in place. And frankly, I’m hard-pressed to understand how politicians, who constantly vote themselves bigger salaries and expense accounts, are qualified to set bank executive salaries. They effectively WERE in charge of Fannie and Freddie executive compensation, and that wasn’t a stellar success.

What I would say, however, is that financial institution earnings should only be recognised over a seven year period, and bonuses based on those earnings should be held in escrow until that seven year period is up. Imagine if we could now tap into the bonuses of investment bank employees over the past seven years in order to shore up the balance sheets of those banks. That would include the bonuses paid to Mr Fuld, Mr Greenberg, and Mr Greenspan. Anybody care to run the numbers? I think it would be material.

I’m nervous.
The big question I’m asking is which sidelines don’t have landmines? My team and I are fortunate to have stepped out of many markets before the current flood of fear. We stepped right into a few problems, but in large part dodged the cannonballs. So far so good. But what does it mean to have cash in the bank, when banks themselves are failing? What does it mean to hold dollars, when the dollar is being debased in a way that would feel familiar to the Reserve Bank of Zimbabwe? These are very dangerous times, and nobody should think otherwise.

Economic oversteering

Wednesday, January 23rd, 2008

Yesterday, we saw the most extraordinary failure of economic leadership in recent years, when the US Federal Reserve pressed the “emergency morphine” button and cut Federal Reserve rates by 0.75%. It will not help.

These are extremely testing times, and thus far, the US Fed under Bernanke has been found wanting. Historians may well lay the real blame for current distress at the door of Alan Greenspan, who pioneered the use of morphine to dull economic pain, but they will probably also credit him with a certain level of discretion in its prescription. During Greenspan’s tenure at the Fed, economic leaders became convinced that the solution to market distress was to ensure that the financial system had access to easy money.

This proved effective in the short term. When LTCM looked set to explode (private investments, leveraged up dramatically, managed by Nobel prize-winning financial theorists, placed a bet on a sure thing which didn’t pan out quite as expected) Greenspan engineered an orderly unwinding of its affairs. When the dot com bubble burst, Greenspan kept the financial system energised by lowering rates so far that they were, for a substantial period, at negative levels.

A negative real interest rate means we are effectively paid to take out loans. That might sound good, but how would you feel if I used the words “paid to take a few more hits of crack cocaine”? The underlying problem was that people had become accustomed to high rates of return and did not want to accept that real rates of return in the US were moving down. They had become accustomed to easy money, and Greenspan’s policy ensured that money remained accessible at a time when people had demonstrated a low ability to invest that easy money well.

Low rates give people an incentive to invest in stocks, even if those stocks are not earning very much. This meant stock prices recovered quickly, and the effect was amplified by the fact that low rates increased corporate earnings. This was a so-called “soft landing” – disaster averted. He must have known the risks, but the one big warning sign that would likely have convinced Greenspan to return to normal rates was missing: inflation. Low rates, and especially negative rates, have historically always resulted in inflation. Greenspan kept rates low because there were no signs of inflation. It seemed as if the US had entered a new era where the correlation of rates and inflation no long held true. People explained it by saying that the US was increasing its productivity dramatically (productivity increases are like anti-inflation medicine). Now, with hindsight, it appears that the real reason for the absence of inflation was that the Chinese were increasing their productivity dramatically, and that US consumers were spending so much on Chinese goods that Chinese productivity growth, not US productivity growth, was keeping US prices low.

When tech came off the boil and people should have been using the pause to clean up their affairs, Greenspan made it easy for people to get themselves into a worse position. Easy money made stock market prices artificially high, so stock market investors felt rich. Worse, easy money made house prices artificially high (by about 45%), so everybody felt wealthier than they had planned or expected to.

To make matters worse, a series of financial innovations created a whole industry designed to help people go back into debt on their houses. I remember trying to watch TV in the US and being amazed at the number of advertisements for “home equity withdrawals”. They made it sound like turning your major personal financial asset – your paid-off house – into an ATM machine was a good thing. In fact, it was a means to spend all of your primary store of wealth. And with inflated house prices, it was a way to spend money that you did not really have. A convenient way to get into a deep, dark hole of family debt. The result? The average American owns less of her home today than  she did 30 years ago – 55% as opposed to 68%. Easy money makes people poorer.The company with the most irritating ads, Ditech (and I feel ashamed to be contributing to their website search ranking with the mention, perhaps it will help instead to link to their customer feedback), has a tagline “People are smart” and a business model built on the idea that “People are dumb”. Their “most popular” product strikes me as being tailor-made to make it easy to turn home equity – an asset – into new debt.

Why did Greenspan do it? I think he genuinely believed that there was something different about the modern world that had altered the laws of economic gravity. I suspect he no longer feels that way.

But Greenspan is no longer Chairman of the Fed. Ben Bernanke blinked, yesterday, and in that blink we have the measure of the man.

Greenspan acted carefully, logically, and basically prudently. Several years of anomalous economic data are a reasonable basis to think that the rules have evolved. You would have to have a Swiss (700 years of stability) or Chinese (“we think it’s too early to tell if the French Revolution was a good idea”) approach to stick with economic theories that are at odds with the facts for very long. Greenspan made a mistake, and it will have huge consequences for the US for a generation, but he had reasons for that mistake. Bernanke just blinked, he panicked, despite knowing better.

We now have rigorous economic explanations for all that is happening. We have come to understand, quite clearly, what is going on in the world. The deflationary Eastern wind has been identified. We know there is no productivity miracle in the US, no change in the laws of physics or economics. So we know that the US patient is addicted to easy money morphine, medicine that was prescribed with good intentions by Dr Greenspan, medicine that has in the last 7 years made the patient more ill and not less. More morphine today constitutes malpractice, not economic innovation. We know the consequences of more morphine – stock prices will rise artificially (4% yesterday, on the news of the shot), house prices will stumble along, companies will take longer to default on their loans.

Bernanke might be hoping to do what Greenspan did – retire before the addiction becomes entirely obvious. Too late. While the Fed is clearly not willing to admit it, the markets have just as clearly taken their own view, that the prognosis is not good. They are smart enough to see that all Bernanke has done is cover up the symptoms of malaise, and many are using the temporary pain relief to head for safer territory. I expect that any relief will be brief, market recoveries will  fade, the rout has been deferred but not averted.

I started out by describing the Fed’s actions as a failure of economic leadership. Some folks are lucky enough to lead from the bottom of the cycle, up – they take over when things are miserable and can only really get better. They look like heroes even if their voodoo has no mojo, so to speak. Others are less lucky, they get handed custodianship of an asset that is at the peak. As for Bernanke, he’s in that latter category. He needs to be able to speak clearly and frankly about the hard work that lies ahead in the US. He needs to appeal to the very best of American industriousness – a traditional willingness to work hard, be smart, and accept the consequences of refusing to do so. He needs to lead under the most difficult circumstances. But that’s what leadership is about.

Fortunately for Bernanke, central bank independence is widely believed to be the only credible approach to economic governance. That independence gives Bernanke the right to stand at odds with political leaders if needed. Given the recent White House announcements – more morphine, further indebtedness for the worlds most indebted country – there’s no stomache for a real program of rehabilitation in the Bush Administration. Bernanke will have to lead without political support, a very difficult task indeed. Our greatest and most memorable leaders are those who lead through difficult times. The same is true of failures of leadership. Appeasement, or rehabilitation. Chamberlain, or Churchill. Thus far, Chamberlain.