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. ]]> http://www.markshuttleworth.com/archives/220/feed 67 http://www.markshuttleworth.com/archives/139 http://www.markshuttleworth.com/archives/139#comments Wed, 23 Jan 2008 12:58:25 +0000 mark http://www.markshuttleworth.com/archives/139 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.