Thursday, 28 April 2016

The trigger for the next financial crisis

We know that financial crisis are recurring. The last one was in 2008, almost 8 years ago, so it is not difficult to forecast that a new one is in the making.

The trouble for investors is that it is almost impossible to forecast when a new crisis will arrive. It may be next month, next year or in five years. Who knows?

Another annoying feature of financial crisis is that it is equally difficult to foresee which drop will spill the glass, that is, what will be blamed as its trigger.

Paul Krugman just listed two possible candidates – China and oil – in his NYT op-ed “The 8 A. M. Call”.

So, let me add another candidate – IRRBB Interest rate risk in the banking book – caused by the excessive reliance of banks on the derivatives market.

This choice may sound odd, given that the Basle Committee has been working hard on new standards for this risk which will be implemented in 2018, aimed at preventing IRRBB to materialize when interest rates normalise from historically low levels. Indeed, the notional value OTC derivatives which at end-2014 was 6.5 times larger than all outstanding debt securities has been reduced by 70 trillion USD in the first half of 2015.

It really does not matter if the crisis is triggered in these markets, or any other place like the M&A or the currency markets. The “fire” can be started anywhere, as long as the “wood” is close enough to spread it by contagion.

What matters is to know whether the “firemen” are capable of containing it.

In this regard the perspectives are frightening, given the resistance to apply the so-called Volcker rule to ring-fence commercial banking from investment banking, the exhaustion of ammunition by central banks to deal with a liquidity trap and the balance of public finances in some major economies.

Thursday, 14 April 2016

Brexit: A brief history of economic disintegration

History is full of episodes of political and economic disintegration, which were often the natural culmination of experiences of forced integration. With a few exceptions, most empires ended through a process of violent and anarchic disintegration. Whether we think about the ancient empires of Alexander, Rome, the Qin Dynasty or Persia, or if we consider medieval empires like the Charlemagne Empire, the Islamic Caliphate or the Mongol Empire, or if we look at the modern empires of Britain, Ottoman, the German Reich and the Japanese Empire or the breakup of the Soviet Union and Yugoslavia, the lessons are the same. The separating regions often end up in civil war and always erect barriers to trade and investment through tariffs and instable currencies which bring economic decline.

The inevitable initial sacrifice in terms of economic and human misery is often followed by prolonged periods of underdevelopment (all too visible in Africa) in the separating regions, but there are some notable exceptions like the separation of the United States of America from Britain.

Do these lessons of history have any relevance in the case of an eventual separation of Britain from the European Union (the so-called Brexit)? If so, would the UK follow the general pattern of decadence and misery or could it replicate the US successful experience?

The first question is relevant because the European Union is a voluntary association of countries, not a forced empire. So, an eventual exit of a member state should be seen as the natural counterpart to a voluntary membership and should not be cause for war or vicious conflict. Nevertheless, we cannot ignore that Great Britain is itself an association of three nations – the English, the Welsh and the Scots – which may have quite distinct views in relation to the European Union, wish may lead some to question in which union they wish to participate - the European or the British.

Although military violence cannot be expected, social unrest may still arise in a strongly divided nation in relation to an eventual separation. Moreover, it will also depend on the attitude of the remaining member states in the European Union. Namely, whether they will be understanding and friendly or will be hostile and competitive, for example, by promoting an international financial centre to rival the City of London.

So, political attitudes in London, Brussels, Berlin and Paris would have an important bearing in the outcome of an eventual separation. Nevertheless, the answer to the question whether a separate Britain would be a failure or a success story requires an understanding of the economics of disintegration.

As a preamble to that understanding, let me just give the reader a chart depicting the experience of economic growth in Britain relative to that of France and the USA, before and after joining the European Union.
The chart is impressive. Before joining the European Union, the UK lagged France by over 30%. Since joining, it still lagged the USA by 20% until 1998, but managed to match the GDP growth in France. Since the creation of the Euro, Britain managed to overtake France by 10% and to match the growth in the US economy.

Given the success of Britain in the European Union, for outsiders it is hard to understand the decision to hold a referendum on its continuation in the Union. Is it simply local politics, or there are any fundamental reasons?

Sunday, 20 March 2016

Trump vs. Hitler: some dangerous similarities

“Entire libraries have been filled with books attempting to explain how a once-homeless failed artist could have launched a war machine that eventually resulted in 60 million dead, and a death machine that killed 6 million in the Holocaust's gas chambers. More are certainly to come. The rise of the Nazis defies any simple narrative, coming as it did out of a myriad of interlacing events, ideologies and historical accidents”. “

The quote above is true, not only in relation to the policies expounded by the two men, but, more dangerously, by the social and political conditions that permitted Hitler’s rise to power.

In other posts (see: here and here) I have already explained the similarity between the economic conditions in the 1930s and today. I will just add that today they are not as dire, but can turn so if the next financial crises exceeds that of 2008 and reaches the level of 1932.

Turning now to the political conditions, I recall that today’s dissatisfaction is two-fold – a generalized disillusion with the centrist political establishment in Western countries and a rise in nationalist illusions among former communist states who failed to thrive under capitalism. Unfortunately, both disillusions may converge into a dangerous spiral of nationalism in a 1930s fashion.

What worries me is the reaction of moderates in the left and the right who seem to start taking an appeasement approach to Trump, like the one that cleared the road to Hitler.

Its worrisome, to see how many moderate Republicans are trying to embellish the Trump discourse or to believe the wishful thinking that he will moderate his views when in power.

Moreover, the same stance is being taken by some radical classical liberals’ followers of Hayek, whose dislike of Hilary Clinton blinds them enough to endorse a candidate like Trump whose policies are extremely nationalistic and protectionist (see my exchange with Don Boudreaux here).

So, we live in dangerous times. And, whether we like it or not, we have to rely on the hope that Hilary Clinton is elected and brings some sense to the political arena. She is not the candidate of the Republicans, but, if they fail to stop Trump and do not support her, they may end up playing Hindenburg’s role 83 years ago.

Sunday, 28 February 2016

Demagogia sobre a ADSE

Está em marcha um processo de desinformação e disparates legislativos que põe em causa a sobrevivência do seguro de saúde dos funcionários públicos, designado por ADSE.

O processo começou com Sócrates que aboliu a obrigatoriedade de descontar para a ADSE, prosseguiu com Passos Coelho que aumentou desnecessariamente as contribuição para 3.5% de modo a fomentar a transferência dos quadros mais bem remunerados ou jovens para o setor privado e continua com Costa que se prepara para descapitalizar a ADSE alargando-a a todos os familiares dos funcionários públicos com menos de 30 anos.

O sistema da ADSE é muito invejado porque reembolsa a todos os seus participantes uma parte significativa das despesas de saúde e dá-lhes liberdade de escolha entre o Serviço Nacional de Saúde e o sector privado. Atualmente acaba por pagar mais de 20% da faturação dos hospitais privados.

Aparentemente, são razoáveis os clamores à esquerda e à direita para abrir a ADSE a todos e acabar com esta dita descriminação que favorece os funcionários públicos.

Porém, se pensarmos melhor verificamos que esta argumentação é idêntica à demagogia dos comunistas quando se propõem acabar com os ricos para ficarmos todos pobres.

Na verdade, o sistema da ADSE é generoso para os funcionários públicos mal remunerados porque são subsidiados pelos restantes que pagam uma contribuição excessiva. No entanto, essa contribuição é subsidiada pelos colegas e não pelos restantes contribuintes. Existem outros sistemas e subsistemas bem mais generosos (nos sectores da banca, defesa, energia e telecomunicações), alguns com contribuições adicionais das entidades patronais.

Contudo, o sistema da ADSE só é possível porque a percentagem de profissionais e quadros no sector público é mais elevada (cerca de 60%) do que no privado (cerca de 30%). Basta um pequeno exemplo numérico para avaliar o impacto desta estrutura profissional.

Por exemplo, se quer no privado quer no público o salário médio mensal dos trabalhadores qualificados fosse de 2500 Euros e o dos não qualificados de mil Euros, com uma contribuição de 3.5% seria possível comprar €67 de cuidados de saúde por mês para cada funcionário público e apenas €51 para os trabalhadores do privado.

Tal seria possível porque cada quadro no sector público subsidiava com €32 os não qualificados enquanto os do setor privado apenas financiariam os não qualificados em €16.

Qual seria o resultado de juntarmos toda a gente num único sistema.

Tal sistema só podia gastar €54 por beneficiário. Isto é, em média os trabalhadores do privado teriam mais €3 e os do público menos €13.

Será que vale a pena em termos do bem-estar geral? Não, porque a generalização do acesso ao setor privado faria imediatamente subir os preços e baixar a qualidade dos seus serviços de tal modo que os €54 passariam a comprar menos serviços de saúde do que os €51 iniciais.

Tal como acabar com os ricos não beneficia os pobres, também acabar com o privilégio dos funcionários públicos mais pobres não irá acabar com os pobres do privado. Em suma a inveja e a ignorância não são bons conselheiros.

Tuesday, 22 December 2015

Robotics and the value of labour

For a long time, economists have used production functions to study the impact of changes in the elasticity of substitution between capital and labor in factor income distribution. When the elasticity of substitution is one the relative shares remain constant, when it is greater than one the share of capital increases and when it is less than one the share of labor rises.

Most economists believe that the remarkable stability of the relative share of capital and labor in total income experienced in capitalist countries is due to the fact that technical progress is either neutral (and the elasticity of substitution is one) or is mildly labor-saving but the relative earnings of labor in relation to capital will decline due to a relative labor abundance, thus moving the elasticity close to one. But, what will happen to capitalism if technical progress turns extremely labor-saving and labor income becomes negligible or negative?

For instance, imagine a futuristic scenario where each one of us owns personal robots better than us in all domestic and professional tasks, not just the simply tasks of cleaning and similar. Science fiction typically depicts such scenario in terms of who will be the master, us or the robot, but I will assume that humans will be the masters.

Following the law of comparative advantage we would leave to the robots the tasks where they had a comparative advantage, for both pleasant and unpleasant jobs. However, by increasing the number of robots relative to that of humans, humans would be able to skip entirely all the unpleasant tasks. Therefore, the few pleasant jobs left to humans would be mostly the design and supervision of robots and to decide on collective investments. Because these function will not occupy many people jobs for humans will be so scarce that workers might be willing to pay for the privilege to work rather than be paid.

So, in such a world, how would capital accumulation and economic exchange work? Could the six principles of capitalism survive in such world? Can we imagine exchanges to continue as usual but now with trading between robots at a speed not accessible to humans?

In such a world the accumulation of human capital (skills and education) will be driven by non-economic factors and everyone’s income is essentially determined by capital returns. Thus everyone would need to own traditional assets and robots either directly or indirectly through collective investment vehicles (e.g. pension funds) or the government.

That is, the markets for goods and services could work as they do now but the labor market would be substantially different, since humans would no longer be sellers but buyers in such market. Likewise, preferences for consumption and accumulation will be altered since in such society the leisure class will be a majority while the working class is a small minority.

There would be then three types of assets, the traditional forms of property, the human replicas (slave robots) and the embodied skills and human capital necessary to qualify to buy the right to work. The first two types of capital can be merged in two categories - traditional assets and slave robots. Therefore, one could still use the conventional two-factor model so that in a product function we were left with two single inputs, traditional capital and slave robot labor, and again define an elasticity of substitution between them in the usual way.

The only requirement is that slave robots be separable from their owners so that they may be traded like any other type of capital. In this futuristic world, private property would still be needed to drive consumption and capital accumulation, but human labor supply would no longer constrain the rate of capital accumulation and could be considered as perfectly elastic. Therefore, the personal fortune of each individual robot-owner will depend entirely on its initial endowment, investment skills and luck on selecting their portfolio of capital and robots.

The jobs for humans would be a status symbol to be achieved through other means rather than competitive markets, namely through hereditary rules, lottery or voting. All job positions could be theoretically auctioned, like old master paintings, but it would be inefficient. Such a society would resemble Ancient Rome but with robots instead of human slaves.

Nevertheless, it is unlikely that self-reproducing slave-robots could be left entirely in the hands of private individuals. Even assuming a good regulatory environment, most people might prefer state ownership fearing that robots might turn against humans.

If that happens one could no longer rely on comparative advantage, even in the context of a single factor (slave-robots) model, because that factor would be jointly owned (state owned). Moreover, slave-robots would be more homogeneous than humans which would make them less differentiated in terms of comparative advantage. So, new solutions will have to be found.

In conclusion, the ways humans chose to regulate the production of humanoid slave-robots will determine how a new economic system may differ from capitalism.

Monday, 21 December 2015

Capitalism and consumerism

Capitalism is the world’s greatest production machine. However, eventually, production needs to be consumed. Thus, capitalism can only go on growing if consumers are willing to consume. So, it is consumerism indispensable to the survival of capitalism?

Of course, we are still very far from a society of plenty, but should capitalism go on for several centuries producing wealth at the rate it has produced in the past, we may expect to reach such a status.

Alternatively, we may consider that consumer demand is infinitely elastic since humans can always either design new items of consumption (e.g. inter-galactic travel) or, because when their appetite subsides, it may be encouraged through advertising. For instance, most people would live quite well with just a pair of shoes per year. However, the fashion industry persuades us to have dozens or hundreds of them and we become trapped into an unreasonable pursuit of consumption that contributes little or nothing to human happiness.

Moreover, consumerism creates many side effects that generate also production opportunities for capitalists. For instance, to use the words of Harari (2015), “Obesity is a double victory for consumerism. Instead of eating little, which will lead to economic contraction, people eat too much and then buy diet products – contributing to economic growth twice over.… The new ethic promises paradise on condition that the rich remain greedy and spend their time making more money, and the masses give free rein to their cravings and passions – and buy more and more.”

Nevertheless, the reliance of capitalism on consumerism creates two distinct overcast clouds on its future. First, it increases human alienation which may degenerate into revolt against capitalism. Second, and most importantly, it sets a boundary on how much such an economic system can rely on consumer sovereignty and consumption-led growth.

In relation to the first it is opportune to remark that this argument is already used as the basis for the anti-capitalism of some religious leaders and communists. It is hypocritical that, having failed to solve poverty through charity or having created misery with their social experiments, they now want to accuse capitalism for having provided the opportunity to consume to the masses.

The reliance of capitalism on consumer-led growth is necessarily finite, unless humans transform themselves into consumption machines. The point of consumer saturation is certainly centuries away but it will happen. So, when that day comes who will substitute the individuals' demand for goods and services? Whether it is the government or a new type of institution it will have to be driven by a new form of rationalization different from consumer welfare. That is the valuation of leisure, consumption and work will change and may not be decided on competitive markets.

Overall, consumerism and waste is not fundamentally caused by capitalism but it sets a limit on the duration of capitalism. The other constraint is set by the relative contribution of machines and labor to the production process.

Sunday, 20 December 2015

Capitalism and globalization

Will capitalism conquer the world? May be yes, but, per se, this is not a desirable outcome, because some diversity in economic systems is always beneficial for humankind.

What is more relevant is to assess whether the globalization of capitalism will be a positive or negative force in the current world. In this regard the balance between positive and negative impacts is clearly positive. I shall explain why below, but first let me explain why anti-capitalism movements are often also anti-globalization.

The detractors of globalization have three main lines of attack, namely that: globalization kills local and national cultures, that multinationals exploit non-unionized labor and lax regulations in poor countries and destroys national sovereignty and decision centers. Anti-capitalist advocates attribute to capitalism whatever they think is wrong in society. For instance, feminists blame capitalism for the unfair treatment of women, animal rights groups blame it for animal maltreatment, environmentalists say it is responsible for the destruction of nature and “climate change”, civil rights groups charge capitalism with promoting racism, peace activists attribute war and conflict to capitalist greed, moralists claim that commercialization and consumerism are responsible the loss of religious and social values, consumer-advocacy groups accuse capitalism of putting profits before people.

As explained in previous chapters none of these charges withstands the most simple scrutiny, let alone the counter-evidence provided recently by the turn to capitalism of former socialist and communists systems in China and other less developed countries.

First, and foremost, the globalization of capitalism accelerates the eradication of extreme poverty on a global scale, with the consequent positive effects on health, education and consumption. But, as is normal, accelerating economic growth also has its side effects, namely in terms of environment and demography. Likewise, it will accelerate the rise in the capital/labor ratio and the consequent impact on their relative share of income, which needs to be tackled through an increased capital ownership by workers either directly or through pension funds.

Nevertheless, the major impact of globalization will be through changes in political systems and regulations. Globalization unleashes forces that simultaneously strengthen and weaken the case for regulation. For example, greater freedom of movement for goods, labor and capital weakens the role of national governments. But the fear of sudden mass movements with disruptive consequences on infrastructure and employment calls for global regulation. Thus, using a parallel with monetary theory, the question whether the world is an optimal jurisdictional area for all the fundamental principles of capitalism is critical.

Without detailing all the issues let me just illustrate with a few. For instance, can we conceive of a global corporation reporting and paying taxes to single world entity? Or, can we anticipate an international court to judge violations of the rule of law? Would it rule under a system of common or civil law? Most of these question remit to the fundamental problem of how to structure different levels of government from a local to a global level and the respective enforcement apparatus, within a democratic system.

Although a body of generally-accepted international law is being developing slowly, it will probably take some centuries before a comprehensive system makes its mark. In the end, the fastest route may still be a progressive economic and political integration at the regional level like in the European Union.

In conclusion, although capitalism and globalization are both desirable and reinforce each other, any non-synchronized acceleration in one of them may backfire into a joint relapse.

Friday, 18 December 2015

Capitalism and the economics of happiness

It is difficult for humans to be happy on an empty stomach or without shelter. Yet, in most surveys about the sources of happiness, people usually rate higher other determinants of happiness such as family and health. So, it is wealth-creation (the main objective of capitalism) the only road to happiness? The answer is obviously no!

Different people pursue happiness in different ways, namely through meditation, friendship and many other ways that do not depend on the availability of the material comforts of life (see Layard, 2005). Yet, it is also unquestionable that the abundance of material comforts may facilitate or prevent the attainment of happiness.

One important factor to notice is that the pursuance of material wealth is often detrimental to the other factors contributing to human happiness, namely family life, community and friends. However, most people will pursue wealth regardless of the economic system.

Therefore, as it is often the case, the drive for wealth should not be confused with the results of an economic system (capitalist or other). For instance, imagine that humans were divided in two groups – satisfiers and maximizers. It will take a lot of reward to convince the first to emigrate and leave behind family and friends. So, in capitalism only its higher rewards can be blamed for enticing the urge to move on those individuals.

Nevertheless, the opposite is equally true. One should not ignore the key role played by wealth in family life. In particular the Portuguese adage that “in a hungry family all fight and none is right”.

Indeed, the impact on family life and health through industrialization and urbanization was initially very disrupting and resented in the early days of capitalism, which led many social-minded philosophers to blame capitalism for that.

Likewise, long working hours, women employment and job insecurity often contribute to some of the greatest causes of unhappiness, namely separation/divorce and unemployment. Yet, this cannot be fairly attributed to capitalism, especially when we compare its working conditions with those under slavery, serfdom or communism. Moreover, it gave women a degree of freedom never enjoyed in the past both in terms of self-supporting income and domestic help.

Of course, greater freedom inevitably comes with a greater sense of insecurity. In particular, the freedom of contracting could not provide a job-for-life and the sense of security enjoyed by the serfs tied to the land. But, to some extent the state ended up replacing the landlords in providing unemployment insurance and other welfare programs. Moreover, it freed men from compulsory labor and military service which were a major cause of death.

Finally, at the cultural and moral levels, capitalism is often criticized as responsible for the loss of a sense of belonging and for growing resentment and envy, all factors that diminish happiness. Again, the greater freedom, wealth and opportunities created by capitalism in turn favored individualism, consumerism and egalitarianism, which have happiness-reducing consequences. However, they also had significant happiness-increasing consequences in terms of liberty, abundance and social mobility, which, on balance are more important.

In conclusion, like all new economic systems, capitalism brought its own share of disruption to traditional values and certainties which wears down some sources of happiness. Although its facilitation of many other sources of happiness largely outweighs such erosion, there are some utopias that it cannot and should not promote, such as wealth equality. While equality of opportunity is indispensable for economic efficiency, trying to impose an equality of results would require eliminating individual risk and rewards and entrepreneurship which are fundamental for capitalism.

Wednesday, 16 December 2015

The control of rent-seeking behaviour

Initially business regulation focused on anti-trust policies and barriers to entry. However, rent-seeking behaviour is not exclusive of natural or government sponsored monopolies and oligopolies. Rent-seeking is generally defined as the pursuit of payments beyond those necessary to have the service or factor supplied. Although most of these situations involve licensing, e.g. as in the case of doctors, taxis, drugs etc., or natural monopolies (as in the case of land), there are situations where market dominance may create the same type of rent-seeking behaviour.

I shall illustrate this with two examples related to new technologies and distribution, that is, – rent seekers vs. innovators and distributors vs producers.

With free entry, innovators will enjoy only a temporary monopoly until new imitators come in and drive profits to zero, thus eliminating any rents. However, in sectors subject to winner-takes-all economics that is no longer the case, because innovators can only compete until one of them dominates the market. That is, inventors become like lottery players, playing in the hope of winning a jackpot. Those who get it either retire or become a kind of private equity fund (doing little or no new research) but buying up any new innovators that threaten their dominance.

This eat-or-be-eaten is not always negative. Indeed, many so-called serial entrepreneurs thrive on finding new business opportunities and not on running them for long periods and therefore welcome the possibility of cashing-in and having a higher turnover in their investments. The problems exist when the acquirers use bundling and financial power to stop prematurely the natural selection of the winners.

Consider for example the social network Facebook’s acquisitions of Instagram and WhatsApp, for 20 billion USD, in order to secure dominance in global photo-sharing and mobile messaging. Can we be sure that those services had already achieved their position of winner-takes-all through competition or did they reach it prematurely by being acquired by a dominant player in the same space?

It is important to note that most of those payments were in Facebook shares, which may be seen as counterfeit currency if they are excessively overvalued because of the expected longevity of its oligopolistic position. So who is rent-seeking, the innovators or their acquirers? Probably both, because the innovators capitalize on the anticipation of a wider monopoly position while the acquirer achieves a higher valuation on the assumption that it will be able to maintain its dominant position and capture the rents achievable through such position longer than normal.

However, it is not uncommon that the acquirer ends up writing-off many of such acquisitions and ends up being the “sucker” while the tech entrepreneurs cashes in hefty gains. So, as long as this processes increases rather than limits entrepreneurship, the potential for market perfecting policies on the part of regulators is very limited.

This is possible because inventors also hold a monopolist position. This is quite different from the position of distributors and suppliers. To the extent that retailers manage to concentrate their retail outlets in a few locations their stores achieve a local oligopolistic situation which allows them to pursue rent-seeking. These oligopolies are often reinforced by local planning and licensing regulations.

For instance, during sudden recessions consumer demand contracts and retailers try to stop falling sales through discounts and lower prices. However, these reductions are transferred to their suppliers so that they manage to protect their profit margins throughout the recession. They are able to do so because suppliers no longer have direct access to end-user clients . Therefore, most of the adjustment takes place at the producers level. However, in contrast to the tech sector, here a write-off in the producers’ investment generates a reduction in entrepreneurship but the distributors will not incur write-off losses.

A similar process occurs in sectors (e.g. petrol stations) where the producers are in an oligopolistic position while the retail distributors are many and receive a fixed payment. Obviously, in this case, the producers are the only able to pursue rent-seeking.

That is, there are cases where producers impose a fixed price to retailers e.g. soft drinks, ice cream, petrol and domestic gaz. And the opposite, cases where distributors impose a price to producers, e.g. research, supermarkets, etc. Such practices are certainly anti-competition and may justify some form of regulation. However, in those sectors where both producers and distributors have oligopolistic power (e.g. IT and healthcare) it is not clear whether regulation can add much value.

In conclusion, striking the right balance between market perfecting regulation and intrusive messing up it is not always easy. For instance, in the financial sector excessive regulation often results in the protection of the incumbents which have the resources needed to cope with heavy regulation. Nevertheless, in most domains, whenever the right level of regulation cannot be ascertained, one should err on the low side.

Tuesday, 15 December 2015

Pro-business or pro-market?

When evaluating public policies there is a widespread confusion in the identification of pro-business with pro-market policies. This is a dangerous confusion, because not all business interests are pro-market. In this regard the phenomenon observed long ago by Adam Smith about businessmen reunions where (“the conversation ends in a conspiracy against the public, or in some contrivance to raise prices”) is as alive today as it has always been.

Therefore, it is crucial to assess if any policies classified as pro-business are not really for specific-interest groups and anti-competitive practices. In general, it is important to realize that both insufficient and excessive regulation work for the benefit of incumbents with market power. This said, it is equally true that there is no way of fixing theoretically the right balance for regulation.

So, in the end, the judgement on pro-market policies must be based on economic theory and on how such policies eradicate well known distortionary practices. Sometimes, this requires playing on the opposite interests of specific-interest groups.

For instance, in the energy industry regulators often play some players against the others, either industry segments or corporations. This is so because the players are often sophisticated and ruthless.

For example, oil companies like BP or Repsol are not choir boys and yet they were recently taken for a ride by local companies and their political allies in Russia and Argentina. It is often said that under crony capitalism one needs a crony to deal with another. This may be so, but taking sides on the infighting between oligarchs does not guarantee that one is not replacing a special interest by another one. Thus fighting for competitive markets should not be confused with business infighting.

Business ethics is another field where pro-business should not be confused with pro-market. There are often two opposing camps on this debate, some wanting to transform businesses into social or philanthropic institutions while others think that the end (profit maximization) justifies the use of any means, including testing the limits of the law. Both are wrong, because capitalism cannot flourish without simultaneously upholding the profit motive and the rule of law.

Another concern regards the tolerance or even support for distortionary price policies through price controls or subsidies. Although such policies are usually promoted by claiming that they are temporary special measures, they invariably end up creating special interest groups which are difficult to dislodge.

Finally, the generalized idea that firms need to grow to be able to compete is equally misleading. When pursued to the limit winners would inevitably transform into oligopolies and turn to the pursuit of rent-seeking opportunities. However, fixing firm size limits or forcing company breakups it is neither easy nor a guarantee of success as more than 100-years of enforcing antitrust legislation suggests (see Bork, 1993 ).

To conclude, since business people are neither more evil or saintly than the rest of the humans, regulatory measures too much focused on preventing their potential evil or trying to transform them into saints will be inefficient and messy. Regulation should focus more on the playing than on the players and should only be pro-business whenever this does not collide with being pro-market.

Monday, 14 December 2015

Wacky WACC and the cost of capital

WAAC is an acronym widely used in corporate finance which stands for Weighted Average Cost of Capital. It is often identified (confused) as the marginal cost of capital or the rate of return required by a firm. In discounted cash flow models, WACC is used as a discount rate to evaluate investment projects or to value companies.

There are several controversies regarding the way it should be computed (e.g. see Fernandez, 2011) but I do not address them here. I shall focus on its abusive identification with a true definition of the cost of capital. Indeed, the WACC is neither a cost nor a required return, but an weighted average of both.

Initially, finance theory discussed the concept of the cost of capital in the context of how to fix the rates of public utilities, in order to recover the costs of investment, their replacement costs, their financing costs and any other costs. In corporate finance, it originates from the valuation of investments, and can be regarded either as a discount rate or a multiple used to obtain the present value of expected future net cash flows.

So, what is the appropriate discount rate? Since different investors may use different valuations for different objectives, there is no single rate derived independently of specific markets and circumstances (e.g. Somers, 1971, even argues that “appropriate discount rates are not only project-specific, they are project-unique”).

Nevertheless, modern corporate finance, has been dominated by a specific choice that is consistent with the model of the irrelevance of capital structure and dividend policy. At the theoretical level, the modern school of finance (Modigliani and Miller 1958) postulated that the cost of capital, measured as the market rate of return, is a perfectly definite quantity not subject to manipulation through capitalization or dividend policies.

On the contrary the old school of finance (Durand 1952 and 1966), regards the cost of capital as too nebulous and elusive to play a key role in financial policy. I shall argue that the “old school” argument is more reasonable and does not introduce an unnecessary bias in favor of managerial capitalism.

From an empirical point of view the approach followed by the modern theory of finance may be dismissed on the grounds that a valuation based merely on a small share of total financing – traded debt and common stock – is necessarily unreliable. In fact, that was the argument for its dismissal by its first proponent (William, 1938).

Nonetheless, from a theoretical point of view, it could still be useful. However, it happens that its theoretical value is also limited, even at the mathematical level, despite its straightforward mathematical definition.

Weighted averages must be meaningful. For instance, one may calculate the weighted average cost of a piece of fruit in two baskets by summing the average price of each basket multiplied by the percentage of fruits it contains, regardless of whether both baskets contain apples or one has apples and the other has pears.

However, for most purposes one is only interested in averaging close substitutes, e. g. apples with apples or apples with pears, not baskets with a mix of completely different fruits. Likewise, with various sources of funding one must ascertain if they are really close substitutes beyond a narrow range within the capital structure.

So, for a start, one may consider weird a metric like WACC that averages two distinct terms - the cost of debt, which is indeed clearly perceived as a cost and easily measureable, and the required return on equity, which is not unquestionably defined or easily perceived as a cost in an accounting sense but as a potential gain that needs to be estimated. This mix up is reasonable if presented as an expedient or academic exercise but not as a scientific foundation for investment decisions made by different agents.

It is true that seen from an investor perspective exchange-traded debt and equity issued by a firm look like two substitute financing instruments suitable for arbitrage. However, debt and equity financing are not identical or sufficiently similar instruments to be considered perfect substitutes for controlling shareholders or for pure arbitrage. They may be sufficiently correlated for statistical arbitrage but that is not enough to combine them in the same basket. Let me show why by explaining first why the return on equity cannot be considered truly a cost like debt.

Imagine a business run by Mr. Management and funded by Mr. Supplier, Mr. Creditor and Mr. Stockholder. From time to time Mr. Management organizes a tender to finance the firm´s funding needs and asks suppliers, debt providers and stockholders to bid. Mr. Supplier would have to compete with other suppliers to offer better payment terms for the amounts procured. Similarly, Mr. Creditor needs to outbid other debt providers and Mr. Stockholder would need to beat other equity investors.

It is obvious that the tender would have to offer investors different terms for different types of funding. For suppliers, other than business preference, the firm may not offer any explicit consideration for deferred payment. To creditors it offers to pay interest in cash or kind. To stockholders it offers a payment in kind by giving them part ownership in the company.

Suppliers, creditors and shareholders bid for the three types of funding would depend on the respective consideration and the seniority of their claims on the firm’s assets. Stockholders are the last in terms of seniority and the cost of funding (the return demanded) declines as the seniority of the claims increases.

Now, imagine that Mr. Management has a fiduciary duty to minimize net working capital, the cash conversion cycle and funding costs. So, he must bargain hard payment terms and fund as much as possible from the cheapest source of funding. The first two suppliers of finance are easy to bargain independently, but not so with stockholders.

Stockholders pose a special challenge since they should be able to bid for how much they wish to plowback into the business and the possibility of providing additional financing. Indeed, Mr. Management would need to make sure that the value of the stock owned by their existing shareholders would not be reduced by the ownership dilution of their holdings. That is the new capital would need to earn enough to meet the current owners required rate of return plus any dilution costs.

When Mr. Management is also the majority owner of the company this paradox is easily solved by treating the other shareholders as junior partners. However, this is not the case for firms operating under managerial capitalism. In such firms, the directors’ ownership is small or inexistent making them simply agents of other stockholders. These, in general, have only small stakes. Indeed, their capital dispersion may be so high that managers are able to select shareholders rather the other way around, creating serious agency problems when choosing different sources of funding and defining objectives.

So, the key issue is whether firms should leave the amount of equity (including retained earnings) as a residual source of financing after exhausting all other funding sources or instead should the shareholders decide how much they wish to fund the business and let the others with the residual to be funded through other sources?

Traditionally, textbooks avoid this question by assuming that shareholders can attain their objectives in terms of capital structure through homemade leverage, leaving the firm to invest up to the point where its marginal return equals the marginal cost of capital.

But then, the capital structure and the marginal cost of capital cannot be determined separately when both depend on the same determinants (lenders mark-ups and risk aversion) and leverage has simultaneously contractionary and expansionary effects on investment (Marques-Mendes and Mheica, 2006).

For a simple illustration of the kind of confusions caused by the cost of capital theory consider the valuation of two unlevered companies with the same cash flow. Imagine that they are quoted in the same market and one of them is seen as outperforming and the other as lagging the market, so that the first appreciates more than the market while it rises and falls less when it declines and the opposite happens with the second company. For instance, assuming that when the market declines at a rate of 2% the first company declines at 1% and the second at 3%, and the opposite happens during rising markets, the average betas would be 1.09 and 0.93, respectively. Assuming further that the risk free rate and equity risk premium are 4 and 6%, respectively, the second company would be worth more 10% than the first company. So, using the popular CAPM model to estimate the required rate of return, the first company would have a higher beta and therefore a higher rate of return. However, assuming that it is the true cost of capital, this would mean that investors would value more the second company which is the opposite of what they are doing.

The reasons why such an obscuring theory achieved such popularity among academics and professionals were already given in another post. So, I will conclude by recalling how a reasonable minor departure from profiting maximization was seized by special interest groups on the basis of a somewhat wacky theory.

Saturday, 12 December 2015

Maximizing profits or stakeholder value

The role of firms has been in a slippery slope ever since finance theory began replacing the pursuit of profit maximization by maximization of shareholder or firm value.

Before outlining this evolution let me recall first why for-profit organizations choose to incorporate and its consequences in terms of finance.

Following Veblen (1923), one may say that a “corporation arises out of a collective credit transaction whereby funds supplied … are entrusted to the corporation as a going concern … therefore, an impersonal incorporation of liabilities to the stockholders, and by employing these liabilities as collateral (formally or informally) it will then procure further capital by an issue of securities (debentures, typically bonds) bearing a stated rate of income and constituting a lien on the assets of the corporation.” For him, the two main consequential facts were: a) an inflation of credit (increased leverage), and b) a capitalization of funds, essentially liabilities, with fixed charges. This way the value of a firm could be gauged by the value of its securities traded in exchange markets.

So, in the 1930s, people began questioning whether the profit or return maximization rule used in economic theory to optimize the allocation of resources through market exchanges. In particular, if it was appropriate to ignore the non-pecuniary motives that so often drive business or if a focus on current income would be myopic, ignoring uncertainty and long term considerations.

The non-pecuniary motives were rule out, on the usual grounds that on average they would have a small impact, but different schedules of future income could not be compared unless using an appropriate index of time preference to convert future income into its present value.

Hence the suggestion that investors replace profit maximization by maximization of investment value, defined as the discounted value of an expected income stream.

However, this shift was not a simple question of semantic. While under profit maximization the optimal business expansion proceeds until the marginal return on capital equals the rate of interest, for the maximization of investment value stockholders must consider if their shares will be worth more or less following the expansion.

That is, the rate of earnings on the new investment must exceed not only the interest cost of borrowed money but also the rate of earnings required by stockholders to maintain the value of their shares. This rate is the opportunity cost for stockholders and, although it is not an out-of-pocket cost, it can be interpreted as a cost for the corporation.

As shown in Durand (1952), the required return is higher than the interest rate and therefore the optimal level of expansion as determined by the schedule of investment value is smaller than the level determined by the schedule of total return. Most importantly, the required schedule of the rate of return depends on the method used to capitalize earnings. For instance, with capitalization based on operating profit the interest rate and the required rate of return coincide up to the point of zero borrowing, while if capitalization is based on net profit the required rate schedule will be always above the interest rate curve.

Under the net profit approach the required return curve defined as a function of financial leverage has a maximum which implies the existence of an optimal capital structure. This is at the core of the heated debates on the cost of capital and the neutrality of capital structures mentioned previously (see Modigliani and Miller (1959) and Durand (1959)). For reasons given above the subsequent academic literature choose to ignore the theoretical implications of the choice of capitalization method and proceeded with a theory of corporate financing based on the concept of neutrality of capital structure.

From the 1960s onwards, this otherwise reasonable substitution of profits by investment value was used to justify the linking of management compensation to the stock market which led to the uncontrolled rise of their compensation relative to shareholders and employees. Whether the cost of this side-effect of shifting from profit-based compensation to stock market-based compensation exceeds the benefits of a better selection of investments through investment value is an unsettled empirical matter.

What a cursory look at the history of this process shows is that the pursuit of stockholder value maximization, which was initially welcomed, come to be also increasingly criticized for generating “short-termism”.

A living symbol of the shareholder value theory was Jack Welch during his tenure as CEO of General Electric from 1981 to 2001. But, according to Steve Denning (Forbes, June 26, 2013) he became one of the strongest critics of shareholder value. On March 12, 2009, he gave an interview with Francesco Guerrera of the Financial Times and said, “On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy… your main constituencies are your employees, your customers and your products. Managers and investors should not set share price increases as their overarching goal… Short-term profits should be allied with an increase in the long-term value of a company.”

It is interesting to notice that, instead of narrowing the constituency that management has to serve, he not only enlarged it substantially but also demoted investors to a secondary role. Under managerial capitalism, this is consistent with a rising perception of management (and not the owners) as the real rulers of corporations.

In summary, history has shown that moving from corporate profits to stakeholders value made the metrics to assess performance more vague and accountability more diffused, while leaving unsolved the supposed short-termism of corporations and compromising their future by transforming them into major self-serving bureaucracies.

Given that this process generated many market and fiscal distortions one has to consider whether regulators and tax authorities opposed them or were accomplices on this evolution. The role of regulation is difficult to ascertain because of the successive cycles of excessive/deficient deregulation-regulation-deregulation. So, there is little empirical evidence on which one can rely.

However, there is a common sense perception that excessive regulation damages small investors by treating them as children while protecting the big players which have the scale and resources needed to cope with the cost of regulation. Likewise, the recurring shifts in the taxation of dividends and capital gains distorts most serious attempts to estimate long-term investment returns. There is nevertheless a large field of taxation – subsidization - where it is easier to assess if regulation (or lack thereof) contributes to an unfair leveled playing field. I will illustrate that below through various examples.

Thursday, 10 December 2015

An overview of finance theory under capitalism

The remarkable rise of financial markets in the first quarter of the XX century was followed by an increased interest in finance. Initially the emphasis was in security analysis, but since the 1950s its focus shifted towards portfolio theory, markets and new financial instruments such as derivatives.

Before the XX century, finance theory was mostly a branch of mathematics (actuarial calculus) dealing with the pricing of risk in fixed income securities (debt) based on the probabilities given by mortality and bankruptcy tables. Given the stable nature of such tables finance was not seen as ideological or having anything to do with the fundamental principles of capitalism.

However, following the rising issue of variable income securities (equity) by joint stock companies, finance theory become progressively the realm of accountants and lawyers dealing with the valuation of stocks on the basis of the calculation of future profits and the rights of each class of shares issued. These concerns were already at the core of the principles of capitalism (property rights and free markets), but remained largely non-ideological because of the nature of such valuations based on common sense forecasting of business profits and the growing prohibition of share manipulation. Such valuations were generally accepted as relevant to value firms.

Yet, this benign acceptance of security valuations came to an end following the 1929 stock market bubble and crash. During that period valuations were so much at odds with the corporate fundamentals that financial analysts had to look elsewhere for explanations.

The first attempt appeared in 1934 with the publication by Graham and Dodd of Security Analysis, a book that has gone through two major revisions but it is still seen today as the bible of financial analysis. The book covered many of the pitfalls of traditional financial analysis but did not cut with the tradition.

However, security analysts were not the only trying to find explanations for extreme volatility in market prices. Accountants responded by increasingly recording non-cash transactions in an attempt to find explanations and macro economists began explaining why arbitrage was not reducing such large departures from price equilibrium.

For this, both professions had to come up with new theories (not new facts) to explain past and current valuations. These theories had to draw on assumptions (subject to ideological bias) and could not be tested in a laboratorial sense.

These rival theories searched for supporters while special interest groups searched for theories that served their interest. Consequently, finance theory ceased to be a reasonably neutral instrumental tool to become a battle field of ideologies with an impact on the interpretation of the principles of capitalism, especially on the role of private property and the profit motive.

This process was fostered in the 1950s by the sudden interest in finance by macroeconomists with a tradition of competing schools of thought and doctrines.

Curiously, accordingly to Miller (1988), the Modigliani-Miller interest on the cost of capital had been awakened by listening to a paper presented by Durand (1952), the last preeminent scholar in the old finance tradition. Modigliani and Miller (1958) developed a general equilibrium model for a closed economy aimed at explaining the “determinants of aggregate economic investment”. By consolidating the accounts of the business and household services into a single balance sheet debt and securities no longer appear, thus proving the proof of their first proposition about the irrelevance of the capital structure.

This proposition had already been proved in finance theory by Durand (1952) for security valuations based on operating income rather than net income, which he did not consider a best approach to capitalization. He suggested that the businessmen’s interests were better served by the maximization of the present value of their investments rather than their profits, because the first took into account their time preference. Moreover, the cost of issuing debt or equity would have to consider the effects of increased leverage or equity dilution on investment value to assess the rate of return required on the investment to preserve shareholder’s value. That way, this required rate of return could be interpreted as an opportunity cost of capital.

Durand’s conclusion was that: “Given a method of security appraisal, the costs of raising capital can be both defined and measured. At the same time I have tried to show that there is at present no generally accepted system of appraisal; hence there can be no generally accepted system of measuring costs”.

In particular, Durand claimed that none of the two methods widely used in analyst’s valuations – capitalized net income or capitalized net operating income – was adequate or correct, when strictly interpreted. Not surprisingly, he was the first (Durand, 1958) to refute the Modigliani-Miller proposition on the grounds that it may apply to certain partnerships but not to corporations, since it neglected a fundamental principle of capitalism – limited liability. Later, Durand (1989) extended his critic to the static nature of a theory based on constant growth rates, by showing that “growth, when resulting from a premium rate of return in an imperfect market, will manifest itself in a premium stock price”.

Nevertheless, Miller and Modigliani (1961) extended their approach to the case of dividends to prove their second proposition about the irrelevance of dividends for firm valuation. Both propositions relied on pure capital markets and the possibility of creating so-called homemade leverage and dividends to create conditions for arbitrage between debt and equity that made structure irrelevant for valuation. These papers were necessarily controversial and triggered an unprecedented interest of macroeconomists in finance which extended also to econometricians and finance professionals.

This would create an new age in finance theory in academia. Given the rather complex and theoretical nature of the Modigliani-Miller approaches, it is still unclear why this happened so suddenly. Especially, since the greatest innovation with a practical use – Harry Markowitz (1952) paper on portfolio optimization - had remained forgotten for almost a decade.

It is nevertheless plausible to assume that the interest of company managers in encouraging a theory that would free them to use whatever capital structure they liked and to decide on how and when to return funds to the shareholders did not remain unnoticed. Likewise the replacement of profit by firm value maximization fade away the monitoring of their performance while justifying their growing compensation in terms of stock options .

In this new era of so-called modern finance, or new finance if we add behavioral finance, theory and practice became increasingly divorced. Contrary to tradition, practitioners began using complex academic theories to impress their marketing targets the same way salesman use super models to sell cars.

Thus modern finance theory became the realm of economists and econometricians, hiding their primeval ideological bias under a heavy use of complex modelling and econometrics.

Curiously, modern finance theory had begun in the right foot with Durand’s (1952) paper on the “Costs of Debt and Equity Funds for Business”, which questioned a proclaimed shortage of equity capital as the reason for the increased retention of earnings and borrowing.

Unfortunately, Modigliani and Miller (1958) reversed Durand’s conclusion and used the cost of capital concept to develop their model on the irrelevance of the capital structure on a firm’s value and the neutrality of dividend policy, by recurring to devices such as shareholder’s leverage and homemade dividends.

Despite the protests of Durand (1959), the Modigliani-Miller theory became fashionable among academics and was seized by managers to reclaim their long held desire to treat indifferently debt holders and stockholders. This fostered the idea (and reality) that managers select shareholders not the other way around, in order to maximize the owners value but that of an enlarged constituency ranging from employees to suppliers.

Combined with accommodating fiscal policies this “new ideology” justified an enormous rise in institutional investment and consequent facilitation of the rise of managerial capitalism. This fueled a number of potentially nefarious policies and political collusions. I address below some of these ranging from the abuse of the weighted average cost of capital to the attempts for (re-)privatization of money.

In conclusion, finance theory may not have had an impact as large as that of technology, but it was still significant. Its role has been mainly accommodating in explaining the trend for financialization and managerial capitalism. On the contrary, it has been lacking on exposing the excesses of financial deepening in finance-led capitalism. Since this is not always benign, one would expect more from financial theorists.

Tuesday, 8 December 2015

Asymmetries in access to leverage

There is a justified apprehension that in credit-based economies, of the type associated with capitalism, the excessive reliance of credit on collateralization perpetuates an unfair advantage for those endowed with more capital. The popular sentiment that money-attracts-money and misery-attracts-misery. However, the rise of capital markets and the spreading of banking philosophies based on the ongoing concern principles, means that market capitalism dilutes such concerns about the misallocation of savings.

Before addressing the potential misallocation of leverage under financial capitalism, let me make a qualification about the differences between savings and investment and credit and borrowing. The two concepts are often confused because ex-post, in an accounting sense, their value is identical and also because in a popular sense saving is seen as a form of abstinence. Likewise, lending is popularly identified with renting an existing asset, e.g. a lawnmower or cash.

To be more exact we should define investment as the carrying of any asset (whether the butter in the fridge or the computer in the office) from one accounting period (whatever period unit one uses, year, month, etc.) into the next period, either because it cannot be entirely used up within a single period or for precautionary or speculative reasons.

Under this definition one would consider consumption as the use of a portion of newly produced or existing assets during the current accounting period. Thus, as Keynes put it, “when investment changes, income must necessarily change in just that degree which is necessary to make the change in saving equal to the change in investment” . Hence, savings and investment are jointly determined by the propensity to consume, the schedule of the marginal efficiency of capital and the rate of interest.

Therefore, one needs a theory of how financial leverage influences these determinants. In the absence of such theory, one can nevertheless intuition (see Mendes 2000) that the rise of finance capitalism has two offsetting effects on investment – contractionary and expansionary – whose net effect has to be ascertained under specific circumstances.

In particular, large scale investments need to be collateralized through a mix of financial assets and guarantees involving a complex engineering between banks and governments. This necessarily degenerates into collusion between these two sectors which occasionally may crowd-out the funding of enterprise in favor of speculation and government spending. In this sense it is a threat to market capitalism.

However, some speculative occurrences in financial assets have as an underlying a non-financial asset like real estate or similar which causes a misallocation of resources into non-financial assets (e.g. the sub-prime real estate bubble and crash in US). On other occasions it is not clear if the speculative frenzy began with non-financial assets and after transmitted to the financial sector or vice versa. However, such cycles are neither the result nor a threat to capitalism.

In conclusion, finance capitalism may cause some misallocation of resources and favor the leveraging of some sectors (e.g. managerial capitalism) but it is not a fatal threat to market capitalism.

Monday, 7 December 2015

HFT, overtrading and casino capitalism

The extraordinary rise in financialization is the result of a growing economy and new trading and communication technologies. These reduced transaction costs putting speculation at the reach of a growing number of people, for increasingly short-lived and minuscule price discrepancies.

This can be illustrated by a permanent level of overtrading and the rising role of speculation in a casino-fashion, which may be exacerbated by the recent development of high frequency trading (HFT) at speeds only accessible to computers.

HFT refers to algorithmic trading which, according to some estimates, accounts for about 70% of all equity trading in the US stock exchanges. HFT has always existed whenever volatility and sentiment led investors to change quickly their positions. However, in the past the frequency of trading was limited by slow message networks and human communications (despite the development of gestural messages among traders).

With the development of electronic communications and trading platforms, human traders progressively reduced the time to move in and out of positions to a fraction of a second.

However, with the emergence of high speed computing and sophisticated decision and order transmission algorithms, now human traders can be replaced by computer traders which are not subject to such limits. Indeed, by connecting directly their computers to the exchange trading platform, some claim to be able to move in and out of a position in micro-seconds (one millionth of a second ) capturing a fraction of a cent in each trade and still make a profit.

For the time being the investment strategies more likely to be adopted by fast trading robots are front running and pump and dump (both illegal) as well as market making, ticker trading and various types of arbitrage. However, it is foreseeable that it will extend to all types of investment strategy.

The progressive substitution of human trading by robotic trading will certainly transform the equity market into a dual market of the kind already observed in currency markets, where the share of transactions for commercial (tourism, exports and imports) or investment motives (savings and portfolio allocation) becomes very small when compared to that of professional speculators. This evolution raises two types of concerns – excessive overtrading and casino-like price formation.

One must note that overtrading it is usually defined in two ways. In a business context the term is used to describe companies that are doing more business that their working capital can sustain. In the context of markets the term is usually used to describe the brokers practices to influence their customers to engage in excessive buying and selling. I will retain here a broader definition based on financial cycles due to rising volatility and increased speculation.

The drivers of financial cycles would not be fundamentally different from those driving business cycles if it was not for the fact that trading in financial assets seems to go on rising unabated despite recurrent crisis and significant consolidation. For instance, the recent substitution of 18 currencies by the Euro did not result in any reduction in forex trading, quite the opposite. Between 1998 and 2013, the daily average volume of trading rose from US$1.5 trillion to US$5.3 trillion, an amount equivalent to 17.5 times the value of the daily production in the world.

This is only possible because the market is dominated by a dozen of large banks (or market makers) engaged in what one may consider a never ending zero-sum game through which they can only grow by taking ever larger bets against each other. The continuity of this game has an obvious benefit by creating a huge liquidity pool, so that those trading for commercial or investment reasons no longer are limited by the size of the market.

However, this benefit may have serious costs in terms of new operational risks and loss of the information provided by prices. Operational risks occur in the form of flash crashes of the kind occurred in New York on May 6, 2010 and in Singapore on April 23, 2013. Nevertheless, despite the individual havoc that these may cause, they may be considered as “teething problems” which will be minimized to avoid its frequent recurrence and the contamination of the real sector of the economy.

On the contrary, the transformation of markets into casino-like gambling has two enduring risks – boosting financial crisis and diluting the importance of markets for the efficient allocation of resources.

In itself, HFT has not been at the origin of financial crisis, and it is still too early to know if it plays any role in their amplitude.

Since price signaling is a key foundation of market capitalism, there has been a heatedly debate on whether speculation improves markets. In theory, its stabilizing role seems to win the argument, at least in currency markets. In these markets the fundamentals still play a role in the long term, because in currency markets some players (central banks) are legally entitled to collude to manipulate the markets into stabilization. However, in equity markets only trading halting rules perform such function because there is no entity with a stabilizing role.

So, whenever the level of overtrading in equity markets reaches currency proportions we do not know if monetary authorities are able or willing to step in to stabilize equity markets in a similar way. What we know from the latest bubbles is that central bankers alerts about “irrational exuberance” may be ignored for several years. For instance, during the internet bubble of the 1990s it took four years from 1996 to 2000 before the bubble burst by itself.

Overall, neither HFT nor overtrading risks represent a global catastrophic threat to capitalism similar to that of a nuclear arms race or experiments with high-energy super colliders.

Nevertheless, we need to know more about their distortionary impact on price formation and the allocation of leverage to competing projects. Otherwise, to put it in Keynes words (1936): “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done”.

Thursday, 3 December 2015

Globalization and winner-takes-all

The globalization of markets and capitalism has increased the opportunities for businesses with a winner-takes-all model. Such business are characterized by high cost of entry once a dominant player has acquired the bulk of the market. Their rise is explained by the benefits of one-stop-shop found in many services.

For instance, in social media users value the opportunity of having all their friends in the same platform (e.g. Facebook). Typically the providers of such services compete by offering a loss-making free service until they manage to establish a quasi-monopoly. Once they have achieved that, they can monetize their dominant position through advertising or by other means. This is not a natural monopoly nor is it protected by any entry barriers other than capital resources.

This strategy is only possible because of the existence of venture capital funding willing to bet on the various contenders for the market, but once one has been established as dominant it is no longer profitable to try to dislodge him.

Similar cases occur when, due to locational or brand recognition advantages, some businesses rely on the captivity of the final consumer to transfer to their suppliers any demand adjustment costs. These situations occur in industries as disparate as publishing and groceries. For instance, during economic crisis supermarket chains force their suppliers to cut prices or offer discounts to sustain consumer demand.

A somewhat similar situation, but less stringent, occurs in the so-called 20/80 sectors where 20% of the producers have 80% of the market and vice versa. Here, removing the entrenched incumbents is difficult because the market may overvalue them and the entry costs are too high. It usually takes a long period and some new technology to achieve that.

These conditions are more common in global businesses ranging from soft drinks to computers. For instance, Microsoft dominance of operating systems was only challenged by the arrival of the smartphones and tablets.

With the globalization of capitalism these conditions become more common but once the globalization process has been completed their number will subside.

Therefore, overall, globalization and winner-takes-all business models are not lethal capitalism and must be seen simply as a temporary nuisance to market capitalism.

Wednesday, 2 December 2015

Control theory and minority shareholders

Shareholder dispersion raises two related issues – the possible emergence of a control premium and how to protect minority shareholders from collusion between managers and controlling shareholders.

The growing size of firms requires an ever growing dispersion of shareholders and it becomes impossible or risky for a single investor to control 50% +1 of the votes. For instance, in 2015, the largest strategic shareholder (Mitchell’s Michael Kent) in the smallest cap constituent of the S&P 100 index - Devon Energy Corp – owned only 5.07% of the company, less than the 5.46% owned by The Vanguard Group which caters for retail investors. Moreover, the top 10 investors owned jointly less than 32%, while overseas investors from 30 different countries owned 28%.

So, since individual shareholders or groups of controlling shareholders often own less than 50% of the votes, it is normal that such control might be challenged by other investors, thus creating a market for company control. Of course, this requires the existence of an advantage in controlling a company sufficiently large to justify a so-called control premium.

Why should there be any advantage in being part of the control group if trading on insider information is forbidden and management has to treat all shareholders fairly? Finance literature usually explains such interest in terms of governance to discipline the incumbent management more efficiently than through internal control systems.

The assumption underlying such reasoning is that the influence it gives to controlling shareholders in terms of nominating and compensating managers following policies aligned to their interest is offset by a strong discipline preventing managers and controlling shareholders from engaging in tunneling and abuse of non-controlling shareholders.

Yet, even in large markets, like the USA where it is possible to have a lively takeover market, most of the takeover deals are driven by short term financial profits secured through buyout and arbitrage strategies, often at odds with the interest of long term investors. Moreover, even where the judiciary can be relied upon to prevent corporate raiders from expropriating the target’s resources there are still circumstances when some categories of investors can collude with management.

Elsewhere, Mendes (2011), I examined why trade investors may collude with managers to vote for star-like compensation, lowering the return to other investors which lack any self-interest market mechanism to prevent such predatory behavior. In the case of trade investors the materiality and scope for collusion depends on the possibilities to switch suppliers, their relative size and the greed of management. So, the question now is to discuss if it is possible to correct such inefficiency through regulation.

The simplest way to regulate is to impose limits on the ownership of major suppliers, to limit their rights or a combination of both. The first could be easily defined but it can be easily evaded. In particular, for suppliers of financial services, such limits could be easily circumvented by investing indirectly through investment funds managed by them.

Limiting the voting rights of trade investors who are major suppliers is probably a better solution. It does not disrupt arms-length trading relations and it is easily enforced. The only debatable issues would be about the classification of trade investor and the voting restrictions. Beyond the traditional restrictions on voting in related-party transactions, restrictions should cover voting for the election of management and their remuneration, but they could extend to voting in the governance and auditing committees.

Nevertheless, regulation always has its own costs, which cannot be disregarded lightly. In particular, discouraging trade investors may have its costs in terms of business intelligence and synergies.

Still, overall, I believe that easing takeover regulations and limiting the voting rights of trade investors are market perfecting policies, contributing to true market capitalism and the protection of minority shareholders.

Monday, 30 November 2015

Wealth accumulation and the profit motive

From the early XX century the rise of large corporations and consequent separation between ownership and control has dominated the debate on entrepreneurship and capitalism. The debate naturally turned to whether – business concentration and owner absenteeism – would reduce the role of the market and the profit motive as foundations of capitalism and wealth accumulation.

In itself, wealth accumulation neither goes always pari passu with status and power nor does its regional and occupational origin follows a rigid stratification. Nevertheless, some periods are usually associated with a particular source of wealth or class of individuals.

For instance, at the turn of the XIX century in Britain, London commerce and finance were seen as the origin of the largest fortunes of the epoch. Likewise, at the turn of the XX century in America, the Silicon Valley internet entrepreneurs and the New York hedge fund managers were regarded as those more likely to accumulate great fortunes.

So, both in relation to the sources of wealth and to its distribution, we may identify cycles that are usually due to various causes but never as a direct result of capitalism.

Nevertheless, the path to capital accumulation does affect the efficiency of capitalism since different groups have different propensities to save and pursue different investment strategies. In particular, the rise of institutional investors adds new agency problems in relation to portfolio allocation and a possible dilution of the profit maximization motive caused by the owners absenteeism and a growing rent-seeking monopolization.

Indeed, these agency problems were already felt in the early XX century by authors like Thorsten Veblen (1921) who stated that: “The company … is, therefore, an impersonal incorporation of liabilities to the stockholders, and by employing these liabilities as collateral (formally or informally) it will then procure further capital by an issue of securities (debentures, typically bonds) bearing a stated rate of income and constituting a lien on the assets of the corporation.“

The questioning of the role of the firm culminated in the classical book by Berle and Means (1932) arguing that: “The property owner who invests in a modern corporation so far surrenders his wealth to those in control of the corporation that he has exchanged the position of independent owner for one in which he may become merely recipient of the wages of capital... [Such owners] have surrendered the right that the corporation should be operated in their sole interest...”.

This trend led finance theorists to treat shareholders as if they were debt holders and to a growing influence of managerial capitalism; with firms turning into bureaucratic organizations without the entrepreneurial spirit of the early promoters.

Many large firms frequently collude with governments and become more driven by rent-seeking than value added under competitive conditions. Often they are also managed through planning and search to grow through mergers rather than entrepreneurship. These fears, which were already present before the 1940s, are obviously a threat to capitalism, but they do not mean that modern capitalism is already following the path of Venice which transformed from a thriving trading city in the XV century into today’s museum city.

Accountants’ ever increasing recording of non-cash transactions in financial reporting also eroded the traditional use of profits as the right bottom line metric to measure business performance. As net income becomes less and less meaningful, investors moved up the income statement and use other measures such as operating and gross income. And, as these progressively become subject to creative accounting, they had to turn also to cash flow statements. This proliferation of metrics did not help the profit motive.

Moreover, finance experts progressively substituted profits by shareholder value which blurred further the use of profits. And things are getting worse, since many increasingly replace this concept by the broader one of firm value. Because these metrics are based on specific theories, they are easily abused by managers with self-perpetuating and self-aggrandizement agendas .

To conclude, the rising wealth created by capitalism facilitated the emergence of ever bigger firms, creating a growing divorce between owners and management, fostering the replacement of profit maximization by vague metrics of shareholder and firm value, which, together, compound the erosion of the profit motive as a foundation of capitalism. Fortunately, this is largely confined to the managerial sector of capitalism and, although a serious threat to be fought, the erosion of the profit motive will not be lethal to capitalism.

Friday, 27 November 2015

Human capital and social mobility

In general, capitalism is based on meritocracy. For instance, paternal earnings had the least effect on sons’ earnings in Canada, Norway, Finland, and Denmark, where less than 20 percent of income advantages were passed onto children (Isaacs, 2008). However, there are concerns that this does not apply across the board (e.g. the USA, UK and Italy have low mobility) and that mobility is mostly determined by the parents education.

Yet, there are also concerns that under capitalism markets do not work well for long term human capital investment.

For instance, some professionals see their investment in training destroyed because of supply and demand mismatches. This happens to many graduates who end up in low skill jobs. This mismatch between qualifications and job opportunities may be specific to some markets or may be the result of cyclical trends, but it is not a feature of capitalism.

Markets with a permanent excess supply of labor are usually found in industries with winner-takes-all business models. For instance, in the entertainment industry there are only a limited number of slots for handsomely paid super-stars, which act as a magnet to the many candidates to win the super-star lottery. The consequence is that most of the runners-up end up working in bars or McDonald’s, thus losing the investment they made in art school.

Changes in cyclical trends are also significant and can be illustrated by teachers. The demand for teachers depends on population growth with demographic cycles usually long but, occasionally, suddenly shifted by migratory flows or changes in enrollment policies that cause large mismatches in demand that cannot be corrected quickly.

For instance, the baby boom of the 1950s and the economic growth in the 1960s generated an impressive growth in the population of schooling age and enrollment rates. However, the subsequent decline in fertility rates had the opposite effect. It had a dramatic effect on the employment and earnings of teachers who, starting from a position of high social status, ended up unemployed or in a low-status low-wage sector. That is, their investment with a view to social climbing through education had a negative return.

Although the return on education depends on many factors, including parenting, it is obvious that the laws of supply and demand influence the income and status of the various professions which are subject to rotation in status. This flexibility is required by competitive markets but it affects differently the various professions.

For example, if someone trains to be a sales representative in one industry and that industry shrinks he or she can still move to another industry because his qualifications are not specific to that industry. That is not the case in highly specialized jobs. These have a higher risk of becoming obsolete or requiring extremely high costs of retraining.

However, while free competition may increase the risk of human capital obsolescence it also increases the opportunities for more investment in human capital, and the later exceeds by far the first. Moreover, the impact of free competition on human capital is probably less than that of technology and demography.

In conclusion, capitalism may be disruptive in relation to returns on human capital and social mobility, but it is not a major cause on the inequality of individual returns. On the contrary, it is a driving force in the promotion of equality of opportunities.

Thursday, 26 November 2015

Capitalism and philanthropy

Although capitalist are frequently depicted as ruthless profit seeking individuals, it is nevertheless true that most philanthropists are businessmen. That is, they may be unforgiven when making money but generous when bequeathing it. How can we explain this apparent paradox? It is a matter of self-interest, the result of guilt, vanity or is it the result of institutional constraints? I shall explore these issues with special reference to the USA where philanthropy is more widespread.

According to the Giving USA Foundation, Americans gave $358.38 billion in 2014, a 7.1% increase from 2013. Of these, corporate giving amounted to $17.77 billion (a 13.7% increase from 2013). The total given was equivalent to 2.1% of gross domestic product in 2014, of which about half goes to religious and educational projects. It largely exceeds the $148.18 billion contributed by the US as international net official development assistance in 2013.

These figures suggest that, when encouraged, the private sector is capable of contributing substantial amounts of money for redistribution on a non-profit basis. Whether, it is also more efficient on its allocation and use than the government it is an open question. Common sense dictates that each sector has its own comparative advantages in relation to specific groups of beneficiaries, and therefore the state and private roles should be complementary rather than competitive.

Another important issue is whether capitalists should be free to bestow their giving to whom they wish. Each individual has its own set of priorities and should be free to select them. Regardless of what each individual thinks, we cannot say that Bill Gates is more philanthropic than Rockefeller was simply because the first gave money to fight malaria in Africa while the second gave a villa in lake Cuomo to be used as a retreat by academics.

Obviously, the state should not follow the wish of individual politicians without bearing in mind the priorities of society as whole expressed by free voting. Moreover, the state priorities should not be imposed on private donors. All that authorities should do is to encourage through co-financing or tax breaks the allocation of private donations to certain objectives.

A more controversial issue is whether the donors generosity should be left to each individual or if a minimum rate should be applied. For instance, if at the time of death they should be subject to an inheritance tax on all wealth not bequeathed to charities. In chapter 13 we explain why inheritance taxes provide a powerful restraint on wealth concentration required to preserve market capitalism. However, this only applies to large fortunes. All the others should be left to be masters of their own generosity.

Indeed, although there are some scrooges among capitalists, it is important to notice that most of them are only greedy when making money and not when giving it away. So, in general, philanthropy not only supports capitalism but it also complements it by supporting those that by misfortune or careless were left out by the wealth produced under capitalism. This said, philanthropy should be an individual decision, not something that should be practiced by corporations, for the reasons I gave in another post.

Monday, 16 November 2015

Why socialism often ends-up in dictatorship

In contrast to a capitalist system, socialist regimes invariably transform into authoritarian or totalitarian political regimes; regardless of whether they reached power through popular vote or revolution.

That revolution often ends up in non-democratic regimes is an historical fact that can be explained by the revolutionaries desire to cling to power, regardless of whether they are pro or anti-socialists and anti-democracy.

What needs explaining is why socialists who were voted into power and promised to respect democracy also turned into non-democratic regimes. We can find two different routes.

First, when socialism evolves into communism. Then, it necessarily abandons its pro-democracy ideals because communism was based on the concept of a class (proletariat) dictatorship later renamed popular democracy.

Whether socialism will inevitably degenerate into communism was already debated in the XIX century. For instance, in Bastiat’s Law (1850), the author claimed that “men will resort to plunder whenever plunder is easier than work… As soon as the plundered classes gain political power, they establish a system of reprisals against other classes. They do not abolish legal plunder”.

Indeed, one hundred years later, a similar pessimism about human nature was the basis for Schumpeter’s (1942) prediction that capitalism would degenerate into a form of corporatism to be replaced by socialism.

Fortunately, history has shown that socialism does not always evolves into national socialism or communism and sometimes reverses into social-democracy, which accepts both capitalism and democracy. However, as the Scandinavian experience shows, this reversion has to be substantial otherwise the regime will not survive.

There is another possibility for socialism to survive temporarily within a democracy by exploring what we may call Latin-American populism.

The most emblematic example is found in Venezuela, a country with the oldest bipartisan democracy in the region. Former President Hugo Chavez was elected with the support of a largely impoverished population which was “bribed” to re-elect him through state sponsored social programs paid by the middle classes and the un-economic exploitation of the rich natural resources of the country for the benefit of a small group of trusted cronies.

However, this model of socialism is inevitably doomed for two main reasons: 1) the economic inefficiency of the system is so high that even the dilapidation of natural resources is not to enough to hide a generalized economic decline, and 2) the demands of its supporters on the welfare state rises with any new benefit so that public finances soon collapse.

These two factors are abundantly seen in Venezuela, where the socialist rulers, faced with growing opposition, have introduced all sorts of paranoiac prohibitions and persecutions in order to hang on to power, including the prohibition of travelling abroad for media directors and the detention of the opposition leader.

In conclusion, socialism will inevitably send democracy to a kind of limbo, from which it is only possible to exit by reversing its path towards social-democracy or by evolving towards state capitalism or communism and dictatorship.

Thursday, 24 September 2015

As próximas eleições e o dilema de escolher o mal menor

Nas atuais eleições muito Portugueses enfrentam o dilema de ter de escolher o menor dos males. Muitos eleitores desejam punir a atual coligação mas temem que alternativa socialista seja ainda pior. O dilema foi apresentado de forma brilhante neste artigo ( ) da Maria João Marques, que o resolveu afirmando que pessoalmente não iria votar na coligação mas apelando a que outros o fizessem. Será esta a melhor solução?

A resposta a esta questão depende da perceção que temos sobre a importância do nosso voto.

Se acreditarmos que o nosso voto poderá ser decisivo então temos que optar pelo mal menor, e a Maria João devia votar na coligação.

Se, como as sondagens sugerem, nem a coligação nem o partido socialista estão perto da maioria absoluta então já temos maior liberdade de voto, mas a nossa decisão deve ser influenciada pelo tipo de governo que poderá sair destas eleições.

Se for um governo minoritário liderado por quem tiver mais votos, então a decisão da Maria João devia depender de quão próximo estão os dois rivais. Isto é, se as sondagens apontarem para um empate devia votar na coligação, caso contrário, terá a liberdade de optar por um voto de protesto.

Se, a alternativa for um governo de coligação, então terá de avaliar se a melhor solução para as próximas eleições, que se seguirão a um governo com vida provavelmente curta, é ter o seu mal menor a liderar a coligação ou não. Se a sua avaliação for sim, então devia votar na coligação. Se for não, terá liberdade para fazer um voto de protesto.

Vejamos agora quais são as suas opções para um voto de protesto, agrupando-as em dois grupos – protesto por omissão ou votação em partidos “alternativos”.

O voto de protesto por omissão tem três opções: abstenção, voto nulo ou em branco. Infelizmente, o nosso sistema eleitoral não permite a representação dos votos nulos com cadeiras vazias no parlamento, e, alguns eleitores temem que a sua mesa de voto possa transformar o seu voto nulo em válido. Por outro lado a abstenção pode confundir-se com o desinteresse e não com um voto de protesto. Finalmente, num país com muitos idosos e analfabetos, o voto nulo tem a desvantagem de poder confundir-se com os erros genuínos desses eleitores. Tudo pesado, talvez o voto nulo ainda seja a sua melhor opção se não tiver partidos alternativos a quem possa dar o seu voto.

A votação em partidos alternativos deve distinguir entre partidos com possibilidade de terem representação parlamentar ou não.

Infelizmente, em relação ao primeiro grupo, entre nós a escolha não é muita pois apenas temos dois partidos de extrema-esquerda (PCP e BE), o que no caso da Maria João invalida esta opção.

Quanto aos partidos de protesto a sua maioria também é de extrema-esquerda ou extrema-direita com as quais a Maria João não se identificará. Os restantes, ou são partidos pessoalizados em torno de demagogos com objetivos pouco claros (e.g. PDR ou JPP) ou são partidos de grupos de interesses específicos nem sempre transparentes (e.g. MPT, PURP ou PAN). Se a Maria João simpatizar com algum desses movimentos (o que não me parece), a sua opção será votar no mais simpático.

Em conclusão, em situações em que temos de escolher um mal menor cada eleitor deve fazer a sua avaliação das múltiplas alternativas que tem (aqui ilustradas com o exemplo da Maria João). Já fiz a minha própria avaliação seguindo este método. Resta-me desejar que o método também possa ser útil a outros eleitores.

Monday, 24 August 2015

Capitalism without democracy?

Is capitalism indifferent to the form of government? Not in its pure form of market capitalism.

Just like competition and free markets are indispensable for economic success, democracy and freedom are essential for a good system of government and the rule of law. For this reason, capitalism and democracy are often said to go hand in hand.

Yet, there are some on the right and left who still believe the opposite. Some take such view on the basis of a mistaken interpretation of democracy and capitalism, while others simply dislike the outcomes of both systems.

Democracy is “Government of the people, by the people, for the people”. This form of government is achieved through majority rule by people's representatives, subject to the constitutional separation of powers and the rights of the minorities, who are elected periodically on the basis of one person one vote.

The alternatives to democracy can be gathered into two groups – totalitarian and authoritarian. Totalitarian regimes are typically governed by a despot or a small group of leaders, invoking an ideology or religion as the general basis for all aspects of life, where any form of opposition is brutally repressed. Authoritarian regimes are a softer version with less dogmatism in terms of ideology or creed, and granting some level of economic and religious freedom as long as their personal enrichment and hold on power is not challenged.

Former examples of totalitarian regimes include Nazi Germany and Stalin’s USSR, while living examples can be found now in countries like North Korea and Saudi Arabia. Today, the classification as totalitarian or authoritarian in countries like Iran, Russia or China is controversial.

For instance, the classification within a given category is not indifferent to the regime evolution, and in this sense one may say that China is moving towards an authoritarian regime while Russia is moving towards a totalitarian system, although, objectively, now there is still more freedom in Russia than in China. Likewise, the distinction between democratic and authoritarian regimes is also controversial in countries like Singapore.

In fact, nowadays, authoritarian and totalitarian regimes do not follow an open anti-capitalist ideology and may even portray as strong capitalist supporters, as long as their rule is not challenged.

The two standard yardsticks to judge the evolution of a political regime are the direct state involvement in the economy and the exercise of civic freedoms under the rule of law. These do not necessarily preclude regimes with strong leaders or with one-party long-term dominance.

However, these inevitably end up creating a self-perpetuating elite that will oppose any competition. To overcome such danger the pursuit of liberalism constitutes an important antidote to preserve both capitalism and democracy.

Indeed representative democracy and capitalism share similar problems in terms of governance. As sometimes I remind my students, there is a remarkable similitude between shareholders and electors. For instance, elections are the equivalent of the shareholders annual meeting, asset managers are similar to political parties, the board of directors resembles the parliament, and the executive officers the government while the senior managers are like the top civil servants.

Therefore, they share similar challenges. For instance, in terms of representation, the need to avoid a divorce between the electors and the elected is analogous to the separation between shareholders and management. Likewise, the rise of self-perpetuating insider elites in political parties is similar to that found in the selection of company board members.

Not surprisingly, the false alternatives to representative democracy, namely direct and “guided” democracy, have an equivalent in the attempts to extend voting rights to non-shareholders and on collusion to adopt rules restricting voting rights.

In conclusion, capitalism and democracy are two distinct but mutually-reinforcing systems. When in pursuit of their true form – market capitalism and representative democracy – they are inseparable. Temporary moves away from any one of them is only possible for short periods or under perverse forms of capitalism.