If you let the financial services industry do exactly what it wants, the financial services industry will eventually get itself — and by extension the economy — into staggering amounts of trouble. If you force it to behave, it might just thrive.

I don’t think you can ever force anyone to behave.  I was never successful forcing my kids to behave when they were four years old, and I have no more success now that they are teenagers.  This thesis leads to some bad logic.  Mr. Fox continues:

I thought about this while listening Tuesday to David Swensen, the legendary manager of Yale University’s endowment, arguing that acting as a fiduciary for other people’s money and maximizing profits are incompatible activities. “A fiduciary would offer low-volatility funds and encourage investors to stay the course,” he said. “But the for-profit mutual fund industry benefits by offering high-volatility funds.”

Swensen said this at a Bloomberg Link conference held in honor of that great fiduciary, Vanguard founder Jack Bogle.

I have a few issues with this.  First, the data argues that low-volatility funds are not the answer.  If low volatility were the answer, customers would hold their low-volatility bond funds longer than they hold their high-volatility stock funds—but they don’t.  Holding periods, according to DALBAR data, are only marginally different, around three years in each case, so that argument goes up in flames.  Second, investment firms always encourage investors to stay the course, sometimes to a fault.  (And they usually end up getting criticized for it later by some Congressional panel with 20/20 hindsight.)  Seriously, did you ever read material produced by any reputable investment firm suggesting day-trading or short-term speculation?

Mr. Fox extols Jack Bogle and Vanguard for being great guardians of the investor, yet Vanguard is one of the biggest players in exchange-traded funds, something Mr. Bogle has decried as a terrible product that encourages speculation!  Does that make Vanguard evil?  (I don’t agree with that either.  ETFs don’t kill people; investors shoot themselves.)  Reality is a lot messier than an idealogical paradigm.

It all boils down to incentives.  Human beings are not all that tractable.  It’s certainly not easy to get investors to behave rationally either, and it’s not for lack of pleading by the investment companies.  Believe me, every firm would rather you keep your account there permanently!  But rather than “forcing” someone to behave, why not give them incentives to behave?

An anecdote might illustrate my point.  I worked many years ago at Smith Barney, Harris Upham when it was still private.  Share ownership was widely distributed and many people—partners and aspiring partners—felt like they had a stake in how things worked.  It was viewed in the industry as a stodgy firm that was not willing to take big risks, which was pretty much true.  The partners didn’t want to take big risks with the firm’s money because the firm’s money was their money!  Eventually the partners sold out to a public company.  The first convertible bond underwriting client that was engaged after the firm became public went bankrupt before it made its first semi-annual interest payment.  I can’t prove it, but I suspect that the partners weren’t as concerned about the underlying credit quality of the issuer when it wasn’t their money at stake anymore.  (In an interview, John Gutfreund of the old Salomon Brothers said using other people’s money was the beginning of the end.)  How many toxic mortgages would have been securitized if the partners’ personal money were at stake, or if even public firms had been required to retain substantial amounts of each pool?  Surely much less monkey business would have gone on.  (Stupidity you can’t regulate.  But if someone knows they have a grenade, they’re not happy about playing catch with it.)  Intelligent structuring of incentives will solve many of the problems that Mr. Fox rightly points out.

And, one could argue that incentives are already having an effect.  Mr. Fox mentions in passing some good actors in the industry (and I’m sure there are others):

Some of these for-profit advisers (Capital Group and T. Rowe Price spring to mind) have built a reputation for looking out for investors’s interests.

And guess what?  These firms are now huge because they realized they would have the best chance at sustainable, long-term growth by looking out for investors.  Enlightened consideration of their incentives led them to behave in ways that maximized their long-term growth.  There are other firms in the industry that have marketed celebrity portfolio managers, or have pushed performance when they were hot, or have launched all manner of ill-conceived products, but they have generally come to grief in the longer run.  (Short-termism, by the way, is not limited to for-profit enterprises.)

Could the industry incentivize even better behavior?  Possibly, and that is certainly a goal worth pursuing.  But to lay the blame for industry problems on the profit motive is just lazy thinking, in my opinion.

HT to Abnormal Returns

In 1978, the farmers in a small Chinese village called Xiaogang gathered in a mud hut to sign a secret contract. They thought it might get them executed. Instead, it wound up transforming China’s economy in ways that are still reverberating today.

The contract was so risky — and such a big deal — because it was created at the height of communism in China. Everyone worked on the village’s collective farm; there was no personal property.

“Back then, even one straw belonged to the group,” says Yen Jingchang, who was a farmer in Xiaogang in 1978. “No one owned anything.”

At one meeting with communist party officials, a farmer asked: “What about the teeth in my head? Do I own those?” Answer:  No. Your teeth belong to the collective.

In theory, the government would take what the collective grew, and would also distribute food to each family. There was no incentive to work hard — to go out to the fields early, to put in extra effort, Yen Jingchang says.

“Work hard, don’t work hard — everyone gets the same,” he says. “So people don’t want to work.” In Xiaogang there was never enough food, and the farmers often had to go to other villages to beg. Their children were going hungry. They were desperate.

So, in the winter of 1978, after another terrible harvest, they came up with an idea: Rather than farm as a collective, each family would get to farm its own plot of land. If a family grew a  lot of food, that family could keep some of the harvest.

This is an old idea, of course. But in communist China of 1978, it was so dangerous that the farmers had to gather in secret to discuss it.

One evening, they snuck in one by one to a farmer’s home. Like all of the houses in the village, it had dirt floors, mud walls and a straw roof. No plumbing, no electricity.

“Most people said ‘Yes, we want do it,’ ” says Yen Hongchang, another farmer who was there.   “But there were others who said ‘I don’t think this will work — this is like high voltage  wire.’  Back then, farmers had never seen electricity, but they’d heard about it. They knew if you touched it, you would die.”

Despite the risks, they decided they had to try this experiment — and to write it down as a formal contract, so everyone would be bound to it.  By the light of an oil lamp, Yen Hongchang wrote out the contract. The farmers agreed to divide up the land among the families. Each family agreed to turn over some of what they grew to the government, and to the collective. And, crucially, the farmers agreed that families that grew enough food would get to keep some for themselves.

The contract also recognized the risks the farmers were taking. If any of the farmers were sent to prison or executed, it said, the others in the group would care for their children until age 18.

The farmers tried to keep the contract secret — Yen Hongchang hid it inside a piece of bamboo in the roof of his house — but when they returned to the fields, everything was different.

Before the contract, the farmers would drag themselves out into the field only when the village whistle blew, marking the start of the work day. After the contract, the families went out before dawn. “We all  secretly competed,” says Yen Jingchang. “Everyone wanted  to produce more than the next person.”

It was the same land, the same tools and the same people. Yet just by changing the economic rules — by saying, you get to keep some of what you grow — everything changed. At the end of the season, they had an enormous harvest: more, Yen Hongchang says, than in the previous five years combined.

Listening to this story makes me much more optimistic about the possibility for eventual intelligent economic reform.  The power of incentives to transform behavior is truly remarkable!  Thoughtful incentives make the economy better for everyone.  I hope it is not lost on policymakers that a 15% tax on the huge harvest generates more revenue than a 70% tax on the lousy harvest.  (Even bad incentives, I suppose, make the economy better for certain groups while making it worse for others.  Relative strength is a good way to detect who is benefiting and who is being held back.)

Quoting Martin Luther King Jr. on the topic of the responsibilities of leaders in a democratic society:

“Cowardice asks the question—is it safe? Expediency asks the question—is it politic? Vanity asks the question—is it popular? But conscience asks the question—is it right? … There comes a time when one must take a position that is neither safe, nor politic, nor popular, but one must take it because it is right.”

That time is now. Our nation’s economy is at risk. The Federal Reserve has done everything it can to reduce unemployment without forsaking our sacred commitment to maintaining price stability, or crossing over the monetary river Styx into full-blown debt monetization. I personally don’t care which party is in the White House or controls Congress. All I know is that the “honorable” members of Congress and presidents past, Republicans and Democrats alike, have conspired over time, however unwittingly, to drive fiscal policy into the ditch. They purchased their elections and reelections with popular programs so poorly funded that they now threaten the economic well-being of our children and our children’s children. Instead of passing the torch on to the successor generation of Americans, they have simply passed them the bill. This is the opposite of honorable.

Like all of you here, I am sickened by our politicians’ tendency to kick the can down the road, even when it is starkly clear that doing so jeopardizes America’s well-being. Small wonder that some recent polls show only 9 percent of the American people view Congress favorably. (One senator posited that the 9 percent consisted of blood relatives and congressional staff!)

But this is the holiday season, and especially now, I am given to viewing the world through optimistic eyes. The Christmas spirit may be overwhelming my judgment, but I believe that the American people—from the mainstream to the Tea Party to the unemployed and disaffected who have taken to the streets—are in the process of forcing politicians to get their act together. There is a loud, distinct, clarion call for leadership—for the people we entrust to right the rules that determine our economic future, cast away cowardice, expediency and vanity, and get on with leading us out of our fiscal wilderness.

The best-known example comes from Europe–or Sweden, to be exact–which probably explains why the European proposal has met with such strong opposition.  From 1984 to 1991, Sweden implemented a series of taxes ranging from 0.5% on equities to fractional basis points on certain bond trades.

The results were disastrous.  As any sane person might expect, trading volumes plummeted in Sweden as investors moved their money to more lubricated markets.  Within six years, the options market vanished entirely, futures volumes fell 98 percent, and 50 percent of equity trading moved offshore.  Even bonds, which had fractional basis-point taxes, suffered an 85 percent reduction in trading volume.

The article proceeds to calculate that if volumes stayed unchanged, taxes would amount to another 10% of GDP!  That’s about 50% of the current entire tax base.  As the Swedish example makes clear, volumes won’t be unchanged.  Nor does it seem like a good idea to cripple the economy with a potentially enormous tax increase.  In Sweden, the revenues turned out to be modest, but the damage to the Swedish financial system was severe.

Perhaps we will learn from history, or perhaps we will simply prove Hegel’s theory:  The only thing we learn from history is that we learn nothing from history.

• 82% of Americans disapprove of the way Congress is handling its job.
• 69% say they have little or no confidence in the legislative branch of government, an all-time high and up from 63% in 2010.
• 57% have little or no confidence in the federal government to solve domestic problems, exceeding the previous high of 53% recorded in 2010 and well exceeding the 43% who have little or no confidence in the government to solve international problems.
• 53% have little or no confidence in the men and women who seek or hold elected office.
• Americans believe, on average, that the federal government wastes 51 cents of every tax dollar, similar to a year ago, but up significantly from 46 cents a decade ago and from an average 43 cents three decades ago.
• 49% of Americans believe the federal government has become so large and powerful that it poses an immediate threat to the rights and freedoms of ordinary citizens. In 2003, less than a third (30%) believed this.

The whole article is eye-opening.  People were not happy with the government after Watergate, but they are far more disgusted now.  Gallup has a nice table in response to the question, “On the whole, would you say you are satisfied or dissatisfied with the way the nation is being governed?”

Source: Gallup

If 81% of Americans—majorities of both political parties—are dissatisfied, that means 19% are happy with how things are going.  Has anyone actually met one of the 19%?

As background, we all know the arrogance of the Efficient Market Hypothesis, right? Particularly the high and mighty godfathers of EMH. Eugene Fama is on record as saying “God himself” could not dispute the efficiency of markets.

And of those EMH fathers, few were higher and mightier — or more insanely arrogant — than Paul Samuelson, the founder of neoclassical economics…

So here’s the thing that blew me away.

Right at the same time EMH was gaining real traction… and right at the time Paul Samuelson was proclaiming in favor of absolute randomness for the markets…Samuelson was investing his OWN money with Warren Buffett — and with Commodities Corp.

At the very genesis of EMH gaining a foothold as indisputable academic dogma, the guy pounding the table for that dogma was making big side bets with the great investors and traders of the era!

I mean, talk about chutzpah!

Here is this “I’m too brilliant for you to comprehend” S.O.B. telling the entire world that no one can beat the markets — and thus helping to deeply legitimize academic theories that would later be major contributors to systemic crisis through the foolhardy actions of poorly run institutional funds — and at the very same time, the guy is investing his own money in the private belief that markets can be beat!

It’s like the Pope practicing Islam on the side.

….

So the high priests of EMH never actually believed their own theory. They just got legions of less bright minions to take EMH as diehard gospel, with the final culmination of arrogance + ignorance being Alan “Bubbles Can’t Be Recognized” Greenspan and Ben “Global Savings Glut” Bernanke.

In other words, “one of the most remarkable errors in the history of economic thought” — per the description of Yale professor Robert J. Shiller — was not just an error but a lie.

It’s always been our contention that a well-executed systematic process designed around a strong return factor—whether relative strength or value—should have a good chance to outperform the market over time.  Unfortunately, Bogleheads, some financial journalists, and even some financial advisors now assert the superiority of passive investing.  I wonder if they have ever looked at Ken French’s data or wondered why Paul Samuelson was not putting his money where his mouth was?

I was in a bookstore over the weekend where I saw no fewer than six books suggesting that capitalism and our economic system had failed. The prescription in most cases was more government and more income redistribution. They system might be broken, but with the way our business and economic incentives are currently structured, I suspect the prescription of more government intervention will not help at all. The underlying incentives need to be fixed.

Adam Smith’s “invisible hand” is a useful economic concept. For a moment, let’s strip away all of the idealogy surrounding the invisible hand and get down to the base assumption: people act in their own self-interest.

Market theorists contend that with everyone acting in their own self-interest that markets run economies much better than bureaucrats. This is stupid. Bureaucrats contend that markets favor some groups and disadvantage others, so they should be able to step in and fix things. This is equally stupid.

The only thing the invisible hand guarantees is that people will act in their own self-interest. That makes the ultimate outcome mainly a matter of creating the proper incentives. If you have dumb incentives, the invisible hand will run the economy like a moron. If you have smart incentives, the invisible hand will run the economy like a genius.

Let’s look at a couple of examples. Let’s say that you have a private investment partnership, like Goldman Sachs or Smith, Barney, Harris, Upham used to be. On the one hand, the partners are incentivized to maximize their earnings through trading and underwriting. On the other hand, since the capital in the partnership is their own money, they are also incentivized not to blow up the firm. This prevents all manner of lousy underwriting deals and insures that trading leverage is managed carefully. The result is a company that tries to make as much money as possible without destroying the firm. This is the invisible hand at work with proper incentives. Everyone is working in their own self-interest, but those interests are balanced.

Now, think for a moment about a modern institution we will call Megabank. It is public, not private. Acting in their own self-interest, the traders and investment bankers are still incentivized to maximize their own compensation. However, the money the trading desk is using does not belong to the traders–it is other people’s money (OPM). What are the odds that they will overleverage in an attempt to make a huge bonus? Likewise, what incentive does an investment banker have to underwrite only good deals? (In fact, the bad deals usually come with bigger fees—bring it on.) Plenty of employees will act responsibly, of course, but moral hazard has been introduced. With everyone acting in their own self-interest, the invisible hand has this firm headed for the emergency room.

Think about AIG’s incentives: if they are allowed to underwrite insurance (credit default swaps) that is incredibly profitable because no reserves are required, is it likely they will underwrite a little or a lot? Think about a homebuyer’s incentive: tell the truth and stay in your apartment, lie a little (or a lot) and move into a nice house. Think about a sub-prime lender’s incentive: if they are allowed to offload all of the bad loans through securitization, are they likely to underwrite a little or a lot? Are they likely to care about the ultimate credit quality or default rates? With these sorts of incentives in place, what did policy makers think was going to happen? Now, what would happen if instead they had to eat their own cooking and retain a significant portion of the sub-prime loans on their balance sheet? Might that change their behavior? What if, instead of doing same-day exercise and sale of their stock options, executives had to exercise and hold the company stock for three years after their affiliation with the company ended? Would their stewardship change in any way?

The problem with the invisible hand is not that it doesn’t work—the problem is that it works incredibly well. This puts an enormous burden on policy makers to think carefully about how incentives are structured–and about what the ultimate consequences might be. Congress appears to have a very limited understanding of either the invisible hand or the consequences of incentives. It’s safe to say that most parents, who have to deal with kids and behavioral incentives all the time, are doing a better job, since most of their children live and become productive members of society.

I don’t know whether you think this is a brilliant piece of political economy or something so obvious that a fifth-grader could figure it out. But we, as a society, have apparently not figured it out. If we decide we want vast national savings, lots of capital formation and innovation, and a clean environment—all of that is probably achievable with properly thought out incentives. There are always trade-offs, and incentives usually have to include a lot of carrots and a few sticks. The invisible hand can’t give us everything, but with thoughtful incentives, we can do a lot better than we are doing now. We don’t have to let the invisible hand sucker punch us.

—-this article originally appeared 8/3/2009.  There are still a lot of books suggesting that capitalism has lost its way and, unfortunately, still very little coherent thinking about incentives going on.  It doesn’t have to be this hard.

This is a candidate for quote of the week!  It’s a good reminder that risk is omnipresent, in life and in financial markets.  It doesn’t matter what you own or don’t own—you’re still exposed somewhere.

When I was trying to figure out if there was a housing bubble or not, the academic economists I had come to trust said no, the fundamentals explain this. Sometimes this was backed by econometric analysis. But many people outside of academics, or at least a few, said there was a bubble. This was often backed by logic, intuition, and simple charts rather than sophisticated econometrics based upon theoretical constructs. For the most part, I dismissed the people I should have listened to, especially if it contradicted what the academics were saying. Most of all, I relied too much on the experts in the academic community instead of listening to all the evidence and then thinking for myself.

One of the reasons I didn’t listen is that until I started blogging, I was pretty arrogant about academic economists. As far as I was concerned, pretty much, academic economists knew more about everything related to economics than anyone else. But one thing I’ve learned from the wide array of voices in the blogosphere is that I was wrong. Academic economists have a lot to learn if they are willing to listen.

If only some Modern Portfolio Theorists were as honest and open-minded as Dr. Thoma!  The best point he makes, I think, is about listening to all of the evidence and then thinking for yourself.  There’s plenty of blame to go the other way too.  Practitioners have sometimes been all too eager to accept and implement academic theories, even when they make very little sense or have been based on incredibly suspect assumptions that do not obtain in the real world.  Other practitioners are arrogant and dismiss the idea that academics know anything at all, something that is also not true. 

There’s always something to learn from people in other fields.  Daniel Kahneman and Amos Tversky were psychologists studying decision-making processes—until someone connected the dots and realized that market participants make decisions with uncertain outcomes all the time.  Many years later, psychologist Daniel Kahneman ended up with a Nobel Prize in Economics.

There is particularly a lot to learn in finance if academics and practitioners would interact more and actually listen to one another.  Both Warren Buffett and George Soros have written about problems they perceive with the Efficient Markets Hypothesis, yet some academics dismiss their billions of dollars extracted from the market as some kind of lucky coin-flipping.  Even a rudimentary knowledge of statistics and the law of large numbers would tell you that someone who has made thousands of trades a year over four decades and has ended up with billions of dollars in profits (like George Soros) is not just lucky!

Good theory-making always derives from observation: examine data to see what is happening and then construct a theory to explain why it is happening the way it is.  If you can figure out why, you can extrapolate and test your hypothesis.  (The budget debate is a great example of bad theories—everyone has an idealogy, but no one is citing past historical examples or data.  Open-minded economists and business people with common sense are more likely to do the right thing than political idealogues.)  More interaction might lead to better theories, and better theories would lead to better policy-making for all of us.

When there is too much leverage in the system, there is always a risk that things go wrong quickly and unexpectedly.  Ken Rogoff and Carmen Reinhart have an op-ed piece on Bloomberg today about the debt overhang and its implications for economic growth.   They are the only commentators who have been consistently correct about the path of the financial crisis, probably because they are the only one who have studied the actual data.  That, and maybe because Ken Rogoff is a genius.  But I digress.

Source: www.csmonitor.com

Here is Rogoff and Reinhart on the debt crisis:

As public debt in advanced countries reaches levels not seen since the end of World War II, there is considerable debate about the urgency of taming deficits with the aim of stabilizing and ultimately reducing debt as a percentage of gross domestic product.

Our empirical research on the history of financial crises and the relationship between growth and public liabilities supports the view that current debt trajectories are a risk to long-term growth and stability, with many advanced economies already reaching or exceeding the important marker of 90 percent of GDP. Nevertheless, many prominent public intellectuals continue to argue that debt phobia is wildly overblown.

Although we agree that governments must exercise caution in gradually reducing crisis-response spending, we think it would be folly to take comfort in today’s low borrowing costs, much less to interpret them as an “all clear” signal for a further explosion of debt.

Those who would point to low servicing costs should remember that market interest rates can change like the weather. Debt levels, by contrast, can’t be brought down quickly. Even though politicians everywhere like to argue that their country will expand its way out of debt, our historical research suggests that growth alone is rarely enough to achieve that with the debt levels we are experiencing today.

Those who remain unconvinced that rising debt levels pose a risk to growth should ask themselves why, historically, levels of debt of more than 90 percent of GDP are relatively rare and those exceeding 120 percent are extremely rare. Is it because generations of politicians failed to realize that they could have kept spending without risk? Or, more likely, is it because at some point, even advanced economies hit a ceiling where the pressure of rising borrowing costs forces policy makers to increase tax rates and cut government spending, sometimes precipitously, and sometimes in conjunction with inflation and financial repression (which is also a tax)?

The relationship between growth, inflation and debt, no doubt, merits further study; it is a question that cannot be settled with mere rhetoric, no matter how superficially convincing.

In the meantime, historical experience and early examination of new data suggest the need to be cautious about surrendering to “this-time-is-different” syndrome and decreeing that surging government debt isn’t as significant a problem in the present as it was in the past.

I’ve done a massive cut-and-paste job with their essay and tried to hit the highlights.  I recommend that you read the whole piece, which is more extensive and covers additional topics.  Their thinking is important because they are neither alarmists nor happy talkers, just economists who have actually done a careful study of how debt levels affect economies.

Why do I even bother with this, since I am certainly not an economist?  I have two motivations in mind.  1) I think it’s important to focus on the actual historical data, as Rogoff and Reinhart do.  Without data, you’re just another dude with an opinion.  Americans have been subjected to way, way too much idealogy from blowhards in both parties in Congress on the debt issue—and no one is looking at the data.  2) How debt is handled will have a big impact on investment opportunities around the globe.

Think about the differences from country to country!  The UK showed a stiff upper lip and enacted austerity measures immediately.  Greeks are protesting in the streets about the debt, corruption, and proposed austerity and are edging ever closer to restructuring—a polite term for a partial default.  Spain is pretending they don’t have a problem at all.  Japan has endured 20 years of financial repression—20 years!!—with low interest rates for savers, no economic growth, and has piled on even more debt.  The US has gone from hoping for a grand bargain on tax reform and deficits to a mini-plan to squabbling about doing anything at all.

The investment climates will be very different as a result, and money always goes where it is treated best.  Traditional strategic asset allocation will be very difficult in this environment, where responses to the debt problem are still being formulated.  Reliance on past returns, correlations, and volatilities could be ruinous, much as they would have been in Japan in 1990.  It seems to me that a relatively flexible, tactical solution is called for that allows investment in a wide variety of markets, to seek out returns wherever they may be found.