Tuesday, December 09, 2008

The Other Road to Serfdom

The trouble with socialism is socialism. The trouble with capitalism is capitalists.

That quote is attributed to the late Austrian analyst Willi Schlamm, and its underlying truth is particularly relevant given the current economic crisis and the familiar path that has led us to it. Mr. Schlamm's argument comes down to the premise that the inherent weakness in capitalism is not the system, per se, but rather the greed of the actual capitalists operating within it.

In this context, greed itself is often a short-sighted, impulsive and obsessive animal and rarely, if ever, does it consider posterity or even the next fiscal year. In other words, greed tends to create a system in which short term gain is valued over substantive, balanced and sustained growth. But since you cannot separate the capitalists from the system of capitalism, it becomes necessary to corral the inevitable greed, set parameters on its excesses and channel its incentivizing capacity into productive directions. As capitalist champion Milton Friedman said:

What kind of society isn't structured on greed? The problem of social organization is how to set up an arrangement under which greed will do the least harm...

Unfortunately, those that most loudly proclaim their faith in capitalism fail to appreciate its basic nature, and are most dedicated to removing the structural regulations and oversight necessary to keep capitalism from bringing about its own demise. Such aversion to regulation has risen to take its place beside the cult of tax cuts and faith in free market solutions as one of the Modern GOP's three sacrosanct economic principles (call it the "Strong Hayek" troika). In each case, the faith based, categorical, oversimplified outlook has replaced empiricism, pragmatism and a nuanced appreciation of capitalism's strenghts and weaknesses.

According to Grover Norquist's GOP, all tax cuts are good and all tax increases are bad - regardless of the context, underlying fiscal realities and other variables. The free market is always more efficient than the public sector - regardless of the relative inefficiency and negative health outcomes resulting from a system of private health insurance (for example). Similarly, all regulations are an evil impediment to free market dynamism - a market that, if left to its own devices, would self-regulate its way to optimal efficiency.

This isn't just magical thinking, nor is it simply absolutist. It is an outlook based on a lack of appreciation for human nature that has led to repeated real-world calamities. Matt Yglesias flags an article that discusses one of the most recent examples of how greed - unencumbered by regulations and unchecked by public sector involvement - undermines a well-functioning capitalist system:

Since the subprime mortgage troubles exploded into a full-blown financial crisis last year, the three top credit-rating agencies — Moody’s, Standard & Poor’s and Fitch Ratings — have faced a firestorm of criticism about whether their rosy ratings of mortgage securities generated billions of dollars in losses to investors who relied on them.

The agencies are supposed to help investors evaluate the risk of what they are buying. But some former employees and many investors say the agencies, which were paid far more to rate complicated mortgage-related securities than to assess more traditional debt, either underestimated the risk of mortgage debt or simply overlooked its danger so they could rake in large profits during the housing boom.

[For the self-regulation] scheme to work the rating agencies need to place a higher value on the long-term viability of their brand than on short-term profit opportunities. But of course we know that people are often short-sighted, and often heavily discount the future relative to the present. Relatedly, for the scheme to work we need the firms to be primarily concern with the long-term interests of the firms rather than the interests of the managers. But even if Moody’s, qua company, winds up taking a giant hit over this, it’s still not clear that Moody’s top executives won’t have come out ahead. [...]

[I]t would make a lot of sense to try to develop a public agency that rates credit instruments. [This] wouldn’t stop anyone from relying on private sector ratings if they wanted to. Nor would it guarantee that the public agency would always get things right. But it would provide a check on some of the distortions that the current system produces.

This is a very similar dynamic to the investment banking lapses during the age of the Internet bubble, which I will attempt to explain in general terms (restated, in part, from a prior post). Within the major investment banks, there are various divisions. One such division handles the underwriting duties, and another conducts market research on various companies on a sector by sector basis. A quick and dirty definition of underwriting: In an IPO, or any subsequent offering of stock, companies usually seek out an investment bank to underwrite the offering (for a fee) pursuant to which the bank secures buyers for the stock (often times purchasing the stock itself for resale), distributes the stock through the markets and provides rekated services - in essence managing the process for the company looking to sell the shares.

In theory, and in practice for some time, the research and underwriting branches were separated by an internal firewall in order to prevent the imperatives of the underwriting side from contaminating the objective analysis of the research side. This is important to the health and attractiveness of our financial markets. It is in the interest of investors, the markets, the companies themselves and our economy in general that there is a knowledgeable investor class that can rely on objective research and corporate transparency mandated by disclosures in filings made with the Securities and Exchange Commission. Faith in that transparency spurs investment from Americans and abroad.

Thus, it is in the interest of the banks to maintain the firewall in order to preserve confidence in the US markets, and thus ensure the continued inflow of investment dollars. But with the burgeoning number of stock offerings being undertaken during the expansion of the Internet bubble, the firewall began to crack. The underwriting divisions began pressuring the research divisions to issue inflated "buy" ratings on stocks and author favorable reports on the economic health of underwriting clients in order to acquire or maintain the banking business of those companies. The goal of maintaining the long term viability of the markets was jettisoned in favor of the lure of short term profits.

In many cases, the researchers were privately deriding stocks that they were praising to the unsuspecting public. If you recall, this was the era of the celebri-analysts who began popping up on the cable TV outlets, the most notorious of which was probably Merrill Lynch's Henry Blodgett who infamously called a stock he was publicly recommending a "piece of sh*t" in a private email. Unfortunately, many Americans trusted these "objective" analysts, and continued to pour money into companies that the analysts and I-Bankers themselves knew were hollow shells and lost causes. In the end, countless Americans were financially wiped out, or set back considerably, while the bankers and executives absconded with windfall profits.

Yet despite the parameters of these financial scandals, and their potential impact on the integrity and attractiveness of American financial markets, the Securities and Exchange Commission (populated by industry insiders as is the Modern GOP's modus operandi) was lax in maintaining oversight and uninterested in pursuing charges against any of the wrongdoers, or changes to the system. It took then Attorney General of New York Elliot Spitzer's own pursuit of state remedies to shame the SEC into taking action on a federal level.

Just as business will be served by a healthy environment, functioning infrastructure, quality public schools, single-payer health insurance and a whole host of programs that "capitalists" take a hostile stance toward, so too does business thrive when there are umpires on the field to make sure the rules are being adhered to. Despite what ostensible free market aficionados might claim when bemoaning the dreaded bugaboo of regulation and oversight, it is, in fact, in the best interest of capitalism, and America's brand of it, to maintain open and transparent markets with a free flow of reliable information to potential investors. The only way to achieve this is to require it through regulation. You cannot trust industry to monitor itself - whether that industry be investment bankers, or ratings agencies. Greed does not provide those incentives. Quite the opposite.

The best features of capitalism lie in its creation of conditions conducive to rewarding the worthy, efficient and innovative. Of course, that depends on the market's ability to recognize and reward those products/services. Greed can either help or hinder that process. It's up to us to provide sensible regulations to make greed work for us, not against us. Reducing the conflict of interest inherent in the decision making process of the managers in charge of the ratings agencies would be a good place to start.

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