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Monday, January 5, 2009

Part 1: Our Anemic Economy, the Question of How Versus Why

In his inspired article the anonymous columnist Spengler at Asia Times Online looks at why the state of our economy is as it is. His commentary is refreshing because he examines the question of 'why', not the mainstream question of 'how'. For instance, most people today understand that our economy ran on a hollow and deep sub-prime housing bubble, and that's -how- our lifeblood of capitalism had been draining out (well before it went primetime in 2008). But -why- did this happen? Without understanding that, we're bound to repeat the same mistakes.

Spengler offers this answer: it's because people run the markets, but in turn the markets ran the people. That's why everything happened, plain and simple. Before the explanation, let's beef up the context some.

  • How: the sub-prime real estate bubble;
  • Why couldn't they see there was no there there? (i.e., investing so much into something that can innovate very little beyond the balance sheet nor create new products. By contrast the tech bubble yielded much good, that's how you're reading this post.)
  • How: complacent regulation and monetary policy, whereby they spun gold from straw;
  • Why do that, when it's obvious that gold one day reverts to mere straw?
  • How: a sophisticated financial playbook that can pad balance sheets;
  • Why do that, when you're just scrupulously transferring your problems to another part of the ecosystem?
  • How: an entire generation of borrowing for mass consumption, a spree with the world's savings to spend;
  • Why do that, when you probably knew that credit was leveraged by fatally sub-prime assets?
  • How: Wall Street, Alan Greenspan, Ronald Reagan, Margaret Thatcher, GWB (for the masses haha), Bill Clinton, bankers;
  • Why guys, why?
Notice that each 'how' explanation begs the question why, and that you can endlessly revolve around these mainstream explanations and still gain little insight into why it all happened.

Mr. Spengler is a pro at doing just that. Among the most big-picture conservative commentators I've read on this subject, his conceits are exquisite enough to warrant attention. Spengler would say that up to this point, we've been looking for the reason -why- in all but the most obvious place, which is in the mirror. For him and like-minded peers, the reason why our economy gets anemic lies in the basics, in how people behave and interact with the market.

If you ever thought that well, maybe everyone was just greedy, then you're on the right track. Chances are you probably have (duh), but it's a bit more complicated than that. Actually we all know and accept that greed is part of the capitalist game, and in fact can inspire great productivity. And so with eyes wide shut, we institute greed as our market incentive structure with the singular purpose of spurring better and higher profits. Through all our ups and downs, it's worked so well so long so many times.

And here's the catch: the market can't natively tell right from wrong. In fact, if the wrong-thing-to-do results in the fattest profit margin, the market will go ahead and call that a winner. Markets only know how to punish incompetence and inefficiency; their only job is to organize and mobilize resources as efficiently as possible according to the rules of the road. So by design, markets are morally neutral and can't control if good guys or bad apples set those rules of the road, and nor should they if you want to make real money and/or stay in business (think Chinese sweatshops).

You see where this argument is going. As Spengler succinctly puts it, "if moral rot has taken hold of a society, the market mechanism will take it to hell faster and more efficiently than any of the alternatives." In other words, even a market economy that's fundamentally sound (a la McCain) can become a race to the bottom very quickly. It happens because people run the markets, but then in turn the markets run the people.

Let's say you are the boss of a top-tier investment bank who exhibits impeccable moral integrity. And let's go out on a limb and say that you responsibly foresaw the disaster of 2008. That is to say, let's give you the benefit of the doubt and say you surmised that some Wall Street geniuses figured out how to supercharge their balance sheets. Those geniuses were then able to claim profit margins far fatter than they could in an alternate universe called Reality. Because you knew this was the wrong thing to do, you willingly chose not to supercharge your own balance sheets because it was the right thing to do. You knew that things would turn out to be a race to the bottom, because you knew that gold spun from straw is still straw. You just didn't know how much time that scenario would take to unfold.

But before you can see your prediction play out, you will be punished by the market because that's what markets do: punish inefficiency and incompetence as measured by profit. Pretty soon, you, your staff, and your shareholders would be out of decent payouts because your margins couldn't hang with the big boys. Soon thereafter, pressure will mount for you to get in the game or hit the road. You are forced to realize that your duty to compete in the market comes before your moral discomfort. Telling yourself that you're not breaking any laws anyway, you supercharge your balance sheets like everyone else and just hope that things will work themselves out in the market as they always have. In the meantime, all your subjects seem to be happy and your job is secure. What else can you do anyway?

And just like that, the race to the bottom has a new entrant and thereby propagates itself to live another business cycle. And the market is happy it did its job.

That's how when people run the market, the market ends up running them. To Spengler, this systemic interaction between people and the market is -why- things came to a head in 2008. And so he joins the chorus of conservative voices today that blames our anemic economy on the moral rot of individuals, rather than concede anything is wrong with their economic fundamentals per se. Some would say that this is just a politically expedient explanation, but the conservatives do have a point (especially at the pen of Spengler). In the year of Bernie Madoff, moral rot in the market is probably something that conservatives and liberals can agree on. Their eternal conflict is in how we go about fixing it: do we fix the people, or do we tweak the system? (I say both)

Spengler elegantly lays out his prescription in said column, and I find myself in full agreement. Nonetheless, in Part 2 of this series I'd like to pick a bone with his prescription, namely that it cannot possibly work. Stayed tuned! It's coming whether you like it or not.


Anonymous said...

Awesome analysis and well said!!

Dave C said...

It's a well written entry, and certianly raises interesting points that cause me to refine my own thinking on the subject.

I disagree with some of the basic conceits, of course. I simply don't believe in a system that is devoid of influence can exist. Human beings are the basic components any interaction, and human nature will always be a part of it. Greed is a constant, it can't be regulated away.

You bring up a great example of a CEO who is pressured by market competition to bolster his companies numbers in ways he knows to be risky and artificial. That certainly exists. Of course his reward would be happening now, when the market is punishing these poor practices. Naturally, he's influenced by expectation, so its unlikely that he would. But that, of course, is what would make him the exception and thus deserving.

Regardless, this entry is driving towards the marriage of human nature and markets, which I think is fruitful ground for this discussion.

I look forward to the upcoming installments.

miles said...

Mmm.. I don't recall suggesting that a system devoid of influence can exist? In fact I agree with you; I recognize that even the most centrally planned economy is not devoid of influence. Don't forget, Spengler is a hardened conservative commentator.

As a case in point, my CEO story was to point out that even if he was just and not greedy, he would still be forced to act greedy because the market demands it. Yes, if our ethics-abiding CEO stuck to his guns and went against the market trend from the very beginning, perhaps he would be praised today and even rewarded. However, it's likely he would have been sacked long before that day came. What possible incentive does he have to have his good conscience hurt him but then to possibly benefit the next CEO(s) in line?

Simply put, the markets capitalize greed and I agree with you that it cannot be regulated away. To do so in a heavy handed way would be to undermine the very basis of capitalism!

Regulation, however, is a very broad term, and it's from that flexibility where I draw hope. Economics is not my strong suit, but it's clear to me there must be some kind of downstream mechanism that identifies potentially hazardous trends in the market. Let the markets run as unregulated as possible but someone with power must be watching, and there must be a watcher that watches the watcher. The potential dangers of an unmitigated and under-regulated market economy are too serious to not have a rigorous checks system in place.

Spengler advocates this himself, namely SELF-regulation at the individual level. But as I will argue in my next installment, it can't possibly work. What we need is a solution that creates a market incentive for dissent in the market.

Later on in this series I'd like to propose some kind of watchdog agency with teeth, some kind of organization that can empower our morally bound CEOs. Instead of preemptive regulation, which is fraught with dangers and anathema to "free markets", I propose REACTIVE regulation.

Institute some kind of insurance framework for people who bet against big market trends that would otherwise undermine reasonable dissent, as in the case of the moral CEO. If they bet wrong, they would lose anyway and be punished, but at least they would have a realistic chance to win in the future without sacrificing their company in the present. Of course this watchdog agency would need to have some kind of mechanism for identifying such trends and placing an economic value on dissent. I would suggest looking to academia for this mechanism, they would not be controlled by greed and be relatively free from partisanship.

Ugh I'm totally just making this up, it's probably not possible in the real world. But I just don't see that there's an alternative to preemptive regulation otherwise! Dave, what does your world view tell you about this proposal? My suggestion basically amounts to creating an alternate market that runs against the mainstream market in the hopes that they will balance each other and keep things in check.