Let us explore belief creep closer to home. If Chinese communism was really Legalism, and now superficially looks like capitalism, what of the Western version of capitalism? First, let us look at the content of the belief, and we can consider the causal mechanism later. (You are probably guessing that it is a C/D ideology, but it’s a little more complicated than that.)
Capitalism is an economic system whereby the means of production is privately owned, and the operation of business is determined by a market economy without interference by government. The content of the belief can be broken down into two main elements. Firstly, if owners of capital and providers of labour all operate with a view of maximising their return, it will maximise the aggregate wealth of all people; and secondly, society and the individuals within it always benefit from greater wealth. The second element appears self-evident in a society where poverty is widespread, but I will explore this in detail later. In this chapter, I want to focus on the first element.
THE HISTORY OF GREED
Aspects of free markets and merchant capitalism can be traced to ancient Rome and medieval Europe. However, most historians see capitalism as evolving in England and its origins can be traced to the sixteenth century. Prior to this, the dominant social and economic system was feudalism (which is basically the same as Chinese Legalism).
Feudalism gradually came undone with the rise of mercantilism, which arose from the expansion of European colonial power. Mercantilism is the theory that trade alone produces wealth, i.e. it does not address the means of production. Traders from England (and other European powers) returned home from their new colonies with previously unknown goods that they sold for profit. Mercantilism replaced feudalism simply because the merchants quickly became richer than the landowning aristocracy. Because these goods were new, there were no laws regulating their supply thus ushering in free trade. However, mercantilism was not true capitalism because these new goods were produced far away under conditions that were not capitalist. In fact, they were produced under conditions somewhat approximating feudalism or legalism.
The wealth that resulted from mercantilism was reinvested in industrial machinery, and this gave birth to industrial capitalism. The focus of this was England in the late eighteenth and early nineteenth centuries – a period usually referred to as the Industrial Revolution. Complex systems of production and labour organisation were developed. None of this was regulated, and this gave rise to rapid economic development.
Capitalism was born of shifting historical forces, but it was Adam Smith who gave it a theoretical structure that replaced mercantilism as an ideology. Many regard Smith as being the founder of modern political economic thought. In The Wealth of Nations171 he argued that individual self-interest of capital owners has the unintended consequence of the greater benefit of society. He argued against monopolies, duties and tariffs and government regulation of business. Smith was a close friend of the philosopher David Hume, and was certainly influenced by Rousseau and his views on how primitive societies evolved into advanced civilisations. It is no surprise that Smith’s day-job was professor of moral philosophy at The University of Glasgow. His masterwork is, as much as it is the first true work of economics, a treatise on social justice. Readers of the ideologically redacted sound bites never get to the bit where he explores the exploitative consequences of laissez-faire capitalism – driving down wages to worker’s pain threshold.
David Ricardo, a sometime critic of Smith, was much more in favour of laissez-faire capitalism. His “Law of Comparative Advantage”172 demonstrated that, even if trading party A could produce all goods more efficiently that trading party B, there were still benefits to both parties in trading with each other. Essentially, the overall production of both parties, and therefore their aggregate wealth, would be increased if B focusses on producing the goods in which their relative inefficiency is the least. The Law of Comparative Advantage became the theoretical basis for free trade. This idea gained rapid acceptance and had political consequences. Prior to the Law of Comparative Advantage, England had numerous laws designed to prevent free trade and protect domestic producers and business owners. The Corn Laws were a system of tariffs on grain designed to protect English landowners from being undercut by cheaper overseas producers. The Navigation Acts similarly restricted operations in English ports to English ships. The Corn Laws were repealed in 1846 and the Navigation Acts in 1849. This is the beginning of free trade, and perhaps marks the true origin of globalisation.
The late nineteenth century saw other important developments in capitalism: most notably, the rise of finance capitalism. Under industrial capitalism, owners of the means of production were also the operators. Finance capitalism was the gradual separation of owners and managers of business. Control of production and the financing of industry became distinct specialties. These developments led to the expansion of stock markets, company law and complex banking systems. The downside of finance capitalism quickly became apparent. Once it became possible to syndicate the ownership of business, there ceased to be a limit on how large a business could be. This led to monopolies, and today, most governments of industrialised countries have laws limiting market concentrations.
Finance capitalism also led to the rapid development of financial speculation and this led to cycles of boom and bust. These emerged in the late nineteenth century and reached their peak with the stock market crash of October 1929 that caused the Great Depression of the 1930s. At this time, many Marxists predicted the collapse of capitalism. During the Great Depression, it appeared that the Soviet Union could avoid these cycles, and the Soviet practice of central planning briefly appeared to be the future of economic thought. But capitalism had a new trick: Franklin Delano Roosevelt announced the “New Deal”. This was the dramatic increase in government spending that ultimately dug the US and the world out of their slump.
The New Deal was a political strategy largely based on the economic theories of the economist John Maynard Keynes. He argued that government could increase economic activity by direct spending or “pump-priming”. Keynes was the dominant economist for a period, and his theories led to the emergence of what is known as the “mixed economy” – one where private and public spending and investment combine to maintain economic growth and stability.173 The theories of Keynes and the evolution of mixed economies caused the Great Depression to become a distant memory. It led to the post World War II boom. This period saw the evolution of the welfare state, most notably in Europe, where government captured excess economic output through taxation and redirected it to provide safety nets to the people. This period also saw economic trends away from industrial production towards service industry – the so-called “Post Industrial Society”.
The post-war boom was already over by the 1970s, which saw the emergence of “stagflation” – a period of both high inflation and low economic growth. This led us to dump Keynes, and replace him with Milton Friedman, whose big idea became known as “Monetarism”. This is a return to laissez-faire capitalism, but with a twist: the government can move the level of economic activity up and down by controlling the supply of money. Central banks emerged as the principal tool by which governments controlled their economies.
The incredible thing about capitalism today is just how dominant an ideology it has become. It transcends every known culture and creed. Even the Chinese Communist Party is capitalist now. Capitalism is the dominant economic model in almost all countries, irrespective of what religion is dominant. The only exception to this is that there is no capitalist country that is Buddhist – the reason for which I will explain later.
GREED VS GOVERNMENT
The previous section, a deliberately rapid history of capitalism, is included because I am trying to stress that it is belief creep on steroids. We should call the capitalism of Adam Smith CAPITALISMTM to separate it from all the stuff inspired by it. Compared to the almost static ideology of China, capitalism is an ideological jumping bean. The frequency with which new theories of capitalism arise is driven by the increasing speed at which old theories lead to economic disequilibrium and become discredited. Governments rely on economists to explain to them why the last collapse occurred, so that they can adjust policy to prevent a recurrence. In fact, the history of capitalism could be said to be the history of how new theories of economics were developed purely to correct the unfortunate consequences of the old one.
This process will never end.
At the time of writing, we are still recovering from the last economic collapse – the Great Credit Crunch of 2007. Economists on the political Left blame this on bankers and those on the Right blame it on regulators, and the regulators are desperately trying to prove that someone did something criminal. The central problem is that all of them believe in capitalism, and therefore are logically unable to see there is a problem with the ideology itself. Belief creep in Western capitalism has bought us to a point where it simply stops functioning. Like Chinese communism, it has evolved into something totally different to what it says it is.
Almost all capitalist theories have underlying them the “Trickledown Theory”. This is that if the owners of capital are permitted to pursue profit without restriction, that wealth trickles down to all members of society. The idea is that the wealthy will spend their money on goods and services and this will lead to a flow of money right down to the lowest levels of society – maids and shoe-shine boys.
The strange thing about trickle-down economics is that you will never hear an economist use the term. “Trickle-down economics” is the height of economist uncool because they need to keep their science pure, and this means addressing the overall level of economic activity. The distribution of wealth is solely a political matter. While economists might be a bit touchy about the expression, the fact remains that if wealth isn’t trickling down, then capitalism is failing to serve humanity. Has something happened in the evolution of capitalism that means that this could actually be the case?
Yes it has!
What I want to demonstrate is that when capitalism is properly organised by financial elites, the wealth does not trickle down; it trickles up.
HEADS I WIN, TAILS YOU LOSE
The central principle of capitalism is that capitalists should make economic decisions based on their self-interest. But who is a capitalist? In Adam Smith’s day, a capitalist was an owner-operator of the means of production. Their fortunes both rose and fell with the success of the enterprise. The successful ones retired and delegated the running of the enterprise to managers, who were paid servants who did the owners’ bidding. The identity of the capitalist is already getting murky because the separation of ownership and management has started to create conflicts of interest – a problem area generically referred to as “corporate governance”. The balance of power gradually shifted from owners to managers, with owners gradually becoming passive. Today, we should think of a capitalist, not as the owner of the capital, but as the person who makes the decisions concerning its allocation. If the ideology works because the capitalist acts in his self-interest, we need to look to the interests of today’s capitalist: the decision maker, who likely isn’t the owner.
The conventional mechanism for ensuring aligned interests between managers and owners is to give managers share options in the company they manage. But this is a problem. If the managers have share options, then they get the upside of the enterprise, but not the downside. The owners of the enterprise get both the upside and the downside. This does not make their interests aligned because the manager does not care about downside risk. The managers’ share option is the option to buy shares at a fixed price on or before a fixed date. This is called a “call option”. The manager has an incentive to maximise the value of a call option, but the owners want him to maximise the value of the shares.
What is the difference?
The value of a call option can be calculated using a formula known as the Black-Scholes formula, devised by two economist / mathematicians, Fischer Black and Myron Scholes. The formula computes the value of an option based on the following variables:
The manager has the incentive to maximise the value of the option, not the stock price. The value of his option is dependent on other things than just the stock price. Clearly, the strike price and the time to expiry are not within the control of the manager because these are contractual terms. However, the manager has the incentive to maximise the stock price at the time of expiry. He can do this (for example) by delaying the payment of dividends until after expiry of the option. The manager cannot influence interest rates, but he can lower the cost of the enterprise’s debt by skilful treasury management. However, it is difficult to argue that the manager’s and the owner’s interest diverges much over this.
That leaves volatility.
Volatility is the variability of the share price. This can be defined mathematically, but essentially it is a measure of how much share price changes in either direction. Volatility, in other words, is a measure of the likelihood that the share price will make a very large move in either direction. If volatility increases, the value of the option increases. If this happens, then the manager will (on average) get rich disproportionately more than the owner.
Can the manager act to increase the volatility of the enterprise’s share price? You bet he can!
It is important to distinguish between the volatility of the share price (which is the variable in the Black-Scholes model) and volatility in the operation of the enterprise. However, if the manager shakes up the operation as hard as he can, then he is increasing the likelihood that the share price will make a big move – either up or down. If you aren’t a natural mathematician, the simplest way to visualise this is to imagine that I take you to a casino and tell you that you can keep 10% of the winnings, but you bear none of the losses. Assuming that you act in your own self-interest, you would find the table that played the biggest stakes and would place the biggest bets. In other words, you would max-out the risk that I permitted you to take.
If the manager follows my simple advice, then he has a 50% chance of making $10 million on his share options and a 50% chance of wrecking the company. Nothing in Las Vegas offers better odds than this because he gets the upside but not the downside. What is fabulous about this strategy is that it requires very little business acumen. Obviously, the employees and shareholders must not realise that the manager is pursuing this strategy, but that is easy. To conceal it, he needs some really good business jargon that can be bought from any business school. If a single manager pursued this strategy it would be obvious, but the invisibility of the strategy is that almost all managers are doing it and so the strategy has become accepted business practice. Family businesses (where the family owns shares and not options) are invariably carefully and prudently run, and this is the way a business should be run in the CAPITALISMTM of Adam Smith – it benefits the owners and society. Share-option-owning executives dismiss this family business approach as archaic. But the swashbuckling strategy is rational when the decisionmakers get upside, but not downside. In this case, the capitalist benefits, but society does not.
Let’s get back to trickle-down economics. If the above is going on throughout the economy, then in which direction is the trickling going? Certainly, the manager is going to have to spend his $10 million (assuming the outcome is the lucky 50%). This could be to the benefit of some fortunate pool-boys, nannies and all the nice people who work at the Mercedes factory. But what if the outcome is the unlucky 50%? The manager has the incentive to max-out risk, and this increases the chances that the company will fail. The unlucky 50% means that lots of workers (who cannot fall back on savings) will lose their jobs. If the manager runs the business in a prudent fashion, then it will be safe and boring and will pay healthy dividends to its shareholders and nobody will lose their job. However, the value of the share option is not optimised. Managers might counter my argument by saying that they are professional or that they have an incentive to protect their reputation. I disagree. What is more, I think that this has shifted over the past two decades.
Twenty years ago, even the most high-flying of corporate executives rarely made enough money to retire in a year. Most of them needed at least ten good years to finance retirement. In these circumstances, reputation did matter because if things went wrong, they needed to be able work somewhere else. Today, a half-decent executive can earn enough money to retire in a single good year. Currently, the pay of US CEOs is 262 times the average worker. This ratio was 24 in the 1960s.174 Their pay jumped 27% in 2010, while everybody else’s was stagnant175 and the stock market barely moved. In fact, many CEOs get a pay rise when their company goes bankrupt.176 Why care about your reputation?
The corporate governance problem is simply that managers and shareholders do not have alignment of interests. However, the ideology of capitalism makes clear that a capitalist should act in his own interest. But the flow of trickle-down has reversed – the capitalist gains upside from maximising risk, while the little guy takes all the downside. Capitalists will all argue that they are honest hard-working people. But incentives are thought-fluff – they only happen in your head and nobody else gets to look in there. This is often summarised as “socialism for the rich and capitalism for the poor” – a classic political argument. This contrast is interesting because what I want to demonstrate is that capitalism is a form of hybrid that is a C/D ideology from the perspective of the masses, and an A/B ideology from the perspective of financial elites.
Adam Smith’s CAPITALISMTM was that the self-interest of capitalists maximised society’s wealth. But belief drift has resulted in ideological failure, and the result is the maximisation of society’s risk.
HEDGE TO REDUCE YOUR RISK
All this might sound like a problem, but corporate CEOs are mere amateurs at this game. One hedge fund trader summed this up nicely: “You ask a big CEO what he makes, and it’s a huge number, but it’s all tied up in stock and options. Traders get paid in cash. It’s liquid. It’s real. You can go ‘Here, look’, and slap someone across the face with it.”177
It is unclear exactly when the hedge fund made its first entry in the history of capitalism, partly because their initial growth was slow. However, once the concept gained acceptance, they went exponential. The invention of the concept is generally attributed to Alfred Winslow Jones who was originally a financial journalist. He sought to find a way that would enable investors to make money whether markets were going up or down. If capitalists profit from the failure of enterprises, then this is antithetical to CAPITALISMTM.
Hedge funds adopt numerous strategies, but the general idea is that they should be profitable whichever direction the economy or the market is heading. They achieve this by utilising every type of financial instrument ever invented. In fact, banks invent financial instruments purely because they permit hedge funds to pursue their intended strategies. The term “hedge” fund is a misnomer. A “hedge” is a financial contract that you enter into purely to protect yourself from market movements. The “hedge fund” name originates from the vision of Alfred Winslow Jones that you could hedge against downward market moves, and it was a small step from here to the realisation that you could use hedging instruments to profit outright from downward movements. However, everyone in the industry wants to keep the term because it gives a cosy impression of prudence and considered risk-management.
This impression is false.
Corporate executives get upside but not downside, and so it is with hedge funds. It is the fee structure that is perhaps their defining feature. Hedge fund managers charge their investors a flat management fee based on the net asset value, say 2%, and a performance fee which is a percentage of the upside achieved by the fund, say 25%, as measured against a benchmark index. In hedge fund jargon, this is often summarised as “2 and 25”. Generally, the amount of fees that a hedge fund manager can charge is based on the manager’s reputation, which basically means past performance. Note that the losses all go to the investors. The prize for outrageous fee structures probably goes to the Medallion Fund, managed by Renaissance Technologies Corp, which charged 5 and 44.178 That means that even if the fund makes a gross investment return of zero, the investors will be charged 5% for the privilege of putting up their capital. On top of this the manager will take 44% of any upside over a benchmark performance measure.179
What then is the incentive of the manager? It is the same as the incentive of a corporate executive but magnified. This fact is not lost on hedge fund managers, who talk opaquely about the “trader’s option”. At least, this is opaque to anyone who does not understand option theory. In simple terms, what it means is that the trader has the incentive to take as much risk as he is permitted. By following this simple strategy, the trader has the possibility of making $1 billion for himself, or losing $100 billion of other people’s money. Pretty good odds you might think, and I’m not kidding about the numbers.
In 2005 there were two hedge fund managers whose personal income exceeded $1 billion, and in 2006 the number rose to five.180 That is their income for a single year. The five one-year billionaires from 2006 included the head of the aforementioned Renaissance Technologies Corp. 2007 also produced five one-year billionaires, topped out by John Paulson of Paulson & Co. (I think there is a connection.) He earned $3.7 billion in 2007 and another $2 billion in 2008.181 He made most of this money betting that the US mortgage market would collapse. He was right. His personal $3.7 billion represents $26 for every US household182, and his profit came from the fact that so many people lost their homes to foreclosure. Mr. Paulson celebrated his payday by making a donation of $15 million to the Center for Responsible Lending, a Washington-based nonprofit organisation183 Oh! The irony! On my calculation, this donation is about a day’s work assuming that Mr. Paulson doesn’t work weekends. I would like to hope that this donation was taxdeductible, but due to a loophole in tax law most hedge fund managers only paid tax on their fees at 15%. But why, Mr Paulson? Why? Was not this token act compunctious?
In terms of the potential for losses, we need to explore the history of hedge fund wipe-outs and look at the growth of the industry. The first wipe-out of international infamy was Long-Term Capital Management. Hedge funds like to boast about how many maths PhDs they have on the staff. Of course they do! They need them to work out the arbitrage in their fee structures. Sadly, the maths PhDs just weren’t clever enough to prevent the collapse of this hedge fund. LTCM collapsed in 1998 with a loss estimated at $4.6 billion. The US Government was concerned that LTCM could bring down the entire financial system, so the Federal Reserve orchestrated a $3.5 billion bailout. A syndicate of banks to took over LTCM’s positions and unwound them in an orderly fashion.
In 1998, this was a near disaster for the entire financial system. At the time of writing, $4.6 billion would be considered quite a small hedge fund. The period 1998 to 2013 saw total hedge fund assets under management (not including leverage) increase from $210 billion to $2.4 trillion.184 In September 2006, Amaranth Advisors LLC collapsed with losses of $6.5 billion.185 According to some reports, they lost $6 billion in a single week.
So is it possible that the system could incur the $100 billion wipe-out that could herald the start of the economic ice age? There is not yet a single hedge fund that is that large. At the time of writing, the five largest fall in the range of $20 to $50 billion (with some of the managers also running several other funds). However, this is not the limit of the losses that could arise from a hedge fund’s trading strategy going awry because we have to add their debt (provided by banks) to their equity (provided by their investors). There have certainly been hedge fund wipe-outs that have annihilated their investors’ capital and some of their banker’s debt as well. AIG was an insurance company, not a hedge fund. However, their total loss for 2008 was $99 billion186; tantalisingly close to my nice round number, and almost all of this loss occurred from a unit of AIG that operated much like a hedge fund. The executives in this unit exploited the “trader’s option”: maxing-out of the risk they were permitted to take.
An added aspect of the potential for hedge fund losses is that their fortunes are not independent, and many of them will be following similar strategies at the same time. Although it is not just a hedge fund loss (despite many of them being involved), the International Monetary Fund estimated that total losses from the Great Credit Crunch of 2007 will total $1 trillion.187 The US mortgage giants Freddie Mac and Fannie Mae alone are estimated to account for $154 billion.188 Much of this problem arose because different firms were simultaneously following similar strategies, but the executives didn’t care because it wasn’t their money at risk. In these circumstances, there is safety in numbers because if everybody is doing it, it can’t be your fault.
So, looking at this from the point of view of the hedge fund manager, if their upside is so huge, what is their downside?
Practically nothing!
OK, so if your hedge fund blows up and you lose all your investors’ money, you won’t be a member of the billion-dollar club that year.
Never mind!
Brian Hunter, the natural gas trader who gets the blame for bringing down Ameranth in 2006 was reported to have had personal earnings of $75–100 million in the previous year.189 Not only that, but the destruction of Ameranth didn’t seem to blot Hunter’s career. Memories fade rapidly in this business. Even with the pedantic bores at the Federal Energy Regulatory Commission charging him with market manipulation, he still managed to get back to trading with an outfit called Peak Ridge. Rumours started to circulate that he was involved with a giant hole in their profit and loss account too.190 Even Ameranth wasn’t his first little slip-up. He was suspended from trading by Deutsche Bank in February 2004.191
Brian Hunter is not the only phoenix to rise from the ashes of other people’s losses. Eric Rosenfelt, a co-founder of the collapsed LTCM was briefly back in business with Quantitative Alternatives192 – a name that suggests that, like LTCM, it employed mathematical algorithms in its trading strategies – and then he settled at Crescendo Partners. Myron Scholes (of Black-Scholes model fame), another co-founder of LTCM and a Nobel laureate, was also back in business with Platinum Grove Asset Management. It would seem that a Nobel Prize trumps a hedge fund collapse when weighing up one’s past.
Where does all this leave trickle-down economics?
Totally forgotten!
Arbitrage is the creation of value by buying in one market and selling higher in another. Early mercantilism was about arbitrage between goods produced in the colonies and sold in Europe. Industrial capitalism was about the arbitrage between raw materials and labour, and manufactured goods.
The benefit of CAPITALISMTM is that when capitalists pursue arbitrage they generate net wealth and individual self-interest benefits society as a whole. Capitalism does not do this any more. It no longer serves mankind and has ceased to generate wealth for the whole of society. A group of powerful individuals have figured out how to circumvent the ideology. By taking the upside and none of the downside they have created the ability to enrich themselves irrespective of whether society benefits. Arbitrage can now lead to reallocations of wealth simultaneously with a diminution of wealth.
Self-interest has led capitalists to figure out a way to arbitrage the very ideology of capitalism itself, and consequently the ideology has failed.