Wednesday, 17 September 2008

Saving Capitalism from the Capitalists

(The title of this post refers to a book written by an old classmate of mine, but more on that later)

They've done it again! After Bear Stearns, Fannie Mae and Freddie Mac, the Fed has bailed out the American Insurance Group (AIG) by effectively nationalising it. Bravo!

Once again, the ugly principle of modern capitalism has been revealed - "Privatise profits and socialise losses". No wonder the common man (or woman) thinks of capitalism as a system that helps the rich exploit the rest of society to get even richer.

This is no way to run a market economy! If we must let corporations succeed, we must also let corporations fail. Why must taxpayers' money be used to bail out failing companies?

The answer, we are told, is that "a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance".

Oh, yes? And pray to what do we owe this "market fragility"? (Uncomfortable silence from the government, the Federal Reserve and captains of industry)

I don't want to see a systemic collapse any more than the next person, but propping up failing companies isn't the right way to prevent that. It just postpones the inevitable. The next threat will be bigger and more dangerous. I want to see a situation where the collapse of individual firms does not trigger a systemic crisis.

How can we achieve this happy state where individual firms are incapable of taking the market down with them?

Let me provide my prescription to prevent the kind of financial instability we are witnessing today -- a liquid market.

A liquid market is one where no single buyer or seller (or even a small group of them) is big enough to move prices. All buyers and all sellers in the market are essentially price-takers. Consequently, the arrival or departure of any (or a small group) of them at any time will cause scarcely a ripple in the market as a whole.

Here is where I differ in philosophy from libertarian and other proponents of laissez-faire capitalism. Unlike them, I don't believe that a complete absence of government interference is the answer. Yes, in general, I'm against government regulation and intervention, - with one significant exception. I like the kind of government regulation that keeps markets liquid. I'm a strong proponent of -- brace yourselves for the A-word -- Antitrust.

Antitrust is the preventative instrument that governments must wield to ensure that no single player in the market can "add to the market's fragility" by its failure. Indeed, the sign of a healthy market should be the sheer number of companies failing (and being created) all the time.

Government regulators today work to contain risk at the level of the individual firm. While they study the industry as a whole, the sole instrument by which they control risk in the market is capital adequacy as applied to individual firms. They prescribe minimum levels of capital to be maintained by financial institutions to provide for their obligations in the event of failure. But this kind of regulation is very low-level. I call this "micro-regulation" along the lines of micro-economics, because it applies to individual firms. While micro-regulation is required, what we also need is "macro-regulation" (like macro-economics), which applies at the level of the economy as a whole. What is the use of adequate capitalisation at the level of the institution if the market is itself going to be fragile? How can we ensure that the market itself is adequately de-risked? The answer - liquidity.

A country's prudential regulation watchdog must act in concert with the country's competition watchdog to ensure that the micro- and macro- indicators of market health are maintained at adequate levels. We must stop thinking of competition watchdogs as populist agencies that do nothing more than ensure a fair deal to consumers. Their role is much more important than that.

The prudential regulation watchdog will operate based on triggers that correspond to capital adequacy levels. If the level is breached, the agency will swoop down on the offending institution and ensure restitution to required levels. (They already have the power to do this in most advanced economies, and many of them are quite proactive.) The competition watchdog will operate based on triggers like the Herfindahl-Hirschman Index (HHI), a measure of the degree of competition in a given market segment. They must similarly have the power to swoop down on markets where the index is breached, and effect restitution through any means necessary, including a break-up of the largest players. (In practice though, competition watchdogs tend to be rather weak-kneed, perhaps because the role they play is perceived as populist rather than economically critical. Anti-competitive action is viewed as economically disruptive, rather than as economically corrective, and both business and the investing public express annoyance at such activity. How often do we hear of corporate break-ups, or even of mergers that are blocked?)

Forcible break-ups of large players must not be considered a punishment for being successful, as they are often portrayed. Rather, they are in the interests of all players - shareholders, customers, deposit-holders, policy-holders and employees. When the US Justice Department broke up AT&T into 7 "Baby Bells" in 1984, that did not cause its shareholders any long-term loss. On the contrary, within a decade, each of the Baby Bells had grown to be larger than the original Ma Bell. [Of course, economic sense went out of the window later, and the Baby Bells obtained permission to merge and stifle competition once more.] The lesson is that shareholder wealth can grow through break-ups, and so they are not something to be feared, but to be welcomed. Indeed, a break-up may be the best way to help investors realise value once the original corporate vehicle's market capitalisation plateaus.

"Amoeba DNA"


But aren't corporate break-ups costly and a waste of everyone's time and energy? Well, as the eXtreme Programming folk over in the IT world like to say, "If something is hard, do it often." We need to inject "amoeba DNA" into corporations, so to speak, so that when they reach a certain size relative to their market, they are ready to split (or be split). In this way, there is always a large number of players in a market, providing diversity of investment opportunity, and there is a Darwinian system that rewards only the most efficient, so every dollar invested is used to maximum advantage. As a side-benefit, the market is immune to the failure of a few players, because no player is big enough to influence the market as a whole.

This is my economic philosophy. I call it Liquidism, and I have explained it here, here, here and here.

What does the title of this post mean? This is the title of a book (read a synopsis here) by an old B-school classmate of mine, Raghuram Rajan, who went on to become Chief Economist of the IMF. The book's main insight is that competition is the lifeblood of capitalism, but capitalists hate it. More precisely, incumbent players in a market will always try and manipulate government to protect them from failure and prevent newer competitors from entering their market. It is the duty of government to resist the pressures exerted by these petty capitalists and act in the larger interests of capitalism itself (i.e., a liquid market). I'm gratified to see that an eminent economist like Rajan makes pretty much the same arguments as myself (an amateur student of economics) - that markets must be liquid, competition maintained at high levels, and that governments must be prepared to let businesses fail even if it means employees are thrown out of work.

The book does not offer much comfort to employees facing the loss of their jobs due to downsizing or business failure, but there is a powerful argument that should appeal to them all the same. I would argue that job losses are inevitable in a dynamic economy, but what causes them to hurt is the lack of liquidity in the market. If no single firm is large in comparison to the market, then the constant loss of jobs as firms disappear will be mere drops in the ocean, and people will find other jobs almost as soon as they lose their old ones. The pain will be so diffused it will hardly be perceived. Far from being traumatic, the loss of one's job will be nothing more than an annoyance lasting a couple of days, maybe even an exciting opportunity to improve one's prospects.

Is anyone listening? Or must the world go through a lot more pain (and a lot more waste) before we learn to apply capitalistic principles rigorously and keep the engines of the economy humming?

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