Tuesday, 30 September 2008

The lighter side of the financial crisis

Although I cannot vouch for its authenticity, there is some grave news coming out of Japan as the repercussions of the US financial crisis hit that country.

In the last 7 hours Origami Bank has folded, Sumo Bank has gone belly up and Bonsai Bank announced plans to cut some of its branches. Yesterday, it was announced that Karaoke Bank is up for sale and will likely go for a song, while today shares in Kamikaze Bank were suspended after they nose-dived. Samurai Bank is soldiering on despite sharp cutbacks, Ninja Bank is reported to have taken a hit, but they remain in the black. Furthermore, 500 staff at Karate Bank got the chop and analysts report that there is something fishy going on at Sushi Bank where it is feared that staff may get a raw deal.

[Update 25/08/2012: This is my own - Sudoku Bank has been unable to make the numbers.]

And in earlier news from Wall St:

Helium was up, feathers were down. Paper was stationary.
Fluorescent tubing was dimmed in light trading.
Knives were up sharply.
Cows steered into a bull market.
Pencils lost a few points.
Hiking equipment was trailing.
Elevators rose, while escalators continued their slow decline.
Weights were up in heavy trading.
Light switches were off.
Mining equipment hit rock bottom.
Diapers remain unchanged.
Shipping lines stayed at an even keel.
The market for raisins dried up.
Coca Cola fizzled.
Caterpillar stock inched up a bit.
Sun peaked at midday.
Balloon prices were inflated.
Scott Tissue touched a new bottom.
And batteries exploded in an attempt to recharge the market.

The Current Financial Crisis - My Biggest Fear

So Congress rejected the bailout plan, the markets reacted by (what else?) crashing, and now the world is waiting with bated breath to see what happens next.

This being an election year when the contest is particularly close, truth can safely be expected to be the first casualty. The name-calling and one-upmanship between the candidates and their parties has already begun.

There is great temptation on the part of everyone involved in the debate to take the path of maximum populist appeal. The unanimously agreed villain of the piece? Deregulation. The solution? Lots of regulation.


So now the answer is to control, stifle, smother and shackle the economy so it can't collapse? You poor sods, now you've really done it!

No one can recommend the free market in the current climate without being booed, it appears. The free market (taken in the sense of an unregulated market) has now been blamed for all the world's ills. Yes, the lack of controls has been a major culprit, but it wouldn't have been such a killer if the market had been truly competitive. The collapse of a few players wouldn't have developed into the market-threatening crisis that it has now become.

In the process of blaming the free market, I fear we may be walking away from the one thing that can get us out (and forever keep us out) of this kind of mess - a free market! And my regular readers know that when I say "free market", I mean a liquid market. A market with plenty of competition. Because freedom for me does not carry the petty meaning of a freedom without restrictions. It means a freedom that cannot be taken away. Only liquidity (the inability of any single player or small group of them to influence the rest of the market) can protect the freedom of all players in the market. To enjoy freedom, we need to (paradoxically) accept the constraints demanded by freedom, i.e., the guaranteed powerlessness to unduly influence others.

I think we should start using the phrase "liquid market" or "competitive market" instead of "free market" from now on. The term "free market" has been tainted, ironically because the financial markets weren't really free but highly illiquid and oligopolistic with a few very large and powerful players who operated without the checks on their behaviour that a competitive environment would have naturally provided. It's no use trying to educate people about what the term "free market" should really mean. In the aftermath of a systemic collapse, no one wants to hear what would appear to be hair-splitting or intellectual sophistry. People cannot now be convinced that a free market is the solution we need and not the problem.

I think we need to start characterising the problems of the last few years as an "oligopoly", an "illiquid market" or as "cronyism". Any and all of these terms would be an accurate description. And we should then point to "liquid markets", "competition", "transparency" and "accountability" as the answers, rather than "regulation".

Competition provides most of the regulation we really need. All we need to do is ensure that our markets stay competitive.

Regulation by government bodies is important and has its place, but knee-jerk legislation mandating more regulation will exacerbate the problem. Complexity hinders transparency.

Will the wisdom of crowds see through the current round of election-sozzled name-calling and understand what the economy really needs?

I'm hopeful, but not optimistic.

Saturday, 27 September 2008

My Economic Philosophy - 8 (Beyond Socialism and Capitalism)

(This is the eighth of n pieces on my emerging economic philosophy called Liquidism.)

I came across this hilarious illustration today:

While funny, it's also sad that both systems have come to represent a zero-sum game in the eyes of many people, a belief that one person's gain must always result in another person's loss. I don't believe this is true. I believe that wealth is potentially infinite, and human civilisation is constantly improving the incentive systems that cause us to apply our ingenuity and industry to increase our collective wealth, with everybody being better off as a result. I believe in the capitalist ideal based on competition and liquid markets (not the cronyism and oligopolistic markets that pass for capitalism nowadays). At the risk of appearing trite, I can sum up my economic philosophy with another illustration:

It could be argued that what I call Liquidism is just "capitalism done right", but it does involve some non-intuitive aspects. I arrived at this economic philosophy in stages, and it's the fortuitous result of many coincidental experiences in my life.

My journey began when I realised that "freedom" could mean two very different things, and that one kind of freedom is higher than the other. A freedom that cannot be taken away is superior to a freedom without restrictions. I thank the Free Software / Open Source software communities for sensitising me to this difference.

Then I discovered the beauty of Ayn Rand's philosophy (and its limitations). Ayn Rand opened my eyes to the fact that capitalism was not just an economic system but a political philosophy grounded in the notion of individual freedom. The economic aspects of capitalism flow out of the political philosophy.

With that insight, I tried to derive (from first principles) an economic system from a philosophy of freedom, but using the higher of the two kinds of freedom I talked about earlier. In essence, I was trying to redefine a "free market". In the process, I realised that a truly free market had to be a guaranteeably liquid market, not a market without controls. That meant that there was a legitimate role for government (in the absence of any self-correcting behaviour on the part of the market) to step in and enforce liquidity whenever required. In other words, antitrust is not an enemy of the capitalist system (as libertarians make it out to be), but its saviour. That's where Ayn Rand is wrong.

From there, it was only a short step to realising that Liquidism is the next logical step in prudent economic policy, taking the "Australian model" of prudent fiscal policy (avoiding budget deficits) and prudent monetary policy (keeping inflation low through alert interest rate manipulation) to its natural conclusion by ensuring high market liquidity as well. I have been privileged to be part of the Australian economy for over a decade now, and I marvel at the simple yet effective way in which the Australian government and central bank have together kept the economy consistently booming in the face of worldwide boom-bust cycles. The Australian model has many aspects of a welfare state, but that welfare state operates within the discipline of a balanced budget. Australia has shown the world how to reconcile capitalism and socialism. However, many segments of even the advanced Australian economy are held to ransom by oligopolies.

It's unfortunate that nowhere on earth can an example be found of the perfect economic system. Worse, very few people have shown an interest in getting there. Until now.

I have finally seen the vindication of my philosophy in the market failures of 2008, and I realised (as did an eminent economist and old classmate of mine), that capitalism has to be saved from the capitalists. In a truly liquid market, the effect of a single player (or even a few players) has no perceptible impact on the market as a whole, so bailouts using taxpayers' money are never required. But in our imperfect world, large players always act to preserve their oligopoly, by making it harder for themselves to fail (governments are forced to prop them up using taxpayer's money in the larger interests of market stability, making a mockery of the free market in the process) and by erecting scale barriers to newer entrants. I'm sure the downsides of having extremely large players in the market has become apparent to others as well. We just need to join the dots and go where the logic leads us, i.e., to a guaranteeably liquid market, where no player can ever become large enough to unduly influence the market.

However, entrusting the role of market "liquefier" to governments is fraught with danger. Governments are corruptible, as we all know. The timidity of competition watchdogs in our economies is testament to the power of incumbent market players to protect their interests. Governments and legislative bodies are influenced more by market incumbents than by companies yet to be formed. Therefore, liquidity-seeking behaviour needs to be driven into the DNA of the basic unit of capitalism itself - the corporation. Corporations need to have an "amoeba gene" that causes them to grow and split ad infinitum, rather than grow and merge. This is the only way that the market can inherently (i.e., without external intervention) be prevented from consolidating into an oligopoly or monopoly. Such a solution would satisfy Ayn Rand as well. In this context, it must be pointed out that divestitures do not reduce shareholder wealth. On the contrary, new wealth can be released when diseconomies of scale are eliminated and competitive energies are unleashed. The few examples we have of corporate breakups (such as AT&T in 1984) bear out this optimism.

I think it's time the world innovated a new kind of corporation that contributes to market liquidity instead of opposing it. This may need to be defined and enshrined in law, just as the notions of "joint stock company" and "limited liability" were previously formalised through acts of legislative bodies. The capitalist system can then be relied on to generate wealth in a sustainable way, without needing constant government oversight and intervention, and without suffering the periodic system-wide collapses it is prone to in its current suboptimal form.

My concept of Liquidism has been a gradual awakening rather than an epiphany. I still read semi-informed (yet heated) debates in many forums about the merits of different ideologies and varied reasons for our recent financial crises. Although I don't want to sound overconfident, I'm increasingly convinced that I have found the answer to these questions. I think Liquidism is the key to future financial stability and world prosperity.

Three Palindromes and a Spoonerism

We've all heard palindromes that make no sense, such as
Mad Zeus, no live Devil, lived evil on Suez dam.

I much prefer palindromes that make sense in a plausible context, not contrived ones like "Step on no pets" or "Draw pupil's lip upward".

My favourite ones are these three:

An ad for Toyota:
A Toyota. Race fast, safe car. A Toyota.
A sports-hater's plaintive plea to be left alone:
Golf? No Sir, prefer prison flog!
(I can identify with that!)

An anti-smoking slogan:
Cigar? Toss it in a can. It is so tragic.
And a good spoonerism I read yesterday in MX fits in neatly with the story of the Knave of Hearts:
The Queen of Hearts, she made some tarts,
All on a summer day:

The Knave of Hearts, he stole those tarts,
And took them quite away!
Q: How did the knave respond when questioned about the lack of pies?
A: With a pack of lies.

My Economic Philosophy - 7 (The Place of a Welfare State in a Capitalist Economy)

(This is the seventh of n pieces on my emerging economic philosophy called Liquidism.)

The Welfare State has always been synonymous with Socialism and generally viewed as incompatible with Capitalism. This belief has polarised opinion along rather simplistic lines, between those who favour government support for the needy, and those who believe that all economic decisions should be made by "market forces" (a term that implicitly excludes the government). And then there are the pragmatists who believe in a mixture of the two, unencumbered by any ideology.

I have evolved a different view, and my philosophy not only provides an ideological basis for the pragmatic approach but also lays down clear guidelines for how big the Welfare State can be.

I have written about what is known as the "Australian model". From a social perspective, the Australian model is a wonder of the modern age because it manages to reconcile a capitalist economy with elements of a Welfare State, such as state-subsidised healthcare and social security. From a purely economic perspective too, the Australian model is a wonder because it has managed to deliver 17 straight years of growth while the rest of the world reconciled itself to the "inevitability" of periodic recessions.

What's the secret?

The economic model is no big secret. It lies in responsible government spending that yields a (growing) budget surplus and thereby refrains from provoking the inflation that unfailingly follows deficit financing. As a bonus, the budget surplus delivers flexibility in investing for the future (the Future Fund) and acts as a cushion against economic shocks. The secret also lies in an alert central bank that promptly raises interest rates as inflation rises and lowers them when the economy slows. These two levers of the economy, when prudently applied, maintain conditions of low inflation, low unemployment and uninterrupted growth.

Of course, the Australian economy could do with even greater efficiency, and this can only occur when the oligopolies in its various markets are broken, but that is not the topic of this post.

Returning to the social perspective, how does Australia manage to be a successful capitalist economy while also supporting aspects of a Welfare State? Even if it works (as it clearly does), isn't there at least a theoretical contradiction between the two?

My answer is no, there's no contradiction, because the perceived dichotomy between a Welfare State and a capitalist economy is false.

It leads back to the fundamental definition of "freedom". If freedom is taken to mean the untrammelled freedom of individuals to act, only constrained by the rights of other individuals and with no "controls" by external authorities, then every act of government (as a player in the market) is seen as a violation of freedom. The model of a "free market" by this definition of freedom is a laissez-faire system where government does not interfere with the functioning of the market, either as a regulator or as a bulk consumer.

If, however, freedom is seen as something that must be guaranteed never to be taken away, then some controls are inevitable. The model of a "free market" by this definition of freedom is a liquid market with a large number of buyers and sellers, where no single buyer or seller (or a small group of them) can significantly influence prices or the stability of the market as a whole. Actions by government violate no principles as long as the market stays liquid.

And this explains the seeming paradox of a Welfare State within a capitalist society. By itself, government action in a market is neither good nor evil. The crucial question is whether such action breaks one of what I would call the three pillars of the economy (a balanced budget, the right level of money supply and healthy levels of competition in the market).

The Welfare State is an example of government spending. Is this a legitimate activity in a market economy? In a democracy, government is an agent of the people in a legal sense, and so government spending on behalf of the people is really no different from individuals spending their own money. The various mechanisms of democracy ensure that the agency of government spends the money of its principal (the people) in a way that serves the interests of the principal. I believe that government spending in a functioning democracy is legitimate, as long as it does not lead to a budget deficit.

(One could argue that government spending that leads to a deficit budget is also legitimate because in a democracy, it reflects the will of the people. I disagree, because deficit budgets in effect borrow from the future. They are inflationary, and they rob our descendents of wealth. Our children, grandchildren and unborn descendants do not have a vote, even in a democracy. We have no right to rob them of their wealth without their consent. And so government spending has legitimacy only as long as the budget stays balanced.)

The constant demand by "free-market" advocates to privatise social security seems pointless to me. I can't see any economic reasoning behind it, merely an ideological one stemming from the dubious definition of freedom as an absence of external controls.

So how large should the Welfare State be? As large as the budget allows. The government is a consumer on behalf of the people, and like any consumer, should live within its means. "Free-market" advocates tend to criticise "big government", but to my mind, the problem is not "big government" but "irresponsible government". I say, if the government has the revenue to sustain a large Welfare State without running into deficit, then go for your life! There are no absolute limits (in dollar terms) to the size of a Welfare State. The only limit is the size of the budget.

So in my opinion, there is no contradiction between a capitalist economy and a Welfare State. Those who start off with an inferior definition of freedom ("no controls on individual freedom") exhibit a knee-jerk opposition to any action by government, which seems a bit silly to me. To those who define freedom as something that cannot be taken away, it is obvious that there are clear-cut principles that determine what governments can and cannot do. As long as the Welfare State abides by those principles, its proponents need not be apologetic or defensive about its existence.

We can have our cake and eat it too.

US bailout bad, Australian bailout good

I've been a vocal critic of the Fed's bailout of Bear Stearns, Fannie Mae, Freddie Mac and Lehmann Bros. And so I should be expected to similarly disapprove of the Australian government's recent bailout of players in the non-bank lending market.

Ah, but there is a difference. More than one difference, as a matter of fact.

The US bailout was primarily aimed at preventing a market collapse, which is a symptom of a larger problem - a highly illiquid, oligopolistic market. The Australian bailout of second-tier lenders, in contrast, is aimed at preventing the collapse of competition in the market. There is no fear of a market collapse in Australia. There has just been a tightening of credit, which hurts smaller players more than it does the larger ones.

The US bailout shores up market leaders in an oligopolistic market. The Australian bailout shores up second-tier players in a market that threatens to become oligopolistic if they go under.

The US bailout props up entire companies, regardless of their dodgy asset base. The sub-par quality of these assets stems from the subprime crisis that originated in that country. The Australian bailout is more discriminating. The government is making $4 billion available to buy up not dodgy securities but AAA-rated (secured) mortgages from second-tier lenders. These assets are Australia-based with no links to the US subprime market.

The US bailout deepens the government's budget deficit. The Australian bailout still leaves the budget in surplus.

The US has lost the plot where competition is concerned. Their "free market" is about as free as Sukarno's "guided democracy" was a democracy. In contrast, it appears that the adults are still in charge of Australia.

So there is a world of difference between the US model of capitalism and the Australian one after all, and I'm not just waving the Australian flag because I'm a citizen. The leaders Down Under just seem to have a fundamentally more sensible approach to the economy than those at the helm of "the greatest country in the world" - keep markets competitive, don't run up budget deficits, invest taxpayers' money in sound assets.

Labor keeps my vote.

Friday, 26 September 2008

Two Quotes from Henry Ford (or When to Second-Guess the Customer)

Henry Ford's most famous quote is probably this:

"They can have it in any color as long as it is black."

But Ford is also known to have said this:

"If I'd asked my customers what they wanted, they'd all have said they wanted a faster horse."

I think he was right on the money with the latter statement, but the former was just arrogance.

Ford lost out to General Motors mainly because of his failure to meet the legitimate demands of the market. In 1921, Ford had 60% of the market for new car sales. But Ford doggedly insisted on selling a single model (the Model T), while GM began to offer a full line (Cadillacs, Chevrolets and Buicks) at different price points. Obviously customers preferred GM.

The lesson this holds for me is, you can ignore your customers' demands as long as you give them something even better (a car instead of a faster horse). If you merely ignore their demands, you do so at your peril.

I've seen a lot of timidity in the area of software design, where software makers go to great lengths to ensure a good "user experience". They do this by running focus groups and testing various user interfaces to see which ones users like best. This is a valuable approach, but it virtually rules out developing bold and innovative products that create new markets.

After all, no computer user could have asked for the mouse in an age when the only interface to computers was a keyboard. The invention of the mouse surely required a leap of imagination, and its inclusion with the first mass-market computers must have taken prodigious courage on the part of their makers, because every user has struggled to master its use on their first encounter with it. Yet the mouse is nothing less than a marvel of user interface engineering.

The lesson here is that intuitiveness is a function of learning. What seems unfriendly and unusable initially becomes indispensable over time.

We must be bold enough to look beyond customers' stated wants and their current mindsets and instead visualise what can be. Entrepreneurs owe their success not only to their responsiveness to customers' needs but also to their vision of a future that may not exist at the time.

Tuesday, 23 September 2008

My Economic Philosophy - 6 (The Next Innovation after the Corporation)

(This is the sixth of n pieces on my emerging economic philosophy called Liquidism.)

It may not be obvious to many (and in fact may actively be denied by some!) that the great prosperity enjoyed by enormous masses of people in the world today has come about thanks to some ingenious inventions in the area of finance as much as in the areas of science and technology. What Science discovers and Technology invents, Business produces for the mass market, and Finance funds that production. The Industrial Revolution could not have had the impact it did without a corresponding Financial/Legal Revolution.

My personal choice for the most important financial/legal innovation of the past five hundred years would be the joint stock company with the added clause of limited liability.

This is the innovation which allowed the mass of humankind to participate in and guide the exploitation of ideas, not only directly (by funding them), but also indirectly (by favouring some over others). By limiting the liability (the risk) of investors to the amount they invest (and preventing creditors from pursuing them for the debts of the corporation), the limited liability company encouraged shareholding on a scale never seen before.

This set in motion a virtuous circle of truly gargantuan proportions. A large mass of investors funded the practical applications of theoretical innovation. In turn, the corporate vehicles that converted ideas into tangible goods and services made their investors richer. Wealth began to flow to society on a scale unparalleled in history, and the mill has never stopped churning since.

In terms of an actual date in history, perhaps 1855 could be considered the official turning point. This was when the Limited Liability Company finally became the accepted norm in Britain thanks to an act of parliament.

The LLC has served the world well, but the world may be discovering the limitations to its usefulness. The world economy today is dominated by limited liability companies, but what use is a system that suffers major upheavals every few years? Capitalism may have created enormous wealth over the past two centuries, but all that seems to register nowadays is the wealth that is wiped out in a single day of a stock market crash.

I have written in the past (1, 2, 3, 4, 5) about my economic philosophy of Liquidism, and how a liquid market can be relatively immune to systemic collapse even if individual players in the market fail.

The problem with ensuring liquidity is that enforcing it is hard in practice. Ensuring liquidity goes against the grain of the capitalist system as it is currently structured. Calls for the break-up of monopolies and oligopolies are wrongly depicted as "leftist", whereas a high level of competition is in fact the capitalist ideal. This inherent contradiction is summed up in the book "Saving Capitalism from the Capitalists". I've elaborated on this earlier.

Today's firms are geared for individual growth, whether organic or through mergers and acquisitions. Firms are not at all well suited for divestiture or corporate break-ups, which can facilitate market growth with its associated liquidity advantages. We need both types of growth, going hand in hand, to achieve wealth creation without the dangerous instability that seems to accompany the concentration of wealth among a few very large firms.

Are there any mechanisms available to achieve that?

In today's world, a new kind of company is becoming common - the company designed not for independent existence, but purely as a takeover target. Venture capitalists often fund startups whose sole business plan is to be taken over by a larger company at an attractive price. This is the way the startup repays its investors.

Why can we not consider the opposite (the business division that is designed to be spun off as an independent company)? Shareholders in the original company are automatically offered a stock split, with ownership in the newly formed company. As more and more units are spun off, the original shareholders' holdings become more diversified. And as the child entities begin to thrive and grow in their respective niches, the wealth of the shareholders begins to grow as well.

The constant creation of new companies increases the liquidity of the markets in which they operate, reducing systemic risk. From time to time, a governmental competition watchdog (suitably renamed to reflect its systemic risk mitigation role) provides a friendly nudge to encourage some divestitures (if antitrust is an ugly word to some), but in general, the spin-offs are internally driven.

In this newer world, continuous amoeba-like phases of organic growth and splitting are seen as the best way to grow shareholders' wealth.

What we need, therefore, is the next major financial innovation. We need a built-in mechanism within a corporation that will propel it to seek out wealth through a combination of growth and divestiture, rather than through growth and merger.

Arguments based on economies of scale have often been made in favour of mergers, but having worked in small companies as well as large ones, I can testify (anecdotally) to the extreme diseconomies of scale that are exhibited by large companies as well. Large companies in an oligopolistic market charge their customers more than they should and pay their shareholders less than they should. The difference is lost through sheer inefficiency. On balance, I think shareholders are served better by smaller and more diversified players.

I wrote before about injecting "amoeba DNA" into the modern corporation, so that it naturally supports market liquidity instead of opposing it. I believe that is the next financial innovation that needs to happen, perhaps with some legislative support to push the world in that direction.

In sum, capitalism has served us well so far, but we have lately stumbled upon some of the limits to its wealth-creating potential. The reasons have to do with market liquidity as a whole, which individual firms are not designed to address. Newer firms must be built in smaller and more agile units that can be readily started, shut down, combined or (more importantly) spun off from larger ones. That will take the capitalist system to the next higher plane of its existence.

Human civilisation has evolved in sophistication to the point where sustainability should now be built into its powerful wealth creation vehicle.

Monday, 22 September 2008

Iron Man - Rusty Premise

I saw Iron Man during a recent flight and was more than just disappointed. I don't know if the "political context" appealed to American audiences or not, but it put me off completely.

Don't get me wrong. I can handle hours of mindless violence and destruction. I'm not so high-brow. It's the pseudo-moralism I can't stand.

So the hero decides to stop making weapons because he realised that American weapons are being turned against American soldiers? So that's what's wrong with the war in Afghanistan! Riiiight....

On the other hand, news reports of American soldiers killing Afghan civilians are nothing to be concerned about, I guess. Nor is it a big deal that the US has been cozying up to the real bad guys for years. Oh no, it's the use of captured American arms against Americans that's outrageous.

As a person born in India, arguably the biggest target of terrorism in the world today, I should have been rooting for the forces of democracy. Unfortunately, Iron Man is such a sickeningly righteous, racist movie that I found myself almost cheering for the other guys...

If America is to win over its enemies, Americans must first learn to look at themselves through foreign eyes. They may not like what they see.

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?

Tuesday, 16 September 2008

Thank you, Brendan Nelson

One could tell it was going to happen one of these days, and today was the day. Dr. Brendan Nelson was ousted as Liberal Party leader in an intra-party coup this morning. His sudden gamble to force the leadership issue early resulted in an equally abrupt end to his 10-month job as leader of the opposition. Now the job is Malcolm Turnbull's, and Australia will be watching to see what he will do.

This post is mainly to say thank you to a man who took on the difficult and thankless job of leading the shambles of John Howard's defeated party after the old man ran it into the ground last November. [The swing to Labor at the last election was so great that Kevin Rudd will probably remain PM for another term, so Malcolm Turnbull shouldn't count his chickens just yet.]

Dr. Nelson may not have raised confidence in the Liberals during his brief spell of leadership, but he did command immense respect for the dignity and decency with which he conducted himself, and for the civilised tone that he brought to Australian politics. That is no mean achievement in these days of gutter politics. I felt it was worth mentioning his thoughtful speech when Prime Minister Kevin Rudd formally apologised to the Aboriginal people in February. True to form, he put his own feelings behind him today and urged his partymen to support their new leader. Thanks once again, Dr. Nelson, and I sincerely wish you the best in your life and career. This is not the end. Your contributions to Australian public life are significant and will surely continue.

I'm inclined to give Malcolm Turnbull a sporting chance. I know he's widely disliked, but that's probably because he's so obviously ambitious. It's no secret that he wants to be PM one day. That's not a crime, and I won't hold it against him. Unlike many other career politicians, Turnbull has actually worked in the real world, having founded companies like OzEmail and been a partner at Goldman Sachs. He's also actively pro-environment and wants Australia to become a republic, both causes that get my vote.

Turnbull may not do much more than erode Labor's gains in 2011, but in 2014, he may be the one to watch.

History was probably made today.

India, Inc. should sell off its loss-making Kashmir division

If you were the CEO of a multi-trillion dollar enterprise and you had a division that was making losses for years, diverting resources from more profitable divisions, creating bad press for the organisation and contributing to poor employee morale, what would you do?

India, Inc. is an enterprise in exactly that situation. For sixty years since Independence, Kashmir (or more correctly, the Kashmir province of the Indian state of Jammu & Kashmir) has been a black hole consuming endless resources in terms of both money and human life and providing no tangible benefits in return. It's ironic that India, the back-office of the world, which is selling the business benefits of outsourcing to a host of global corporations, has failed to apply the same hard-nosed business principles when it comes to its own affairs. Have the CEO (the PM), his management team (the cabinet) and the board (members of parliament) been managing the enterprise in the best possible way to further the interests of their shareholders (the Indian people)?

This is a case fit for a business school discussion. What should the management do with this chronically loss-making division?

I don't believe the Kashmir question has ever been phrased in business terms before, which is why it has so far been a taboo subject that "patriots" have been expected never to question.

At long last, a section of the intelligentsia has begun to think the unthinkable and voice their thoughts in print. Vir Sanghvi, Jug Suraiya and Swaminathan S Aiyar are 3 prominent columnists who have written up some very eloguent arguments about "letting Kashmir go". I particularly like Vir Sanghvi's article. The well-known activist and author Arundhati Roy (who wrote "The God of Small Things") summed up the collective national fatigue with Kashmir by saying "India needs aazaadi (freedom) from Kashmir as much as - if not more than - Kashmir needs aazaadi from India."

And it's not just a flight of fancy by some elites sitting in their ivory towers. The response to this idea from the general population has been dramatic. A recent poll conducted in 9 Indian cities showed that fully 30% of the country's (urban) population agrees with the idea of letting Kashmir go. So much for an unthinkable idea! I'm sure as time goes on, the idea will gain more supporters. After all, the debate has just begun, and there is already so much pent-up support.

Imagine the benefits that can ensue when a loss-making activity is stopped and funds are immediately available for profit-generating ones instead. India badly needs investment in infrastructure, especially in transport, power and communications. Investment in infrastructure is a multiplier in economic terms. It accelerates economic growth. China has shown the world that growth rates in excess of 10% a year are sustainable. India needs to aim for such a target, and throw every spare resource into achieving that target. The prize is the potential status of being not just the world's largest democracy (already achieved), not just the world's most populous country (projected to happen by 2050), but being nothing less than the world's biggest economy! With a population potentially greater than China's and with more favourable demographics, this is not a pipe-dream. But it requires vision, planning and investment to get there. Worthless diversions like Kashmir are an unaffordable luxury to a country with a far greater tryst with destiny. Kashmir is a needless drain on India's precious resources.

But the idea is still a wrenching one. I grew up in India and the image of the Indian map in my mind is the (untrue) official Indian one with an undivided Kashmir shown as fully Indian territory. That became the "look" of India to me and, I'm sure, to hundreds of millions of Indians. I could almost see a person standing with their left arm around Bangla Desh and face turned westwards. Foreign publications that showed a truer map with the actual line of control as the border were rubber-stamped with the bristly phrase "The external boundaries of India as depicted are neither correct nor authentic", or something of that sort. Yes, the Indian map without Jammu and Kashmir looks admittedly ghastly. It looks like India has been beheaded. That would be my initial, emotional response. A map with Kashmir alone gone would look like India has (literally) lost face. But I can swallow that and look beyond it.

When you analyse and break them down, I guess the only reasons against a sell-off would be national security, logistical complexity, national pride and what I'd call "sunk costs".

The "sunk costs" argument is the easiest to debunk. Essentially, this is saying, "India has spent so much money and sacrificed so many lives to retain Kashmir. If we give up Kashmir now, it will be a waste of all that money and all those brave soldiers would have died in vain." The argument against it is simple: "We should stop throwing good money after bad, and we will prevent even more soldiers from dying unnecessarily by putting a stop to this pointless exercise." After all, the Kashmir situation doesn't look like it is going to turn the corner anytime soon. Why put up with this haemorrhage in good money and good men indefinitely?

National pride is a trickier issue. There's no rationalism here, so it's hard to argue with someone with a strong opinion. However, the issue can be reframed in a number of ways.

1. The prosperity of India is far, far more important than the retention of Kashmir. Our national pride should be in our socio-economic achievements, in bringing prosperity and egalitarianism to an already democratic society. Kashmir is tiny compared to the current and potential achievements of India.
2. Kashmir is needlessly giving India a bad name. We are being equated with a colonial power. We, who struggled to get the British out of India! We, who sympathise with Tibet to the extent that the Dalai Lama and his followers have enjoyed political asylum in India since 1959. We, who are overwhelmingly opposed to the American war in Iraq. How can we now behave the same way as a colonial oppressor and stay on in a place where we're clearly not wanted?
3. Even the Soviet Union allowed its republics to secede. Where is the shame in letting a recalcitrant province go its own way?

I don't know how convincing these arguments will be, but as I said before, the debate has just begun, and there will be more and better arguments.

That leaves national security and logistics.

The national security argument can cut both ways. What I call the "domino theory" held by many hardliners says that giving up Kashmir today will require India to give up other territories tomorrow. I'm not convinced, and I think this is just paranoia. Secessionist movements in other parts of the country have been tamed without territorial concessions, and it must be remembered that none of them has been a festering wound like Kashmir. [We will create more festering wounds unless we move quickly to redress the legitimate grievances of victims upon victims of communal violence in our country.] The point is, the Kashmir situation has probably deteriorated beyond the point where a solution can be found within the framework of the Indian union.

On the other hand, consider the fact that Kashmir has always been the single most important irritant between India and Pakistan, responsible for every single armed conflict between the two countries (except the 1971 war). There has been no progress on a South Asian free trade zone thanks to the antagonism between its two biggest countries. A huge economic bonanza awaits the region once the Kashmir issue gets settled. When the economies of the region get inextricably intertwined, war becomes an increasingly distant possibility. Strategically, there is in fact a strong national security argument in favour of letting Kashmir go.

Finally, the tricky issue of logistics. We remember the horrors of Partition in 1947. The last thing we need is another massacre with the body count running into the millions. India needs to float the idea of a coming "velvet divorce" gently and years in advance. It will allow people to make their plans and execute them without panic. There's also the messy issue of compensation for hundreds of thousands of Indians who have been forced out of Kashmir by the threat of violence. That's actually a tractable problem. Displaced Kashmiris within India can be generously compensated with a fraction of India's budget for Kashmir for a single year.

I know I'm advocating that India should let Kashmir go, but my guess is that most Kashmiris, faced with a stark choice, will vote with their feet and wind up in India anyway. India is the biggest engine for economic growth this side of the Himalayas. The Kashmiris' options are unfortunately quite limited, and uniformly unsatisfactory. They can either create an independent landlocked state for themselves with no resources and no industry and be an instant basket case, or be absorbed into a troubled Pakistan with its sputtering economy, perilous law-and-order situation (which puts it on a collision course with the US over terrorism) and very uncertain prospects overall. As an independent country, they will probably be humiliatingly dependent on India anyway, and the terms they receive will be far less generous. They're probably best off where they are (a much-pampered province within India), but I (just like an increasingly large number of Indians) am now skeptical whether the status quo is in the best interests of India.

If the Kashmiris finally get what they have been agitating for, it could turn out to be their worst nightmare, and India's lasting relief.

Saturday, 13 September 2008

Is Compulsory Voting a Contradiction in Terms?

Today was Election Day in New South Wales for local councils. As usual, we were warned that if we did not vote, we would have to pay a fine ($55).

This compulsory voting business has always puzzled me. It reminds me of the old joke about the politician who said, "If I'm elected, everyone in the country will be free to do what they please. And those who don't will be made to do it."

But now I'm beginning to think compulsory voting is a good thing, and the turnaround in my opinion has been gradual.

When I first arrived in Australia and learnt that voting was not just a right but also a duty, I was indignant. I think of myself as being fairly conscious of civil rights, and have always keenly followed news items that deal with rights.

Just a few years earlier in India, there was a well-known case of a man who had attempted suicide. He was arrested under Section 309 of the Indian Penal Code which made attempted suicide a crime. Indian law is based on 19th century British jurisprudence. While the Brits have since moved on, India remains stuck in a judicial time warp. I found it abhorrent that attempted suicide could be viewed as a crime, and was gratified when Justice Hansaria of the Supreme Court made history by ruling that Section 309 was unconstitutional. The Indian constitution (a much later and more enlightened document compared to the rest of Indian jurisprudence) upheld the right to life as a fundamental right, and the wise judge noted that "the right to live implied the negative right not to live", otherwise the right was meaningless. (I don't know what happened to the poor defendant after that. I hope he received counselling and psychiatric help.)

Disappointingly, a larger bench of the Supreme Court later reversed that decision and upheld the constitutional validity of Section 309. I suspect that questions of euthanasia (always a tricky subject) got mixed up with the issue of suicide and caused a judicial retreat to a safer, more defensible position.

In any case, applying Justice Hansaria's original logic (which resonated very strongly with me), I thought the Australian rule on compulsory voting was a major contradiction. Doesn't the right to vote imply the right not to vote?

But here's the upside of the obligation, and it has taken a few years to sink in.

A major problem that plagues a democracy like India's is bogus voting. Voter ID cards are a very recent phenomenon (and they have their own downsides in terms of privacy and government control, as any civil rights activist will tell you). There were no voter ID cards when I was an eligible voter. I remember that we had to go to the polling booths early to cast our votes if we wanted to prevent someone else from voting in our names.

The most breathtaking example to me (of what can only be called a mockery of the process) was when a neighbour of ours went to the polling booth in the afternoon to find that someone had already voted in her name. She then barefacedly asked the polling officer if she could vote in my wife's name, as she knew for a fact that my wife was out of town and wouldn't be voting. Even more surprising is the fact that he let her! It just goes to show that the problem was so endemic that even a polling officer found this a reasonable request.

Such a situation could only occur because voting in India is not compulsory. There would be an outcry if everyone turned up to vote and some of them found that they were marked as having already voted. That would automatically put an end to bogus voting. In contrast, Australians probably wouldn't know what bogus voting is. The reasons may be partly cultural, but I think compulsory voting also makes such kinds of electoral fraud systemically impossible.

A secondary (but probably more important) effect of forcing everyone to vote is that citizens are forced to take responsibility for the running of the country at every level - national, state and local. We can't sit back and blame the politicians or blame someone else for electing unsuitable leaders. When things go wrong, we and we alone are to blame. It's pretty confronting.

I realise that I now actually like being forced to vote. I feel engaged. I feel I'm part of the process and I have to do my bit. I sat up last night and familiarised myself with the parties and the candidates in my local ward. I would have felt very guilty turning up at the polling station without knowing a thing about what the election was about. It would have been like turning up to write a examination without studying (although I must confess that situation is not exactly unfamiliar to me!)

There has been a lot of angst expressed in recent times in Australia and other Western countries about the loyalties of migrants. Personally, I don't think there is much cause for worry. The most irresistible power is one that is soft, gentle and insidious. You don't build loyalty to a country by forcing people to sing the national anthem or by quizzing them on cultural aspects of the country before granting them citizenship. You win them over by engaging them intimately in the running of the country itself, at every level of government. Loyalty then becomes unconscious.

This is my country because I feel personally responsible for the way it is run. I cannot remain disengaged and alienated. I have to express my preferences. And I have every confidence that my vote is counted in the final tally.

It reminds me of something very interesting that I read about the difference between the brain and other organs. You have a heart, a liver, a stomach, but you are your brain.

I have rights and I have duties, but I am a citizen. Nothing brings that home to me as forcefully as compulsory voting.

Monday, 8 September 2008

Slogan for Fair Trade Coffee

I thought of this rather clever slogan for Fair Trade Coffee:

Fair Trade Coffee - helps you sleep better.