Archive for November, 2010
In this post, I apply the framework outlined previously to some empirical patterns in the financial markets and the broader economy. The objective is not to posit crony capitalism as the sole explanation of the below patterns, but merely to argue that the below patterns are consistent with an increasingly crony capitalist economy.
The Paradox of Low Volatility and High Correlation
As many commentators have pointed out [1,2,3], the spike in volatility experienced during the depths of the financial crisis has largely reversed itself but correlation within equities and between various risky asset classes has kept on moving higher. The combination of high volatility and high correlation is associated with the process of collapse and typical of the Minsky moment when the system undergoes a rapid delevering. However the combination of high correlation and low volatility post the Minsky moment is unusual. In the absence of bailouts or protectionism, the economy should undergo a process of creative destruction and intense exploratory activity which by its diffuse nature results in low correlation. The combination of high correlation and low volatility instead signifies stasis and the absence of sufficient exploration in the economy, alongwith the presence of significant slack at firm level (micro-resilience).
As I mentioned in a previous post, financing constraints faced by small businesses hinder new firm entry across industries. Expanding lending to new firms is an act of exploration and incumbent banks are almost certainly content with exploiting their known and low-risk sources of income instead.
The Paradox of High Corporate Profitability, Rising Productivity and High Unemployment and The Paradox of High Cash Balances and High Debt Issuance
Although corporate profitability is not at an all-time high, it has recovered at an unusually rapid pace compared to the nonexistent recovery in employment and wages. The recovery in corporate profits has been driven by a rise in worker productivity and increased efficiency but the lag between an output recovery and an employment recovery seems to have increased dramatically. So far, this increased profitability has led not to increased business investment but to increased cash holdings by corporates. Big corporates with easy access to debt markets have even chosen to tap the debt markets simply for the purpose of increasing cash holdings.
Again, incumbent corporates are eager to squeeze efficiencies out of their current operations including downsizing the labour force but instead of channeling the savings from this increased efficiency into exploratory investment, they choose to increase holdings of liquid assets. In an environment where incumbents are under limited threat of being superceded by exploratory new entrants, holding cash is an extremely effective way to retain optionality (a strategy that is much less effective if the pace of exploratory innovation is high as an extended period of standing on the sidelines of exploratory activity can degrade the ability of the incumbent to rejoin the fray). Old jobs are being destroyed by the optimising activities of incumbents but the exploration required to create new jobs does not take place.
This discussion of profitability and unemployment echoes many of the common concerns of the far left. This is not a coincidence – one of the most damaging effects of Olsonian cronyism is its malformation of the economy from a positive-sum game into an increasingly zero-sum game. The dynamics of a predominantly crony capitalist economy are closer to a Marxian class struggle than they are to a competitive free-market economy. However, where I differ significantly from the left is in the proposed cure for the disease. For example, incumbent investment can be triggered by an increase in leverage by another sector – given the indebted state of the consumer, the government is the most likely candidate. But such a policy does nothing to tackle the reduced evolvability of the economy or the dominance of the incumbent special interest groups. Moreover, increased taxation and transfers of wealth to other organised groups such as labour only aggravate the ossification of the economic system into an increasingly zero-sum game. A sustainable solution must restore the positive-sum dynamics that are the essence of Schumpeterian capitalism. Such a solution involves reducing the power of the incumbent corporates and transferring wealth from incumbent corporates towards households not by taxation or protectionism but by restoring the invisible foot of new firm entry.
STABILITY AS THE PRIMARY CAUSE OF CRONY CAPITALISM
The core insight of the Minsky-Holling resilience framework is that stability and stabilisation breed fragility and loss of system resilience . TBTF protection and the moral hazard problem is best seen as a subset of the broader policy of stabilisation, of which policies such as the Greenspan Put are much more pervasive and dangerous.
By itself, stabilisation is not sufficient to cause cronyism and rent seeking. Once a system has undergone a period of stabilisation, the system manager is always tempted to prolong the stabilisation for fear of the short-term disruption or even collapse. However, not all crisis-mitigation strategies involve bailouts and transfers of wealth to the incumbent corporates. As Mancur Olson pointed out, society can confine its “distributional transfers to poor and unfortunate individuals” rather than bailing out incumbent firms and still hope to achieve the same results.
To fully explain the rise of crony capitalism, we need to combine the Minsky-Holling framework with Mancur Olson’s insight that extended periods of stability trigger a progressive increase in the power of special interests and rent-seeking activity. Olson also noted the self-preserving nature of this phenomenon. Once rent-seeking has achieved sufficient scale, “distributional coalitions have the incentive and..the power to prevent changes that would deprive them of their enlarged share of the social output”.
SYSTEMIC IMPACT OF CRONY CAPITALISM
Crony capitalism results in a homogenous, tightly coupled and fragile macroeconomy. The key question is: Via which channels does this systemic malformation occur? As I have touched upon in some earlier posts [1,2], the systemic implications of crony capitalism arise from its negative impact on new firm entry. In the context of the exploration vs exploitation framework, absence of new firm entry tilts the system towards over-exploitation1 .
Exploration vs Exploitation: The Importance of New Firm Entry in Sustaining Exploration
In a seminal article, James March distinguished between “the exploration of new possibilities and the exploitation of old certainties. Exploration includes things captured by terms such as search, variation, risk taking, experimentation, play, flexibility, discovery, innovation. Exploitation includes such things as refinement, choice, production, efficiency, selection, implementation, execution.” True innovation is an act of exploration under conditions of irreducible uncertainty whereas exploitation is an act of optimisation under a known distribution.
The assertion that dominant incumbent firms find it hard to sustain exploratory innovation is not a controversial one. I do not intend to reiterate the popular arguments in the management literature, many of which I explored in a previous post. Moreover, the argument presented here is more subtle: I do not claim that incumbents cannot explore effectively but simply that they can explore effectively only when pushed to do so by a constant stream of new entrants. This is of course the “invisible foot” argument of Joseph Berliner and Burton Klein for which the exploration-exploitation framework provides an intuitive and rigorous rationale.
Let us assume a scenario where the entry of new firms has slowed to a trickle, the sector is dominated by a few dominant incumbents and the S-curve of growth is about to enter its maturity/decline phase. To trigger off a new S-curve of growth, the incumbents need to explore. However, almost by definition, the odds that any given act of exploration will be successful is small. Moreover, the positive payoff from any exploratory search almost certainly lies far in the future. For an improbable shot at moving from a position of comfort to one of dominance in the distant future, an incumbent firm needs to divert resources from optimising and efficiency-increasing initiatives that will deliver predictable profits in the near future. Of course if a significant proportion of its competitors adopt an exploratory strategy, even an incumbent firm will be forced to follow suit for fear of loss of market share. But this critical mass of exploratory incumbents never comes about. In essence, the state where almost all incumbents are content to focus their energies on exploitation is a Nash equilibrium.
On the other hand, the incentives of any new entrant are almost entirely skewed in favour of exploratory strategies. Even an improbable shot at glory is enough to outweigh the minor consequences of failure2 . It cannot be emphasised enough that this argument does not depend upon the irrationality of the entrant. The same incremental payoff that represents a minor improvement for the incumbent is a life-changing event for the entrepreneur. When there exists a critical mass of exploratory new entrants, the dominant incumbents are compelled to follow suit and the Nash equilibrium of the industry shifts towards the appropriate mix of exploitation and exploration.
The Crony Capitalist Boom-Bust Cycle: A Tradeoff between System Resilience and Full Employment
Due to insufficient exploratory innovation, a crony capitalist economy is not diverse enough. But this does not imply that the system is fragile either at firm/micro level or at the level of the macroeconomy. In the absence of any risk of being displaced by new entrants, incumbent firms can simply maintain significant financial slack3. If incumbents do maintain significant financial slack, sustainable full employment is impossible almost by definition. However, full employment can be achieved temporarily in two ways: Either incumbent corporates can gradually give up their financial slack and lever up as the period of stability extends as Minsky’s Financial Instability Hypothesis (FIH) would predict, or the household or government sector can lever up to compensate for the slack held by the corporate sector.
Most developed economies went down the route of increased household and corporate leverage with the process aided and abetted by monetary and regulatory policy. But it is instructive that developing economies such as India faced exactly the same problem in their “crony socialist” days. In keeping with its ideological leanings pre-1990, India tackled the unemployment problem via increased government spending. Whatever the chosen solution, full employment is unsustainable in the long run unless the core problem of cronyism is tackled. The current over-leveraged state of the consumer in the developed world can be papered over by increased government spending but in the face of increased cronyism, it only kicks the can further down the road. Restoring corporate animal spirits depends upon corporate slack being utilised in exploratory investment, which as discussed above is inconsistent with a cronyist economy.
Micro-Fragility as the Key to a Resilient Macroeconomy and Sustainable Full Employment
At the appropriate mix of exploration and exploitation, individual incumbent and new entrant firms are both incredibly vulnerable. Most exploratory investments are destined to fail as are most firms, sooner or later. Yet due to the diversity of firm-level strategies, the macroeconomy of vulnerable firms is incredibly resilient. At the same time, the transfer of wealth from incumbent corporates to the household sector via reduced corporate slack and increased investment means that sustainable full employment can be achieved without undue leverage. The only question is whether we can break out of the Olsonian special interest trap without having to suffer a systemic collapse in the process.
- It cannot be emphasized enough that absence of new firm entry is simply the channel through which crony capitalism malforms the macroeconomy. Therefore, attempts to artificially boost new firm entry are likely to fail unless they tackle the ultimate cause of the problem which is stabilisation [↩]
- It is critical that the personal consequences of firm failure are minor for the entrepreneur – this is not the case for cultural and legal reasons in many countries around the world but is largely still true in the United States. [↩]
- It could be argued that incumbents could follow this strategy even when new entrants threaten them. This strategy however has its limits – an extended period of standing on the sidelines of exploratory activity can degrade the ability of the incumbent to rejoin the fray. As Brian Loasby remarked : “For many years, Arnold Weinberg chose to build up GEC’s reserves against an uncertain technological future in the form of cash rather than by investing in the creation of technological capabilities of unknown value. This policy, one might suggest, appears much more attractive in a financial environment where technology can often be bought by buying companies than in one where the market for corporate control is more tightly constrained; but it must be remembered that some, perhaps substantial, technological capability is likely to be needed in order to judge what companies are worth acquiring, and to make effective use of the acquisitions. As so often, substitutes are also in part complements.” [↩]
In a recent article, John Kay discovered the temptations of negative skewness, even for non-bank investors. Although some may label this irrational or even a scam, seeking out negative skewness may be entirely rational in the presence of policies such as the Greenspan/Bernanke Put that seek to avoid tail outcomes at all costs. The product that John Kay describes is a equity reverse convertible bond with an auto-call feature and European barriers. A cursory internet search shows that atleast in Europe, these products are not uncommon and most are not dissimilar to the specific bond that he describes:
“If the FTSE index is higher in a year’s time than it is today, you receive a 10 per cent return and your money back (no doubt with an invitation to apply for a new kickout bond). If the FTSE has fallen, the bond runs for another year. If the index has then risen above its initial level, you receive your money back with a 20 per cent return. Otherwise the bond runs for another year. And so on. The race ends – sorry, the investment matures – after five years. If the FTSE index, having been below its initial level at the end of years one, two, three and four, now lies above it, then bingo! you get a 50 per cent bonus.
There is, of course, a catch. If you miss out on the five-year jackpot the manager will review whether or not the FTSE index ever closed at more than 50 per cent below its starting level. If it hasn’t, then you will get back your initial stake, without bonus or interest. If the index breached that 50 per cent barrier your capital will be scaled down, perhaps substantially.”
The distribution of returns of this bond is negatively skewed: In return for taking on a small probability of a significant loss (if equities fall by 50%), the investor is compensated via a highly probable but likely modest profit – it is probable that the investor only gets his principal back and the most probable profitable scenario is redemption in one year with a return of 10%.
But if the investor takes on a negatively skewed payoff, doesn’t the bank by definition take on a positively skewed payoff? And does that not invalidate my entire thesis on moral hazard? No – In fact, structured products which provide negatively skewed payoffs to bank clients frequently allow banks to take on negative skewness. Banks do not simply hold the other side of the bond – they dynamically hedge the risk exposure of the bond and it is this dynamically hedged exposure that has a negatively skewed payoff.
Dynamic hedging differs from static hedging in that the hedges put in place need to be continuously rebalanced throughout the life of the transaction. Most banks restrict their hedging to first-order and second-order risks such as delta, gamma, vega etc and only rarely hedge higher order risks. How often this rebalancing needs to be done depends on the stability of the risks themselves (how stable the risks are with regards to movements in the market and movements in time) and the realised movements in the market itself. At the extremes, a product with stable risks in a stable market environment will require only infrequent rebalancing of the hedge and a product with unstable risks in an unstable market environment will need to be rebalanced often. In a world without transaction costs and slippage, none of this matters. But in the real world, increased slippage costs dramatically reduce the profitability of a dynamically hedged structured product when markets are unstable and/or the tenor of the product increases.
For many structured products such as the auto-call reverse convertible, the risk exposure of the dynamically hedged position is as follows: a high probability of a stable and/or short lifespan combined with a small probability of an extremely unstable and long lifespan. Typically, the bank would hedge the delta and vega of the bond sometimes utilising out-of-the-money puts and calls to replicate the skew exposure. In most probable scenarios, the risk exposure of the dynamically hedged position is fairly stable. If the market simply goes up and stays there, the bond redeems with a 10% return after one year and the hedge would have to be rebalanced very few times in a smooth manner. If the market simply goes down significantly, the risk exposure simplifies into one resembling a put option owned by a bank. But what if the market goes down a little bit and stays there? Or even worse, what if the market goes down dramatically and then reverses course in an equally swift manner but stops short of the redemption level? It is not difficult to visualise that in some scenarios, the losses due to slippage can quite easily swamp the profits and fees made at inception.
The losses are exacerbated as it is precisely in these unstable market conditions when hedges need to be rebalanced frequently that transactions costs and slippage spiral out of control – the bank then faces the option of running the risk of an unhedged position or locking in a certain and significant loss. Although many traders would argue that remaining unhedged is the more profitable strategy (sometimes correctly), senior managers almost always choose the option of locking in a known loss even if it wipes out the past profits of the business. Moreover, the oligopolistic nature of the market and the homogeneous “same-way” exposure of the banks implies that all market participants will need to hedge at the same time in the same manner. The execution of such hedging itself may also affect the fragile fundamentals of the related market in a reflexive feedback loop.
The simplistic argument against TBTF banks owning a derivatives business is as follows: bankers accumulate large positions of a long tenor yet get paid bonuses based on annual performance. If the positions accumulated in this manner blow up afterwards, the bank and often the taxpayer is left holding the can. Banks counter this argument by pointing out that these positions are typically hedged. In a world of static hedging, this may be an acceptable argument. But in a derivative book that needs to be dynamically hedged, the argument falls apart. Most existing books of dynamically hedged derivative positions are a negative NPV asset if the likely slippage in future market disruptions is incorporated into their valuation, especially if these slippages are computed over the “real” distribution rather than a “normal” one. Warren Buffett found this out the hard way when Berkshire Hathaway lost $400 mio in the process of unwinding General Re’s derivatives book even though the unwind was executed in the benign market conditions of 2004-2005 and Gen Re was only a minor player in the derivatives market.
Even in a calm market environment, most long-tenor dynamically hedged positions are marked significantly above their true NPV net of expected future slippage. In the good times, this dynamic is hidden by the profits that flow in from new business. But sooner or later, the negative dynamics of the book (the “stock”) overwhelm the profits on the new business (the “flow”) especially as the flow of new deals dries up. And when the bank in question is too big to fail, it is not the stockholder or the retail investor but the taxpayer who will ultimately foot the bill.