What They Do with Your Money
I have long been fascinated by the history of Chinese workers saving their money, then depositing it in banks where they earned little or no return but were promised safety. The banks invested their money overseas, effectively lending to foreign consumers so they could buy goods manufactured in China. This cycle, virtuous as long as it lasted, was temporary. Eventually Chinese savers would realize that they could do better, and they invested directly in their own local equity and property markets as these developed. By 2000, there were more individual shareholders in China than members of the Chinese Communist Party.
Then beginning in June of 2015, individual investors in the Chinese stock market received a nasty shock as the value of their shares fell by a third. So changing tack, they invested in real property, and now that market is overheated as well–the world awaits the pop of another asset bubble. Citizens weren’t warned or protected against losses in the stock market (in fact they were encouraged to buy) and undoubtedly some will be losers in real estate as well. Many have pointed to institutional and regulatory weakness in a rapidly developing economy as the cause of these growing pains. But are developed markets any different?
Let’s look at the United States, still the world’s largest economy, without Chinese socialist characteristics and state control. As a result of the 2008 Financial Crisis, many Americans suffered losses to both their real estate and equity portfolios. When this happens as a result of market shifts, well, a market by definition produces winners and losers. But what if the game is rigged? This is the central question, and not just about financial markets. It casts a shadow over political institutions as well in the most extraordinary election in recent US history. And make no mistake, whoever wins the Presidency, doubts and distrust will remain, and in fact are likely to intensify in a world of increasing income inequality.
To answer this question, there could be no timelier nor more relevant discussion than in the pages of a new book, What They Do with Your Money, How the Financial System Fails Us and How to Fix It by a triumvirate of authors, Stephen Davis at Harvard Law School, Jon Lukomnik at the Investor Responsibility Research Center and David Pitt-Watson, a shareholder activist now at the London Business School. They take particular aim at financial managers, the people who manage other people’s money:
We think we’re hiring expertise, but what we are really buying–expensively–is luck. The most rigorous studies suggest that over more than a century, the financial system has plowed back any productivity gains to serve itself rather than us…
Despite its reputation for employing the best and the brightest the finance industry is inefficient. Since the time of the railroads, over the past 130 years, when other industries have generated huge increases in productivity for their customers, the finance sector has generated none at all.
This is a really big idea, and it deserves a chart to show comparative changes in productivity in various industries and countries over the past century.
Putting this into perspective, the authors describe how over time individual savings were gathered to create a pool of capital that is now $85 trillion dollars. This was the genesis of the financial services industry, whose job it is to invest this money productively so that savers receive a return on their investments. They do not believe that professional managers have been earning their keep.
The book claims that the industry is riddled with perverse incentives, and is overly reliant upon models and algorithms. Their solution to protect investors is “a return to the the basic tenets upon which successful financial systems depend” including transparency, governance, and correctly aligned incentives. Their approach is legal and ethics-based, calling for common sense rather than economic prescriptions. The book certainly takes aim at economists, quoting both Frederich Van Hayek’s warning against imitating the physical sciences, and John Kenneth Galbraith dictum “The pretention of economics that it is a science is firmly rooted in the need for an escape from blame…”
Amusingly, using Queen Elizabeth as an example of everyman who cannot understand why economists did not predict the crisis of 2008, the authors ask:
So what is missing? How might we reform economics so that it handles the critical questions to which we need answers? How can we think about the financial system in a way that might give us early warning of the next crisis and help the system improve its productivity and hence its contribution to our welfare?
This goes to the heart of their argument, which is that economists and institutions such as the IMF failed not because they didn’t understand markets or were poorly regulated, but that fundamentally they did not understand risk. Market participants thought that risk followed normal distribution patterns and that for example, extreme events were extremely unlikely and moreover, were predictable within a range and could be dealt with if they did occur, through regulation. This is another big idea which deserves further discussion and the reader’s attention.
Underlying this provocative and iconoclastic book is a questioning of the basic tenants of capitalism itself. Against a backdrop of a slow growth, low return global economy with unforeseen geopolitical risks, where approximately 15% of all assets are now earning negative interest rates, how can capitalism survive? What are the incentives for savers? The authors laud more direct ownership and participation by investors, and look to technology to provide some of the answers by creating access to information. Their suggestion to tax capital gains at decreasing rates based upon the time an asset is held is intriguing, as is the suggestion that allowing capital losses to be deducted against ordinary income would encourage more investments by offsetting risks.
The authors feel that absent active and more direct ownership of assets, capitalism and the financial services industry will fail, its weaknesses revealed by the Global Financial Crisis. I believe that the issue is more fundamental, that the absence of cost of capital in the present environment is the clearer, more present danger to investment and growth worldwide.
Moreover, capitalism began with the rise of modern manufacturing, which required investment in facilities and equipment, all slowing today. As manufacturing becomes diffused through innovations such as 3-D printing, will the financial system be able to adjust? As Fintech takes hold, it could be that we are on the verge of finally achieving productivity gains in the investment world.