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Friday, January 15, 2010

I've got something to say about executive pay, China, Google, the GFC and Economics.

I recommend a read of "Against the Gods, The Remarkable Story of Risk" to get a good idea of what risk is and how it's been manipulated to form value over the ages. It's a boring book, but a fairly quick way of getting your head around the issues. Then read the paper: The “Other” Imbalance and the Financial CrisisRicardo J. Caballero1December 14, 2009. You could also follow this link to a simple classroom experiment showing the generation of wealth in a market.

Caballero reapportions blame away from "sub prime", lending/saving imbalance, putting the blame towards the demand for "safe" investment assets. It might seem a clever bit of hand-waving, but adding this dimension does bring some predictive power that the commonly held position didn't.

Firstly, let's talk about what the GFC wasn't/isn't caused by. The GFC isn't caused by big pay checks and bonuses for "fat cats" at the "big end of town". The GFC wasn't about boguns borrowing more than they could afford. The GFC wasn't caused by poor legislation or lazy regulation. All of these were factors in establishing the environment for the GFC, but were any of these the cause (in isolation, or combined), we'd have seen a GFC long long ago, and it would be constantly ongoing. None of these factors have substantially changed in the recent past.

Secondly, let's mention what should have happened according to standard economic theory: meltdown. There should have been a massive, comprehensive and paralysing cessation in credit from the big creditors (China) to the big borrowers (USA). This didn't happen. That this didn't happen is telling. There is something else at play. The market demand for AAA investments increased through the crisis. There was a "flight to quality" which artificially inflated the value of land (artificially buoying the AAA rating of some tranched products, enhancing the sub-prime problems). This counter-intuitive bubble in property is also symptomatic of the problem of a massive market imbalance caused by risk aversion in the big lending economies. The core idea is that there's a huge market demand for safe (AAA) investments, and not enough supply. The complex and ethically suspect tranched "sub-prime" products are a symptom of the market attempting to innovate towards satisfying the demand. There are plenty more financial products which we could point to which hid risk in complexity, but the sub-prime example is easy to use because it's so emotionally loaded. Executive pay and fat-cat bonuses are similar dog-whistles for the GFC. But neither adds up to a tipping point.

China is rapidly developing into a functioning engine for the world economy. The Chinese people are saving vast amounts of money. Chinese sovereign funds are being used conservatively around the world. But internal to China, where are the AAA assets? Why did the Chinese monies "flight to quality" go towards US AAA products, and not into Chinese AAA investments? It's telling that China's market, when things get titchy, doesn't circle the wagons. It flocks to get the wealth outside of China. After all the growth, with all the pride, all the protectionist advantages, why this flight?

Right down at the very bottom of this pile of dog's breakfast is uncertainty. Where "risk" is measurable, uncertainty is not (Knightian uncertainty). The degree to which uncertainty can be converted to risk determines the degree to which risk can be responsibly assumed. AAA ratings are determined by measuring risk. These measurements are based on any number of "constants" and common "units". "Constants" and "units" require economic history, consistency, and transparency. China has the luxury of none of these attributes. There is no market history, no regulatory consistency, and certainly no transparency.

China is attempting the experiment of retaining a "command economy of ideas" while granting a higher degree of control of the money economy to the market. Where the founding fathers of western capitalist economies joined ideas like free press and freedom of association with the free market, China keeps them divorced. This is not a proven path. It has never been done on this scale. In my opinion it's akin to giving the kids the keys to the car, but not allowing them to learn to drive first. And now we're on the road with them, all one billion.

Until China develops and publishes their business API, the interface by which outsiders can do business in China, there will be few AAA assets developed in or by China. Until China is able to produce AAA assets in numbers roughly equal to their demand for them, there will be a great imbalance. Another path, even less likely, is Chinese capitalists assuming greater risk (higher risk asset). But this would require a broad cultural change. I don't see that in the offing.

The blame usually falls on western countries for providing the, obviously in hindsight, overly complex and poorly engineered AAA assets. But those organizations were trying to feed a demand. Had they not attempted to feed that demand the inequity would have shown up sooner. And that may have been subtly worse. Had the well run dry for China 5 or 10 years earlier, we may have seen their growth halt before they really had enough momentum to bridge the gap themselves.

It's almost impossible to tell "what could have been". But it's important to get beyond the simple populist explanations for the GFC, to dig a bit deeper, to include ideas beyond greed, money and regulations. This crisis has shown the vital role ideas like freedom and liberty play in a functioning economy. Freedom and liberty are the minders of Rule of Law, allowing for the frank and open discussions required to refine the laws. And without effective Rule of Law in China we'll continue to suffer from the hollowing effects of their apparent growth. Very risky times ahead. It's scary seeing the direction things are headed with so little we can do to change it.

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