Wednesday Night #1431

Economy wonks and wonky economics
photos and more on Wednesday-Night.com

Prelude
New guests were introduced, Eric Fisher, an entrepreneur in technology and President of iDeal Networks; John Molson School of Business Associate Dean of Research, and Van Berkom Chair in Small-Cap Equities, Professor Lorne Switzer ; and David Rudin of Hart House (University of Toronto), whose reputation as a debater is formidable (he was one of the directors of the 2009 U of T High School Tournament).

Westmount Mayor Karin Marks will not run again
Mayor Marks  has devoted some 18 years to Westmount politics and deserves a life. Her departure without endorsing any candidate will pose a dilemma for Westmount where, for at least the last 6 elections, the mayoralty has been won by acclamation. Thus, there is no process in Westmount to accommodate what will no doubt be a hotly-contested election.

Market rally – for the wrong reasons?
This mini-Bull Market is ignoring totally everything that is happening outside the Market. A number of people who made money by selling as the market declined are slowly adding to their positions. The market will therefore likely go higher. Commodities are late-cycle events, therefore Toronto is lagging.
One economist believes that the fact that corporate profits are up because of cost-cutting based on increased unemployment is a clear indication that we are still not addressing the underlying causes of the financial crisis. Another decries the immorality of a model that rewards the  ‘quants’ and salesmen rather than the inventor, venture capitalist and worker whose efforts have created the object sold (or the stock in the company).  The technicians’ view is that even random events cluster to create cycles and point to previous recoveries to illustrate that historically, cost-cutting is a good news event and ‘jobless recovery’ is not a new phenomenon. The response:  many ‘random” events are in fact forecastable; there is a difference between things that have not been forecast and things that cannot be forecast.   On the other hand, it appears that financial models do not take sufficient account of the Pareto principle or  80-20 rule , which posits that for many events roughly 80% of the effects come from 20% of the causes.  But, argues another of our economists, we still need to pay more attention to causes; if we do not fully understand what happened, then we cannot ensure that it will not happen again.

Economics, economists and the economy
While it is easy to reject certain aspects of the market economy – like democracy in Winston Churchill’s famous quotation, it is the worst system except for all the others – it has so far been impossible to create viable alternatives

There is a fundamental fact of life that says that short-term interest rates are lower than long-term interest rates. Thus, it is tempting to borrow short and lend long – this explains banks. And, for those who remember, there was a banking system in Canada known as the 3-6-3 system (the classic little old lady depositor received 3%; the banker lent it out at 6% and at 3 o’clock, he went out to play golf).  Three percent may not have been an exciting return, but it was earned on someone else’s money.  Although this appears to be a riskless operation, in fact there were a number of banking crises in the 19^th century either because borrowers couldn’t repay, or the depositors wanted their money back. The solution was the establishment of a Central Bank (the Dutch in the 17^th century and the British in the 19^th the U.S. Federal Reserve after the Panic of 1907 ) to bail out solid but illiquid banks. Once Central Banks, Reserve requirements and eventually Deposit Insurance were established, the economics profession broadly assumed that aside from glitches, the banking system would look after itself.  So macroeconomics became the study of employment, actual output/potential output, economic growth, etc.

What was overlooked was that bankers are clever people – or they can hire clever people . Soon, they devised methods to have access to money that did not come from the general public but was short-term money that could be borrowed on paper from pension funds, insurance companies, corporate treasuries.

Once they borrowed short, they loaned long (mortgages) and when the situation became worrisome, they created mortgage-backed securities, removing them from the balance sheet and taking the profits on someone else’s risk. Adding to the problem were the people who sold insurance (which under American law could not be called insurance as it would then be regulated by the states), or swaps and later credit default swaps (CDS)  [see also] – and all of the complex derivatives that together created  a nightmarish and highly complex form of Ponzi scheme. Had the government not bailed out AIG , it is highly possible  that the entire financial structure would have collapsed, not just Lehman. The problems that arose from the swaps lead some to believe that a form of regulation regarding the banks’ sources of funds should be applied to institutional sources as they are applied to the individual depositor. More on banks’ funding needs

Where did the science of economics go wrong? In one economist’s view, there are two answers. First, – and in line with some of Jeremy Bentham’s theses  – that economists did not take sufficient account of psychology and culture in the nature of supply and demand and consumer behavior. Second, that economists failed to recognize how the behavior of X affects the behavior of Y – similar to the Heisenberg effect, whereby the actor/observer influences other actors/alters what is being observed.
We also cannot ignore the role of the G.W. Bush White House, which failed to respond  to many warnings with respect to weaknesses in the business models and the system, and fiscal imbalances, and blocked any significant change to the system.

Incentives, planning and time frames
The bottom line is that economists have a duty to re-examine incentive structures in the economy. Why are executive bonuses tied to short-term performance? So far no-one has designed a system that can measure the long-term performance of an executive and reward people 30 years later when the impact of their performance can be judged correctly. Given that today’s executives will certainly not be employed by the same company and likely not even the same industry, how could the bonus be devised?
There is no incentive to take the long view. Investors demand ever higher returns (not only motivated by greed, but also driven by the demographics and needs of a growing population of retirees for a higher cash flow which creates a demand for income trusts, derivatives, etc.).   In response, companies plan only for the short term gain. CEOs, who are often in their job for two or three years do not fulfill their most important role of long-term planning. Transparency and governance are lacking. What is really in the shareholder’s interest rather than that of the executives?  Shareholders also have a responsibility to inform themselves and especially on matters of executive compensation.
Institutional time frames dictate certain behaviors – if the institutional perspective is short term, then long-term planning is impossible.
One might also question whether democracy  is really suited to long-term thinking? Governments – particularly minority governments – are subject to political timeframes imposed by the need/desire to be re-elected.   Consequently, today the only long-term planning is done by the military or security departments. This has led to the securitization of the climate debate.

I N V I T A T I O N

UPDATE A timely announcement on ABCPs (one of Tony’s favorite topics)  will no doubt add fuel to the discussion
ABCP ACCOUNTS NAMED
A group of aggrieved retail investors seeking redress from securities regulators in the wake of the collapse of the $32-billion asset-backed commercial paper market has accounts with some of the country’s largest bank-owned investment dealers and two independent brokerages, sources say.

At the suggestion of Tony Deutsch, who comments “This article below is pretty good. The only thing I would add is that the finance models are all retrospective, while the decisions they are supposed to facilitate are prospective” – and under his guidance – this Wednesday, we propose the topic recently raised and thoroughly examined by the Economist, and a few related pieces.

WARNING: There is homework for this evening – at least for most of us. But though the topic is serious, with Tony to lead the discussion, we know it will be amusing as well as informative, and relevant to all with investment portfolios, pensions and/or financial management responsibilities.

The questions are introduced in WHAT WENT WRONG WITH ECONOMICS
OF ALL the economic bubbles that have been pricked, few have burst more spectacularly than the reputation of economics itself. A few years ago, the dismal science was being acclaimed as a way of explaining ever more forms of human behaviour, from drug-dealing to sumo-wrestling. Wall Street ransacked the best universities for game theorists and options modellers. … In the wake of the biggest economic calamity in 80 years that reputation has taken a beating. In the public mind an arrogant profession has been humbled.

Following that introduction, there is a choice — Tony believes we should separate the two topics by several weeks – so you may vote on which comes first: He reminds us that “The macro topic is an update for them who once took intro Economics, and retained an interest. The finance topic is for them who still wonder why so much money (presumably including theirs) was lost by all those nerds in thick glasses.”
Either we may pursue Efficiency and beyond and the debate between proponents of the efficient-markets hypothesis (EMH) that has underpinned many of the financial industry’s models for years, and those who espouse behavioural economics This will lead us along the path of financial engineering, complex derivative and other products, opinions of such as Nobel economics laureates Joseph Stiglitz and Myron Scholes and the debate about how bubbles are created – heady stuff!
Alternatively, there is the ‘turmoil among macroeconomists’ who are hurling scholarly (‘ancient and basic analytical errors’) and not-so-scholarly (‘truly boneheaded arguments’) insults across academia’s ether. As the article concludes: “Economists were deprived of earthquakes for a quarter of a century. The Great Moderation, as this period was called, was not conducive to great macroeconomics. Thanks to the seismic events of the past two years, the prestige of macroeconomists is low, but the potential of their subject is much greater. The furious rows that divide them are a blow to their credibility, but may prove to be a spur to creativity.”

Tony also suggests as a companion piece David Brooks’ column Wise muddling through, adding “this plays right into the point in The Economist article that there is no usable Macro model”

For fun we might also address the thorny dilemma regarding ‘bailout politics’ and poster child Andrew J. Hall’s $100 million bonus

A propos pension funds, read about the plight of Harvard’s endowment fund Rich Harvard, poor Harvard. A highly relevant story was published in the Harvard Crimson in March of this year: “Analyst says she was fired for criticizing controversial investment practices”. Finally, in the department of the Law of Unintended Consequences, Barron’s reports that the IRS is starting to investigate university compensation practices for in-house and third-party endowment managers – seems that Harvard may have been too clever by half.