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Friday, 20 January 2012

Vigorous Capitalism

In another brilliant instance of intelligent capitalism in operation, Warren Buffet has taken advantage of herd irrationality by so-called professional investors in the UK. He has bought another 2% of the shares in Tesco [increasing his holding to 5%] at a time when the shares had fallen by around 15% in price because of a single set of bad trading results.Buffet is famous as a long-term investor in companies whose future prospects meet criteria that have been formed in his extremely well-developed mathematical brain. Most of his punts have been proven successes; and sometimes the success has been secured by him reinforcing his investment by buying shares in a company, or lending money to it, when it has hit a temporary bad patch on its growth path.

Who are the idiots who sold shares in sufficient numbers to depress the price by a huge percentage, on so thin a pretext? Not small-scale personal investors: most such people take a similar long-term view to Buffet's. They are mostly professional investors, buying and selling shares for institutions - pension funds, insurance reserves, investment trusts, charities etc - who possess degrees and professional qualifications [many of them in 'actuarial science'] and supposedly have experience that enables them to make intelligent decisions. Why, then, did a large number of them offload shares in Britain's most-successful-ever retailer in huge volume on a single report, and despite the fact that the company made clear that it understood and was already addressing the causes for the relatively poor performance? Some did so like automata because the funds that they managed were committed to 'track' the stock-market index. Some saw the price going down and joined the rush. A few may have been quick-moving opportunists who sold as soon as the price began to fall so that they could use the money to buy more shares at a lower unit price in a few days [or even a few hours] time. The combined effect of their selling was to give Buffet a great opportunity.

Friday's news also included the item that the Chinese sovereign wealth fund has bought 8.68% of the shares in Thames Water. This means that users of water and sewerage supplied by Thames will be paying tribute to investors in China, as well as in Abu Dhabi and Australia; who will also be able to exploit loopholes in UK water regulation to increase the dividends that they receive by increasing the debt that the water company and its customers will have to carry in future and cashing-in on such deals.

In the first case supposedly clever professional investors were the mugs, in the second a massive disadvantage to British consumers was created by Parliament and its advisers when they privatised the water industry. In both cases intelligent foreigners took advantage - quite legally - of dysfunctional systems.

Also on the same day the press reported a speech by a senior Bank of England official who suggested that international accounting standards [that were created by a forceful Scottish 'expert'] had not 'stood the test of time' and had almost certainly added to the misunderstanding of the credit bubble and the exaggerated assessment of the calamity that followed the crunch. This is because the standard assumed that there was a 'fair value' of any asset that was magically equal to the market price of the small sample of similar assets that were actually sold on any day. The sublime idiocy of such a notion was unnoticed all through the process by which it was adopted by international regulatory structures. Hence it was strangely appropriate that on the same day both the British Prime Minister and the Leader of the Labour opposition should make speeches on how to transform a much-criticised form of capitalism into a 'responsible' system that would guarantee prosperity and 'fairness' for all. The both suggested [in different terms, but with similar aspirations] that markets were the best way to generate wealth and to distribute it fairly among the population, provided that markets were regulated properly. There is a germ of truth in this assumption.

No market has ever succeeded in a vacuum: markets only work if they are interconnected with the rest of the economy: they need buyers to enter with purchasing power that was gained outside that market, and in it the sellers offer produce which incorporates components [including inputs by autonomous human beings] that are attracted from outside the market. No market has ever been free of crooks and liars and predators: people who decide that they can gain personal advantage by bending or breaking the rules that the other buyers and sellers assume everyone in the market is following. No market has ever been composed - and no market will ever be composed - of participants with exactly equal intelligence, the same ethical principles, identical capital resources, and identical access to all the same data as all the others [about their specific market and about the prevailing economing conditions and about prospective changes] which they all interpret in exactly the same way. So the assumptions about 'perfect competition' that set the criteria for formal market theory in Economics are utter balderdash; and any attempt to regulate markets as if they can be compelled to conform to the theory are doomed to fail.

So when the politicians step down from their podiums and ask their civil servants how on earth they can give effect to the high-blown [loudly applauded] rhetoric about 'responsbile capitalism' they get an answer in two parts: both of which are wrong.

The first part of the answer is to look for some well-publicised cases of 'unfairness', some individuals who are paid vastly more than the norm for employees in the country, and suggest that their income should be capped - or even reduced - at source, and then subjected to confiscatory taxation. In the last couple of days the media and some politicans have picked on Stephen Hester, the Chief Executive of the Royal Bank of Scotland; and they have suggested that he should not receive the income to whch he is entitled under his contract. He was brought into the bank, from a good job elsewhere, to pull it away from the catastrophe into which its former managers had dragged it. Because it was a state-supported institution in crisis, Hester patriotically accepted an unusually modest salary for a bank Chief Executive, to which was attached a bonus scheme if he achieved certain steps to assist the recovery of the business. Now the 'gutter press' and some policy-making fools are suggesting that the state should order the Royal Bank of Scotland to welsh on the contract, to appease public anger at the fact that some people in other banks whose functions are not understood by the policy advisers [and even less by the press] are getting much more than Hester; mostly as bonuses for proprietary trading.

The second string to the advice offered to politicians is much more long term than the scalp-hunting of individuals. It is to 'enhance' the system of regulation within which markets should be constrained. The phrase 'risk-based regulation' has recently been in high fashion but very few people in business have understood the concept. Business men and women well understand risk: they take risks on their own behalf and that of their firms every day: those who have the sharpest appreciation of both opportunity and risk are usually the most successful in planning investments and avoiding losses. It is now considered necessary to determine what categories of  risk the regulators should require companies to avoid, or to mitigate if they cannot be eliminated if they must necessarily be accepted to enable the operation to continue. Some policy advisers have reached deep into formal Economics and suggested that regulators should compute the future long-run average cost of producing the output and require the price regime to converge with the assumed future cost. Provided the generality of firms in the market are moving towards convergence of prices around equality with the average cost at a selected future date, the market should be allowed to operate freely. The theory predicts that firms whose prices rise above the trend will fail to secure customers because rational consumers will buy cheaper alternatives. Similarly the theory predicts that firms that charge below cost price will bankrupt themselves. The firms that charge prices broadly in line with average cost of production [including a fairly-calculated 'cost of capital' that is the same for every firm] are good: the market will eliminate the others.

Such a model ignores branding, and therefore ignores the predominant determinant of 'value' in the perception of the vast majority of global consumers. Any attempt by regulators to impose such a naive theory would be ruinous to the real economy. But the concept of regulating to aim for average long-term cost pricing is presented on the political agenda because it is the one idea that people trained in Economics can think of in the present circumstances: old-hat Victorian marginalism is presented as the new panacea. My simple text PPE explains this point in depth. Such regulation as is now being advocated would transform the present economic crisis into an unmitigated calamity.

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