• Stuart Fowler

The future of capitalism: much like its past

The self-destruction of a large part of the equity capital of many of the world’s leading banks, requiring taxpayers to step in and refinance them, is enough to make people think that the capitalist system itself cannot continue unchanged. Many of the broad sheets, plenty of bloggers and all the usual anti-globalisation suspects have therefore been asking momentous questions about the future of capitalism.

This is a bit silly, not because the adjustments to the crisis will not be extraordinary but because the different national versions of the market economy are by nature adaptive systems, like religions, reforming in the light of changing social and political demands.

To the extent the public reactions to the crisis are already relatively well-formed, the changes likely to be imposed on the workings of the market economy are probably easily predictable and are mainly technical, to do with financial regulation and the future conduct of monetary policy. The adjustment process will push up government spending everywhere but more so in leftward-leaning governments like America. But even that may not permanently raise the proportion of government spending and transfer payments in already mixed economies. The major unknown is the extent to which governments resort to both protectionism and competitive devaluations. But even these are not terminal for capitalism and will contain the seeds of their own eventual rejection and reversal.

Darwinian economics Mercantile capitalism gave way to mixed economies, combining socialist redistribution with incentives to wealth creation through businesses great and small. The spread of Bolshevism through European capitals was enough to bring the first world war to an end, where at one stage no end was in sight. Successive world wars for ever changed the social order that once preserved capital in the hands of a relatively small number of ultra-wealthy families. But the democratisation of capital that we now take for granted also required institutional structures that allowed small investors to gain cheap and easy access to capital markets tax-efficiently.

These changes point to a Dawinian evolution of mixed-economy capitalism. Since the 1950s, in the UK at least, it has barely changed, because society has not wanted it to change further. Indeed, if the pendulum has ever swung too far from the cosy consensus (as marked, for instance, by public spending of about 40% of the total UK economy) a political reaction at the ballot box has led to its prompt reversal.

Versions of the mixed economy vary and those differences have also tended to hold for several decades, such as between the French or Swedish model and the UK model. This in no way validates French Prime Minister Sarkozy’s simplistic description of the anglo-saxon model as ‘laisser faire’ liberalism.

Viewed against this perspective, the political consensus looks likely to condone a massive lurch to higher public spending. Whether this is intuitive or not, people seem to sense that it is a natural role of government to act as a counter weight to the harmful lurches in private-sector spending and investment. Indeed, sector flows and balances mean that if households and companies are trying to strengthen their weakened financial position either or both of foreign trade and government finances must provide the balancing flows. This is not all the same as assuming that the public appetite has somehow shifted to a permanently higher share of public spending for which there is at present no evidence.

On the contrary, it is going to be very difficult for politicians, regardless of whether left or right-leaning, to maintain a public consensus for their own tricky balancing act between temporarily high public spending, higher taxation, high public borrowing and maintaining incentives to the wealth-creating business sector. But the assumption that the public will be looking for that balancing act, and testing its credibility, remains the best forecast.

Technical changes If this analysis is correct and the politics are not fundamentally changing as a reaction to the crisis, the policy changes that do appear on the cards are much more technical in nature and relatively prosaic to laymen. They can be spotted in four areas:

  • Monetary policy

  • Banking regulation

  • Shareholder motivation

  • Market-based accounting

Economists’ judgement of the policy errors that led to the boom and bust are almost unanimous in singling out weak monetary policies, particularly in the USA and particularly in the period after 9/11 when the political imperative appeared to shift to avoiding recession at any price. It is not even necessary to bring in laisser faire bank regulation to explain the expansion of money and credit that fuelled the US housing boom, record low savings and high debt and the leveraging of corporate balance sheets, particularly in private equity. None of these things would have been possible if monetary policy has been much tighter.

That said, the repeal of the Glass Steagall Act that previously separated commercial lending banks and trading investment banks facilitated an explosion of growth in non-traditional lending and trading activities in US banks, at the same time that light-touch regulation and rites of passage from building societies to banks were drawing UK banks into similar unfamiliar activities, typically funded not by stable customer deposits but day to day liquidity in wholesale interbank markets. In the UK, a dangerous experiment in banking itself was aggravated by New Labour’s own policy experiment, removing the prudential role over the banking system of the newly independent Bank of England and handing it to the FSA under a regime of bank regulation that saw different aspects under the aegis of the Treasury itself, the Bank and the FSA.

The banking system blow-up has much in common with the history of investment scandals, which this website regularly refers to. Both are characterised by regulation that errs on the side of fostering product innovation, for fear of being anti-competitive and anti-progress, even though product innovation has been the source of all the scandals.

In this instance the product failures that brought down the banks were partly to do with the underlying product design but also to do with the banks’ measurement of the risks involved, which was both largely self-regulated and heavily dependent on assumptions about the correlations between positions which might appear to be ‘matched’, or netted off, but only on the most simplistic of assumptions. The products mainly involved were credit derivatives and securitised structured products involving both sub-prime mortgages and more traditional receivables.

Several technical enablers outside banking were also required to spread such toxic products so widely: the indiscriminate adoption of an over-simplistic valuation model (even though the reliance made of it was criticised many times by its originator), the failure of rating agencies to provide any independent counter-balance to this extreme form of model risk and software programmes to support high-volume creation and distribution of such structures by banks to non-bank investors.

The whole episode calls into question the readiness of businesses to apply to the new ‘knowledge economy’ the same standards of technical and scientific integrity that we are used to in the old engineering and manufacturing economy.

This does involve regulation, or should have done. In the insurance sector in the UK, our impression is that the FSA is quite intimately involved in the stochastic models used to stress test individual insurers’ balance sheets to ensure solvency but there appears to have been much less involvement in the technical risk management approaches widely used in banking, perhaps because the regulation of banks has become more internationally co-operative than UK insurance regulation.

This clearly has to change and there will probably be a ready consensus between banks’ shareholders, senior management, accounting bodies, governments and regulators themselves.

There is also a clear connection being made between the regime for determining bank capital adequacy and the avoidance of monetary policy errors. This is perfectly logical if the banking system is the means of money creation, not printing presses. The consensus developing here is that capital requirements need to be counter-cyclical, so that loss reserves increase and lending growth slows as economies approach over-heating, and vice versa. When bank balance sheet quantities were the main means of controlling economic activity, which was also a time when bank management acted more prudently to manage shareholder’s risk of failure (such as when many joint stock banks were still significantly owned by either traditional banking families or wealthy regional entrepreneurs), bank balance sheets and monetary policy objectives were far less likely to be in conflict.

The link between shareholder and management interests, but much more widely than just in banks, is another technical change likely to differentiate the period before and after this credit crisis. This is not about changes in rules so much as changes in practice and is all about people learning lessons from the mistakes leading up to the crisis. These changes in practice are likely to involve a rethinking of some fairly important aspects of finance theory. In particular, we think the entire concept of ‘shareholder value’ was far too flakey.

It would be going too far to suggest that new ideas about how to maximise shareholder value, or enterprise value, in some way reshaped capitalism and so equally the abandonment of some of these ideas will also not reshape capitalism.

The last technical change we have identified as a likely policy response to the crisis involves accounting, specifically the practice of valuing balance sheet positions on the basis of direct or indirect market prices, which could be a public-market price, a derivative-based price or an interest or discount rate.

No cosy consensus exists here. Users of valuations, notably our own investment management industry, is passionately and deeply divided over the issue of whether the principle of fair-value accounting is practicable given the obvious fact that the principle of efficient markets is clearly in practice a poor description of how markets actually behave. The problems are greatest when the principle, which assumes fair value can only be established between willing buyers and sellers, is clearly inconsistent with the reality that in the absence of liquidity market price discovery is either impossible or whatever transactions are occurring are between willing buyer and forced seller.

Forget the arguments, this one will be determined by political expediency. In the US, fair value accounting has already been suspended where banks think fair-value price discovery is impossible. A recent letter to the FT from portfolio manager Tim Guinness reminds us that this also occurred in the Great Depression, in 1938. It was also a feature of the Japanese Government’s response to bank losses in the 1990s. The fact is, confidence in banking solvency is a function of people’s view of the future prospects for loan losses, and so a much wider concept of confidence in the face of economic uncertainty. It is not a function of the most recent balance sheet.

Geopolitical uncertainties Globally, the future success of our many different versions of the mixed economy will be shaped less by the application of these technical changes than by how many policy errors are made by governments in dealing with the crisis.

Many of these potential errors relate to the relationships between nation states, which is why the G20 meeting was both right and timely in emphasising the importance of cooperation and avoiding beggar-my-neighbour policies.

However, even if mistakes are made that have the effects of delaying the necessary adjustments and perpetuating some of the problems of recession, this may not have any impact on the public’s attitude to the economic system itself or on its tolerance of a mixed economy. Indeed, to the extent the errors are ones that have an impact on foreign trade volumes and the wealth divide between rich and poor nations, it seems likely that this will increase support for globalisation, not weaken it.

The geopolitical factors that look relevant during the lengthy adjustment phase are:

  • Financial balances (and working relationships) between creditor and debtor nations

  • The possible loss of dollar ‘hegemony’ (all about those relationships)

  • The rise of China (partly about those relationships)

  • Protectionism

  • Competitive currency devaluations (a barely disguised form of protectionism)

  • Inflation risks in the wake of exceptional fiscal and monetary stimulus

  • Global warming and the sharing of adjustment costs between nations

  • Fossil fuel rationing (intimately linked to global warming)

  • Another commodity boom after prolonged low prices and production cuts

As a list of potential sources of policy error or conflict between states, this is pretty long. But it is realistic in terms of the scale of the uncertainty that investors in practice need to come to terms with. It is also realistic in terms of the likely duration of the problem, as these are issues that will tend to emerge as a response to, or as secondary effects of, the most immediate policy responses to crisis.

We do not think that this is all that difficult for investors to come to terms with. This is because at No Monkey Business we take the view that the long histories of achieved real returns from equity investing and from conventional bonds (ie those not indexed to inflation), from a series of international markets and regions, tell us everything we need to know about the impacts on the real returns from the major asset classes of massive secular shifts, as well as normal business-cycle shifts, in economic performance, inflation and taxation.

As long as investors’ future expectations for the range of real returns possible from investing in these asset classes, and the range of possible portfolio effects from highly unstable and unpredictable correlations, are based on this rich data history, optimal decision making can continue in the face of uncertainty.

What is likely to emerge in practice from such an approach is:

  • Conventional bonds are an inflation bet investors would do well to avoid altogether

  • The range of possible real outcomes from equity investing expands with time, it does not reduce

  • Realistic outcome uncertainty may conflict with investors’ views of their own risk tolerance

  • Until they know what it will cost them (in higher resources or lower outcomes) to avoid equity risk

  • Secular shifts in economic conditions will overwhelm asset-class diversification

  • So risk management requires dilution of risky exposures by something risk free

  • For most private-client goals, the only risk-free asset is index linked gilts



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