A collision with reality

The end had ceased to charm, and how could there ever again be interest in the means?

The end had ceased to charm, and how could there ever again be interest in the means? I seemed to have nothing left to live for. This is how the English economist and philosopher John Stuart Mill described in his autobiography the onset in the winter of 1826-27 of his nervous breakdown. It was prompted by a realization that the principle on which he was raised and by which he had livedthe greatest happiness of the greatest numberwas so incomplete a description of human nature that happiness could not be obtained by its practical applications: the consumption of material goods and sensual pleasures.

Despite its imaginative shortcomings, utilitarianism recast as neo-classical economics has through various mutations enjoyed a remarkable degree of success in both markets and public policy. There is even a respectable school of behavioral economics that holds that all human decisions, however great or small, can be explained in terms of the maximization of utility. That it originated in Chicago is unsurprising, since the Chicago School is the intellectual heir to the Benthamites. Its influence over financial theory and economic policy could even be said to be responsible for everything that has happened in financial markets since Nixon took the U.S. dollar off the gold standard in August 1971.

Certainly the Chicago School has furnished modern financial markets with almost all of the ideas by which they have operated since the 1970s. Obviously, sound money and low public spending, but especially the belief that unimpeded markets are efficient, in the sense that they are populated by rational economic actors, achieve the optimal equilibrium of supply and demand at market-clearing prices, and that those prices reflect all publicly available information. Financial markets, whose participants generate and distribute price information in real-time, and keep assiduous records of the prices at which tens of thousands of assets have changed hands over many years, have proved the ideal business in which to apply neo-classical concepts in the real world.

Whether they have lived by those concepts consciously or not, bankers, broker-dealers and fund managers have applied them to the financial markets throughout these last four decades. The Black-Scholes formula, for example, on which the development of the entire derivatives industry has turned, relies on measuring standard deviations, which in turn depends on the notion that the prices of assets are normally distributed, which in turn depends on the principle that movements in the price of assets are necessarily unpredictablebecause, if they were predictable, prices would never be at market-clearing levels or reflect all available information.

Some of the links between neo-classical economics and the markets are unexpected, even contradictory. It is the case, for example, that Chicago economics elevates the monetary over the fiscal, but a theory that holds that unimpeded markets always find equilibrium ought to have no need of central banks. Yet central bankers have proved some of its most devout disciples. Many, convinced of the ability of competitive markets to keep prices in check, have dismissed the most obvious symptoms of asset price inflation as movements in relative prices or reflections of a step-change in the real rate of growth. At other times, they have explained outrageous speculations as the arbitrage necessary to bring supply and demand in a market back into balance. Even now, it is not uncommon for central bankers to dismiss obvious signs of inefficiency in financial markets, such as excessively generous fee structures, as impossible amid such competitive market conditions.

Central banks have survived repeated and spectacular misjudgement for the paradoxical reason that their usefulness lies elsewhere. The largest obstruction to the attainment of equilibrium in markets is human nature, and neo-classical economics knows little of that. In fact, neo-classical economics is scarcely interested in biology at all. It is physics that its practitioners envy, and the tautological discipline of mathematics is its chosen mode of expression. News that imaging can measure blood flows between different parts of the human brain, for example, was welcomed by economists as a means of identifying the non-rational parts of the human mind.

Only a behaviorial economist would regard movements of blood between parts of the brain as more important to decision-taking than the system of credit, or the ways in which the evolved human mind interacts with that system. For what has survived from the savannah to become the chief paradox of life in the richest societies in history is not knowing when to stop. What was prudent stockpiling in conditions of scarcity manifests itself in an age of abundance as the absence of satiation.

All appetites, like those for food, seem only to increase as wants are met and desires fulfilled. This is the primal origin of the oceans of credit that have characterized the developed economies over the last 40 years, and whose tidal power has washed away the objections of those (such as environmentalists) who would prefer to rebalance supply and demand at much lower levels of consumption. Central banks exist to police the boundary at which the limitless appetites of our species coincide with the ability to produce limitless quantities of credit.

At bottom, central banks exist because credit exists. They can be abolished only with the abolition of the creation of credit. Though this step would make the largest single contribution to permanent financial stability, it will not be taken so long as human nature continues to evolve so slowly. Credit is not money (it coexists always with its opposite pair, debt) but it shares the capacity of money to break the bounds of satiety and time in a way that physical goods never can. The Greeks, who inhabited the first fully monetized society, understood the moral consequences of this. The mythical Erysichthon cut down the sacred grove of Demeter, and used the timber to build himself a banqueting hall. He was punished by being made insatiable, to the point where he sold his daughter into slavery to procure more provisions, and eventually devoured his own flesh.

Modern consumers are not very different from Erysichthon. As he felled trees and sold his daughter, so credit plunders from the future in order to fund consumption today. This is not of course how the manufacturers and makers of markets in credit see themselves. Asked to justify their existence, most bankers, investment bankers, broker-dealers, fund managers and stock exchange officialsall of whose roles, stripped of the idiosyncratic forms a single phenomenon can take, rely to a greater or lesser extent on the expansion and intermediation of creditwould say that they are part of a complex system that ensures scarce resources of capital are put to their most profitable use. In this sense, they are the efficient markets hypothesis made flesh.

It is a world view that achieves its least apologetic form in investment banking. Investment bankers believe themselves to be the cleverest, most talented people, working for the best organizations in the most competitive, efficient and global markets in the world. Oddly, nothing exemplifies this self-regard more vividly than the aptitude of investment bankers to conclude meetings by thanking each other, not for the exchange of knowledge or companionship, but for their time. This is not only because their time is exorbitantly expensivetime, as they say, is moneybut because information is money, and for increasingly short periods of time.

Modern financial markets are driven by information, and the need to exploit that information instantly. They absorb information (such government statistics and company results) and, by acting upon it, generate other information (prices for money, credit and securities). This process is judged socially useful because it ensures that savings are allocated to their most efficient use. But something odd is happening. The combination of digital technology and telecommunications, coupled with the growing use of sophisticated mathematical techniques, has greatly accelerated the ability of financial intermediaries to collect, absorb, process and act upon information. But it is not obvious that the information is telling them what neo-classical economics told them to expect.

In fact, the data suggests that John Stuart Mill was quite right to conclude that the utility-maximizing homo economicus is inadequate as a description of human nature. It says that investors are not the perfectly rational actors the efficient markets hypothesis assumes, but are heavily influenced by fear and greed. Nor do prices in financial markets conform to the random walk and normal distribution curve that theory predicted. Rather, prices reflect the fact that financial markets are a complex adaptive system, whose nature is evolving continuously. Large and prolonged price movements occur. Price discrepancies are not arbitraged away promptly. Most predictably of all, it is now obvious that a market cannot be abstracted from its participants. The decisions of traders and investors affect those of all other traders and investors, all the time. In other words, prices are heavily influenced by competing trading and investment strategies.

These findings prove that financial markets are a lot less efficient than the dominant theory of the last 40 years has insisted. Telling criticisms of it date back to the 1960s, and its weaknesses were unarguable from the 1990s. Yet no revolution has taken place yet in the way investment bankers (and fund managers) go about their business. Institutional inertia is obviously part of the explanation, but is demonstrably inadequate in an industry whose history records a startling readiness to translate academic theory into practical applications. The truth is that the efficient markets theory is too important to the self-image of financial intermediaries, and especially to their interaction with the companies that populate the real economy, to be abandoned.

Since at least the 1980s, investment banks and fund managers have insisted that shareholder value is the principal purpose of listed companies. As a philosophy for ensuring joint stock companies are run in the interests of their owners, it appears coherent. By threatening to raise the cost of capital of the company, or even transfer control of the company to new managers through a takeover, insistence on a rising share price ensures that their agents (the management) continue to run the company in the interests of the principals (the shareholders). In theory, shareholder value is also the best way to create and preserve employment, because a rising share price will reflect higher earnings from satisfied customers. Shareholder value even puts pressures on suppliers to become more efficient, since paying less for inputs fattens profit margins.

It is not hard to see why investment bankers and fund managers subscribe to this philosophy. It provides a theoretical underpinning for fee-generating and performance-enhancing takeovers and mergers. The dysfunctionality of their own corporate cultures, in which high rewards are the compensation for total insecurity, makes it relatively easy for people working in financial markets to believe that every employee at every listed company should feel permanently insecure in his or her job; that the dumbest money belongs to the customer; that stock market bubbles are there to be ridden, not deplored; and that every company should prefer purchasing additional earnings to investing in them. After all, if an investment bank wishes to enter a market, it simply purchases the necessary skills from its competitors.

Their exits are equally insolent. In fact, investment banks push into and pull out of markets in a near-whimsical fashion, regardless of costs, for they have limited horizons and even more limited patience. Few investment bankers question this modus operandi. Most are mercenaries, unaccustomed to thinking beyond the next bonus, and struggle to see why a corporate CEO should plan further ahead than the next set of quarterly results. For them, the financial markets are not a sphere of human action in which they are both cause and effect, but an abstract mechanism for the punishment of inefficiency, with which they are never truly integrated but to which their personal fortunes and those of their employer are indissolubly liked.

The irony is that banks, and particularly investment banks, are notoriously inefficient. They are also noticeably inept at the generation of shareholder value. Though the bonus culture ensures that investment bankers continue (unlike employees in other industries) to experience a direct link between working hard and being paid well, it also ensures that in the long run no business generates less shareholder value than investment banking. It works like this: The employees eat the rewards at the top of the credit cycle, leaving shareholders and taxpayers to absorb the costs of their excess at the bottom of the credit cycle.

This asymmetry has a second ironic consequence. The consequent overstatement of profits by the banking industry leads to a constant misallocation of capital to the very entities that describe the efficient allocation of capital as their principal raison dtre. Banks routinely overstate their profits, chiefly through hedging devices and mark-to-market and mark-to-model valuations based on unrealistic assumptions that enable them to minimize current loss provisions and capital costs. This in turn reflects a corporate culture in which lavish personal bonuses are paid long before the profits on which they were based are found to be exaggerated. Indeed, it takes a special brand of naivet not to laugh when regulators argue that senior bankers should be paid in bail-in bonds, which would automatically convert to equity if the financial position of their institution deteriorated.

But it is not necessary to be a cynic, or a conspiracy theorist, or even to believe in the totalizing power of finance, to understand why the management of major industrial and commercial companies have come to share the bankerly belief in shareholder value. Their compensation is usually tied to the performance of the share price of the companies they run, even though it is obvious that their ability to influence the share price is indirect. They control the capital and labor employed in the business, which has some sway over the share price, but is not even the principal determinant of it. Indeed, in complex and evolving stock markets driven chiefly by competition between trading and investment strategies, share prices often part company from economic value for years at a time. At all times, they owe more to general market trends than company-specific achievements.

It follows that most company CEOs, including some in the banking industry, become extremely rich for reasons far removed from the strategy they set or the decisions they take. Shareholder value provides a useful rationale, especially if the rewards are paid while the share price remains strong. But the pursuit of shareholder value also has consequences beyond the boardroom, in the sense that managements will take actions to boost share prices even if they are not in the long-term interest of the company.

It is sometimes argued that the long-term interest of the company is hard to define. Only for those who fail to consider the alternative. In the end, the best test of the ability of a company to create value is survival, because survival is impossible unless the business is getting more than it is spending. Making a profit depends on proving more attractive than competitors to customers (who buy the output), shareholders (who put up the capital), employees (who do the work) and suppliers (who furnish the equipment and the raw materials).

Shareholder value is a fleeting and inexact measure of the ability of a business to sustain the support of these constituencies over the long run. Indeed, capital markets for corporates are of such recent provenanceas late as the 1950s, neither Wall Street nor the City played much part in raising equity capital for industrial and commercial companiesthat it is more accurate in historical terms to see the stock market as the creature of industry and commerce than industry and commerce as the creature of the stock market.

In his memoir of life in prelapsarian Vienna, The World of Yesterday, Stefan Zweig described how his father ran his weaving business in northern Bohemia before the First World War. It was more important to him to own a sound business with the force of his own capital behind it than to extend it to huge dimensions by taking out bank loans and mortgages, he wrote. The one thing of which he was truly proud was that no one had ever in his life seen his name on a promissory note, and he had never failed in his life to be in credit with his bank. … The fact that he still gradually became rich, and then even richer, was not the result of bold speculation or particularly far-sighted operations, but of … expending only a modest part of his income and consequently, from year to year, making an increasingly large contribution to the capital of the business. Like most of his generation, my father would have considered anyone who cheerfully spent half his annual income without thought for the future a dubious wastrel at the very least.

In the long run, this is the only way to grow an economy, let alone a company. It entails human beings, using what knowledge they have, investing surplus capital in businesses that create economic value by using techniques and technology that produce more for less. The credit cycle attempts to circumvent this steeper path, where it does not seek to skip it altogether by appropriating the surpluses of the future. The results are plain in the current crisis, in which only the printing of money and the deliberate suppression of the natural rate of interest makes the ill-judged investments of the boom financeable still. About this, the efficient market hypothesis has nothing interesting to say.

In fact, its theoretical vision of well-informed, rational inhabitants bringing supply and demand into perfect balance by acting on excellent information increasingly has nothing interesting to say about anything at all. It is convenient for the purposes of mathematical modeling, but it bears little relation to reality. As it happens, John Stuart Mill foresaw this too, confessing to Thomas Carlyle that his faith in utility had meant he had never conversed with a reality; never seen one; knew not what manner of thing it was. After his Damascene moment, he chose instead to pursue the internal culture of the individual.

That pursuit drove him in the end to endorse another single truth (that the only constraint on liberty is actions that harm others) but Mill is scarcely alone among economists and philosophers in his fondness for reducing all phenomena to the workings of a single principle. The earthier amongst us are well-advised to leave such philosophizing alone, and see markets for what they are: another sphere of human action in which all philosophiesindeed, all motives, all values and all ambitions of the multitudes of individuals that inhabit the Earthare seeking their fulfillment.