The largest financial bailout in United States history, which some traders are starting to call the ‘Securitized Housing Investment Trust’ (hint: think acronym), is causing an existential crisis amongst those who hold to purest free market ideology. Senator Jim Bunning, Republican of Kentucky, echoed this sentiment when he said, “The free market for all intents and purposes is dead in America.” These ideologues doth protest too much, methinks.
Since the 1929 crash, the last time the nation faced an economic train-wreck of this magnitude, the U.S. Government has effectively been in the insurance business and it has generally served us well. The vast majority of laws and regulations are designed to mitigate risk. Drunk driving laws minimize the number of car wrecks, and the short-tick rule (until recently eliminated) prevented unfettered short-selling from forcing solvent companies into insolvency.
Government institutions enforce these policies. What is the purpose of the military but an insurance policy against attack from other nations? What is the key purpose of a central bank other than insurance against a run on banks?
In fact, the present-day capital market system, which has been responsible for raising living standards to the highest in world history, relies upon laws and regulations: the Securities Act of 1933, the Securities Exchange Act of 1934, the Commodity Exchange Act of 1936, and the Investment Advisers Act of 1940. Although not perfect (and definitely requiring an overhaul), these laws have served Wall Street and LaSalle Street very well over time.
The problem with fundamentalist free market ideology is that it is only theoretical, and ultimately not pragmatic. Truth is, without government establishing the premise of private property enforced through law and justice, contract markets would soon devolve and be quickly replaced by gangster capitalism akin to Putin’s Russia. There is a term for the unfettered combination of concentrated power, ideological adherence and capitalistic greed, it is called “fascism.”
There is another term “beta,” which defines the systematic return/risk of assets. This concept is related to Modern Portfolio Theory and underlies the oft-stated investment strategy of buy-and-hold. What is not well-understood, even by many sophisticated investors, is that this theory is flawed. The issue is portfolio construction. Accordingly, the definition of “true beta” or “true market portfolio” must be extended to encompass other economic factors.
What academics came to recognize was that approximately one-third of non-governmental tangible assets in the U.S. are owned by the corporate sector, and only one-third of these corporate assets are financed by equity. As a result, Jagannathan and Wang concluded that assumptions underlying the concept of beta must be altered in order to resolve anomalies in the model. In other words, “true beta” or the “true market portfolio” must include the “aggregate wealth portfolio of all agents in the economy.” This is a revolutionary view with both political and economic ramifications.
Business balance sheets do not in practice reflect public infrastructure assets which businesses are dependent on. For example, a trucking company’s greatest asset is not its fleet of trucks, but the U.S. Highway system. Likewise, public liabilities such as the cost of pollution are also not reflected on balance sheets. This is beginning to change with the idea of integrating regulations into “cap-and-trade” contract markets involving emission allowances.
It is time for a new economic ideology to take hold which adheres to a progressive view. Government and free enterprise are actually joint partners in promoting economic growth and well-being. Certainly, political will effects a constant tug-of-war between interests, but this is not unlike the struggle between a sales-trading desk which drive revenues for an investment bank, and internal compliance managers who ensure balance between risk and reward.
The problem with the prevalent populist stream of conversation regarding free markets versus socialism is that such dialogue is anachronistic. Rather, the conversation needs to shift to good versus bad governance, and public policy which enhances the value of the aggregate wealth portfolio of all agents in the economy.
Mack Frankfurter
Mack and I have done a lot of arguing about the state of the capitalist system. His "new beta" gives me faith, because it comes not from a liberal suburbanite like me, nor a liberal economist. It comes from a guy who loves capitalism, loves the markets, and makes his living there.
Thanks, Mack.
7 comments:
Brilliant analysis. Brevity and clarity!
If you didn't see George Will on This Week this morning, please watch:
http://abcnews.go.com/Video/playerIndex?id=5849844
While I'm a big Mack fan... or at least a friend... I find it amusing that someone who I know to be a Nietszchean will-to-power, greed-is-good economist is suddenly espousing a new, progressive, government-has-its-place view. New to him, perhaps. But then, we'll see a lot of that in the coming months.
Seems to me what he jargonistically calls a "revolutionary" public policy which "enhances the value of the aggregate wealth portfolio of all agents in the economy" is simply what most of the world calls "liberal democracy" or "social democracy" or here, (if you have the wherewithal to separate it from communism - we do not have as many words for helping each other out as most developed nations) "socialism." It's not a new idea, and is working fairly well for all the nations whose Euro is presently kicking our ass.
But if someone's looking for a simple, new model, I'll propose one. In this century where we are competing with communist governments who have learned a trick or two about capitalism (Russia, China) our best response will be a free market state that has learned a trick or two about socialism. I believe the federal government should be responsible for what I'll call the One Hand of Governance. You should be able to count government's sphere on one hand, five fingers: 1. Transportation, 2. Education, 3.Health Care, 4. Welfare (as in, take care of the sick, homeless, the criminal and the insane), 5.Self Defense (and by that I mean DEFENSE, as in stand there and look tough and if someone hits you hit em back harder, without moving, and then, as you were, soldier), Do those things impeccably. Then let the free market rock, with the one proviso that the five holies are holy, and you shall not impinge on them. If you do, you lose your job and go on Welfare.
You'll note, by the way, that housing is not on my list. Anyone who's lived in socialist housing knows that's not the way to go.
Okay, you can write me in on Nov. 4.
I think Mack's thesis is "new" or "revolutionary" to market guys- not to us normal saving progressives.
And it makes me hopeful, because his brain gets a fair amount of attention these days, so maybe the market zeitgeist is changing.
You're right, though: there'll be a lot of born again public interest over the next couple of months. Here's hoping it leads to results, and govt a bit closer to your five-finger philosphy.
plus: don't tell him I said so, but I think his thesis comes out of losing an argument or two with me :-)
Touche! Let's just say I've found my inner-Keynesian :-)
Note: this short essay was written with free market ideologues in mind... who, to say the least, are experiencing an existential crisis.
Some of the language I use is an allegory to academic economic literature, and so references a body of financial concepts that enter into the philosopical realm.
In my own defense, I have always been a dabbler in various economic frames of reference, but never a strict adherent to any particular idea. That may seem wishy-washy to some, but it keeps things interesting (in my own head at least) and hopefully allows room to learn and grow (evolve).
Jess/Bly, I look forward to getting together soon and evolving this conversation over dinner!
I believe that all the world's problems could be solved over a dinner, if the food and wine are just right!
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