Sunday, June 29, 2008

Answering TvT: Is financial deregulation the cause of the current crisis? (amv)

Two weeks ago fg, os, and I visited Berlin to meet the Kocheler Kreis, a social democratic gathering of economists, politicians, and journalists at the Friedrich Ebert Stiftung which is owned by Germany’s Social Democratic Party. Main topic of the second conference day was the current financial crisis, shaking not only the profit schemes on Wall Street but also challenging all those who are in the difficult business of making sense of the stirring incidents. There we had the chance to meet TvT, a fellow graduate at the IMK, who has done very interesting work on the deregulation of financial markets, its impact on real investment and management, and the resulting increase in households’ leverage which of course is the most prominent source of recent turmoil. Now, as everybody who knows the may remember, I do not think that financial crises are intrinsic to capitalism and the free play on financial markets. Bubbles can surf only on the tide of liquidity encouraged by central banks and enabled by the institutional setting we have chosen with our current monetary regime (as argued here - and in accordance with Calvo - I believe that also the current oil hype is due to central bank manipulation).

TvT challenges this view. If low interest rates gave momentum to the crisis, why is it that the 1960s were not shaken by such incidents? There, US real interest rates were low, but households saved much more and thus did not leverage beyond sound economic reasoning. Why is this? He remarks that in contrast to the 1960s, investments into physical capital from the early 80s until the mid 90s decreased despite the low rate of interest. This would indicate, that financial deregulation has deprived self-interested behaviour on financial markets from its beneficial impact on real growth. Smith’s invisible hand, the translation of self-interest into social benefits, stopped to do its work. The epitome of this kind of financial misbehaviour is to be found in the shareholder value concept popularized as such by Rappaport. The new institutional setting encourages short-sighted maximization which results in a cumulating spread between profits and real investments.

Ok. Let me take up here. First, the shareholder view is nothing new (although it was in the 1990s that it began to trickle down to Business Schools, Consulting Firms and to management gurus, the latter a new specie themselves). From the late 18th Century economists argue convincingly that to maximize profit is what capitalists do and since Adam Smith we know that this leads to the equalization of profit rates which increases consumer welfare. Is their any difference in regard to shares? No, all assets derive their value because they entitle to an income stream (which at the end of the day has to be earned on the market for consumption goods). Thus, the value of assets involves an intertemporal dimension. Here the equivalent of profit maximizing of the firm selling commodities is the maximization of present values. In the case of stocks this implies the maximization of shareholder value. Thus, there is nothing new under the sun.

But is it true that management behaviour changed in the light of deregulation? Sure. Was it beneficent? I do not know. What I do know is that the contracts shareholders make with their agents are themselves part of the institutional setting shadowing profit maximization. The market process thus includes the competitive evolution of these patterns of behaviour. Competition as a discovery process is not perfect and does not ensure that we are currently confronted with a first-best solution regarding the art of management. But it provides the most efficient selection principle over time. Creative destruction, as Schumpeter points out, also applies to new kinds of organizational patterns. Surely, we all can think of better rules of conduct compared to the present state of affairs. But are we wise enough to outperform the market process over time? Is TvT sure that he or any other expert can come up with better alternatives, outperforming the self-interested behaviour of the many, of those confronted with the relevant knowledge of their specific time and place? If the answer is negative it would be highly problematic to impose rules which are enforced by law and monitored by any federal agency. As Tullock has convincingly argued (even more convincing in the light of evidence) such rules of conduct are much less suitable to change in the light of new or better knowledge. If I have to decide between the market and any political process to supply me with the most suited institutions, I bet on the market process.

Be it as it may, I do not think that TvT’s evidence of mismanagement is as clear as he believes. First, let me take up the case of decreasing real investments - compared to the 60s/70s and in relation to current profits. The data he uses to measure real investment excludes financial cooperations. If the Deutsche Bank invests in SAP IT systems in the same way as Daimler does, what exactly makes this investment less real? Especially the US faces an immense structural change and enjoys investments in financial services which in contrast to other services in the sector for services are accompanied by major productivity gains. I cannot see anything but a presumption that financial services are something virtual or at least not beneficiary in terms of real income. It does not surprise me since Keynesian theory explains the leakage of activity by the purchase of bonds and other titles. However, adding investments of financial cooperations may show that real investment did not shrink to the extent emphasized by TvT.Let us turn to the 1960s and the question of why investment was higher in the 60s/70s than investment in the 80s and the early 90s. First of all, we should not forget the Vietnam War. Like most wars it demanded a having restructuring of the capital stock towards highly capital intensive production. Budget deficits were high but the low real rates of interest show that they were monetized by the Fed. This increase in government spending power from artificial funds increased demand and investment in all goods complementary to war time production. The Vietnam War found its end and so the production structure returned to a less capitalistic configuration. Since capital goods are usually highly specific this involved a long process of disinvestment and can be seen as a negative and enduring productivity shock starting in the mid 70s. This is of course only one reason, perhaps not the most pressing but very illuminative. In general, low interest rates tend to produce such boom-bust cycles in productivity and investments. Here is one answer to the productivity slowdown which endured until 1995.

As shown, the 60s became inflationary, a trend which accelerated until the late 1970s. The disinflation costs made necessary (and which are associated with the name of Paul Volcker), further dampened real investment. Now, after monetary policy following a much more restrictive path - which marks the beginning of what we call the Great Moderation today - the Reagan Deficit pushed up interest rates and crowded out investments even further. And if you believe in long waves, it is at the end of the 70s that the fourth Kondratieff came to an end. The next wave is seen in the IT-Boom beginning in 1995 which had to wait until investments in computers accumulated to a potential network so that the internet set free its productive impact.

Do we really need the change in management conduct to explain the low investment and productivity path from the beginning of the 80s until the mid-90s? Is the deregulation of financial markets really the most obvious answer we can give? I don’t think so.