Survival of the fattest...

And so the financial world ticks on. Stock-markets continue to move up the world over and there are shoots of confidence re-appearing. The FT this weekend headlined that London has seen sales of £1mm properties back to the record pre-recession days, and investment banker's wallets are looking as good as ever. As regular readers will have noted, I'm pretty cynical about all this and think there is plenty more to play out. What I believe has happened is that the financial world has been prescribed some antibiotics that are starting to have an effect on the areas that were "credit infected", but in the background the weaknesses that existed within the framework of the world's financial system have only been masked by the medicine.

At a very basic level, there has been a systematic transfer of the losses within the global economy from private to public sector, and a systematic postponement of the ramifications of a faulty system from this generation to the next. Current public debt levels aren't sustainable in places like the UK or Ireland, without taxes increasing significantly or growth rates increasingly dramatically in the coming years. Fundamentally, modern society is not very good at confronting things head on. Most of the time this is because we don't have to - it's very often possible to take the antibiotics to address a short term problem, even if the longer term consequences are likely to be even worse.

This problem doesn't just apply to the economic world. It applies to the whole nature of the way in which modern societies operate now and into the future. We are creating "super-bubbles" as George Soros would call them, by putting bandages over wounds that need major surgery. This idea has been prevalent in the medical world for some time, where the discussion about whether Darwinism is relevant anymore is widespread. The progress of modern medicine has thrown Darwin's concept of "natural selection" into disarray - the selection process in the world of people is less about Nature taking its effect on who will thrive or survive, and more about which humans have access to the best medical treatments.

In a way the Darwinian process has mutated itself - Warren Buffett has said a few times that his ability to thrive in the current society is because the skills he has are highly valued, yet if he was born 3,000 years ago he would have been at the back of the herd when it came to outrunning the chasing lion. His limited physical prowess would have seen him naturally de-selected in those times, but in current society his mental faculties have allowed him to afford the best healthcare and consequently to thrive. In the same way, Stephen Hawking's capacity to interpret the inner workings of the universe, whilst immensely physically disabled, have allowed him to thrive. And no offense to Mr. Hawking, but I suspect he's better at understanding black holes than he is at throwing spears at wild animals.

As much as the mentally gifted like Buffett and Hawking have a firm foothold in our society, at the other end of the spectrum the "deselection" process may have stopped in certain societies altogether. While the wealthy have more comfortable beds and more attentive nurses in their private hospitals, the universal nature of healthcare in the western world has almost meant that there is no selection process, Natural or otherwise. We have effectively stopped the process of the "survival of the fittest" which as a consequence may ultimately contribute to a form of super bubble in the future. Nature will find a way to restart the natural regeneration process, but because we are postponing that process currently, when the "forest fire" comes it may well be of super-sized proportions. We will have taken so many antibiotics to ward off short-term issues that there is a significant risk of being blindsided by some form of natural disaster. Swine flu, for example, is apparently less likely to affect older members of society notably because when they were young they tended to have far less access to antibiotics than the current baby boomer generation and consequently have more antibodies to fend off mutated viruses like H1N1.

In my view, the way governments and regulators have addressed the current financial crisis is merely symptomatic of a wider bandaging that is prevailing in the Western world. We are becoming less resilient to future problems, whether they be economic, social or health related.

The recent bushfires in Australia, are a fitting metaphor. Small bushfires are part of Nature's process - they happen naturally and they play an important role in the regeneration of the land. It's perfectly understandable that humans would interfere in order to prevent those small bushfires. In the bushfire sense, however, by preventing the small fires that naturally occur over many years, a very large area of land has not been "regenerated" and consequently the scope for a one-off massive fire is increased. The pictures from around Melbourne earlier this year were the manifestation of years of human interference, which in the short-term, had previously looked extremely positive.

In a similar vein, there are those who bravely suggest that the significant aid flows into Ethiopia in the late 1980s to address the impact of famine and widespread starvation, may have only solved part of the problem - and in doing so created an even bigger risk for the future. Aid flows may have soothed the hunger of many for a time, but without a systematic change in the way in which the at risk people in Ethiopia address farming and how famine conditions arise, then the survivors of the last famine and their offspring may be victims of an even bigger catastrophe. As un-PC as it is, those voices quietly suggest that more people may end up dying in Ethiopia as a consequence of the massive influx of aid - on the basis that the real issues that caused famines there have never really been addressed.

On a more positive note there are examples of natural regeneration being harnessed effectively, in a way that has long-term sustainability. "Farmer Managed Natural Regeneration" is a reforestation technique developed in West Africa in the 1980s and 1990s, now practiced on 30,000 square-kms of land in the Niger Republic as well as Chad, Burkina Faso, parts of Ethiopia and Mali. Natural Regeneration refers to the natural process by which plants replace or re-establish themselves. FMNR relies on the presence of remaining live tree roots - reproduction comes from self-sown seeds or by vegetative recovery (sprouting from stumps, lignotubes, rhizomes or roots) after the tops of the plants have been killed (by fire, cutting, browsing, etc.).

In an economic sense this process is not dissimilar to what the 1940s Austrian economist Joseph Schumpeter called "creative destruction". Many businesses around the world have proverbially had their heads chopped off, particularly if the assumptions upon which their business plans were based included: cheap debt, regular and predictable demand growth, asset prices continually rising, and the adding of capacity being low risk.

In the Schumpeter world, these businesses would be forced to adapt or die, and therefore would leave only the "fit" survivors, who would be better prepared for the trials of the next generation. There would be a regeneration process where old ideas are adapted or cast aside and new ideas and processes are creatively implemented. Unfortunately, as with many aspects of modern society the response to this financial crisis has not been to accept change head on, but to bandage up the old system and postpone the real Reckoning. There aren't too many obvious lessons to be taken from the farmlands of Chad, but accepting some destruction and the ensuing natural regeneration may well be one. For the long term it's the only approach that will be sustainable.

Give an inch...

We took our 8 week old son to our local GP this week after a real struggle to book an appointment. The media coverage of swine flu has clearly played its part in filling doctor's surgeries across the country and around the world, so access to the diaries of medical professionals is tough. Having said that, on arriving at the surgery there was a large white board in front of the receptionist's desk with two numbers on it - 216 and 178. These were the numbers of hours of missed appointments in that surgery over the previous two months. Based on the number of GPs working there, and based on a 5 day working week this equates to around 3 hours per day, per doctor of missed appointments. What an unbelievable waste, and what a representation of how selfish some people can be.

As I sat there waiting to introduce our little fellow to Dr. Greaves I was pondering why such a situation should exist, and what should be done to correct it (I like to think there is always a solution, economic or otherwise). Fundamentally, as I have grown to believe, if you give something to somebody for nothing, they will not treat it with anywhere near as much respect as something that they have to contribute towards. While all taxpayers do indirectly contribute to the provision of the health service in the UK, their contribution at the point of consumption is nil - and to me that is where the problem lies.

The NHS in the UK has its faults, but at its core it is full of good people trying to do good things for people. It is an unwieldy and difficult organisation to run, and sadly for the employees of the NHS their position in society is undervalued. I believe that this is at least partly because what they give to people has been turned into a right for all, and this sense of entitlement and the fact that it is undervalued go hand in hand.

On a visit to Hong Kong last year, I visited a GP and paid the equivalent of £15 for the privilege - and received prescription medicine worth comfortably more than that figure. In France, there is a flat charge of around 3 euros per GP visit - a small sum, but one that I am sure guarantees that more appointments are fulfilled. The absolute level of contribution does not need to be a large figure, in fact it could be that a charge is only applied for missed appointments, but the principal that I believe needs to be applied is that in order to have a relationship that is fully valued there needs to be give and take. This rule doesn't just apply to running a health service, but is probably a pretty sound approach to running any organisation.

As Barack Obama pushes for healthcare reform in the US, he has been met by scathing criticism from the Republican right and progressing the reform bill through Congress is likely to be very tricky. At its core the aim is to provide health insurance for the 47 million Americans who do not have any, and drive down the spiralling costs of healthcare. The issue of whether a particular standard of healthcare is a right or a privilege goes to the core of what it is to be American, and is separating opinion accordingly.

In the UK the "Welfare State" concept as coined by William Beveridge in 1942 aimed to address the five "Giant Evils" in society: "squalor, ignorance, want, idleness and disease". Clement Attlee's 1945 Labour government pledged to eradicate these Evils, and the government undertook measures in policy to provide for the people of the United Kingdom "from the cradle to the grave." On the surface, a very noble and moral ambition.

The policy itself resulted in massive expenditure and a great widening of what was considered to be the state's responsibility. It would appear that the reform bill that Barack Obama is trying to push is polarizing US opinion for this reason - firstly it will be very expensive to provide, and secondly, in the context of all of the financial bailouts of the past year, it may represent a structural shift in the level of state involvement in peoples lives for the foreseeable future.

In a country that prides itself on the people in its society that demonstrate the ability to help themselves, this looks like an unacceptable form of charity. The American dream upon which the last 50 years of economic growth is based has at its core the principal that regardless of who you are, hard work will allow you to progress. There aren't many situations in the US where you get something for nothing. From my point of view, past governments haven't done enough to truly help the real underclass that is growing in their society, but I can completely understand the segments of US society who don't want to create some of the helpless aspects of British society engendered by the freeloaders using the NHS. As always there is probably a middle ground to be found, one that retains the charitable aspects of the NHS, but that also means that healthcare is properly appreciated by those who have access to it.

Something for nothing is an unsustainable situation not only for the cost associated, but further because of the way it affects the motivations of those who have access to it. As Mae West once said, "Give a man a free hand, and he'll run it all over you."

Heads I win, tails you lose...

There is a lot of ongoing discussion in the world's media about the so-called "scandal" that is the investment banking bonus system. While there is plenty to be displeased about, much of the available commentary is mis-guided guff that misses the point. The real issue is this: If individual "rain-makers" make a lot of money for their respective banks, then they should get paid. If, however, in making that money those individuals take big risks that under certain stressed circumstances could threaten their bank and potentially the entire financial system then those returns need to be risk adjusted. Currently that doesn't happen and that is where the major issue lies.

At the moment there is a huge "externality" in the financial system. An externality is an impact or cost on a party that is not directly involved in a particular transaction. In the financial system the externality is that bankers own the upside of the risks they take, but in extreme circumstances (like the ones we have seen) the taxpayer bears the external costs of too much risk. One of the central goals of effective economic policy-making is to "internalize externalities", which basically means that the risks and rewards are borne solely by the participants in a transaction. The biggest current conundrum of this nature for global policy-makers is climate change, with the financial crisis not far behind. From the environmental point of view - a Chinese coal-fired power station benefits from the price it can sell its power at, but the negative "externality" of its contribution to global warming is borne disproportionately by all.

The real aggravation with the bonus "scandal" is that the externalities within the financial system remain unmitigated even after all that has happened. Policy-makers have yet to "internalize the externality". Traders can take huge risks, where if their bets pay off they benefit significantly, and if they don't then shareholders, creditors and in extreme cases taxpayers all suffer. We have been in a similar position before.

In 1933 after the Great Depression the US government established the Federal Deposit Insurance Corporation as part of the Glass-Steagall act. FDIC provides deposit insurance which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. Today FDIC insures deposits at over 8,000 institutions with $13.5 trillion in assets. Insured deposits are backed by the full faith and credit of the United States, and since the start of FDIC on January 1st 1934, no depositor has lost a cent. FDIC is not unique and has been replicated in various forms around the world.

At the time, FDIC was an excellent concept - the banking system was much more localised than it is now, and most of the financing that banks had came in the form of deposits from it's corporate and retail clients. Consequently, the insurance premium that banks paid to FDIC covered most of the risks that could lead to a proverbial run, in the event that the bank took the wrong risks.

Close to 75 years on, in 2009, in terms of market protections the banking systems of the world haven't moved on much from the basic deposit insurance concept, yet in the interim period the changes in global capital markets have made the deposit insurance concept woefully insufficient. When Lehman Brothers was declared bankrupt last September its demise heralded a sequence of events that almost broke the entire financial system. As an investment bank, Lehman did not finance itself through deposits, but through international bond and equity markets, so FDIC was irrelevant to Lehman.

What needs to happen is a proper acknowledgement by all parties that the banking system is implicitly underwritten by an insurance policy written by the taxpayer. Currently there is no premium paid by the banks for that insurance policy. The only direct benefit to the taxpayer of that insurance is in the event that the banking system fosters an economic environment that generates high tax revenues and lots of jobs. In the recent past that benefit has been significant - global GDP growth was stellar, and lots of jobs were created - but as has become clear that economic boom happened on the back of a serious increase in the amount of risk in the system.

In order to internalize the externality that exists in the financial system, there needs to be some form of premium paid to central banks by financial institutions based on the amount of risk that they are taking. If each individual bank choses to take on more risk, then that is their prerogative, if less then likewise - just like a car or house insurance policy. If a person chooses to drive a fast, expensive car then they should pay more insurance, and they should pay yet more if they have a history of driving recklessly. There are of course practical issues with the implementation - where are the premiums paid for a global bank, how to measure risk and how to minimize what I will call the "Goldman effect" (political interference in pricing the insurance policy) - but the principal of the insurance policy concept is the best way to approach the heads I win, tails you lose nature of the banking system. If policy-makers get that right then the bonus issue will correct itself.

Myner's strike

Warren Buffet was once asked what sort of typical holding period he and his Berkshire Hathaway clan liked for their investments. "Our favourite holding period is forever", he replied. With that simple concept in mind, we can begin to understand what has led to the Sage of Omaha topping the world's rich lists. He is an "investor" in the truest sense of the word, taking an active interest in the sales of widgets, cans of diet coke, or whatever else the portfolio of companies he owns do their daily trade in. He can be separated from many would-be "investors" who roll their dice day-in day-out on global capital markets, hoping to make a quick buck or million. In many cases these punters have little or no vested interest in the operational performance of the underlying companies that keep our economies ticking. This doesn't necessarily stop them making money, but it's certainly questionable as to their value add in making the world tick.

Over the past few years as technology has leapt forward this set of "investors", though, has become incredibly important. The speed at which capital moves around the system can make or break companies in short order. Many of these companies are perhaps destined to fail - but the lack of basic understanding of the fundamentals of companies that these "investors" are equipped with often can turn a bad headline or rumour into panic selling, or vice-versa on a hunch or whim. While its true that more participants in global capital markets is good for liquidity, it's not necessarily good from a transparency perspective or in terms of reducing uncertainty. It's a bit ironic that investment banks and brokers love uncertainty and volatility, and they profit most during these times, yet their biggest clients hate it and really struggle when their future funding or relationships with suppliers is up in the air.

At its core capital markets is simply about the interaction between people who need money, to carry out business plans, and people who need to put money to work, pension funds and the like. A good capital market will take capital to the places where the best returns are to be found, and to business that create products that people want. What is great is that these trades between participants can be mutually beneficial. Warren Buffett believes in that process and understands how he can benefit from it working effectively, and so do the companies that benefit from his investment.

The financial crisis has revealed that markets can appear to favour speculation over long-term ownership – hence Washington and London’s recent investigations into curbing speculation in the oil markets. It has also revealed that equity sometimes is not as solid as it might appear – hence the banking crisis. There is now doubt that restoring confidence in the system will require investors who take more than just a passing interest in the long-term health of the companies they own. The question for policymakers is how best to encourage this.

The separation between these two types of participants in global capital markets has come into focus in the UK this week. Gordon Brown's City Minister, Lord Myners, has been mulling over proposals that will reduce the speculative nature of stock market investing, and encourage a focus on the longer term. One of the proposals he has put forward is a two-tier shareholder structure, whereby longer term holders of shares would have increased voting rights. He said: “There is a lot of evidence to suggest that most institutions are uncomfortable with the responsibilities of ownership as opposed to investment. We need to fix that, otherwise we have ownerless corporations.”

From my perspective, I applaud the mindset that Lord Myners is bringing to bear. He is clearly trying to advocate the Warren Buffett school of value based investment. The solution to this policy dilemma is not straight forward, however. Set aside the practical matter of defining what is meant by long-term versus short-term investors – a tricky and arbitrary process. Blow-ups in Europe – such as Porsche, with its complicated system of preference and ordinary shares – suggest that two-tier systems wouldn't be a universal solution. Europe’s experience suggests that having two tiers of shareholders leaves second-tier investors captive to forming potential destructive shareholder cliques that wouldn't solve the bigger problem.

As the Lex column in the FT pointed out this week - it is far better for policymakers to focus on market-based incentives. One might be tax relief on dividends. A shareholder who bought and held a company’s stock for five years, say, might see the tax rate on his dividends gradually decline to zero. Once a share was sold, the clock on the tax benefits would re-set rather than be transferred to the new owner. As the FT commented: "That would represent an improvement for all stakeholders, as it would encourage long-term shareholders while also discouraging shares being used as vehicles for ramping and short-term speculation."

Again that solution seems like a pretty good one, but it might throw-up other unintended consequences (it would certainly create some lucrative work for creative tax lawyers). It's not clear to me what a perfect solution would be, and there probably isn't one. But on the positive side, it is good to see that this sort of discussion is taking place as the recovery process depends on readjusting the whole financial system to a longer term outlook.

Play it as it lies

This week in the UK, the government-to-be Conservative party announced plans to abolish the regulatory body that oversees financial markets - the FSA. In a move that sets out a major part of the policy battleground for elections coming within the next year, the Conservatives intend to lay out their full plan for regulating the financial system on Monday. Under the plan, the FSA's responsibilities will be split between the Bank of England and a new consumer protection agency. "Crucially, this will bring together the operation of monetary policy with regulation of the banking system so that the economy is not built on debt," said George Osborne, the shadow Treasury Secretary. His view is that the present regulatory structure, in which the Treasury, the Bank of England and the FSA jointly oversee financial stability, failed to spot the dangers of a build-up of debt in the banking system ahead of the financial crisis.

The truth is that the build up of debt in the system was patently clear for all parties to see, and the regulatory failings of the FSA were only a subset of a bigger systemic issue. The whole western economic model retained incentives for the debt build-up that occurred, from the resulting government tax revenues to the capacity for increased household discretionary spending. There was a complete lack of what I would term "self regulation". The system itself was not self correcting, and worse still the incentives to behave rashly weren't just limited to bankers.

While the FSA will take a bullet for the ensuing mess, the Conservative's restructuring plans will fall well short if there isn't an underlying shift in the way in which people and institutions self regulate. While that is an easy comment to make, it's a pretty big step in the real world. The world's financial system is too complicated to micro-regulate - the only way it will stay in good order is if their is a seismic shift in the moral code that its participants bring to bear everyday in their places of work. Not an easy transition at all.

Having said that, there are examples of the process of self regulation working very well, and some of the best of these examples come from the sporting world.

A couple of weeks ago, the world watched as a 59-year old came within inches of winning the British Open golf tournament - the biggest tournament in that sport. The spectacle was incredible for that alone, but the level of sportsmanship and grace he displayed in the process, makes Tom Watson a real hero of the game. The game of golf is almost unique in that it is almost entirely self regulating. Players record their own score and are expected to call penalties on themselves as they occur. In big tournaments a referee is on hand to help clarify situations where there might be a grey area in the application of the rules. Rarely if ever do the ruling bodies ever actually call penalties on the players - it is the players who are expected to regulate themselves, and if they ever fail in this responsibility then they truly become outcasts within the game.

To call a player a cheat in golf is the biggest slur possible, and to be found guilty of cheating will see you forever banished to the far corners of the golfing world. It is a far cry from the acrobatic cheats who try to con referees in football, and a far cry from the type of bankers who stealthily acted in the knowledge that their reputations weren't the most important part of their make-up.

This situation didn't just occur, so what is it about the game of golf that created such an environment? And is there an equivalent recipe that could be applied to the way in which financial markets, for example, are regulated?

In a similar vein, cricket was once the bastion of sporting self regulation. I was reading an article this week about one of the games truly great players - the Australian wicket-keeper/batsman Adam Gilchrist, who not only was one of best players of his generation, but was also deemed to be one of the most honest. The article recounted a tale of this honesty.

From Paul Kimmage in the Times: "Australia have won the toss and he is walking out to bat with Matthew Hayden against Sri Lanka in the semi-final of the 2003 World Cup. After five overs they have 34 runs on the board. Gilchrist has 22 of those runs and is feeling good. The spin bowler Aravinda de Silva has been sent on to bowl. Gilchrist blocks the first ball. The second ball is flighted and Gilchrist goes down and tries to sweep it behind square leg but the ball ricochets off the bottom edge of his bat and hits his front pad just above his ankle. He hears frantic screams of "Catch it! Catch it! and turns around to see Kumar Sangakkara, the Sri Lankan wicket-keeper with the ball in his gloves. "Well, that's that," he thinks. But the umpire Rudi Koertzen is shaking his head. "Not out." Koertzen is wrong (not for the first time). Gilchrist knows he has made a mistake. There is a voice inside his head screaming at him: "Go. Walk." He starts to walk.

There’s another voice in his head. It’s telling him he’s crazy. It’s warning him his teammates will be incensed. It’s telling him this is not what cricketers do. But there’s no turning back. He reaches the changing room, grabs a drink and joins his teammates in the viewing room. Someone asks if he had seen Koertzen shake his head and say not out. “Yes,” he replies. “I saw him.” A few minutes later, Ricky Ponting is out for two and joins them on the balcony. The team are struggling. The board reads 2-37. “Did you see Rudi give you not out?” Ponting asks.

“Yes,” Gilchrist replies.

This is how he describes what happens next: “Not much was said after that. The implications of what I’d done would play out over the next hours, days, and even years . . . All the media interest was in my decision to walk. What a bizarre world it seemed, where a simple act of honesty made such headlines. I never thought my act reflected badly on other players, and I still can’t see how an inference can be drawn that because I walked, anyone who doesn’t walk is a cheat. That’s not the case. The ethics of the matter are tangled, and I do not think there is anything dishonest or dishonourable in a policy of not walking. The matter is not black and white; you cannot put the honest people in one box and the dishonest ones in another.”

The reality for Gilchrist was that over the course of his career, his honest behaviour was preempted by umpires around the world and his reputation probably served him quite well. The umpires felt comfortable that Gilchrist would be "self-regulating" which made their jobs easier and ultimately made them less likely to give him out if he himself did not think he was out. Gilchrist had more of an issue with teammates whose perspective on the game was different from his, which made it harder and harder to act with the level of honesty that he became known for.

Gilchrist, would be described as "old school" - the way he played the game was once the standard attitude of the "gentlemen" who took the field in earlier generations. As the quality of the technology available to the umpires in cricket has improved, so the responsibility for self regulation has more and more been removed from the individuals playing the game. This greater regulation may have made the game more accurate, but the purists might suggest that it has not made the game better - more and more individuals try to cheat the system because their sense of personal responsibility has been removed and placed in the hands of the umpires.

To translate this analogy into the language of financial regulation is not straight forward. A point to consider, though, as we try to re-regulate the system after the turmoil of the last couple of years is that the "spirit of the game" cannot be forgotten in the process. In the legal world, after years of expensive training, the threat of being "struck off" stands in the background protecting (to some extent) the spirit of that game. Perhaps more needs to be done in the financial world to create an ethical backdrop - certainly the CFA qualification spends a lot of time focused on this issue, and perhaps should become an industry standard. One of the problematic differences, however, between the legal profession and the banking world is the annual bonus system, which means that not playing within the spirit of the game can be so rewarding in the short-term, that the threat of being "struck-off" may be too far in the future to be a sufficient disincentive.

Standing on a golf course the vast majority of golfers would not allow their own playing partner to cheat, let alone the opposition. That same mentality hasn't been translated into the offices of the world's financial community. To try to regulate the financial system from a purely over-sighted way (like a football referee) is both very costly to do well, and ultimately will be unsuccessful. It needs to come hand in hand with proposals to address the ethical underbelly of the whole game. Perhaps the rulers of the golfing game, the Royal and Ancient, can provide some guidance.