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Have Bankers Been Practising Socialism? The Debate About the Top 1 Per Cent

Boris Johnson has got into trouble for his statement that it is “surely relevant to a conversation about equality” that just 2 per cent of “our species” has an IQ over 130. Over the past couple of years, the Occupy movement has made headlines by attacking the top 1 per cent.

The summer 2013 edition of the top American Journal of Economic Perspectives focuses specifically on the “Top 1 Per Cent”. This is written almost exclusively in English rather than maths, and top economists debate a range of intriguing questions.

Gregory Mankiw of Harvard has a piece entitled simply “Defending the One Per Cent”. Mankiw points out that IQ is “about as heritable as many medical conditions”, as are factors such as self-control and interpersonal skills. Taking this into account, America is truly an equal opportunity society. The specific family environment itself counts for very little. Further, the tax system in the US is very progressive. The poorest fifth pays 1 per cent of its income in federal taxes, the middle fifth 11.1 per cent, and the richest 1 per cent pay 28.9 per cent.

That said, Britain’s Tony Atkinson, with his colleagues, point out that changes in the share of income going to the top 1 per cent have been very different in the Anglo-Saxon economies than in those of Continental Europe. Over the past century, in the US, UK, Canada and Australia the share has followed a U-shape. It was high, fell, and is now back where it was early in the 20th century. In Europe, it looks much more like an L-shape. There has been some increase in recent decades, but the rise is small. They conclude that specific institutional factors must be responsible, since all the developed countries have all faced the same global economic environment.

The Labour Party’s old Clause Four promised to “secure for the workers by hand or by brain the full fruits of their industry”.  It seems to me that in the Anglo-Saxon economies, many “brain workers” have been practising socialism in the most unlikely settings. In Silicon Valley, for example, almost all the value of high-tech start-ups is embodied in their key personnel, who have not been shy of taking large equity stakes. The successful companies generate enormous wealth for a small group. In hedge funds and banking, the “workers” have certainly seized the full fruits. It is precisely in these sectors of the economy where the Anglo-Saxon countries are strong. Hence we see a sharp increase in the share going to the top 1 per cent.

One of the papers raises the question: why has democracy not slowed rising inequality?  People like Steve Jobs are seen as deserving their success because it is based on merit, whereas bankers are vilified. But it is fiendishly difficult to legislate between the two. For centuries, England has wrestled with the problem of the deserving and undeserving poor, the “sturdy beggars” of Elizabeth I’s Poor Laws. The same now applies in reverse to the super-rich.

As published in City AM on Wednesday 11th December 2013

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Britain’s New Industrial Policy: Can We Learn from the Mistakes of the Past?

The phrase ‘industrial policy’ seems to take us decades back in time. In 1964, a powerful catchphrase of the new Labour Prime Minister, Harold Wilson, was the need for Britain to embrace the ‘white heat of the technological revolution’. Sadly, by the 1970s this vision had deteriorated into a list of institutions, stuffed with dull businessmen and trade unionists, meeting to decide how to prop up yet another failed sector of the UK economy.

But the concept is now back in vogue. Perhaps surprisingly, given the historical experience, the coalition chose to preserve Labour’s Technology Strategy Board (TSB) quango. The TSB has a budget of £400 million to “accelerate UK economic growth by stimulating and supporting business-led innovation”. A key way in which it plans to do this is through the purchasing decisions of the public sector.

In October, Sir Andrew Whitty, CEO of GlaxoSmithKlein, produced a report commissioned by the Department for Business, Innovation and Skills on how universities can better support economic growth and drive exports. Whitty calls for the creation of “Arrow Projects”, supporting cutting edge technologies and inventions where the UK leads the world, with, in an excruciating pun, “universities at the tip”. Universities and Science minister David Willets eulogised the report. In language redolent of Soviet Five Year Plans, he stated that “we are making strides to help commercialise the work of universities under the Eight Great Technologies”.

It is easy to mock both the symbolism and the content of speeches and reports such as this. But the intention deserves to be taken very seriously. Thinking back again to the decades of the 60s and 70s, far-left radicals used to denounce the ‘military-industrial complex’ of the United States. Yet it has been precisely the interplay between the defence and security sectors and high-tech commercial companies that has led to America continuing to lead the world in technological innovations.

A fascinating new book by Bill Janeway, Doing Capitalism in the Innovation Economy, gives many such examples. The creation of the internet is well known, others include automatic speech recognition and digital computing. Janeway has made a personal fortune, not by financial speculation or by trading complex derivatives, but by developing and leading the Warburg Pincus Investment team which provided financial backing to a whole series of companies which built the internet economy.

A fundamental point which he makes is that both scientific research and invention, and its subsequent exploitation through practical innovations, necessarily involves a great deal of waste. This is something which British bureaucrats have, in the past, been unable to grasp. Ideas which are genuinely path-breaking cannot be conceived in advance. And, equally, the value of their practical applications is something which cannot be imagined before it happens. This means that many such ventures will fail. They cannot be conceived in advance. And, equally, the value of their practical applications is something which cannot provide the box-ticking security of projects which add tiny amounts of knowledge, or which make trivial improvements to an existing technology. So, Arrow and the TSB are to be welcomed, provided that they, and the Public Accounts Committee, recognise that most things fail.

As published in City Am on Wednesday 4th December 2013

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Banging up bankers is the wrong punishment – it won’t change behaviour

The behaviour of the banking sector in the run up to the crash is still very much in the public eye. But this is nothing new. Readers of a certain age may recall Bernie Cornfeld, and his company Investors Overseas Services (IOS). It failed dramatically in the 1970s after allegations of fraud. IOS encouraged the flight of capital from developing countries and tax avoidance in the West. Meanwhile, Cornfeld enjoyed an exceptionally flamboyant lifestyle, had mansions all over the world, threw extravagant parties and lived with a dozen girls at a time – movie stars, supermodels and princesses. The only penalty he suffered was eleven months in a Swiss jail, after which he was acquitted.

It is not only bankers who might find the trade-off between risk and reward attractive. So how do we manage to get them to behave responsibly? Cornfeld was very astute. He remarked “if you want to make money, work directly with money. Don’t horse around making light bulbs.” Clearly, people work in banks because they want to make money. John Maynard Keynes wrote in the 1930s that, if people in the financial sector were not driven by money, the work would be intolerably boring. He went on to say that the markets performed a useful social function. Many people in them exhibit serious pathological tendencies, and the pursuit of money diverts them from violence and crime.

The standard way of discouraging irresponsible activity is by changing the incentive structure. This is what lies behind the recent Parliamentary report recommending jail sentences for reckless bankers. Deterrence is important. But there are two parts to any deterrent: the severity of the penalty itself, and the probability of receiving it.  Andrew Tyrie’s report says that top bankers should not be able to use the defence that they did not know what was going on. But even if the law already permitted jail terms, how would the Co-op Bank debacle be dealt with? It reportedly fell into trouble due to the risky loans of the Britannia Building Society. When the Co-op took Britannia over in 2009, these loans were certified as acceptable by two sets of auditors and the Financial Services Authority. Who would do the porridge? The motives of Tyrie’s report are perfectly understandable. But the risk is that regulators with job security and gold-plated pensions will simply use the wisdom of hindsight to assign guilt. It is easy for a bureaucrat to say that, if a loan ever goes bad, even years after it has been granted, someone must be to blame. Uncertainty about the future is an inherent part of the human condition. Incentives do matter. But their real impact comes when they stimulate permanent changes in attitudes and values in the relevant social network. A statement that, for the next five years at least, no one from the City will be given a peerage, knighthood, or even invited to Buckingham Palace garden parties would work wonders. It would send the clearest possible message that the financial services sector needs to clean up its act.

As published in City Am on Wednesday 26th June 2013

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Trouble at Co-op Bank raises questions about fitness of the mutual model

IT’S not all fun and games at the Co-op Bank. Just over a month ago, the bank was serious about acquiring 632 branches from Lloyds. Now its debt has been downgraded six notches to junk status, and veteran HSBC banker Niall Booker has been brought in as replacement chief executive after Barry Tootell resigned.

Inquests have begun, and it is only human nature to look for a scapegoat other than the large amount lost on the bank’s new IT system. Management has delved into its hat, and, hey presto, here is the old Britannia Building Society, merged with the Co-op in 2009. It is, we are solemnly told, the bad debts on the Britannia’s commercial property portfolio which are the problem.

But is there more to this than meets the eye? At a time when other UK banks are rebuilding their balance sheets, the Co-op’s has worsened. In 2009, in the depths of the recession, the bank made a profit. Its write-off of bad debt was only £112m compared to the £24bn impairment figure at Lloyds. This comparatively excellent result was claimed to be due to the “cautious approach taken by both heritage businesses”. Now, instead of being described as cautious, Britannia’s portfolio is portrayed as being very risky indeed.

It is hard to see, on the face of it, how a loan portfolio can survive 2009 in good shape and now be seen as a wreck. It does seem as if the Co-op has relatively recently taken a particularly gloomy view of UK economic prospects over the next five years or so. Commercial property values are sensitive to the state of the economy and, on a sufficiently pessimistic view of the next few years, almost every bank in the UK would be in serious trouble. Of course, the official Co-op view of this crisis could be completely correct. Only time will tell.

But the bank’s current predicament does raise the wider issue about the evolutionary fitness, as it were, of the co-operative structure as way of doing business. Co-ops have been with us since at least 1844, when the Rochdale Pioneers were founded, but have never come close to being the dominant species in the corporate environment. For well over a century, the shareholder-based organisation has reigned supreme.

Organisational structures do not spring fully formed into the world. Like almost everything, they evolve over time by a process of natural selection. In principle, any variant or any mutation might be thought to have a chance, however small, of becoming dominant. The weird and wonderful variety of things that have become Top Boy at some point suggests that this is true.

But a recent scientific paper in the august journal Nature on 16 May provides evidence against this idea. Some variants can indeed become successful and survive, but there may be inherent limits on how much fitness they can develop. The co-operative form of organisation may fit this bill.

As published in City Am on Wednesday 29th May 2013

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International Airlines Group: a ‘fantastic object’? The psychology of mergers and acquisitions

International Airlines Group (IAG), formed in January 2011 by a merger of British Airways and Iberia, is in the news. Operating losses at Iberia in the first nine months of the financial year are believed to be in excess of £200 million.

Since the start of last year, IAG’s shares are down by nearly 40 per cent. Shareholders have a right to feel disgruntled. They might, for example, reasonably raise queries about the revenue forecasting methodology of IAG, just how far out were the projections? Or they may ask how much ‘revenue synergy’ – his task specified on the IAG website – has actually been achieved by Robert Boyle, the Director of Strategy. The list can go on.

Such details of the problems are specific to the BA/Iberia merger. But the principles are general across a whole range of merger and acquisition activity amongst publicly listed companies. Twenty years ago, three American business school academics carried out a studied which transformed the approach to analysing mergers and acquisitions.  There was a lot of work about the impact on share prices of an announcement of a merger, and on the value to the shareholders of the company being acquired.  Julian Franks, Robert Harris and Sheridan Titman looked instead at the long-run impact on the share price of the company in the driving seat.

What they found was not good news. Their results gave rise to a whole new area of academic activity, the so-called ‘post-merger performance puzzle’.  Most of the time, the shareholders of the acquiring company lose out. Each individual case has its own particular reasons, but initiating a merger or acquisition is usually bad news for your shareholders.

For believers in economic rationality and efficient markets, this is a puzzle of the first magnitude. On this view of the world, people are allowed to make mistakes. But they are not permitted to do so consistently. For every merger which underperforms, there should be one which delivers unexpectedly large benefits to the shareholders. And there have been such a large number of mergers and acquisitions that executives ought to be able to learn from previous mistakes. Instead, we observe that there is a persistent downside for shareholders of the acquiring company. Occasionally they gain, usually they lose.

IAG is just one more example of this phenomenon. It is one more nail in the coffin of the concept of economic rationality. To understand why very experienced managers still pursue mergers and acquisitions, despite the track record of such activity, we need to turn less to economics and more to psychology.

George Soros in a speech in June this year borrowed a phrase from University College London psychoanalyst David Tuckett, when he described the boom phase in the EU as being a ‘fantastic object’, unreal but immensely attractive. Executives may create such objects when they think of mergers and acquisitions. BA remains a vital part of the British economy. Let’s hope that Willie Walsh brings IAG back to Earth and sorts out the mess.

As published in City AM on Wednesday 14th November 2012

 

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If it can happen to Google, who can feel safe?

The dramatic crash in Google’s share price and the temporary suspension of trading in the company’s shares made headline news.  The event was triggered by the 20 per cent year-on-year fall in profits in the third quarter of this year.

As usual, there was no shortage of explanations of why this happened – after the event!  A simple search of Yahoo! Finance of more than 40 brokers shows that in the previous three months, all had recommended ‘strong buy’, ‘buy’ or ‘hold’.  Not a single one classed the stock as ‘underperform’ or ‘sell’.  Indeed, over the entire previous year, Google’s share price had risen more or less continuously.  The total increase had been around 30 per cent.

But once the collapse had happened, everything became crystal clear.  It was apparent that the $12.5 billion acquisition of Motorola had been a mistake, because the cell phone manufacturer has been left behind by fashionable rivals.  Further, it was obvious that advertisers were reducing their payments on click-through ads because of the switch to mobile devices by consumers.

It is good fun to mock highly paid analysts when they get things wrong.  But the Google incident has much wider implications for the sort of world in which companies now have to operate.

A specific point concerning the internet is that we are still in a state of flux about how to set prices in this revolutionary medium of communication.  Standard economic theory is no help at all.  This tells a company to set price equal to marginal cost.  In other words, to equate price to the cost of producing and selling one more item.  But for many web-based applications, the marginal cost is to all intents and purposes zero.  Once your system is set up, it costs nothing when the next customer clicks on the site.  Any company following this economic precept on pricing would soon go bankrupt.  All we can say is that we are in a process of very rapid evolution, and no-one has yet worked out a satisfactory answer on price.

The wider issue relates to corporate reputation more generally.  In the highly networked and connected world in which we live, companies can be blindsided by entirely unexpected reactions to events.  Google knew about Motorola and advertising rates.  More importantly, Google knew that the analysts knew.  But the actual reaction seems to have come as a complete surprise to everyone involved, the company and the analysts.

The publication of the notorious cartoons of Muhammad in Denmark attracted little attention, despite vociferous protests from Danish Muslims.  Four months later, the Muslim world erupted in reaction to them.

This inherent uncertainty about which stories will gain traction and in what way is a deep feature of networked systems.  Systems in which people react to the reactions of other people.  Even small scale events or an adverse comment on a blog have the potential to go viral.  Understanding and managing reputation in this new, emerging world is a major challenge for all companies.

As Published in City AM on Wednesday 24th October 2012

 

 

 

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