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On Business and Economics in Volatile Times
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June 30, 2009
One of the concepts that every student of economics ought to know - though many fail to grasp its significance - is moral hazard. Essentially, moral hazard is a behavioural change induced by insurance. People who have taken out insurance know that if they loose, part of the loss will be covered by the insurance. This influences their decisions because the insurance changes the risk profile of alternative options. Put simply, insured drivers are likely to have more accidents.
Concerns about moral hazards guide a lot of regulatory policy. Many governments would like to help people experiencing hard times to help them avoiding poverty. Yet, generous help, say unemployment benefits, may reduce peoples' efforts to get out of their crisis themselves. This sort of moral hazard considerations are a common part of many debates on regulatory issues.
The financial crisis has created dilemmas such as these on a much grander scale. Governments have been bailing out some of the largest businesses because of their impact on the wider economy, notably banks and, more recently car manufacturers. The shareholders usually lost out in these bailouts - as they should, after all they have been reaping the benefits of a high risk high return strategies when times were good. But does that resolve the moral hazard issue? Will bank bail outs lead banks to take on more risks than they should? Will car manufacturers pursue risky growth when then should be downsizing?
Some rescue actions indeed may have caused such effects. Guarantees and loans aiming to keep business afloat are likely to create moral hazard problems. Moreover, even in cases of nationalization, shareholders and other investors often did get more than nothing (the outcome if bankruptcy was not prevented), even if they loose a lot.
On the other hand, managers often act in the shareholders interest only in theory. They pursue their own interests - which are defined by their own remuneration and power. The real moral hazard problems seems to have been created by the remuneration packages for top executives. Incentives schemes such as share options link top managers' salaries to share prices. Yet, share options imply an unequal distribution of risks: If things go well, the manager reaps potentially huge rewards. If things go badly, they may get no bonuses, but won't loose their own assets. This unequal distribution creates a moral hazard problems that may induce excessive risk taking. Hence, it is shareholders that should take action, and introduce better remuneration packages for the top executives supposedly acting on their behalf! Notably, share options should be redeemable only after much longer time periods than is currently the norm.
The crash in the financial markets challenges many of the assumption of the economics and finance theories that we teach - at least in the basic models, the 'must knows' for undergraduate students. In particular, our basic models are build around the assumption that markets are efficient, and hence prices are fluctuate randomly around an equilibrium price that reflects supply and demand. Modern finance theory goes a bit beyond such models to explain deviations from equilibrium - and thus the possibility of bubbles (Randall Morck gave a great lecture on this topic at the AIB conference).
For a long distance flight, I recently picked up George Soros' updated book on the global economic crisis. Soros is a well know investor who made billions in financial markets. Yet, if you expected investment tips, you would be disappointed. Soros is outing himself as Popperian philosopher, developing what he calls "The Theory of Reflexivity". Essentially, he is arguing that markets cannot be efficient because the underlying assumptions about human behaviour don't hold. Contrary to the natural world, social phenomena are based on decision makers' analysis of the likely outcomes of their own decisions. Hence, outcomes are not independent of actions, and cognitive limitations undermine the supposed rationality of the decision making. In Soros' own words "knowledge requires a separation between thoughts and their objects - facts must be independent of the statements that refer to them - and that separation is difficult to achieve when you are part of what you seek to understand" (p.26). He calls this reflexivity, situations where the objective and subjective aspects do not correspond. This lack of correspondence can lead to processes where "changes [in the real world] occur as a result initial misconception or misinterpretation by the participants, introducing an element of genuine indeterminacy into the course of event" (p.29).
Soros uses his philosophy to explain how financial markets really work - and the fact that he made a lot of money in financial markets suggest that he might be on to something interesting. He rejects the efficient market hypothesis as inconsistent with human behaviour. More fundamentally, he rejects the applicability modelling approaches derived from the sciences: "reflexivity prevents economists from producing theories that would explain and predict the behaviour of financial markets in the same way that natural scientists can explain and predict natural phenomena". In basing decisions on distorted subjective perceptions, market participants can cause bubbles in financial markets that, as we have seen in 2008, can a) be huge, and b) affect strategic decisions by businesses outside the financial markets. 89
My synthesis probably is a bit too simplistic, but I just wanted to give the gist of the argument. I was reminded of Simon's concept of 'bounded rationality' - Soros' reflexivity seemed to be a special case of that. My main problem with his theory is that it does not lead to an alternative approach to explain and predict markets. I couldn't work out how he would, given his philosophy, prevent bubble from emerging, or how he would regulate markets (given that regulators would be subject to the same cognitive limitations as market participants). Though recognizing that bubbles exist, and are in fact quite common, seems to help making a lot of money.
At times when all the talk in the UK politics is about long-term government budget cuts, it is refreshing to see some decision makers - even politicians - thinking long term. Last night the German parliament took a decision that merited a small note in the German Press, but is headline news in the Danish and Swedish Press. After 19 years of planning and negotiating, the Germans finally said yes to the bridge over the Femern Belt between the German Island of Femern and the Danish Island of Lolland. It will cut the travel time between Hamburg and Copenhagen by an hour, and thus connect both Denmark and Sweden (itself connected to Denmark by a bridge of similar magnitude) closer to Europe.
The financing model is kind of interesting. The Germans only pay for the upgrading of the motorway and rail link on their side. The Danes build and pay for the bridge - and in return collect the toll, a rather unequal distribution of risk and returns. Seems that entrepreneurial spirits are more alive in Copenhagen then South of the border. I suspect the Germans will come to regret that ... in about two decades or so. If you are construction engineer, head for Denmark now, a lot of work is awaiting!
I suspect I may become a bit nostalgic when I first travel over that new bridge in 2018. When I was living in Denmark, the train to Germany always included a romantic break when the train pulled on the ferry, and one could swap the train seat with some fresh air and duty free shopping. That will finally become history.
Once upon a time, GM was one of the most prestigious companies of America, producing one in two cars sold in the USA. Yet, that seems like a live-time ago. Market share has been falling over the decades, and in recent years even the absolute numbers of cars sold dropped from about 4.5 million cars a decade ago to 3 million in 2008. In the US, GM has now entered bankruptcy, and the US governments seems to take over what is left.
In Germany, GM's demise has played out as a particular drama. GM is one of the largest car manufacturers in Germany, still using the brand Opel acquired back in the 1920s. Thus, the crisis in Detroit send not just employees, but German politicians into panic. One by one they took to the stage, making promises to their constituents - 'never will I allow Opel to go bust...'. State-premiers and ministers from both coalition parties in the federal government all had their interests, and made their promises. On the other side of the Atlantic, it seems, smart business negotiators just waited ... and increased their demands for state guarantees. Eventually, a deal came out that would sell Opel to Magna of Canada as leader of a consortium also involving Russia Sberbank - with 35% of equity retained by GM. What I couldn't work out is how they would separate GM and Opel, given the shared model platforms, technologies and patents, and the tightly integrated supply chains. Either way, the new company would be economically dependent on GM for technologies and rights. Somehow it all feels like the German politicians have been pulled over the table, big time. American taxpayers should say 'thank you'.
While politicians were competing to be the rescuer of Opel, one stood up to say stop! Minister of Economy zu Guttenberg, only recently promoted, tried a tougher bargain, and got flak from the trade unions in response. However, counter-intuitively, the latest opinion polls suggest that zu Guttenberg gets the highest rating from voters! Perhaps voters do understand that paying huge subsidies to big business is not quite the best policy.
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