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Sunday 25 October 2009

The Business of Capital is Bust

Investment Bankers Aren’t Hairdressers

In a recent Financial Times article one of their feature writers opined that the main problem the world has with investment banker bonuses is jealousy rather than the unfortunate fact we’re going have to sell our children to pay off the debt their antics have mired us in. She goes on to expound on how these monetary geniuses offer unique services that deservedly command huge fees by way of an extended metaphor about hairdressers who are able to charge £300 for a haircut that doesn’t require blow-drying for a quarter. I have a local barber that does the same for £295 less. It's called a crew cut.

The discourse of jealousy is rife in financial circles at the moment, it being an easy way for poor put-upon bankers to justify and defend themselves to themselves. The reality’s more complex and deserves a properly serious treatment because investment banking is a vital function in the modern world. The business of capital needs a proper defence, not half-baked childish psychological theories which merely justify the status-quo and irritate the hoi-polloi without addressing the real, underlying problems.

Good Capital, Bad Capital

If we needed evidence of how important the business of capital is to our economies then the problems of the past couple of years, when the availability of investment capital has suddenly been choked off, should be sufficient. Without massive, free flows of capital our world doesn’t function very well and those people who are able to create, manage and direct those flows are incredibly important. Whether we like it or not such people will make vast amounts of money as they levy their tolls on the passing financial traffic.

However, there’s good capital and there’s bad capital and it’s fiendishly difficult to tell the difference (although when it's directly borrowed from taxpayers at century low interest rates it's a bit easier to spot). Unfortunately the downside of the creation of bad capital takes time to become clear and if we reward the purveyors of it in the same way as we reward the managers of the good stuff we create perverse incentives for quick-rich merchants to dig a huge financial black hole for taxpayers to backfill – see Perverse Incentives Are Daylight Robbery and Gaming The System for a more extended discussion of this.

It’s inevitable that those people able to generate huge amounts of capital will come in for a certain amount of opprobrium since they’re the embodiment of the destructive processes of capitalism. They oft-times make huge fortunes by destroying the livelihoods of others but, in so doing, open up new investment and business opportunities that would otherwise have languished in abeyance due to the lack of investment capital. That's capitalism for you - the guys in the black hats win every time but the Lone Ranger gets to trade in Silver for a T-Bird and a winter condo in Florida.

Michael Milkin, Capitalist Hero

Take Michael Milkin, the junk bond trader who eventually spent time in a US penitentiary for securities violations. Milkin is popularly regarded as the embodiment of greed and as an essentially destructive force. His ability to raise huge quantities of capital was a major factor behind the rise of the leveraged buyout (LBO) which saw many well known businesses getting taken over by sharp pencilled financial specialists whose main aim was to generate excess returns on previously moribund capital by gearing up balance sheets to generate yet more capital for further corporate actions.

Ultimately this process extended into so-called ‘greenmail’ where potential takeover victims found themselves on the end of phantom takeovers where the aggressor was able to use Milkin’s promise to raise capital to fund the takeover as leverage to force capital reconstruction. In common parlance this meant that the target companies had to take on debt to return capital to shareholders – including the greenmailers.

Efficiency at the Point of a Knife

While all of this is vaguely unsavoury and clearly impacted ordinary workers in the target companies, many of whom lost their jobs as a result of the efficiency improvements needed to fund the corporate activities, there is an economically important benefit to such actions. Done properly these types of activities release capital tied up in old, inefficient and slow growth businesses to invest in new, efficient and high growth ones. Arguably without Milkin there’d be no internet. Unfortunately, once a financial bandwagon starts rolling it’s hard to avoid every greedy copycat in the vicinity jumping on board.

So it was with LBO’s as the levels of leverage being applied to takeover victims grew steadily higher and higher. With such mounting debt came ever more dubious justifications from the investment industry, ending with the analogy that excessive debt made managers more careful, like a driver with a dagger mounted on the steering wheel, pointing at their heart. As Warren Buffett wryly observed, that just means that the smallest pothole is fatal. So it proved of the most highly geared companies. And Michael Milkin, hero of the capitalist system, went to jail.

Excessive Gearing

It’s in the nature of the business of capital to overreact in this manner and the system of incentives that lies behind it is a major factor in these swings. By rewarding the creators of bad capital just as heavily as the creators of good there’s every reason for every individual to chase the capital dog to the very limit – which usually means the creation of excess gearing.

The breakdown in world finances that the world has suffered since 2007 is largely due to the investment banking industry finding ever more creative ways of generating capital. We saw in It's Not Different This Time that the excess returns made by banks since the early 1990’s are almost entirely attributable to increases in leverage of their balance sheets rather than a reward for skillful and intelligent risk taking. Which is what you get when you reward people for generating capital without regard for its pedigree.

An Anthropologist on Wall Street

Part of the problem for the financial industry is that it deliberately sets out to generate insecurity, because in movement and instability lies opportunity. If there’s no corporate activity then there’s no money being generated. This insecurity drives to the very heart of the investment business as the individuals within it seek to maximise their returns in the minimum time available, before they themselves are reorganised.

As Karen Ho, in her anthropological study of Wall Street, has observed, this restlessness translates into the need to create corporate instability outside of the financial industry and has major implications for workers in industries with no experience or capability of dealing with the levels of insecurity this causes. The ordinary employee simply doesn’t have the skills to cope with the type of seismic change that investment bankers habitually live with.

Greedy and Responsible?

It’s little wonder that when the folks on Main Street think of investment bankers it’s not as the lubrication that makes the free, capitalist world go round but as a bunch of overpaid, greedy and remote technocrats with little understanding of the real world. Which is probably not too far from the truth, even if it’s a bit one-sided.

However, the business of capital is far too important to the world to leave it at that. The investment banking industry needs to reform itself from within: there are no people better situated to flag the difference between good capital and bad and to create incentivisation schemes that differentially reward the purveyors of each. A socially responsible capital creation industry is probably a bit too much to hope for, but a system of delayed incentives based on the generation of real returns as opposed to simply rewarding the creation and movement of capital will go a long way towards creating an industry and a global economy subject to less inherent instability.

Reform or Be Reformed

It’s already clear governments are going to enforce changes which, mostly, will end up damaging the capital generation capabilities of the world. This is because, external to the industry, no one can differentiate between bonuses for good capital and those for bad – so you get a “one size fits all” solution which suits no one and will lead to subdued global growth for years to come. The natural inclination of the denizens of the world of capital creation is to grab as much as they can now, ignoring the fact that this money has been spirited away from consumptive children, poorly puppies and impoverished pensioners to prevent an even greater crisis.

For the sake of the industry, and the world, it would be better if the investment banks addressed their own problems rather than simply moaning about the irrelevant jealousy of the masses because, unless they do, the business of capital will be bust for a generation. The world can do without £300 hairdos but it can't survive without good investment banking: it's time to take a razor to both.

Related Articles: Moral Corporations: An Oxymoron?, Hedge Funds Ate My Shorts, Gaming The System, Perverse Incentives Are Daylight Robbery, It's Not Different This Time


  1. My view is that people make explanations of the economic crisis far more complicated than they need to be.

    Stocks were priced at three times fair value in January 2000. If you do the math, that tells us that there was about $12 trillion of money floating through the economy fated to go "poof!" in the not-too-distant future.

    What should we expect to see happen to an economy that loses $12 trillion worth of assets? About what we see before us today, no?

    I don't think it had anything to do with the bankers. Except that they believed in the Efficient Market Theory to the same extent as most of the rest of us. And they happened to be in the wrong place at the wrong time. Someone had to be there when things went "pop!' It happened to be the bankers. But I don't see that as being the biggie here.

    I see the $12 trillion of funny money as being the biggie. I point to the reckless and non-stop promotion of the Passive Investing concept (the idea that there is no need to lower one's stock allocation when prices become insanely dangerous) as the primary cause of that one.


  2. no, the problem is that the bankers received a bailout that allowed themselves to remain solvent when they were not. but it does not end there. it is compounded by the fact that 'real people' are not being bailed out, rather, the very institutions that were saved are now foreclosing on the 'real people', or demanding untenable aggreements on distressed loans given to 'real people'. 'real people' here that this is happening to other 'real people', and whether it is their own situation or not, they are enraged. It is also begining to dawn on 'real people' that the personhood status given corporations is a privileged gift. the greedheads days are numbered... viva la revolucion!

  3. Great article. Only criticism I would make is the consistent mis-spelling of Michael Milken's name as "Milkin".

  4. Ideally all the investment banks would have gone bust last year which would have triggered the shakeout that was needed.
    But as the collaterall damage of that would have been massive economic, and probabaly social, disruption governments choose the lesser evil of bailing out the banks.
    The trick now is to resolve the agents v principals dilemma of allowing bankers to use our capital in a sensible way. The key is for our capital to be adequately rewarded for the risks managers take with it on our behalf.

  5. A message from the hoi-polloi:

    Not much time to respond (working) STOP
    Hoi-polloi understand well enough already. Amusing that you seem to think not. Guess you’re very detached STOP
    Hoi-polloi already got used to idea of wankers in The City getting paid lots back in the 80s- remember- British society meets nature-red-in-tooth-and-claw- all a long time ago now- we’ve so got over the jealousy thing already girlfriend STOP
    Angry now because of public money bail-out rescuing useless *failed* wankers who keep their jobs despite being useless and *failing* but then continue to get paid lots- comprende? STOP
    Investment banking not as important as you think. Just another pond-life world like all the rest. All ultimately based on dull drone hoi-poloi activity STOP
    Not only money taken from puppies and orphans (“uh- uh- oh- you’re so funny”) but also from doctors, dockers, taxi-drivers, squaddies, chiropodists, plumbers, jockeys, radio-presenters, sociologists, shelf-stackers, North-Sea divers, tree-surgeons, assemblers, call-centre workers, psychiatric nurses, telecoms engineers, musicians, shop assistants, cooks, bookies, farmers, physicists, blacksmiths, miners, teachers, train-drivers, fishermen, work-shy benefit-cheats, poets, typographers, firemen, drug-designers, mountain-climbers, key-grinders, vets, politicians, estate-agents, hairdressers and pompous house-husbands with too much time on their hands... (I could go on) STOP
    Can’t ever fix- capital always has and always will be misallocated- “it is ebb and flow, tidal gravity, it is ecological balance”. Structural change would help (regulation- the process- largely discredited) so at least separate utility and speculative banking so that failure can happen, then no problem with them paying each other as much as they like. Less anger ensues STOP

  6. You're right - there needs to be a massive change.

    But it won't be able to come from within - why will investment bankers who are there now want a change? they are just taking the money now and running as they know in a few years that it will be it be all over - the gov't won't have money left - or maybe they'll put up VAT to 30% so bankers can continue with their state subsidised employment.

    PS - "A message from the hoi-polloi" - great post :)

    We better get praying to God that we will see some justice in this world - and soon (as looks like everyone else is too scared of the 'talented' bankers in the city!)
    In Jesus name.

  7. Well, well, well. That is one of the weakest posts from you I have read so far.

    First, there is no good or bad capital. There is _real_ capital and then there are speculations. What banks incl. investment banks were doing since the 90s was speculation. What you call bad capital has in fact nothing to do with capital, i.e. utilised productive capacity. Housing per se has zero productive capacity. It is not capital.

    Next you confuse loanable funds theory with "we are doing God's work" claims. Loanable funds theory died together with the gold standard. In the fiat money world banks create money and that is how they managed to get to such leverage and to blow bubbles. In the fiat money world loans create deposits and everything else is satisfied by the central bank since its primary policy target is short-term interest rate.

    Finally, the only reason that Milkin and LBOs have to live is because we (governments) subsidize them. There is no intrinsic or economic reason why interest payments should be tax deductible and the only economic effect of it is to pass these taxes onto banks at the expense of budget and broad public. This then leads to larger loans that banks will give and in the end higher asset prices. The essence of financial industry is to capture any income of non-financial sector in interest payments. Any benefits that we, consumers, explicitly gain is implicitly shifted onto asset price and in the end larger loans that we, consumers, have to take.