COMMENT Abolishing risk destroys wealth
By Axel Merk
Our willingness to engage in risks drives our prosperity. In the United States,
we urgently need a public debate on risk, one driven by reason, not emotion.
Without risk, individuals are bound to lose the purchasing power of their
savings; corporations that don't take risk will fade into oblivion; and
governments that regulate away risks destroy the growth engine of their nation.
The US is the most prosperous nation because it has embraced risk taking.
Silicon Valley has created some of the greatest innovation because it has been
a magnet for entrepreneurs. When we evaluate our love-hate relationship with
investment banks, let's not forget that as one of their key roles, they
facilitate the aggregation and deployment of risk takers' capital. When
policymakers interfere with crucial elements of the American growth engine, we
all deserve a broad debate on the subject.
The reason why most of us invest is because we are concerned
about the purchasing power of our savings. Sure it's great to achieve returns
in excess of what it takes to preserve purchasing power, but inflation and
taxes are bound to destroy savings over time if we don't take risks in an
effort to achieve higher returns.
There are very few families in the world that have managed to retain great
wealth over generations. There are two main reasons for this: those who rely on
their savings to support their lifestyle are bound to lose them over time; and
those who do take risks may or may not make the right decisions. But those who
do not take risks are certain to lose. Those who do take risks have a chance of
staying ahead of the game. A society thrives when creative destruction is
endorsed: rewarding successful risk-takers makes a society prosper as a whole,
as successful companies and industries will grow, whereas weaker ones are
allowed to fail.
The US is not the only country that thrives by endorsing creative destruction.
China has allowed the low-end toy industry to fail, accelerating a shift
towards goods and services that cater to, as we call it, the higher end of the
value chain. The country is positioning itself where it can compete. China
knows it can't keep its currency peg forever; it knows that allowing the
currency to rise is the most effective way to tame domestic inflationary
pressures.
And the US? We try to destroy the financial services sector on top of
manufacturing. Jimmy Rogers, the former hedge fund manager known for his love
for commodities in particular (he says Wall Street traders should learn how to
drive a tractor to cater to the boom in soft commodities), has just been
appointed to the board of a commodities exchange in China; China is ready if we
want to give up the quasi-monopoly the US has enjoyed in trading commodities.
Singapore, too, is waiting with its doors wide open: the city may be the winner
of those alienated by policies coming out of New York and London. In the US, in
contrast, policies all decade long have fostered an acceleration of outsourcing
in an ill-guided pursuit of consumption at any cost. I would like to say that
it ended in the credit bust, but unfortunately, there's no end in sight to the
policies that got us into trouble in the first place.
Don't take me wrong: a lot of bad has come from Wall Street and the anger in
the public is real and justified. But we need to keep a cool head and not throw
out the baby with the bath water when meddling with the core values of what
made the US successful over time.
Risk itself is not bad. What is bad is that we say we need to set up
bureaucracies to manage systemically critical institutions without even
defining what "systemically critical" actually means. What is bad is to think a
super-regulator will somehow prevent the next crisis rather than merely further
increasing the barrier to entry.
What is bad is to reward bad decisions in the banking sector by draining money
from taxpayers to support failed banks. What is bad is to put in place wage
controls without a public debate on whether that's indeed a prudent course of
action; traditionally, wage controls have never worked - the most recent time,
when Congress decided to no longer allow tax deductibility of salaries in
excess of US$1 million in the 1990s, gave rise to an explosion in the award of
stock options and a shift in focus to micro-managing quarterly earnings,
inadvertently contributing to the present mess we find ourselves in.
Greed is part of human nature. The challenge for policymakers is to put the
right incentives in place to increase the odds that - for society as a whole -
more good, than bad, results from greed. I emphasize incentives because
incentives typically work better than regulation. The Chinese have long tried
to manage economic growth with regulation - giving mandates to banks about how
many loans may be issued; the Chinese may soon come to the realization that it
is far more efficient to allow market forces to dictate growth, and that using
levers such as interest rates and a freely floating exchange rate will be more
effective.
Regulation breeds corruption, loopholes, lobbying, and so forth, and, by
implication, inefficiencies. The more general the levers of policymakers, the
more effective they are. For a central bank to engage in private-sector asset
purchases is extremely inefficient. The Federal Reserve has been substituting
rather than encouraging private-sector activity. The Fed's actions to buy
mortgage-backed securities have cemented the government's ownership of the
mortgage market. A free society with a government-owned mortgage market? Please
don't tell Adam Smith, who would turn in his grave. The government hasn't
stopped there, but there's no need to expand for the purpose of this argument.
Risk taking is good. What is not good is to have gains privatized yet losses
socialized. It is good that someone is willing to risk their savings to put
their money where their mouth is. It's not good that someone puts someone
else's money where his or her mouth is, then collects the gain, but is not
responsible for the losses. How do you fix this? With salary caps? With a
systemic risk regulator?
In our humble opinion, no, that's the wrong approach, as it paralyzes financial
institutions. We may hate them now, but without them we would be worse off. We
need to turn our anger into constructive suggestions, not destroy a backbone of
economic growth.
Every major bust in history was the result of excessive credit expansion. Some
have argued that one needs to actively restrict credit expansion. The argument
against this debate - a debate worth having - is that it would put regulators
in the game of managing asset prices. As we are in a world where central banks
set interest rates and control money supply, I do think they should be vigilant
that excessive money supply does not push up all asset classes without a
comparable pickup in real economic activity - the clearest bubble indicator, in
our view.
If risk is good, what is bad? What is bad is that someone's risk appetite can
bring down someone else. And that this threat provides a guarantee that the
risk the speculator takes is asymmetrical: Heads, I win; tails, you lose. Well,
fix that. How about: Heads, I win; tails, I lose. It's really that simple.
I don't have a problem with anyone speculating, as long as his or her risk does
not impose on my wellbeing. Indeed, speculators are a crucial part to our
economic system; without speculators, we would have frequent shortages in
commodities: producers, be they in oil or agriculture, would not be able to
hedge their production and thus produce less as they face uncertain revenue,
but certain production costs. In many areas, speculators are crucial to the
real economy.
There has been much debate about certain transactions that, in some people's
eyes, serve no common good. Should parties A and B be allowed to engage in a
contract that party C goes out of business, even if parties A and B have no
stake in C's success or failure otherwise? But let me turn the question around:
what is our business to regulate such transactions? Regulators start meddling
with such transactions if such decisions become "systemically important" -
presumably this means when such transactions can rock the financial system as a
whole because of the leverage typically inherent to them.
There's a cure for this: force anyone engaging in a leveraged transaction to
post collateral and to mark such transactions to market every single day. On
regulated exchanges, this happens all the time. Take as an example, when oil
traded at $100 a barrel in 2008, a speculator placed a leveraged bet it would
fall down to $50. As oil soared to over $140 a barrel, the speculator would
have been asked by the exchange to post additional collateral along the way. If
the speculator is unable post the collateral, the exchange will close out the
position, even if the speculator may ultimately be right (as oil did make it
down to $50 later in the year). The point of this mechanism is that the failure
of any one player does not jeopardize the system. Further, because the rules
were clear from the outset, the speculator had better think twice before
putting up so much leverage.
Banks are fighting tooth and nail about applying the same rules to credit
derivatives and other transactions. They argue it is not necessary because
their positions will ultimately be profitable, that the crisis valued their
securities inappropriately. Of course they would say this: anyone holding an
asset is inherently biased to the upside. In any event, that's besides the
point. It's the risk to the system that must be averted. And the way it is
averted is by providing a market-based mechanism to wind down leverage before
it causes a problem. A regulated exchange is ideal in such situations, but
similar mechanisms can be implemented when a regulated exchange is not
practical.
One can require financial institutions to have a greater capital cushion. The
trouble here is that most proposals are not working with market forces and, as
a result, will be diluted through lobbying once the memory of the latest crisis
fades. It's beyond the scope of this newsletter to go into details of possible
avenues here, but there are market-based approaches to make banks more
resilient, for example by making them more dependent on long-term debt and less
on the overnight funding markets - the lack of access to capital in the
overnight funding markets brought both Bear Stearns and Lehman Brothers to
their knees.
One can also work with tax incentives; for example, apply them to leverage in
general, such as eliminating the possibility for corporations to deduct
interest expenses (one needs to offset this with a reduction or elimination in
corporate income tax).
Aside from risk, the place regulators should tighten the reigns is in
boardrooms. Executives foremost report to the board of directors, and that's
where the oversight must be rooted. Boards must have oversight of policies that
reflect their fiduciary duty when it comes to how much risk executives may
take. Such policies must be clearly communicated to stakeholders. The point is
not to restrict risk taking unnecessarily, but to inform everyone that deals
with the firm what their risk profile is. It's then up to others to choose to
conduct business with or invest with the firm.
What is important is that the public has a healthy debate on what is to be
done; we are rather concerned that policymakers impose restrictions in the heat
of the moment that will cause more harm than good. The peak of the crisis has
abated - in some ways, the perceived stabilization has reduced the sense of
urgency. But, ultimately, the reforms being negotiated will not only affect
your ability to achieve and sustain wealth, but that of the US as a whole. Tell
your elected officials they have a job to get done.
Your savings are at risk if you don't engage in this fight. This fight is
rather unpopular right now as we see how executives of companies on government
support are fast rebuilding the system that proved unsustainable the first time
around, while receiving top dollars in compensation. But that's precisely
because too few are involved in the real issues that foster bad
decision-making. As the financial crisis has shown, there is a real impact on
your wealth when bad incentives lead to a financial meltdown; but there is also
a real impact on your wealth when America's growth engine gets crippled. If we
don't initiate a broader debate, we may get the worst of both worlds.
Axel Merk is manager of the Merk Hard and Asian Currency Funds,
www.merkfund.com.
Merk Insightsprovides the Merk perspective on currencies, global
imbalances, the trade deficit, the socio-economic impact of the US
administration's policies and more. You can
sign up for the Merk newsletter and follow his blog. Axel Merk's
recently released book SustainableWealth:
Achieve Financial Security in a Volatile World of Debt and Consumption,
explores the dynamics that drive this world before discussing how you can
invest in a boom, in a bust, in a personal or economic crisis.
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