Secret sauce – or obfuscation discount?

19th century copybook example used by Wikipedia to illustrate Kipling's poem
19th century copybook example used by Wikipedia to illustrate Kipling’s poem

A headline in this morning’s FT – Secretive active ETFs[1] lose out to their fully transparent rivals – leapt out at me and put me in mind of Kipling’s October 1919 poem Gods of the Copybook Headings.

FT journalist Steve Johnson notes that “The new portfolio shielding models were expected to encourage actively managed funds to enter the ETF market, something many active managers had been reluctant to do because they feared daily holdings disclosures would reveal their “secret sauce” allowing other investors to front-run their funds and steal their intellectual property.”

The idea of some fund managers that they possess “secret sauce” suggests a dangerous hubris, redolent of aspiring Masters of Universe heading for a fall.  Even if some may develop some special insight or clever algorithm to give them a temporary lead until their competitors catch up or until their perceived advantage turns out to be no more than a couple of rolls of the dice falling their way, the underperformance and lack of appeal of the non-transparent ETFs to investors suggests that any perception of the existence of “secret sauce” is outweighed by the discount that investors apply because they can’t see what is going on.

My instant reaction to the story was “What Dummies?”.  While transparency of the composition and activity within an exchange traded fund may fall short of the “perfect information” ideal, investors in ETFs are a reasonably sophisticated bunch and will want the assurance that goes with transparency and be naturally suspicious of anything short of transparency.

Which brings me to Kipling’s poem.  It was written in the aftermath of the First World War, with Kipling expressing pessimism about the nostrums that he perceived taking hold at the time. The current edit of Wikipedia describes what is going better than I can: In the poem, Kipling’s narrator counterposes the “Gods” of the title, who embody eternal truths, against “the Gods of the Market-Place”, who represent an optimistic self-deception into which it supposes society has fallen in the early 20th century.  For my purpose, the believers in “secret sauce” are the God’s of the Market-Place, and the God’s of the Copybook Headings are the students who stayed awake during Economics 101[2] and acknowledge the existence of the obfuscation discount.

As I pass through my incarnations in every age and race,
I make my proper prostrations to the Gods of the Market Place.
Peering through reverent fingers I watch them flourish and fall,
And the Gods of the Copybook Headings, I notice, outlast them all.

We were living in trees when they met us. They showed us each in turn
That Water would certainly wet us, as Fire would certainly burn:
But we found them lacking in Uplift, Vision and Breadth of Mind,
So we left them to teach the Gorillas while we followed the March of Mankind.

We moved as the Spirit listed. They never altered their pace,
Being neither cloud nor wind-borne like the Gods of the Market Place,
But they always caught up with our progress, and presently word would come
That a tribe had been wiped off its icefield, or the lights had gone out in Rome.

With the Hopes that our World is built on they were utterly out of touch,
They denied that the Moon was Stilton; they denied she was even Dutch;
They denied that Wishes were Horses; they denied that a Pig had Wings;
So we worshipped the Gods of the Market Who promised these beautiful things.

When the Cambrian measures were forming, They promised perpetual peace.
They swore, if we gave them our weapons, that the wars of the tribes would cease.
But when we disarmed They sold us and delivered us bound to our foe,
And the Gods of the Copybook Headings said: “Stick to the Devil you know.” 

On the first Feminian Sandstones we were promised the Fuller Life
(Which started by loving our neighbour and ended by loving his wife)
Till our women had no more children and the men lost reason and faith,
And the Gods of the Copybook Headings said: “The Wages of Sin is Death.” 

In the Carboniferous Epoch we were promised abundance for all,
By robbing selected Peter to pay for collective Paul;
But, though we had plenty of money, there was nothing our money could buy,
And the Gods of the Copybook Headings said: “If you don’t work you die.” 

Then the Gods of the Market tumbled, and their smooth-tongued wizards withdrew
And the hearts of the meanest were humbled and began to believe it was true
That All is not Gold that Glitters, and Two and Two make Four
And the Gods of the Copybook Headings limped up to explain it once more. 

As it will be in the future, it was at the birth of Man
There are only four things certain since Social Progress began.
That the Dog returns to his Vomit and the Sow returns to her Mire,
And the burnt Fool’s bandaged finger goes wabbling back to the Fire;

 And that after this is accomplished, and the brave new world begins
When all men are paid for existing and no man must pay for his sins,
As surely as Water will wet us, as surely as Fire will burn,
The Gods of the Copybook Headings with terror and slaughter return!

[1] Exchange Traded Funds

[2] I could equally have used this poem to illustrate the disastrous budget of Lizz Truss and Kwasi Kwateng and, who assumed office (briefly) as prime minister and chancellor of the exchequer exactly a year ago.

Lockdown reading: Piketty’s Capitalism and Ideology

The Year of Revolution - a clash of ideology Chartists meet on Kennington Common in 1848
Chartists meet on Kennington Common in 1848 – the year of the Communist Manifesto and “All things bright and beautiful”

I went into the first Covid-19 lockdown in March with three doorstep sized volumes to keep me going.

The 912 pages of Hilary Mantel’s Mirror and the Light were riveting, even if I knew from the outset that Thomas Cromwell’s career would come to an abrupt end at Tower Hill in 1540. The 1088 pages of David Abulafia’s magisterial The Boundless Sea kept me entertained as it opened my eyes, chapter by chapter, to the way that different parts of the world became progressively connected by maritime exploration, communication and trade.

I had started turning the 1041 pages of Thomas Piketty’s Capital and Ideology before restrictions started to be lifted in May but, despite finding some stimulating ideas in his opening account of the different sources of power of different parts of premodern society (which he describes as ternary or trifunctional, and have echoes in the Escondido Framework’s account of  the three currencies or sanctions), it was not until the re-imposition of lockdown (the UK government’s Tier 4 restrictions) that I finally completed it.

I admire much of what Piketty has done in Capital and Ideology.  His effort to document the movements in the shares of income and wealth between different groups in different societies throughout human history, and particularly the past century or so, is admirable and revealing.  It is possible to challenge some of his assumptions and definitions, but the picture he paints of the direction of the trends in material inequality are compelling.  I agree with his spin on Rawls’s maximin principle: “To the extent that income and wealth inequalities are the result of different aspirations and distinct life choices or permit improvement in the standards of living and expansion of the opportunities available to the disadvantaged, they may be considered just.”  (p.968).  His chapters on the increasing support of the “Brahmin” classes educated to degree level for parties of the left and the corresponding “Nativist” alignment of parties of the traditional right and “left-behind” communities are persuasive. But the book is far longer than it needs to be, many of its graphs add little, and he strays from the professorial scholarship of the economist/social scientist-turned-historian into an undergraduate level of prescription.

Piketty’s underlying thesis is that “no human society can live without an ideology can live without an ideology to make sense of its inequalities.”  I didn’t need to read 1041 pages to recognise this: growing up in a churchgoing family, I remember singing the third verse of “All Things Bright and Beautiful”

The rich man in his castle,
The poor man at his gate,
God made them, high and lowly,
And ordered their estate.

These days, it is generally omitted!

It may or not be a coincidence that Mrs Cecil F Alexander wrote these words in 1848, the “Year of Revolutions”, in which Marx and Engels also wrote The Communist Manifesto.  Piketty chooses to reformulate the opening words of its first chapter “The history of all hitherto existing society is the history of class struggles” as “The history of all hitherto existing society is the history of the struggle of ideologies and the quest for justice.”

There is something in Piketty’s thesis about the relationship between the ideas that prevail at any point in time and the organisation of society and its impact on the distribution of wealth and income.  It may be that I started out as a historian whereas has come to history by way of economics, but I find that he oversimplifies to sustain his argument.  Ideas ebb and flow and they can influence behaviours, but this is not the same thing as saying that they determine behaviours.  He falls into the trap of assuming that the behaviours that are generally ascribed to “capitalism” are the product of the past few centuries.

He frequently quotes Karl Polanyi with approval, who was even more blinkered in this respect, regarding capitalism as an entirely modern phenomenon.  Peter Acton has undermined Moses Finlay’s thesis that the ancient economy was shaped by considerations of status and civic ideology rather than rational economic considerations, demonstrating in Poiesis: Manufacturing in Classical Athens demonstrates that the commercial decisions of Athenians “were for the most part…consistent with today’s understanding of good (rational, profit-maximising) business practice[1]. It does not require a 21st century reading of the biblical parable of the talents to see that the notion of investing for a return was established by the time the Christian gospels were written.  And Abulafia’s The Boundless Sea, contains plenty of evidence for the commercial underpinning of the development of maritime trade over many centuries.  One of the primary shortcomings in Polanyi’s approach was that set very specific conditions around anything that he would define as a market and, by framing his argument in this way, created a platform for his dismissal of the longstanding heritage of commercial activity.  It is as though Polanyi, and to a lesser extent Piketty, seek to dismiss market mechanisms and their place in human societies on the basis that, prior to Adam Smith and his successor, the conditions assumed in classical economics had neither been articulated nor did they prevail.

Essentially, it is not that Piketty is wrong, but his case is overstated and needs reframing.  It is not that ideology determines the form of economic organisation, but it helps shape relationship between the parties.  In Escondido Framework terms, the prevailing ideological frameworks will influence the attitudes and trade-offs made by parties in their relationships with each other at market interfaces.  For example, a religious ordained prohibition on usury does not undermine the human behavioural drivers for gratification today over gratification tomorrow and discounting for risk (although these can be culturally influenced), but historically has resulted in work-arounds (eg Islamic finance) or lending being undertaken by a community less constrained by the prohibition.  Certain activities, as in caste based societies, may be undertaken by tightly defined social groups, with implications for the commercial terms on which these activities take place.  But this is not the preserve of caste societies: while the boundaries may be less clearly defined and not religiously ordained, even in contemporary society there is an intergenerational stickiness in occupations and values, traditions and attitudes acquired in childhood shape occupational choices and behaviours.

So, two cheers for Picketty for the underlying thesis.  And, in due recognition of his own disclaimer in his concluding chapters, he has set out to provoke further debate and provide the foundation for further scholarship rather than provide the definitive answer

However, where I find Capital and Ideology most flawed in when Piketty moves from diagnosis to prescription.  In particular, his leap from describing to the increasing inequality in economic outcome for the richest few percent compared to the poorer mass of the population to concluding that all would be solved by appointing worker representatives to corporate boards highlights the danger of straying too far from your own area of expertise.

The inequality that Piketty documents arises from the endowments that we start out with in life (geography, genetics, family wealth, upbringing, education) and our life choices and chances (too many possibilities to enumerate).  These will shape whether we end up with investable wealth (the impact of this on equality is thoroughly documented in his earlier work: Capital in the 21st Century) and whether we end up in positions in which we have market power and are able to extract economic rent, which has arisen most egregiously in recent years for executive directors of large companies as a result of shortcomings in corporate governance.  Addressing inequality arising from our endowments needs primarily to be by “levelling up” in terms of investment in education and social support, particularly in early years, and widening opportunities, but in relation to inherited wealth is a proper area for taxation.  Addressing inequality arising from investable wealth is also clearly an issue for taxation and also needs international solutions, but is a complex matter not least because of the risk of creating perverse incentives and unintended outcomes.  Taxation has its place in addressing inequalities in income, but as with addressing issues surrounding taxation of wealth and wealth transfer, is also fraught with difficulty.  Piketty raises these issues quite correctly.

But addressing inequality arising from market power and the ability to extract economic rent is a proper matter for better corporate governance and regulation to address market failure.  Piketty fails to recognise the role of market failure and consequently the need to address this, and also the problem of the increasing ability of corporate management (and some of the services that support them), to extract economic rent (ironically, at least in part, at the expense of the owners of investible wealth), and that this is purpose behind the need for reform of corporate governance.  His own prescription, worker representation on boards, is not the solution for reasons that I have argued elsewhere.  Rather, and this comes back to his underlying thesis around ideology, there is a need to widen the understanding about the proper purpose of the company (the core of the Escondido Framework), and an improved understanding of the role of boards in serving them.

[1] Acton P (2014) Poiesis: Manufacturing in Classical Athens. New York: Oxford University Press

Role of stakeholders in purposeful business

The second session in the British Academy Future of the Corporation – Purpose Summit took place earlier this afternoon, with a focus on the role of stakeholders in purposeful business.  The proposition in the Escondido Framework that what most people call stakeholders should be thought of as customers of the firm is at odds with conventional stakeholder theory, but for the purpose of this review I will talk about stakeholders as conventionally understood.

Some of the richest material in the session came from Victoria Hurth from the Judge Institute, although perhaps I reach this conclusion because the language she employs comes closest to that used in the Escondido Framework model of the firm.  She framed her introduction to the session by talking about the relationship of corporate purpose to stakeholders being one in which the role of the market is to mediate the pressures from stakeholders.  She also talked about tapping the wisdom of shareholders to give meaning to the purpose of the company, which may be another way of looking at the Escondido Framework view that the organisation exists to resolve the symbiotic needs of the stakeholders.  She wrapped her introduction with an argument about need for diversity on boards to help with a paradigm shift away from a shareholder value driven model of the firm to one driven by purpose in the service of stakeholders – but without demonstrating the logic behind her argument.  There may well be plenty of meat underlying her assertion, but today she did not have the time to make this part of her case.

Frances O’Grady, from the TUC, made the case for hearing the voice of the workforce on the boardroom, referring back to Theresa May’s proposals for changes to corporate governance and the subsequent review that I contributed to and commented on in 2016 and 2017.  She explained that she is agnostic about whether worker representation should be in the context of a unitary board or a two tier board following the model in some northern European countries.  She also argued for a change to directors’ duties, by implication beyond those set out in Section 172 of the Companies Act requiring them to take account of all stakeholders, to require more focus on the long term.

Dan Labbard, CEO of the Crown Estate (an organisation whose roots go back to 1066 and  William the Conqueror) addressed the question of whether a focus on purpose creates additional risk to the corporation.  He argued that a focus on purpose equips the corporation to recognise and then organise to address risk, in contrast to a primary focus on profit.  He build on this argument by encouraging organisations to proactively go out to their stakeholders with a purpose led strategy, rather than merely responding to stakeholders, and to look at risk through a stakeholder perspective.

Jim Snabe chairs two of Europe’s biggest corporations, Siemens and Maersk.  He framed his concerns around the impact on companies of globalisation, technological change and the climate crisis.  He argued for leadership anchored in corporate purpose, which describes as explaining why your organisation exists.  Leading two companies with two tier boards, he is an enthusiast for this model, explain that the “management board drives the bus” while the supervisory board “sets the GPS”.  He sees four roles for the supervisory board: ensuring the strategy is correct by asking the right questions; ensuring that the strategy is aligned with the United Nations strategic development goals; promoting the next generation of leadership; and defining success in terms of addressing the needs of all stakeholders.

Colin Mayer opened the responses to questions by observing that it is difficult, notwithstanding the variety of means that can be considered (different board structures, consultative bodies, citizen juries), to capture the views of stakeholders. (for the Escondido Framework perspective, visit the section of this site addressing governance and some of the relevant earlier posts).

How is business adopting purpose around the world?

The British Academy’s Future of the Corporation – Purpose Summit is an important contribution to developing our understanding of what business is about, and a subject at the heart of the Escondido Framework.  Possibly as a result of the selection of speakers, this afternoon’s opening felt a bit like a vehicle for  Colin Mayer’s view of the world, particularly for those in the audience who stayed on for Mayer to answer the questions posted during previous hour – (including his final response, in answer to the question that I had posted “Is purpose the answer to the questions “why does this business exist?” and “what do we do that creates value for customers, employees and suppliers?”, which was an emphatic “Yes”).

It was a pity that technical difficulties meant that it was impossible to hear the opening contributions from Mayer or from Stefan Oschmann, CEO of Merck, and that Ashley Grice, CEO of BrightHouse (a creative consultancy owned by the Boston Consulting Group, not to be confused with the bankrupt business that used to rent consumer durables to cash strapped households in the UK) had a false start and when she resumed once the technical problems had been addressed, spoke thirteen to the dozen presumably being anxious that she would run out of time.

Grice is her own worst enemy, or her delivery and articulation of the importance of corporation purpose risks undermining what I think is her core message.  The technical problems today may have been part of the problem.  However, her claim to have been part of a movement born in 2003 sounded a little bizarre, failing to recognise those who have been ploughing this furrow for many years, including people like Colin Mayer, and also Mark Goyder from Tomorrow’s Company whose name cropped up among the questioners in the chat box.  No-one can doubt her passion, even if her references to the bionic company were puzzling.  The most compelling part of her message was the value of purpose as something to engage the people in the company, because people need to find meaning in their work and their organisations, which (I am paraphrasing here) means they benefit from doing something worthwhile.

Alan Jope, CEO of Unilever, brought the session alive.  He is a Unilever lifer, and comes across as a worthy successor to Paul Polman not only as a leader of the company but also as an advocate for a view that companies exist for a purpose rather than for profit, and that making profit serves the purpose of the company (in that without profit companies do not have investors or access to capital and, of course, if the chief executive fails to keep the investors happy they will be replaced as chief executive).  He remarked that “companies without a purpose risk foundering on the rocks of moral bankruptcy” and told us that the purpose of Unilever reflected a founding mission “to make cleanliness commonplace and lessen the load on women” that had been updated to the 21st century as “making sustainable living commonplace, improving livelihoods and respecting and protecting the environment”.  Jope’s commitment to corporate purpose is expressed in three beliefs: that brands with purpose grow; companies with purpose last; and people with purpose thrive.  He concluded by observing that collectively we have two big problems to address: inequality in all its forms and climate change, and that business has to play its part in addressing these.

The final speaker was the shadow chancellor of the exchequer, Annaliese Dodds.  Following Alan Jope, with his clearly articulated and well structured case for corporate purpose, was a hard act, but she made a competent fist of the challenge.  However, she did not manage to display the clarity of vision of what the corporation is about that Jope managed in his contribution or Colin Mayer provided when answering questions.  In common with many others, she blurs boundaries and does not have a clear model in mind that allows her to express why governments have a role to play in regulating and on occasion supporting private businesses.  I hope she did not intend to convey the impression that hitherto different industries were of different social worth (with ones that make or grow stuff at the top) and she had only come to recognise the importance of business such as logistics, retailing and social care as a consequence of the Covid-19 crisis. As someone who has worked in distribution and retailing, now works in an industry adjacent to social care, I know that the organisations that I worked in had purpose and that we created value for society!

The session ended with a short Q&A, in response to questions posted in a chat box.  It was depressing to see how many questioners struggle with idea that purpose and profit have a symbiotic relationship.  However, it is that very lack of understanding that justifies the efforts of those who are trying to deepen the popular understanding of the way that businesses actually work.  I was disappointed by Colin Mayer’s response to a question about charities in which he failed to recognise how much charities have in common with businesses that trade for profit, in the equivalence between the way that charities have to satisfy their funders and the need of “for profit” businesses to satisfy their investors. But, as mentioned earlier, he rescued himself with a clear articulation of purpose in the answer to the question planted by this commentator.

Markets, State and People by Diane Coyle

Rousseau observed that “Man is born free but everywhere is in chains”.   Many people in business, politics and media talk about markets in a similar way, as though “free markets” are the natural state and desirable order and any intervention by an agency of the state or collective popular action is represents an undesirable fettering of enterprise.

Economists since Adam Smith have recognised that markets can fail and may need to be subject to intervention.  Even figures as inspiring to simplistic supporters of free markets as Milton Friedman recognise that there are proper roles for the state where markets fail.

Diane Coyle starts in much the same place as other economists who look at limits of markets and the place of government intervention in markets.  She starts with conventional analysis of market failures, listing seven instances of failure in the conditions required for free markets to be efficient.  She returns these seven types of failure throughout her examination of the relationship between markets, the state and people, and description of the appropriateness of state intervention or collective action to address.

In cataloguing the failures and the responses to them, Coyle assists the reader, from the economics or politics undergraduate or MBA student getting their first exposure to welfare economics and public policy, through to the general reader seeking a better understanding of how the world works. She draws on and explains clearly the work of people like Coase, Ostrom and Thaler who have broadened and deepened our understanding of how people both cause and respond to the seven types of failure she describes.  The book is furthered enriched, and the lessons consequently rendered more accessible, by a peppering of case studies illustrating the core arguments.

Coyle also tackles government failure, highlighting the shortcomings in bureaucracies (or among public servants) and as a consequence of political failures (or failures of politicians) that result in the application of the wrong policies to address the market failures.  The text seems to peter out in the final chapter where she addresses what she appears to hope is the solution to the problems of government failure, which is the application of evidence to economic policy.  In this chapter that she reveals the limitations of her experience as a career academic and regulator, with a rather slight addressing of the use of statistics and cost benefit analysis.  This doesn’t detract from the power (or readability) of the previous nine chapters, but point to the opportunity for someone else to write something of similar tone and quality to fill the gap on how to test public policy initiatives to address market failure.

Lessons for capitalism from the East India Company

William Dalrymple has helped people who don’t have the time to wade through 576 pages (or perhaps already have backlog of doorstep sized items of reading matter on the bedside table already) by writing an extended article on the subject of his new book about the East India Company in the FT.  However, it is a compelling article and means that I may add “The Anarchy: the Relentless Rise of the East India Company” to my list for Santa this Christmas.

This is a company of superlatives, starting out as a joint stock company operating under charter arising from a petition by entrepreneurs and investors to Elizabeth I, growing to become an empire with 60 million subjects, its own army of 200,000 men , accounting for half of the trade of the leading trading nation.  It’s global impact was enormous, from the fears about its reach – as well as its role in the tea trade – that contributed to the revolution in the Thirteen Colonies, to the part it played in the Opium Wars.  Microsoft, Amazon, Google, Apple and before them the oil majors – they were clearly nothing to this behemoth.

Dalrymple brings out in the his article the complex relationship of the Company to British state, from its original charter, through the continuing lobbying into government, the corruption in the relationships between the Company and the establishment (for example, in 1693 shelling out £1,200 a year to prominent MPs, described by Dalrymple as the first corporate lobbying scandal), and the final demise of the Company in the wake of the Indian Rebellion.

Dalrymple’s article has the effect of drawing attention to is the inadequacy of conventional theory, both “Microeconomics 101” and the Theory of the Firm, to describe one of the greatest commercial entities the world has ever known.  Some of things at work are the complex interfaces with the British state and its politicians, and also its deployment of its own naval operations (envisaged in its original charter) and an army to deliver a return to its joint stock holders, as well creating an entity became transformed into the biggest single component of Britain’s empire.

As I write this, I think he has done the job with his teaser article to promote the book.  Perhaps I should ignore the size of the unread pile by my bed and add “The Anarchy” to the letter to the bloke with the reindeer and sleigh.

Revisiting Colin Mayer’s “Firm Commitment”

I first read Firm Commitment[1] when it was first published in 2013 and found the opening chapters – which include a well-constructed critique of the shareholder value paradigm – offered the tantalising prospect that Colin Mayer might be about to expound a theory similar to the Escondido Framework description of the firm occupying a solution space bounded by market interfaces. Unable to recall where his diagnosis of the failings of the modern firm and his prescription for addressing them departed from my own, I recently revisited his book.

Returning to Firm Commitment, I rejoiced again at much of the description in the early chapters of the shortcomings in the classical model of the firm, in which share ownership is linked to provision of investment capital and the assumption of risk. In common with the Escondido Framework, he describes the company as an structure independent of ownership and sees one of its purposes being long term survival, delivering value to society at large. He comes close on occasion to describing some of the other risk bearing parties, the market related transactional considerations and the interests of different stakeholders. In particular, he bemoans the failure of corporations to engage with wider social and environmental concerns.

But rather than continuing down the path developed in the Escondido Framework he focuses on the shareholder and sees the failure of the modern corporation lying in the lack of commitment of shareholders to the company. His prescription is reform to tie in shareholders to the company, to increase their commitment to the firm – hence the book’s title. In contrast to our model, Mayer remains committed to a view that shareholders “own” the company, rather than owning pieces of paper that entitle them a share in the profits of the company and which have a value reflecting a market perspective on the discounted value of the expected future cash flows. What he is unable to explain is how tying in shareholders in this way will improve the quality of decision taking by managers, enhance their accountability, or contain their ability to extract economic rent in the form of salaries, bonuses and equity incentives.

[1] Firm Commitment, Colin Mayer, Oxford University Press 2013

It takes a village to maintain a dangerous financial system – and a corporate governance system too

Hillary Clinton popularised the African proverb “It takes a village to raise a child” when she adopted it as the title for her 1996 book. A lawyer representing victims of abuse by Catholic priests in Boston extended when interviewed in 2015 by observing that “If it takes a village to raise a child, it takes a village to abuse a child.” Anat Admati, George G.C. Parker Professor of Finance and Economics at the Graduate School of Business at Stanford University, translates this sentiment to the financial sector in her in chapter in Just Financial Markets? Finance in a Just Society, a collection of essays edited by Lisa Herzog, published by Oxford University Press[1].

Admati’s focus is on the banking system. Her thesis is that the failings in the system, illustrated by the 2008 crash, are a result of the failures of a wide range of players, not just those working within financial institutions, but a host of regulators, commentators and other stakeholders. Very powerfully, she comments on the contrast between the finance industry and other industries (eg aviation) where safety is paramount and all consequently all the stakeholders work together to design effective regulation and where the case for compliance is compelling. But, as she points out, even the most obvious case for regulation to drive safety may require disasters and egregious failures before regulation and compliance catch up with the need (eg in nuclear power and the motor industry).

Her chapter provides a compelling account of the “wilful blindness” of principals, stakeholders, regulators and commentators on the financial system and suggests that even after the dangers inherent in the design, operation and lack of necessary regulation of the banking system were revealed in the crisis, the underlying problems remain unaddressed.

Her arguments are applicable far more widely. She has written an important paper about that should be read with an eye to how her observations can be applied to other industries and, indeed, beyond the commercial enterprises into public sector organisations and not for profit bodies.

[1]Chapter 13, It Takes a Village to Maintain a Dangerous Financial System. Abstract: I discuss the motivations and actions (or inaction) of individuals in the financial system, governments, central banks, academia and the media that collectively contribute to the persistence of a dangerous and distorted financial system and inadequate, poorly designed regulations. Reassurances that regulators are doing their best to protect the public are false. The underlying problem is a powerful mix of distorted incentives, ignorance, confusion, and lack of accountability. Willful blindness seems to play a role in flawed claims by the system’s enablers that obscure reality and muddle the policy debate.

“You can’t have it both ways, Prime Minister”

“we should never forget the immense value and potential of an open, innovative, free market economy which operates with the right rules and regulations” (Theresa May, at an event to mark 20 years of the Bank of England’s independence)

With the Leader of the Opposition due to demonstrate his lack of understanding of markets in his keynote speech to his party conference yesterday, it was only natural that the prime minister should use the opportunity given by an invitation to speak at an event to mark the granting of independence by, ironically, a Labour chancellor of the exchequer to the Bank of England, to mount a defence of the market economy.

But what conclusion are we to reach about someone who manages to contradict herself so thoroughly, not just from speech to speech, or within one speech, or within a paragraph, but within a single sentence. When does oxymoronic become plain moronic?

Wikipedia helpfully spells out the roots and origin of “oxymoron”, and its evolution. “An oxymoron is a rhetorical device that uses an ostensible self-contradiction to illustrate a rhetorical point or to reveal a paradox. A more general meaning of “contradiction in terms” (not necessarily for rhetoric effect) is recorded by the OED for 1902.”   There is no possibility that the sentence from her speech, quoted at the head of this posting, is a rhetorical device. Markets are either regulated or they are “free”. Definitionally, they cannot be both at the same time.

One of the axioms underpinning the Escondido Framework is that, in the absence of a raft of elusive conditions (perfect information, symmetry, “unbounded” rationality, perfect competition etc), regulation is always required to make markets work sustainably. Mrs May has indicated clearly since becoming prime minister that she appreciates this instinctively. Am I being too generous to her in wondering whether her apparently casual use of language is a calculated sop to appease the more bone-headed in her party (which gathers for its own conference in Manchester later this week) and they will only hear the word “free” and not notice the reference to “rules and regulations”?

I can’t help wondering what was going through the civil servants’ minds when they inserted the heading “A well-regulated free market” into the published text[1] of the speech. Cock-up or conspiracy? While stepping through the black door of Number 10 feels a bit like stepping through a looking glass and tumbling down a rabbit-hole simultaneously and, in serving their political masters, civil servants are required to “believe impossible things” [2], the combination of “well-regulated” with “free” is so impossible that conspiracy seems more plausible than cock-up. If so, to paraphrase the Queen of Hearts,“Off with their heads!”





[2] “Alice laughed: “There’s no use trying,” she said; “one can’t believe impossible things.” “I daresay you haven’t had much practice,” said the Queen. “When I was younger, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.” Alice in Wonderland.

Highlights from October 2016 Harvard Business Review

My two picks from the latest Harvard Business Review relate to two Escondido Framework themes: the way that executive teams have been the beneficiaries of the misunderstanding by shareholders (or, rather, their representatives on remuneration committees) of what motivates them and how the relevant market relationships work; and the need to think about employees as customers.

An article titled “Compensation, the case against long-term incentive plans” reviews the work of Alexander Pepper, set out in his book “The Economic Psychology of of Incentives: New Design Principles for Executive Pay (Palgrave Macmillan 2015). Pepper documents how pay for performance incentives, and Long Term Incentive Plans in particular, fail to work as proponents expected. The four reasons are summarised as follows:

  • Executive are more risk-averse than financial theory suggests
  • Executives discount heavily for time
  • Executives care more about relative pay
  • Pay packages undervalue intrinsic motivation

HBR’s review of Pepper’s work, in its Idea Watch section, comes not long after news broke in London on 22nd August that Woodford Investment Management was to scrap all staff bonuses, based on the belief that ‘bonuses are largely ineffective in influencing the right behaviours.’

The second article of interest is an article by Cheryl Bachelder, CEO of fast food franchise Popeyes: “How I did it…… The CEO of Popeyes on treating franchisees as the most important customers”. It’s not so much the lesson expressed in the article’s title that excites me, but an extract in the middle of the text that takes the message a stage further, recognising staff as customers:

At one point in my career, I was touring restaurants to talk to team members about the importance of serving guests well. I met a young man who was not excited about my “lesson”. He asked who I was. “I’m Cheryl,” I said. “Well Cheryl,” he said, “there’s no place for me to hang up my coat in this restaurant, and until you think I’m important enough to have a hook where I can hang up my coat, I can’t get excited about your new guest experience program.” It was a crucial reminder that we are in service to others – they are not in service to us.