The Bear’s Lair: Is this really capitalism?

Capitalism has never existed in its perfect from. Even in the late eighteenth century when Adam Smith wrote, apart from a number of mediaeval holdovers, there was the East India Company, which Smith himself regarded as a monster of corruption and government meddling. Similarly Pierpont Morgan regarded pure unfettered capitalism as inherently wasteful, and preferred to combine competitors into a trust, preferably with himself or one of his partners in control. Nevertheless, both the economies of 1776 and 1900 could reasonably be described as capitalist. Today however, as deviations from the capitalist model multiply, there is a new worry: at what point do the capitalist mechanisms stop working, and transform the economy into a new non-capitalist paradigm, in which new rules must be learned. We may be about to find out.

For the past seven years, in most countries of the world we have been operating with interest rates forced down by central banks to levels at which the risk-free cost of capital is negative. This contravenes a central principle of capitalism, which is that capital allocation is the most important function of the free market. If capital is made essentially free or indeed subsidized, then no care will be taken in its allocation and projects will be undertaken that make no economic sense.

You can see evidence of this tendency all over today’s economy; for example the money allocated to hedge funds that underperform a simple stock index fund and are now being marketed as alternatives to long-term bonds. Warren Buffett bet in 2010 that hedge funds would underperform a “buy and hold” stocks strategy over the following decade; at present he is vastly ahead.

Even a 2008-style stock market crash may not save the hedge funds’ bacon; in 2008 they outperformed the 38.5% drop in the S&P 500 index, but by nowhere near enough to make up for a decade of underperformance. Hey pension funds and other dozy institutions (yes, Harvard, this includes you!) you don’t have to pay 2% annually and 20% of the profits to buy bonds! Top hedge fund managers earned $11 billion in 2014, a lousy year for their investors. If that’s not misallocation of capital, I don’t know what is.

The effect of this misallocation has now become abundantly clear, primarily through productivity statistics. First quarter U.S. productivity, announced this week, was down by 1.9% at an annual rate from the previous quarter, which itself was down by 2.1% at an annual rate from the quarter before. It was the first time since 2006 that productivity suffered two quarters of decline – and in 2006 one of the two down quarters was marginal, down only 0.3%. The last time the U.S. economy suffered two successive quarters in which productivity was down by more than an annualized 1% was in 1993. However even the 1993 productivity decline was a blip in an otherwise strong trend — productivity rose by only 0.1% in that year, but had risen by 4.3% in the previous year. In this economy, labor productivity has risen at a rate of only 0.6% since the end of 2010, the worst sustained performance since 1979-82, a “double dip” recession in which resource allocation was hugely distorted by the 1979 Iranian oil crisis.

This hasn’t just been a problem in the United States. In Britain, labor productivity is still lower than before the 2008 recession. As in the United States, resource allocation has been distorted by seven years of negative real interest rates, although in Britain’s case the coalition government did not add a layer of excessive regulation to the problem, as President Obama’s administration has since 2009.

If central banks continue to keep interest rates at artificial levels, the capital allocation process will be destroyed. Capital will be universally available through leverage to the well-connected and to governments. Periodic market crashes will doubtless wipe out a decade of capital accumulation at a stroke, leaving the economy correspondingly more impoverished, but it seems most unlikely under present policymakers that interest rate management would be significantly affected. Most likely, such a crash would merely lead to redoubled efforts at monetary “stimulus” distorting capital markets still further.

Eventually there would be very little capital allocation by the private sector at all, other than through leveraged speculative games, and long-term investment would become entirely financed by governments. At that point, I think it’s fair to say that we would have abandoned capitalism altogether. An economy in which the majority of long-term investment is undertaken through government schemes might not be socialist/communist – it might be fascist, Song Dynasty feudal, or some other aberration, depending on how the political process played out. However it would certainly not be in any meaningful sense capitalist.

There are other respects in which the capitalist system is being subverted to an unprecedented extent. One is regulation. Theoretically, a modest amount of regulation is not incompatible with capitalism. Indeed, since man’s natural instincts are towards robbery and rapine, a certain amount of either regulation or self-regulation is necessary in order for markets to function in an honest manner.

Magna Carta began the process of limiting the extent to which the man with the biggest bunch of thugs could steal your property, and John Locke, with his “life, liberty and property” articulated how property rights were an essential part of a free and civilized society. It is in many respects a great pity that Thomas Jefferson perverted Locke in his Declaration of Independence to celebrate the “pursuit of happiness,” a soppy French concept with no bearing on civilization whatsoever.

The London merchant banks showed how self-regulation and an oligarchic market could protect customers from even the largest financial temptations to rob them. Regulation has eliminated that structure, and has brought a need for ever more complex and draconian regulation to achieve results that are still inferior to those of the gentleman’s club of the merchant banks, at costs immeasurably greater. Today’s banking regulation indeed increases the likelihood of chicanery in the markets, because by imposing draconian fines for crimes defined post-facto that were in fact merely errors, it raises both the cost of capital and the risks of participation in the banking sector.

The billion-dollar fines for LIBOR manipulation are just one example of this. LIBOR was defined in 1985, as a codification of a market practice dating back to the 1960s. It worked perfectly well when used for its original purpose, the pricing of bonds and other instruments with a floating interest rate, but fell apart when turned into the nexus of a multi-trillion dollar derivatives market, because the incentives for tweaking the modest slack in the system became so much greater as the notional principal amounts on which rates were set exploded. A redefinition of LIBOR (or even its abandonment) was undoubtedly due, but the media hysteria and opportunistic prosecutions by greedy publicity-seeking DAs were entirely uncalled for.

The U.S. railroad system spiraled from prosperity into multiple bankruptcies after its 1887 regulation by the Interstate Commerce Commission. The same will undoubtedly happen to other industries in which regulation has inserted its sweaty hand to such an extent. In particular, environmental regulation is quickly making a pig’s breakfast of the energy sector, promoting wholly uneconomic energy sources and in many places banning simple and highly attractive market developments such as fracking.

The result will be both power outages and bankruptcies. The smart homeowners and entrepreneurs of 2030 will study very carefully indeed where the energy picture has been least distorted by the regulators, in order to establish themselves in a location where immensely expensive and unpleasant disruptions to their lives and livelihoods are least likely. (Conversely, if compensation schemes are introduced, clever shysters will position themselves in highly regulated areas to fleece the public through such schemes – it was ever thus.)

Once regulation becomes as pervasive as it is today in the banking and energy sectors it, far more than the market, dictates the direction and amount of investment. With that happening, the normal market checks and balances no longer apply, and outcomes can be highly suboptimal, with huge facilities for which there is no use and both products and their pricing distorted beyond measure. Technically, this isn’t socialism; it is more like the economy of William the Conqueror, in which the dictat of the feudal lord determined all.

Finally, in the international arena, China’s new Asian Infrastructure Investment Bank should be welcomed, if only because it breaks down the funding monopoly of the Bretton Woods-established World Bank and IMF. There is only one worse way of allocating resources than by elected governments; it is to allocate resources by unelected well-paid international bureaucrats, responsible to nobody, with a mandate to “do good” without either market or political checks and balances. Competition between such institutions, and hopefully a limit on their funding, will improve their performance as they will respond to signals from each other if not to signals from the public or the market. In this small respect, therefore, the forces hamstringing the market have been rolled back a little.

Currently, there is one major unknown; whether “funny money” in the next market meltdown will move us definitively away from a market economy, or whether we will be squeezed gradually away from it by the regulators expanding into sector after sector. It doesn’t much matter; if current trends are not quickly reversed, the exquisite mechanism of the free market, that has brought so much prosperity to the world, will definitively cease to function.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)