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Abolishing Risk Destroys America and Your Wealth

Economics / Economic Theory Oct 26, 2009 - 08:28 AM GMT

By: Axel_Merk

Economics

Best Financial Markets Analysis ArticleOur willingness to engage in risks drives our prosperity. 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 U.S. 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 policy makers 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 U.S. 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 U.S.? 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 U.S. has enjoyed in trading commodities. Singapore, too, is waiting with its doors wide open: Singapore may be the winner of those alienated by policies coming out of New York and London. In the U.S., 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 bathwater when meddling with the core values of what made the U.S. 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 increasing the barrier to entry further. What is bad is to reward bad decisions and reward good ones 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 $1 million in the ‘90s, it gave rise to an explosion in stock options being awarded and the focus shift to micro-manage quarterly earnings, inadvertently contributing to the present mess we find ourselves in.

Greed is part of human nature. The challenge for policy makers 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, etc., and, by implication, inefficiencies. The more general the levers of policy makers, the more effective they are. For a central bank to engage in private sector asset purchases is extremely inefficient. The Fed 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 he 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 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. 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 approached to make banks more resilient, e.g. 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 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 in boardrooms. Executives foremost report to the board of directors, and that’s where the oversight must be rooted. Boards must have in 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 unnecessarily restrict risk taking, 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.

Important is that the public has a healthy debate on what is to be done; we are rather concerned that policy makers 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 U.S. 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.

In my book, SustainableWealth: Achieve Financial Security in a Volatile World of Debt and Consumption, to be released this month (and available for pre-order now), I dive into the dynamics that drive this world before discussing how you can invest in a boom, in a bust, in a personal or economic crisis. Make sure you sign up for the newsletter and follow the blog.

Axel Merk
Author of Sustainable Wealth
President and Chief Investment Officer, Merk Investments

This report was prepared by SustainableWealth.org, and reflects the current opinion of the contributor. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment product, nor provide investment advice. SustainableWealth.org is a trademark of Merk Investments, LLC.

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