The Pakistani Spectator

In capitalist economics, the common wisdom is that to make money, you have to have money. Here in the US, nearly everyone identifies himself, or herself, as a member of the “middle class,” even people who are earning more money than 98% of Americans. Just about the only people who would admit to being “upper” class would be those relatively few rich, non-retirement-age investors who make more money through their investments than through their jobs (if they even have jobs), those whose primary means of making money is to invest the money they already have.

Of course, there is a paradox behind this common wisdom, because even if you inherit wealth, somewhere back in your family history there had to be someone who managed to make money without already having money. In a healthy, growing economy this sort of “pulling himself (or herself) up by his bootstraps” isn’t impossible – you work hard, for long hours, spend less than you make, and finally invest some small savings in some small business, where even more hard work, and smart choices, and perhaps a bit of luck, can grow the business. If you make really smart choices, perhaps a better design for what you sell, or something more subtle like just a better way to run some standard business, then the business might grow quite large from a small beginning.

The whole theory of capitalism and free enterprise (which I agree with – see my earlier article Communism versus Capitalism) holds that the self-interest of investors looking after their personal invested wealth will tend to ensure that the available capital resources (things that are used to make the products we consume) within an economy will tend to be used most efficiently when those investors seek to maximize their profits, and this is not only good for the investors, but it tends to be good for everyone, in the long run.

Clever business people have found an alternative way to make money beyond a simple salary without first having money, however: Make money investing other people’s money! The obvious way to do this is simply theft, but there are plenty of more socially accepted ways to invest other people’s money, such as getting an unsecured, interest-free loan from one’s father-in-law. “Sonny” gambles the money on some high-risk investment and keeps the profit (and the credit for being such a clever fellow) if it works out, while Dad takes all the risk of never seeing his money again if the investment fails. The “upside” is all Sonny’s, while the “downside” is all Dad’s, hardly a fair arrangement! (There are clearly moral issues with gambling other people’s money on investments so risky that you would avoid them if you were investing your own money, but please understand that I am not saying that every sort of loan invested in a business is of this sort – there are plenty of moral folks working hard, building solid, low-risk businesses with generous loans from fathers-in-law and others who want to help, and there is nothing wrong with this as long as everyone understands the risks.) In a diverse economy there are lots of ways to invest that, nine-years out of ten, will pay off slightly better than the average investment, but that will lose everything that one year in ten, with no way of predicting when that “tenth” year will happen. Such investments are described as “picking up nickels (small coins) in front of a steamroller,” a mildly profitable activity, most of the time, that carries an unreasonable risk of being flattened if you slip (and in the real investment world, you can’t avoid the risk of “slipping” just by being careful – the risk is unavoidable and unpredictable!). Picking up nickels in front of a steamroller is clearly not an attractive occupation, but some people find it quite profitable and even (in a very selfish way) quite sensible, if they can just get someone else to pick up the nickels for them, to take the risk of being flattened, such as that hypothetical loan-making father-in-law! Unfortunately, the theory of efficient, unregulated free enterprise, which predicts useful investment choices and sensible risk-taking when we invest our own money does not predict such good results, and such sensible risk-taking when people are investing other people’s money, when the downside risk belongs to someone other than the person making the investment choices.

Now, the risks taken by a few over-generous fathers-in-law are not sufficient reason to regulate free enterprise, as this regulation would be expensive, and would arguably make free enterprise less efficient. To justify heavier regulation of business, we need to find more common cases where business leaders are risking other people’s money in irresponsible ways. One common case, built into the very core of how most public companies are run, is the way that we reward top executives. Executive pay is usually tied to company performance, with extra rewards for leaders (who are not usually the company owners) who deliver higher profits. It seems sensible enough that leaders who deliver higher profits should get higher rewards, right? Such rewards ought to encourage those executives to find better ways to run the business. Unfortunately, although extra profits are rewarded, exceptional losses, even driving the company out of business, are not proportionally punished. Most often, in large US businesses, a failed leader is asked to “resign” and handed a several-million-dollar “severance package” in return for leaving quietly and not saying anything bad about the company – not much of a punishment! Even in the worst case, where the company is so utterly bankrupted that it cannot pay severance packages, the executive is simply fired, keeping all the bonuses that came from the previous years’ risks that ultimately destroyed the company when his luck ran out. Therefore, it is tempting for such leaders to take the easy but dangerous road to higher profits – instead of solving the hard problem of earning high profits relatively safely, just find ways to pump up the profits in return for gambling the company’s future, gambling other people’s (stockholders’) money for their own higher rewards. Essentially, such leaders place their companies into the business of picking up nickels in front of steamrollers! (Remember, too, that even fairly honest people can be very good at deluding themselves for the sake of their own moral comfort – I suspect that many leaders who find risky ways to pump up their company profits are very good at convincing themselves that the risks they take with the stockholders’ money are far smaller than they truly are, so they may enjoy their profits with clear consciences! They may be quite blind to the steamroller threatening their company, because they sleep so much better at night if they very carefully avoid seeing that!)

Now, in ordinary companies, the consequences of such executive-pay packages is that executives are likely to be tempted to gamble the stockholders’ money in ways that run against the stockholders’ interests, producing small added profits in most years while risking huge losses when things don’t work out so well. Stockholders need not simply take these risks lying down, however. They could insist, though the board of directors that they elect, that executive pay packages be reformed, or they could at least insist, again through the board of directors, that the company hire leaders with a demonstrated history of avoiding senseless risks, and that the company have internal regulations that discourage unreasonable risk. The government could also step in, on behalf of all investors, and insist that some sorts of executive pay are simply too likely to reward unreasonable risk, and could impose external regulations that discourage obvious risk taking with stockholders’ money. (There already are many such regulations in US law, but there could certainly be more. For example, government could require that executive bonuses and stock options be tied to long-term profit, rather than short-term profit, so that risks likely to do harm within 5-10 years would look much less tempting!)

All in all, though, for most sorts of businesses, for businesses that make and sell things, or that sell ordinary services, I think current regulations are not so bad. In the worst cases, some stockholders are harmed, but in general careful stockholders are capable of looking after themselves and their own interests pretty well!

However, our recent economic meltdown revealed a sort of business where gambling with other people’s money goes well beyond a risk to the stockholders! In financials companies (banks, brokerages, insurance companies and the like), in a very real sense, the product is risk itself! The best example in this case was AIG, a huge insurance company that got heavily involved with “credit default swaps” a sort of insurance to owners of packages of mortgages (such as banks) that the debts will be repaid properly, one way or another. In recent years this came to look, to AIG, like a fine business. The economy was healthy, so most debtors could repay their mortgages. Even those who got into trouble found it relatively easy to get out of trouble – property values were rising fast, so they could sell their properties at a profit and repay their debts, or they could take out a bigger loan, on the strength of the higher property value, to pay off the earlier loan, or, in the worst case, the bank could foreclose the mortgage and sell the house for more than the debtor owed. In all, AIG could ensure many thousands of mortgages with all evidence from recent history indicating that they would rarely have to pay. Even for low rates, these insurance policies looked like a very profitable business, year to year. Banks were happy, too – for anyone concerned that their mortgages carried too much risk, they could point to contracts with AIG that seemingly completely covered those risks. So, what happened? Well, the calculations of risk were fine as long as the values of land kept rising, but land values had grown over-inflated, partly as a result of how easy it was to get loans, even high-risk loans, as a result of that cheap insurance sold by AIG and others like them! As long as mortgages failed in ones and twos, as in ordinary years, AIG had no trouble covering its losses and still making a lovely profit from its premiums. When the land-value bubble collapsed, however, as bubbles inevitably do, suddenly foreclosures skyrocketed, further driving down land values and making it impossible to recover debts with sale of these properties, so these credit default swaps went from being mildly profitable to AIG to delivering huge losses, more losses, in fact, than AIG and companies like them could cover with their entire cash reserves. Mortgage holders, such as banks, suddenly realized that the contracts such as they had with AIG, which had appeared to cover their risks, were not assured of ever being paid, so the banks faced danger of collapse, and when banks face danger of collapse, the whole economy contracts, as lending grinds nearly to a halt and everyone at once stops spending freely in case they lose their jobs.

When the AIG executives, and executives at companies like AIG, chose to sell mortgage default swaps, which in most years were destined to be a profitable business, they took on a risk that went well beyond their own stockholders’ money! The risk extended, first, to the banks that faced an underappreciated danger that AIG lacked the cash reserves to live up to their commitments in a bad year, and then to the US government that insures the deposits at those banks in the event of a bank collapse, and then to the US taxpayers who must ultimately pay that insurance, and then to the entire US economy, and then to the world economy that follows downward when the US economy collapses. Now that is really risking other people’s money! The risk went way beyond simply risking the AIG stockholders’ money! It is actually possible that the AIG stockholders, even if they had understood the risks better, might have agreed that the risks were acceptable, because, after all, even they were, in effect, mainly risking other people’s money. It is surely true, though, that the US taxpayers, and the workers of the world who are paying the price of that gamble gone bad, who had nothing to gain by taking those risks, would never have agreed, if they had the choice. In effect, AIG, and companies like them, had the entire world picking up nickels for them in front of a colossal steamroller!

The theory of unregulated free enterprise has no solution for this problem, where a few companies can gamble the whole world economy in return for a bit of extra profit to those companies in good years. Only new, much more serious regulation of companies like these can prevent a repeat of this financial meltdown! If people wish to gamble their own money on whatever schemes they expect to bring them profit, that is entirely their own business, but when it becomes clear that part of what they gamble is our money, then voters must insist that regulations sensibly protect their own interests!