people and prices

Is it bad or unhelpful that people respond to prices? Low prices bring out certain behaviors, high prices others.

The high price of gas is an example. It has changed people's behaviors. When the price was at its peak a few weeks ago, over US$ a gallon, people began to steal - from gas stations and even from syphoning gas out of the tank of someone else's car during the night. The car belonged to the wife of a local sheriff and was parked overnight in the family's driveway.

And, driving by Americans is down since gas prices rose. Car buyers have switched their preferences away from SUVs to more fuel efficient cars and fuel hybrids. This change in customer values brought on by price has brought great revenue losses to General Motors and Ford.

But if we as a species were not price sensitive, would the alternative be any more constructive? Consumers would have no power in markets to discipline producers and other sellers as to product and service preferences. The consumer is price sensitive as are the sellers. Both are therefore under discipline.

When price plays no constraining role in market decision-making, irrational exuberance can set in with harmful consequences.

Further, where administrative fiat not price determines what is produced and use, there is immediate recourse to political or theological tyranny and an evaporation of human freedom and personal dignity.

So, prices give markets and capitalism a bad reputation - turning goods, services, and individual hopes and ambitions into mere commodities, stimulating greed, forcing cost cutting and job eliminations or transfers to other communities - but we would pay a moral price for not having market prices I think.

Risk aversion - the instinct to get the best out of any situation - is a trait that does advance the cause of human civilization and happiness.

mis-pricing and asset bubbles: a sad connection?

A habit of mine to turn hours spent in an airplane flying great distances into something more educational than just watching movies is to read something I would not otherwise have time for - like the Memoirs of the Duc de Saint Simon for example.

As with Boswell’s Life of Johnson, Cervantes’ Don Quixote, or Lady Murasaki’s Tale of Genji, the Duc de Saint Simon’s Memoirs were long ago recommended to me as part of the foundational reading of well-educated men and women. Just recently, I saw a reference to the Duc de Saint Simon in the New York Review of Books and so, before leaving for a long flight to Cape Town, South Africa, I went to a nearby college library to borrow a volume of his memoirs to read on the trip.

On the flight, I got through volume 3 of his Memoirs. I can recommend it to anyone interested in a lively, insider’s view of the dysfunctions of French royalty in the early decades of the 18^th century.

But the work contained a surprise – insights into the financial mismanagement that from time to time, on a regular basis, overtakes market capitalism with unseemly greed followed by panic sell-offs.

We have just come through two such episodes in the United States: first the stock-market bubble of the late 1990’s centered on dot.com and telecom companies which was busted by the Enron/WorldCom/et. al. scandals, followed, second and rather quickly, by the virulent bust of the subprime mortgage market and the related market for CDO s, a financial collapse that has yet to run its course.

The asset bubble and ensuing bust swirling around the Duc de Saint Simon in 1719 and 1720 arose from selling shares in the Mississippi Company. The project was the brainchild of a Scotsman, John Law, who proposed his scheme to the Regent of France as a way to earn money for the government. Sales of the stock were very successful; share prices rose to absurd heights; millions were made by those who bought early and sold early; losses, when they came with the collapse of the company, withered the entire economy of France, coming to roost most heavily on those who could least afford the cost.

Saint Simon, a landed aristocrat, never bought shares even when pressured by his friend the Regent to take up thousands for the cash equivalent of a pretty song. Saint Simon didn’t believe in the inherent value of paper assets.

He wrote in his diary:

One day M. le Duc d’Orleans (the Regent of France during the minority of Louis XV) made an appointment to meet me at Saint-Cloud, so as to take the air after he had been working there, and we both sat on the balustrade before the Orangery, looking down the slope of the woods towards Les Goulottes (fountains). He spoke again of the Mississippi Bank, urging me to accept stock from Law. I refused once more, but he continued to press me, producing one argument after another, until at last he grew angry, saying that it was mere vanity to refuse what the King offered (all was done in his name), when so many other persons of my rank and condition urgently desired it. I said that such a refusal would be stupid and impertinent, as well as conceited, and was not my way. Therefore, as he was so pressing, I would explain my true reasons. Not since the reign of King Midas had I heard of anyone who turn all he touched into gold, and I did not think that even Law had this talent. All his ability was, I believed, no more than clever trickery, a brilliant exhibition of juggling, a robbing of Peter to pay Paul, by which some people became rich at the expense of others. Sooner or later, I declared, it would be seen for what it was; enormous numbers would be made bankrupt, and then how, and to whom, would restitution be made? I added that I abhorred the idea of touching other people’s money, and that nothing on earth could persuade me to do so now, not even at second hand.

M. le Duc d’Orleans was at a loss how to answer.

At a later point in his Memoirs as the Mississippi Company was desperately writhing in its death spiral, the Duc de Saint Simon commented:

It had become necessary to substitute something real for the mirage of the Mississippi, converting to a new trading company the Indies Bank, capable of guaranteeing the exchange of 600 million in banknotes and have profits of tobacco monopoly and numerous other vast sources of revenues, but even so it was still unable to meet the demand for payments of its notes and this despite all the measures taken to lower their value which, incidentally, had ruined great numbers of the people by reduction of their savings.

All this known as of 1719 and still we have to suffer globally from the unsustainable issuances of subprime mortgages and CDOs derived therefrom.

Why can’t this great reoccurring flaw in capital markets be permanently corrected?

Is it all because of a greed that lies forever chained to the beating heart of capitalism and, from time to time, makes financial fools of us all?

Or, as I am coming to think, is it more a question of systematic distortion of pricing under certain conditions, leading to mis-pricing that opens the door of markets to “irrational exuberance” and supporting avarice for immediate cash profits.

My argument is the following:

First, when asset bubbles occur, the strategic good sense normally encouraged by micro-economic supply and demand curves does not operate. Under conventional supply and demand interactions, the marginal utility of additional amounts of supply is worth less and less. At some point it therefore becomes unprofitable to produce more of the good or service and so supply contracts and a market equilibrium at a sustainable value is reached between demand and supply. No asset bubble occurs. There is no “irrational exuberance” driving prices ever higher and higher.

Under these circumstances, the price/supply curve slopes downward to the right on the graph where supply is the horizontal axis and price is the vertical axis.

But when asset bubbles build up, the supply curve slopes very differently. It slopes upward to the right.

As price increases, so does supply, without any deterrent effect set in motion by declining marginal utility of additional units of the asset brought to market. This supply curve accurately represents the “irrational’ belief of buyers that more of the good or service deserves higher and higher prices. There is no diminishing demand curve to intersect with the supply curve at a point of sustainable equilibrium. Demand grows; supply responds; and prices keep going up. Each increment of the good or the service seems to have added value attached to it, at least in the eyes of potential buyers.

Everybody is happy; the nominal price value of the asset class keeps growing higher and higher as more and more assets are brought to market to enjoy higher and higher returns – like shares in the Mississippi Company or, in the subprime mortgage bubble, new houses built to take advantage of easy credit. There is no regulation of self-interest by price that cautions producers to keep more product off the market. There is no automatic governor on the engine to keep it from spinning out of control.

Markets for contract rights – shares, loans, mortgages, CDOs – are especially susceptible to such upward sloping supply curves. As prices paid by willing investors rise, more opportunities to buy the contracts are brought to market by creative sellers. Each additional opportunity to invest in these promises for future returns continues to have the same (or greater) utility to buyers than the previous opportunity. The marginal cost of bringing more contracts to the market is almost zero –mostly payment for secretarial formalisms. It was thus very easy for John Law and his Mississippi Company to issue more shares; very easy for Enron to create more special purpose entities with which to manage reported earnings, and very easy for banks to issue both more sub-prime mortgages and CDOs.

But rising prices for assets can only be supported by rising supplies of money with which to buy them. Here is where the price of credit seems to become dysfunctional. In a bubble, as the price of the asset rises, the supply of credit expands as well. Another supply curve sloping upward to the right. Under conditions of “irrational exuberance” official bank interest rates do not rise with the amount of credit being made available as you would think. More and more credit is made available to buyers when bubbles are growing. The buyers, using mostly borrowed money, pass the resulting cash on to sellers.

The dynamic expanding the supply of credit for subprime mortgages was the proliferation of CDO sales. Global capital markets bought up CDOs and the cash from those sales was passed back to the originators of subprime mortgages, who then lent the money out on more subprime mortgages, which kept buyers in the market for houses at ever rising prices.

In the dot.com/telecom bubble, stock prices had been kept high by the arrival of day-traders in the market, using their equity plus borrowed funds to take advantage of rising prices for stocks.

As the risk/return tradeoff inherent in the extension of credit would have it, you would think, that as more and more credit is extended, the most reliable debtors would be taken care of first, so that later extensions of credit should carry more risk, and therefore be harder to sell. One might say that the marginal utility of additional credit carries higher and higher risk for the usefulness of the money lent.

The market for credit should stabilize at the point where investors providing new credits at the margins where new lending is offered and accepted begin to question if the returns and the security they are promised will support the risks they are to undertake. At that point of decreasing returns to credit, lending investors will demand so much for use of their money, that providers of the underlying assets will balk at the price demanded for credit and the market will slowly stabilize around sustainable prices of assets.

But in bubble environments, pricing does not reliably lead to sustainable asset valuations. Rising prices bring on speculation and then growing speculation brings on yet higher prices until buyer’s remorse finally sets in at the margin, new supply is not taken up, and the market suddenly collapses.

Normally as the supply of credit expands, the price charged for increments of credit rises. The normal curve here is one sloping upward to the right. But when an asset bubble is underway, the curve is more flat; as the supply of credit expands, the price for credit does not rise substantially. Credit becomes, relatively speaking, cheaper than it should be. The gap between the thoughtful price for credit (high) and the actual price for credit (low) exposes the market to risk of future collapse.

One reason for this odd pricing of credit is the financial security seemingly provided by rising asset prices. The nominal higher and higher values of the asset offered for sale by the bubble market provide a vision of security protecting the money borrowed to own the asset. The owner/borrower feels confident that he or she can sell the asset at a moment’s notice to repay the debt and the investor/lender feels confident that the asset can be acquired from the owner and sold if necessary to repay the debt.

But when the market collapses, asset values collapse and the credit appears in truth as having been essentially unsecured. It has long been said prudentially that lending too much money to an enterprise makes one take the risks of an equity investor – in for a dollar of risk as well as for the actual dime lent on security.

As asset bubbles expand, another gap in prices emerges to undermine the sustainability of nominal asset values. Under thoughtful analysis, the value of an asset should stay reasonably steady or decline some as more and more assets are brought to market. The value/supply curve is then largely level or sloping downward to the right. This assessment of value is largely sustainable.

But, in a bubble, the value of the asset rises and rises ever higher as more and more assets

come to market. The value/supply curve slopes upward to the right. The growing divergence between the thoughtful curve and the “irrationally exuberant” curve is the gap between sustainability (thoughtful valuations) and collapse (irrational valuations). At some point, the gap between the two valuations becomes so large that it can’t be ignored. Upon the discovery that “irrational” valuations are at risk, nominal asset prices start to drop towards the level of sustainability and the market collapses.

Mis-pricing drives financial markets first to excess and then to collapse. Greed may sustain the mis-pricing and its resulting bubble, but mis-pricing gives to greed its sometime power to trump thoughtful analysis of risk and sound valuations.

Discouraging mis-pricing of both assets and credit would seem to be essential to improving the level of economic justice provided by free capital markets to all participants, but especially to the less well capitalized ones.

If we could better understand the mechanics of how mis-pricing begins in any cycle of excessive accumulation of assets, especially the contract right assets favored by financial markets, we might be able to better eliminate such erroneous pricing signals. Better pricing would tip the odds away from speculators towards genuine value investors.

Two factors, it seems to me, contribute to the onset and the maintenance of mis-pricing.

First is the fact that most providers of contract rights (equity securities, debt obligations, derivatives, etc.) take a fee out of the deal on the sale of the right and leave town so to speak. They have no incentive to price accurately for the sustainable long run. They price to sell in the market at the time. They feed speculation and they feed off of speculation.

Second, and related to the way in which originators of contract rights get paid, is the fact that those who originate contracts rights to sell in financial markets very frequently assume no long-term ownership risk for sustaining the value of the asset. These originators do not retain an interest either in the tradable contract right sold to investors or in the underlying asset, if there is one, which supports the right to future income that is sold to the investor via the contract.

If the fees charged for selling contract rights became less and less profitable as the market for such securities grew, or if ownership responsibilities became more and more unavoidable as the risk of market collapse accumulates, then market-wise, enlightened self-interest would find ways to dampen speculation and to protect asset values.

Ubuntu - what is community, really?

It is Friday July 19^th, 2008, and Nelson Mandela’s 90^th birthday. I am in Cape Town, South Africa, and can see from my hotel Robben Island where Mandela spent 27 years in prison.

His crime: opposing a regime using the powers of a police state to impose an ideology. Ideology is conformist; it is communal righteousness that can brook no challenge from independent thought or mere personal whim. Certain truths apparently so brittle that they can’t survive a rough passage through the storms of human needs, passions and perceptions.

Mandela had a more indefatigable truth than the white Afrikaners did. He rose above communalism and racism – and the feelings arising from 27 years in prison – to lead South Africa away from a dark past.

Here among Mandela’s people – the Xhosa – the cultural frame for building community is “ubuntu”. The Cape Town paper this morning printed an essay from a journalist who visited Mandela’s home village, one rather isolated among hills and fields that was restful and open to the play of natural powers. “Ubuntu” thrives in such villages where you are what your surroundings make you. Expressed in you are others – ancestors, parents, friends, drumbeats, ceremonial honors, childhood games and hard work.

I had come to Cape Town for the quadrennial meeting of the International Society for Business, Economy and Ethics (ISBEE). Several of the scholarly paper presentations that caught my attention discussed African philosophy and ethical traditions. “Ubuntu” was described and highlighted as an anti-dote to Western self absorption with striving and getting ahead of the Joneses.

I could see the point. But one of the presenters – an American teaching in an African business school – made another point as well. “Ubuntu” like any community ethic comes with a price. The price is some degree of stultification and conformity to what the community believes and stands for. If there is too much “we”, what role can there be for the “I”?

“Ubuntu” also leads to fragmentation and rivalries as the circumference bounding the community expands to take in new communities. The question comes quickly: with whom do I experience “Ubuntu”? Just who is part of my “we”.

“Ubuntu” outside the mind and skills of Nelson Mandela seems no check on the divisiveness of tribalism. In Rwanda the “Ubuntu” of the Hutu did not extend to the Tutsis during the genocide.

Now in South Africa, Mandela’s legacy is being challenged by more limited spheres of “ubuntu”. Mandela and his successor, Thabo Mbeki, are Xhosa. The newly elected head of their political party – the ANC – is a Zulu. This man, Zuma, has been brought to trial for corruption and also accused of rape. As I arrived in Cape Town a few days ago, the papers reported that Zuma’s new team at the head of the ANC had sacked for no apparent reason the head of the Cape Town provincial administration. And the head of the ANC youth league, a Zuma ally, had called for the “killing” of a rival party seeking more constitutional checks and balances. What is needed, it was said, was a kind of cleansing, a transformation of the old ways into new ones, power structures more authentically African. Coming under instant criticism for his policy stance, this leader quickly backtracked and said he was only talking of “eliminating” such people.

My thought is to ask in seeking an authentic “ubuntu” based regime for South Africa after Mandela, who will be on the inside and who on the outside?

The View From Mountain House

In real estate the agents say that what counts is “location, location, location”. Sometimes that may be true for our understandings of the world as well. Our location can frame the path of our reflections. Consider walking along an ocean beach or setting in a mountain meadow. For many of us that context can lead to deeper, more inwardly centered, perceptions or, in a similarly restorative way, to looser flows of mental associations that lead us to more fundamental and lasting impressions of what is.

Mountain House in Caux, Switzerland, is such an influencing location. It is where the Caux Round Table started in 1986 and where, much earlier, retreats hosted in the Belle Epoch hotel perched high above Lake Laman (or to some, Lake Geneva) brought about new levels of acceptance between French and Germans, paving the way to a united Europe.

I was just there with some CRT colleagues in a retreat for scholars on Tuesday and Wednesday. They left on Wednesday night or early Thursday morning and I stayed on for a day before going to Warsaw. Thursday was a beautiful day – blue skies, a few touches of clean white clouds, warm sun- but not hot, breezes. And the view from the patio at Mountain House was magnificent; not so spectacular that you forgot yourself, but great (“magnus”) in vistas of high Alpine mountains, towns along the lake shore, the blue of the lake, and in clarity of light and perception.

And the sounds were of birds and the breezes in the leaves.

The hustle and bustle of humanity, the nitty-gritty, the details that provide cover and sustenance for the devils in our lives, were far away from consciousness. One felt a kind of open-ended, natural superiority in life. You could breathe in encouragement and breathe out doubts and anxieties, just as masters of meditation advise for our better health and well-being.

The view from Mountain House on such a day provides scope for our proper ambitions, making us once again masters of our fates and captains of our souls in a world that is conspiring to reduce us to trivia.

The view took me back to Robert Frost’s poem “Birches” which ends thusly:

Earth's the right place for love:

I don't know where it's likely to go better.

I'd like to go by climbing a birch tree~

And climb black branches up a snow-white trunk

Toward heaven, till the tree could bear no more,

But dipped its top and set me down again.

That would be good both going and coming back.

One could do worse than be a swinger of birches.

what is corporate philanthropy?

The roots of the word “philanthropy” are “love” and “man”. A philanthropist, therefore, is a lover of mankind, someone who loves his fellow humans and exerts himself or herself for their wellbeing.

Philanthropy is defined by the Oxford English Dictionary as “practical benevolence towards men in general; the disposition to promote the well-being of one’s fellow-men.”

Thus, while philanthropy has taken on a general meaning of charity out of a compassionate disposition, its underlying meaning points to a much more strategic scope of endeavor.

Philanthropy in gross would encompass any action aimed at improving the well-being of humanity. Philanthropy would therefore include solving problems such as disease, lack of education, poverty, war, famine, global warming, excess consumption of natural resources, tyranny, and so on.

Corporate philanthropy would be the appropriate efforts of business to address these problems and challenges. It implies more than just making charitable donations in an effort to share wealth with the less fortunate.

Corporate philanthropy is then the responsibility of business to make our world better, even through the products and services offered for sale and the ways and means of bringing those products and services to market..

But given the primary social office of business to create wealth on a profitable and sustainable basis for the amelioration of social conditions, corporate philanthropy should have its proper role and function. Business should never seek to substitute for bad government; rather, bad governments should be changed and new, more responsible institutions of public power should take their place. Nor, on the other hand, should business assume responsibility for non-profit operations which seek to provide public or quasi-public goods that do not respond well to market incentives.

Corporate philanthropy can embrace strategic responses to the material concerns of a business’ stakeholders, bringing the demands of corporate social responsibility within its fold. The case can thus be made that corporate philanthropy is not merely optional volunteerism, unrelated to core business functions. No, corporate philanthropy is merely another way of framing the fundamental requirement of business to meet the terms of its contract with society. Under that contract, business must enhance the social capital, the human capital, and the reputational capital on which it depends for successful market performance in order to get back from society those necessary capital inputs.

Who is responsible for global warming after all?

Standards of corporate social responsibility do not make business decisions any easier. In fact, they most likely complicate the decision-making process by adding on to more focused concerns for costs and prices a range of more intangible factors involving analysis of many circumstances outside the enterprise - like the future price of oil or the real demand functions of customers.

A recent article I read on global warming is a case in point. William Balgord recently wrote an op-ed commentary pointing out a link between sunspot activity and temperatures on earth.

It seems that past periods of cool temperatures on earth correlate in time with low sunspot numbers. And to the contrary, high sunspot activity leads to warmer temperatures here.

When there is weak solar activity - few solar flares sending "solar wind" to bath the earth protecting it from cosmic radiation, more cosmic rays (high energy protons) penetrate through and ionize oxygen and nitrogen molecules in our atmosphere. These ions then become nucleating sites for water vapor that so condenses into clouds. With weak sunspot activity, more clouds form on earth and reflect back more sunlight into space, cooling the earth.

In 2007 there were abnormally few sunspots. From January 2007 to January 2008, the average global temperature fell by nearly 1 degree fahrenheit. Rare snowfalls struck Buenos Aires, Cape Town, and Sydney. China was hit by a huge blizzard. Floe ice spread in the Arctic Ocean into the Bering Strait.

The inference for corporate social responsibility of all this would seem to be that, if sunspots are a major determinant of earthly warming and cooling, what is business to do about that? And, how much effort should be made to reduce emissions of green house gases from the factories and usages of human civilization in order to prevent global warming?

From whom should business learn how best to consider its long-term self interest upon the whole set of material considerations impinging on its prospects for success or failure?

Systemic short-termism

In his recent article in Foreign Affairs, former Singapore Ambassador and now Dean of the Lee Kwan Yew School of Public Policy at the National University of Singapore Kishore Mabubani asks whether Western democracies have been "hijacked by competitive populism and structural short-termism"?

"Structural short termism" - now there is a concept worth pondering.

How can short-termism be structural and therefore more insidious a departure from wise strategic thinking?

One way of course if for it to be institutionalized in the goals and compensation patterns of government and business. Clearly, the notorious single-minded focus by many Americans in business on quarterly earnings and hitting the very numbers expected by "Wall Street" is institutionalized short-termism.

But a more dangerous location for structural short-termism is cultural. If short-term thinking drives our beliefs and our values, then our actions will follow along accordingly like sheep to the slaughter.

No law of nature that I am aware of requires that business focus exclusively on immediate earnings. In fact, better heads who have made a lot of money like Warren Buffet expressly look to the long run and the underlying fundamentals of valuation more than to short term results.

I would suggest that our culture is the source of "structural short-termism". A culture that has few if any truths to sustain us, many moral quandries to delude us,and a foundation of nihilism that expresses itself in the seeking of sensation and the accumulation of experiences, is nothing but short term. As John Maynard Keynes once retorted "In the long run we are all dead." So, he inferred, thinking about the long run is a waste of time.

Yet as Kishore suggests, if short-termism is a short-cut into the shallows and miseries of fate, then we should examine our culture more carefully to restore some deep sense of truth and of a sustainable sense of purpose to our lives.