Create Vs. Capture: Hey Dude, Let’s Open a Hedge Fund – it’s just way too tedious to build a real business

Photo: Elle Neill

“When I was a graduate student at Harvard, I learned about showers and central heating. Ten years later, I learned about breakfast meetings. These are America’s three great contributions to civilization.”

– Mervyn King

This article has been updated from an earlier version.

A central point of the Flourishing Project is that our complex economic ecosystems (CEEs) – health, education, housing, finance –  are not necessarily the self-regulating mechanisms tending to better and better performance that economic orthodoxy would have us believe.¹⁾We use the term Complex Economics Ecosystems (CEEs) as a shorthand for very complicated parts of our economies and societies that deliver critical services in certain spheres. CEEs involve a very large number of individual and institutional actors (both private and public) interacting in a myriad of ways. Examples of CEEs include the health system, the education system, and the financial system of modern, industrial economies. There is lots of feedback, and lots of reacting to feedback, but that feedback is not necessarily leading to improving flourishing and often leads to the reverse. The term ‘ecosystem’ is used deliberately here. It is striking to me how much like a complex natural eco-system these CEEs are and, over the past decade, the term has increasingly crept into both professional and lay usage when describing parts of the economy. Indeed, in Andrew’s work in Africa, both senior policy makers and business leaders understand the importance of the economy as an eco-system because they are constantly faced with the negative consequences of missing parts. We think this is progress, but more progress is required, because the implications of ecosystem thinking have not been fully absorbed. We need to rectify this. Whether performance does improve over time is an empirical question but we don’t see any compelling evidence telling us this is definitely the case.

In fact, we believe that it’s very likely that, over time, the performance of these CEEs actually tends to deteriorate, as companies and other institutions (including the state) occupy particular ecosystem niches, defending their respective positions and capturing as much value as they are able.

Such deterioration can be particularly harmful when it occurs in the finance ecosystem. Specific features of the finance ecosystem make it more prone than other complex economic ecosystems to being not fit-for-purpose (where the purpose is to ensure that capital is allocated properly and flows to its highest use, as well as to provide both day-to-day banking for individual companies and appropriate investment opportunities for long-term wealth creation). Put simply, in the finance ecosystem, it’s generally an easier path to get wealthy by capturing value than by creating value. And with so many bright people choosing the capture value route, the finance system is not delivering what it should and supporting flourishing, which is the purpose of the economy.

In hindsight, it’s easy to see that the financial sector was too large in the US and UK in 2007. Of course, these out-sized financial sectors could have been optimal and almost all mainstream economists (and indeed Alan Greenspan, who presided over the debacle) had enormous faith that the finance sector was self-regulating, and so was precisely the right size to be doing precisely the things that needed to be done.

However, the GFC (Great Financial Crisis of 2008) put an end to such fanciful thinking. What we learned, in fact, is that not only did society spend an enormous amount of our resources compensating people in the financial industry, but the finance ecosystem was unable to accomplish its primary purposes. The end results were unconscionable costs to the public, a continued and massive output gap between GDP and potential GDP, and unnecessary personal hardship and misery for those who did not cause the crisis and who did not benefit significantly from the boom preceding the GFC.

Is the financial system special and does it require a different type of approach from other CEEs? We think it is and does and that there are 4 distinguishing characteristics of the financial ecosystem that make it particularly vulnerable to being not fit-for-purpose. As we have seen, the finance ecosystem has so much potential to undermine flourishing that it is worth examining these differences in detail:

1. Infinitely expandable – In 1983, GE was the world’s largest industrial company. It was number 1 or number 2 in every industry it was in (or exited, as Jack Welch required). Its range of industries included jet engines, nuclear reactors, medical imaging, rail locomotives, and appliances – all very complex and specialized industries that required decades of pedigree and enormous engineering and science skills to be successful. In 1932, GE Capital was founded by General Electric, as the financial service unit.²⁾“Company Overview of General Electric Capital Corporation.” Bloomberg: On GE. Accessed July 29, 2020. However, its very rapid growth started in the 1980s. By the end of 1999, GE Capital had more than 60,000 employees worldwide, operating in 55 countries, with total assets of $551 billion US dollars.³⁾General Electric Company (GE), Yahoo Finance.: Yahoo Finance: GE. Accessed November 11, 2013. The stock price of General Electric rose to $52 by the end of 1999 from $16 dollars in 1997,⁴⁾Troy, Clark. “Hedge Funds,” In Search of New Frontiers, 3, 2006. Hedge Funds. Accessed November 11, 2013; Page Not Found July 29, 2020. and maintaining it required a continuous earnings growth deliverable only through the financial services division, a growth that of course comes to an abrupt halt during financial crises. Quite simply, unlike other industries, financial services is easily and infinitely scale-able quickly.

A similar story can be told about other parts of the financial services sector. In 1990, there were 610 hedge funds in the US; by 2006, there were 8,987.⁵⁾There is a theory – espoused by numerous commentators – that our finance system worked better when ‘C’ students from college when into it, rather than top Harvard and Stanford MBAs. In the same period, there were only 5,167 IPOs,⁶⁾Ritter, Jay R. “Initial Public Offerings: Tables Updated through 2010.” 2, 2011 Initial Public Offerings. Accessed November 11, 2013. Page is a biography of the author: July 29, 2020. companies coming to the public markets that make goods and services.

Yet a 3rd way to illustrate that the financial system can expand much more rapidly than GDP is by examining the relationship between total assets and GDP. Figure 1 shows total amount of assets versus global GDP. This graph should be particularly worrying if it is an irreversible trend, as it shows in effect that it now takes significantly more units of debt than it did in the past to produce a new unit of GDP. As many commentators have noted, this is essentially the same effect as with a narcotic whose user requires higher and higher doses to achieve a result – with the post-financial crisis massive quantitative easing as the mother of all fixes (and we will see whats happens as this stimulus is withdrawn.

Figure 1. Total Amount of Assets versus Global GDP.⁷⁾“World Development Indicators.” The World Bank, 2013.

Overall, these examples of the financial sector growing much faster than the real economy illustrate that expanding the financial sector rapidly is much easier than expanding the real economy; indeed, the financial sector can expand even in the absence of long-term real economy growth.

2. Based on future promises – Unlike the market for goods and services, where you generally exchange money for a good or service more or less contemporaneously – in the financial services market, the buyer pays for something now and receives something else in the future. The future value of that something is often unknown (what is the share price in the future?) and so, in effect, the relationship between what one pays and what one ultimately receives is highly uncertain. Indeed, many US state and municipal workers and pensioners are finding out that something they assumed would be there – a stream of pension income based on a fixed formula – may very well not materialize. The seller of assets – if he is able to convince the buyer that the value will be higher in the future – will successfully complete a sale independently of what might happen. Wall Street has an acronym for that – IBGYBG: I’ll be gone, you’ll be gone – which means, ‘let’s just get this done, and get the paper into someone else’s hands because we’ll be paid out and gone when the paper turns out to be worth less than promised.’ For this reason, success in the financial services business is inextricably linked to being good at making promises – and with relatively few consequences for failure (there is always a reason/excuse, and, in any case, if one makes enough money, one can simply retire, as many hedge fund managers did after the GFC).

3. Lack of transparency – Moreso than other sectors, the financial sector has been marked by a tremendous opacity in what it costs to access services. This has ranged from the complexity of fees and interest charges still in place for basic banking to the very high spreads for OTC derivatives that drove investment banks’ bottom lines prior to the GFC.⁸⁾This lack of transparency has been noticed by the authorities, and we are seeing a huge raft of regulation hitting the financial industry to counterbalance this issue (e.g., Vickers’ Commission in the UK, RDR, MiFID2, Dodd-Frank, various treating customers fairly [TFC] legislation). The unexpected cost of US municipalities’ interest rate swaps in the mid-2000s is another. Of course, it is now well understood by many businesses that pricing opacity is a huge benefit to the supplier, with Britain’s current structure of the energy market another clear example.

4. Greater likelihood of being fooled by randomness⁹⁾This concept has a long history, but Nassim Nicholas Taleb provides a recent and lucid explanation in his book, Fooled By Randomness: The Hidden Role of Chance in Life and in the Markets. New York: Thomson/Texere, 2004. – At any point in time, there will be some hedge funds/asset managers doing very well. They will earn their 2+20 fees¹⁰⁾The standard fee model for hedge funds was 2% annual fee (of the investors capital) and 20% of the profits (above a certain threshold return). This fee structure has come under pressure after the GFC. and attract more capital. At the same time, other hedge fund managers will be under their high water mark. From a hedge fund manager’s perspective, it is obviously a potentially good strategy to take risks to earn a high return, because the downside is asymmetric – that is, if things turn out well, both the investor and the hedge fund manager do fine. If things don’t turn out well, the investor loses his capital, but the hedge fund manager merely foregoes a bonus, often having time to aim for the high water mark again. But too many investors chase last year’s winners, believing high returns are a signal of skill. There are so many examples to cite here, but John Paulson’s performance in 2011 is illustrative. In 2008, he made his investors (and himself) an enormous amount of money betting on the sub-prime debacle. In 2011, his flagship fund was down 56%. Do the gains outweigh the losses for his investors? Recent analysis suggests not: “Over the past five years the S&P 500 with dividends has delivered average annual returns of 7 per cent, while equity hedge funds have produced just 1.7 per cent, according to HFR.”¹¹⁾Dan McCrum, “Hedge Funds Gripped by Crisis Performance,” Financial Times, July 28, 2013. McCrum on Hedge Funds. Accessed July 29, 2020.

So, an ambitious and entrepreneurial young person looks at this and faces a choice:

1. Build a company delivering a good or service by finding a unique offering, then build a market position and operating model to service this niche in a profitable way. Typically, this process takes years or decades – and often fails at spectacularly high cost to the entrepreneur… or

2. Go into the financial services industry where operations are infinitely scalable, based on future promises, and where the buyers find it difficult to understand the products and their costs, and are often fooled by randomness.

This is not a tough decision. The first choice is far too tedious and hard work (and too prone to failure) for most people. So when the 2nd choice is available, it’s surprising that smart young people – particularly if they care more about making money that about creating a great company/product/legacy – opt for that.

An analogy from sports illustrates the same point. Is it easier to be the athlete who achieves greatness through tremendous dedication and perseverance (and of course against great odds) or to be laying down bets – with other people’s money (OPM) – on the athlete’s outcomes?

While there may be only a few great athletes (fewer than 100 people on the planet earn a comfortable living playing professional tennis at any one time), there can be an almost infinitely expandable number who earn a living betting on the outcomes of athletic contests, if they can find a way to convince less sophisticated bettors to participate.

So where does all this leave us? The GFC showed us that not only is it quite possible (many would argue probable) that the finance ecosystem is not fit-for-purpose, but also the consequences of problems in the finance ecosystem are severe and highly prejudicial to flourishing. So we need to be spending a lot of time thinking through how the financial ecosystem needs to operate. And this thinking needs to be done in the context of understanding that the rules we set depend on what we are trying to accomplish: individual flourishing to respect the merit of human dignity. Of course, there has been a lot of regulatory effort in the past 5 years. But we haven’t really cracked the code on the type of financial system that will best serve the economy and support flourishing, and many of the new regulations have simply made it harder to operate a bank (and increased the fees of professional service firms), rather than truly made the financial system more effective.

But we don’t want to leave the reader with just a vague promise of future thinking. So let’s finish this article with a radical concept – everyone should be there own bank and investment broker: A Bank of One.¹²⁾We have recently found another interesting formulation of this idea, which adds the helpful concept of having a direct account with the federal government. See Rajiv Sethi. “Why Should Banks be the Only Ones with Accounts at the Fed?” at nakedcapitalism.com: Sethi Article. Accessed July 29, 2020. Once you reach a certain age, you are given an account by the state that acts as a wrapper for all your financial transactions and products. You don’t have an account with a bank… the bank has an account with you. And you don’t have to keep your money in a bank. You can have a direct account with the currency issuing authority. This means that there is no possibility that you will lose your savings, because the currency issuer can always pay you (so the Fed in the US, ECB in Europe, etc.). Your personal bank allows you to switch seamlessly between different products (e.g. loans) and investments and prevents financial institutions from benefiting from the current high time and energy costs of switching.¹³⁾This is similar to the rules regarding mobile telephone numbers in many countries. The number belongs to you, not the mobile operator. You could transfer funds seamlessly from person-to-person without going through a bank. Your account would calculate the returns you have received from various investments so you can make comparisons on a like-for-like basis.

All of these would significantly enhance the individual’s ability to manage his finances optimally. But more importantly, this account would intermediate between the individual and the state for taxes and social welfare payments. This arrangement would allow the authorities to stimulate the economy directly by increasing an individual’s balance with the state, if necessary – a mechanism that we argue would be much more effective at increasing aggregate demand than the current zero interest rate policy.