Tuesday, May 29, 2012

Respecting the Authenticity of the Capital Markets

In Economics today there is a growing movement to shift thinking away from inertial systems towards adaptive processes.  See, for example, The Institute for New Economic Thinking, and biomimicry.org.

The search for scientific predictability and precision engineering is seen as driving Economics in what is seen as a vain pursuit to investigate and illuminate the patterns and paradigms that can guide us in perpetuating our prosperity through the construction of mathematical models that do not and cannot capture the real dynamics of economic activity.

Instead, it is argued that reference should be had to life sciences to model human actors in an evolutionary process of adaptation to changing circumstances.

Paralleling this debate among economic thinkers about the right way to look for economic truth is a practical debate among economic activists about the right way to legislate for prosperity.

Unifying both debates is a shared sense that the Capital Markets are not working quite the way we need them to.  Misaligning the two debates is a difference in method.  Economic thinkers are asking, "what is wrong with Economics?".  Economic activists are asking, "what is wrong with People?"

In my view, both are the wrong question.

Better results will be obtained if we respect the authenticity of the Capital Markets as an ecosystem for value creation, capital formation and wealth distribution that is built on place-based technologies for invention, innovation, information and communication.

These place-based solutions for driving the flow of money through the economy were first adapted in America, in the 19th Century, to meet the needs of Industrial Expansion into a Western Frontier that was so large as to appear limitless.  There always was a limit.  We knew that.  We had reached and mapped it.  It was just that the open spaces within those limits were so vast, that the limit was not really that important.  The vastness was.

Scale is what was needed, and the invented, innovated and adapted the Capital Markets to achieve Scale.

Today, for the most part, the challenges of Scale have been met and mastered.  We live today in an economy that already operates on a global scale.  But it also operates within global limits.  We have traveled to the ends of the Earth, and discovered that they fold back in upon themselves.  We have ventured out into Space and found that there is nothing really out there for us.

We have the Earth, and it is well and truly ours, but it is all we have.

This is a new experience, not only for us, but for all Mankind.  Always, until now, there has been a Physical Frontier, a place beyond the bounds of what is known into which we could expand, endlessly, as our fathers and our forefathers have expanded for time beyond memory.  Today, there is no place to go.  We are here, and this is where we must be.

Scale is still important, but it must be scale within limits.  The Capital Markets were not built for this.  The Capital Markets were built for scale without limit.  Increasingly, as we encounter this new reality of global scale within global limits, we also encounter the limits of the design criteria for the Capital Markets: they are not built to see the limit.  So, the only way they ever find it, is to go beyond it, driving choice and action that is not sustainable.

The Capital Markets are losing their integrity, but it is not because we are not using them correctly.  It is because, increasingly, we are not using authentically.

If we think with those economic thinkers who want to define economic truth as an adaptive process, we can imagine the limits of choice available to actors within any given set of circumstances.  These circumstances can be imagined as six related domains for choice and action.

There is a domain of technology, and the technical capacity to shape things as we find them to arrange them the way we want them.

There is a domain of economy, and the commercial capacity to exchange artifacts of our technology with artifacts of other technology, to increase the wealth of choices we have available to us, overall, as a group.

There is a domain of society, and the emotions of caring and concern that bind us together as a community of shared interest, with a common commitment to the completion of the same work.

There is a domain of politics, and the ability to agree to rules for resolving conflicts over the personal use of shared spaces.

There is a domain of integrity, and the unity of action, expression and intention.

There is a domain of authenticity, and the ground that is both the source and the limit of experience.

The authenticity of the Capital Markets is as a pattern or paradigm for prosperity within an experience of scale without limit.  When applied to perpetuate our prosperity within the new experience of scale within limits, the pattern loses its ground.  It becomes unstable and unreliable.  It's not that it is wrong, so much as that it just is no longer a good fit.

The symptoms of this inauthenticity appear as lack of integrity.  Without a solid ground, the pattern slips and cracks.  Instead of the promised prosperity of open-ended expansion, we get booms that always, eventually, go bust.

Many economic activists are interpreting this lack of integrity in the Capital Markets as the symptom of a social problem.  Such movements as Investor Activism, Socially Responsible Investing, EGS, Impact Investing and Social Entrepreneurship see the problem as bad behavior, and the solution in reprimanding and restraining miscreant actors.  This problem certainly does have social consequences, but the problem itself is not social.  The real problem is one of authenticity.

We need to build a more authentic solution.

Tuesday, May 22, 2012

Building an Ecosystem of EGS Investing

Yesterday's Inbox included a news update from the Network for Sustainable Financial Markets, promoting an article by Raj Thomotheram and Maxime Le Floc'h on "preventable surprises".  It is published in the May issue of the Rotman International Journal of Pension Management.

In the article, the authors lay out a 6 point plan for Institutions to follow in building EGS into their investment practices.  It is hard to think of a point they missed, except for this: there is an architectural flaw in the solutions they propose.

Sometimes in life it is good to live in the moment, figuring things out as we go along, moment-to-moment. Other times, it's better to do a little forward planning.

Our Capital Markets are architected to operate in the moment.  EGS plans ahead.

Do you see the disconnect?

The answer we need to resolve this conundrum can be found in the work of Hazel Henderson at Ethical Markets.  Hazel is on a mission to get Institutions to invest some portion of their portfolios directly into Enterprise, rather than investing indirectly, through the Capital Markets.

Direct investing will give EGS the running room it needs to plan ahead, but direct investing will not work without one other innovation.

The Capital Markets provide Investment with only one strategy for realizing returns: selling out.  It's a buy-low, sell-high ecosystem.

Selling out is inconsistent with EGS.  EGS investors have to stay in, and make their money by sharing in the profits of the Enterprises they are invested in, as and when those Enterprises earn their profits, by delivering value to their commercial counter parties.

Direct investing and revenue sharing.  These are the twin pillars of a sustainable ecosystem of EGS investing.

Hazel cautions that making the shift to direct investing will require re-training the entire profession of institutional investment managers.  But maybe we don't have to re-train everybody.  Maybe it will be enough if we just support the emergence of a new breed of investment professionals, professionals trained in a new EGS ecosystem built on direct investing and revenue sharing.

These professionals will have to compete with the Capital Markets for dollars to invest.  And they will have to compete for Enterprises to invest in.

This may be a good thing.  Competition may be better than regulation for achieving the goals of EGS.

Friday, May 18, 2012

Circulating Wealth

I was made aware yesterday, through an email from the group Wealth for the Common Good, about a petition being circulated through Change.org calling on TED Talks to publish a talk given by Nick Hanauer on the subject of fairness in tax policy.

Nick is apparently a wealthy man who wants to be heard to say that he, as a member of the class we would call rich, does not believe that the rich should not be taxed because they create jobs.  His argument, as I follow it, is that jobs are created when money gets spent in the economy to buy goods and services, and that if wealth is not spread out broadly enough, then there is not enough energy in the economy to support the vigorous buying and selling that makes us all, more or less, rich.

TED has declined to publish Nick's talk, claiming that it is too "political".

The issue of collecting taxes to support public expenditure is always fraught with emotion.  First, there is the sense of invasion by the government into our personal lives.  Then, there is concern about waste, inefficiency, even tyranny, in the governmental expenditure of private wealth.  Always, it is supposed to be for the common good, but reasonable minds can differ about what is "common" and what is "good".  Then, there is the sense that we earned our money, and we should be free to decide how we want to spend it.  All important concerns, that need to be given voice and expression.  But if emotion is allowed to carry the day, will all the voices get heard?

As a self-described "non-credential economic thinker applying the methods of other disciplines" (Institute for New Economic Thinking, "30 Ways to Be an Economist"), I think there is a less politically charged, more analytically based method for framing the discussion that might move the debate into a more congeal, less hostile, direction.  To be sure, we can never remove the political energy of such a personal and emotionally charged issue, but maybe we can at least discuss it without resort to arguments based on demonization, and what the Ancient Greeks (who invented popular  democracy) diagnosed as the logical fallacy of ad hominem attacks.

My point is this.  Wealth is created through the concentration of some subset of the collective resources of a community/society (the difference being only of scale) to provide choices to a larger subset of that community/society about how it wants to live, and be well.  This wealth must circulate through the community/society, if its economy is to remain prosperous and vital.

The question is, or should be, then, What is the proper way for our wealth to be circulated, in order to keep our economy prosperous?

Reasonable minds can differ as to the answer to this question, and in the end, it will likely have to be decided by popular vote, as science probably cannot give us a mathematically correct, objective answer.

Hopefully, most of those votes will be cast by people as an expression of their considered view of what is best for them and theirs, in the context of the larger community and economy of which we are all a part, and on which we all depend, each for our own personal prosperity.

Consideration means "side by side".  We cannot consider rightly if we are not shown all sides.


Thursday, May 17, 2012

Rage Against the Machine

A one-time frequent commenter on a blog I follow rejoined the discussion yesterday, with apologies for being away.  Several reasons were given for this hiatus, including weariness from trying to engage people in changing the way they think.

They then went on to post a long list of quotes from various sources that added up to, what?

This gave me pause, and reminded me that innovation is dangerous work, not to be undertaken lightly.

We cannot step boldly into the new without first letting go of the old.  When the constraints of the old are thus released, all manner of eccentricities are unleashed.  Ideas and opinions that long ago were discussed and discarded get resurrected, and have to be rebuffed all over again.  Not because we do not like them, but because we know they will not work.  We've been through it all before. This is tiresome, but avoidable.  We must proceed with patience.

The path to innovation begins with disappointed expectations that build to frustration, at which point, we stand at a critical juncture.  On the one hand, we can channel our frustration into quiet contemplation and reflection that leads to inquiry that yields the insights that drive invention, innovation and the evolution of knowledge, work and wealth.  This is the true story of our history, and the real engine of our prosperity.  On the other hand, we can let frustration built to anger, and anger build to rage.

Albert Einstein teaches us that insanity is doing the same thing, and expecting to get a different result.  That explains the rage thing.

Sanity, then, is trying new things, in an effort to get a different result.  This is not easy.

Thomas Edison tried 10,000 different solutions, before inventing a light bulb that worked.  When asked about all those failures, Edison replied that they were not failures.  They they were 10,000 ways in which he successfully learned how not to make a light bulb.

If you pick a new goal, but keep doing the same things, that leads to rage, which is crazy.  If you pick a new goal, and then start trying new things, that leads to innovation that is inspiring.

Sometimes, along the way, we have to re-consider some of the ways that we already know will not work.

Tedious, but unavoidable.

Tuesday, May 15, 2012

Tomorrow: Today, only Later

When I was young, my parents taught me not to waste time worrying about things I can’t really do anything about.  Focus on today, and take care of tomorrow, tomorrow.

As I grow older, I am learning that like all good advice, this should not be taken too literally.

We live today in a large, complex economy that delivers a tremendous diversity of choice to an enormous number of people as to how we want to construct our lives to live well, as we each define "living well".

In such a large economy, “today” sometimes extends out over many, many tomorrows.  Decisions made in the short term can have important consequences in the long run, not just for some distant posterity, but for ourselves, as well.

Moreover, our modern economy spans the Globe.  We have traveled to the ends of the Earth, and found that they close back in upon themselves.  We have left the Earth, and traveled into Space, where we have found that there is pretty much nothing out there for us, at least not within the limits of Space and Time that we can travel using technologies that are available to us today (or can reasonably be expected to become available over any number of nearby tomorrows).

So, our economy has to operate on a global scale, but also within global limits, at least until we can invent technologies that will allow us to cross the vast expanses of Space and Time that right now separate us from any other possibilities that might exist elsewhere in the Universe.

This raises questions that are to a large extent without historical precedent; questions we are confronting for the first time in history, about: sustainability in our supplies of Energy; the adverse impact our activities have on the Environment; and the sustainability of our prosperity and the proper working of our Economy, generally.

It is beyond my mandate to persuade others that these concerns are important challenges for today that cannot be put off until tomorrow.

But for those who agree with me that will be better if we do not wait, it is my mission to show the way to making a new choice that is better adapted to building sustainability and shared values into the connection between Enterprise and Investment.

This, in itself, won't solve all the issues surrounding sustainability, but it will enable us to more effectively pursue the many other innovations and adaptations that will.


Monday, May 14, 2012

A Challenge to Institutional Investment

In a prior post, I offered a challenge to Economics to develop a reliable set of tools that can provide an early warning when the effervescence in the Capital Markets is getting too far removed from the underlying value creation in the commercial markets.

Such tools would support regulation to prevent the financial system from episodically crashing our economy.

Today, I want to look at the other possible solution to this vexing problem of booms-that-always-go-bust: competition.

Here, the people in the best position to take meaningful action are the Institutions that have emerged as the new stewards of our private wealth: Insurance, Endowments, Pensions and Annuities.

The challenge offered to these Institutions is to construct new choices for directing Investment directly into Enterprise; new choices that can provide a real alternative to investing indirectly, through the Exchanges that are popularly referred to as the Capital Markets.

This does not need to be a high-risk leap into a New Frontier.  It can be a measured extension of the tried and proven architecture of Institutional Investment Partnerships into new domains.

Partnerships have long been standard practice in Institutional Real Estate.  They are usual and customary in the increasingly popular asset class of Energy and Infrastructure Project Finance.  They are the only way to do tax benefit monetization transactions that are a highly specialized, but widely recognized and generally accepted, form of Institutional Investment.  They are commonly used in large leasing deals, where multiple investors must be assembled, as co-investors, to complete any exceptionally large financing.  They are even the current solution of choice by which many, if not most, Institutions direct investment into the Exchanges.  Managed Funds. Venture Funds.  PE Funds. Hedge Funds.  All these Funds that aggregate money for Institutions to fund different trading strategies executed over different Exchanges within the larger ecosystem of the Capital Markets, are organized and operated as Institutional Investment Partnerships.

These Funds convert cash flows expected to be generated in the commercial markets into financial assets that then can be traded as commodities, at a price, over an Exchange.  In some cases, these Funds even construct financial assets based on other financial assets that are many times removed from cash flow expectations at the level of commercial exchange.  Having converted cash flows into asset prices on the "buy" side, they then re-convert asset prices back into cash flow, on the "sell" side, in order to pay returns to their Investor Partners (aka LPs; mostly selling to other Funds buying for the benefit of other [the same?] Institutional LPs).  All of this buying and selling between Fund Managers managing money for what is essentially the same universe of Institutional Investors, is a large part of what causes the Markets to bubble, and from time to time, to burst.

Why do all this converting and trading?  Why not just invest directly into commercial value creation?

This is exactly what the Institutional Investment Partnership architecture can do, if the partnership is organized directly between Enterprise and Investment, without the intermediation of an Exchange.

This would be a new choice that promises to be better-adapted to building sustainability and shared values into the connection between Enterprise and Investment.  It offers more transparency, a more complete alignment of interest between Enterprise and Investment, a more programmatic strategy for realizing Investment returns that can align more programmatically with the underlying programmatic investing goals of many, if not most, such Institutions.  It is more stable, and more authentic, because it is direct.

To be sure, there will be some new learning to be done, but the basic patterns are already worked out and well understood.  They just need to be applied in a wider range of commercial circumstances.

As this learning gets done, and a broader experience base is built up, these Institutions will have more choice: invest directly in Enterprise; or indirectly, through the Exchanges.  Which they choose will depend on where they get the better deal, both immediately and over the longer term.

But somebody has to make the first move.

Friday, May 11, 2012

A Challenge to Economists

Here is my challenge:

Give us tools that we can use to measure the correlation between prices for assets traded in the Capital Markets and the value creation activities associated with those assets in the commercial markets, so that we can build a consensus around when the bubbling in the Capital Markets is getting out of hand that will support mobilization of the political will required to intervene to back things down before people get hurt.

Bubbles are an essential feature of the Capital Markets. For the most part, they are benign.  To some extent, they are desirable.  As long as the bubbles "stay inside the glass", so to speak, it is not really a matter for much concern.  When, however, the bubbling gets too energetic, the overflow makes a mess that can be quite expensive to clean up.

Economics has already given us the tools we need to intervene if we must.  What is still lacking are the tools we need to mobilize the political will to take action when we should.

Since the last explosion of excessive effervescence, in 2008, many organizations have formed in opposition to ever letting this happen again. One such organization is the Institute for New Economic Thinking (INET). INET was founded with support from George Soros and others to stimulate thinking among Economists about the challenges facing us in the 21st Century.  Among other things, INET has provided a grant to Moritz Schularick, an Economist working at the Free University of Berlin, in Germany, to fund research into the cause of credit bubbles that Moritz contends drive the recurring cycle of booms-that-go-bust in our economy today.

One of the insights that I believe Moritz will be exploring is the relationship between where credit is extended within the economy and the formation of credit bubbles.

This feels like a good step in the right direction.  I consider myself, in the language of INET, a "non-credentialed economic thinker[] using the methods of other disciplines".  I approach this problem as a practitioner in the business of attracting investment into enterprise through alignment of interests along multiple points of value creation.  By focusing my efforts on value creation, as opposed to more industry-standard architectures for driving Investment through asset trading, I have come to see how the proper flow of money through our economy perpetuates our prosperity, but also to see that this flow must be regulated in order to remain proper.  Left to its own devices, the money flow gravitates to one of two extremes: not enough liquidity; or too much.

Consider the infographic, below.  It shows the money flow starting with earning and moving through spending to saving to investing, then back again, to keep the right flows flowing.  

  • When investing flows back in to support earning, that gives us sustainable prosperity.
  • When investing flows back to stimulate spending, that can also contribute to sustainability, but only to a point.  Stimulating spending that accurately anticipates future earning is a proven, successful way to stimulate trading in the commercial markets.  This can help get the cash flow flowing, if it should stall, for example, after a bubble has burst.  Care must be taken, however to keep the investment-based spending properly aligned with future earnings.  As experience teaches, and I expect Moritz's work will confirm, when investing is made to stimulate spending that is not balanced properly against earning, what we get is a credit bubble: an unsustainable rate of spending that creates a false prosperity and leads, eventually, to painful dislocations.
  • When investing flows back into saving, sustainability get short-sheeted.  This kind of investing turns Savings into Asset Prices.  Asset prices are, both in theory and in normal practice, an attempt to reduce an expected flow of future cash streams to a single price point, in the moment.  Every asset price starts out as essentially a discounted cash flow.  The price is always, at best, a guess, and this for at least two reasons.  One, nobody really knows what the cash flows will be.  The future, after all, has not yet happened, and things do change.  Two, reasonable minds can disagree on what the discount rate should be.  This is what creates volatility on the Exchange, as different people form different views on both future earnings and proper discounts.  So far, so good.  Volatility is not instability, and it has the decided advantage of providing liquidity that can help keep the cash flows flowing.  The problem arises when the game of "pump-and-dump" begins.  Earnings expectations are hyped (that is, inflated through hyperbole) to increase prices, so assets can be sold at a profit, and cash flows can be realized (essentially reversing the process that turned cash held as Savings into Assets priced for trading in the first place: do you see the circularity working here?).  Rising prices become a self-fulfilling prophecy.  All asset pricing is essentially speculative, but now the focus of speculation shifts from expectations for future earnings in the commercial markets to expectations for further price increases in the Capital Markets.  As price speculation drives further price increases, asset prices in the Capital Markets become increasingly de-coupled from value creation in the commercial markets.  Now we have not just volatility, but instability.  Sooner or later the earnings will come in at levels below what is required to support the prices being paid, and a "correction" will occur.  This level of instability is bad enough, but it gets worse when artifices are constructed to make prices look more stable than they really are, such that discount rates start getting lowered to justify a further round of unsustainable price increases.  Now, the stage is set for a real economic catastrophe, because the actuarial risk pooling strategies that are designed to provide a certain margin for error in pricing assets by Market participants are no longer properly matched to the possibility for error inherent in the prices being paid for the assets being traded.  When that bubble bursts, the losses overwhelm the portfolio.  When these are the personal portfolios of private persons participating in the Markets with their own money, that hurts.  When they are the quasi-public portfolios of financial institutions participating in the Markets with Other People's Money (i.e. our money), it can be a catastrophe.
In hindsight (and in the abstract), it is easy to see that this is what happens.  The hard thing, that still eludes us, is being able to see in the moment what is developing, as it develops, with sufficient certainty and clarity that we can mobilize the political will it takes to support the intervention that we need to deflate the effervescence. 

That is the most important challenge I see for Economics in the 21st Century: giving us a reliable system of early warning when the bubbling in the Markets is becoming too highly energized, sufficient to allow us to mobilize the political will to step in and re-balance, before something breaks.

Maybe Moritz will show us the way.

Thursday, May 10, 2012

Modern technologies. Modern Choices.

When doing the work of attracting Investment into Enterprise, things always a get a bit awkward when the dynamic shifts from "I have this opportunity, and here is why I think it will work for you..." to "Yes, I'm interested in pursuing this".

It's like the jolt you get when shifting gears on a bicycle.

The usual way in which this shift gets made is with a term sheet.  This sets up discussions about pricing and valuation that lead to much "wringing of hands and gnashing of teeth" as the hot-button issues around control get hashed out.  In time, agreement is reached, a term sheet is signed, due diligence begins and the transaction proceeds towards closing.

This is a proven, effective protocol when executing under the business-investment-as-financial-asset-construction paradigm within the industry-standard, Capital Markets ecosystem.

When executing under the partnership model that I am promoting, the tasks are the same, but the path forward is a little different.  Due diligence gets divided into Alignment of Interests and Fact Checking.  Alignment of Interests comes first.

I like to start by putting the principals in direct communication.  After all, it's their interests that I am working to align.  Conversations are arranged, and information is exchanged, to flush out all the points of alignment, and also to get any points where interests do not align "out on the table".  Some misalignments are so large that it will be impossible to get any kind of deal done around them.  So it feels right that we identify those early.  Others may become less problematic in the context of a larger understanding, so it feels good to keep the dialogue open.

There will be lots of conversation, much of which will repeat the same information.  That is part of the process, for at least these reasons:

  1. Recognition. People need repeated exposure in order to build recognition and familiarity.  That's just how it works.
  2. Socialization.  Institutional Investments have to be socialized within the Institution. As new contributors join the discussion, old ground has to be re-covered.  This can be tedious, but it has proven effective at protecting people from their own enthusiasms. 
  3. Negotiation.  In the course of aligning interests, the parameters for acceptable profit sharing also get worked out.  This always involves a lot of back-and-forth, and round-and-round.
When, over the course of extensive discussions, alignment does emerge, a document is produced to memorialize the key money points.  Fact Checking proceeds in parallel with document construction, as the transaction progresses to a close.

In this partnership process, the parties make extensive use of computers, the Internet, email, the World Wide Web, cell phones, texting, Social Media and a still-evolving set of information and communication technologies ("ICT") to conduct a dialogue among diverse participants, in real time, from remote locations, that converges towards a deal. 

Modern ICT enables the modern choice of partnership investing.  

Wednesday, May 9, 2012

Entitlement in a Meritocracy

Three posts from the blogoshere caught my attention, as they seem to converge around a point worth underscoring.

  1. a post by a Venture Capitalist, praising the book Founder's Dilemmas, which the VC liked for many reasons, "including my favorite around wealth-vs-control ('do you want to be king or want to be rich?')" (the point seeming to be that only by agreeing with your VC investors will you be able to be rich - I wonder what Henry Ford would have to say about that, for instance?)
  1. a report published by The Kaufmann Foundation, criticizing the price/performance  experience of the VC industry from the standpoint of an Institutional Investor who provides the money, and pays the fees, to the VCs
  1. A post by John Fullerton at The Capital Institute on an article published in the New York Times about a book to be published soon by the former head of the NYC office of Bain Capital, reportedly defending the right of deal-makers to take and keep whatever they can from the deals they make, apparently on the theory that the deals they make make all of us better off - so stop complaining (the conversation as reported in the article spoke more about the superrich, but the superrich they are really talking about, it seems to me, are the deal-makers in the deal-making business)
As a member of the deal making profession, I like to think that investment is a difficult business, that it is also a very important business, that not everyone has what it takes to do it well, that those of us who do it, and do it well, should do well for ourselves, because we also do well for others.

But I have to admit to being troubled by what I see as a pernicious hypocrisy spreading through my profession.  We profess to be big supporters of meritocracy in the economy: those competitors who deliver value, should be rewarded with riches; those who do not, should be allowed to fail.  We call this the free market and the market system. But when it comes to the Capital Markets, it seems that what is good for the goose is not always good for the gander.  Too many people who are players in the Capital Markets (by which I mean they are playing with Other People's Money - a point that cannot be underscored too many times) want us to believe that theirs should be the only profession that should get rich just for trying: not for succeeding, just for trying.  If they do succeed, they cover themselves in riches and glory.  If they try and fail, they make sure they get well paid, anyway: someone else has to pay the price of their mistakes, misjudgments, and in some cases, misconduct.

Don't get me wrong.  Directing the Investment side of the flow of money through our economy in an effort to perpetuate our prosperity is an activity that requires that we try many things that do not work out.  In many cases we are dealing with change, innovation, adaptation, and we are trying to anticipate what changes the people will choose, and which they will ignore.  This is not an exact science that can be executed with engineering precision.  It is an expression of human ingenuity that works best when given room to make some big mistakes.  Those of us who participate directly in this process have to be supported in our efforts, even if we end up being part of one of those mistakes.  But support for trying is one thing; being rewarded for not succeeding is another. And making a mess, then leaving it for someone else to clean up, is yet another.

The Capital Markets would not permit such a circumstance to go unpunished in any other market.  Why should the other markets permit such conduct in the Capital Markets?

This is not something that can be allowed to go on, but it is something that will be all but impossible to deal with through regulation.  No, the market must speak.  The customers must call this Market to account.

Who are the customers of the Capital Markets?

Today, for the most part, they are the Institutions that have emerged as the new stewards of our personal wealth: Insurance, Endowments, Pensions and Annuities.  These are the people who have the money.  These are the people who have the ability to make the choice, not to deal with deal makers who do not take responsibility for the outcomes of the deals they make.

Right now, what other choices do they have, really?

Monday, May 7, 2012

The Market Will Choose

Money, when it works right, drives the endlessly recurring cycle of earning, spending, saving and investing that is the engine of our prosperity.

Earning and spending, we all know, have to be in balance.  There is a lot of flex in the system that gives it robustness and resiliency, but there is a limit beyond which it cannot bend: if we spend too much that we have not yet earned, trouble will ensue. We cannot spend more than we earn.

Saving and investment also have to be in balance.  If we do not save, we cannot invest.  If we save, but do not invest, we leak energy out of the system.  Money has to flow.  If it stagnates, it dissipates.

Think of money like electricity.  It can never stop flowing.  We can store it for a little while, like we can store electricity in a battery, but even a battery only slows things down.  Always, the power leaks out, and over time, even if it is not used, the battery will go dead.  Money is similar.  We can store it as savings, but only for a time.  If it is not used, eventually it leaks away.

So money has to flow, from Earning to Spending, from Spending to Saving, from Saving to Investment.  To complete the circuit, Investment has to flow back into Earning.

Investment has to create new value, providing people with new choices that they need, want and otherwise would not have.  It is new choices that create new earnings.   Unless investment creates new choices, earning will slow, spending will curtail, savings will shrink and investment will dry up.  The system will either grind to a halt, or more likely, collapse under its own weight.

"New" can mean different things.  It can mean new instances of a choice we already know and like, but that has to be re-created after each time we use it (or after some number of repeated uses), because the artifacts of exchange are used up or wear out.  It can also mean new choices that empower us to do things we could not do before, or to do things in new and better ways: invention and innovation.  And, it can mean larger quantities of what we have already decided we know, like and what to have more of: growth and expansion.

All of these forms of new value creation require some level of investment to sustain them.  This is how the proper flow of money sustains our prosperity: by sustaining investment that supports earnings that empowers spending (for good living), saving, and investing.

History and experience have shown repeatedly that it is prudent to have some wealth stored up and held in reserve, as a buffer against the vagaries of life.

In addition, we need to spend less than we earn, so that we can invest in earning more.

In our system, we rely on commercial banks (and their variants: collectively, the Banking System) to provide the liquidity our economy needs to move wealth from earning to spending and into saving, but when it comes to moving savings into investment, and investment into new value creation, a number of choices are available.
  1. Commercial banks make business loans, and provide credit in other ways, mostly to facilitate reinvestment and the creation of value that is new in the sense of being a replenishment of what has gotten used up.
  2. Investment banks buy shares in companies which they then list for re-sale as commodities traded over the Exchange, mostly to facilitate investment and the creation of value that is new in the sense of being more of what we already know, like and what more of:  Growth through Economies of Scale.
  3. Institutions (Insurance, Endowments, Pensions and Annuities) form investment partnerships with special purpose Enterprise organized and operated to create value which may be new in the sense of continuing (competition for the Banks), new in the sense of growing (competition for the Exchanges) or new in the sense of innovative (more on this later).
  4. Governments assess taxes to fund projects that are determined to be required for the public good. but not capable of being funded by private means.  These frequently include projects that create value that is new in the sense of innovative.

The Banks, commercial and investment, in combination, are true marvels of human ingenuity when valued for their ability to provide liquidity.  And liquidity is good.  

Unfortunately, it is not enough. We also need sustainability.  Money has to move, but it has to move in the right direction.

Right now, too much money is caught in a short circuit.  The power, so to speak, is not getting to the load.  Too much money held as savings and intended for investment in the creation of new value and the generation of more earnings that will keep the cash flow flowing, and sustain the prosperity of our economy, is instead getting caught in an infinite loop of buying and selling financial assets as commodities traded for a price over the Exchange.  Rising share prices become a self-fulfilling prophecy, creating the illusion that new value is being created, when really all that is happening is that savings are piling up inside these assets.  The proof: earnings fall while share prices rise; an unsustainable dynamic.

For the source of this problem, and it's solution, we have to look to the same place.  And it is not Wall Street, as many would have us believe.  It is on Main Street.

In the 21st Century, new stewards have emerged as the keepers of our wealth.  Insurance. Endowments.  Pensions.  Annuities.  These programs are increasingly the vehicles we use to manage our savings and provide for our posterity.  To be sure, banks are still important, but we also have these other choices now that provide programmatic solutions for specific financial concerns, and these choices, for those concerns, we like better than banks.  Insurance gives us protection against the financial impact of catastrophic losses.  Endowments take care of those we care about, but who for whatever reason cannot effectively take care of themselves.  Pensions and annuities save up purchasing power that can be drawn down later, to fund our spending needs after we stop earning as we go.

Vast sums of money are entrusted to these institutions, and part of their charter of trust is to use our money to make more money.  We want them to invest for us.  And they want to be our investors.  This is all a good thing, an innovation and an adaptation that gives us a new and better economy in the 21st Century.

These institutional investors favor an architectural paradigm for putting Investment into Enterprise that works programmatically to create new earnings capacity in the economy, generally, and that will programmatically pay returns to investors that align well, programmatically, with the programmatic purpose of our Institutional Investment programs.

The paradigm is the partnership model that is the financing solution of choice for Institutional Real Estate, and also for Energy and Infrastructure Project Finance.

This is all good, as far as it goes, but here we encounter a problem that is also an opportunity.  We have not yet fully embraced the Institutional Investment Partnership as the architecture of choice for putting Investment into Enterprise beyond the large, but relatively narrow, domains of Real Estate and Government-sponsored/subsidized Project Finance.  For more general business finance, including both Growth and Innovation, the Institutional Investment Partnership is used not to make a direct investment in Enterprise, but to make a direct investment in the Exchanges.

This means that the principal advantages of the partnership architecture, and of direct alignment of interest between Enterprise and Investment along multiple points of shared value that balances liquidity with sustainability, are being lost to us.  Instead, we are seeing our savings get trapped inside the Exchanges, where the interests of all, Enterprise, Investment, Government, the general public, must be aligned with the interests of whatever will bring the next new buyer in to make the next trade.

We get lots of liquidity, but not so much sustainability.

In too many ways, Wall Street has become the Las Vegas of finance. Where casinos in Las Vegas run gaming tables, Wall Street runs trading desks. 

The High Rollers on Wall Street are Professional Asset Managers who organize partnerships with Institutional Investors.  These Managers place bets with their Investors’ money, charging a fee for placing the bets, and sharing in profits (but not the losses) if the bets pay off.

It didn't start out that way.  In the 19th Century, when Investment Banking as we now know it was just getting going, the Exchange-based architecture for bringing Investment into Enterprise was the height of innovation, using cutting edge technology of the day for information and communication to finance the innovative enterprises of the day on a scale that had never been achieved in the private sector before then.

The genius of this solution includes: the Dutch auction method for setting the price for securities listed for trading over the Exchange, the broker network for soliciting bids and asks; and the central clearinghouse for settling transactions between buyers and sellers separated from each other by distances of space and time.

Today, we have computers, the Internet, the World Wide Web, cells phones, email, texting, Social Media and all manner of information and communication technologies that connect us together, from remote locations, in real time, eliminating for all practical purposes the distances of space and time that once separated Enterprise from Investment, making a centralized, placed-based solution an inspired innovation.  And today, if and when physical proximity is necessary, we have air travel to cross the miles in minutes, easily and affordably.

We no longer need a centralized, place-based solution to make the connection indirectly that once could not be made directly.  

Yet, we still choose to.

That is not unusual.  It is hard to let go of what we know, and to move into something new and less familiar.  This is a common dynamic with every paradigm shift to innovation.  When large amounts of money are invested in keeping the old way of doing things the current way those things get done, the shift is even harder, because the resistance to change is so high.

Nonetheless we need to make the shift.  It should not be that hard.  We already have the new paradigm with need.  It is the Institutional Investment Partnership that is a proven, effective mechanism for bringing Investment into Enterprise directly, with interests aligned along multiple points of shared value that include both liquidity and sustainability, each in due measure.  This paradigm is already familiar to those we need to use it most, our Institutional Investors who have emerged as the new stewards of our private wealth.

All we need is the right catalyst.  We need to market to know there is a choice.  Once the market sees that choice, the market will choose, and we will make the move.


Thursday, May 3, 2012

The New Stewards of Our Personal Wealth and Prosperity

People are a paradox.

We are at once hoarders and sharers: selfish, and generous; caring, and careless; short-sighted, and long-dated; prescient, and reactionary; egoistic, and altruistic.

For most of us, a good life includes a proper measure of both, each in its own proper place and time.

If we listen to Madison Avenue, however, commercially, there are only two motivators: fear and greed.

On Wall Street, the only motivator is Growth.  According to Wall Street, the only way that we as savers can be turned into investors is if we are convinced that our investments will grow in value, not just incrementally, but exponentially.  Of course, investments don't always go up in value, not along the straight line of constantly accelerating growth that Wall Street wants us to believe they will.  Sometimes they go up.  Sometimes they come down.  Sometimes they go up a lot, sometimes they go down a lot.  It's really hard to predict.

Wall Street doesn't mind this unpredictability.  They see it for what it is: both the cause and the effect of all the buying and selling that generates the transaction volumes on which the Exchange which is Wall Street earns its money.

Growth is so important to sustain the volume of transactions on the Exchange, that Wall Street has fostered an almost religious fanaticism about the matter.  It has become an unassailable axiom among professional Economists that without Growth we cannot have Prosperity.

Of course, that isn't true. Not entirely.

As parents, who among us does not what their child to grow up strong and healthy?  But who would want their child to grow and grow, at a constantly accelerating rate?  No one. They would become freaks of Nature, unsupportable and unsustainable.  Unable to fit in.

At the cellular level, when we have unbalanced growth, we call it cancer, and work to put a stop to it, because if we do not, it will kill us.

Everywhere in Nature, we see growth within limits.  As the limits are reached, growth slows.  If the limits are surpassed, catastrophe ensues: stars explode; trees fall over; populations starve; people develop cancers, and die.

Consider Einstein's famous axiom: e=mc2.  The more energy we put into a thing to drive acceleration, the more massive that thing will become, with a theoretical limit to acceleration being reached at the speed of light, beyond which energy becomes mass, instead of motion.

This happens everywhere, except one place: the growth in human knowledge.  As far as we can see, this process of human cognitive construction is open-ended and unlimited. No matter how much we learn, there is always, it seems, even more that we can know.

This is true also for the economy, when the economy is viewed as the application of human knowledge to alter the way things are to make them work better for us.  The more we know, the more we can do.  And the more we can do, the more we can learn.  It is an open-ended, self-sustaining, intergenerational evolution of knowledge, work and wealth.

This is the true story of our history, the true engine of our prosperity.  Growth is part of it, but only a part.

All through history, and long before we had a Stock Exchange and the Gospel of Growth, people have learned new things, and applied that knowledge to build new choices that have increased their wealth which supported new learning and the invention of new knowledge.

Before there was Growth, there was Prosperity.  And as long as there is Prosperity, there is Investment, Invention and Enterprise.

There has also always been booms and busts.  Knowledge, work and wealth increase in fits and starts.  And the paradoxical construct of the human personality has also always gyrated between scarcity and excess.

Always there has been this safety valve for our excesses: there has always been more land: more places to go, more resources to appropriate.

To be sure, there have also always been borders and boundaries, but our borders have always been porous, and our boundaries only provisional.  For a time, they may appear inviolate, but over time, they have always been re-drawn.  The rhythm, to be sure, has been ebb-and-flow.  Periods of prosperity have alternated with periods of scarcity, and calamity.  Sometimes of our own making.  Other times not.

Always, that is, until now.

In our time, we have traveled to the ends of the Earth, and found that it closes back in upon itself.  We have even escaped the Earth, and travelled out into the infinite reaches of Space.  But there we have found that really there is nothing out there for us.  We went to the Moon, and all we found was rocks.

Does this mean we have reached The End?

I don't think so.  I think the evolution of knowledge, work and wealth will continue apace.  I think there is still much for us to learn, so much so that for all practical purposes, there is no real limit to our learning.  When we finally know all there is to know, then we will really get to know God.  After that, maybe nothing else will really matter!

Certainly, we have not yet reached Paradise in economic terms.  Much has been achieved, but the is still too much lumpiness in the distribution of choice, both from place to place, and over time.

But now we have to worry about something that up until now was not really a concern.  We have to worry about limits.  We can no longer deal with our excesses as we have in the past, by expanding out into a New Frontier.  For us, the New Frontier is learning to live within limits.

This does not mean that things will stagnate.  It does mean that we have to become more mindful of our choices, and more careful to manage our excesses so that they do not become too excessive.

It also means that we can no longer drive investment on the principle of growth without limit.  We have to start looking beyond growth, to the larger dynamic of displacement that is, and always has been, the underlying rhythm to the evolution of knowledge and the expansion of choice.

Expansion of choice.  That has to become our new paradigm, the new principle by which we drive investment, the new standard against which we measure our prosperity.

With the expansion of choice there is a more or less continual re-balancing of relative value between competing alternatives.  Established choices will decline in popularity as new choices are invented and made available through investment in enterprise that empowers us to enjoy an even higher level of prosperity under the circumstances prevailing at the time.

What does this mean in simple, practical terms?

It means we can no longer architect Investment in Enterprise on the model of the Exchange, which requires that the Investor must sell out, in order to get its money out, along with its share of the profits earned by the Enterprise invested in.  This only works if each new buyer believes that past growth will be repeated out into the future, only at a faster rate.  It will not work if everyone knows that at some point a limit will be reached, and growth will slow, and eventually begin to reverse.

Investment must now be made more with an eye to harvesting of returns as profits are generated by Enterprise, mindful that the level of profits earned by an Enterprise will rise and then fall over time, as the choice around which that Enterprise is organized gains and then loses popularity within the community as new choices are invented in the open-ended evolution of knowledge, work and wealth that is the real engine of our prosperity.

This means that trading will become less popular as a strategy for realizing investment returns, and the economy will become less vulnerable to the volatility and instability associated with Exchange-trading as a solution for bringing Investment into Enterprise.

Trading will continue to add value as a source of liquidity to Investment, but liquidity will no longer be the only, or even the primary, strategy used by Investment to realize its returns.  Instead of the norm, it will become the alternative; available to be used only occasionally and opportunistically, if and as necessary or appropriate to respond to changing circumstances that affect investment at a programmatic or portfolio level.  Investment itself will provide its own liquidity; it will, in a sense, be made self-liquidating.

This is not a future event.  It is happening right now. New stewards of our personal wealth  have already emerged to take the place of bankers and traders.  These are the institutions that we use to provide us individually, with programmatic benefits: Pension Funds, Endowments, Insurance and Annuities.  All of these Institutions are engaged primarily in running some form of actuarial risk pool to apply the law of large numbers to socialize the cost of certain major financial events in the lives of each of us as both individuals and as members of society.

Each of these Institutions is expected to invest the personal wealth we entrust to them to build more wealth, as part of their strategy for delivering to us the programmatic benefits that are their reason of being.

Such Institutional Investors do not need an emotional reason for making an investment.  Making investments is part of their job.  To do their job well, they must invest programmatically, executing an programmatic investment strategy that is properly aligned with the underlying benefit program that is their reason for being.

Such programmatic investors will favor investments that perform programmatically.  Except to the extent that they need the liquidity that is the special value of the Exchange, given the alternative of participating in investments that are programmed to perform in line with their own programmatic purposes, they will not choose to expose themselves to the volatility, instability and unpredictability of the Exchange.

Instead, they will choose sustainability.

Which is good, because although our economy will always need a modicum of liquidity, it will also, increasingly become important that we monetize sustainability.

Wednesday, May 2, 2012

Let's Build a Better Way

If the job of journalism is to expose, then Frontline "hits it out of the park" with its Money, Power & Wall Street investigative report, a multipart series that I watched in its entirety on PBS last night.

In this series, Frontline hits all the hot buttons.

  1. the critical importance of banking and finance to the functioning of our economy
  2. the need for the public sector to step in and stabilize private sector financing if and when its starts to disintegrate, lest the economy itself stop functioning
  3. the enormous public sector cost of "picking up the tab" for private sector failure
  4. the way massive failure in one institution reverberates through the entire system, threatening to topple everything  - the so-called "too big to fail" problem
  5. the fundamental failure of this market to effectively regulate its own behavior (the bankruptcy of so-called "moral hazard" as a self-correcting mechanism)
  6. the enormous difficulty we have regulating this industry from outside
  7. the troubling shift in banking culture, from responsible professionals managing the money flow in support of real new value creation, to "go for broke" traders, looking to win in a zero-sum game of high stakes poker
  8. the emergence of derivatives as the Las Vegas of finance, a giant game of "musical chairs" where bets are arranged by professional traders - using other people's money - that always pay off big for the traders, and usually pay off in small ways for the other people, but that from time to time go totally bust, always with catastrophic consequences for the people who put stake the traders in placing their bets, sometimes with disastrous consequences for the larger economic community, as well.
There are undoubtedly many other gems that can be teased out of this excellent work that so comprehensively covers so many shortcomings in a system that is so critically important to each and every one of us, and yet is so incompletely understood even by those of us who make it our business to do our part to make that system work.

There is, however something missing in the Frontline piece.  There is no clear and compelling call to action.  Instead, we are left with a vague sense of, "Whew! We really dodged a bullet there.  Let's hope that doesn't happen again."

Hope won't cut it.  It will happen again.  We just don't know when.  

What can we do?

There are two options: we can remain wedded to the past, and continue to ride a perpetually recurring, but unevenly episodic, and therefor unpredictable, cycle of booms that always eventually go bust; or we can move boldly into the future, seizing the technologies of today to invent new choices that will empower us to replace the booms and busts of yesterday with a new and more sustainable prosperity for today, and tomorrow.

Most of the people who are worried about this problem seem to be heavily invested in holding on to the past, resigned to the recurrence of booms and busts, but intent on using regulation to restrain the banking system, in an effort to minimize its excesses.   While some of this effort is adding value, much of this energy is being wasted.  As the Frontline piece articulates quite well, regulation is not easy to achieve.  We simply do not have a sufficiently popular vision of how the system is supposed to work to muster the political will required to design and implement the rules required to keep it working that way.  It is too large, too diverse, too lost.

But we do not have to accept as inevitable a recurring cycle of booms that always go bust.  We can build a new prosperity of sustainability. We just can't do that with the banking system.  The banking system is not built for sustainability.  It is built for liquidity.  Liquidity is like government; we need to have enough, but not too much.  Right now, we have too much.  That is giving us booms that more and more frequently -- and more dramatically -- go bust.

Unfortunately, very little serious effort is being made to move us boldly into the future by inventing new solutions for sustainably financing the business of sustainability. Out on the frontier, we find people who say the solution is to abandon money, but that really does not help.  Money is the energy that powers the activities of specialization and exchange that is our economy.  Without money, there is less "economic energy", and with less energy, we have a smaller system that offers fewer choices. That is not innovation.  That is reversion.  All the talk about abandoning money gives the whole idea of innovation as a path to sustainability a bad rap.  Money is not the problem.  How that money gets managed is.

We do not need a way to manage without money.  That will not help.  Neither do we need a better way to manage money the same old way.  That is not enough.  What we need is a new choice to manage money in a new and different way, a way that is purpose-built to monetize sustainability.

This choice, it should be noted, will not replace the banking system.  It will not eliminate the need for liquidity, or even compete with the banks in trying to meet that need.  It will, however, compete with the banks for the right to manage our money, offering sustainability, as an alternative to the liquidity provided by the banks.  Both Enterprise and Investment will choose between the two.  Sometimes, they will need liquidity, and banks will continue to be the right choice.  Other times, they will want sustainability, and another choice will be right.

Such competition based on choice will be better than regulation in curbing the excesses of the banking system, and moving us beyond the recurring cycle of boom-and-bust.

This is the innovation we need; innovation that is forward looking and additive, not backward-looking and subtractive.  We need innovation that looks at the technologies we have today in the context of the challenges we face today, and finds a new and different way to apply what we have to meet the challenges we face.  We need innovation that gives us more, not less; new, not old.  We need new ways to do things today that we just could not do, and maybe did not really need to do, yesterday.

Such innovation is not easy.  It requires letting go of the past in order to move boldly into the future.  Not everyone can do that.  Not very easily, or very well.

All innovation originates with personal frustration.  Our expectations for what we think we should experience are disappointed by the experiences we actually have.  When that happens, most of us, most of the time, just shrug our shoulders, and say, "oh, well".  But some say "no".  This is not right.  There has to be a better way.

Once the search is on, finding a solution is only a matter of time.

When it comes to our prosperity, to the creation and direction of the "energy" that drives our economy, we have this choice.  We can just say OK, and continue to ride the recurring cycle of booms that always, eventually, go bust.  Or, we can say No.  There has to be a better way.

I say, "no".  We have the technology.  Let's build a better way!