Tendencies toward a Dwindling Stock of Capital
In his fantastic essay The Political Economy of Moral Hazard, Jörg Guido Hülsmann defines the term ‘Moral Hazard’ as;
… the incentive of a person A to use more resources than he otherwise would have used, because he knows, or believes to know, that someone else B will provide some or all of these resources. The important point is that this occurs against B’s will and that B is unable to sanction this expropriation immediately.
Many financial commentators have written about this perennial problem over the past few years, however they have done so with limited vigor (by my perception at least). Here, I get to grips with the problem of Moral Hazard, and discuss why the profit-motive has been perverted. Finally, I highlight the investment implications of this sociopolitical structure and consider the inevitable consequence: a dwindling stock of capital.
The Unhampered Profit-Motive Vs The Hampered Profit-Motive:
In a society where private property rights are respected, the profit-motive is cleanly identifiable as a universally beneficial mechanism. In a very simple sense, the entrepreneur aims to achieve higher selling proceeds than cost receipts. If he manages to achieve this, then he has clearly done a good thing. If he manages to achieve a profit, then the market has ‘voted’ the end result of his work to be ‘better‘ than what it took to get to that end result. In this way, profit-seekers are naturally guided to do good, and to increase the wealth of society at large.
In contrast, things get somewhat more complicated in the current system. As Hülsmann writes, the presence of moral hazard pushes individuals to act in a different way than they otherwise might have acted:
Thus the essential feature of moral hazard is that it incites some people A to expropriate other people B. The B-people in turn, if they realize the presence of such a moral hazard, have an incentive to react against this possible expropriation. They make other choices than those that they would consider to be best if there were no moral hazard.
So, as investors, it is important to understand how this can affect our personal execution decisions and how that might – in turn – affect the decisions of others. The most glaring example of problematic moral hazard lies in the sphere of governments, as the separation of ownership of assets and control of assets is coercively forced upon citizens in an economy. Hülsmann emphasizes that this kind of moral hazard can be anticipated:
By a “forced” separation of ownership and control we mean a separation brought about against the will of its owner. Although owners might be forced both by governments and by private parties, government interventionism is far more important in practice. This is so not only because of the greater quantitative impact, but also because, in our western societies at least, interventionism is usually enshrined in the law and thus can be anticipated.
So, eventually at least, those who pursue profits end up pursuing something quite apart from normal ‘goods’.
The Lehman Adventure:
With the above in mind, the government’s actions during the Lehman crisis seem rather bizarre. As David Einhorn says in the following video, the Government had the opportunity to purge the system of the long-standing moral hazard that had accumulated until 2008. Indeed, the refusal to save Lehman Brothers was a good step in that direction. However, when they did a 180 on the markets after that, they ruined the good that was supposed to come out of not bailing out Lehman Brothers. So, in refusing to bail out Lehman Brothers (and bailing out others afterwards) they essentially maximized the pain and minimized the ‘gain’. If anything reveals the degree to which US bureaucrats are groping in the dark, it is certainly this:
Tendencies Toward A Denial of Reality:
The Lehman adventure reveals the lack of tolerance for pain that will probably dominate governmental policies over the coming months and years. That is, with the declining tendencies in social mood, the government will be called in to ‘undo’ any mistakes that the private-sector will make. As emphasized above, this tendency is wholly anticipatable by the private-sector, and so allows them to behave more recklessly than they otherwise might have.
So, as we approach this environment, it should become clear that the tendencies in place are toward progressively greater misallocations of capital (for who cares if you’ll get a bail out, right?), and for ever greater denials of those misallocations once they are revealed. So, as a private investor, it may be prudent to hold concrete forms of capital for relatively brief periods of time, and – after this – to embrace the misallocation. For whenever it comes to be known that the dwindling stock of capital had been papered over in the past, the authorities will most likely change the rules to cover-up those mistakes.
The investment horizon is a peculiar one. Certainly, one must prepare for bouts of financial distress (when it comes to be realized that the stock of capital in the economy has been horrifically misallocated). However, at the same time, one should keep in mind that such revelations are unpalatable to the average person (and by extension to the average bureaucrat). Ironically, during these brief periods of financial distress, one should seek to position oneself in line with perceived notions of ‘fairness’. Put simply, when coercive authorities ‘move the goal posts’, one should move one’s aim away from the original location of the goal:
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012