John Kay has been in Australia for the last few days, promoting his new book, Other People’s Money – Masters of the Universe or Servants of the People? Thanks to the Grattan Institute, he and I were interviewed in front of a couple of hundred people on Monday and had dinner afterwards.
John is an academic, a Financial Times columnist and a Scot – a combination that has made him an intellectual provocateur. He knows the asset management business well and chaired the U.K. government review of the equity markets, which reported in 2012. He served as a director of the Halifax Building Society before it was demutualized. I don’t always agree with him, but he is always worth reading.
The starting point of Other People’s Money is Kay’s assertion that the world’s financial sector is too big relative to the non-financial sector, that it has too much political influence, attracts too many of the brightest university graduates, primarily trades with itself and creates too little value for the rest of us. He calls this process “financialization.” It’s been going on for more than forty years.
Kay did not discover financialization, though Other People’s Money may popularize the concept. I’m told that sociologists have been particularly fascinated by the phenomenon. Greta Krippner, who professes that discipline at the University of Michigan, published Capitalizing on Crisis: The Political Origins of the Rise of Finance in 2011, in which she points out that while prior to 1970, the portfolio profits of non-financial corporations in the United States never exceeded 10% of cash flow, by 2000, the ratio was 40%.
Kay does not answer the question of what defines the boundary between “enough” and “too much” finance, and my academic friends tell me there is no consensus on the matter. I doubt Kay thinks that’s important. He sees the volume of trading relative to the real assets represented as self-evidently “absurd.” What interests him is how we got so far over the line, and what to do about the resulting distortions.
The book is less a history than a series of connected essays and anecdotes. It is enormously readable. I particularly liked learning about the divergent origins of insurance. English gentlemen sitting at Lloyd’s coffee shop amused themselves by betting on whether particular ships would make it back to London. Meanwhile Swiss villagers mutualized risk by agreeing that if anyone’s cow died, they would all chip in the buy a replacement. Those two strands are still present in the schizophrenic culture of the insurance industry.
In Kay’s view, finance has four legitimate functions:
- Providing a payments service;
- Connecting savers and investors;
- Helping individuals manage the long process of accumulating savings while working, living on the savings when retired and passing wealth to the next generation; and
- Managing the day-to-day risks of fire, theft and accident.
These services should be provided in as straight-forward a way as possible. We should “eschew unnecessary complexity” and “pay close attention to the management of unavoidable complexity.” Kay gives two reasons for this: complexity increases risk and complexity hides conflicts of interest.
Toward the end of the book, Kay turns to the question of reform. He sees structural change as far more effective that new regulations. I counted sixteen suggestions. Or perhaps they are better described as aspirations. “Anyone who handles other people’s money or who advises them… should demonstrate behavior that meets standards of loyalty and prudence….”
Some of his proposals leave a lot of details to be worked out. For example, he would ring-fence deposits and only invest them in residential mortgage loans and government securities. Other forms of consumer credit, business loans and property financing would be the responsibility of specialist asset managers. I guess what that means is that these assets would be originated and held by mutual funds. Liquidity management would be a challenge.
As I worked my way through Other People’s Money I came to see it less as a policy document than as an exercise in nostalgia. John clearly misses the City of London prior to “Big Bang,” when financial services were provided by thinly capitalized, conflict-free, single-capacity private firms – partnerships in spirit if not at law, with no share price to be spooked by, managed by men from similar backgrounds, who knew and obeyed the rules even when the rules weren’t written down. As the book’s title suggests, he puts great emphasis on personal responsibility. He’d like to see standards of fiduciary conduct “enforced by criminal and civil penalties, directed primarily to individuals rather than organizations.”
One thread that runs through Kay’s polemic is the role of modern financial theory in depersonalizing finance and defining the way people view markets. Transactions have replaced relationships. Clients have become “eligible counterparties.” Another of the historical details that make Other People’s Money so enjoyable concerns William Sharpe, who ultimately won the Nobel Prize for inventing the capital asset pricing model. Kay tells us that Sharpe’s first article on the topic was initially rejected on the grounds that its assumptions were unduly fanciful. Yet within a short time the “CAPM” was treated as a description of real markets.
My historian friends tell me scholars have realized that the most successful models are those that cause markets to resemble them. There’s an invented name for this: “performativity.” Another sociologist, Donald MacKenzie at the University of Edinburgh, describes in An Engine Not a Camera: How Financial Models Shape Markets the process by which the Black-Scholes option pricing model effectively created the market in equity options.
In the words of Oscar Wilde, life imitates art. John’s book is a model, even if there aren’t any Greek letters. He’s painted a picture of the world he would like to inhabit. One can only hope performativity will move the world in his direction.