Central bankers, CEOs and politicians often have economic incentives to take greater risk

Theoretically, the job of central bankers, CEOs and politicians is to protect us from risks that could lead to disaster. As the world’s market feast on easy money and massive debt, one might consider who got us here and that when (not if) the event occurs, they won’t be the ones to suffer

Bureaucrats, politicians, business leaders and others are different from you and me. They don’t care. They don’t have to. If we as investors take risks and they turn out badly, we will suffer. So we try to limit the level of risk. This is not an issue with the ruling class. The results of their decisions may have a large impact on us, but not for them.


Alan Greenspan, the former governor of the US Federal Reserve (Fed), has gone through quite a change in fortunes. Once hailed as the architect of steady growth and low inflation, known as the Great Moderation. He is now credited with being one of the causes of the Great Recession. The reason is that as chairman of the Fed took too many risks. Those risks caused a collapse that has blighted billions of people. Why? He could. For him, they were not risks at all. There was no danger. He had no reason to fear the consequences, if things went horribly wrong.


Basically Greenspan made two mistakes. First, he allowed interest rates to remain too low between 2003 and 2005 which resulted in a US real estate bubble. Second, he failed to use his regulatory authority to crack down on the most dangerous part of the real estate market the subprime sector. In his review of Greenspan’s recent book, the Nobel Laureate economist, Paul Krugman, called Greenspan “the worst ex-central banker in the world”. He also pointed out that Greenspan was also a lousy economist since his predictions since the crises have been wrong.


One would think that there might be a consequence for Greenspan’s colossal failure. Not at all. Since he stepped down he has lucrative consulting contracts with the world’s largest bond fund, PIMCO, a major international bank, Deutsche Bank, and a large hedge fund, Paulson & Co. He is a respected and sought after speaker.


Ben Bernanke, Greenspan’s successor, is in the same situation. He attributed the financial collapse to a failure of regulation rather than low interest rates, which he supported at the time. His policies to stimulate the economy have not really been all that effective and may be very destructive. But he is retiring probably to lucrative consulting positions. So if his three trillion dollar monetary experiment known as Quantitative Easing fails, it is really of no concern to him.


One might ask the same questions about American politicians specifically the Republican members of Congress. This month they shut down the government for two weeks and almost caused a calamitous default on the US’s debt obligations. According to polls taken after the event, 70% of the voters blame the Republicans. So, all the Republican members of Congress should be humbled. They should be worried about the consequences of their political theatre and being thrown out of office. No doubt when these same issues come up next January and February they will be more cautious.


Wrong! Voters have terribly short memories. The last time the Republicans shut the government down, the Republicans only lost 3 seats in the House and gained two seats in the Senate. State legislatures have almost exclusive right to draw the boundaries of voting districts and Republicans control most of them. The result is that the voting districts are drawn in such a way to guarantee that the Republican wins. Almost a majority of the House seats (202) and 88% of the Republican seats in the House were won with margins of over 10%, easily within the definition of a landslide. With such secure districts in the last election the Republicans only lost eight seats despite the fact that the Democrats had 1.7 million more votes in congressional races nationwide.


So do not assume that the Republicans have learned their lesson and won’t shut the government down again in January. The markets didn’t help. When threatened with the possibility of a major financial meltdown stemming from a default, they went up! Republicans have neither fear of losing elections or harming markets. Without consequences they can justify any risk.


Recently CEOs in the US have gone on a share buy-back binge. American companies spent about $450 billion in 2012 buying back their own shares. This figure is likely to be surpassed this year. By March, corporate share buyback authorizations for the year through March totalled $208 billon, the highest on record. Often these buybacks have been achieved with free money provided by the US central bank.


Why has management been happy to leverage up the firm to buy-back its own stock rather than invest the money in corporate growth? Easy, a firm’s management in the US is often given a bonus if the stock rises. The fewer the shares outstanding higher probability is that the price will rise, especially is a free money fuelled market.


With markets at record highs the probability that the company will buy its stock at peak prices is almost guaranteed. This happened before. In 2007, many companies were happily buying back shares at what proved to be peak prices. There is also a conflict of interest. Insiders (i.e. management) have a strong incentive to sell shares received in as compensation when the stock is high. So in effect management is selling to their own corporation. Can you guess which party to this transaction is the greater fool?


Are share buy-backs good for the company? Probably not. Buying back shares sends a signal that management does not feel that investment in the company’s core business would be more profitable than buying-back shares. In a greater sense, it does not bode well as an indication of corporate America’s view of future growth prospects. 


Why does it continue? Easy, no downside. The buy-backs when they are announced are very popular with investors, at least until the stock goes down below the buy-back price. CEOs are well compensated. If the price of the stock goes south and they are terminated, there are usually generous severance packages. Besides with free money, there are fewer interest rate risks.


Nassem Taleb, the author of the Black Swan put this problem more succinctly in his recent paper, Skin in the Game Heuristic for Protection Against Tail Events. “Standard economic theory makes an allowance for the agency problem, but not the compounding of moral hazard in the presence of informational opacity, particularly in what concerns high-impact events in fat tailed domains.”  In essence central bankers, CEOs and politicians are our agents. Theoretically their job is to protect us from risks that could lead to disaster. Neither group is subject to economic or moral limits. Quite the reverse. They often have economic incentives to take greater risks. The result is that it increases the probability of another high impact tail risk or as Taleb would have it a black swan.


So as the world’s market feast of easy money and massive debt, one might consider who got us here and that when (not if) the event occurs, they won’t be the ones to suffer.


(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)

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