The subject of values is one that rarely gets mentioned in the context of markets and economics and largely for good reason. In normal times, when people take on too much risk, over-promise and under-deliver, or act in unethical or illegal ways, they usually end up paying a price. While there will always be bad actors they usually only create idiosyncratic risks in the market.
Usually, but not always. When there is either no price, or only an inconsequential price, to be paid for bad behavior, incentives to refrain from such activities vanish and the behavior spreads. Evidence increasingly suggests this is happening now. Importantly, it creates a much bigger problem for investors; it creates a systemic problem that affects the entire market.
Back in 2009, in the immediate aftermath of the financial crisis, people were stunned by the fragility of the financial system, shocked at the magnitude of losses in stocks and real estate, and ticked off at Wall Street’s role in the affair. Largely in response to the crisis, the Occupy Wall Street movement emerged to protest (among other things) the lack of accountability on Wall Street.
While that movement petered out over time, the issue of accountability resonated with people and the concept of moral hazard graduated from abstract academic topic to topical practical concern. Defined as “lack of incentive to guard against risk where one is protected from its consequences”, it is easy to see why moral hazard became a hot topic after the financial crisis: Virtually none of the leaders of banks or financial institutions suffered the consequences of their risk taking.
Today, moral hazard is still an issue because its insidious nature is to spread — through business, society, and public policy making. For one, it is self-fulfilling. Because leaders of all types have been protected from the consequences of risky behavior, they have had an incremental incentive to engage in it even more. In addition, people are naturally inclined to emulate the "success" of their leaders and they do so by copying what they do. Finally, competition ups the ante: If your competitors are testing (or breaching) the limits of propriety and getting by with it, it is hard not to respond in kind.
If there is any doubt that the problem of moral hazard is still alive and well, a brief perusal of the May 2, 2018 edition of the Financial Times dispels that notion. The “Companies & Markets” section of that edition revealed four separate instances of egregiously bad behavior associated with a lack of consequences, three of them in finance.
The FT revealed [here] for example, that the systematic exploitation of clients is still alive and well on Wall Street: “Goldman [Sachs] forex traders routinely shared information about client orders on electronic chat rooms so they could boost profits.”
The fact that “Goldman Sachs has been ordered by two US regulators to pay $110m for ‘unsafe and unsound’ practices in its foreign-exchange trading business” reveals that the penalty is nothing more than an acceptable cost of doing business.
In other news [here], the Australian financial services firm, AMP, was found to have “ripped off customers and lied to regulators.” Although such revelations are now clearly having an impact on the company, it is happening only after evidence was found that “AMP misled regulators on at least 20 occasions and systematically charged customers fees for no service.”
Not to be outdone by banks, MetLife also made headlines [here]. It turns out the insurer acknowledged that “over a period of about 25 years, it failed to make hundreds of millions of dollars of pension payments to about 13,500 people.” As a result, “the practice allowed executives to boost profits because the insurer released funds from financial reserves that were supposed to support the pension payouts.”
Perhaps the most notable aspect of these cases is how unexceptional they are. None of the stories made the front page and none of the headlines were sensationalist. In fact, each of the items had the same kind of regular, mundane tone as a weather forecast or a traffic report.
There is some subtle, but important information content here. The fact that such egregious misconduct barely stands out any more reveals how widespread it is and how trivial the consequences are. Why are we still seeing such a steady flow of bad behavior almost ten years after the financial crisis? Why has so little been done to curb it? Why does its persistence get so little attention?
One possible answer is fatalism. As noted [here], public attitudes can have a strong impact on whether group behavior tilts toward fatalism or "resistance and activism". As reported, "People fear isolation and tend to express their views only if they conform with the prevailing climate of opinion, at least within a particular group." As a result, it is not unusual for people to fall into a "spiral of silence" by which "the majority believes itself to be in the minority".
In other words, it may well be that people care a great deal about the scale and breadth of misconduct at the highest levels of business and finance but find it hard to overcome inertia to do anything about it. The combination of being too busy, believing that most other people don't care very much, and being resigned to the fact that nothing will happen anyway has effectively institutionalized the practice of looking the other way. People care but consider themselves powerless to change things.
Another possible answer is that the system is broken. For an increasing number of people, it is becoming nearly impossible to work hard, do the right thing and still get ahead. For their efforts, they get rewarded with stagnating wages and vanishing pensions. On the other side of the equation, they get hit with rising gas and food prices and rapidly rising health care and education costs. The only way for many to bridge the gap has been to take out more debt. Credit card debt, student loans and auto loans are all at record highs.
The challenge of just making ends meet is perhaps best summarized by low fertility rates. As the FT reports [here], "The US birth rate declined to a 30-year low in 2017". This was a 2% decline from 2016. That record low was not a function of family planning either. As the New York Times highlighted [here], "American women are having fewer children than they’d like". This appears to be at least partly, if not significantly, a function of difficult economic times.
From the perspective of people who are getting "squeezed" between increasing costs and stagnant income, the epidemic of bad behavior amongst business leaders is just one more indication of a fundamentally broken and unfair system. As John Authers reports in the FT [here]: Not only do "sluggish wages do little to boost consumption", but they also "contribute to a toxic national mood of disaffection." As such, the lack of pushback against bad behavior represents not so much a lack of inertia as a lack of trust that existing institutions can solve anything.
Such disaffection manifests itself in many ways that can fall short of protests, but that can also reveal important changes. For instance, "One set of initials that everybody dislikes is CEO." As Authers explains, "People in America ... are fed up with CEOs chasing the bottom line." To many people, high profits are merely an indication that "companies are ripping them off." CEOs are no longer seen as icons of achievement but rather as paradigms of moral deprivation. Leaders don’t seem that special at all; they are just greedier, get by with more stuff, and get paid better. Indeed, "Americans no longer seem to like capitalism and the behaviour it entails."
“Capitalist behavior” is well represented by the three instances of wrongdoing reported in the FT. Whether it is improperly sharing information about client trades, charging customers for services they didn't order, or making aggressive assumptions in order to boost earnings, each case represents an effort to break rules in exchange for personal benefit. In essence, it is cheating. Such acts, when repeatedly exempted from meaningful punishment, gradually undermine institutions that require trust and in doing so, gradually undermine public goods such as markets and the rule of law.
Another instance of "capitalist behavior" is the practice of asking for forgiveness rather than permission. The rationale is that in the fast-paced world of technology, there is no time to waste on niceties like asking permission for certain things. It is best to seize the moment and if necessary, apologize later. This is exactly what happened with Facebook. Cambridge Analytica recognized the potential power of Facebook data, extracted it through a Facebook app, and then leveraged it by tapping into contacts of contacts. Although the breach of privacy was clearly foreseeable, Facebook responded only by apologizing begrudgingly, incompletely, and after the fact.
In addition, big tech companies have been making life increasingly difficult for startups as the Economist reported [here]. Increasingly the annual conferences of the big tech companies, which are held to "announce new tools, features, and acquisitions”, are being attended by venture capitalists who want to know "which of their companies are going to get killed next." The protective behavior of such companies has become so transparent as to be labeled the "kill zone": "Tech giants try to squash startups by copying them, or they pay to scoop them up early to eliminate a threat." As one venture capitalist reports, today's tech giants are "much more ruthless and introspective. They will eat their own children to live another day."
It doesn't take deep economic analysis to view these examples as undesirable. Indeed the swelling wave of such transgressions has taken its toll on people to the point where "capitalism is no longer very popular." Increasingly, capitalism is viewed as a system fraught with unethical and unsustainable behaviors. It is viewed by many not as an effort to solve problems for consumers in an economically viable way but rather as sanctioned cheating. As a result, "Young adult Americans now tell pollsters that they actively prefer socialism."
All of this provides some important implications for investors. One is that the failure to reign in bad behavior in the business world has done far more harm than can be easily observed: It has undermined trust in institutions and systems. This is reflected in increasingly divergent political beliefs and explains much of the acrimony in today's public debates. For many people the answer lies not in "solving problems" but in changing a broken system.
As such, the important changes to watch for are not small incremental ones that might tweak growth a little bit higher or lower, but rather indications of when tensions will snap and there will be a massive regime change. These are exactly the type of events that have low probabilities over the course of history, but significantly affect outcomes when they do occur. They are also the types of events that are easy for investors to underestimate.
One of the reasons for this is financial. The nature of business cycles is such margins and revenues tend to get hit at the same time — which exacerbates the financial impact of slowdowns. In short, "It is when times grow harder than companies try to bolster sales at the cost of lower margins." The combination of slower sales growth and lower margins often creates a "double whammy" for earnings. Such challenges can be further exacerbated by lower absorption of fixed costs and by the revelation of aggressive assumptions. It's not so much that bad things happen all at once, but they often get realized all at once.
Another reason, though, is political. As Authers suggested, "If 'capitalism' is really a dirty word then there is a chance that direct political action could peg back corporate profits." Of course there are numerous examples of such actions through history ranging from higher penalties to price controls to regulated profits to outright confiscation. Regardless of particular form, political interference creates friction in doing business and its often capricious nature creates uncertainty. At the end of the day, it is safe to assume, "bumper profits are not sustainable. “
One of the great tragedies of such divisive political conditions is that they significantly undermine the potential to diagnose and solve the underlying problems. After all, bad behavior is not endemic to capitalism (which can work quite well) or to CEOs (many of whom act honorably). However, when trust in the system evaporates, so too does the possibility of collaborative problem solving. What is left is a messy and clumsy transition to a different, but not necessarily better system. People don't care about the details right now; they just know that things are not working for them.
The single biggest takeaway from this discussion is that when people lose trust in the values of an economic and social system, it becomes a big risk to the value of that system for investors. This is also an especially difficult challenge for most investment analysts who are primarily trained in finance and economics. The problem is that when politics, society, and economics collide, one must understand all of them in order to understand any of them. Regardless, changes in the prevalence of moral hazard will serve as a good gauge to the timing and extent of a return to both values and value.