First, let's review the patten. Initially, the first suggestions of weakness are met with derision and dismissed. Yet over time the reality becomes common knowledge as more people realize an imbalance is building that has not yet registered in the marketplace. Shortly thereafter, pundits arrive proclaiming that the latency, inertia, and distortions from regulations and other constraints that have kept the marketplace together is actually evidence that old rules no longer apply and prospective investors would be foolish to miss out on the gains that early speculators have amassed. A form of mass delusion ensues until the resulting bubble collides with reality when a critical mass of over-leveraged speculators is forced into a liquidity trap by an unforeseen event that even a few years prior could not have precipitated the crisis on its own. The near-instantaneous need for liquidity sends assets so quickly into the marketplace that it drives all asset values downward, forcing additional liquidation in a self-perpetuating cycle that if left unchecked can wreak enormous collateral damage in the process.
In the aftermath it is discovered that regulatory process in place from the last bubble not only failed to prevent this one, but in some cases was employed to legitimize those speculative excesses. Subsequent attempts to correct the effects of the burst bubble and protect against future excess have the perverse effect of chasing out the well-captialized risk-takers who could most quickly re-establish a growing economy, leaving the heavy lifting to undercapitalized visionaries who will come to dominate the next economy once the overall appetite for risk returns. In the mean time, the insatiable desire for risk reduction will drive social and economic policies that manage to preserve a few jobs in failing industries that quickly find themselves trapped by the very safety net meant for their rescue, unable to attract the talent an capital needed for the dramatic transformation they ultimately require.
It is tempting to suggest that regulation (or the lack thereof) is the root of the problem, I think both sides of that argument are missing the point. Even in a deeply regulated environment, an expanding appetite for risk-taking coupled with a reduced premium for risk taking will drive more and more capital toward higher-risk growth opportunities until unexpected systematic failures re-establish a meaningful risk premium by chasing out all but the most determined speculators. Regulation can be effective when it enables transparency for legitimate marketplace participants, but in practice that transparency proves elusive and is virtually impossible to maintain as the number of market participants mushrooms. The most effective government interventions are those that re-establish transparency as new bubbles form (an almost impossible task given the fact that (1) such moves will be unpopular with those who initially benefit from the opacity, which may include large segments of the public at large and (2) the government will be blamed for the market correction that follows, however mild it might be in comparison to a full-blown crash), and those that re-stimulate the public's appetite for risk following a crash (unfortunately history's best examples are either full-blown war such as WWII following the Great Depression or Reagan's dramatic military buildup and diplomatic confrontation that ended the Cold War, coupled with tax cuts that eventually resulted in the budget surpluses enjoyed during the Clinton era as America finally moved past the effects of all those failed 70s-era interventions).
Over the last 20 years, it's been widely accepted that actions of the Federal Reserve Bank system are most essential to the preservation of a sustainable American economy and I would be the first to agree that Alan Greenspan's actions following the tech bust helped maintain a healthy appetite for risk taking in the subsequent years. But apart from making the occasional speech regarding "irrational exuberance" on the part of investors, there is very little the Fed can do to when market imbalances will respond more effectively to transparency improvements than the blunt instrument of rate changes themselves. And constrained by the myriad charters of regulators with more direct responsibility for preservation of that transparency, any effort to drive fundamental market changes from the Fed would have been met with unbelievable opposition from all quarters.
Yet I believe strongly that sustainable approaches are possible going forward if we can get back to basics in a few areas where we've discovered systematic problems during 2008. Here's the model I have in mind:
- While direct representation of the interests of stakeholders like shareholders and bondholders are not be practical for all business decisions in publicly-held companies, we need to see more legitimate methods for representing their interests. The process that selects directors and drives board-level strategy is often so hostile to individual investors to such a degree that most shareholders make no attempt to participate and board members and senior officers do nothing to include them except when their approval is required. This not only wastes valuable input from shareholders as a group, but perpetuates the notion that shareholders have no real say on how a company is run apart from their veto power. There's an opportunity here for reform, but in many cases government regulations themselves are preventing meaningful innovation here by locking corporate governance structures into models that are a century old (or more) and require a bit of healthy adaptation to remain relevant. It will probably take a bit of experimentation to get this right, so it's more important initially to allow for legitimate innovation first than prescribe a single solution all at once.
- Quarterly financial reporting to shareholders in an era when management often has equivalent reporting tools that drill down to critical financial stats on a daily or hourly basis is an open invitation to creative financial engineering. In today's world, last quarters results typically arrive a month too late when the instantaneous flow of information from other sources has already driven a stock lower or higher. What's needed is a radical change to reporting frequency that applies to all publicly held companies equally and serves to discourage both speculation and insider trading by moving to much shorter reporting periods (perhaps as often as weekly or even daily) that immediately reward good sales and investment decisions while removing the incentives to game the system thru smoothing techniques that ultimately provide no lasting economic value. There will be legitimate smoothing techniques to employ, but the shorter reporting period will force these to be used only when they can be cost-justified over both short- and long-term views.
- Compensation alignment for both ordinary employees and senior executives to changes shareholder value over time is essential. Every attempt at government intervention to date has created further distortions that take us further from this goal, from limits on executive compensation to the process for calculation of stock options. Here's one suggestion on how to move in that direction: Rather than focusing on changes to corporate income tax laws and capital gains taxes, the government could encourage investment and improve productivity by providing tax-free employee compensation for convertible options or restricted shares that (a) must be granted to all employees (with reasonable ratio limits that ensure equitable distributions), and (b) require a holding period of at least 2 years from exercise (in place of a clawback provision which might discourage appropriate risk taking) to discourage management from undertaking short-term manipulations that undermine the long-term value of a stock. This has the additional benefit of increasing our savings rate at a time when an increase is sorely needed in a way that is neutral to existing compensation structures.